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10.01.2008 0


  • On: 10/21/2008 21:56:02
  • In: Monetary Policy

  • Every so often, you read something that just makes you want to laugh out loud for its patent absurdity. It might be some joker pretending the grass is not green, or that water is really blue. However, at least in those cases, the public does not run the risk of being miserably misled about an issue of some import.

    Therefore, laughing at the following may be enjoyable, but the sentiment must be considered seriously. For it is apparently a prevalent view at the Federal Reserve. In “It’s Deflation, Stupid” by Russel Redengbaugh and James Juliano, the authors contend that despite soaring prices from everything to commodities to consumer-purchased goods, inflation is not as much as a problem as asset price deflation (i.e. drops in prices of homes, buildings and stocks, etc.) .

    According to Mr. Redengbaugh and Mr. Juliano:

    “Houses, buildings and stocks are not inflating at all. Treasury bill yields have collapsed, long bond yields have fallen and risk spreads on a variety of assets, from GSE’s to commercial mortgages, have widened to near Bear Sterns panic levels. These are all strong signs of deflation, not inflation.”

    In other words, many investments are not appreciating in value, therefore, that is the problem, and not soaring prices for things purchased by consumers and producers. The authors go on to state that they “fear balance sheet deflation far more [than inflation] and think the Fed should add liquidity to stop this asset price deflation.”

    Yep, you read that right: Mr. Redengbaugh and Mr. Juliano actually believe the Fed should increase the money supply by adding liquidity to help bolster home prices, stocks, and other investments. And if that drives the cost of consumer goods through the ceiling… well “into each life some rain must fall.” According to their argument, “Too much liquidity produces asset price inflation, too little asset price deflation.”

    Of course, they have hoisted themselves by their own petard. It is true that too much liquidity, for example, led directly to the housing boom of the 1990’s. It appeared that just about anybody could get a home loan, and so everyone’s asking price went up. Way up, in fact. The housing market noted the rapidly escalating prices and built an abundance of homes. Too many, in fact. They couldn’t all be sold until, finally, the housing market crashed.

    And Mr. Redengbaugh and Mr. Juliano’s solution? “Add liquidity.” That’s great, just great. What’s next? “A new solution for crime: More crack!”

    Meanwhile, there is no question that the economy is experiencing real inflation right now. Why? Too much liquidity! The consumer price index is up, the producer price index is up. Now that the commodities bubble has popped, those prices may go even higher. That’s because as prices increase for one set of goods, the demand for other sets tends to go down. And once a bubble, especially one as huge as the commodities bubble (or the housing bubble before that), pops, the market ought to expect prices to rise elsewhere.

    As for stocks being down, is that even a monetary problem? Does the Fed need to “add liquidity” and lend the banks some more money so that folks invest in stocks? It would appear that the stock market has more to do with economic growth (or the lack thereof) rather than with monetary policy. This of course raises the question as to whether monetary policy ought to be used as an instrument of economic growth at all.

    Perhaps arguments against “deflation” are really arguments in favor of the Fed’s so-called dual mandate in disguise. Mr. Redengbaugh and Mr. Juliano “fear balance sheet deflation…” Um, don’t they mean losses? That’s what it’s called when the value of an investment goes down. A loss.

    To believe the authors of this highly questionable hypothesis, the U.S. dollar is simultaneously experiencing inflation and deflation. And, they just happen to believe that deflation is the bigger problem—because it directly affects investors, and only the hoi-poloi suffers the effects of sky-rocketing costs.

    It is infrequent that one runs into a piece that so seemingly defies the laws of gravity. Absurd as it is, beware: Fear of deflation runs rampant at the Fed. Despite its patent absurdity, this elegant argument presented by the authors represents the views of a significant school of thought on the economy. And if their view holds sway, the average consumer may soon have very little to laugh out loud about.

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