December 17, 2001 |
should first be a discussion of terms.
When I use the word 'inflation' in the title of this piece, I am referring
to the Consumer Price Index (CPI). Do I agree with that definition of
inflation? No, but I believe it's currently the most widely accepted
definition of the word. Inflation originally was defined as an increase in
the money supply. Period. The definition ended there. Gradually, talk of
rising prices got pushed into the definition which then became, "a rise in
the general level of prices caused by an increase in the money supply," or
words to that effect. Now, the most widely accepted definition, the CPI,
omits any mention of the money supply at all and focuses exclusively on
certain consumer prices.
This has resulted in much confusion. Two people can have a discussion about
inflation and often they're not even talking about the same thing.
Therefore, in an effort to get a point across rather than try to strictly
adhere to one definition or the other, I will not use the word 'inflation'
throughout the rest of this piece. I will speak only of an increasing or
decreasing money supply, and rising or falling prices, and then you can fill
in the definition wherever you like.
Now to my story, which will hopefully make sense of the title.
A Simple Task
I grew up on a small farm in California and our family lived next door to my
Grandparents. My Grandparents loved to garden. Well, one year they were
going back east to visit some relatives for about a week during the summer,
and they asked me to water their garden for them while they were gone. This
was kind of a big deal for me, because I was the youngest in our family and
usually these types of responsibilities were requested of my brother or
sister (I was probably only 10 or 11 at the time). I didn't want to let
Grandma and Grandpa down.
They were to be gone for a week and wanted me to water every other day. They
watered the day they left, so that meant I would only have to water three
times while they were gone. By this time of the year, their garden was down
to just one row of vegetables. Just one ditch for me to water. I did the
watering in the late evening. The first two waterings went off without a
hitch. Faucet on a quarter-turn for 15 minutes. I had it down. Smooth
sailing.
But on the third watering day some family friends had come over and us kids
were playing football in our front yard. Like a dutiful grandson, I excused
myself to go turn the water on, made note of the time, and got back to the
game.
Well, you have to understand, it was the Super Bowl and I was the star wide
receiver. It was a tight game--back and forth. It went on for a while.
Things got deep into the fourth quarter. On a key third down, I ran a post
pattern to the mulberry tree and made a spectacular catch of a poorly thrown
ball that bounced off one of the limbs (a legal catch in our front yard).
When I got up from being tackled. . . that's when it hit me. The water!
This was big trouble.
Without a word, I sprinted towards my Grandparents garden which was about
100 yards away and around the barn. "It must have been on for half-an-hour,"
I was thinking as I ran full-out. It's a good thing no one had a stopwatch
on me, because I believe several Olympic records would have been in danger.
As I rounded the barn, my eyes focused on the faucet and I turned it off
almost as I ran by. Then I bent over at the waist and tried to regain my
breath as I stood there. I couldn't bear to look up and see the destruction.
I just knew the normally light, tan soil was going to be nothing but dark,
chocolate mud everywhere. My failure was going to be completely obvious to
my Grandparents. After panting to regain my breath for a couple of minutes,
I realized I couldn't put it off forever. I looked up.
To my shock and amazement, there was no swamp. In fact, the ditch was just
below full.
How could this be? I ran to the nearest clock at their house, and sure
enough the water had been on for almost 40 minutes. What's going on?, I
thought to myself. Is God watching out for me? Or maybe it was like Mom
always said, maybe I really am special. But somehow even that didn't seem
right. The sun was going down as I walked like a zombie back to the game,
which had broken up because the other family was leaving to go home.
I couldn't get it out of my mind. I thought about it the rest of the night.
I thought about it in bed. Why wasn't it flooded? My Grandparents were
coming back the next afternoon, so I decided I would get up early in the
morning to double check the garden one last time. I just couldn't believe
that I'd been so lucky.
I got up before sunrise and sneaked out of the house. I didn't grab a
flashlight because we kept those in the hall closet with the squeaky door
and someone would hear me. I guess I thought I had to sneak around because
it seemed like I was getting away with something.
