Canada has NEGATIVE Economic Inflation

[Solauren]

Inflation turns negative...

Inflation turns negative, falls below zero for first time in 15 years at -0.3 per cent
By Julian Beltrame, The Canadian Press

OTTAWA - Canada's annual inflation rate dipped below zero for the first time in 15 years in June, as the low cost of filling up at the gas station compared to last year dropped the overall index to minus 0.3 per cent.

The statistical oddity was widely expected and due solely to the rapid acceleration of gas prices across Canada at this time last year.

For comparison, consumers paid 24.3 per cent less to fill up at the pump this June than last year, when gas averaged 135.1 cents a litre.

Filling up last month cost a relatively benign 101.6 cents a litre.

Gasoline prices in June were higher than in May, however, producing an even rarer phenomenon of a negative inflation rate when prices in the real world are on the increase measured over the previous month.

The month-to-month movement showed prices rising 0.3 per cent over May on the strength of the cost of gasoline, which was 8.6 per cent higher in June than it was in May.

Economists have stressed that Canada does not have a deflation problem - a broad and prolonged period of falling prices - and that the dip into negative territory will be short-lived.

Gasoline prices, which account for about five per cent of the Statistics Canada basket of goods that comprise the index, peaked at 136.6 cents last July and fell almost immediately afterwards, reaching a low of 76.5 cents a litre in December.

Policy makers worry about deflation because it tends to influence consumers and businesses into postponing purchases in expectation of future lower prices, thereby further weakening an already struggling economy.

But minus gasoline and the energy component, the cost of most things people purchase in Canada is rising, not falling.

Overall, only three of the major components that go into calculation the consumer price index were in negative territory last month - shelter, clothing and footwear and transportation, which includes prices for gasoline.

Statistics Canada said if the cost of energy were taken out of the calculation, the annual inflation rate would have been 2.1 per cent in June, with higher food prices the main contributor.

As well, the Bank of Canada core inflation rate, which measures underlying pressure on prices and excludes volatile items such as energy and fresh fruit, stood at 1.9 per cent in June, near the central bank's desired two-per-cent target.

The last time Canada experienced a negative annual inflation reading was in November 1994, after the government slashed tobacco taxes in an effort to halt a burgeoning illegal cross-border traffic in cigarettes.

Besides gas and energy, the cost of purchasing a passenger vehicle was also lower in June, falling 5.2 per cent from last year. That was up from 6.6 per cent decline registered in May and 8.3 per cent fall in April.

The shelter component slid 0.8 per cent due to lower prices for natural gas and fuel oil, which were 23.7 per cent and 40.6 per cent lower than last year respectively, and savings from lower home prices and mortgage interest rates.

Clothing and footwear fell 3.6 per cent with women's clothing was down 6.1 per cent.

Food was 5.5 per cent higher in June than a year ago, with health and personal care, recreation, education and reading, and alcohol and tobacco also rising.

Regionally, annual inflation is in negative territory in four provinces, with Alberta the lowest rate at -1.6 per cent.

- The annual inflation rate was negative 0.3 per cent in June, says Statistics Canada. Here's what happened in the provinces and territories. (Previous month in brackets):

-Newfoundland and Labrador 0.3 (0.6)
-Prince Edward Island -1.1 (-0.3)
-Nova Scotia -1.1 (-1.1)
-New Brunswick -0.0 (0.2)
-Quebec 0.2 (0.1)
-Ontario 0.0 (0.4)
-Manitoba 0.6 (0.8 )
-Saskatchewan 1.0 (0.7)
-Alberta -1.6 (-0.7)
-British Columbia -0.7 (0.1)

-Whitehorse, Yukon 0.3 (0.4)
-Yellowknife, N.W.T. 0.3 (0.3)
-Iqaluit, Nunavut 3.0 (3.5)

The annual inflation rate was a negative 0.3 per cent in June, says Statistics Canada. The agency also released rates for major cities, but cautioned that figures may fluctuate widely because they are based on small statistical samples (Previous month in brackets):

-St. John's, N.L., 0.9 (1.1)
-Charlottetown-Summerside, -0.5 (-0.8 )
-Halifax, -0.8 (-0.8 )
-Saint John, N.B., 0.1 (-0.1)
-Quebec, 0.4 (0.4)
-Montreal 0.4 (0.4)
-Ottawa 0.2 (0.5)
-Toronto 0.2 (0.5)
-Thunder Bay, Ont., 0.0 (0.3)
-Winnipeg, 0.6 (0.7)
-Regina 1.8 (1.5)
-Saskatoon 0.7 (0.4)
-Edmonton -1.2 (-0.2)
-Calgary -1.5 (-0.7)
-Vancouver -0.5 (0.1)
-Victoria -0.4 (0.4)

[The Grim Squeaker]

So, negative inflation eh? That's known as deflation, and is considered to be a lot worse than normal inflation since it strongly encourages consumers not to spend but to tuck their savings away. Japan has had this issue since it's economy collapsed (and it suits the retirees there fine since it improves the value of their savings, while the economy keeps slowing down).

http://en.wikipedia.org/wiki/Deflation

[Prannon]

Deflation essentially means that money is disappearing from an economy, whereas inflation means that the money supply in an economy is growing. Generally, when the money supply grows, that means that the economy grows. The risk with a growing money supply though is that it may outpace the growth of things-to-buy, in which case you have the classic case of "too much money chasing after too few goods." When the money supply shrinks, you have deflation, and there literally is less money to go around. The pie of money shrinks for the general populace, and also for investors who might be interested in starting or expanding enterprises that would be beneficial to any economic recovery.

