A Discussion of Modern Inflation Causes

[Winstonm]

Montarists believe that inflation is caused by changes in money supply, but even they don't define it as such...

 

This is somewhat at the root of my conundrum - I have seen this claim, as well, but it is in reference to expanding money supply greater that what?

 

If money supply and demand for money are in balance there should be no inflation it would seem.

 

Then I read the concept of debasement of money - a la the King calling in all the gold and re-issuing 1/2 gold coins.

 

It made me wonder if there were a mechanism that could accomplish this debasement of a debt-backed currency.

 

And now here we are - and I'm still confused. :P

[hrothgar]

Actually, inflation is defined as a change in prices...

 

I believe the cause of the disagreement in terms is probably based on Miltion Friedman's observation that "inflation is always a monetary event."

 

To try to unsettle the matter is to find a universal definition - but it should seem to me that the definition in some way should reflect the cause.

 

For example, simple supply/demand imbalance due to lowered output can cause prices to rise but is that inflation?

 

In other words, perhaps a best (though not textbook) definition might be "a general rise in prices caused by ____.

Winston:

 

Listen to me: There is NO controversy

 

Inflation is a well defined term, like "Red" or "Carbon". When you say the word inflation economists know what you mean and they sure as hell DON'T mean a change in the money supply.

 

There are different measures of inflation: People will often use different market baskets measures the price index. However, there is widespread agreement about the basic definition.

 

Its all fine and dandy to argue about different causes of inflation - folks have suggested all sorts of different causes - but I don't see the point in trying to change basic definitions.

[Winstonm]

Hold everything else the same, increase money supply 2x and you'll get 2x price increases.

 

This is similar to Mike (Mish) Shedlock's definition of inflation: an expansion of currency and debt.

 

The hold everything else the same is the hard part to determine - currency and debt will naturally expand in an expanding economy with an expanding population to accomodate that expansion - how do you determine excessive currency and debt, which appears to be the real drivers of inflation?

[Winstonm]

I'm thinking part of the problem is at the beginning:

 

"My supposition is based on Mr. Eccles statement that the U.S. system is one of debt-money, i.e., all money must be borrowed into existence."

 

 

Actually, this was a the heart of my conundrum - as the problem assumed the statement as true, then....as so on.

[Winstonm]

I'd like to thank everyone for contributing to my understanding on this issue.

 

Edit: I changed my mind - I think Richard makes a worthy proposal to discuss the causes of inflation but let's leave the inflation definition intact.

 

I can start this off with a current hypothesis I have toyed with in that an artificial manipulation of the interest rates that are then held too low for too long (I'm thinking housing, here) has the real effect of compression of economic time.

 

It gives the illusion of growth but in reality it is simply growth borrowed from the future. If future economic actors are lured to make time preference change due to low interest rates, and they do so, then when this inititial "surge" of buyers has been expended, the only way to fill the future void of buying is with marginal buyers - those lower on the credit totempole.

 

Regardless, this time-compression phenomenon would create an artificially-driven demand/supply imbalance - driving prices higher.

[barmar]

I'm also not well schooled in economics (I took one econ class in college).

 

I wonder about your simplifying step of ignoring interest. If you want to consider money in terms of debt, can you really afford to ignore interest? If there were no interest, there wouldn't be any debt, except on a very small scale by altruists (e.g. families and neighbors).

 

Another question I have is about creation of wealth. When a manufacturer takes a bunch of raw materials, puts them together into a product, and it's worth more than the sum of its parts (including the labor), wealth has been created. In the information era, this happens on a grand scale: software, web sites, etc. have very inexpensive raw materials (because labor and "bits" can be amortized over so many units). But if someone is going to become an Internet millionaire, the money they're earning has to come from somewhere, doesn't it? Doesn't this fuel inflation, too?

[Winstonm]

I wonder about your simplifying step of ignoring interest. If you want to consider money in terms of debt, can you really afford to ignore interest? If there were no interest, there wouldn't be any debt, except on a very small scale by altruists (e.g. families and neighbors).

 

Interest only facilitates exchange - the incentive to lend. Of course, due to interest there is not a pure 1:1 ratio of money (liability) to debt (asset). But to understand the underlying priciple, it is easier to eliminate the interest component.

When a commercial bank has $100 dollars in deposits, it can lend $900 according to our fractional reserve banking system. The $900 is created money - out of thin air. The transaction is shown as a loan (asset) to the bank, and a debt (liability) to the borrower. This is the 1:1 relationship I mention.

