MAKING CLAIMS ABOUT THE MONEY SUPPLY

The concept of the money supply is central to understanding events and prospects in modern, mixed economies. What the money supply is doing, and what the manipulators of the money supply are doing, are key indicators of immediate and intermediate economic events. In my blog, I refer to the money supply often. Analysts and writers who are influenced by the Austrian school of economics, and here, as always, I am referring to von Mises and his predecessors, will refer to the money supply in understanding business cycles in modern, mixed economies. So, how do we know what is happening with the money supply?

From the U.S. government we have several measurements of the money supply, called M1, M2, and M3 (no longer published). There is also MZM, my preference generally. There are also indicators such as the balance of payments, for indications of the outflow of money. Another important tool to keep in mind is the changing level of bank loans. The past two asset price inflation events have both been created by bank loans. Finally, there are some private measurements available at various websites.

As with any measurement, it is absolutely necessary to clearly understand what is being measured, how, and how those measured elements relate to your conceptual framework. You must also know how the measurement in question performed in the past, i.e., what the results meant and how the economy performed.

All too often, what I see when reading other authors is that they have chosen tools that reinforce their own expectations. They ignore other tools that currently are pointing in other directions. That is especially true of the people who are expecting hyperinflation in today’s world. I certainly sympathize with the hyperinflationists. There is reason to be concerned, from what I can see. But I do not accept their knee jerk approach.

My approach is to look at all of the indicators that I have identified and try to make sense of them and what is happening in the economy.

One indicator can also be the interest rate set by the Federal Reserve Board. One influential online group recently used the argument that since the Fed had set the Reserve rate at zero, there had been billions of dollars created. In other words, it was automatic. If the interest rate is set well below a market rate, then money will be created. This same reasoning occurs when the Fed creates reserves. For example, in 2008, the Fed created nearly $1T in member bank reserves. People immediately said that the Fed had created billions of dollars in the economy. But, there is a difference here. Lowering the interest rate and creating reserves are not the same as actually printing money. Printing money and shoving it into people’s hands through government handouts or expenditures or payrolls put money into circulation immediately. That money is in play.

But the actions of the Fed are different. The Fed can create reserves and lower interest rates, but the Fed depends upon the banks and businesses to actually put the money into play. If the banks do not lend (which requires a borrower) then nothing happens. That is what we have seen over the last two years. The Fed has tried to put more money into play, but the banks have not cooperated. The Fed’s influence is not automatic. The claim that low interest rates have created massive amounts of money is not substantiated by the level of bank loans and other indicators, e.g., MZM. It is important to objectively understand how this stuff works.

I saw an argument that claimed that it is wrong to argue if the money supply has expanded or not. According to this person, looking at the facts was not thinking in principles. Instead, he said that we should state that the Fed is, “The reality is that money has been created out of nothing and it therefore will alter behavior (otherwise why do it?). … that this money has created price increases in several sectors, commodities and oil among them, despite the ‘we haven't really increased the money supply’ theory.” Somehow, for this person, thinking in principles does not include relating one’s ideas to the real world nor having a sound, fact based argument for our position. We merely sate that the government has made money that raised prices without being able to even demonstrate it, not to mention, prove it. It does not include looking at the present, specific situation and making sense of it or presenting your position in the context of the crisis we actually face. I do not know how this person thinks that we can be convincing or persuasive.

Some will then point out that the Fed has recently been buying Treasuries from the Government directly, thus putting newly made money directly into the economy. That is true. That step leads directly to expanding the money supply and to affects in the economy, generally, to increases in consumer prices. However, given the size of the economy vs. the amount of purchases the Fed has made, the effect is not particularly significant. We would have to see closer to $1T of Fed direct purchases from the Treasury for the Fed to trigger consumer price rises.

Potentially more significant would be the return of sizable amounts of the dollars held overseas via Treasury Bond purchases. With a $1.7T deficit, if $1T was financed from overseas, we would see a mammoth flooding of dollars flooding our markets. This returning money, often as much as $500B in the past few years, has been a source of some of our price inflation. Higher amounts would put more pressure on prices.

Yet another recent argument that I have seen implies that in today’s world, real market forces (as opposed to governmental influences) have no impact on prices. The field of play, this person held, is controlled completely by governments. Again, there was no attempt to demonstrate how this is so. The position was presented as necessarily following from the fact that governments act and have bad influences, there were bad events happening (the raising of oil prices), therefore, it was completely because of government intervention. No facts about the current situation were necessary.

Thus, it is important to look at the various moving parts of the make up of the money supply and their impact. Then, it is imperative that your understanding relates these different measuring tools to the real world in an objective manner. For example, look at M2 http://research.stlouisfed.org/fred2/series/M2?cid=29 , the simple view would be that inflation is rampant and that prices should be going through the roof. But have they? I just saw an observer on PJTV who kept track of his expenditures of a few items over the last year. His personal stats did show across the board significant price increases. What is your experience? Mine has been that there has been little change for some time, with some bigger increases just recently. Even if prices are going up, does that mean that the hyperinflationists are correct in saying that general, average price increases of 20% or more (hyperinflation) are beginning soon? That is a big jump.