This is the most general of general overviews of the inherent evils of deflation. And Grim Squeaker is right. Inflation encourages consumers to spend their money and contribute to the economy since it destroys the value of money over time. Deflation, on the other hand, increases the value of money. Ma and Pa would be heavily encouraged to wait a few months/years to spend their money if its value will actually increase over time. This also is not good for a recovering economy.

So yeah. Bad news.

[Feil]

Um... no, not really. "Statistics Canada said if the cost of energy were taken out of the calculation, the annual inflation rate would have been 2.1 per cent in June, with higher food prices the main contributor." There was a major price spike last year in oil which peaked in June. Obviously, now that oil prices are back down to slightly below their early-2008 levels, comparing the present prices to last year's peak prices is going to show deflation. This isn't bad news. It's not even news at all. Anybody with a graph of 2008 oil prices and a table of average non-oil infaltion rates in Canada could have predicted it as early as February this year. In two or three months, when 2008's sky-high oil prices were going back down, the one-year-back inflation will be back to a normal level, unless the floor drops out from some major industry.

[J]

You guys need too look at the bigger picture, in the context of the current depression recession which is a debt & credit driven event where consumers have had negative savings rates for the past few years, deflation is a good thing. There is no more money to spend, and even if there were, we, as consumers & citizens can't spend our way out of a recession that was caused by too much credit, debt, and spending. It does not work, it's like giving a drunken alcoholic another bottle of beer to sober him up, it's madness. Consumer cannot spend unless they actually have some savings to spare, at the moment they do not, and they will not until they do some SAVING and pay off and/or default their debts. And what does deflations do? It encourages saving and speeds up the default & elimination of bad debts from the system, hence, it's a good thing.

[Arthur_Tuxedo]

Mild deflation is normal in a severe recession, and the deflation that's been seen so far in Canada and the US is too mild to have the catastrophic effects of the deflation seen in the Great Depression. Inflation is what a person needs to plan for in the next decade, not deflation. It's difficult to imagine pumping trillions of dollars into an economy and not seeing huge inflation starting a couple years from now. The nice thing is that most investors don't seem to grasp this yet, so prices of inflation protected bonds are still based on the idea that inflation will be very low over the next decade, making it a good time to buy them.

[Prannon]

I consider myself corrected. I think it's quite telling that most economic points of view point at deflation as being The Really Big Bad, since they're locked into believing that consumer spending has to be constant. It seems that most people point at it and blame it for the Great Depression along with government inaction during that crisis.

So J, what we should really say here is that this deflation is a cyclical phenomenon that we should take advantage of so people save and pay off their debts, and then a few years down the road when we're back in good straights we get back to prudent spending? Am I reading your point correctly?

[ArmorPierce]

Problem is that deflation increases the cost of these debts making it more likely that more people will default.

[xammer99]

Deflation is a very bad thing. Read about the post U.S. Civil War period from 1870 till the 1890's and the federal government's deflationary policy to bring currency values back to pre-war levels. It was a _HUGE_ mess and a major cause of the serious unrest throughout the country, particularly in the midwest amongst farmers. It led to the bimetalism debate, the Grainger Movement, and a bunch of other joy.

Naw, Deflation is not your friend, but then again, neither is the probable hyperinflation we are going to get from the extraordinary levels of deficit spending we have going on now.

[J]

I think it's quite telling that most economic points of view point at deflation as being The Really Big Bad, since they're locked into believing that consumer spending has to be constant. It seems that most people point at it and blame it for the Great Depression along with government inaction during that crisis.

There's actually a very simple explanation; most economists view all credit fueled growth as a good thing, and fail to differentiate between good debts (ie. obtaining a loan to expand a business & improve productivity when needed) and bad debts such as taking out HELOCs to splurge on useless disposable consumer goods. Thus from their point of view anything which discourages people from taking out more credit (in other words, taking on more debt) which deflation most certainly does, is a very bad thing which must be avoided at all costs. It doesn't help that our entire modern economy is based on the continued growth of debts, particularly the financial sector which is absolutely dependant on such, so it should come as no surprise that they regard deflation as the big evil. Deflation will decimate the banks as many of them made bad loans to unworthy borrowers, and as those borrowers default the banks die. See WaMu and Wachovia.

So J, what we should really say here is that this deflation is a cyclical phenomenon that we should take advantage of so people save and pay off their debts, and then a few years down the road when we're back in good straights we get back to prudent spending? Am I reading your point correctly?

It's cyclical but it doesn't have to be, it repeats because we're stupid humans who keep forgetting the past and believing that "this time is different", and it is, until it isn't, and reality crashes down like a ton of bricks. But yes, it's something which rewards those who've lived within their means and put aside some savings, they'll be in much better shape during the downturn and the recovery. Those who HELOC'd their homes to buy 3 SUVs, well, they lose it all. As they should. Being stupid & greedy has a price.

And yes, once the depression recession is over we will get back to sensible spending, at least for a while.

Deflation is a very bad thing. Read about the post U.S. Civil War period from 1870 till the 1890's and the federal government's deflationary policy to bring currency values back to pre-war levels. It was a _HUGE_ mess and a major cause of the serious unrest throughout the country, particularly in the midwest amongst farmers. It led to the bimetalism debate, the Grainger Movement, and a bunch of other joy.