 

This is the concept behind money being "borrowed into existence." Without the new debt, there is no new money created.

 

At the Federal Reserve level, the same thing occurs when the Treasury Department needs cash. The Treasury issues a bond, which the Federal Reserve monetizes by creating money. (Not a complete example as these bonds can be sold to outsiders, but it is the core idea we are addressing.) In this case the government debt creates the new money, a 1:1 relationship.

 

Another question I have is about creation of wealth. When a manufacturer takes a bunch of raw materials, puts them together into a product, and it's worth more than the sum of its parts (including the labor), wealth has been created. In the information era, this happens on a grand scale: software, web sites, etc. have very inexpensive raw materials (because labor and "bits" can be amortized over so many units). But if someone is going to become an Internet millionaire, the money they're earning has to come from somewhere, doesn't it? Doesn't this fuel inflation, too?

 

This is describing normal economic activity - If you buy a lemon for $1 and some sugar for another $1 and produce 10 glasses of lemonade that you sell for $0.50 each, have you created new wealth? Not really, customers simply decided to buy your lemonade instead of a candy bar. Intellectual labor is the same - if you invent the round wheel and it becomes popular, the square wheel will see a drop off in sales.

 

An example is Google - while their advertising revenue has soared, newspaper advertising has fallen - it is simply a preference where the money is spent.

 

The classic definition of the cause of inflation is "too many dollars chasing too few goods."

 

(I took one econ class in college).

 

That puts you one econ class ahead of me, then. B)

[mike777]

Lets back up

Lets assume inflation is good......in some reasonable definition.....very good.

 

1) Lets assume a little inflation is good very good

2) lets assume zero inflation is bad..very bad....including neg infl

3) lets assume alot of inflation is bad..very bad....

 

If we make these big assumptions B)

 

 

Then we all want inflation in some reasonable, agreed defintion.

We need ....really really need debt assumption.....in some reasonable form.....

[kenberg]

Benjamin Franklin once railed about mathematicians as tiresome people who are always asking for precise definitions. Probably so, but like the elephant's trunk we can be useful.

 

"We need debt assumption"

 

This means?

 

This means that someone should pick up someone else's debt? Is this right? And who is to pick up whose?

 

Winston was willing to shut down this thread but it appears to have a life of its own. Actually, as a broader discussion of economic issues, it seems very timely. My broad view is that as individuals and as a country we have been doing a truly impressive job of spending money we don't have. Chickens do come home to roost, sooner or later.

[mike777]

"This means that someone should pick up someone else's debt? Is this right? And who is to pick up whose?"

 

Inflation does..as others have said in this thread.

 

The trick is to not debase the currency too much in order to pay off the debt as Germany did in 1920's paying off its WW1 penalty debt.

 

Perhaps we are going through a current time where we are debasing it a bit too much now but .....the usa is a big country with lots of land, raw materials and most importantly smart, hard working, creative people and new immigrants....assets that are much bigger than any trade or budget deficit.....

 

In any event I still have blind faith in innovation and that our children will have better lives than we have. :)

[DrTodd13]

I've heard that M3 has increased 40% in the last 2 (or was it 4?) years. Does that sound like a "reasonable" level of inflation?

[mike777]

I've heard that M3 has increased 40% in the last 2 (or was it 4?) years.  Does that sound like a "reasonable" level of inflation?

Heck I've been in Health Care and commodities ever since they flooded the banking system with dollars to stop that computer glitch problem back in what 1999,2000,2001 or whenever that was going to bring all the computers crashing down...:) The Fed has been flooding us with M's for a long time. :)

[Winstonm]

Getting somewhat back to the debt discussion, the tremendous growth in the securitization industry had the effect of negating both reserve requirements and captial requirements, allowing an almost unlimited expansion of debt.

 

Mike777 can correct me if I'm wrong here, but I understand for U.S. banks the Basel I capitalization requirements are followed, and the reserve requirements are supposedly 10% (but this is fallacy due to all the modifications - true picture is it is probably closer to 7%-8%).

 

These constraints limit the amount of loans a bank can make - but when those loans are packaged and sold to investors, the bank is then free to make an equal amount of loans again.

 

To a great degree, banks from 2001-2007 became loan originators who collected fees, and not lend and hold the loan type banks we are accustomed to thinking about.

