Positive Economic Commentary
Let's All Hold Hands and Reflate
August 24, 2001
The central banks of the US, the Euroland, and Japan are all under political pressure to crank up their respective printing presses and flood the world with fiat money. And the charts below show that they are complying with their political masters' wishes. In the 12 months ended July 2001, the US M2 money supply increased 9.0% -- more than three percentage points faster than its year-over-year July 2000 growth. Euroland's M2 in the 12 months ended June increased by 7.4% -- almost three percentage points faster than its June 2000 year-over-year growth. And even in Japan, the M2 (+CDs) money supply is growing faster. In the 12 months ended July, Japanese M2 has increased 3.3%. This compares with its 2.0% growth in the 12 months ended July 2000. Is the Fed, the ECB, or the BOJ likely to change their policies in the near term to rein in this faster money growth? Hardly. The Fed just this past week cut the funds rate another 25 basis points and indicated that it stood ready to do it again. The BOJ in the past two weeks has upped the ante on its "quantitative" easing policy. It's just speculation on my part, but my Euros are on the ECB cutting its policy rate before the end of September.
Japan is experiencing deflation and recession relapse. In addition, the Koizumi government has pledged to go forward with various structural reforms that likely will increase unemployment in the short run. Although we Austrian-schoolers know that the printing of more yen will only delay the necessary adjustments to right the capsized Japanese economy, the conventional wisdom is that the road to prosperity is paved with government-sanctioned counterfeit money.
Growth in Euroland's largest economy, the German one, has ground to a halt. And the rest of Euroland isn't exactly setting the world on fire, either. Fiscal conditions are deteriorating to the point that some are calling for a suspension of the "stability pact" that requires governments to take actions -- tax increases or spending decreases -- to restore fiscal health. Rightly or wrongly, there is a lot of angst about the conversion to physical euros in the New Year. A recession at the time of conversion would be considered bad karma. So, when Wim gets back from holiday, the pressure will be on him to cut the ECB's policy rate from its current level of 4-1/2%. And why not? Isn't the euro rallying? Yes. Of course, perhaps one of the reasons it is rallying is that the overnight inflation-adjusted interest rate in Euroland is currently 1.70% vs. 0.80% in the US. Moreover, Wim has shown a greater reluctance to narrow the gap between the overnight interest rate and inflation than has Alan. In other words, global investors may have come to expect a better chance of getting an "honest" return on their short-term funds in euros as opposed to the world's reserve currency, the greenback. Isn't consumer inflation down? Yes, thanks to the recent dip in energy prices. But as the chart below shows, the "core" rate of consumer inflation in Euroland is trending higher and, at 2%, is at the top of the ECB's target range for the total CPI. Unless you believe that energy prices are going to continue to fall rather than stabilize around current levels, Euroland inflation is likely to be an irritant to Wim, especially if he caves in to the pressure to keep the euro printing presses running at high speed.
Does Greenspan want to get Volckered? Kudlow and his ilk have never
forgiven former Fed Chairman Paul Volcker for breaking the back of inflation.
Why should that have upset Kudlowsians? Because in the process of slaying
the inflation dragon, St. Paul also damped federal tax revenues, which
put a spanner in the spokes of the supply-siders' claim that lower tax
rates would increase total tax revenues. So, the federal budget deficit,
rather than stabilizing or falling in the wake of the Reagan tax rate
cuts, as promised by some of the more extreme supply-siders, increased
instead. To be sure, the increase in the deficits back then were not
due solely to slower growth in revenues, but to much faster growth in
outlays. Don't get me wrong, I've never met a tax rate cut I didn't
like. On the other hand, I've never liked anyone I met who blamed Volcker
for the tarnished reputation of supply-siders who over-promised. The
reputation of supply-siders is about to be tarnished again iin that
the Bush administration and the Republican Party are being accused of
losing the non-Social Security surplus because of their tax cut. (As
an aside, while the recent tax cut was endorsed by supply-siders, the
arguments put forth in defense of the cut sounded more Keynesian than
neo-classical.) Of course, two of the reasons the budget surplus has
come down this year are because economic growth has slowed and the stock
market has remained weak. The slower economy reduces the growth in personal
and corporate income tax revenues. The weaker stock market negatively
affects personal income tax revenues because fewer employee stock options
are being exercised. But the bottom line (please forgive me, Mr. Cloos)
is that if tax revenues don't pick up before November 2002, the Bush
administration may be facing a Democrat-controlled Senate and House.
It will take more independence than Greenspan has shown in his Fed tenure
to resist the political pressure that will be brought to bear on him
to keep printing money with wild reckless abandon.
As an aside, when I speak of reflation, it strictly only applies to
Japan, which is currently experiencing deflation. For the US and Euroland,
the decision is not so much to reflate, but to sustain and build on
the higher inflation already in place. The chart below shows, that like
Euroland, that although US all-items CPI inflation has slowed dramatically
in recent months because of the fall in energy prices, ex-energy CPI
inflation marches onward and upward. Again, unless energy prices continue
to fall, the underlying rate of inflation is likely to move higher with
the accelerated printing of greenbacks.
There's another reason for political pressure to be put on the Fed to keep inflating. The US is a debtor nation, in fact, the largest debtor nation in the world. Moreover, the bulk of America's external debt just happens to be denominated in US dollars. Unlike other countries whose external debt also is denominated in US dollars, our central bank can print the dollars. When debt servicing becomes burdensome, inflation can relieve the burdens by lowering the real debt servicing costs. Now, the debtors of America are not going to directly petition Alan Greenspan to speed up the printing presses. But they are going to press their senators and representatives to do something to relieve their economic pain. And because Alan has done nothing to disabuse Congress and the administration of the notion that he is the global economic kingpin, some chips are going to be called.
If the major central banks are intent on reflating, as I have asserted they are, what kind of investments might outperform? Inflation-protected government bonds are an obvious candidate. And given the likely decline in the dollar's foreign exchange value, you might try to find some inflation-protected bonds in other currencies. Euro-denominated ones would be best, but I don't know that any exist. Commodity-related investments might be "interesting," as they say. If global reflation is in, global industrial production is likely to revive. This will mean an increased demand for industrial metals. One metal in particular could quickly be in short supply -- aluminum. A lot of smelter capacity has been taken off line in the US and Brazil because of the increased cost of power. This capacity cannot be brought back on line quickly. So, aluminum prices could shoot up quickly. There's another metal, not so much an industrial one, that might do well if the Big 3 central banks reflate. It's a metal whose value increases when global investors can't get an "honest" return on their money in any major money market. I can't give you the name of this metal for fear of being branded an even bigger kook than I already have been. But I'll give a hint to you Seinfeld devotees out there. Jerry had a shirt named after this metal. The seventh person who sends me the name of this metal gets a free subscription to this publication.
Keep one thing in mind, girls and boys. If printing money created genuine wealth, the Weimar Republic between the Wars would have been the richest nation in the world.
Paul "Croesus" Kasriel The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.
Director of Economic Research