There was a lot more to that than the government's deflationary policy. There also was a huge bubble in railways & construction which imploded in 1873, taking the banking sector with it. Add deflation in the form of the Coinage Act, a big mess in Europe, trade protectionism, bond auction failures, and many other fun things. It was also a very different time than today, the main industries in the US were agriculture and railways, both of which were heavily dependant on loans & credit, far more so than today's economy (save the financial sector), which is why deflation had a far harsher effect back then than it does today.

Naw, Deflation is not your friend, but then again, neither is the probable hyperinflation we are going to get from the extraordinary levels of deficit spending we have going on now.

Hyperinflation assumes a fiat money system and a means for putting the printed bills into circulation, we have neither. Almost everyone believes we have a fiat money system, we don't, we have what's known as a credit-money system where credit, that is debts, spends just like money. Which means our monetary base is NOT the dollar bills real & electronic we have in circulation, but all those bills, plus all credit cards, mortgages, car loans, business loans, lines of credit, student loans, equipment leases, and many others. In addition it should include the equity value of every residence in the US since any home with equity can potentially be HELOC'd and turned into money. Add it all together and it's something like $30 trillion at a minimum.

So here's how it works. Since money can be pulled from homes, they are part of the monetary base. Which means when their value gets destroyed, so does the monetary base of the US. The value of the US residential real estate market is estimated to be around $20 trillion, and in the past year or so that market's lost roughly 20% of its value, meaning $4 trillion went poof from our monetary base in housing alone. Add in the budget deficit & other loans and that's probably around $7 trillion in T-bills that need to be printed up and sold to balance the books and keep the monetary base constant. The US is having enough trouble selling $2-3 trillion this year, $7 trillion would guarantee the collapse of the US T-bill market.

The other part of the equation for hyperinflation is getting the printed money to circulate, that is we need to get the banks to loan it out or we put it directly in the hands of the consumer in hopes that he spends it. Note that we've double the monetary base in the last year and we have no inflation, this is because the money isn't circulating. It's just sitting around in bank vaults because there's no one remotely worthy to loan the money to who doesn't already have a loan, and if the banks loaned it out they'd violate their reserves ratios and get shut down by the FDIC since they're completely broke, and have been for over a year. Mailing the money to consumers isn't guaranteed to work either since few people are in a spending mood, most likely the money is used to pay down bills & debt and anything left over is deposited back into the bank vaults where it sits around doing nothing. Inflation doesn't happen unless the money is circulating and chasing goods & services.

Short of mailing everyone $10 million, hyperinflation isn't likely. Despite all the stupid things the government has done so far in dealing with the current recession, I don't think they're dumb enough to try the proverbial "helicopter drop" of money.

[Surlethe]

Mild deflation is normal in a severe recession, and the deflation that's been seen so far in Canada and the US is too mild to have the catastrophic effects of the deflation seen in the Great Depression.

Mind, the catastrophic effects of the deflation seen in the Great Depression were intimately linked to the cause of that deflation - i.e., the complete and total collapse of the US financial system. A better comparison would be to Japan in the 1990s. In fact, one of the reasons we haven't seen such deflation is because we've been so afraid of it, we've been pumping money into the economy left and right, propping up dead banks, etc.: we have learned the lessons of the Great Depression. The real question is whether we have gone too far the other way; the money the government has spent trying to restart "growth" (as if the economy is a lawn mower engine you can start by adding gas, spraying the intake with starter fluid, and tugging away at the cord) would probably have been better spent setting up a social safety net so that the human cost of the recession would be limited, even at the expense of a longer downturn.

@J: I'm surprised you're not a monetarist, advocating a money supply governed by Friedman's Rule, yet.

[J]

@J: I'm surprised you're not a monetarist, advocating a money supply governed by Friedman's Rule, yet.

Friedman's Rule assumes a fiat money system, which we don't have. We live in a credit-money world*.
It doesn't apply to our reality of a credit-money system so I see no reason to use it.


*see Steve Keen's DebtWatch No 31, in fact, read all of his stuff because it actually reflects reality and attempts to model it.

[Surlethe]

I'm not sure I understand your characterization of the US system as not fiat - technically it is, because the dollar is declared to be legal tender for settling debts. Even if we have lots of very liquid assets sitting around, the Fed still controls the money supply; if (as Friedman was) one is willing to accept credit crunches, deflation, and unemployed financiers when bankers are stupid, the Fed ought to have no problem implementing Friedman's rule.

[TheKwas]

J, what's your education in economics?

[J]

I'm not sure I understand your characterization of the US system as not fiat - technically it is, because the dollar is declared to be legal tender for settling debts. Even if we have lots of very liquid assets sitting around, the Fed still controls the money supply; if (as Friedman was) one is willing to accept credit crunches, deflation, and unemployed financiers when bankers are stupid, the Fed ought to have no problem implementing Friedman's rule.