 

This has been a huge driver of inflation - virtually limitless credit.

[mike777]

Getting somewhat back to the debt discussion, the tremendous growth in the securitization industry had the effect of negating both reserve requirements and captial requirements, allowing an almost unlimited expansion of debt.

 

Mike777 can correct me if I'm wrong here, but I understand for U.S. banks the Basel I capitalization requirements are followed, and the reserve requirements are supposedly 10% (but this is fallacy due to all the modifications - true picture is it is probably closer to 7%-8%).

 

These constraints limit the amount of loans a bank can make - but when those loans are packaged and sold to investors, the bank is then free to make an equal amount of loans again.

 

To a great degree, banks from 2001-2007 became loan originators who collected fees, and not lend and hold the loan type banks we are accustomed to thinking about.

 

This has been a huge driver of inflation - virtually limitless credit.

I am sure you know this but I will just repeat it.

 

Banks create money, they do this through creating loans or "virtually limitless credit", as you put it.

 

As many others have said all this is really just too much money chasing to few goods or services.

 

This may be a bit extreme but basically the Fed, politicians and most us prefer option one debase the currency, flood the system with liquidity, money, credit than option two which is a worldwide depression. As some point, not this year, the cycle will reverse and tight money ala 1981...82...etc will come back in vogue. :)

 

Granted option one and two are extremes but I think it is those fears that drive us. :)

[jtfanclub]

This may be a bit extreme but basically the Fed, politicians and most us prefer option one debase the currency, flood the system with liquidity, money, credit than option two which is a worldwide depression. As some point, not this year, the cycle will reverse and tight money ala 1981...82...etc will come back in vogue. :)

It could be very soon. Depends on how many other banks collapse. Yeah, I know, technically Countrywide didn't collapse. They just got bought out for pennies on the dollar. The tight money of the early 80s and the S&L crisis in which 1600 banks collapsed of the early 80s were not coincidence, though the cause and effect there were kind of a cycle (banks collapsing causing tightening credit which caused more banks to collapse and more tight money, etc.).

[mike777]

This may be a bit extreme but basically the Fed, politicians and most us prefer option one debase the currency, flood the system with liquidity, money, credit than option two which is a worldwide depression. As some point, not this year, the cycle will reverse and tight money ala 1981...82...etc will come back in vogue. :)

It could be very soon. Depends on how many other banks collapse. Yeah, I know, technically Countrywide didn't collapse. They just got bought out for pennies on the dollar. The tight money of the early 80s and the S&L crisis in which 1600 banks collapsed of the early 80s were not coincidence, though the cause and effect there were kind of a cycle (banks collapsing causing tightening credit which caused more banks to collapse and more tight money, etc.).

Banks failing is an argument in favor of even more flooding the system with money, not the opposite and tighten.

 

Banks only fail for one reason, they cannot borrow enough money. In other words if they can borrow they aint going to fail. Of course there are many reasons why no one may want to loan them money but the main one is they think the bank will not repay them.

 

BTW those banks and SL collapsed more in the mid to late 80's. not too much in early 80's. In other words they failed after the start of tight money, not before.

 

Note when all those S&l started going under the Fed loosened the money supply, flooded the system to allow the failed banks to be bought out at firesale prices and they were real steals back then. The gov. took the bad loans and sold the good ones for pennies. I am looking for something like this to happen again. Buy low stuff and sell whatever is high, Gold?

[mike777]

Wiston I just read an interesting short article by Paul McCully from PIMCO called the Liquidity Conundrum.

 

He defines liquidity not as a fixed pool of money but a state of mind regarding risk. Liquidity is the result of the appetite of investors to underwrite risk and the appetitie of savers to provide levergage to investors who want to underwrite risk.

 

He also brings up Hyman Minsky's framework of the:

1) Hedge Unit

2) Speculative Unit

3) Ponzi Unit

 

In effect in 2006 the mortgage industry was granting to marginal borrowers a free at-the-money call option on the value of their property.

 

Hopefully you can find these articles online or at your library. I only have an old fashion hard copy. B)

[Winstonm]

Mike,

 

Thanks for joining this discussion because I am sure you have a lot of knowledge in these areas.

 

One of the conundrums I read about is bond yields - the 1-month T-bill up through the 3-year bond has a yield of under 2% - this would seem to be pricing in a serious recession and therefore would be a disinflation position. I mean, if inflation is going to be the problem why accept a yield of 1.91 for 3 years?

