Sunday, September 23, 2007

On Gary North's curious deflation call

My opinion was requested on Gary North's analysis that the Fed is deflating, contained in How Bernanke has snookered us all, so I went to his site to check out his views. To my surprise, I discovered that he now charges for his views (fortunately I still get a twice weekly blast, including the article in question from the Daily Reckoning). The cynic in me says that a shift to fee based commentary tends to engender overstated simplistic analysis and the argument that the Fed is deflating when growth in the monetary base is slowing but still positive seems to me an oversimplified overstatement.

But I'll add my two cents worth anyway, and given that my views are still free to you, 2 cents worth for nothing seems like good value to me. Of course, those 2 cents don't buy what they used to.

I assume that Mr. North argues within the framework of the quantity theory of money, i.e. crudely put, more is inflationary and less is deflationary. His conclusion of deflation also assumes stable money multipliers such that a decrease in the monetary base leads to decreases in broader money. If the MBase can fall while broader money supplies rise, the MBase will not be a good predictor as was the case when the money multipliers broke down when the Fed was aggressively adding reserves in the early 90s with little increase in inflation.

Of late the multiplier between the MBase and M2 is rising. Assuming John Williams' Shadow Stats are correct, that between what used to be M3 and the MBase is rising even faster, which suggests, a la, Doug Noland, that things are a bit out of the Fed's control.

I tend to agree with Mr. Noland's view that the monetary system is out of control, although I take a more narrow view of the transmission mechanism. During the Asian crisis, the Asian CBs, once they were forced to admit they had a problem, tried hard to tighten, but resolution of their international deficits swamped their efforts. Their currency overvaluations had first to be resolved before the tightening could have an effect. Thus we saw a large almost one step spike in inflation, as a result of previous monetary easiness and currency overvaluation, followed by a normalization.

The problem, in my view, with traditional quantity theory is that it was based on a far more autarkic model, or at least one in which international imbalances would tend towards balance, as IMF policy requires. Open capital accounts make such analysis much more complex in the event, such as exists now with the US, when international imbalances are large and growing.

I like to think of the accumulated foreign official sector holdings of US$s as "stored deflation" in that it gives these foreign CBs bonds to sell (the quantity of which, in toto, is far in excess of what the Fed currently holds, btw) which, when sold, will withdraw liquidity from the market, other things equal.

If and when the accumulation of these holdings goes into reverse, as they must, assuming the current system isn't changed, the Fed will face a similar dilemma as the Asian CBs. If they want to stop an inflationary spiral, they will need to tighten internally while the international markets are tightening for them. That is, US bonds will need to find their clearing yield based on private sector preferences, a yield I believe will have 2 digits, not 1.

But the Fed faces a problem the Asian CBs didn't have to worry (much) about, the derivatives monster. A spike in interest rates will push the big banks' derivatives books into insolvency, and as the derivatives books go, so do the banks themselves.

Assuming the Fed doesn't want that to happen, they will need to be the buyer of last resort in the bond market. That is, in order to keep the financial system functioning reasonably smoothly, without letting interest rates spike, the Fed will need to take these foreign official sector holdings released into the market on its balance sheet, which means the monetary base will rise.

In a sense, this is almost the reverse of the problem Greenspan faced in the early 90s as foreign holdings started to rise dramatically. The buzz phrase back then was "pushing on a string", the Fed let the MB grow by double digits for years without much effect on inflation. Now, using the same metaphor, if the Fed pulls on that string, it will break.

The underlying problem is this- bond yields are, due to years of public sector intervention, way too low to attract private sector interest. Somebody has to eat this loss, and in the event, as I suspect, this somebody is the Fed, Gary North will see the monetary base expand rapidly (as he notes at the end of his analysis, with agreement from me) and inflation will be the result, whether Bernanke likes it or not.