Tuesday, November 30, 2010

The Playful Musings of Illogical Optimists

     I recently came across a "discussion" between Matt Ridley, author of The Rational Optimist, and Bill Gates in John Maudlin's "E-Letter" about the nature of optimism and pessimism. Ridley generally argues that our "success" as a species up to this point has been primarily a result of our inherent ability to trade with each other, as evidenced by the very early use of rare objects far away from the sources needed to produce them. He further argues that, consequently, humans have continued to increase their collective prosperity throughout the ages, despite many dire predictions of impending doom that were being made all the while. Bill Gates has written a book review in which he quarrels with a few specific examples that Ridley had provided (problems in Africa and Climate Change), but he essentially agrees with Ridley's main point that many people are "overly concerned with potential problems", especially in "rich countries over the last several centuries".

     This so-called discussion between Ridley and Gates is, in fact, not much more than a simple back-and-forth between two people who hold self-contradictory views and know little about the topics they discuss. That statement may seem harsh, but reality can and has been harsh, a fact casually dismissed by the writers as being "too pessimistic" for their personal liking. The response by Gates is an amazing example of how human beings, those creatures who have historically been so "successful", are also plagued with many logical fallacies and cognitive biases. In fairness to Gates, these are not isolated flaws limited to the minds of a few American billionaries, but a pervasive feature of human beings in all complex societies around the world. Nicholas Nassim Taleb has deftly illustrated this point in his books The Black Swan and Fooled by Randomness, which I highly recommend.

    Anyway, I will not even dwell on Ridley and Gates' deep lack of understanding about the details of macroeconomics, climate change, environmental sustainability and whatever else they have discussed, because it would devote too much time towards arguments which can be dispelled in a much simpler fashion. I'll just quickly point out that Gates has urged us to consider "super-intelligent computers" as a major threat to humanity unfairly neglected by Ridley in his book, instead of financial meltdown, peak oil or geopolitical instability.

    Not to be outdone by another man's ignorance, Ridley responds that we are gradually transitioning away from carbon-rich coal to "hydrogen-rich fuels like oil and especially gas", so as to render climate change a greatly over-exagerrated threat. A reader can't help but get the feeling that these gentleman expect people to take their completely unsupported assertions as the gospel truth, instead of with the heavy dose of salt they so clearly deserve.

     However, since the limited discussion I read was focused mainly on the broad nature of optimism and pessimism, I will stick to the logical flaws they pepper throughout their arguments. Gates really manages to kill his logical credibility right off the bat when he refers to the following quote by John Stuart Mill:

"I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage."
     Assuming that Mill's assertion is mostly true, we are left with the point that people tend to respect purveyors of "despair" rather than those of "hope". With a logical leap of greatness, Gates then uses Marx's hugely populary theory of capitalism as an example of "excessive pessimism", since it was (is) respected by many people and also made dire predictions about the future of capitalist economies.  He effectively attempts to dispel extremely valid concerns about the sustainability of capitalism, developed over hundreds of years and now more prescient than ever, by confusing a general anecdote with the validity of a specifc scientific analysis.

    Yes, many preachers of "doom and gloom" may get significant amounts of attention and achieve large followings, but that by no means speaks to the credibility of their underlying arguments. By Gates' reasoning, any popular scientific analysis that predicts signficantly negative outcomes should automatically be treated as suspiciously pessimistic, including the widely-accepted theory of man-made Climate Change, which Gates happens to support.

     Unfortunately, the above logic will seem impeccable when measured against that contained in his next few statements. And I quote:

"Pessimism is often wrong because people assume a world where there is no change or innovation. They simply extrapolate from what is going on today, failing to recognize the new developments and insights that might alter current trends."
     Gates' point about people extrpolating past trends into the future is a valid one, but it provides no logical support for his premise that "pessimism is often wrong", because that particular cognitive bias applies just as well, if not more so, to attitudes of optimism about the future (re: constant denial by people in the developed world that economic growth has indefinitely stagnated). Between the twelve lonely economists who were predicting a housing-driven financial meltdown and the millions of people expecting housing prices to rise forever, it should be crystal clear who was in the business of extrapolating past trends. By this point in his review, Gates has established an illogical momentum which cannot be stopped. In an almost unbelievable fashion, he waits for no more than one sentence from the prior passage before dropping this bombshell:

"A lot of the rhetoric about sustainability implicitly assumes that we will exhaust our natural resources, as though there will never be any substitution of one commodity for another in the future. But there has always been such substitution."
     He has immediately employed the tactic he just criticized pessimists for incorrectly using, as if billions of dollars in net worth come at the expense of short-term memory. The suggestion is that humans have always substituted plentiful commodities for rapidly depleting ones in the past, and therefore there is no reason to expect anything different will happen in the future. Apparently, it is only wrong to project past trends into the future when those trends don't support the argument you are trying to make. Gates has completely missed the lesson of that cognitive bias, which is not that humans have always innovated their way out of historical problems, but that the specific future behaviors of complex systems are inherently unpredictable. Broad structural shifts such as energy or resource scarcity, on the other hand, are quite predictable within a range of certainty.