 

How much of this credit will simply evaporate in insolvency and falling asset values.

I read a collaborative report that said if home prices fall 15% it would create $2.6 Trillion in negative equity - that a bunch of asset implosion to fade. And this report was solid, from JPM, GS, Fed Bank Chicago, and Princeton.

 

As you point out, the active balance sheet management of leveraged institutions will be under enormous pressure to: A) lower assets, B) Re-capitalize or C) Assume higher risk leverage.

 

As you point out, B is best if it can be managed - borrowing to recapitalize is expensive, though, when everyone is looking for capital at the same time.

 

Most don't realize that the Fed can provide liquidity to the banks, but they cannot provide capital - once again it looks like we will be "dependent on the kindness of strangers" to solve out Blanche Dubois economy's woes.

[Winstonm]

Mike,

 

You may want to look into this, too: http://www.brandeis.edu/global/rosenberg_i.../usmpf_2008.pdf

 

It is what I referenced above about total losses in housing and negative equity.

 

I think there is no doubt that economic activity is psychological in nature - in this I believe the Austrian school has it closer to correct than Keynesians or neo-Keynesians - Ludwig Von Mises had a lot of interesting insight.

 

I agree that a significant problem is d-i-s-t-r-u-s-t, that no one knows who or what holds what kind of risk and everyone is sitting on their hands hoarding their liquidity - this is what forced the TAF auctions, IMO.

 

But another significant problem is insolvency - which is not simply a liquidity crisis.

If this were only a liquidity crisis, the Fed could eventually manage the problem

 

But it is out of their hands - the Fed can't influence by much the capital markets.

 

In effect in 2006 the morgage industry was granting to marginal borrowers a free at-the-money call option on the value of their property.

 

That's a good analogy.

 

Here's some more interesting information. The big bulge in subprime occured in 2004, 2005, 2006 as good-credit customers were spent and lower end customers were encouraged in order to sustain the euphoric rise.

 

In 2004, 25% of all new mortgage loans were subprime. In 2005-06, 30% of each year were subprime. 80% of those subprime loans went into AAA pools.

 

No wonder the RMBS markets is shut down.

[Winstonm]

Treaury yields mentioned above:

 

March 2008

Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr

03/03/08 1.99 1.70 1.80 1.74 1.61 1.84 2.48 2.96 3.54 4.37 4.42

03/04/08 2.01 1.66 1.76 1.72 1.65 1.86 2.53 3.02 3.63 4.46 4.52

03/05/08 1.91 1.53 1.75 1.72 1.66 1.91 2.59 3.10 3.70 4.55 4.60

[kenberg]

I read a collaborative report that said if home prices fall 15% it would create $2.6 Trillion in negative equity - that a bunch of asset implosion to fade. And this report was solid, from JPM, GS, Fed Bank Chicago, and Princeton.

As it happens, I just this morning read Robert Samuelson in the Post:

 

"The Federal Reserve estimates that owner occupied real estate is worth almost $21 trillion".

 

This Fed figure appears to be approximately the basis for the 2.6 trillion loss if home prices drop by 15%. (The math would give a little more than 3 so they are not working with exactly the same figures but close enough. What's a few billion more or less.) Note that we are talking of total value here, whether or not there is a mortgage is not part of this computation.

 

As Samuelson points out and as I have thought (great minds think alike ;) ) this needs to be taken with a grain of salt. Suppose you own an asset worth $100. Speculative fever hits and your asset rises to $200. Reality sets in and the price drops to $150. Calling this a 25% drop in value is maybe technically correct but certainly incomplete. Actually, over a period of maybe not many years, you have made out well especially if you bought on margin. This seems to be pretty much what has happened with houses. Housing prices more or less doubled in this area over a few years (I have to be vague, I don't follow it closely) and now of course have fallen off substantially. But people who bought four years ago rather than two years ago still have a substantial profit.

 

Again as it happens, I know someone who did just that. They bought four years ago, they are moving, they can sell at a profit. Great? Well not so great. They took out a substantial second mortgage to either cover their expenses or sustain their lifestyle, depending on how you want to phrase it. Oops.

 

I am sure that they are one of many.