Some argue that because certain prices went up, there is inflation. Most recently, these are the prices of gold, oil, and food commodities. But prices go up and down for various reasons. That is especially true in a “mixed economy”, where government actions have hidden, unforeseen, and often weird, effects. You have to be careful when attributing reasons for price movements, which means actually finding a cause and effect. For example, the decades old efforts by governments around the world to control oil discovery and production in many different ways means that there are restrictions on production and supply. The result is an artificial shortage of oil. Supply shortages would mean higher prices, given level demand. In our situation today, and for the last several years, demand is actually growing. So you have three different factors pushing the price of oil upward, including whatever inflationary pressure there might be. But the price would be going up anyway. When discussing the price of oil, you cannot objectively leave out the supply restrictions and all of the reasons for increases in demand.

Turning back to the analysis of the money supply, my overall point is that many things are happening within an economy that will affect whatever actions governments take to manipulate the money supply. How it plays out and what the ultimate effect will be depends upon those factors. To accurately explain events, you need to have identified the actual causal connections and explained other details that may seem to be contrary to your conclusion. A site or writer who ignores those contrary elements only means that they are pushing their pet theory without actually relating it fully to reality. Economics is a difficult science, but it is a science. Economics is about the real world, and one’s standard of truth must be consistency with reality.

The Fraud of Waste and Fraud

“There are widespread misperceptions about the state of the federal budget. A majority of voters incorrectly believes the federal government spends more on defense/foreign aid than it does on Medicare and Social Security (63%). Also, a similar majority (60%) incorrectly believes problems with the federal budget can be fixed by just eliminating waste, fraud and abuse.”

This quotation is from a recent poll.  Read the top of the second page.

There we are. People are believing the politicians, especially the liberals. People are not connecting any legitimate idea of waste to a $1.7T deficit. There is a disconnect. This disconnect is going to get us into bigger trouble than any of the other fears that we have considered. This disconnect means that when the meltdown into depression begins people will again be open to the claim that capitalism is at fault. Potentially, our only safeguard will be that the meltdown will be bigger than the last one and the authorities will not be any more prepared than they were last time. They will not have an organized, planned capability to meet the various challenges that a meltdown in a complex civilization like ours will create.

Please allow me to offer my small support to Yaron Brook. He is absolutely right that the immediate present is the best time we have ever seen to make our point, that capitalism, freedom, egoism, and reason are the correct path to take. We may not have another chance.

It is sometimes a bad sign when someone suggests that their own particular area of interest is the most important. I don’t wish to suggest that other areas, say, health care or the war on terror, are minor or less scary. I merely want to say that if we don’t focus on the debt and the deficit and get that turned around, we won’t have the time or energy to spend on other things. A depression in the U.S. will be very bad because we have so far to fall and we depend upon very complex and highly sophisticated economic interrelationships. Just look at the problems we begin to face when the price of gas goes up some. Think of the problems we might have if the supply of gas is greatly reduced. Just think of the process of getting food into our cities, not to mention medications.

Let me suggest another way of looking at your activities. It seems to me that there are several ways of deciding what to focus on. One, which I would normally think is the best, is to focus on what interests you the most. If your interest, for whatever reason, is running a business, for example, it would be appropriate for you to spend your time and energy to free up business practices.

But, consider this, if there is a tidal wave coming at your shoreline residence, you are risking you life by arguing about business regulation. The deficit and debt issues facing us today and the next few years are the economic equivalent of a tidal wave. It will sweep everything before it. We need to either stop the tidal wave or protect ourselves from it as best we can. Look at what is happening in economies much less developed than our own that are having to face up to their debt. What is bad for them will be worse for us.

On the “Front Page” on JPTV, Yaron Brook and his friends try to emphasize that what is happening with our debt is not just another big deficit, like we have seen in the past. The ObamaDeficit is larger by several orders of magnitude, and projected to become bigger. That is bad enough, until you remember that Obama’s predictions are based upon rosy estimates of the economy. It is a tidal wave.

So what do we need to do? There are two avenues to pursue to achieve a solution to this problem. As with any question of budgeting, there is income and there is spending. Most addressing this issue are focusing on spending, especially the entitlement programs. I don’t want to imply that cutting spending isn’t important, it is. Certainly, much of what Obama has added to the budget can be safely discarded (like his medical programs).

Attacking the entitlement programs is a problem. It isn’t that people, especially younger people, aren’t able to accept cuts in entitlement programs. But you do have to find a way to communicate that you don’t want to kill all the old folks. If we can get people to consider financial sanity, a way can be found to ramp down the entitlement programs with out creating a class of impoverished old people.