Technically you could say it's a fiat system since the government prints the bills and says they're legal tender, but the problem here is you're only looking at a small part of the whole, particularly if we're only looking at the part over which the Fed has control, that being the monetary base or M0, which at $1.7 trillion is less than the amount of consumer credit outstanding ($2.5 trillion or so, mostly credit cards & car loans, doesn't include mortgages, HELOCs). The Fed does not control the broader categories of money such as the M1 (hey, how's that M1 multiplier doing? Oops...), M2 and MZM measures of the money supply, and it certainly has zero control over the bond market where debts are sold for money. Nor does it have control over credit cards and loans, the Fed can't add nor pull $500 billion from the consumer credit balance like it does with the M0 supply. The Fed can try to jawbone and influence it, but it doesn't exercise any direct control.

The point is this: A fiat money system assumes the government and central bank has nearly complete control of the money supply, and can print & poof dollars at will. In our real world it does not, it can only do so with a small subset of the money supply, that is the M0 measure. The rest, that is HELOCs, treasury bonds, consumer credit, business credit, and so forth, all of which are "money good" and add up to tens of trillions of dollars will do whatever the market pleases. It's out of the control of government and central banks. We have, as Prof. Steve Keen notes, a credit-money system with a small fiat money subset, it's a credit-money dog with a fiat money tail, and the tail can't wag the dog.

J, what's your education in economics?

I don't have one, unless I count the intro course I had to take as part of my course distribution in university. It's all self-taught plus on the job training since I've been working with foreign trade & economics a lot for the last little while.

[Surlethe]

Technically you could say it's a fiat system since the government prints the bills and says they're legal tender, but the problem here is you're only looking at a small part of the whole, particularly if we're only looking at the part over which the Fed has control, that being the monetary base or M0, which at $1.7 trillion is less than the amount of consumer credit outstanding ($2.5 trillion or so, mostly credit cards & car loans, doesn't include mortgages, HELOCs). The Fed does not control the broader categories of money such as the M1 (hey, how's that M1 multiplier doing? Oops...), M2 and MZM measures of the money supply, and it certainly has zero control over the bond market where debts are sold for money. Nor does it have control over credit cards and loans, the Fed can't add nor pull $500 billion from the consumer credit balance like it does with the M0 supply. The Fed can try to jawbone and influence it, but it doesn't exercise any direct control.

The Fed does not directly control them, but it does theoretically control interest rates. Controlling interest rates, it controls the market for loans. Sure, in practice it might be unwilling to let the banking system hang out to dry when bankers make unrealistic assumptions, but if the Fed adopted Friedman's rule and simply increased the money supply at 3% annually, we wouldn't have the tail wagging the dog.

The point is this: A fiat money system assumes the government and central bank has nearly complete control of the money supply, and can print & poof dollars at will. In our real world it does not, it can only do so with a small subset of the money supply, that is the M0 measure. The rest, that is HELOCs, treasury bonds, consumer credit, business credit, and so forth, all of which are "money good" and add up to tens of trillions of dollars will do whatever the market pleases. It's out of the control of government and central banks. We have, as Prof. Steve Keen notes, a credit-money system with a small fiat money subset, it's a credit-money dog with a fiat money tail, and the tail can't wag the dog.

I think you're mistaken about a fiat money system. All fiat money says is that the government declares and prints legal tender; it doesn't make any assumptions about a central bank. Therefore, the money supply is entirely (theoretically) within the control of the government. The logic of Keen's argument relies on the assumption the Fed can't allow a credit crunch, which is an assumption no libertarian - monetarist, in particular - would make.

[J]

The Fed does not directly control them, but it does theoretically control interest rates. Controlling interest rates, it controls the market for loans.

Theory doesn't work in practice, at least not in the last year or so. If what you say is true, then changes in the Fed discount rate will precede changes in the effective Fed funds rate. Go to this NY Fed page and check the boxes for the official discount rate and the effective funds rate and it'll make a nice chart for your date range. Since last summer, changes in the official discount rate lag behind changes in the effective funds rate, meaning that the Fed has lost control of interest rates and is merely following the market. It gets pretty ugly around October of 2008.

Furthermore, longer term loans such as commercial papers, mortgages, and various sorts of consumer loans are all indexed off the yield on T-bills and T-notes, plus a spread. For example a 30 year mortgage is tied to the yield of a 10 year T-note, plus ~2%. The Fed cannot control the yields on Treasuries, Helicopter Ben tried to do this via quantitative easing and outright printing, it failed, and the yield on the 10-year (and everything longer than a year) got away from him (printing started in March). (More data the the St. Louis Fed)

Sure, in practice it might be unwilling to let the banking system hang out to dry when bankers make unrealistic assumptions, but if the Fed adopted Friedman's rule and simply increased the money supply at 3% annually, we wouldn't have the tail wagging the dog.

Hmmm? I'm not quite clear on this, are you saying that if the Fed increased the money supply at 3%/year, the money supply would be larger than the credit/debt supply after a given amount of time?

I think you're mistaken about a fiat money system. All fiat money says is that the government declares and prints legal tender; it doesn't make any assumptions about a central bank. Therefore, the money supply is entirely (theoretically) within the control of the government.

Right, but the problem we have is that credit = money, and credit is neither declared, printed, nor controlled by the government. A bank can give all its customers a $10k line of credit, said credit spends just like a stack of Benjamins printed by the government. In effect the bank has just printed up 100 Benjamins for each of its customers, as said credit can be exchanged for a stack of bills. Or California, it's printing up a boatload of IOUs which are directly exchangeable for money. The government only has control over a small subset of what is "money", that is the fiat money tail of the credit-money dog.

