From The Daily Capitalist

This is an article I wrote for a newspaper that is a reprise of my reasoning why I think we are headed for stagflation. The article will appear next week, but it will be familiar stuff for Daily Capitalist readers.

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The Fed voted two weeks ago to print money as much money as they think is necessary to fight deflation, economic decline, and rising unemployment. It is a major policy change little noticed by the media.

There has been a lot of noise in the media lately about deflation. While a few of us have been forecasting deflation and a decline in the economy for some time (your truly since December, 2009), it is as if most economists had just discovered it.

The reason for all this concern is the weak economic data coming in:

Jobless claims jumped to a 9-month high which forecasts rising unemployment.

Consumer spending is softening.

Disposable income is flattening.

New manufacturing orders are declining and inventories are rising.

Durable goods orders are falling.

Credit continues to shrink, both for consumers and businesses.

GDP was revised downward for Q2.

The Consumer Confidence Index took a big slide.

Commercial and industrial real estate is still declining.

Home sales continue to decline.

Some of the leading indicator indices are falling, such as the ECRI and the Consumer Metrics institute.

There are two more data points that really have the Fed concerned. One is that the Consumer Price Index is very low. While you would think that low rates of inflation are good, the Fed wants inflation.

The other thing that bothers the Fed is that money supply is declining and has been doing so since last December. They think that we may be heading for deflation.

What does all this mean? It means that everything the Fed and the federal government have done to revive the economy has failed. From massive fiscal stimulus (spending $787 trillion on mostly wasteful projects), to the TARP bailouts of Big Money, to zero interest rate policy (“ZIRP”), to gimmicks such as Cash for [your industry here], they have failed to stimulate the economy.

With all the bad data coming in, it is no wonder that the Fed, as reported in the minutes of its June, 2010 meeting, was so pessimistic:

Participants generally anticipated that, in light of the severity of the economic downturn, it would take some time for the economy to converge fully to its longer-run path as characterized by sustainable rates of output growth, unemployment, and inflation consistent with participants’ interpretation of the Federal Reserve’s dual objectives; most expected the convergence process to take no more than five to six years.

They are saying that they think it could take 5 or 6 years from 2008 for things to turn around.

What they overlook is that it is the Fed’s manipulation of the money supply that is the cause of our boom-bust cycles: they are the problem, not the solution. And that is why their policies are failing.

Which gets us back to the inflation-deflation issue. It is an axiom of faith with the economists who control Fed and government policy that the economy needs a little bit of inflation to grow. They think that all the Fed has to do is step on the money pedal and the new money stimulates the economy, money supply grows evidencing healthy business lending, prices rise modestly, employment rises, and the economy grows.

The only problem with that idea is that it isn’t working.

Why have they failed?

It all has to do with the banks, mostly the regional and local banks that finance about one-half of our economy. These banks have two problems. First, as a result of the crash, their balance sheets are clogged up with (mostly) bad commercial real estate loans. Bad loans tie up a lot of capital that banks would otherwise lend out. Second, because of the economic decline, business customers aren’t borrowing. And it’s not just because banks have tightened lending standards; businesses see weak demand plus, with all the new laws passed, they are very uncertain about the future.

The Fed saw the plight of banks and they lowered the interest rate (the Fed Funds rate) to zero on money banks borrow from the Fed to make loans. They have also massively increased the pool of money available to banks to tap into (money base).

But, if banks aren’t lending and borrowers are reluctant to borrow, the new money never gets lent out, and the giant pool of new money just sits at the Fed as banks’ reserves.

Since the money is not being lent out, which is their main tool to increase money supply, money supply is now declining, and that is deflation. This is why the Fed is very concerned with a potential “deflationary spiral,” a phenomenon that occurred during the Great Depression.

What can the Fed do? They can’t lower the Federal Funds rate because it is already as low as it can go. And this hasn’t worked anyway.

This is what the big change in Fed policy was all about.

There was a huge internal fight at the Fed between the anti-deflationists and the anti-inflationists, and the anti-deflationists won. The Fed decided they would fight deflation through “quantitative easing” or “QE.”

With QE, another tool the Fed has to increase money supply, the Fed buys Treasury debt (bills, notes, and bonds) from its primary dealers and prints money to pay for it. This puts money directly into the economy.

It’s not as if this is something new. From last year through April of this year, the Fed bought $1.25 trillion of debt issued by Fannie Mae and Freddie Mac. They also bought about $700 million of Treasury debt. This put $2 trillion of new money into the economy. This apparently wasn’t enough.

The second important thing they announced is that they will replace their Fannie/Freddie paper with Treasury debt. This seems harmless at first because the Fed is not increasing its total debt holdings—yet.

They announced this with a seemingly innocuous statement: that they would keep their current level of debt at about $2 trillion. In Fed-speak this means they are clearly worried about the sinking economy, and that they will print as much fiat money as they think is necessary to increase the money supply to induce inflation.

In economic terms, buying Treasury debt is called “monetizing” debt. In plain English it means that the government prints money to pay for its debts. This policy has been the downfall of many governments who destroy their currency through hyperinflation.