     Finally, the most egregious logical fallacy employed by both Ridley and Gates is that of projecting their personal definitions of "success" onto the whole of humanity, throughout all of time. They view the technological and sociopolitical developments over centuries of evolution as being clearly beneficial to all of mankind. If certain arbitrary measures have improved for specific segments of human society, such as "lifespan, nutrition, literacy, wealth", then clearly progress has been made and all of the pessimism was much ado about nothing. It is a deeply-rooted fallacy held by many people born in the developed world and living in relative stability, who tend to ignore the large historical and ongoing costs incurred to make their current lives possible. 

    They are ignoring the Earth's struggling ecosystems, the extinct biological systems, the destructive wars, the massive geopolitical instabilities formed over centuries, the lives of future generations, the tragic disconnects with nature, the deterioration of moral fabric, the structurally pervasive inequality and the very reasons why Bill Gates feels compelled to donate such large sums of money to humanitarian aid missions in the first place. All of the above and countless other things have directly occurred or will occur as a result of the human "progress" that now makes them so optimistic.

     Of course, I'm just an unknown blogger who has written no book published by a major clearing house or reviewed by an American business icon in the Wall Street Journal. If I want to engage in this discussion of optimism and pessimism with Ridley and Gates, then my best shot is in the comment section underneath the online WSJ publication. After all, what good is informed knowledge and logical consistency when it underlies a "pessismistic" world view? John Stuart Mill was wrong, in so far as anyone who makes temporal generalizations about complicated social dynamics is wrong. In modern society, pessimism about the future is largely shunned by the mainstream, because so many people are fully expecting and entirely dependent on their promised lives to materialize.

    We have been convinced by people like Bill Gates, and by our willful suspension of disbelief, that the growth story of the past will continue on indefintely into the future, and that the material gains from this growth will be fairly distributed to billions of people around the world. I say "we" because I have a hard time shaking free of this story myself, like a little child who has just learned Santa Clause doesn't exist. It takes courage and persistence to despair when others illogically scream at you to hope, so my question is this - when are we going to allow adults into this ever-important discussion? I suspect that when the next leg down of the ongoing financial crisis occurs and energy costs skyrocket, Ridley and Gates will lay low and speak with muffled voices, but still retain their optimism, because they have more than enough to survive.

*The "discussion" is sourced from here

Friday, November 19, 2010

From One Corrupt Congressman to Another

"A chain is no stronger than its weakest link, and life is after all a chain." -William James

     The House Ethics Committee has just voted to confirm there is "clear and convincing" evidence that Charlie Rangel (D-NY) has violated at least eleven different Congressional ethics rules. His violations include failing to pay taxes on his property in the Dominican Republic, illegally transforming a rent-controlled residential apartment into a campaign office and using his status as head of the Ways and Means Committee to secure funds for his public policy center. What is the punishment recommended by the Commitee for this Congressman's criminal and unethical behavior? Censure! That's right folks. Rangel will be forced to stand on the floor of the House in front of his peers, in the narrowest sense of that word, and be lectured to by its Speaker, which will either be Nancy Pelosi or John Boehner depending on the timing.

     I'm not sure exactly what the Speaker would say in this censure, which Representative Butterfield (D-NC) had the nerve to label an "extreme" punishment, but rest assured that the following is the gist of the message which will be sent:

"From one corrupt Congressman to another, congratulations on successfully fleecing the American people and abusing their trust for years, without suffering any real consequences for your actions. We could have forced you to resign from Congress, or maybe even subjected you to criminal prosecution for tax fraud, but you and everyone else here knew from day one that would never happen. Drastic measures such as those would threaten to expose the systemic corruption in this institution, and could very well subvert our entire operation!

No, not one person here wants to see that happen... but we will censure you for your actions. Take this punishment as a signal old man. You have "served" the people for decades now, during which time you siphoned off your fair share of political rents. Now, it's time for you to move over and make room for some of the new guys. After all, there's a learning curve to this here game, and plenty of eager politicians who are dying to play."
     Representative Maxine Waters (D-CA) is also up for a hearing before the Ethics Committee in a few days, on the charge that she diverted TARP funds to a financial institution in which her husband had a financial stake. What are the chances that she escapes the hearing with nothing but a slap on the wrist like her buddy Rangel did? Vegas oddsmakers would probably give you a 100 to 1 for taking the other side of that bet. I keep naively hoping that Congress will decide to dismiss the Committee's recommendations and throw the book at Rangel, Waters and all others like them. After all the bickering and rhetoric leading up to the 2010 elections, you would think that the House Republicans would at least go after corrupt Democrats with full force.

     That is, of course, until you realize that the Republicans have just as much to lose from harsh punishment as Rnagel and Waters do. They are the new face of the House, will most likely be the new face of the Senate in 2012 and perhaps even of the Presidency. These people didn't get to where they are now by ignoring the cardinal rule of American politics - accountability for one means accountability for all. The game has clearly defined rules and very strict boundaries that no one must cross. If everyone was held accountable for their "sloppy" or "stupid" actions, as Rangel described his, or for their "acts of ommission" and "failing to carry out [their] responsibilities", then who would be left to make wise policy decisions for the American people? Well, that's how the deeply embedded insitutional players think anyway.