The logic of Keen's argument relies on the assumption the Fed can't allow a credit crunch, which is an assumption no libertarian - monetarist, in particular - would make.

Are you referring to the following?

If a firm accesses its line of credit to, for example, buy a new piece of machinery, then its debt to the bank rises by the price of the machine, and the deposit account of the machine’s manufacturer rises by the same amount. If the bank that issued the line of credit was already at its own limit in terms of its reserve requirements, then it will borrow that amount, either from the Federal Reserve or from other sources.

If the entire banking system is at its reserve requirement limit, then the Federal Reserve has three choices:

* refuse to issue new reserves and cause a credit crunch;
* create new reserves; or
* relax the reserve ratio.

Since the main role of the Federal Reserve is to try to ensure the smooth functioning of the credit system, option one is out—so it either adds Base Money to the system, or relaxes the reserve requirements, or both.

This is what our central banks do, so I do not see a problem with using it as an assumption.

[Surlethe]

Hmmm? I'm not quite clear on this, are you saying that if the Fed increased the money supply at 3%/year, the money supply would be larger than the credit/debt supply after a given amount of time?

...

Are you referring to the following? ... This is what our central banks do, so I do not see a problem with using it as an assumption.

I think this is the heart of the disagreement. Yes, I was referring to what you quoted. My contention is theoretical: if the Fed were truly independent and did not have as one of its goals a stable credit system, it would not be compelled to respond when the banking system came to it with outstretched hands. That's what I meant by not permitting dismissal of option one. A Fed following Friedman's rule would look on dispassionately as the banking system collapsed and rebuilt itself: there would probably be a long drawn-out credit crunch as the economy adjusted to a constantly-growing money supply. Ultimately, I would expect the money supply to be larger than the debt supply after the economy finished adjusting.

Practically, you're probably right; the financial system has too much influence (successful rent-seeking, I think is the proper term) and society has too little will for belt-tightening for the Fed to actually maintain the independence and discipline required for them to implement Friedman's rule. But as an ideal world to push for, it would be great for the Fed to rise above the financial rent-seeking that drives the creation of credit money, and that's all I'm saying.

[J]

I think this is the heart of the disagreement. Yes, I was referring to what you quoted. My contention is theoretical: if the Fed were truly independent and did not have as one of its goals a stable credit system, it would not be compelled to respond when the banking system came to it with outstretched hands. That's what I meant by not permitting dismissal of option one. A Fed following Friedman's rule would look on dispassionately as the banking system collapsed and rebuilt itself: there would probably be a long drawn-out credit crunch as the economy adjusted to a constantly-growing money supply. Ultimately, I would expect the money supply to be larger than the debt supply after the economy finished adjusting.

I see. Well, it's possible in theory but there'd have to be certain conditions in place; for instance all levels of government would have to run a fairly balanced budget or otherwise that's a few hundred billion in credit creation via bond sales every year unless we print away & monetize the debt. Monetizing makes the currency traders unhappy and we have a similar situation as a couple paragraphs down.

The other issue is if there's a significant differential between the growth rate of money and that of GDP, this has the potential for interesting, and not necessarily in a good way, effects in the Foreign Exchange market. The FX crosses could get really weird as traders try to balance & profit from their currency portfolios which is not going to be fun for trade, and that will have some unpredictable consequences for the economy.

Suppose we have two countries, both of which are adding 3% to their money supply each year. Country A has a GDP growth of 4% a year while Country B is stuck at 1%, ForEx traders will go "hey, wait a minute, Country B is printing and devaluing their money", they all punch their sell orders for Country B's currency and go running for the safety of Country A, and now you have an FX dislocation where suddenly, Country B needs to pay twice as much for all imports. If Country B is mostly an export economy, well, it's not too bad and it might even be good, but if it depends on imports it just got forcibly sodomized.

I'm also unsure if the rate of credit creation can be slowed down below that of money creation without truly draconian regulations and enforcement. It would imply the end of fractional reserve lending (I think) and make loans nearly impossible to come by, which certainly kills credit creation but I'd hate to think what that does to our modern economy & society.

---

Ultimately I don't believe the problem lies with the Fed, the government, the regulators, our society, Wall Street, or any one party. It's all of them, the entire system is broken. Our system assumes constant growth, requires constant growth, and tries to create growth at all costs until it can't, at which point we have what's going on right now.

[Surlethe]

I think this is the heart of the disagreement. Yes, I was referring to what you quoted. My contention is theoretical: if the Fed were truly independent and did not have as one of its goals a stable credit system, it would not be compelled to respond when the banking system came to it with outstretched hands. That's what I meant by not permitting dismissal of option one. A Fed following Friedman's rule would look on dispassionately as the banking system collapsed and rebuilt itself: there would probably be a long drawn-out credit crunch as the economy adjusted to a constantly-growing money supply. Ultimately, I would expect the money supply to be larger than the debt supply after the economy finished adjusting.

I see. Well, it's possible in theory but there'd have to be certain conditions in place; for instance all levels of government would have to run a fairly balanced budget or otherwise that's a few hundred billion in credit creation via bond sales every year unless we print away & monetize the debt. Monetizing makes the currency traders unhappy and we have a similar situation as a couple paragraphs down.

