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Tuesday, January 26, 2010

The Price of Nothing

Fools, and other people's funny money, are soon parted:

Chairman Bernanke’s claim is a great canard. The Fed is a serial bubble blower. Let’s first consider the Fed-generated demand bubbles. The easiest way to do this is to measure the trend rate of growth in nominal final sales to U.S. purchasers and then examine the deviations from that trend. Nominal final sales grew at a 5.4% annual rate from the first quarter of 1987 through the third quarter of 2009.This reflects a combination of real sales growth of 3% and inflation of 2.4%. 

The nominal final sales measure of aggregate demand contains three significant deviations from the trend (demand bubbles). The first followed the October 1987 stock market crash. The second followed the Asian financial crisis and the collapse of the Russian ruble and Long-Term Capital Management in 1998. The last jump in nominal final sales was set off by the Fed’s liquidity injection to fend off a false deflation scare in 2002.

The Fed’s zigzag pattern is clear: an overreaction to a so-called crisis, resulting in the excessive injection of liquidity (a sales boom), followed by a draining of liquidity and a recession (a sales slump). The most recent aggregate demand bubble wasn’t the only one that the Fed was pumping up. The Fed’s favourite inflation target – consumer prices, less those for food and energy – was increasing at a regular, modest rate. Over the 2003-2009 period, this metric increased by 14.3%.

Ah, yes. The Consumer Price Index. As the US Labor Bureau's own website explains:

The CPI represents all goods and services purchased for consumption by the reference population (U or W) BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:

FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)

HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)

APPAREL (men's shirts and sweaters, women's dresses, jewelry)

TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)

MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)

RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);

EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);

OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Pretty comprehensive, eh? Not quite. Guess what's missing? 

The CPI does not include investment items, such as stocks, bonds, real estate, and life insurance. (These items relate to savings and not to day-to-day consumption expenses.)

Rather important omission, you might think. In a Fed induced expansion, the funny money, sorry quantitative easing, flows into capital goods and real estate first. It then trickles to the rest of the economy. I'll let Murray Rothbard explain:

Now what happens when banks print new money (whether as bank notes or bank deposits) and lend it to business? The new money pours forth on the loan market and lowers the loan rate of interest. It looks as if the supply of saved funds for investment has increased, for the effect is the same: the supply of funds for investment apparently increases, and the interest rate is lowered. Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. Now, when saved funds increase, businessmen invest in "longer processes of production," i.e., the capital structure is lengthened, especially in the "higher orders" most remote from the consumer. Businessmen take their newly acquired funds and bid up the prices of capital and other producers' goods, and this stimulates a shift of investment from the "lower" (near the consumer) to the "higher" orders of production (furthest from the consumer) — from consumer goods to capital goods industries.

This flow of funny money also drives up real estate prices. Construction is a "higher order" level of production, a large fixed cost that can take years to complete and lasts, often, decades. This in turn requires large amounts of capital which must, typically, be borrowed. An inflationary boom is usually well underway in real estate development and the stock market before it begins to show up in CPI. Statistics are also backward looking. They tell you where the economy has been, sort of, in the last few weeks or months. Since CPI only starts picking up on inflation long after the fact, it's even slower on the uptake than advertised. If that wasn't bad enough, then there's the CPI's methodology. Back to the Bureau of Labor:

For each of the more than 200 item categories, using scientific statistical procedures, the Bureau has chosen samples of several hundred specific items within selected business establishments frequented by consumers to represent the thousands of varieties available in the marketplace. For example, in a given supermarket, the Bureau may choose a plastic bag of golden delicious apples, U.S. extra fancy grade, weighing 4.4 pounds to represent the Apples category.

The last time I went to a supermarket, last Saturday for those interested, I counted seven varieties of apples. For the record my favourites are Red Delicious, and I regard golden delicious eaters with some suspicion. Now seven different kinds of apples can mean seven different prices, unless the store levels a flat per pound price. Now take something rather more complex, and with a greater variance in price, like home electronics. How useful is the picking of one representative example going to be? The CPI, then, is a best guess of what was happening in part of the economy, some months back. 

Central planning didn't work because there was no price signalling system to make it work. Yet the Federal Reserve, as well as various other Central Banks, are using inherently flawed statistics to guess what the correct level should be for the money supply. It's no wonder they spark booms, and then force busts. Reaching a fine balance is something only a market can do, a market where real prices can determine the supply of money. Now some might be wondering how you determine the "price of money." Answer: interest rates, which are themselves only the time preference for money, or more accurately what money represents. Central banking needs to be abolished for the same reason, and with the same urgency, as central economic planning was twenty years ago. 

Posted by Richard Anderson on January 26, 2010 | Permalink

Comments

Publius,

Excellent post. I'm a bit uncomfortable with this however:

"how you determine the "price of money." Answer: interest rates"

Discount rates are not the price of money, but the price required to invest your savings (or to part with it - time preference). This almost sounds like the famous (and absurd) Keynesian theory of interest rates. The price of money is the price of all other goods and services in the economy.

As for the inflation analysis: spot on. The fact that owner's equivalent rent is used to estimate housing costs most likely underestimates overall price increases as well. So by how much do you figure our GDP numbers are overestimates? ;)

Posted by: Charles | 2010-01-26 8:34:03 AM


"Reaching a fine balance is something only a market can do, a market where real prices can determine the supply of money."

