Wednesday, November 03, 2010


American pie - now worse even than the clothes in Don's vid

[Warning - contains scenes of US monetary growth that some viewers may find distressing]

On the day of the US election results and the latest round of Fed dollar printing, Tyler was intending to do another of his "just like the 70s" retro-posts. You know - an incompetent discredited President wildly out of his depth in a busted economy, a central bank deliberately debasing the currency, and a frightened demoralised populace looking for scapegoats. Kind of idea.

But once he sat down to start typing, Tyler realised it's actually worse than the 70s.

Let's consider US monetary policy. Back in the 70s the US Federal Reserve Board was far too lax in the face of rising inflation, an inflation that spilled over to the rest of the world and brought huge increases in the world price of oil and other commodities. Following the de-linking of the dollar from gold in 1971, the US currency was soggy throughout, falling by about 20% overall (in trade-weighted terms).

Eventually of course there was a day of reckoning. Inflation was threatening to get seriously out of control - like it always does after such monetary laxity - and the legendary Paul Volcker was appointed as Fed Chairman to sort it out. Which he did, but only at the cost of sky high interest rates and two recessions in three years.

Now here's the thing - the Very Scary Thing. Compared to today's Fed, the high inflation, weak dollar,  pre-Volcker 70s Fed was an absolute model of monetary rectitude.

We need to look at the so called monetary base. No, don't skip forward to the end - the monetary base is really quite simple (at least in theory). It comprises the money issued directly by a country's central bank - the Fed in this case. That's all the notes and coin in circulation, plus the money commercial banks hold on deposit with the central bank.

And what's the significance of this monetary base?

Well, most of what you and I think of as money comprises not the notes and coins we have in our wallets, but what we have sitting in our own bank accounts. The bank is where we keep our money, and we spend it by writing cheques or flashing a plastic card. In other words most of our money is merely an entry in our bank's accounting ledger - it is not a direct obligation of the central bank.

What that means of course is that most of our money depends not on the central bank, but on the commercial banks being able to honour our cheques and plastic (which can sometimes get a little scary, as we recently rediscovered on the pavement outside Northern Rock).

However, modern banks are not allowed to create this accounting entry money willy nilly ad infinitum. Against every extra bit of money they create, they have to hold a fraction of its value as reserves with the central bank - those central bank deposits we already mentioned as part of the monetary base (this is called the fractional reserve system).

That places an upper limit on how much money the commercial banks can create relative to how much money the central bank has issued in the form of the monetary base. And it means that the size of the monetary base is crucial in determining how much money can get created in the economy overall.

That's why the monetary base is sometimes called "high powered money". It is very high octane, and it needs to be handled with great care.

Still with this?


Because over the last two years the Federal Reserve has increased the supply of this high octane monetary base by an astonishing amount. It's Quantitative Easing programme has more than doubled the monetary base. In two years they have printed more high powered money than had been printed in the whole of previous US history:

Take a good hard look at that chart. Scary or what? It makes the high inflation 70s Fed look like a bunch of puritan tight wads. It is a monstrous historic act of monetary irreponsibility.

And even worse - even worse - the Fed are reportedly about to do even more. Even more!

Now of course, what they say is that they are having to do this to stave off depression, or at least, the dreaded double-dip. That although they've stoked up the supply of high powered money, the overall money supply - the stuff that US citizens have in their own bank accounts and which they can actually spend - has barely moved. And indeed it hasn't (M2, the most widely used measure, is up barely 3% year-on-year).

But that is only what's happened so far. There is now a superabundance of the Fed's high octane fuel sloshing around, and sooner or later there's going to be a spark. An inflation spark.

Maybe it will be the current lift-off in world commodity prices. Or maybe it will be a collapse of the dollar. Or more likely it will be both, feeding into a vicious spiral just like back in the 70s.

And what happens then?

I'll tell you.

Accelerating inflation means money is worth less. You need more of it just to stand still. The real world money supply starts to grow. And because of all that high powered money in the reserve accounts of the commercial banks, and because they have every incentive to exploit excess reserves, the money supply can grow quite fast.

Higher prices will feed higher money growth, higher money growth will feed a weaker dollar and yet higher prices, which will feed yet higher monetary growth.

It could all happen very quickly. Suddenly the Fed is facing an inflationary conflagration with no off-switch.

Reverse the printing presses pdq?

Yeah, sure. And you honestly think the Obama/Bernanke combo is capable of doing that.

No. The horrible truth is that the US has embarked on a 70s style inflation, only with even more fuel on board.

And the even more horrible truth is that it may well be deliberate. Faced with the prospect of a US economy weighed down for decades by the huge debt burden it's built up, its current rulers have decided they'd rather take the escape hatch labelled inflation. Who cares if the rentier Chinese get burned?

There will of course, be consequences down the line. But they'll be for someone else to sort out.

Bye bye Miss American Pie.

Meanwhile, we've said before and we'll say it again - sell money.


PS We don't usually do this, but Rob has suggested in the comments that we should redraw the graph with a log scale. Good suggestion so here it is:

Conclusion? The rate of increase under Bernanke really has been higher than at any time since 1918 (ie the line is steeper than it has ever been before). As we say in the main post, the monetary base has more than doubled in the last two years, something that took five years during that last ramping up you can see in the late-30s/early-40s (and you know, at that point there was a war on).

PPS It's not quite a Chevy to the levy, but we must mark the sad passing of 84-year old Pontiac - the original all-American muscle car. And the reason we care is that Mrs T's Dad owned a Pontiac back in 50s London. No, he wasn't rich but he did work in a garage, and this car had clearly been brought over originally for some rich yank stationed here. A pic is in order (not that said Dad is in this particular pic):


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