“Global equity markets are falling, with the Dow Jones Industrial Average down around 250pts. A benchmark 10-year Italian government bond is yielding 7.4%. Every country whose sovereign debt went over the 7%-mark has required a bailout. I was in Italy a month ago, and the yield was under 6% (still pricey for a developed country).

A bailout of a country Italy’s size would be a gargantuan task — probably a larger effort than heretofore. It is beyond the capacity of the EU. Italy’s debt is just too large. I doubt China would purchase any real assets until labor-market reforms and pension reforms were enacted. China actually wants a return on its investments.

If the IMF gets involved, it would require massive new funds for which the US taxpayer would be on the hook for around 18%. I wonder how that would go over in the US House or even the Senate? That doesn’t mean the Obama administration won’t try to organize a rescue. The Fed has been backstopping the EU banks for some time.

Will the Euro survive? Will the global financial system survive?”

Jerry’s email answer to the last two questions was: “probably and possibly!” I’m not sure of the order he intended.

But see Italy Bond Attack Breaches Euro Defenses today on Bloomberg.com. The simple answer is that monetary governance without fiscal governance does not work. The sooner that is realized, the sooner sovereign bailouts will stop, and the sooner the European nations can begin a healthy recovery.

When he heads home to the US he focuses on his home state of California which is essentially bankrupt. First to fail though will not be the state government but the local municipalities the worst of which is Vallejo which filed for bankruptcy in May of 2008. There is, of course, more to come. Here’s a brief interview with the author:

In sum, the situation is that the ECB has been buying debt of the bankrupt nations, Greece followed by Portugal, Ireland and perhaps Spain in order to support the EU and more to the point the banks in each EU nation, including those of France and Germany. If ECB support is withdrawn, the banks holding the worthless paper at par, will no longer be solvent! This is the equivalent of Lehman Brothers bankruptcy on steroids!

Assuming the worst for the sake of argument we must ponder the consequences in Europe. Runs on banks are real but probably unnecessary as the currency has no consistant value. Gold, diamonds and high value commodities work as mediums of ad hoc exchange. A barter economy ensues. Europe-dependent international trade at best slows and at worst pauses until enough mediums of exchange can be agreed upon.

The dollar, as the ready-albeit unjustified-medium surges to bubble proportions. US exports become dramatically more expensive for any remaining buyers. US export sales and production slow to deep recession levels. Layoffs ensue. GDP plumets. Federal and state government entitlement demands rise with no ready relief.

The Fed initiates QE3 flooding the economy with more (depreciated in real terms) dollars by buying increasingly worthless US debt.

Will the US which has enjoyed the dumb-fat luxury of being the world reserve currency since Bretton Woods follow the EU and fold? Will there be another substitute world reserve currency? Are all central banks becoming political animals or fiscal policy proxies? How will world trade right itself?

All that said, what’s the effect on your family, your business, your community, your nation and your investments? Is “guns and gold” the mantra of the day? Something to consider!

Let Them Eat Chips

February 24, 2011

by Jerry O’Driscoll

In today’s Wall Street Journal, David Wessel (“Capital” column, A5) revisits the question of whether current Fed policy is inflationary. He correctly states the Fed’s position is that inflation is caused by expectations. Inflation will stay low if people expect it to stay low.  He quotes Fed Chairman Bernanke: “The state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”

The Fed chairman of course has the causation precisely backwards. Fed policy systematically shapes inflation expectations. His statement is the product of the focus on the short-run and ephemeral over the long-run and permanent. In that, Ben Bernanke follows a long line of central bankers.

In A History of the Federal Reserve, Volume 1: 1913-51, Allan Meltzer summarizes the central bank mindset from the banking school writers like Thomas Tooke down to the Fed. Tooke “denied that money, credit, or base money bore any consistent relation to prices. Most Federal Reserve officials remained in this tradition in the 1920s. They denied that their actions affected prices” (57-58).

Unfortunately for defenders of Fed policy, today’s paper is filled with stories of rising inflation. In Singapore, consumer price inflation is running at 5.5%. In Vietnam, consumer price inflation is running at over 12%. There are food riots in India. In yesterday’s Wall Street Journal, George Melloan detailed the linkage between economics and turmoil in the Middle East. Consumer price inflation in Egypt rose to 18% annually in 2009 from 5% in 2006. In Iran, inflation rose from 13% in 2006 to 25% in 2009. As Melloan wryly observes, “about the only one failing to acknowledge a problem seems to be the man most responsible, Federal Reserve Chairman Ben Bernanke.”

Monetary policy is not the sole culprit in food price inflation. There have been supply shocks. Central bankers always point to supply shocks to explain rising prices. But it is not just food prices rising, but most commodity prices. Plus, as noted, broad measures of consumer prices around the world are signaling rising inflation.

The Bernanke’s response is two-fold. First, he questions the linkage between his policies and what is happening to global prices. Second, he argues other central banks are in a better position to mitigate the effects of Fed policy. Both arguments are disingenuous.