What I think would help the most is focusing on getting capitalism working, that is, remove the restrictions and regulations. Kill the mixed economy. A few years ago we went through a phase of semi, sort of, half-assed deregulation. There was actually significant results from just the minor changes we saw. If we can begin building on the importance of letting people have the freedom to act, we can “grow” our way out of our mess. I think that the central driving force of our efforts needs to be: make America capitalistic! In this case, focusing on business regulation will help divert the tidal wave.

Instead of going off in many directions, let’s focus our energy and thought on pushing capitalism and the truth about the nature and impact of the Federal debt.

The Debt and the Republicans

I saw an announcement from the Obama Administration that the Federal Deficit for 2011 would be $1.7T. This morning I see big headlines about a momentous fight in the House over cutting $60B from the next budget. The article called it a massacre and suggested that it was the biggest cut in history! This is absolutely part of the big lie, from all concerned. The Republicans, and everyone else, know that $60B in one years budget is a rounding error. It is meaningless. The American public is being sold another big lie.

Also, historically in these things, these really aren’t cuts, but a reduction in the new spending levels. In other words, making up an example, if the spending on these areas last year was, say, $600B, and the new level is $700B, the actual level, after the great cuts by the Republicans, would be $640B, or still an increase of 6.67%. In typical fashion, the news article does not make it clear what has been “cut”.

What are we to make of BO’s announcement that the deficit will be $1.7? HA! As I noted in my recent post on the debt, last years deficit was announced as $1.7, but in fact the increased debt on the Treasury’s balance sheet was $3.3T. So, two things: First, it is unlikely that the deficit will only be $1/7T. The government will overspend and under collect. Employment will not improve as predicted and Social Security and Medicare will require more cash from the budget. Interest rates will also probably be higher than predicted. The deficit will be much wider than his public statement. Second, the “off the budget” obligations will further balloon the actual debt, which, after all, in reality, is what will soak up any real savings the public accumulates. In spite of all the posturing and back patting, the Republicans will have done nothing to keep us out of a depression. Who will tell them?

Treasury Grab of Retirment Assets: So Far

As far as I can find, there has been no public comment or action from the government regarding this issue since the hearings last September. The IRS, in its December annual statement about planned new regulations, etc., included annuities and pension plans in its list, without any indication as to what it has in mind.

The news reports about the combined Treasury and Labor Departments’ hearings last September do not mention any discussion regarding the fears that I and others have voiced. Our fears is that the Federal government will soon try to take some action that will force Americans to place our retirement savings in U.S. Treasury Bonds. The government need not take our savings, just control where we put it. Putting our savings into Treasuries will reduce our potential retirement income flow, remove more money from the productive economy, and further destroy our freedom of action. If, as I expect, interest rates on Treasuries begins to climb, the size of our investment portfolios will shrink.

There were two sets of themes in the testimony during the hearings. Those who are self-styled experts on retirement focused on what they perceive as the failure of American’s to properly prepare for retirement. They are concerned that people will not make good choices about their savings after retirement and that retirees will run out of money. They regard a guaranteed lifetime income option as vital. I doubt that these people were confronted with the question of forcing the poor, misguided Americans to place their savings in lifetime income vehicles. That is really the question. Somehow, the thinking seems to be, just having the option will be the solution. Later, the experts will discover that the option isn’t being used, at least sufficiently, and the experts will cry that further measures need to be taken to take care of us.

The other theme was the concern of industry representatives, almost entirely members of the insurance industry. Beginning in the mid-90s, critics of the insurance industry, including many regulators, have attacked the industry for putting annuities within pension plans and IRAs. In the critics’ view, pension plans and IRA’s provide tax deferral, which annuities also provide. The criticism was that there were cheaper investment vehicles than annuities to put into a 401(k) or Simple Plan. Critics, such as Susie Orman and the industry regulators, claimed that the only reason annuities were sold were much higher commissions and profits. These complaints ignored the actual commission rates of the majority of mainstream insurance companies (as well as other issues). These critics also tended to ignore features of annuities that weren’t provided by other investment vehicles, such as the lifetime-income feature and the insurance element.

The comments of the insurance representatives at the Treasury and Labor Departments’ hearings was that these criticisms had to be addressed. Their companies would not participate if they were exposing themselves to legal harassment, even if the harassment was ultimately baseless. I expect that the criticisms of annuities by regulators is the primary reason why annuities aren’t available in 401(k) plans now. It is also possible that the government will use the intent of private insurance companies to profit from their business as a justification for creating a government annuity, thus fulfilling the fear that all of this is just a ploy to force retirement plan money into funding the U.S. government.