     How many times over the past decade have we had to put up with meager settlements, petty fines, symbolic reprimands or absolutely no punishment for blatantly criminal activities? Whether it be high-level executive officials frabricating intelligence and sanctioning torture, top bank executives committing systemic fraud and laundering drug money or legislative officials accepting bribes and abusing their authority, we have seen it all spontaneously come to light and then be buried in the depths of public consciousness just as quickly. Any real puishment for these actions would lead to the end game in short order, because once they give us an inch, they know we'll quickly take a mile. Indeed, to sacrifice the weakest link is to sacrifice the entire chain.

*All facts sourced from the following CNN article

Saturday, November 13, 2010

The Keynesian Vacuum Universe

"Nothing in the world is more dangerous than a sincere ignorance and conscientious stupidity"
- Martin Luther King, Jr.

     If only we existed in a Keynesian vacuum universe, then the current Administration's economic policies may have actually succeeded in fixing the ailing, debt-ridden economy! Here are some of the reasons why:

-   Swapping bad private debt for public debt would not negatively affect the sovereign bond market in any meaninful way, since all public creditors would realize that it is just a temporary measure to clean up balance sheets and restart economic growth. The prior value of that bad debt would eventually be restored, and it would be repurchased by private actors. The taxpayers would recover all of their money, or maybe even make a small profit.

-   Deficit spending would also not affect the bond market for the same reason above. It would go directly to consumers and small businesses who could pay off debt and start productive enterprises that create useful products/services, which could then be consumed. No money would be wasted on pork or in bureacratic institutions, because the government would know exactly where the money needs to go and how to get it there efficiently.

-   A "Deficit Reduction Commission" would effectively deal with any potential possibility of a public debt crisis by making small tweaks to entitlement spending and tax policy, leaving defense spending alone so all Americans can feel safe and secure. As soon as the Commission produced its report, all measures proposed would be instantly voted on by Congress and approved. The minor tweaks, of course, would not have any unintended consequences, such as stifling economic growth (and making deficit/GDP worse) or royally screwing War Veterans by cutting their health benefits.

-   Government backstops and subsidies of the housing market would not be taxpayer money wasted, because the bailed out banks and subsidized borrowers would pick up the housing bubble where it left off in 2007. As credit conditions eased, home prices stabilized and unemployment decreased, the government could draw down its market interventions and aggregate demand for homes would not plummet.

-   The Dodd-Frank Wall Street "Reform" Bill would not create any level of uncertainty or unintended consequences in financial markets, since it would extremely clear and targeted with its new measures. The new regulators would analyze the root causes of the financial crisis, propose measures to address these structural problems, implement those proposals via new regulations and enforce the regulations. All new regulators would be insulated from financial industry capture, and would work solely for the benefit of the American public.

-   Quantitative Easing by the Federal Reserve would not blow speculative bubbles in any financial markets, and even if it did, that speculation would not artificially increase the prices of commodities for consumers and productive businesses (squeezing their profit margins). Money would flow to the banks from asset purchases, and these banks would lend that money out to consumers and small businesses at affordable interest rates. Asset prices would not go parabolic again via leveraged speculation, because investors would have learned their lessons from the last credit bubble.

-   QE would also successfully devalue the dollar enough to make debt burdens more manageable and boost U.S. exports, but not so much as to cause rampant, unchecked inflation. In the Keynesian vacuum universe, other countries do not care about American monetary policy that serves to flood the entire world with dollars used for intense financial speculation.

-   Moral hazard would never be an issue. Bailouts and subsidies for banks, businesses or consumers would not affect the future decisions of these market participants, courtesy of the laws of  the vacuum universe.

     And if we really existed in a vacuum, then we would have never had a global credit bubble or financial crisis in the first place. Life would have been clean, simple and forever productive. It would always be a warm and sunny day outside, with cheerful birds chirping and the faint laughter of little children in the background. In this universe, political leaders and pundits could look their country's population in the eyes, and tell them that their economy is healthy and their country is "the greatest" with a straight face. The people would never question the wisdom of those wielding power, and their minds would always be at ease. That is, of course, until they snap back to reality and are forced to face their existence beyond the comfort of the vacuum.

Saturday, November 6, 2010

Plutocracy Now!

     Every so often, Americans should stop everything they're doing for a moment, and reflect upon the nature of their country. Specifically, upon what has traditionally been this country's defining characteristic. Was it our capitalist economy? No, there are many capitalistic countries around the world and capitalism was not first formulated by Americans. What about our emphasis on personal freedom? Well, once again, many countries preach the virtues of freedom and many groups of people have fought for freedom well before America was formed. Surely it has been our diverse populace and our tolerance of all races, genders, sexual preferences... yeah, right. Personally, I would answer that it was our written Constitution and the democratic values embodied within it.