 

Maybe it will all work for them (it would be tacky to bet otherwise, but I am pessimistic) but if not then I really don't want to pick up their debt for them either individually or collectively as a taxpayer. Been there done that By government fiat) in the S&L years. It's tough, but when the dice roll their way they collect. If not, they are entitled to the losses.

 

Yes I noticed that you said "Negative Equity". But the figures from the Fed seem to indicate more that it would be a simple loss in value. Perhaps this mean the same thing ? I'm still building my vocabulary.

[Winstonm]

Ken,

 

The big problem occured from 2004-2006. The "negative equity" I refer to is the current value of the home compared to its mortage.

 

During this time frame 25-30% of all new mortgages went to subprime borrowers, and many of the loans were 95%-100% LTV (Loan-to-value). This is the negative equity to which the paper I cite refers. Also, many of these loans were ARM or (Adjustable Rate Mortgage). The average time reset for ARM loans is 2 years, so the 2004 batch has reset. 2007 would have reset 2005. 2008 will reset most of 2006 ARMS.

 

But in this negative equity, there is more. Many instituions granted HELOC for homeowners (Home Equity Lines Of Credit). These were like an ATM the homeowner could tap for cash. A lot of previoulsy non-underwater homeowners leveraged up with HELOC and the housing price collapse has put them underwater, as well.

 

The magitude of the problem is understated still, until you start reading about the proposed solutions - then you get the sense that a lot of brainy people are somewhat unnerved and a little scared by possible outcomes. Most of the bailouts are in some form of nationalization of mortgage debt via the GSEs (Government Sponsored Entities, Fannie Mae and Freddie Mac, and then having the loans insured by the FHA) This passes the risk of further value collapse from the holders of the loans to the U..S. taxpayers

 

The FHLA (Federal Home Loan Administration) has already provided billions and billions to shaky institutions (Countrywide Financial, most notably) - although FHLA banks are not truly government agency, they are quasi government.

 

I'm not yelling that the sky is falling - but for the first time ever there is at least some amount of real risk of a global financial meltdown (0.1%, maybe). The fact that risk of this magnitude is even considered as any possibility at all gives an idea of how serious is the real situation.

 

Over the next two years we will see a number of bank and thrift failures - from 50-100 unless things get really bad. I would suggest anyone with money not to exceed the FDIC guarantee limit an any one institution for the next 3-5 years.

[kenberg]

OK. I figured that equity should involve mortgages as well as house value. Of course when we look at a sudden drop in prices the drop of value and the drop of equity should be the same dollar amount since the mortgage doesn't change. At any rate, it's a large drop.

 

Still, the argument that the guy who bought in 2004 should not be in trouble seems right, at least as prices around here seem to be going. The sale price of his house skyrocketed to unrealistic heights, then settles back down, but still at values significantly higher than in 2004 (this is from local observation but I think that the national numbers say similar things). At the very least, someone who bought in 2004 has to make his case as to why he needs help. I'm guessing that often it is because he became overly optimistic about the inflated value of his house and did something with that money that didn't work out so well. This is what I see and hear often.

 

As always, some people are doing their best and have suffered an unforeseeable misfortune. Individual or collective help may be warranted. But if a guy owns a house that is worth more now than when he bought it, he will have a tough time convincing me I should give him some money, through taxes or charity, to shelter him from the fallout of the housing crisis.

 

This matters for policy, because one purpose of a policy might be to help the poor struggling homeowner. Another approach might be more focused on keeping their mistakes from dragging the rest of us down with them. The policies from these two approaches are apt to be different.

[Winstonm]

This matters for policy, because one purpose of a policy might be to help the poor struggling homeowner. Another approach might be more focused on keeping their mistakes from dragging the rest of us down with them. The policies from these two approaches are apt to be different.

 

 

Exactly, Ken.

 

But what we are getting mostly is proposals to bail out the financial institutions wrapped in a mantra of "saving the poor homeowners".

[kenberg]

Yes. Fortunately Paulsen, if I spelled that right, and others seem to be on to the game. Unfortunately Congress doesn't care.

 

In an election year this could get a bit crazy (and these days every year seems to be an election year). So far we have had a successful bi-partisan effort to give most everyone some money and various suggestions to ban (for some number of months) foreclosures. The latter strikes me as being along the lines of banning gravity because too many people are injuring their hips when they fall.

 

Just an early morning cynical thought. Back to work. I plan to compute the Laplacian in spherical coordinates. Best if I prepare. Maybe I'll assign it as homework.