With dawn approaching, I walked over to my Grandparents garden. I squinted
to try and see the ditch in the darkness. Then I started to walk alongside
the ditch to try and examine it. As I got about halfway down the ditch, I
stepped to put my weight on my right foot and without warning it sunk about
6 inches into the tilled soil. I panicked. Whereas yesterday God had helped
me out, today he was going to open up the earth and see to it that I got
swallowed up whole! I was going straight down to hell to pay for my sins,
just like they taught me in Catholic mass.
I tried to take another step to escape, but when my left foot landed, it too
sunk down about 6 inches. This time I could tell it was muddy. So there I
was, both feet stuck deep in mud and struggling to get out, which, if you've
ever tried to do it, is not easy, especially for a little guy.
By now it was getting lighter outside and I could see what had happened. The
ditch had just been filled with water the night before, so it was a dark,
chocolate mud color. But so were the surfaces of a bunch of little trails
going away from the ditch.
Gophers.
Sometime between the second and third waterings, gophers had dug into the
ditch. I didn't notice it when I turned on the water. Much of the water had
gone into the gopher tunnels and only after sitting in there overnight did
the moisture appear on the surface. I had been stepping right on top of the
gopher tunnels and collapsing them. That's how I got stuck.
I couldn't get my feet out of the mud. I knew I was big-time busted anyway,
so I started yelling for help. My Grandparents, who, unbeknownst to me, had
come home ahead of schedule on a late flight the night before, eventually
got out of bed and came to my rescue. "You little dickens! What in the world
are you doing out there playing in that mud at this time of morning?!" my
Grandpa said as he approached. When I told him the whole story, he was
laughing so hard he nearly left me there.
Our Garden Economy
Now, let's try to relate my experience to today's economy. No, this won't be
a perfect analogy (analogies rarely are), but hopefully it will help explain
why I believe the CPI is not rising rapidly, even as the money supply has
expanded rapidly.
Think of the garden as our economy. The water flowing into the ditch is the
supply of money and credit, and can be increased or decreased. Mr. Greenspan
is controlling the faucet (money supply and interest rates). The actual
water level in the ditch roughly represents the CPI.
When the fed makes money too easy and too plentiful, you never know how it's
going to filter into the economic system. In recent history, it has nearly
always tended to come through on the demand side of the economy. This tends
to lead to a rise in the prices of the consumer items measured in the CPI.
Too much water coming through in this manner will lead to the water level in
the ditch increasing to the point of overflowing. Weeds will then grow on
the surface of the garden and will fight with the plants for the supply of
water, eventually choking the life out of many of the plants.
But this time around, credit and money went into the supply side of the
economy in the form of new companies and excess capacity. A speculative
mania occurred simultaneous to, and in conjunction with, easy money. So this
time, easy money attracted gophers. Unnecessary internet, tech, and telecom
businesses, for example. Overcapacity in many other areas as well. Gophers
can also dig tunnels from one part of a garden to another. This would
represent the way housing has been sucking much of the money away. We think
we're watering one ditch and the money is actually going into another ditch
(which we're not monitoring), flooding our plants over there. Too much water
is just as bad as too little.
If You Have A Twisted Enough Mind, Even Caddyshack Is About Economics
Remember one of the final scenes in Caddyshack? Carl the greens keeper (Bill
Murray) shoves a high-pressure hose into one of the gopher holes and turns
it on full blast. Eventually, water spouts show up all across the golf
course. Well, if you overlay that scene onto my garden analogy, that's sort
of what we've had. The CPI may not have moved up much, but we saw massive
price rises in financial assets such as internet stocks, wireless stocks,
telecom stocks, etc., and later, stocks in general. Home prices have also
moved up sharply in most of the country. Water is being diverted out of the
ditch to other places.
So all that water is indeed going somewhere. While many people have their
eyes glued solely to the CPI, right behind them water spouts have been going
off. But eventually, as easy money policies have attracted more and more
gophers, and then those gophers breed, and so on, the water has to go into
more and more gopher tunnels. Rather than a garden, we have a mess.
Eventually the water spouts stop, either because of too many gopher holes or
because the tunnels are collapsing and closing them off, or both.
But the key is, it's necessary that this happens. The gopher holes need to
be eliminated otherwise our plants will die, one way or another. Money
siphoned away also prevents us from planting new plants and allowing us to
expand our garden.