     No other country had ever codified the structures and processes of their governing institutions to such an extent in one single document. Many people focus on the Bill of Rights when speaking about the Constitution, but the first four Articles are just as important. They synthesized political ideas that were developed over hundreds of years by some of the most insightful thinkers, such as separation of federal powers, checks and balances, vertical division of powers (federalism), an independent judiciary and, of course, representative democracy. The latter emphasizes the notion that any policies enacted by the federal government must be authorized by the people, through their elected representatives who are held accountable to constituents every few years.

      So what's the state of our Constitutional democracy today? Simple, it doesn't exist. International corruption surveys typically rank the U.S. higher (less corrupt) than most other countries, but this simply proves how bad these surveys are at capturing the essence of real, hardcore corruption. We could write stacks of books on the prevalence of money in politics and the swarms of lobbyists who descend on Washington every single week, and many people have, but it's simpler to just focus on the most egregious example of corruption. The most powerful, influential economic policy-making institution in the country, the Federal Reserve ("Fed"), is an unelected body that is completely unaccountable to the people. Well, let's back up and start with the fact that this institution's very existence is most likely unconstitutional. Here's why:

     Article I, Section 8 of the Constitution states that Congress has the power to "coin money" and "regulate the value thereof". The Supreme Court has long held that Congress can delegate its legislative powers to Executive agencies as long as it provides an "intelligible principle" to guide the agencies' action. We don't even have to reach the question of whether the Federal Reserve Act sets out an "intelligible principle", however, because existing precedent states that Congress cannot delegate its powers to private institutions. Schecter Poultry (held "a delegation of its legislative authority to trade or industrial associations...would be utterly inconsistent with the constitutional prerogatives and duties of Congress). In that case, the Supreme Court struck down parts of FDR's National Industrial Recovery Act which authorized these private organizations to draft "codes of fair competition" and submit them to the President for approval.

     The Fed, by it's own admission, is an independent entity within the government "having both public purposes, and private aspects". By "private aspects", they mean the entire operation is wholly-owned by private member banks, who are paid dividends of 6% each year on their stock. Furthermore, the Fed's decisions "do not have to be ratified by the President or anyone else in the executive or legislative branch of government" and the Fed "does not receive funding appropriated by Congress". In 1982, the Ninth Circuit Court of Appeals confirmed this view when it held that "federal reserve banks are not federal instrumentalities... but are independent, privately owned and locally controlled corporations". [The Legality of the Federal Reserve System, 5]. Yet, the Fed has exclusive control over the government's ability to create money and regulate its value through the targeting of interest rates and open market operations (when the Fed buys an asset, it typically prints the purchase money out of thin air). How Congress can delegate its Consitutional powers to this independent, privately owned and unaccountable institution is beyond me.

     Still, the Constitutional issue is just the tip of the iceberg when it comes to this twisted institution's embodiment of all things undemocratic. When Congress (and the people it represents) makes a valid delegation of its powers to an executive agency, it almost always retains a level of control through its powers of appropriations, impeachment and oversight. For some not-so-strange reason, the Fed isn't appropriated any funds by Congress, and so it cannot be financially "starved" like any other agency. The members of the Fed's Board of Governors also cannot be impeached by Congress, which is especially twisted, since the President of the United States can be impeached for "high crimes and misdameanors". [The Legality of the Federal Reserve System, 8]. What about oversight? Well, a Congressional committee holds "hearings" every once in awhile to ask the Chairman a few irrelevant questions, but if this process is what passes for "oversight", then we have truly gone off the deep end.

     Speaking of committees and oversight, when Fed Chairman Ben Bernanke testified under oath to Congress in July, he said in no uncertain words, "the Federal Reserve will not monetize the [federal] debt". [1]. Fast forward to the day after mid-term elections, in which the American people clearly voted for LESS spending/printing, and the Fed announces its plan to monetize $900 billion in treasury bonds. [1]. The Chairman has proven his previous testimony before Congress to be a blatant lie, but instead of condemning the Fed's recent actions, the federal government has welcomed it with open arms. That's quite some oversight we have there. Perhaps the best way to oversee the Fed's actions would be to actually figure out what in Lloyd Blankfein's name it's been doing.

     In this country, that's easier said than done. The Government Accountability Office is not allowed to audit the Fed's transactions for or with foreign governments, central banks, nonprivate international organizations or those made under the direction of the Federal Open Market Committee ("FOMC"). It just so happens that these are the types of transactions which are most influential on global and domestic financial markets, especially the open market operations. These operations are conducted by the FOMC, who is comprised of the Board of Governors (7 members appointed by President and confirmed by Senate) and five representatives from the regional Fed Banks. Although the President appoints the Board of Governors, he must choose from a list of candidates provided by private institutions, and the other five representatives are also typically nominated by private member banks. Talk about an organization with conflicts of interest, lack of transparency and lack of accountability all tightly woven into its very fabric!

     In the last two years, the almighty Fed has printed trillions of dollars in our name to buy worthless mortgage assets from "too big to fail" banks. It has lent these banks our hard-earned money at about 0% interest, so they could lend our own money back to us at 3%+. These banks also used our free money to ramp equity and commodity markets, which mostly benefitted the top 1% of our population who owns 43% of financial wealth [2], and conveniently, also owns the Fed. The latter has kept interest rates at next to nothing to punish savers and encourage speculation, making everything less affordable for average Americans who have seen their wages stay the same, decrease or disappear. What's left standing is the perniciously powerful, highly secretive and entirely unaccountable Fed, who now epitomizes the state of American democracy.