Commodities, plus most traded goods, are priced in dollars. The Fed creates base money. The more base money, the higher the dollar price of goods globally.

The Fed Chairman argues that foreign central banks can offset the Fed’s policy. As discussed here recently, this is true only to a limited extent if at all. Small, open economies have great difficulty in offsetting inflows of the global currency. If these central banks raise domestic interest rates and appreciate their currencies, they are likely to attract additional capital flows. If not, they risk sending their economies into recession.

Bernanke’s defense amounts to a restatement of Treasury Secretary John Connally’s quip to Europeans during the Nixon prequel to current dollar policy: “It’s our currency, but your problem.” The Fed inflates, and other central banks must mitigate.

Consumers purchase daily and weekly the goods whose prices are increasingly rapidly: food, energy and clothes. The goods whose real prices are falling, such as consumer electronics, are purchased infrequently.  But they keep measures of consumer prices subdued. Marie Antoinette famously remarked that the French peasants rioting over bread prices could eat cake. Policymakers apparently believe US consumers can do the equivalent of eating microchips: stop eating and driving, and just buy more electronics.  In reality, US consumers face the prospect of a falling standard of living.  They can’t eat chips.

Thanks to Jerry O’Driscoll

He attributes the major cause to “quantitative easing,” the artificial creation of money as a way to spur full economic recovery. Theoretically this is supposed to lift spending and thus lift businesses; in essence it’s supposed to prime the pump.

“What really happens is that the money first goes to the financial markets, whose players mostly create bubbles by investing in whatever is fashionable. The reason is twofold. One, financial players expect to make quick money. Two, families and businesses reeling from the credit excesses of recent years are not ready to borrow as much as their governments say they should (the personal savings rate has trippled in the U.S. since 2007) and banks are probably not willing to lend as easily as they used to.”

“For a while, then, it looks as if more quantitative easing is necessary because consumption remains insufficient and unemployment high. So central banks print even more money. To justify themselves, sometimes they point to (highly unrepresentative) consumer price indexes that show low inflation. Until, of course, it is too late and the symptoms begin to show up everywhere.”

Llosa points out that even the Fed’s efforts are being discovered for the fraud that they are. Ten year Treasury yields have shot up, despite efforts of the Fed to keep them low by printing money. This is of course dishonest. “What governments, particularly in the United States and Europe, are doing is attempting to whittle down their huge debts by debasing their currencies while continuing to borrow scandalous amounts of money. They are also hypocritically using the devaluation of their currencies brought about by quantitative easing to compete internationally — while accusing others, with good reason, of manipulating their own money to keep up their export machines.”

Watch out, the endgame will be painful, perhaps worse than the Carter years!

“The hot money was caused by the Fed’s low rate easy money policy and consequent dollar depreciation. It flows out of the U.S. seeking higher returns. Foreign central banks intervene buying dollars to prevent their local currencies from appreciating. When central banks issue base money to buy dollars, domestic interest rates are forced down and domestic inflationary pressure is generated. Primary commodity prices go up quickly because speculators can easily bid for long positions in organized commodity futures markets when interest rates are low.”

McKinnon’s three periods:

• The Nixon shock when the U.S. abandoned the gold standard resulted in the surge of dollar prices of primary commodities.
• The Greenspan-Bernanke shock of 2003-2004 when the fed funds rate was reduced to 1% and followed by a falling dollar.
• And, the Bernanke shock starting in 2008 with short term rates at zero and quantitative easing (money printing) resulting in commodity price inflation in 2010 alone of over 30%!

Historically the remedies for this U.S. monetary folly, were not fun. Remember the “stagflation” of the 1970s, with inflation, unemployment, volatile exchange rates and little productivity? Well the cure came with Volcker at the Fed raising the fed funds rates drastically, touching 22% in 1981! And the Greenspan-Bernanke interest rate shock of 2003-2004 sowed the seeds of the weak dollar bubble economy in 2008. The biggest bubble was real estate with 50% increases in average home prices from 2003-2006!

Two lessons according to McKinnon: 1. Sharp price increases in auction-market goods like primary commodities is a warning sign that the Fed’s monetary policy is too easy. In 2010 CPI indexes shot up more than 5% in major emerging markets while only 1.2% in the U.S. 2. General price inflation in the U.S. “only comes with long and variable lags.” After the Nixon shock of 1971 inflation exploded in Japan in the 1972-1973 period but by December 1979 the U.S. CPI and PPI were higher than 13%!

In short, the inflation we ship abroad comes back to bite us where the sun doesn’t shine, and really bad!

In concluding commentary McKinnon points out that the U.S. can basically do what it wants, and since Bretton Woods has had the luxury of managing the world’s exchange and reserve currency. “But by ignoring inflationary early warning signs on the dollar standard’s periphery, which in turn lead to rising domestic prices and asset bubbles, the Fed has made both the world and American economies much less stable.”

Let’s hope Bernanke heeds the obvious. If not, we’re due for a repeat of the Carter years.