An Economist Drowned While Crossing A River That Was An Average
of 3 1/2 Feet Deep
That old joke reminds us that economic statistics can be extremely
misleading. Sometimes to the point of being nearly worthless, if not
outright dangerous. To illustrate this, let's take an extreme, absurd
example of a "gopher hole" business.
You and I are each going to start a business. We're going to swing shovels
at each other's heads. That's our business plan. $10 a pop. We start in. You
smack me on the head and I pay you $10. Then I smack you on the head and you
pay me $10. It's a new industry. Word spreads that this new industry could
go global. People get excited and competing companies form. New employees
are hired at great expense. Soon, new shovel-swinging companies are
springing up everywhere. None of them are making money, but they all start
building huge infrastructure because they want to expand globally before
even finding out if they can make a profit or if this is really a needed
service. Some cater exclusively to women, others to teens, others to those
who like to watch people swing shovels naked. Rather than exchanging actual
money, some companies just start making bookkeeping notations to make it
appear as though money has changed hands.
The industry grows. Analysts begin to examine the stocks of shovel-swinging
companies. Industry magazines sprout up. The demand for shovels is so great
that it starts to affect previously boring shovel-making companies. Their
stocks take off too. Real estate must be built to house the new offices of
shovel-swinging companies. Furniture, office supplies, carpeting, launching
parties, industry gatherings, etc. Pretty soon, all industries in the entire
economy are booming. Corporations ramp up to meet the new demand.
Individuals borrow and spend to live at their new, higher lifestyle, while
letting their profits in shovel-swinging stocks continue to grow. Housing
booms, new car sales go up, etc.
But what has really happened here? Obviously, it's all complete nonsense.
We're just harming ourselves. What we have really done is wasted our
precious time, and squandered our valuable capital, exchanging it for
worthless pieces of paper in shovel-swinging stocks, or for real things that
we now have far too many of. Yes, we need shovels. But not 16 jillion of
them. A boom in a completely worthless industry eventually affects the real,
legitimate industries.
Yet a curious thing occurs. By all statistical measurements this would be
appear to be a strong, robust, booming economy. GDP, which is really just a
measurement of transactions, is booming. $10 each time we pop each other on
the head. Plus, all the other transactions that take place as the general
economy booms. But GDP doesn't tell us whether these investments were wise,
whether capital is allocated to areas of the economy that really need it, or
whether there is even a return on the capital invested.
Similarly, employment is going at full tilt! "Dude, this place is booming,
man. You got to get out here and get in on this." Unemployment falls below
levels previously thought impossible. Then, you know what, somebody invents
a double-headed shovel, allowing you to hit two people in the head at once,
and because of the way productivity is measured, industry productivity
figures jump by 100%! GDP, employment, productivity, we're hitting on all
cylinders!
But of course it's all complete foolishness. Because. . . .
Capital Allocation Matters
That is perhaps one of the most important principals of economics. To
suggest that all Mr. Greenspan has to do at any given time is watch a
certain group of statistics and then raise or lower interest rates, or
increase or decrease the money supply and all will be well, is nonsense.
Statistics don't tell us if capital has been allocated properly. A false,
ephemeral boom gives many of the same statistical readings as a real boom
with a strong foundation. Once the collapse comes in the above
shovel-swinging economy, what difference would it make if interest rates
were lowered substantially? Or, if we adjusted the money supply by adding
two zeroes onto the end of every $100 dollar bill, or subtracting two
zeroes, what difference would that make? These are worthless companies. They
provide no value to society. They provide no return on capital. They need to
go bankrupt. It is impossible to prevent them from going bankrupt. There
simply is no need for such an industry. Monkeying around with interest rates
and the money supply is not going to save the industry from its much-needed
demise. In fact, artificially lowering interest rates will probably only
serve to keep the false boom alive and allow these worthless businesses to
stay afloat even longer. The best thing that could happen is to cut money
off from them altogether and immediately, so that we can all get back to
doing something worthwhile.
Yet even after all the uneconomic, worthless businesses are gone, the real
industries will still be left with real overcapacity that was engendered
during the boom of a false industry. As demand for their goods declines,
either profits and/or wages must come down, otherwise there will be layoffs.
Again, artificially lowering interest rates will only keep more unneeded
capacity around longer.
What Is The Money Supply?