     We have all become subject to the misguided and/or malicious whims of a few wealthy individuals operating the levers of economic policy, with no adequate means of challenging their power. Our most treasured contribution to poitical society has been reduced to a bunch of meaningless articles and amendments, containing equally meaningless words. We the people, in our pursuit of "a more perfect union", have fallen into an age-old trap. Our economic policies, currency and laws are all manufactured by our very own private dictator, who amasses a fortune from our collective exploitation and destruction. Then, this despot continues to operate like nothing ever happened. We can scream "ABOLISH THE FED" all day, non-stop to every single politician at the top of our lungs, but it will never happen.  The reality is that there is only one way back to a true democratic system now, and this path will require nothing less of us than the courage of our forefathers.

Wednesday, November 3, 2010

A Probabilistic Assessment of Short-Term Inflation or Deflation

*I apologize for the skewed format of this article... having some technical difficulties with blogspot

The blogosphere has been rife with debates over whether the U.S. economy will experience inflation or deflation over the next year or two. Typically, those on either side of the debate believe that, regardless of the specific outcome, it will be severe and destructive, but there are some who believe it will be a milder process. It has also become clear that those on either side of the debate are almost certain that we will experience the outcome they advocate. I am of the view that the best we can do in our complex financial economy (which is highly inter-connected to the global economy) is discuss the broad factors that make one or the other more likely to occur. It appears to me that there are at least three critical questions which should be answered to determine probabilities of outcomes in the controversial inflation/deflation debate:

  1. What do the financial elites want to happen given the current economic circumstances?
  2. Will the Administration (includes Congress for this discussion) and/or Federal Reserve  attempt to pursue policies that accommodate the elites' preferences?
  3. If the answer is "yes" to #2, can the Administration and/or Fed be successful in achieving these goals.
After considering how much wealth is controlled by the elites (top 1% holds 43% of financial wealth) [1], and therefore how much political influence they exert, we can assume the answer to #2 will almost always be "yes". This answer is further reinforced by past political experience and a bit of common sense. That leaves us with #1 and #3, which are difficult questions to answer with high levels of certainty. However, many insightful analysts have attempted to answer these questions using facts, data, trends and experience, and have produced very plausible predictions.

          Many people may criticize the following analysis for leaving out many different factors that could potentially affect the likelihood of inflationary or deflationary outcomes. However, when too many variables are included, the analysis required to determine chances of specific outcomes grows disproportionately more difficult. This article has attempted to use broad strokes to sketch a general picture of the probabilities involved, sacrificing detailed calculations for targeted clarity. It is somewhat of a perturbation approach, where a few primary factors are used to create a “ballpark estimate”, and then this estimate can be later refined by including smaller, more detailed factors. For example, when physicists attempt to predict the motion of the Earth within the solar system and through the universe, they cannot factor into their calculations every gravitational force that acts on the Earth. Instead, they focus first on the Sun’s gravitational effect, since it is the most influential force by a large factor. After making this relatively simple calculation, they can gradually add in the effects of the next most influential bodies, but they will never arrive at an exact prediction of the Earth’s motion because the calculations eventually become too complex.

          Before delving into the discussion, I must note that it will be based on several different assumptions for the sake of simplicity. Instead of mentioning them within the discussion, I will just list them up front and let the readers decide whether they are reasonable or not:

          - The financial elites do not want severe deflation or hyperinflation, since these outcomes would
            wipe out the value of their numerous debt assets or wipe out the value of all their dollar-
            denominated holdings respectively.

          - The Administration/Fed will almost always attempt to pursue the policies that the elites want them   
             to (95% of the time for inflation; 90% for deflation)
          - The financial elites cannot unilaterally (without Administration/Fed) make decisions that will affect
            the probabilities of inflation or deflation (we will assume they will make self-interested lending 
          - The Administration/Fed’s attempts to inflate, if they choose that option, will not be significantly
            counter-acted by currency devaluations of other countries. They may have a temporary effect, but
            financial/militaristic incentives to work with the American power elites and threats of protectionism
            will balance this dynamic out.

          - Hyperinflation will only occur when financial elites prefer inflation, and severe deflation will only

            occur when elites prefer deflation.

          - Issues associated with peak oil/resources will not be a factor within the next few years.

The following definitions of inflation and deflation, borrowed from The Automatic Earth, will be used [1]:
  • Inflation - Marginal increases in the amount and velocity of credit money relative to goods/services.
  • Deflation - Marginal decreases in the amount and velocity of credit money relative to goods/services.

What do Power Elites Prefer – Policies Supporting Mild Inflation or Mild Deflation?

