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http://globaleconomicanalysis.blogspot.com/2009/12/fictional-reserve-lending-and-myth-of.html

http://2.bp.blogspot.com/_otfwl2zc6Qc/SzaX3fVcQGI/AAAAAAAAMSA/0DQgVZ-1VtM/s1600-h/m2.jpg

PeakTrader said...
If someone has a choice of either buying an entertainment system or health insurance and chooses the entertainment system, then gets sick or injured, and can't afford the medical bill, then who pays? It may be the people who bought the health insurance instead of the entertainment system. So, it seems, the person without health insurance should pay somehow for making a poor choice.

Perry said...
Okay, I agree that M2 is telling us a non-inflationary story for the moment, but what about the future? We may all be dead in the long run, but I plan on being around for a few more decades. What I would like is for someone to paint a reasonable, non-inflationary scenario for what's going to happen to the massively inflated monetary base. The monetary base has more than doubled. Doesn't that have to come into the economy at some point, and cause price inflation. What is the scenario that would stop that from happening? I've asked this question before, in many places, but no one answers. Kind of gives me the feeling that those who are telling us not to worry about inflation are just whistling past the graveyard. Would love to have some reason to think otherwise. Well, how about it? Someone? Anyone?

PeakTrader said...
The steep rise in the monetary base isn't inflationary, because banks aren't lending much. Banks are building-up their capital reserves or ratios.

What may be inflationary is slower real growth, because nominal GDP minus real GDP is inflation, and U.S. trading partners are absorbing fewer dollars.

Also, I may add, the Fed is expected to preempt inflation, when the economy inflates enough.

Perry said...
Thanks Peak Trader, but that really doesn't scratch my itch. I basically know all that. I also know that the Fed is supposed to be able to manage this, but what seems iffy to me is the mechanism. I'd like to see someone paint a picture of how the mechanism will work, either to reabsorb the reserves or keep them from flooding out into the economy.

PeakTrader said...
Perry, the Fed will sell bonds to banks, to drain dollars out of the commercial banking system

Lyle said...
Much of the inflation discussion assumes the Milton Friedman theory of money quantity driving inflation.
But how can you get wage inflation with 10% unemployment (except in some niches). With mfg running at low capacity utilization there is no shortage of goods, so no source for inflation there. With so much money disappearing into the foreclosure bucket, some of which is offset by bailouts, again hardly a source for inflation. Finally the second element of the quantity theory of money and inflation is the velocity of money and much of the created money is just sitting. Yes it could start moving, but when is the question.

So until you see unemployment down in the 6 to 7% range don't worry its unlikely to happen.

For longer range ideas, consult your tea leaves, or go to Delphi and consult the oracle, or similar ancient and well tested method of predicting the future.

Perry said...
Thanks Peak Trader. Next question -- why will the banks buy the bonds? Presumably the Fed will want to sell at a point when velocity (and therefore inflationary pressures) are on the rise, which would seem to be a time when banks would be less inclined to buy bonds. This would seem to imply, at the very least, that the bonds will have to be sold at a steep discount in order to attract the buyers needed to shrink the monetary base. Doesn't that imply that the Fed's balance sheet may have trouble reabsorbing all the cash?

PeakTrader said...
Lyle, in the 1970s, there was 7 or 8% unemployment with 7 or 8% inflation, i.e. stagflation.

I stated above: What may be inflationary is slower real growth, because nominal GDP minus real GDP is inflation, and U.S. trading partners are absorbing fewer dollars.

Moreover, a supply shock, e.g. $200 oil or a spike in food prices, can be inflationary.

Perry, bonds are bought and sold on the open market, i.e. open market operations. The Fed creates and destroys money. Recently, it created money buying bonds.

However, what I expect is an illusion of prosperity. 2009 is a turning point where government placed massive inefficiencies in the economic system. So, Americans will get less for their work.

Lyle said...
Recall that before stagflation there was a long period of rising inflation starting with LBJ, then we had the wage/price controls of Nixon, whip inflation now of Ford and then got stagflation. That took about 10 years to happen. Inflation did not shoot up but rose gradually to its high value.