Indeed, but in the long run the deficits would have to be balanced. Basic macro: the government can influence short-run inflation by creating debt via bond sales, but in the long run the inflation rate is almost entirely controlled by the change in the money supply (this is an empirical fact that lends weight to the equation of exchange as an important, even if incomplete, model). Basically, an entirely independent Fed consistently running on a Friedman rule is going to essentially force the government to run a balanced budget by refusing to monetize debt - any debt creation beyond that predicted by reserve ratios ultimately has to be balanced by creation of actual money, or else the entire house of cards comes crashing down, as we've seen.

The other issue is if there's a significant differential between the growth rate of money and that of GDP, this has the potential for interesting, and not necessarily in a good way, effects in the Foreign Exchange market. The FX crosses could get really weird as traders try to balance & profit from their currency portfolios which is not going to be fun for trade, and that will have some unpredictable consequences for the economy.

Suppose we have two countries, both of which are adding 3% to their money supply each year. Country A has a GDP growth of 4% a year while Country B is stuck at 1%, ForEx traders will go "hey, wait a minute, Country B is printing and devaluing their money", they all punch their sell orders for Country B's currency and go running for the safety of Country A, and now you have an FX dislocation where suddenly, Country B needs to pay twice as much for all imports. If Country B is mostly an export economy, well, it's not too bad and it might even be good, but if it depends on imports it just got forcibly sodomized.

Not sure if I agree with this, for a couple of reasons. First, Friedman's rule is more specifically that the money supply is increased at a rate about equal to the long-run growth rate so that inflation stays at about 0%. For the US, this is about 3%, but for other countries, such as the slower economies of Western Europe, it's closer to 1.5-2%, so the money creation would proceed according to their respective rates. Some years it will be faster, others slower, but on the whole it will average to the long-run growth rate.

And that brings me to the second point: generally a dislocation the way you're describing it is going to be a short-run event caused by short-run factors. Perhaps it might occur if one country abruptly switched to constant money supply growth without warning, but in general, since GDP motion is pretty continuous (i.e., countries don't shoot from 1% to 4% growth in a matter of days or weeks), the motion in the currency markets will be similarly continuous, and will roughly act to maintain purchasing parity.

Actually, I'll guess that the currency markets and their effects on trade will act to move GDP back toward the equilibrium rate (supposing both countries have long-run growth of 3%, in accord with Friedman's rule). If the FX markets move from A's currency to B's, then A's exports will look more desirable to B and, conversely, B's exports will look less desirable to A. Therefore, A's net exports will increase, boosting the economy's growth, while B's will decrease, pushing its growth rate down.

I'm also unsure if the rate of credit creation can be slowed down below that of money creation without truly draconian regulations and enforcement. It would imply the end of fractional reserve lending (I think) and make loans nearly impossible to come by, which certainly kills credit creation but I'd hate to think what that does to our modern economy & society.

I'm betting that the market would reign in the rate of credit creation through brutal Darwinian methods. A credit crunch followed by a financial panic is the natural outcome of credit creation consistently outpacing money creation: unwise lending practices lead to mass defaults, interest rates go sky-high, and the entire system seizes up; bank after bank collapses, and the economy goes down the shitter. Now, the financial system would not be permanently fucked, but if the Fed tossed it under the bus for its mistakes once, it would take that history into account and be more restrained in the future (moral hazard and all that).

My impression of the endogenous money theory you linked and described is that it's a version of the neoclassical theory where the Fed continually conducts low-level bailouts of financial system's rash decisions. If the Fed remains aloof, I'd think reality would look a lot more like neoclassical theory's predictions: fractional-reserve banking would play a much larger role in the creation of money. And banks would be much more cautious in credit-creation because they'd know they couldn't count on the Fed for extra reserve loans. (I'm not sure I entirely agree with Keen's analysis, and I'm reserving judgment for a later date since math has been sucking up a lot of my brainpower the last few months, but assuming it's correct this is what I'd think you'd expect.) Absent regulation, you'd probably also see an enhanced business cycle with regular bank panics, similar to the 1800s (a precious metal standard takes the money supply out of the government's hands much as an independent Fed does; the difference is that the former results in random fluctuations of currency depending on mining, while the latter is much more controlled).

Anyway, to bring the discussion full circle to practical implementation, if you were to do Friedman's rule in the US, you'd have to get Congress to write a 0% inflation rate target into the Fed's charter. Since the Fed would no longer be trying to micromanage the economy, and especially would be unable to bail out banks by creating money, you'd have to write and enforce much stricter financial regulations to avoid future credit crunches. Ideally, this would be combined with some sort of limit on spending: Constitutionally regulate government deficits in some countercyclical way and require it to regularly pay down the debt when growth is above 0%? Anyway, this would probably be impossible in the US without a populist revolution, since the financial system has far too much rent (on principle, they'd never support a Fed that would countenance prolonged deflation!), but it's a nice bit of counterfactual speculation.

---

Ultimately I don't believe the problem lies with the Fed, the government, the regulators, our society, Wall Street, or any one party. It's all of them, the entire system is broken. Our system assumes constant growth, requires constant growth, and tries to create growth at all costs until it can't, at which point we have what's going on right now.

I agree and disagree here. On the one hand, criticism of our social emphasis on "growth at all costs" is certainly, I think, valid. Prima facie, criticism of the assumption of constant short run growth is also valid - you'd have to be a moron to deny the existence of the business cycle. That's how an economy works.