            Mild Inflation (25%)

The argument for power elites preferring mild inflation is perhaps the most intuitive. Inflation of the money (credit) supply to devalue the currency should lead to rising asset prices, as more money is chasing the same supply of assets. Financial elites have large investments in real estate, stocks, bonds and commodities and should therefore benefit from higher prices and interest rates. If consumer prices are also supported, then there could be a resumption of hiring by various businesses, which would certainly help restore some confidence in the economic structures of the status quo elite. In a more general sense, inflation manufactured via another credit bubble would return the economy to a state of consistent growth, allowing power elites to continue playing their cruel games. However, this argument contains the following assumption, which may simply be incorrect: that creating a modest amount of growth in the money supply, by getting debt-money to investors and consumers, will actually lead to higher prices.

The prominent blogger Charles Hugh Smith (“CHS”) has provided a very insightful argument for why the elites would not prefer mild inflation [2]. To understanding a key part of this argument, it’s important to note that the economic situation now is unlike it has ever been in the last 60-70 years and also that the elites are aware of this fact. There has been an enormous, decades-long credit bubble in the private sector (~300% Debt/GDP in 2008), and now the consumers, who make up 70% of GDP, are buried beneath a mountain of debt. Despite the Administration and Fed's programs to inject trillions into the economy via stimulus and quantitative easing, the velocity of money has remained stagnant as investors, small businesses and consumers hesitate to lend, invest or borrow. It is very plausible that a modest increase in money supply will simply lead businesses and consumers to pay down some debt and hoard any remaining cash in the face of future uncertainty. We certainly see a version of this dynamic in the stock market, where institutional investors continue pulling money out of equities despite the recent rallies [3].

For the above reasons, the economy will most likely be in a prolonged period of low growth and subdued asset price inflation despite modest amounts of further stimulus or monetary easing. Even some of the major investment banks (financial elites), such as Goldman Sachs, have predicted a negative GDP print in Q4 2010. [4]. The current dynamic for elites is much different than the one existing after the Great Depression, where losses on cash holdings from consistent devaluation of the dollar via inflation were more than offset by returns on asset investments. CHS points out that the dollar has lost more than 95% of its value since 1913, but the Dow Jones Industrial Average has actually risen at about seven times the rate of dollar depreciation over the same time period. It would be prudent to assume that the elites have learned their lesson from 1966-1981, when a period of “stagflation” (low growth coupled with high price inflation) wiped out much of the value in their stock and bond holdings. [5]. The last thing the elites would want is a period of inflation in consumer prices, which eats up the value of their debt assets, but doesn’t contribute to high returns on financial investments.

Mild Deflation (75%)

CHS explains that mild deflation, on the other hand, would increase the purchasing power of elites holding cash, money market instruments and short-term treasuries, while also increasing their returns on debt assets. When inflation is negative, the real interest rate paid on debt (= nominal IR - rate of inflation) is higher than the nominal rate. As long as the deflation doesn’t become too severe and wipe out heavily indebted consumers, businesses and governments, the financial elites can continue making decent returns while setting themselves up to buy various assets for pennies on the dollar in the future. [6]. By maintaining their wealth and political control, the elites can also ensure that any new regulations or fiscal/monetary policies continue to be in their favor (backstops of the housing market, monetization of treasury debt, higher taxes on the middle class to pay interest on public debt, welfare benefits to quell social unrest, watered down “reform”, etc.). Therefore, on whole, it seems significantly more likely that power elites would prefer a path of mild deflation above all else, but the question of whether it is even possible to maintain this Japan-style malaise still remains.

What can the Administration and/or Fed Accomplish?

            Mild Inflation (10%)

It would appear that the Administration and Fed have been completely geared towards creating inflation up to this point in time. The former attempted to re-capitalize major banks with TARP and mark-to-fantasy accounting, promote consumer spending with stimulus and stabilize housing prices through Fannie, Freddie and the Federal Housing Administration. It has also provided billions in jobless benefits and other aid to struggling citizens. The Fed has attempted to stabilize the housing market and banks’ balance sheets through asset purchases of mortgage-backed securities and zero-interest rate policy. The latter, along with the direct monetization of treasury bonds by the Fed, also serve to finance the Administration’s deficits at low interest rates (banks borrow at 0% and lend to the government at 1-4%).  

Despite all of these measures, consumer price inflation remains close to 0% (excluding energy/food) [7], unemployment remains close to 22% [8] and consumer credit continues to contract [9]. Of course, the stock and bond markets have benefitted greatly from these policies since the beginning of 2009. The former, however, has become increasingly unstable this year as retail investors continue to opt out in large numbers and robots with synchronized time horizons are left to buy and sell to each other. [10], [11]. The bond market, however, is much bigger than the stock market and its stability is significantly more crucial for the power elites and politicians. It appears at this time that, although it is in a huge bubble, the bond market will remain relatively stable due to investors’ preferences for “safe havens”, the desire of external creditors’ to support our consumer economy, and, of course, the permanent open market operations (“POMO”) of the Fed.