I saw no mention of any consideration of what kind of annuity that should be offered, e.g., fixed (like a bank CD) or variable (which allows investments in stocks and bonds with in the annuity). If the intent is to put more money into Treasury Bonds, variable annuities would not be allowed. Nor did I see any mention of the interest rates that would be paid on a fixed annuity. With the Federal Reserve Board forcing interest rates to be very low for long periods of time, the income available to an annuity holder would be very small. For someone who lived a long time, an income resulting from a low interest rate would suffer financially, especially if there were any level of inflation, even 1%. Fixed annuities only make sense in a gold standard, where even a low rate of interest would provide a growing standard of living.

We are now left waiting for Treasury and the Labor Departments to take the next step, if any. It may be that the next step would be to propose a law for Congress to consider. It is another shoe that we are waiting to hear from.

Debt and Depression: Our Present and Future

In my last post I tried to be as clear as I could be regarding inflation in the U.S. To reprise: Inflation isn’t here now, even though some prices of important products in our economy are rising. We may get inflation, but don’t get excited about it until it happens (which doesn’t mean that we shouldn’t get excited and angry about actions taken by BO, the Treasury, the Congress, and the Fed that will lead to inflation).

My unhappiness with the inflation hawks is that their constant focus on inflation detracts from other issues. Inflation is not the only bad economic calamity that can afflict us. Right now the increasing level of debt being taken on by the Federal Government is a greater threat. As Yaron Brook has stated, the level of debt the U.S. Federal Government has taken on and will take on will likely result in an economic depression. The consequences will be no better than the results of the current recession or the 20C depression. Our economic and political leaders resist learning from experience. We will experience long-term suffering.

There are two recent bits of information that prompt me to write this post. First, I saw the news release that the Congressional Budget Office expects that Social Security, which is now running a deficit, will continue to do so. That is, Social Security will be a drain on the Federal Budget from now on. It was expected that Social Security would no longer produce a surplus for our Presidents and Congress to play with at some point but not for another few years. Because of the recession, and the very low levels of employment and consequently lower Social Security tax collections, deficits for that “entitlement” program began last year. Add to that the deficits in the Medicare system and you have reached the stage where the major entitlements are drawing on the general fund.

The other piece of information I learned was that the actual federal debt level is significantly higher than the figures that Washington bandies about. The figure they use is high enough, shamefully high, dangerously high. The reputed Treasury Debt, the amount authorized by law, which we will reach shortly, is $14.3T. When you add in bailouts, Fannie Mae, Freddie Mac, student loans and other “off-balance” sheet funding, it becomes $20.173T, which is 44.75% higher. Supposedly, the deficit for the last fiscal year was something like $1T, but when you look at the actual Treasury balance sheet, the obligations of the Treasury grew by $3.3T. In other words, our debt, which is threatening to put us into a severe depression, is growing faster than the politicians will admit. We look more like Greece than Germany.

Looking forward, we see that the spending programs that BO has pushed into law will continue to add piles of debt, that the growth of the numbers of Americans over 65 will require more and more spending (Medicare will be the biggest drain!), that the unfunded entitlement of retired federal workers pensions and medical benefits will add more demand on the federal budget, and there will be more disasters in the economy that the government will feel required to remedy by spending money it doesn’t have.

The damage that this debt exacts is two fold. First, it removes savings from the economy that could have gone to productive activities. We are being deprived of the possibility of improving our lives, or even maintaining our standard of living. When government officials admit that it could be years before employment reaches earlier levels, it is this drain on savings that is really the reason. Second, it will increase the amount of interest payments that the federal budget has to cover. Currently, and for the last few years, the Fed has done all it could to keep interest rates low, very low, often near zero. But the Fed is not omnipotent, although it seems to think that it is all knowing. As the U.S. Federal Government continues to need to sell more and more bonds to cover its obligations, the only way that it will be able to attract more savings will be to raise the interest rate it offers. Even the U.S. Government must compete for money on the market. Since the market is international, neither the Treasury nor the Fed can control the real interest rate that the market will demand. When interest rates go up, the drain and strain on the Federal Budget will be immense. The federal politicians and bureaucrats, who look no further than their own immediate whims and power, will be surprised, and will have no means of acting to counter (although some will want to push for higher levels of inflation, which will make things worse, of course). When interest rates go up, all of those who trusted the government and bought the Treasury Bonds that financed all of the spending, will see their beloved assets fall in (dollar) value. It will be a just reward.

Debt is the threat. Debt is the danger. And we are not focusing on it. We are allowing it to sneak up on us. Wake up and pay attention.

What to do? That is, what is the solution? First, what the politicians and bureaucrats propose isn’t a solution. We will be in worse shape with more laws, more regulations, more spending, and more made-up money by the Fed.

