Thursday, March 24, 2005

 

The Fed creates credit not money, the Wal-Mart economy

I promised to write about deflation and depressions a long time ago. Frankly, the subject is daunting and after giving it some thought I would rather take it in bite sized chunks.

There is a common misperception about the way the Federal Reserve (Fed) works in our economy. It is due to the terminology that is common among people throughout the worlds of banking, finance and academia. The Fed does not create money, it creates credit. Even this is misleading. The Fed makes credit available to the banking system, the banking system makes credit available to its customers. But the customers do not have to use that credit/borrow that money if they don't think there is anything worth buying/investing in. This is important to understand because it is the way that an economy can suffer from deflation.


First to define deflation: A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit. Simple enough. "Why not just print more money/offer more credit to reflate the economy," you might say. Good question. (Patting you on the back) The problem is that deflation is in our collective minds. We create deflation when we have the expectation that prices will continue to fall and then we postpone purchases or demand lower prices before we buy. Those of you over 35 probably remember the inflation of the seventies. Inflationary expections pushed demands for higher wages, etc. Fed head Paul Volcker raised interest rates and this is credited for breaking the back of inflation. Back to back recessions in the early 80's caused people to stop expecting higher prices. It is hard to demand a raise when you don't have a job.

Just like inflation, deflation is the result of people having certain expectations. I should explain something else before I go on. There are two types of inflation. There is commodity/consumer price inflation (1970's) and asset price inflation(1990's). During the late 80' and 90's the U.S. economy was in a period of what economists called disinflation. Prices of consumer good's and commodities were not rising as quickly as they had in the 1970's. Economists are people, too, and people have a tendency to emphasize the problem that is last on their minds. With consumer prices not rising quickly and the quality of many products increasing substantially because of technological innovation we were in the best of all possible worlds by the standards of the 1970's.

What everyone ignored was that we were experiencing inflation in the 90's, asset price inflation. Of course, this inflation tended to benefit a substantial portion of the population so what's the problem? Nothing, except for the fact that asset price inflation sets the stage for deflation. You see deflation is always the outcome of an asset price bubble. Bubble is the other term used to describe an asset price inflation that carries values too high. I should say that "too high" is a question open to debate. Alan Greenspan gave his irrational exuberance speech back in 1996. (Just for fun you should go and look at the levels of the Dow and Nasdaq back then) Obviously, saying that something is overvalued is not enough to cause the price to go down.

The Fed can make credit available at very attractive levels and not have a consumer price inflation. (I will discuss why one type of inflation is prevalent versus the other some other time) Instead, asset prices rise and rise and everyone who owns stocks and bonds and houses is happy. Everyone who doesn't...well screw the proles.* So let's say the Fed sees asset price deflation in the form of a falling stock market and they make lots of credit available to the public, what will happen? (Hint, this is exactly what happened starting in late 2000) What can happen is that people will switch from watching CNBC to watching real estate ads in their local paper. I cannot complain about this. I bought a home in 1999 and sold it last year for a healthy 64% profit. It seems that the public has switched from speculating in stocks to housing. This is not all that different from the 90's when one stock sector would get hot and then cool then another. What really made me smile was that the last really hot stock sector of the bubble was biotech stocks. If you remember, these same stocks were very hot in 1993-94 before fizzling.

One thing you should know is that the Fed has made credit available pretty much throughout the 90's and 00's. I think Easy Al, see Fleckisms, learned a bad lesson during the crash of 1987. Make credit available during a crisis and you will avoid the crisis. Sounds good but it teachs those that take risks that if they take a big enough risk the Fed will bail them out. The public learned this lesson well and we had been buying stocks with wild abandon until 2000.

What causes bubbles to pop? Very easy, people change their minds about buying and borrowing. This is what I want to you to know. There is no way to know when that will happen and there is no way to get people to switch their mindset once the collective A-ha moment occurs and the masses decide that owning Yahoo, Sysco Systems, Xillinx ;-) or three condos in Florida is a bad idea. You can tell them that there are objective measures of value which show that a particular stock or the stock market in general is too expensive and that it will almost certainly be a poor performer for long term investors but that does not matter. We are wired to look for short term pleasure and a rising price is good enough excuse to buy. We think linearly and we love to extrapolate trends into the future to the point of ridiculousness. When the speculation stops and prices start to go down people will grow increasingly more pessimistic. At the bottom you will hear a lot of people question whether the United States can survive. That would be a good time to buy stocks.

I will tell you what is going to happen, the Fed will continue to make credit available but no one will want to borrow it. For one, many people have borrowed to the hilt leveraging real estate. They own assets with debt and they will not have enough income to service that debt. For those of us who might have money readily available or good credit ratings, we are going to sit back and watch prices fall. Like in a Wal-Mart store you will pick up the paper and see stock prices with minus signs next to them and houses with the magic word "reduced" in the real estate section. Watch for falling prices will be the slogan for this era. If you do not need to buy stocks or housing then you will not be inclined to buy them for an investment when the price keeps falling month after month, year after year. The opposite cycle of expectations will keep people from buying as prices fall.

When? Your guess is as good as mine. I just know that it will.



*A lot of people I knew, including myself, missed a good portion of the 90's housing bull market. For young people who were priced out of assets in the 90's they have good reason to be unhappy about a housing bubble that carried real estate prices well beyond any increase they saw in their incomes. That is a societal inequity which results from a fiat currency. Prices of assets do not reflect the value to those who consume them. It is the reason the Fed is tasked with maintaining price stability. I do not know why asset price stability is not part of that other than the political pressure to avoid clamping down on easy credit. (see Laurence Kudlow who has laughingly accused Al.com of being too tight with credit) Stable prices allow people to plan for the future because they can save and invest knowing that they will get a fairly certain return on the
ir money. The Federal Reserve was supposed to be beyond politics, it isn't. I hope that now we can see the deletrious effects of rampant speculation that the people of this country will demand a stable currency and banking system which does not feed this frenzy.


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