            Hyperinflation (30%)

Many commentators involved in the inflation/deflation debate believe that, in pursuit of inflation, the Administration/Fed will inadvertently jump start a process of hyperinflation. This argument typically follows the following logic: every time the economy renews its deflationary pressure, the politicians and central bankers will keep spending/printing money to fight it off, and eventually we will reach a tipping point of confidence in the U.S. economy and its currency as a reliable means of exchange. History certainly seems to suggest the first part of this argument is accurate, but the sociopolitical dynamics involved have significantly changed in the last few years. Both the public and politicians who pander to them have expressed much disdain for further spending or printing, and on top of that, its unclear how many trillions would even be necessary to combat the deflationary pressure. As mentioned above, the elites must maintain relative stability in the bond market to protect their holdings and the current power structure, and another $5-10 trillion in printed money would be counter-productive to this goal. For these reasons, it seems unlikely that the government will print enough money to spark hyperinflation, but that certainly does not mean we can rule it out.

A blogger named Gonzalo Lira has produced a series of articles presenting a unique perspective on how hyperinflation could occur. [12]. To summarize, he believes that a temporary spike in commodity prices (such as oil) will lead to institutional asset managers selling a portion of their large treasury holdings (paying artificially low yields) to buy into the ramp. This small sell-off will occur before a somewhat large treasury auction, and so the Fed will step in and buy to stabilize yields. Similar to what we currently see during the POMO operations, asset managers and primary dealers (“PDs”) will start unloading larger amounts of treasuries onto the Fed to turn a quick profit and reinvest proceeds into the commodity space. Asset managers will then begin to dump huge portions of their holdings, since they see the PDs selling and the Fed buying a large volume of treasuries at a time when they are already on edge about the precarious nature of the economy and bond markets. This cycle represents a classic positive feedback, where asset managers dump treasuries for liquidity, causing the Fed’s buying to stabilize yields, causing even more managers to dump while there is still a willing buyer with unlimited cash. All of this action will occur within a few hours at most, and the managers will turn to commodities as a relatively safe and perhaps quite profitable place to invest their cash.

Mr. Lira believes that physical commodities will be perceived as the only sure store of value, and will therefore shoot up between 150-250% by the end of this panicked week. Once this spike translates into significantly higher gas prices at the pump, average consumers will begin selling all of their paper assets and buying hard commodities out of fear of prices continuing to rise in the future. [13]. It is easy to see how this process will eventually translate into a self-reinforcing spiral, where almost all discretionary assets will be swapped for energy, food and other essentials, eventually leading to skyrocketing prices and hyperinflation. What’s even more frightening is that the Administration and Fed will be practically helpless to do anything about it at this point, since their limited tools will be woefully inadequate once the consumer has lost complete confidence in the currency.

Although it presents a very interesting hyperinflation scenario, the problem I see with Mr. Lira’s argument is two-fold:

(1) A large, temporary spike in oil prices is unlikely to occur or lead to a treasury-dumping spiral – The spark for a short-term spike in oil prices would have to be a major disruption of Middle East supply through a military conflict or a voluntary embargo by exporting nations. In contrast to 1973, when OPEC nations decided to place an embargo on oil exports due to Western support of Israel in the Yom Kippur War [14], the U.S. now has strategic military bases throughout the Middle East and would not allow such an embargo to even take place. [15]. Any further military conflicts that take place in this region will have the U.S. military directly involved, and it will certainly do everything it can to make sure America’s share of oil supply is not disrupted. In fact, a prerequisite for any military action would be to have a solid plan for securing production facilities in the region.

 If the supply of oil to America is disrupted by military action in the Middle East, then the Administration will most likely institute price controls on gas at the pump. Mr. Lira states that these controls would simply create a black market for goods and do nothing to reverse the underlying hyperinflation, but he is assuming these controls would only occur after there is a run on treasuries and hyperinflationary concerns reach the average consumer. It is more likely that the government will immediately cap the price of oil, perhaps through an executive order in the name of “national security”, which will destroy the incentivize for asset managers to dump large amounts of treasuries for commodities in the first place. When the potential upside gains of commodity plays can be artificially limited, it would be very risky for investors to bet against the federal government.

(2) The outstanding debt obligations of consumers/businesses are still excessive – The major reason why the U.S. economy naturally faces a deflationary depression is because there is too much private debt outstanding, and the need to destroy this debt suppresses aggregate demand for consumer goods or financial assets. Currently, when the price of oil gets significantly above $85/bbl, consumers are priced out of the market and demand destruction ensues, since demand is still relatively elastic to price changes. A temporary spike in oil prices would most likely lead asset managers to sell off stocks and commodities as well, since they are worried that consumers will heavily cut back on spending and pay off debts. This process is what the U.S. experienced in 2008 after oil hit $140+/bbl, and although the circumstances have changed since then, the underlying realities of excessive debt and artificially high consumer demand are still present. From this perspective, a temporary spike in oil prices would actually trigger a deflationary collapse rather than hyperinflation.