Many focus on the spending and suggest that we should stop spending on Social Security and Medicare, not to mention BO’s massive programs. While we will have to stop the spending, this battle is a very difficult one. Included in the resistance to this idea are all of those who are depending upon those programs. Part of the solution will have to be some way to avoid massive losses of older people.

I think that there are other things to do first. These steps aren’t easy either, in the political sense, but they don’t threaten to destroy people and the results will include the solution to our problems. What do we do? We free the economy. We get rid of regulations and government interference. We get rid of many government employees. I wrote about this before, so I won’t repeat myself. But the point is that with a productive economy, we can clean up the debt and find a way out of the obligations that the government has foolishly undertaken.

To achieve the goal of freeing up the economy to be productive we have to teach our fellow man the truth about capitalism, both its moral worth and its real success. That means we ourselves must know about it. Learn what capitalism is. Learn how it functions. Learn its history. Learn how the economy you live in works. We cannot teach what we do not know. I assume most of you have read and understood “Capitalism: The Unknown Ideal”. If you haven’t, read “The Capitalist Manifesto”. Read Hazlitt and Bastiat.  Read the great Austrian economists, von Mises and his predecessors.  Read “Meltdown” by Thomas Woods. Keep an eye on the debt, the money supply, and the prices you pay. Realize that there is no free market in the United States.  None.  Every market has elements of government controls and interference. Talk to your neighbor and the man in the street. Remind them that capitalism has been attacked and subverted for over a century in the U.S. Spread the word. Capitalism can save us. Only capitalism can save us. The others have tried and failed. Let’s return to our greatness.

INFLATION PRIMER

More and more people are getting on the inflation and hyperinflation bandwagons lately. There may be reason to worry about inflation, several, in fact. But, for the most part, the reasons that are being offered for today’s bandwagon do not justify the conclusions that people are making.

My position is this: Real inflation is a major cause of economic disturbance and the destruction of economic value. Inflation needs to be eradicated from our lives and our political system. To remove inflation from our economy would require that we understand it at it’s root and have an accurate history of its influence. Instead, what these people tend to offer is just pointing at some prices that have risen that are special to us or in the news. Even when they mouth reference to the money supply, they do nothing to relate the money supply to the price increases they are seeing. They are just adding confusion. So, I am offering another post about inflation with a slightly different focus.

First, of course, rising prices is not inflation. Rising consumer prices may be a consequence of inflation, one of them, but it is only a consequence, not a cause, and it is the cause that we want to understand clearly. It is the cause that is the actual problem. It is the cause we need to eradicate from the economy.

The Austrians (and as further explained and expanded by Ayn Rand) are the ones who identified inflation accurately. Inflation is government manipulation, read expansion, of the money supply. When more money is pushed into the economy, prices, at least some prices, will rise. There are two important points.

First, prices cannot rise without there being more, new, made-up money. Without more money, some higher prices would just mean that fewer of those products could be sold. People would still have only so many dollars to spend. Higher prices for some goods means that the standard decisions people make as to what to buy and not buy must now account for a different price structure than before. Prices are always changing. All prices could not be rising at the same time without there being more money in circulation. Stuff would be left sitting on the shelves. Consequently, if some prices rise, other prices would have to drop, or production would have to be reduced. There are only so many dollars.

Some people try to avoid the basic physics of the issue by talking about the velocity of money, suggesting that if a unit of currency changes hands faster there is the opportunity for prices to rise without more money actually being created. No attempted explanation of inflation using the velocity of money that I have seen actually lays out how that is suppose to work. I can’t figure it out. Try it. The vast majority of people get paid on a regular rotation, i.e., weekly, biweekly, or semi-monthly. How do you fit a higher velocity into that arrangement? You can’t. Higher velocity is out.

Second, the Austrians determined that the entry point for new money makes a difference, meaning that new money does not effect the entire economy the same way, but ripples out from the point of entry. Over the past twenty plus years, the entry points for new money have been limited to just a few parts of the economy. It is easy to identify those connected directly to the Federal Budget because the prices of related items have been going up rapidly and consistently for all of those years. The list connected to Federal Government spending includes medical services and related products and higher education. Recently, Federal employee salaries can be added to that list.

Besides the budget, the other main entry point of new money is by way of the activities of the Federal Reserve System. I have gone into detail how that happens in this blog, so I am not going to restate it. The consequences of the Fed expansion of the money supply normally hit asset prices first. Stock prices and housing prices are pushed by the expansion of the money supply by the Fed – sound familiar? (Constant deficits in our Balance of Payments can also only be explained by the expansion of credit.)

Okay, so that is inflation, i.e., increases in the money supply. Well, take a look. Is the money supply expanding? Ahhhh, no. It isn’t. So where is this inflation?

What the people who are declaring that inflation is upon us are pointing to are certain, specific prices. Right now the major ones are oil, food, and commodities. Certainly, these prices are going up. But, is it inflation?

