The Fly in the Inflation Ointment


The European Central Bank lit a fire under the stock markets of Europe and America on Thursday night. More bond buying is expected from the money printers, which is apparently a good thing. But is it? To answer the question, we turn to central banker extraordinaire, Ben Bernanke.

Where would we be without Bernanke’s QEs? What would have happened if the Federal Reserve Chairman hadn’t resorted to the good old printing presses? What if he hadn’t pumped up the global financial system, including Australia’s banks?

We’ll never know the answer. But we do know something Bernanke doesn’t. He has his causes and cures mixed up. And that means there’s money to be made.

The problem Bernanke is dealing with is America’s over indebtedness. It has too much public and private debt. He thinks that the solution to this problem is inflation. If prices rise, it’s easier to pay off a given amount of debt. And so deflation is the cause of America’s troubles. That’s because debt is harder to pay if prices are falling.

Looking at the problem like this is like blaming a tight shoe on the size of a centimetre. Changing how many millimetres make up a centimetre won’t make the shoe fit.

Inflation is the cause of the problem, not the cure. And deflation is the symptom that the economy is repairing itself. It’s getting rid of all that debt. More on why Bernanke is wrong in a moment.

Your investment opportunity bundled up inside his mistake has changed. It used to be about investing in the recurring bubbles caused by monetary policy. The trick was to find them before they really got going and sell out before they burst.

Let’s look at the American housing bubble as an example of how monetary policy creates bubbles for investors to profit from. After the tech bubble crashed, America went through a recession. Interest rates were pushed down to combat the recession. To get prices rising and Americans spending, Federal Reserve Chairman ‘Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble,’ said economist Paul Krugman at the time.

Alan Greenspan’s low interest rates and money creation achieved just that. Homeowners made a lot of money. Of course, it was just a debt-funded bubble. And at some point, you just can’t borrow any more. Then the bust hits. (Krugman got his Nobel Prize in 2008.)

As always, the central bank came back with more inflation, allowing the next bubble to get going. At least, that’s what was supposed to happen.

Monetary policy is looser than it’s been in our lifetime. So where is the bubble now? Unfortunately, we’ve missed it. It’s in government bonds. Central banks have been pumping trillions into sovereign bonds around the world. The Australian calls it the best bull market in our lifetimes. But bond prices can’t go much higher for many nations.

So where’s the next bubble you can make money on? Well, there may not be a next one. Unless you’re willing to buy properties in Germany. There, the European Central Bank’s loose monetary policy is inflating the housing bubble the Germans missed out on in the 2000s.

Spot the Bubble

Germany house price

So why might there not be another bubble after the government bond bubble? Because, at some point, central banking policies fail to get any traction where they’re supposed to. Central bankers want houses, stock markets and other assets to go up in price when they print money.

That makes people feel wealthy, which makes the economy look rosy. But what if consumer prices move instead of asset prices? What if the kind of inflation that makes us poorer instead of (feeling) richer takes place?

Then there’s trouble. Unless you’re a nincompoop and like the idea of consumer price inflation. Enter Germany’s Wolfgang Muenchau. He reckons a 4% rate of inflation would be a good idea for the Germans.

His argument is that money printing doesn’t increase prices, because it didn’t in Japan.

There, the money supply increased but deflation persisted. He then negates his own argument by pointing out the Japanese raised interest rates, bringing on deflation. But let’s focus on his first argument – that a change in the money supply doesn’t affect inflation.

The mistake Muenchau makes is to assume the counterfactual is a 0% rate of inflation. In other words, he assumes there would be 0% inflation without central bank intervention. Because the inflation rate hasn’t moved far above 0% in places where central banks have printed money, there hasn’t been any inflation from the money printed.

This is like saying there won’t be a plane crash because you can’t see anything in the aircraft cabin falling. Once you look out the window, you realise something is up.

Muenchau also assumes that only the money supply changed during the period of deflation in Japan. Otherwise his analysis would be useless. If, for example, there was a financial crisis while the money supply expanded of course there would still be deflation.

The question is what effect the growing money supply did have, given everything else going on. It might have offset some of the deflation, for example.

Knowing all this, has there been inflation as a result of all the money printing since 2008? Well, take a guess at what would have happened without central banks printing money. The price level would have crashed. During the Great Depression it fell by about a quarter.

We don’t know how much it would have fallen in 2008 and 2009, but chances are a lot. Therefore, money printing has had a significant effect. The inflation created just offset deflation.

The difference of opinion between Muenchau and common sense only matters if you accept that deflation is an important part of the economy trying to purge excessive debt. Stopping the deflation by creating inflation prevents the economy from fixing itself.

That’s why the global recovery has been so poor. In fact, American income fell more during the recovery than the recession!

The real worry is that the policy makers won’t give up on trying to find a new bubble to inflate. Seeing very little happen as a result of their efforts so far, they will just do more. Eventually, their money printing will gain traction in consumer prices.

All you have to do to protect yourself is go out and buy some gold. Problem solved, right?

The coming inflation may be a whole lot worse than what America experienced in the 1970s. Much worse. But we’ll save the ‘why’ for next week.

Until then,

Nickolai Hubble.
The Daily Reckoning Weekend Edition

About the author: having recently escaped from academia, Nick decided to drop his tights (the required attire of a trapeze artist) and joined Port Phillip Publishing. Instead of telling everyone about the Daily Reckoning, he now spends his time writing for the weekend edition.

ALSO THIS WEEK in The Daily Reckoning Australia…

Iron Ore Prices Sink Like a Stone
By Dan Denning

Let’s shove that question aside for just a moment and return to the urgent matter of the plummeting iron ore price. When last spotted, the spot iron ore price was busy falling below US$90. It’s over 50% down from around this time last year. Many interested parties want to know how much further it will fall, or when it will rebound.

The Australian Dollar is Not the Euro
By Dan Denning

We flirted with the idea that Australia has higher interest rates than the rest of the developed world because it has to. When you run a regular current account deficit, you have to promise higher yields on your stocks and bonds to make up the difference. If the Reserve Bank of Australia lowers interest rates too much, it could trigger a flood of foreign money out of the country and usher in a banking crisis.

The Shove the US Economy Needs
By Bill Bonner

Ben Bernanke – yes, the Hero of ’08 – is in the spotlight. Will the Fed announce a sweeping programme of ‘open ended’ QE – buying bonds whenever it wants? Will it thereby help the US jump over the ‘fiscal cliff,’ like Evel Knievel over the Snake River (poor Evel didn’t make it; he ended up in the river and almost drowned)? Or will the Fed hold its tongue… and its fire?

The RBA is Impotent, Not Omnipotent
By Greg Canavan

As we’ve pointed out before, very low interest rates are not exactly a sign of good economic health. Ask Japan, the US, Europe or Britain. That lower rates are on their way is inevitable. The question is how low can they really go, and how effective will the cuts actually be?

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

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