I disagree. Money supply manipulations are attempts to control wages and prices via monetary policy instead of (or in addition to) controlling prices with fiscal (e.g., government taxing and spending) policy.

When it comes to fiat currency: the right supply of money - now and at all times into the future - is the number of dollars we have right now. Not a penny more, not a penny less, ever, for any reason. If we need half-pennies, then the issuance of every two half-pennies should require the simultaneous destruction of one penny.

When productivity rises, prices rightly fall (and the standard of living increases for those whose own productivity rises accordingly). When productivity descends, prices rightly increase (and the standard of living decreases for those whose own productivity descends accordingly). In short: prices should follow value, rather than following the whims of those public or private sector entities that manipulate the supply of dollars (most of which, incidentally, is privately-created, and privately manipulated...especially in Canada, where there is no law requiring banks to hold any reserve to back the additional dollars they create for themselves and lend to others).

Posted by: Paul McKeever | 2010-01-26 9:27:43 AM


When productivity rises, prices rightly fall (and the standard of living increases for those whose own productivity rises accordingly). When productivity descends, prices rightly increase (and the standard of living decreases for those whose own productivity descends accordingly). In short: prices should follow value, rather than following the whims of those public or private sector entities that manipulate the supply of dollars (most of which, incidentally, is privately-created, and privately manipulated...especially in Canada, where there is no law requiring banks to hold any reserve to back the additional dollars they create for themselves and lend to others).

Posted by: Paul McKeever | 2010-01-26 9:27:43 AM

Paul, wealth will rise and fall for all, not just those whose productivity increases or decreases.

Posted by: TM | 2010-01-26 10:33:40 AM


"Fools, and other people's funny money,..." Our only hope is in "securities." This guy wants to help out with the "recession."

A Criminal Makes a Plea from Jail
By Stephen J. Gray

To whom it may concern in the justice system:

I am presently incarcerated in a maximum security prison. The crime I was imprisoned for was securities fraud. While doing my hard time in jail, I have been reading the financial news and this makes me very unhappy and upset. I now believe I was falsely convicted as today’s justice system appears to me to be more forgiving of marketplace indiscretions.

I have been reading that some respected financial firms were promoting dubious financial securities as a great investment while at the same time selling themselves out of these investments they were promoting. Could this be called “misrepresentation” in legal parlance as “misrepresentation” is the word used to describe securities fraud? I also read that these respected firms sold these questionable securities to pension funds, mutual funds, state governments and everybody and anybody they could suck in. They even charged large fees for moving, pushing and recommending this financial toilet paper. Some of these blue chip firms were even given taxpayers' monies in something called stimulus packages, as some of them claimed they needed this money to continue in business (and that if they did not get it the financial system would fail and everybody would be in the dumpster). This makes me wonder if this was a form of financial blackmail.

Quite frankly, I never thought I would see the day, when what used to be considered outright thieving and fraud would become legitimized. I certainly feel I am missing out in the opportunities now available in the free market system and the access to unlimited supplies of taxpayers’ dollars. I do not believe it is fair that I am presently imprisoned while others like me are running free and some are advising governments how to save the financial system after selling it short.

I feel that I should be out there in the financial world working within the free market system and using my talents to buy and sell and make an honest dollar, and perhaps even help the country get out of recession. I can move securities with the best of them and I believe my expertise is being wasted here in jail. I know how the system works out there and I sincerely believe I can be of help. I believe the country needs me and I would be willing to take only a small fee for helping sell these rotten securities that are still available to whatever suckers I can find. I am sure I would be welcomed back with open arms by my colleagues who have never yet been in jail and who are always looking for new ideas and new ways to profit from these types of products in the financial market.

In closing, I ask that you consider my offer of help and perhaps free me immediately. Times are changing and we must change with the times. What was a crime yesterday does not appear to be a crime today. Hoping you will consider my plea and let me loose once again into the financial system, home once more amongst friends in the financial world and working at what I do best.

Sincerely
Unfairly Convicted Criminal Number 999.

Satire by Stephen J. Gray
January 16, 2010. http://graysinfo.blogspot.com

Posted by: Stephen J. Gray | 2010-01-26 1:36:32 PM


TM wrote: "Paul, wealth will rise and fall for all, not just those whose productivity increases or decreases."

TM: just so we're understanding one another: I was speaking about a situation in which the number of dollars (i.e., currency+credit) comprising our money supply is held constant. Under such circumstances, ones income depends upon ones productivity relative to the productivity of others. If everyone except Bill doubles his productivity, overall productivity nearly double, but Bill's real income will halve, because he is no longer producing as much value as is being produced by his average fellow man. In other words: if Bill's output stagnates while the output of others increases, Bill will get less money for his effort, but those whose output kept pace with the societal average will have unchanged income, and those whose output grew faster than that of the average person in society will have an increased income.

Posted by: Paul McKeever | 2010-01-26 3:05:55 PM


TM,

You'd be correct if the money supply is increasing (even at a slower pace than goods and services).

Posted by: Charles | 2010-01-26 3:23:43 PM


Paul, Charles, thanks. I need a few lessons I see.

Posted by: TM | 2010-01-27 8:55:35 AM



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