Mild Deflation (30%)

According to analysts such as Dr. Steve Keen, “Mish” Shedlock and Nicole Foss, the Fed is simply “pushing on a string” when it sets to generating inflation in the economy. [16], [17], [18]. Without any desire of consumers to borrow or creditors to lend at affordable rates, the trillions printed by the Fed will simply lay dormant as excess reserves or, at best, help keep the financial markets relatively stable. As for the Administration, it would have to give away a whole lot more “free money” before consumers and businesses begin spending/investing again in any meaningful manner. The best the government can do at this point is pump liquidity into asset markets and continue handing out benefits to the unemployed and poor among us. As CHS explains, the main goal here is to keep consumers paying off credit cards and mortgages, tax revenues flowing, financial markets somewhat stable and the general population placated, while economic actors continue to deleverage. [].

If the goal of power elites and the government is to manage this process of mild deflation, then perhaps the Fed is not pushing on a string at all. CHS has produced another piece which clearly shows that the government’s policies since 2008 have merely served to keep the system alive by transferring wealth from taxpayers to the top 10% of the population. Specifically, the Fed has blown more speculative bubbles in stocks, real estate and commodities, which mostly benefits the owners of financial wealth and also reduces the purchasing power of the bottom 90% through artificially high energy/food prices. Much of the toxic mortgage debt has been removed from the elites’ balance sheets and handed to the taxpayer through various government programs. [19]. This path has not been one to sustainable inflation, but rather one that keeps the power elites in business while cash flows in the general economy slowly dry up and investment capital relocates to emerging markets.

Severe Deflation (60%)

As mentioned before, however, the political capital for further deficit spending and monetary easing is drying up quickly as well. The Republicans have taken back the House of Representatives, picked up a few seats in the Senate and will certainly oppose further stimulus by the Administration. John Taylor has suggested that the Fed will also be on a much tighter leash when Congressman Ron Paul becomes head of the sub-committee overseeing its operations. [20]. Although the Fed will most likely shovel out another $500B-$2T in treasury purchases via “QE2” (waiting for the announcement as I write this), it is becoming clear that there are diminishing returns to its efforts. A QE2 package that is smaller than the initial QE program, and only targets treasury bonds, will only serve to keep interest rates low and perhaps give a small, temporary boost to equity markets. It will certainly fail to stave off further deleveraging in an economy worth ~$14 trillion that also has trillions more in unserviceable debt.

So the question becomes whether the Fed's incremental liquidity programs can at least maintain modest deflation. The best answer to this question seems to be “not too likely”. The Fed actually has little ability to counter-act the debt deflation in the consumer economy, since it cannot print money and give it directly to small businesses and consumers, and Congress will also have its hands tied after the elections. What the fiscal conservatives fail to realize is how fast the economy will unravel once government subsidies are drawn down. Dr. Keen points out that the trillions spent and printed by the government after 2008 helped to decelerate the rate of credit contraction in the private sector, and this deceleration actually reduced unemployment and projected the illusion of an economic recovery. For this deceleration to continue, the private debt to GDP ratio would soon have to begin increasing again, and this is extremely unlikely to occur in an economy with ridiculously high levels of debt. [21]. If and when housing prices begin falling again, pushed along in no small part by the “fraudclosure” crisis, we can be certain that the acceleration of debt destruction will turn positive. The excessive debt, inventory and over-capacity of American consumers, businesses and markets will reveal itself in full force, and the economy will be caught in a deflationary spiral once again.

The Guesstimated Probabilities of Each Outcome

      In the perturbation sense, the strongest influences governing inflation or deflation are the natural state of the economy, the preferences of American power elites and the policy tools of the Administration and Fed. We can express the results of the simplistic inflation/deflation analysis by translating the qualitative discussion above into percentage probabilities, based on general conclusions regarding the likelihood of each outcome. To summarize, power elites would prefer mild deflation over mild inflation at a ratio of about 3 to 1, when considering the current economic circumstances. Similarly, the Administration/Fed will be able to achieve mild deflation over mild inflation at a ratio of about 3 to 1. Hyperinflation will occur three times as often as mild inflation when power elites prefer inflation (mainly due to Mr. Lira’s scenario), and severe deflation will occur twice as often as mild deflation when elites prefer deflation. The following table lists these percentage probabilities along with the chance that the government will agree to pursue the power elites’ preferred policy, and multiplies down each column to acquire a resulting probability of each outcome.

Mild InflationHyperinflationMild DeflationSevere Deflation
Preferences of PE25%25%75%75%
Government Ability10%30%30%60%
Chance of Agreement95%n/a90%n/a
Resulting Probability3% 8%

 **probabilities are rounded to nearest whole number

            The resulting probabilities above add up to 77%, which leaves another 23% for outcome combinations and also further refining of the stated outcomes’ probabilities. Perhaps the initial assumptions could be modified to make the analysis more realistic. Some readers may feel that I have derived faulty probabilities from the discussion, or even that the discussion itself contains flawed logic. I encourage readers to take the framework and general discussion points that are presented in this article and generate their own probabilities for specific outcomes. The analysis could also be refined by including the next most influential factors that have been left out for purposes of simplified calculation (i.e. European sovereign debt crisis, global currency devaluations, coordination by international elites, geopolitical factors, etc.). Personally, I believe that the probabilities listed above are at least a ballpark estimate of potential outcomes over the next year or two. Of course, without extensive data-mining and the use of computer-simulated dynamic models, we may have to simply rely on time to eventually tell the tale.