To add further difficulty to the mix, it is not even that easy to determine
the supply of money. Many economists and commentators look solely at the
banking system for money supply figures. But what about all the credit that
gets created outside the banking system itself? Doesn't this serve as
"money" also? Let's say you own a restaurant, but have no cash. I have $100.
You sell me a $50 gift certificate. Now you have $50 cash, and I have $50
cash and a $50 gift certificate. Credit has been created and that credit
serves as money too. So long as others agree to accept your $50 gift
certificate, I could use it to pay for things. This $50 of credit creation
would show up nowhere in the official money supply figures, and yet money
was created. Asset-backed financing works in a somewhat similar fashion.
Vendor financing would be if the restaurant owner let me pay over time. Such
financing was used extensively during the tech bubble.
Much of the credit and many of the paper assets created during the boom
effectively added to the "money" supply. No, it's not actual currency or
bank deposits, etc., but it could and often does serve as "money." So one
could argue that much of the increase in the money supply during the boom
happened entirely outside of the banking system and went largely unmeasured.
Similarly, if our example restaurant were to now go belly-up, the gift
certificate becomes worthless and that money is effectively destroyed. So
the money supply is shrinking when this happens. Much of the credit created
via vendor financing will never be paid back. That money is gone.
Poof Goes Enron
Last time, while talking about the credit insurers, I mentioned that I
thought we might see situations where you could see credit seize up if some
of these institutions ran into trouble. The Enron fiasco may provide an
example of what could happen. Yes, it appears Enron may have been doing some
very dubious bookkeeping in addition to owning a few alchemy machines. But
the point here is to notice what happened once its customers and trading
partners learned Enron was in financial trouble: they vanished. Massive
amounts of revenue disappeared in months if not weeks, while at the very
same time huge liabilities came due all at once. That was the point I was
trying to make last time.
This is exactly the problem that I believe could appear in other places
throughout the financial system precisely because much of the money and
credit creation has happened outside of the banking system proper. Add to
that the various forms of derivative and counterparty agreements both inside
and outside the banking system and you have plenty of opportunity where this
type of thing could occur again. And it does not have to be because of some
sort of fraud. It could simply be that the values of legitimate assets have
fallen to a point that the company or institution gets in trouble and can no
longer make good on its guarantee or counterparty agreement, or what have
you. The customers disappear, and the liabilities come due. Very quickly.
This is not even to say that such instances are highly likely, but just a
notice to recognize that such possibilities do exist. And if you accept the
argument that credit can serve as a very real part of the money supply, then
it is possible that we could see a very large drop in the "money supply"
very quickly. Far more likely is that much of this credit will simply be
destroyed slowly.
So I am not nearly as certain as some people are about whether we will see
higher prices or lower prices. Yes, I can envision a scenario where many of
the "gopher holes" have collapsed or been closed off and we then start to
see the CPI rise. But I can also see a scenario where the very collapsing of
those uneconomic businesses, investments, financial assets, etc., leads to
drops in the amount of available credit or "money." Because much of it was
simply thrown away and/or led to overcapacity that will serve to keep
consumer prices down, especially if layoffs continue and real estate were to
decline significantly. This could really lower the consumer demand side of
the equation.
Mr. Bastiat, I Presume
Frederic Bastiat taught us to look beyond the immediate and the obvious.
Consider not only that which can be seen, but also consider the unseen.
So while we're trying to figure things out, keep in mind that there are
times when we may not even be looking at the right things. I don't know if
we're in for rising prices or declining prices. But we should pay respect to
the possibility of declining prices, even in the face of what appears to be
an increasing money supply. Such an event is indeed possible, depending on
how that money is put to use and how much other unseen "money" may be
contemporaneously getting destroyed. If the money supply is increased by
100%, but the same amount of money or credit is flushed down the toilet,
then the reality is the money supply has not increased, even though the
official figures may say it has. And, obviously, speeding up the process, or
increasing its size, doesn't necessarily help things either. It probably
makes things worse.
Firm Ground?
Back when I was squinting through the darkness, peering into the ditch of my
Grandparents' garden, I was totally unaware of many other things that had
taken place. I was caught completely by surprise when my feet sunk.
As I believe Joseph Schumpeter said of the Great Depression, "Investors
stood there ground, and the ground gave way beneath them."
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