On the other hand, if you're directing criticism at the assumption constant long-run growth, I'm not sure I agree. To my knowledge, long-run growth comes from two sources: the procurement of new, and replacement of old, per-capita capital and the development of new technology. Underlying the first is the successful exploitation of natural resources. Neither is poised to stop, although you might argue - and I'd agree - that the transition from an oil base to a nuclear-electric base will be long, painful, and slow equilibrium growth significantly while it occurs. As long as those two conditions are in place, although the economy will oscillate around the long-run growth path and the path itself might change based on the efficiency of the economy and exogenous conditions, it will continue to grow.

[aerius]

Practically, you're probably right; the financial system has too much influence (successful rent-seeking, I think is the proper term) and society has too little will for belt-tightening for the Fed to actually maintain the independence and discipline required for them to implement Friedman's rule. But as an ideal world to push for, it would be great for the Fed to rise above the financial rent-seeking that drives the creation of credit money, and that's all I'm saying.

As a sidenote, I like how economists have come up with a cute term for organized fraud and leeching off the work of others. It's not fraud, buying off the government, and leeching off society, it's "rent-seeking". Gotta love it.

And while I won't get into the whole Friedman's Rule and monetary system debate, it seems to me that the implementation of his rule in an idealized system of some sort is a hell of lot like Communism; sounds great in theory, but works like shit in practice because many of the conditions needed for it go completely against human nature. And since it can't work, then why the hell should we care about it other than as an intellectual exercise? It doesn't reflect reality, it most likely can't work in reality, so let's leave it in the Ivory Towers and work on stuff that does work.

[J]

First, Friedman's rule is more specifically that the money supply is increased at a rate about equal to the long-run growth rate so that inflation stays at about 0%. For the US, this is about 3%, but for other countries, such as the slower economies of Western Europe, it's closer to 1.5-2%, so the money creation would proceed according to their respective rates. Some years it will be faster, others slower, but on the whole it will average to the long-run growth rate.

And that brings me to the second point: generally a dislocation the way you're describing it is going to be a short-run event caused by short-run factors. Perhaps it might occur if one country abruptly switched to constant money supply growth without warning, but in general, since GDP motion is pretty continuous (i.e., countries don't shoot from 1% to 4% growth in a matter of days or weeks), the motion in the currency markets will be similarly continuous, and will roughly act to maintain purchasing parity.

In the long run you're correct, at least in theory, however in the shorter term there's a lot of potential for damage, just as there is in our real world system. While monetary growth equals the long term GDP growth, there will be variations in the short-term and we can and will see significant swings between countries. The problem with ForEx is that it's the most highly leveraged form of trading, a small 1-2% move can wipe out a trader unless he's well-hedged and trigger a cascade of margin calls and forced selling or short covering (incidentally, this is why we're seeing almost daily 1-3% moves in the FX market in the past year, whereas before it was rare to see moves of this size). We could of course try & reform the global FX market and take down the leverage ratio, but then those trillions in FX money will leave the game to chase other markets so we could have an unintended bubble somewhere.

Actually, I'll guess that the currency markets and their effects on trade will act to move GDP back toward the equilibrium rate (supposing both countries have long-run growth of 3%, in accord with Friedman's rule). If the FX markets move from A's currency to B's, then A's exports will look more desirable to B and, conversely, B's exports will look less desirable to A. Therefore, A's net exports will increase, boosting the economy's growth, while B's will decrease, pushing its growth rate down.

Not necessarily. Take the OPEC nations' trade with the US which is essentially oil for dollars. If the USD is devalued then the price of oil goes up and/or the Arabs decide to sell their oil to someone else, say, Japan. The US is screwed either way since its dependant on oil and now has to pay more and/or scale back consumption which further destroys its economy. In this case we end up with a positive instead of negative feedback loop.

I'm also unsure if the rate of credit creation can be slowed down below that of money creation without truly draconian regulations and enforcement. It would imply the end of fractional reserve lending (I think) and make loans nearly impossible to come by, which certainly kills credit creation but I'd hate to think what that does to our modern economy & society.

I'm betting that the market would reign in the rate of credit creation through brutal Darwinian methods. A credit crunch followed by a financial panic is the natural outcome of credit creation consistently outpacing money creation: unwise lending practices lead to mass defaults, interest rates go sky-high, and the entire system seizes up; bank after bank collapses, and the economy goes down the shitter. Now, the financial system would not be permanently fucked, but if the Fed tossed it under the bus for its mistakes once, it would take that history into account and be more restrained in the future (moral hazard and all that).

My impression of the endogenous money theory you linked and described is that it's a version of the neoclassical theory where the Fed continually conducts low-level bailouts of financial system's rash decisions. If the Fed remains aloof, I'd think reality would look a lot more like neoclassical theory's predictions: fractional-reserve banking would play a much larger role in the creation of money. And banks would be much more cautious in credit-creation because they'd know they couldn't count on the Fed for extra reserve loans. (I'm not sure I entirely agree with Keen's analysis, and I'm reserving judgment for a later date since math has been sucking up a lot of my brainpower the last few months, but assuming it's correct this is what I'd think you'd expect.) Absent regulation, you'd probably also see an enhanced business cycle with regular bank panics, similar to the 1800s (a precious metal standard takes the money supply out of the government's hands much as an independent Fed does; the difference is that the former results in random fluctuations of currency depending on mining, while the latter is much more controlled).