I would add another sector to the list of higher prices, the U.S. stock market, which has gone up a bunch in the last couple of years. Why has it gone up? The facts about the U.S. economy don’t support that kind of optimism. The actions of the U.S. government continue to make things worse. The market is being pulled along by a ton of money sitting around. It is the same thing that happened in the late-1990’s and mid-2000’s.

So what about the prices of oil, food, and commodities. Okay. Fact one. In any economy (where individuals can make decisions at least to some extent), in any situation, for all kinds of reasons, prices will be on the move. Some prices will go up, some will go down. We do see prices going down all of the time in our world. That is especially true of high tech stuff. Prices change because people’s preferences change. Demand changes. The supply changes because of new technology, new business structure, new sources, governmental action. There are a host of different reasons. You have to look at specific industries to understand the price movements. More than that, if it is inflation that is causing consumer prices to rise, the general trend would affect the entire economy, in a ripple effect. When the price rises are confined to specific sectors of the economy, it is necessary to look closely to determine what is happening. In is not proper to just declare that it is inflation. Looking closely at medical services, oil, and commodities results in very different conclusions for each sector. That is especially true when the best data available on the money supply (admittedly government data, but not sufficiently corrupt) show that the money supply is not expanding to speak of and credit has contracted.

I have already discussed the constant rise in the prices of medical services, which is a direct consequence of government spending. Let’s try oil. The price of oil is an international price. For its price rises to be a consequence of inflation, it would be necessary for there to be inflation of significant amounts in many countries. But, there are more obvious and immediate explanations as to why the price of oil has gone up, and may continue to rise. Two explanations, actually. First, as a result of the anti-industrial movement (which includes the ecology movement), the production of oil has been forcefully reduced nearly worldwide. In a few countries, the production is kept lower than those countries are capable of for the reason of attempting to influence the price (OPEC, of course). We all know that the supply of oil is less than a free market is capable of providing. Second, we have a couple large countries, very large countries, that have finally begun to open their economies up sufficiently that they have produced a modicum of wealth. These countries are now also buying oil in larger quantities than they have in the past. Just a little increase from these very large countries has a significant impact on the price of oil. So, we have a supply that is less than possible and a significant increase in demand, and, surprise, oil prices rise. Standard stuff. Inflation is not necessary to explain the price of oil. To the extent that there is inflation, the increase in the price of oil will be worse. If a specific country has inflation, its currency will tend to buy less internationally over time, and the price of oil in that country will rise faster.

The second half of the analysis of the oil price applies to commodities, including food. There is more international demand. Higher demand means higher prices for basic, auction-derived prices such as commodities. China and India are buying more than they did a few years ago. If there is the possibility of greater production, the higher prices will attract more supply and the price may go down, but that does not happen overnight.

Food prices, especially within a large country like the U.S., is more dependent on local factors. I have not seen sufficient reports to make a well-founded conclusion as to why prices have begun to move upward. International grain prices have moved upward, but really have only a minor impact on the prices of consumer goods in the U.S. The cost of wheat in a loaf of bread in the U.S. is only a small fraction of the price at the store. Transportation, i.e., oil prices might be more important. Weather is important. The important point is that the factors causing our food prices to rise are not an increase in the money supply and are somewhat different that the reasons why oil and other prices are rising.

Then there is the issue of inflation here vs. inflation there, in the present day case: inflation the US vs. inflation in China. China is experiencing inflation, both asset and consumer price inflation. It is also experiencing sufficient growth that allows people and businesses to buy basic materials on the world market that they couldn’t before. Both of these factors make up the fact that China is a major reason why international prices are increasing. To fully understand what the impact of China’s rise (as well as India’s) means, it is necessary, as always, to gain perspective. Don’t just focus on selected markets that fit with a particular expectation or world-view. Look at the big picture.

What is my suggested perspective maker? French wine! The prices of good French wine have gone through the roof, up maybe as much as 3 or 4 times what they were a couple years ago. The reason is that a very small percentage of China’s 2,000,000,000 people have discovered the good stuff and have the money to start buying. They have bid up the prices. The Chinese are bidding up the prices of many things right now. The world has been rolling along with a few industrial countries and a lot of undeveloped ones as the status quo. Imagine the situation if many countries were to open up their economies to individual efforts and wealth. The demand for basic commodities would skyrocket! The old, restricted level of production would not be able to respond, shortages would ensue, and prices would rise. That scenario is pretty much what we are seeing. Newly freed countries would mean periods of economic adjustment as changes in distribution patterns developed. Ultimately, either we would see greater production, and thus higher standards of living all around, or we would see massive shortages and breakdowns in the world economy. In this respect, the emergence of China and India as economic powers will be good for all of us. Countries that refuse to deregulate, like the Europeans are blindly doing, will be faced with falling standards of living and fiscal nightmares, as is happening. For those who have tied their thinking to the dominance of the U.S. in the world economy, there will be confusion. In a world that is free and prosperous, the U.S. would be a great competitor, but not the richest nation. It is not the biggest country. But it would be incomparably richer than it is now. Higher productivity and creativity worldwide would mean greater wealth for all, and we would benefit.