PeakTrader said...
Lyle, I didn't say inflation shot up. Inflation is too much money chasing too few goods. We've done a good job destroying goods, including imports. However, the destruction began with excess goods, because the U.S. economy was most efficient, in creating and capturing goods in the global economy. Now, we just need to print or lend enough money.

rjs said...
youre doing the same thing you did in the previous post, measuring output by dollar value, and that only means our output is more expensive, not more...

PeakTrader said...
RJS, you should see "terms of trade."

"An improvement in a nation's terms of trade is good for that country in the sense that it has to pay less for the products it imports. That is, it has to give up fewer exports for the imports it receives."

Also, the output is more expensive, because the quality is better. Otherwise, lower quality goods can be substituted or imported (if it's a tradable good).

If more Americans buy SUVs than compact autos, then the good becomes more expensive.

More debate:

https://www.blogger.com/comment.g?blogID=28997633&postID=8037604090128992268

PeakTrader: Dollars come back in the form of investment. The problem is the dollars flow out from the private sector and come back to the government (when foreigners buy U.S. Treasury bonds). So, the government needs to give those dollars back to the private sector. That's why contractionary fiscal policy preceeded recent recessions (since the U.S. became an open economy). Also, I stated before:

Changes in fiscal policy can change the velocity of money. However, in the long run, V and T are constant. So, M equals P.

Also, I may add, in the equation MV = PT, if M and P are constant, then V = T, i.e. V, the velocity of money, or the number of times money is exchanged, equals T, the number of transactions, or the quantity of goods exchanged. The goal of monetary policy should be to keep actual GDP close to potential GDP, which smooths-out the business cycle creating optimal growth (since there's neither strain nor slack in the economy). The fact that there are monetary tightening and easing cycles, to close output gaps, are attempts to smooth-out T in the short-run. V and T fluctuate in the short-run, which require adjustments in M to stabilize P and smooth-out T. For example, if people decide to hoard money, then V and T will fall (in the short run). So, M needs to rise (higher than a constant growth rate).

Ron H. said...
Perry, I think you are right to worry. I don't think your questions have been answered.

I am not an economist, and by no means an expert, but from my reading of von Mises, Hayek, and Hazlit I believe that inflation is an increase in the money supply. Rising prices, including wages, are a reaction to that increase, not the inflation itself. as Peak Trader puts it "...Too much money chasing too few goods." causes prices to rise.

I believe the M3 money supply (which is no longer published) would show the inflationary signs you are looking for. When banks stop de-leveraging and start lending at a more normal pace, I think the M2 will show that also.

The reason banks are not lending more freely, and the reason businesses are not hiring, is most likely that few dare predict the future due to the shenanigans going on in Washington.

Many now believe that the Fed can't possibly guide something as complex as the US economy without causing unintended consequences at every turn. Witness the recent housing market bubble. Easy credit for a very long time caused distortions in the market. True, there are many other factors causing us to be where we are now, but I believe that Fed action is one of the primary causes of the current recession.

As Peak trader says, the Fed will sell bonds to banks, to drain dollars out of the commercial banking system. Why will banks buy these bonds, you ask? well, because they will carry an attractively high interest rate. This will in turn cause other interest rates to rise, as borrowers compete for scarcer funds, which will cause the economy to slow.

gettingrational said...
Peak Trader, We are saying the same thing as far as money leaving the country I think. Money leaves the country and returns in the form of treasury purchases instead of goods and services purchases.

Velocity of mnoney would grow dramatically if dollars were spent on U.S. Goods and Services. Instead it is dead-ended with foreign treasury purchases; most notably by China to keep yuan parity with the dollar. Obama should be hammering away at China to buy U.S. Goods and Services and let the yuan float.

I am afraid of a lost decade for the U.S. but with inflation because of the falling value of the dollar.

Craig said...
It's always a challenge to figure out where the Fed's newly-printed money will enter the economy and cause its mischief. Usually, it's through easy lending practices which drive up borrowing -- but that isn't working.

