Probably the most powerful meme in the market today, held by both bulls and bears alike, is the belief that the Fed can inflate at will. Of course, to some extent it is always true. The Fed can print physical currency in vast quantities, which leads to the pictures of people buying their groceries with wheelbarrows (Weimar Germany) or backpacks (Zimbabwe) full of bank notes of staggering denominations.

However, it is my opinion that, despite his words, Mr Bernanke doesn’t want to be associated with Mr Mugabe’s economic theories and so he will not resort to physical currency printing on that scale. Therefore, if he is to inflate the “electronic money” supply, he needs to work through the banking system, because the “electronic money” supply is credit - bank credit. Just as a reference point, M2 is about $7.7 trillion, and the currency supply is about $0.77 trillion, so the “electronic money” supply, at least basis M2, is about nine times as large as the currency supply. Arguably, there are many other liquid assets that fill the role of money but the essential point is that any expansion of the “electronic money” supply depends upon an expansion of bank balance sheets. Which depends, in turn, on an expansion of the banking system’s capital base. With 60% or more of their collective assets dependent on real estate-related lending, the banking system is losing capital, not expanding. This is exactly what happened in Japan. The BoJ flooded the banking system with reserves, but banks crippled by loan losses could not expand their lending and deflation lingers to this day. In the end, the Japanese government took steps to recognize the losses with a program very similar to the RTC which cleaned up the Texas S&L massacre, and re-established a healthy - but smaller - banking system. It is worth noting, by the way, that M2 has essentially stopped growing since March of this year, and M3 has begun to fall.

But, you say, the price of just about everything, especially food and energy, is going through the roof. True enough. But that’s not inflation. “Inflation is always and everywhere a monetary phenomenon” said Milton Friedman, and they gave him a Nobel Myrdal prize, so he must have been correct. And even price inflation is about the “general” price level. While the prices of corn and crude oil have been going up, the prices of houses have been falling - about 15% in the last year, according to the S&P Case-Shiller index released this morning. Housing constitutes 23 percent of the CPI, but is measured with a ludicrous and arbitrary measure called “Owner’s Equivalent Rent“. If the CPI were calculated with a proper measure of housing costs, core price inflation would probably be negative, although food and energy price increases would have kept the headline number higher.

But the food and energy price increases are probably transitory, because they are primarily a result of speculative activity. Yes, China and the rest of the developing world have increased their consumption of resources, but the price signals have been doing their work and Americans have been reducing their consumption by, for example, reducing their driving by more than 5% over the last year. The inflation meme has led a lot of people to want to hedge their assets against inflation, leading to the creation of “real asset” or commodity index funds which simply stay long various commodities, usually by rolling huge futures positions. These funds of course have driven up prices, because the commodity supply couldn’t increase fast enough to absorb the influx of money into these funds. Then of course the folks who put money into these funds thought they were incredibly smart as they caused the inflation that they set out to hedge against. There couldn’t be a better example of George Soros’ reflexivity idea:

The key feature of these events is that the participants’ thinking affects the situation to which it refers. Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences.

It is ironic that this whole idea of real asset funds was started by Jim Rogers, who was Soros’ right hand man for many years. But I digress. Price signals in commodities adjust both demand and supply. Energy is probably one of the slowest to respond, but it is well established that supply responds to price signals with a two to five year lag and five years ago, crude oil was under $40. This is not to say that we don’t have a long term supply issue with oil, we do, but for the time being I expect to see energy prices continue to fall. This will bring price inflation more in line with monetary inflation - moving from disinflation to outright deflation.

The true threat to the economy is not the Fed printing currency, it is the slow collapse of the financial system, starving consumers and businesses of the credit that has been the fuel of growth, bringing about an economic dark age. It is, however, the Fed that caused the collapse of the financial system, by encouraging it to over-extend itself. 

A couple of notes following up on previous posts.