But, back to the point of this post, greater demand for commodities, or anything, and subsequent rises in prices is not inflation. Only increases in the money supply by government action is inflation. Keep your causes straight.

China and the world economy

Over the last two centuries there have been many obvious examples of different political economic systems in practice. It all began with the Industrial Revolution that occurred in capitalist countries. Latter, there was the rise of communism and its moral/economic attack on human life. We had the immediate comparison between East and West Germany. For years there has been the obvious comparison between North and South Korea and Cuba and the Cuban refugees just a few miles away in Miami. Now we have the fascinating spectacle of communist China having an apparent capitalist bent. Still, with all of this obvious evidence, there are few people paying attention and noticing the consequences.

But even many of the people watching the Chinese economy are not noticing what is happening, not really. The closet socialists in the U.S. bemoan that America can’t act like the Chinese government and just get things done. We have all of those antiquated laws and protections in place. The Chinese, people are saying, have a better approach to making an economy run well. On the other hand, we have some advocates of capitalism who tout Communist China as a sort of new birth of freedom. Neither of these evaluations are correct. China has opened up options for personal action that the Chinese have never seen. It is a heady feeling, and the Chinese citizen is taking this opening and stretching it as wide as fast as he can. But his feeling is based upon the opportunity and not the reality. The reality is that China is still a communist country. It isn’t free. It still embraces the old prerogatives that communism teaches, plus, the government is attempting to become an economy manager in the manner it perceives the Western governments to be. This is not a good mix for the long-term.

My comments are about the problems that underlie Chinese economy today and the big crisis that is coming. But, if my information is correct…

When China bursts and falls, it will be the capitalist elements that will be blamed. Just watch!

People are very surprised about the success of the Chinese over the last 10 years. They tend to forget that the same Chinese government has killed millions of its citizens. They forget the destruction of the democracy movement just a few years ago. In their minds, China seems to have just come out of nowhere recently.

It is the case that there is a lot of productive energy being used by the Chinese citizen for his own benefit. People living in the right areas are seeing an enormous increase in their standard of living. There is real capital accumulation and utilization. Markets are working. People are finding productive jobs. There is a lot of good happening. The productive aspect of the Chinese economy is not an illusion, unlike the Russian economy which was an illusion during the Soviet era. Yet, there are major problems.

The problems revolve around the fact that the government has not renounced either its own communist nature or the general approach that every other government in the world accepts, namely the twisted Keynesian approach to government controls. This communist government isn’t using the traditional five-year plan, but it is attempting to act as if it can perfectly control the economy by using the “mixed economy” rules that have constantly failed in the West.

It has greater control over the banking system than any Western country does. The banks are either owned outright by the government or controlled sufficiently to make no difference. Consequently, the standards for making loans and evaluating the banks soundness are much poorer than in the West. Estimates are that anywhere from one third to two thirds of all loans made by Chinese banks are not performing, i.e., payments are not being made and the loan will be a loss. That is a percentage far higher than any Western bank has had. You can be sure that the Chinese banks do not have the capital or the reserves to cover those losses. When the weakness of Chinese banks is recognized and begins to affect the economy, the Chinese government will step in and create reserves, i.e., it will inflate the money supply even more than it is already doing now.

The real estate market is in much worse shape than it was in the West. There are reports that the Chinese built an entire city for something more than a million people in the interior. This city stands empty and is, no doubt, beginning to deteriorate. In the real cities, reports are that 60% of the apartments that have been sold are not drawing electricity, i.e., no one is in them. Yet the Chinese are continuing to build at a rapid pace. For those who buy, not having the mortgage system that Western countries have (which is not necessarily a benefit for the West because much of the structure is government created, and thus is not efficient or market driven) the Chinese buyer has a much higher percentage down payment on the property. When the Chinese real estate market fails, the losses are going to be more centered on the productive individual rather than on the banks. Suddenly losing a large part of their new wealth will place a strain on the population of the cities. Things may not remain stable.

At some point, some unforeseen event will stop the continued upward spiral of real estate building and price increases. The last buyer will buy, and all that will be left are sellers, and prices will fall, buildings will go empty, loans will be recognized as losses, banks will either fail or have massive amounts of made-up money shoved into them. Inflation in China could increase dramatically.