I'm not so sure. See, as long as we have fractional reserve lending, the banks can lend out (ie. credit creation) several (or many) times more money than what they hold in reserve. So for instance if the Fed prints up a stack of bills and gives them to the banks, the banks will then lend out several times that amount in the form of various business & consumer loans. If the Fed's newly minted stack of bills is mailed to the people, the money is either deposited into a bank where several times its amount gets lent out or it's spent in a local business where it then finds its way to the bank via business' account and is then lent out as before. Every dollar that's printed by the Fed will make its way to a bank where it's "multiplied" several times through the magic of fractional reserve lending, and since lending is credit creation, the amount of credit created will always be larger than the amount of money printed by the Fed. The credit-money complex remains larger than the fiat dollar money set.

I can think of a couple ways to break the cycle, we can make lending standards so absurdly high that it effectively creates a full reserve banking system and puts credit creation on a 1:1 or lower ratio to money creation, or we can somehow make credit non-fungible with money in the broader marketplace. The latter breaks the credit-money system since credit can no longer be spent like money, so it isn't money anymore and only the Fed's printed fiat money remains.

Anyway, to bring the discussion full circle to practical implementation, if you were to do Friedman's rule in the US, you'd have to get Congress to write a 0% inflation rate target into the Fed's charter. Since the Fed would no longer be trying to micromanage the economy, and especially would be unable to bail out banks by creating money, you'd have to write and enforce much stricter financial regulations to avoid future credit crunches. Ideally, this would be combined with some sort of limit on spending: Constitutionally regulate government deficits in some countercyclical way and require it to regularly pay down the debt when growth is above 0%? Anyway, this would probably be impossible in the US without a populist revolution, since the financial system has far too much rent (on principle, they'd never support a Fed that would countenance prolonged deflation!), but it's a nice bit of counterfactual speculation.

And make the rules & laws even more sacred & impossible to change than the Constitution. It took quite a few decades, but we managed to throw away nearly all the laws & regulations put into place during & after the Great Depression to prevent another similar depression. And here we are. As my husband noted, we may as well find a way to make Communism work for all.

On the other hand, if you're directing criticism at the assumption constant long-run growth, I'm not sure I agree. To my knowledge, long-run growth comes from two sources: the procurement of new, and replacement of old, per-capita capital and the development of new technology. Underlying the first is the successful exploitation of natural resources. Neither is poised to stop, although you might argue - and I'd agree - that the transition from an oil base to a nuclear-electric base will be long, painful, and slow equilibrium growth significantly while it occurs. As long as those two conditions are in place, although the economy will oscillate around the long-run growth path and the path itself might change based on the efficiency of the economy and exogenous conditions, it will continue to grow.

I tend to view it in terms of total energy consumption and efficiency. Everything we do depends on growing, mining, or making something, and technology determines how efficiently we do so and how much we get out of the process. So far everything's gone swimmingly well, maybe too well, but now we're in uncharted waters. Maybe my work has made me a little too contemptuous of our government & industry, I just have a hard time seeing how we can carry out a transition from oil to whatever's next in anything other than a half-baked (err, make that fully baked) fashion.

I don't see growth in the meantime unless we have some widespread societal reforms, as long as we keep fighting to return to the world which was in 2005, we will not progress. Picture it as being caught in a riptide off a beach, you can't swim against the tidal rip and expect to return to your particular patch of the beach where you've laid out your towels & beach umbrella, trying to do so will dump you 10 miles out in the ocean where you'll drown. Rather, you need to swim across the current as it carries you outward, and once you're free you can swim back to the beach, but it'll be a different part of the beach, or maybe a different beach altogether. We need to accept a new reality and build a society & system around it, then, and only then can we continue to grow. Or maybe we'll choose not to grow, as that may be part of accepting our new reality.

We're not doing that, everything we've done (bank bailouts, pumping credit into the system, trying to make housing go up, trying to get securitization moving) is an attempt to return to the world of our past, we're swimming against the riptide and being carried straight out to sea. If we don't stop, we'll pass the point of no return and drown. We need to accept that the past is over and done, we're not going to get out of this mess until we do so.


ps. hmmm...I seem to have taken this way, way, way off topic...ummm...Surlethe, this is all your fault!

[Surlethe]

As a sidenote, I like how economists have come up with a cute term for organized fraud and leeching off the work of others. It's not fraud, buying off the government, and leeching off society, it's "rent-seeking". Gotta love it.

Like any other term, it's got its history. My understanding is that the term started describing actual land renting, and then grew to mean "money you get from merely owning something other people want". From there it grew to mean "money you get from not doing any work"; and from there, it found its natural political application: lobbying.

And while I won't get into the whole Friedman's Rule and monetary system debate, it seems to me that the implementation of his rule in an idealized system of some sort is a hell of lot like Communism; sounds great in theory, but works like shit in practice because many of the conditions needed for it go completely against human nature. And since it can't work, then why the hell should we care about it other than as an intellectual exercise? It doesn't reflect reality, it most likely can't work in reality, so let's leave it in the Ivory Towers and work on stuff that does work.

Well, you might as well say that a noncorrupt government is idealized, since any system run by people will have traded favors, mutual backscratching, etc., so why should we care about it? I actually think that if the government could muster the political will to smack down the business sector, Friedman's rule could be implemented; I'm just cynical that such a general rollback of plutocracy could happen, short of a communist revolution.

PS- I'm headed for the Ivory Tower anyway