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November 14, 2005

What is reflation?, Mon., Nov. 14, 2005, 7:40 AM

Reflation is a monetary policy undertaken by a central bank in order to head off a perceived deflation. Unfortunately, this is happening today because we are saddled with a problem that economists call Stagflation.

The policy tools of the central bank are two-fold: increase the money supply or decrease interest rates.

These two do not have to go hand in hand.

There is actually another central banker's tool, one that is often used by government as well, which is called moral suasion. And just like the case of government, you will see that a central bank can say one thing, but actually do another.

Today, that's happening at the Federal Reserve Bank of the U.S. As the Fed sends out the tightening" message, which they do in conjunction with the FOMC decisions to increase interest rates, they have also been increasingly accommodative via increases in money supply.

Interested readers should learn all they can about the reserve ratio" and the required reserve ratio", which is sometimes called the cash reserve ratio". You just need a cursory understanding because it is a simple concept.

If you google these terms, you will find adequate explanations. Here is one from About.com.

The core of the issue is the velocity of money. A healthy economy needs money turning over at a certain rate. Unfortunately, for the Fed today, that is not happening in the U.S. because too much money has been leaving the U.S. economy to flee into emerging economies (China and India for instance) or offshore to tax havens, where there is a zero tax rate.

In both cases, for different reasons, that money is coming back into the U.S. via the fixed-income market, which is keeping bond yields lower than the risks that exist in the economy today. That is Greenspan's conundrum.

Another is the U.S. government conundrum, which is that, years ago the U.S. decided to be the biggest tax haven in the world (by far) by not taxing interest earned in U.S. fixed-income investments by foreign investors. This is the sham of all time because it was based on the premise that foreigners could finance the growing U.S. government debt, but that's another story.

In any event, what is happening today is that foreign money is keeping domestic interest rates too low, causing overheating in the housing real-estate market via ultra-low mortgage rates. That situation has sparked a large amount of mortgage-related cash-backs, which many say is a problem, but I would disagree with " up to a point. We are quickly reaching that point, where the ability of the mortgagee to continue to service the added debt is now in doubt.

The bigger problem is what is called the wealth effect of rising real estate prices. If people say that a house is worth 2x, when the rental value of that house then drops below a fair cash on cash return that is above the income level needed to exceed inflation rates, then the 2x price is itself inflationary. And that is what has happened. People think they are in good shape financially, but it's only because of inflated value of real property.

Now with concern about the real estate bubble" spreading, the so-called wealthy" are turning to other kinds of property to sustain the wealth effect. They are turning to diamonds, gold and collectibles. Again this is all inflation because there is no economic increase in wealth. By that I mean the owner of a diamond or a gold bar or collectible cannot rent them out to earn a fair return.

So the Fed needs to put its foot down by raising interest rates, and through moral suasion with government and commercial banks.

The Fed chair goes to Washington frequently to ask the VIP's to cut spending, but they ignore him (increase spending actually). He then goes to the commercial banks to say please don't worsen the real estate bubble, but they ignore him (increase the creation of Mortgage-Backed Securities of dubious credits).

The Fed really does try to get commercial banks not to lend for purposes that end up as an inflation-push. The Fed would simply like to see all commercial bank loans go to corporations and individuals who would use that money to create wealth, because that creates sustainable jobs and, like I say, a healthy economy.

Higher interest rates discourage many people from borrowing in order to spend their money on inflation-inducing goods. Unfortunately it is not such an effective tool for government because government isn't spending their own money, they spend yours and mine. It's a free bar, and they are enjoying the drinks.

But as I said, the biggest egg laid by government years ago has now grown up to be a serious problem. Too many large capital pools in the U.S. and in other high-tax jurisdictions are now using zero-tax offshore jurisdictions to hoard their assets, and shield them from domestic tax authorities.

In a sense you cannot blame them. If we could all get away with it we would because who wants to fund a group of self-serving, ineffective, governments that cannot seem to run a budget prudently like the rest of us have to (both personally and in the corporate form). But what's good for the goose seems not to be required for the gander, and some of us (those with the resources to do this effectively) protect ourselves in the legal aspects of tax avoidance, and some of us get involved in money laundering.

But, I ask, who is really at fault?

International monetary agencies recognized this situation in the 1990's and organized groups like the Financial Action Task Force to combat money laundering in the tax havens. But the problem continues because, at the core of the problem, government allows foreign money to finance domestic budget deficits.

Cut out domestic debt, and these offshore accounts are forced to put their money with foreign dictators. They will, but only to a point, because the first rule in money management is to protect your capital before trying to earn a return on it. And foreign dictators have this proclivity to stealing other people's money.

So the Fed now has the difficult task of putting enough money into the U.S. economy to circulate through the system, turning it over on the car lots and in the movie theaters, etc, to an extent where consumer demand grows enough to crank up domestic production of autos, Hollywood films, beef for the steakhouses, and so forth.

Right now, America is dying in these areas, and the Fed recognizes the seriousness of the problem. My no tickee for laundry (or cars, etc)" description is apt. The consumer is in trouble, and needs a boost.

Ergo: the Fed decided to print money. The Fed H.6 report is freely available. Check the massive increase in money supply in the past quarter.

I didn't make up these numbers; so please don't shoot the messenger.

What we have today is a Fed that is reflating because it knows that to kill inflation in the real-estate sector will lead to deflation. They need to give us on the one hand a drug to fight one problem (inflation), and another drug with the other hand to try to remedy the anticipated side-effects.

The patient is confused. And there are money doctors like me who are starting to question the contra-indications of the medicines that are being forced down our throat.

Life is getting tougher. People are getting in the way.

Well, it's been a slice, but I have to get back to work now. Too much wealth to be made; too many taxes to be paid.

And I can't be watching my gold and keep typing at this rate. Sorry.

Posted by Posted by Bill Cara on November 14, 2005 07:40:38 AM | Category: Economics

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