No, this time, the Fed is monetizing big chunks of the federal deficit. It's lending to banks at near zero and the banks are turning around and buying Treasury bonds. The newly-created money is entering the economy through the government's spending.

It's what happened during LBJ's administration setting off the inflation of the '70's and it's somehow fitting that it will be Obama's spending that will cause the inflation of the late teens.

I mean, why do you think the Chinese are running for commodities as fast as they can?

Stocks higher? Famed investor says don't bet on it
December 27, 2009

As CEO at Newport Beach, Calif.-based Pimco, El-Erian, 51, oversees nearly $1 trillion in assets, more than the gross domestic product of most countries. So when he talks, people listen.

What he's saying now:

--Stocks will drop 10 percent in the space of three or four weeks, bringing the Standard & Poor's 500 index below 1,000 -- though he's not predicting when.

--The unemployment rate will be hovering above 8 percent a year from now.

--U.S. gross domestic product will grow at an average 2 percent or so for years to come -- a third slower than we're used to.

El-Erian says many of the bulls don't appreciate just how much the government props still under the economy are masking its weakness.

http://www.nolanchart.com/article5583.html

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Scott Grannis said...
If you accept that M2 is a better measure of money demand than of money supply, then any large decline in M2 growth that comes on the heels of very fast growth is a clear portent of rising inflation. Because it means that M2 velocity is rising rapidly; all the money that was accumulated during the panic of '08 is now being released into the economy and that is what can and most probably will support a higher price level.

PeakTrader said...
Scott Grannis, every period is different. So, it's difficult to compare. For example, from 1995-00, there was accommodative monetary policy, because the Greenspan Fed knew the economy could expand at a faster rate without accelerating inflation. The Fed was correct. M2 increased with disinflation.

Currently, much potential output is being displaced by government, which is inflationary. However, unemployment remains too high to fuel much inflation. Falling M2 may mean money balances are being depleted to maintain autonomous consumption.

The confusing connection between M2 and inflation by Scott Grannis

This post is a follow-up to a post of mine last month, and to a recent post by Mark Perry questioning whether it is reasonable to expect a pickup in inflation given the big slowdown in M2 growth over the past year. The short answer to his question is yes, it is reasonable to expect inflation to pick up despite the big slowdown in M2 growth. Indeed, an inflation pickup is made more likely by the fact that M2 growth has slowed sharply, after rising sharply in late 2008.

To begin with, the chart above tells us two things: 1) the connection between M2 and inflation is not always consistent, and 2) M2 growth and inflation often (but not always) move in different directions, contrary to what a standard monetarist framework might predict (e.g., faster money growth should lead to more inflation according to standard monetary theory).

For example: Consider the huge pickup in M2 growth from 1970 to 1972, followed by a significant slowdown in inflation from 1972 to 1974. M2 then decelerated sharply in late 1973, only to be followed by a huge pickup in inflation in 1974-75. M2 decelerated in 1978, and was followed by surging inflation in 1979-80. On a more modest scale, M2 decelerated sharply in 2003, and was followed by rising inflation in 2004-5.

The explanation for this, I believe, can be found in the confusing nature of M2. We've all been taught over the years that M2 is arguably the best measure of money supply. I would argue instead that it is one of the best measures of money demand. After all, the Fed only supplies reserves and currency to the world, and currency makes up only 10% of M2. The other 90% of M2 exists because people want to hold money in the form of checking accounts (10%), retail money market funds (10%), small time deposits (13%), and savings deposits (57%).

This distinction—whether M2 represents money demand or money supply—makes a world of difference. When M2 growth slows sharply, I think it usually means that money demand has collapsed; people want less money, so they take it out of their savings account and spend it. That's equivalent to saying that the velocity of money has turned up. Rising money velocity means that a given amount of money can support a greater volume of transactions and/or a higher price level. This follows from the classic equation M*V = P*T.

What we have seen over the past 18 months is this: in Sept. '08 the Lehman bankruptcy sparked a global panic over the imminent collapse of the banking system; this in turn caused money demand to surge as a precautionary measure; rising money demand showed up in a big increase in M2; rising money demand meant a huge decline in money velocity, and that is what caused spending to plunge, economies and industries to shut down, and inflation to fall. Since late March we have been on the positive side of this process: confidence has returned, money demand has declined, M2 growth has slowed to a crawl, the economy has picked up, and inflation has picked up.

