Commentary
The latest inflation numbers were once again described as “cooling.” That seems to be the go-to word for something that is still bad but not as terrible as before. It is bad as a metaphor of temperature that has nothing to do with the prices you actually pay at the store. In plainer terms, prices are still roaring ahead with no end in sight. Everything is getting more expensive, just not as fast.
To invert the calculation, you could also say that the dollar’s purchasing power is still falling. The dollar has lost as much as 40 percent of its 2019 value overall and much more in particular sectors. That’s the realistic calculation of the Reality Index, which is far more accurate to the real world than the Consumer Price Index which is replete with hedonic adjustments and other statistical tactics that disguise the extent of the problem.
The Federal Reserve has tried to tamp down the inflation rate with increases in the federal funds rate. That makes borrowing by banks more expensive, tightens credit, and, in theory, this tightness is felt entirely up the yield curve, affecting longer-term rates all the way to the 30-year mortgage. That makes borrowing more difficult but also reduces price pressure and can even shrink the money supply.
Is that happening? Sort of. It worked for a while but M2 money aggregates are on the move again, running somewhat ahead of the inflation rate and beyond that which can be absorbed by rising output. This means, if I’m correct, that we are going to have above 3 percent inflation for the time being.
The new Fed chair, Kevin Warsh, has a problem on his hands here.
Actually, however, the issue is more serious than he likely knows. To understand it, you have to go beyond the obvious effects of loose money which is price inflation. You have to examine the ways in which loose money as provided by interest-rate manipulations distort investment patterns.
Just consider, for example, existing federal funds rates. Everyone thinks they are high. But in reality, you have to adjust these for inflation to discover the real rate. If inflation is running 3.4 percent and federal funds is set at 3.6 percent, that is virtually flat in real terms. If you accept the numbers of the Reality Index, inflation is running at 4.3 percent, roughly a third higher. In that case, interest rates are slightly negative right now.
What does it mean to have zero or negative interest rates? It means there is always an arbitrage opportunity for people and institutions to borrow, throw the money at rising financial valuations due to inflationary forces, and pull out a profit. This is where we are today and likely why the stock market seems to forever go up despite a serious dearth of real earnings.
In other words, the traditional workings of capitalism—I will explain this in a moment—are fundamentally broken at the level of the production structure. The problems with this might not appear immediately but they gradually erode all the essential forces that make capitalism function in a proper and balanced way.
Let’s extend the time horizon outward of this policy and see where we are today. If you adjust the federal funds rate for inflation, you can see that short-term interest rates have hovered around zero and sometimes dipped far below for the better part of a quarter of a century. Even now, rates are running at zero by conventional measures and negative by alternative measures.
The low real rates of the 1950s and 1960s found their justification in the high savings rate at the time. The capital stock was high and growing because savers experienced a high reward in a low-inflation environment. The inflation of the 1970s made a mess of that, leading to the great fix of the 1980s where high rates squeezed excess liquidity out of the system. We entered into a path of real economic growth that lasted from 1982 all the way to the end of the century.
Back in 1987, Fed chair Alan Greenspan pulled a fast one with what was called the Greenspan Put. He intervened with extra liquidity to prop up the financial markets. It seemed to work but in the worst way. It sent a signal that would govern Fed policy for the following many decades. A third pillar was added to the Fed’s job: keep markets up. The only means of doing so was to grab the only hammer the Fed really has: the ability to manipulate interest rates.
What is the interest rate? It is a price, same as any other price. It governs the supply and demand for credit. It’s a particularly important price because it affects investment and savings decisions. Under sound money, saving money should pay a return. It’s a reward for deferring consumption. It is the bonus you get for being thrifty. Others with more urgent needs borrow from the store to save capital for their own projects.
The result is a complex structure of production that balances out time commitments with savings and investment decisions. In the long run, the rate of return on capital should be roughly identical to the interest rate and hence the return on savings. If you read any 19th or early 20th century book on the workings of capitalism, this is what you find. It is an elucidation of the inherently balancing forces of the supply and demand for capital and credit as governed by the interest rate, which itself is set by market forces.
The Greenspan Put was an experiment in manipulating that rate in a way that punishes savers and rewards borrowers and financial titans. As time went on, the experiment became more audacious, following the Dot Com bust then 9/11 then the 2008 financial crises. In time, the financial markets got addicted to the scheme whereby it was always and everywhere remunerative to borrow at low rates and pay for the service with returns in the financial markets.
The result is what David Stockman has called “The Great Deformation.” He was the first to explain fully how this mechanism fundamentally distorts the way capitalism is supposed to work. When you hear about the problem of financialization—how leverage has devoured real production in every sector and driven out genuine industry—this is what it means. It is a direct consequence of this interest-rate manipulation.
As I pointed out above, it is nowhere at an end. Rates in real terms are still, even now, running around zero percent. This is absurd because our savings rates nowhere justify this, unlike in the 1950s and 1960s. From an average 10-15 percent back then, we are down to 2.7 percent today. Thrift continues to be punished while casino-style leverage keeps winning the day, entirely due to the Fed.
In practice, this meant private earnings on the upside and socialized losses on the downside, while savers scrambled for a safe haven. This is not capitalism. It is financial fascism ushered in by paper money.
Meanwhile, we are seeing the rise of socialist ideology. They think they are targeting capitalism but old-style capitalism no longer exists. We live in a credit soaked and leverage-addicted world in which paper money is the main asset both for domestic use and for export.
No one has carefully considered what the exit strategy from this disaster looks like. I wish the new head of the Fed all good luck in unraveling this mess.
Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
