The Fed's Maginot LineCentral bank intervention and inflation:...

The Fed's Maginot Line

Central bank intervention and inflation: One thing leads to another

A popular misconception holds that central bank interventions in banking crises and financial markets panics in the form of liquidity injections are in and of themselves inflationary. Not so. These policies indicate a path decided, a choice in an economic policy fork in the road – a trap, if you will. We first identified the Federal Reserve's "inflationary decision making process" back in 1999. Sadly it is neither difficult to discern nor complicated to explain. It is a well worn path taken by governments that have made a compounding series of policy errors. They are eventually backed into a corner, unable to finance expenses; lacking the will to reduce them, abandoned by allies due to economic or other troubles at home, the printing press its last defense of political obligations.

It starts when government determines in a recessionary environment, such as occurs after the collapse of an asset price bubble – as in tech stocks in 2000 or housing in 2007 – that high interest rates are politically unpalatable; they slow economic recovery and sharpen recessions in the short term. Recessions lead to rising unemployment, and unemployment mass produces unhappy voters. The printing comes under many names – reflation, deflation fighting, economic stimulus, or "emergency" actions taken without political cover of modern economic theory du jour.

Rather than allow markets to set interest rates at a natural higher equilibrium level among the factors of supply and demand for debt and inflation and default risk, the bank intervenes with liquidity – a fancy name for cash – to keep rates low. If the central bank does more than its trade partners on its own the result is both low interest rates and a weakened currency, as we have seen in the US since 2001 despite efforts by US trade partners to limit the dollar's fall with purchases of dollar denominated financial assets, mostly treasury bonds but, disastrously, also asset backed securities and Fannie Mae and Freddie Mac agency debt, which left the US five years later in the unfortunate position of needing to buy the discounted securities back with fully valued treasury bonds.

The weak dollar policy has never been acknowledged but the result is often pointed to by politicians and politically motivated economists as providing a fortunate boost in the US export sector, and lauded by the Treasury and Fed as effective economic stewardship. The inflation that inevitably resulted, especially in imported energy but all commodities, is the seed of a greater inflation that will follow, even as wages deflate in the recessionary economy.

Unconventional Policy

The extraordinary and unconventional policy responses of the US central bank were widely broadcast in policy papers issued by the Fed in the early 2000s under the heading of "fighting deflation." Like the Maginot Line that ably defended France against a direct attack by Germany across the German or Italian border at the start of WWII but failed when Germany attacked from Belgium instead, the Fed's deflation defense leaves the US vulnerable to an inflation invasion arriving from foreign shores as higher import costs, and whipped up by a lack of palatable options to fund government as tax revenues and foreign borrowing decline.

Poor Zimbabwe did not owe the world trillions in its own currency and so did not hold its trade partners hostage to cooperate in "unconventional coordinated interventions" designed to keep a stricken and fatally flawed global financial system alive that every day seems to beg to be allowed to die in peace.

Zimbabwe's fate was sealed back in 2003 when it embarked on its own "unconventional" methods of fighting bank failures and economic collapse.

The road to Inflation

Make no mistake: the US is on the road to inflation, and has been from the time it determined in the early 1980s to extend American purchasing power by means of foreign borrowing and domestic asset price inflation. The political will needed to get off the inflation path previously arrived in the late 1970s in the person of Paul Volcker. He worked in the background for many years to build consensus among US allies for the drastic measures taken in the early 1980s to kill The Great Inflation before it developed into a hyper-inflation. Is there a new Volcker out there, working with leaders in Asia and Europe and across the US, building consensus for a global currency appreciation, to get off the short term politically expedient of depreciation in order to avoid the long, difficult task of trade and monetary realignment?

The market action this past week votes: no. Stocks are pricing in continued leaderless, ad hoc responses by national governments, currency blocks, and trade blocks, although the G7 today issued a statement that major industrialized countries planned to do something or other together, drastic and soon, but not certain exactly what. A global financial system predicated on free capital flows and winner-take-all as the Asians learned during the 1997-98 currency crisis turns out to not lend itself to a process of geo-political reconciliation and shared economic sacrifice in a crisis. I can hear the Asian leaders say, "You want us to contribute to a global bailout pool now that you are in trouble? Remember the tens of billions your currency speculators pulled out of our economies ten years ago, throwing our economies into sudden recessions, while we kept our capital markets open at your insistence? We do. Count that as our share to your pool today."

As local and federal property and income tax revenues collapse in the US along with property prices and incomes, the Federal government will come under increasing pressure to print to fund all manner of "fixed" expenses – fixed in the sense that no politician wants to give up foreign or domestic spending commitments, from military outlays to health care entitlements to pension fund guarantees.

The blundering is by no means confined to the US. In Germany, where the ratio of public debt to GDP is even higher, older citizens who are keenly aware of the historical results of bad leadership in times of economic crisis have bought all of the gold available from banks; the spread growing between spot and physical gold prices reflects a growing panic that the inflationary decision making process will run to its logical conclusion world wide.

The statement below of Dr. G Gono, Governor, Reserve Bank of Zimbabwe, 30 April, 2008 grimly testifies to the likelihood the US, like Zimbabwe, may soon relearn that the "discredited textbook dogmas" that the Zimbabwe central bank and now the US central bank abandoned were conventions for a reason: every divergence from them, while politically expedient in the short term, is always a long run economic disaster.

By matter of degree and speed, the process that causes a nation to lose purchasing power varies with scale, political organization, institutions of government and industry, relations with trade partners, history, and culture – the full composite of the political economy. But one lesson always holds true: a leader, as JK Galbraith once said, is one who confronts directly the fundamental anxiety of his nation in his time. Ours have for more than 30 years avoided ours by means of papering them over with new forms of credit produced by increments – junk bonds, CDOs, and other products of financial engineering. As the mirage of extended purchasing power through finance dissolves into the night, they leave behind liabilities and expectations to be met by the same leaders but with the remaining machinery of low finance, the old fashioned type, the one that simply prints money. - Eric Janszen

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