I spent some bits criticizing Paul Krugman of the New York Times for his assertion that the futures market doesn’t influence the price of crude oil. In addition to the arguments that I set out, what I didn’t know was that many OPEC countries actually use the futures market prices as a benchmark to set the contract prices at which most oil is actually sold. Apparently this is done because the spot market is too thin, and therefore too easily manipulated. This excellent post, with supporting references, sets it out. The same kind of speculative money also appears to be driving up grain prices (Edit: although one imagines that burning food isn’t helping). I think that we can safely discount any notion that the futures market does not affect actual selling prices.

Edit: This is probably all Jim Rogers’ fault, by the way. While there have been commodity funds and commodity pools for a long time, I think Jim was the first to start a mutual fund whose asset value per unit tracked a commodity index. Jim developed his own index, more broadly based than others such as the GSCI, and then (circa 1998) started a fund, the Rogers Raw Materials Fund, whose return was based on the change in the index. There has since been an avalanche of new money chasing this idea. I’m not sure what the state of the fund is currently, I think it got caught up in the Refco bankruptcy for which the CEO just got sent to jail. If you want to see the effect of these index tracking funds, check out what happened when Goldman Sachs unexpectedly reduced the weighting of gasoline in the GSCI in August 2006, from 8.75 percent  to just 2.3 percent. This change caused indexers to unload gasoline futures in a hurry; wholesale gasoline fell 82 cents over four weeks, an unprecedented drop; and crude oil, which in July 2006 had traded over $79 -  a record -  fell to around $56 by January 2007.

The government action eliminating the tax on forgiven or cancelled debt resulting from a short sale or foreclosure seems to be accelerating the “walk-aways,” where borrowers simply decide that their house was a bad trade and cut their losses. Jim the Realtor posts a comment made on his blog which typifies the “just a business decision” attitude. Edit: In the Sac Bee,

Walking away is embarrassing, Fatius, a pipefitter and welder, admits. But staying is “stupid,” he says.

The lenders and the housing market are in deep, deep trouble.

Steve Roach pipes up from his new job in Siberia Asia. His point is one that I have made in the past - central banks cannot ignore asset prices.

“It is high time for monetary authorities to adopt new procedures–namely, taking the state of asset markets into explicit consideration when framing policy options. As the increasing prevalence of bubbles indicates, a failure to recognize the interplay between the state of asset markets and the real economy is an egregious policy error.”

(Note: readability grades: Kincaid: 16.3, ARI: 16.9, Coleman-Liau: 16.5, Flesch Index: 22.4/100, Fog Index: 18.0, Lix: 57.0 = higher than school year 11, SMOG-Grading: 15.2 - must be a real economist)

And from the same Fortune section, we have Jeremy Grantham:

“There is a lot of pain still to be had in the equity markets, particularly aimed at the risky end of the spectrum. We think the fair value on the market is about a third lower in the U.S and EAFE from today and about a quarter less in emerging markets.”

And Jim Rogers:

“I have been and continue to be short the investment banks and the commercial banks. If they bounce up, I’ll probably short more. I’m certainly not buying anything. The market’s only down 8%. I don’t consider that a buying opportunity. The things that I’m short, some people probably think are buying opportunities, but I don’t. I’ve been short the banks for close to a year, and for a while it was not fun. But I added to my positions, and now it’s a lot of fun.”

And to round out the crew with a wistful note, we have Warren Buffett:

“In one way, I’m sympathetic to the institutional reluctance to face the music. I’d give a lot to mark my weight to “model” rather than to “market.”"

“Real estate prices will go down 40-50 percent in bubble areas. There will be massive defaults. This time it’ll be worse because we haven’t had this kind of speculative buying in U.S. history,” Rogers said. Reuters.

Worse than that, IMO. But we’ll see.

Jimmy Rogers, in a speech given in Singapore: “The U.S. dollar is in the process of losing its status as the world’s reserve currency, sterling went down 80% from top to bottom (when it lost its status as the world’s reserve currency), the U.S. dollar’s going to go down a lot in the next decade or so.”

Clearly this is the case. I don’t see any other way that the excess consumption can be curbed. The dollar will go down, but nominal wages will not increase to compensate.