I think it is reasonable to expect this process to continue, especially given the 1-2 year lags that we see in this chart. Plus, the inflationary potential of falling money demand is likely to be boosted by the Fed's willingness to keep interest rates very low for an extended period. The evidence of the commodities market and the gold market tells us that people already are actively trying to reduce their money balances in favor of more exposure to commodities and hard assets. And the dollar has fallen very close to its lowest levels ever; dollar demand is clearly weak.

Let me be quick to add that I don't see the seeds of a huge increase in inflation (yet). But I think there's enough monetary fuel out there to push inflation higher over the next year, to 3-4% or more. That might not sound like a lot, but it's above the upper limit of the Fed's 2% target, and it's a lot more than the bond market and the Fed are currently expecting. And that can make for very interesting markets.

PeakTrader:

Consumer borrowing falls sharply in November
By Martin Crutsinger, AP Economics Writer , On Friday January 8, 2010

WASHINGTON (AP) -- Americans borrowed less for a 10th consecutive month in November with total credit and borrowing on credit cards falling by the largest amounts on records going back nearly seven decades.

The dramatic declines raised new worries about whether consumers will cut back further on spending, making it harder for the economy to mount a sustained rebound.

The Federal Reserve said Friday that total borrowing dropped by $17.5 billion in November, a much bigger decline than the $5 billion decrease economists had expected.

Americans are borrowing less for a number of reasons. They remain fearful about their job prospects and they are also trying to replenish depleted investments. The government reported Friday that employers cut an additional 85,000 jobs in December, bringing total job losses to 7.2 million since the recession began in December 2007.

Even consumers who would like to increase their borrowing are finding it hard to get credit at banks. Many banks, hit by the worst financial crisis since the 1930s, have tightened lending standards. While economists have worried for years about the low rate of U.S. savings, the concern now is that consumers could derail the recovery if they start saving too much of their incomes. Consumer spending accounts for 70 percent of total economic activity.

"With consumers facing difficult labor market conditions and tight credit conditions, downward pressures on credit are likely to remain strong and improvements will be very gradual," Gregory Daco, an economist at IHS Global Insight, wrote in a research note.

November's $17.5 billion drop in total credit was the biggest amount in dollars terms since records began in 1943. That represents an 8.5 percent fall from the October borrowing level. That was the biggest percentage drop since total credit declined 9 percent in May 1980.

The borrowing category that includes credit cards fell by $13.7 billion, an all-time record decline in dollar terms. The drop was 18.5 percent from November, the biggest decline in percentage terms since a 29.6 percent plunge in December 1974.

The Fed's credit report excludes home loans and home equity mortgages, only covering borrowing that is not secured by real estate.

The drop in overall credit for 10 straight months was a record in terms of consecutive declines, surpassing the old mark of seven straight declines set in 1943 and again in 1991.

Borrowing in the category that includes credit cards has fallen for 14 straight months, also a record.

With the string of declines, overall consumer borrowing by the Fed measure has fallen to $2.46 trillion.

http://finance.yahoo.com/news/Consumer-borrowing-falls-apf-526281786.html?x=0&sec=topStories&pos=4&asset=&ccode=

PeakTrader said...

The California budget crisis resulted in tax hikes in the middle of a deep recession. The sales tax was increased to 9.75%; vehicle registration fees, tolls, rapid transit fares, etc. all rose sharply.

On the federal level, the government has squandered a lot of money. Consequently, it seems, the IRS has become more aggressive collecting taxes. Also, I heard the Senate health care bill is a stealth tax hike, because taxes, from households and firms, would begin in 2010, and coverage would begin in 2013 or later. Moreover, it seems likely the Bush tax cuts will expire next year to also help reduce the budget deficit.

U.S. households are forced to improve their balance sheets the hard way, if they have a job. There's a lot of ignorance, and inexperience, and intellectuals.