What will be the immediate economic consequences? Questions that perhaps cannot be answered in advance include, what will the Chinese do with their hoard of dollars, Euros, and foreign exchange? What will they do with their U.S. Treasury Bonds? There are observers who have been suggesting that China is looking to sell off the U.S. government securities. I haven’t thought so, for no other reason than that the Chinese really don’t want to see the value of those holdings to dive. It made no sense for the Chinese to start selling. But when their economy goes puff!! Who knows what they will do? The degree of collapse cannot be appreciated. There has been no economy of that size, with that many people, so connected to world trade, that has had the size of bubble that China now has. Yaron Brook suggested that their bubble is larger than any seen before. So may be the consequences.

We can easily see that one immediate consequence for the rest of the world will be a hit on the commodity markets and those countries that are depending upon the Chinese, e.g., Brazil. These countries will see an immediate fall in revenue. Commodity prices will fall, hard.

For ourselves, the consequences will also first connected to the commodities. The price decline will include gold. The number of buyers will decline and the sellers, especially the Chinese sellers will expand. At least during the crisis and for a while afterward, gold prices will be lower. Other commodities will also decline, especially those that the Chinese have been big buyers, e.g. oil. (See what happened in 2008.) The upward pressure on prices for goods in the U.S. that are tied to commodities will be reduced. Consumer prices could even decline.

What will happen after that is hard for me to predict. The Chinese economy is not as closely tied to other countries as ours is. Their banking system, for example, is pretty isolated, from what I can see. Would companies producing for export be forced into closing? Would their exports suffer? Imports would suffer. To the extent that the gap between imports and exports widened, there could be problems. To the extent that the wealthier countries depend upon exporting to China there would be adverse consequences. We will have to see how all of that plays out.

We have no clue what precisely Chinese government would do, except that they are wedded to the belief in the power of the government. To the extent that they see their citizens’ reactions to be threats to communist power, they could unleash the military again. They could try Western style mixed economy solutions, and expand and lengthen any possible recovery. It is unlikely that they would somehow learn that the governmental actions in the economy do not produce prosperity.

No doubt, in the West, government after government will step forward to save the day. At this point, with interest rates on short-term money at near zero, it is laughable that any might think that their theories are going to have any beneficial results. But, our great leaders are also wedded to their theories. Remember, their theories are not based upon any real evidence, but make believe. That they haven’t worked in the past will not hinder their efforts. The Western world might still be in “recovery” when China blows, which means our “recovery” will dip. Our economy will certainly suffer.

The stock market in the U.S. will definitely decline. Since the financial center may not be hit as badly as before, the decline in equities might not be as large, but it will not stand up to this bad news. I am firmly in the camp that considers the market’s recent rise to be pushed by inflation, i.e., government created money. Riding U.S. stocks is a very risky endeavor today. I don’t see a fundamental justification for stocks to have risen. New pressure from China will undercut the equity market.

Frankly, only commodities seem to me to offer any opportunity for increasing wealth today or even just protecting what you have (besides owing a successful business that can deal with economic shocks). I don’t mean riding commodity prices upward. I mean being able to take advantage of the up and down volatility of the prices of commodities.

When China does blow, as people have done in the last sixty years, there will be a flight into the dollar (another reason why commodity prices will drop for those of us in the U.S.). As badly as the dollar is managed, it will look better than any option (other than gold, maybe). Eventually, the damage done to the U.S. economy will be apparent and the dollar will lose strength. Still, when considering the alternatives, no other currency will look stronger. We are now seeing the weakness of the Euro. Bailing out a couple of Euro zone countries with new loans only broadens those who must suffer under the debt burden. Analysts do their calculations and bemoan the apparent fact that there is no way out for an economy with so much debt. Opening up their economy so that it can actually be productive never enters into their consideration.

When is China going to implode? Sooner or later? China is now experiencing some problems with price inflation. For years, as part of the creation of all of that real estate, the Chinese have been expanding bank credit and thus the money supply. They thought that everything was okay until prices began to rise during their “recovery” from the mortgage-backed securities crisis. In response to the crisis, the Chinese government did its stimulus gimmick, spent a lot of money it didn’t have, patted themselves on the back for the apparent recovery of their economy, and now consumer prices are rising. Surprise! Now the Chinese government has to act again. Since interest rates are still very low, they are having to increase the reserve requirement, i.e., banks there, just as they must under our Federal Reserve System, must keep a percentage of their deposits in accounts at the central bank. The higher the reserve percentage, the lower percentage of loans a bank can have outstanding. The Chinese central bank has now increased that percentage for the third time in the last few months. Further, officials in China have placed price controls on certain items, which as anyone knows, does not work. So we are now seeing some significant cracks in the Chinese economy. I don’t know if these cracks are sufficient to cause the bust, but they are at least the beginning. We can look forward to Bernanke like statements about how there is no problem, how the problem is small, then that the problem is only in one sector, and then how the Chinese government saved the world from another evil consequence of capitalism. Plan on it.

What we can do is to start telling people ahead of time what they can expect to see, especially the “capitalism did it” excuse. Maybe fewer people will believe it this time.