I've been asked by a lot of people to comment on Mike Shedlock's recent attack on Peter Schiff
, and his view that America is facing a deflationary recession rather than stagflation.
There should be little doubt for any regular reader of this blog that I disagree with Shedlock, as I've repeatedly argued for the stagflation scenario. So, why do I disagree with him? Well, to some extent it is a case of our old disagreement about the money supply definition
. But I'm going to comment on Shedlock's specific fallacies in the articles.
Shedlock Fallacy #1: "There are constraints on the Fed that he ignores. For example the Fed cannot simultaneously target both money supply and interest rates. Should the Fed pursue a massive printing campaign, interest rates will rise."
No, not true at all. That's the old fallacy that interest rates will necessarily rise in response to higher inflation. But that's only true if the central bank agrees that higher inflation should be met with higher interest rates, which is often not the case, and which is why real interest rates are often negative (like now).
If the Fed decides to buy all government bonds (or corporate bonds or mortgage backed bonds) until the yield fall to whatever level they like, say 0.5% or 1%, there's nothing anyone can do to stop them since the Fed has unlimited power to create money out of thin air. Even if all private investors and foreign governments dump their bonds, the Fed can still simply buy them all with the money they create out of thin air. That implies massive inflation and extremely low interest rates at the same time.
Shedlock Fallacy # 2: "Regardless of what anyone thinks, prices can only rise to the extent that people can afford to pay for goods and services or that banks are willing to extend credit. Without a driver for jobs, and with downward pressure on wages for the jobs we do have, prices will be constrained. If somehow prices rise above people's ability or willingness to pay for them, there will be not be buyers."
No, no, no. If this were really true, we wouldn't have hyperinflation in Zimbabwe where we've seen a severe depression with regard to production and unemployment.
Shedlock is here in essence arguing for a Keynesian "aggregate demand" view of inflation, according to which stagflation is impossible. But as stagflation is a real phenonema (in its most extreme form in Zimbabwe), this argument is simply false.
Shedlock fallacy #3: "That assumption is the US dollar drops....The fundamentals in the UK and EU are as bad as in the US and the property bubbles just as big."
That's actually to some extent true with regard to the U.K.,as I recently explained
, and this is why I am bearish about the pound too.
However, the situation is not as bad in the Euro area, which still has a current account surplus.
While Shedlock agrees that the yen will rise, he overlooks the more important yuan, whose continued rise vs. the dollar is a certainty and which will help push up inflation in America, both by making imports from China more expensive and as this increase their demand for commodities given a certain dollar price.
Shedlock fallacy #4: "Take away the US market for goods and China and Japan have massive overcapacity. Without exports to the US and Europe, China would crash. This situation might change 10 or so years down the road, but export economies are not remotely close to being able to ignore the US consumer, at least not now or anytime soon."
Not entirely untrue, but Shedlock overlooks the fact that China has undertaken drastic actions to restrain domestic demand in the form of umpteen increases in interest rates and bank reserve requirements. They thus have a lot of scope to compensate from falling U.S. consumer demand by simply refraining from continuing with these tightening measures or even reversing them.
Shedlock fallacy #5: "Given massive overcapacity in housing, commercial real estate, restaurants, nails salons, etc there is simply no reason for businesses to want to expand business. Nor is there any reason for banks to be willing to extend credit to all but the most credit worthy borrowers. Rising defaults may even impair capacity to the point many banks are unwilling or unable to lend at all. The only reason expansion got as carried away as it did is the psychology at the time suggested residential and commercial property would forever rise.....
....Because the Fed can encourage but not force lending, that shift in the pendulum affects the Fed greatly. The Fed can enhance the current primary trend (as it did in the creation of the housing bubble), but neither the Fed nor anyone else can reverse the primary trend.
Regardless of encouragement, who are banks going to be lending to when asset prices are falling and unemployment is headed higher? And those are conditions that both Schiff and I agree on. With enough defaults, banks will become so capital impaired they could not lend even if they wanted to! We are seeing signs of that in Citigroup already.
And as I have said before, the Fed is a private business. The Fed is not going to give away money any more than Pizza Hut is going to give away free pizzas for a year to all comers."
[the last section was from Shedlock's second post]
Here Shedlock makes two fallacies. First, there is no evidence that the banks are refraining from lending, as bank lending has in fact accelerated in recent month during the alleged "credit crunch". In the 20 weeks between August 1 and December 19
, commercial bank lending rose 5.85%, which is 16% at an annual rate. Many banks will likely lend on the basis of bailing out their borrowers, knowing that they will fail if they don't.
Secondly, and much more importantly, even if banks get unwilling to lend, they (and the Fed) can then simply start buying securities, and that way expand the money supply, something Murray Rothbard pointed out to the Mike Shedlocks of 1991 in his essay "Lessons of the Recession"
The one thing true Shedlock pointed out was that the stagflation vs. deflation debate mattered because it had investment implications. If we have stagflation, commodities are the place to be, if we have deflationary recession, government bonds are the place to be. To bad for Shedlock then that he and others who invest in government bonds are going to get screwed big time as inflation takes away their value.
Curiously, he argues
that gold will do well in deflation (Which we might consider "Shedlock fallacy # 6"). Well, to the extent he invests in that he will be a winner despite his false view of the economy. But, he is simply wrong that gold will do well under deflation. Deflation here refers to the real value of paper dollars, not gold, and if the value of paper dollars were to rise that would imply a falling relative value of gold which unfortunately is not used as money and since 1971 lacks any link to the U.S. dollar.
His argument that gold is not an inflation hedge because it fell between 1980 and 1999 overlooks that the tight monetary policies of Paul Volcker destroyed the demand for gold as an inflation hedge. With real interest rates high, it made more sense to invest in bonds than gold. Also, massive central bank sales and the dollar rally of the late 1990s temporarily depressed gold.
Now, we see gold make a comeback because central bank sales has been limited and many emerging market bank cental bank actually buying, but most importantly because inflation is accelerating and this increases the demand for gold as an inflation hedge.