The Great Divergence

[kandrathe]

You claim to be a fan of Milton Friedman. Yet you seem to be contradicting two of the ideas that made his reputation.

Yes, he was a genius, but...

First, he, along with Anna Schwartz, authored *the* classic interpretation of the great depression, which concluded unambiguously that the depression could have been avoided, if only the Fed had printed a boatload of money and bailed out all the banks. This is what is happening now, yet you seem to be predicting doom, directly in contradiction to what Friedman and Schwartz concluded. The infamous "helicopter drop" is a direct quote from Friedman, and yes, this was a serious proposal.

He argued the Fed allowed the money supply to contract by 1/3 during causing the depression, from what would have ordinarily been a bad recession. To paraphrase Friedman from his book, "Capitalism and Freedom"...

... the Fed tightened the money supply in mid 1929 in an attempt to curb "speculation". The stock market crash some months later precipitated a lack of confidence in the economy, and people became cautious in their consumer behaviors, causing the recession. The Fed did nothing to ease the tightness of money, and by November of 1930 many Banks began to fail with runs on the banks. More, and more banks failed over the subsequent months leading to more, and more people losing confidence in the banking system entirely. The Fed did not provide the reserve currency, as per its mandate, to keep banks from draining their assets due to a panicked populous. When Britain went off the gold standard in September of 1931, the Fed acted vigorously to the external drain of gold reserves, further intensifying the crisis. Then, in January 1932, they raised the discount rate sharply to end the gold crisis, and this caused a spectacular increase in bank failures. He ends the chapter paraphrasing Clemenceau, money is too serious a matter to be left to the Central Bankers.

Second, he pioneered the idea of rational expectations of inflation in bond pricing. People do not buy bonds assuming that there is zero inflation. That would be stupid. They buy bonds using their best information to predict likely future inflation, and adjust what they are willing to accept as a price appropriately. If people are buying bonds at near 0%, then that means they are not predicting massive inflation. They must be predicting low inflation or deflation, otherwise, these bonds would not be a good purchase.*

If you disagreed with this analysis, you could make a killing by shorting US government bonds - the "vigilante" scenario. But this is not happening. Pundits on the right are screaming from the rooftops that inflation is imminent, but they have not yet put their money where their mouths are, indicating considerably less economic confidence in their position.

Rational expectations also means that the only way to get seriously screwed by inflation is either by a rapid, unexpected inflation, or by holding lots of cash in a mattress or savings bank. Bonds are priced to include inflation, so they don't count.

-Jester

*or that the rest of the economy is such a wasteland that a near-0% rate of return is the best possible investment. But even then, if they were expecting 10% annual inflation, they could buy almost anything - gold, oil, land - rather than bonds.

But, people don't always behave rationally, which is why you see the rise of "adaptive expectations" advocates and "behavioral economics". If you explore the details of the CPI for the past year, as I did, you'd see that for the broader basket of goods, prices are falling. For example, the prices of houses plummeted, and are still dropping. But, in the same category, you have rent, which is skyrocketing. Makes sense, right. The foreclosures drive people out of their homes, which now stand vacant, and the people are forced to move into apartments. The demand for housing is nil, due to the lack of confidence that bankers have now in giving people loans. The demand for rental property is climbing, due to the increased need for people to have shelter. The CPI masks the inflation, and deflation within housing. Another example would be automobiles. New car sales, are similarly depressed due to the banks reticence to offer loans, but used car sales are skyrocketing, driving up the costs. Again, the CPI masks the inflation, and deflation within that commodity. Energy prices are consistently increasing, as well as certain commodities that are in demand outside of the US.

Fed Stands Pat and Says It Is Still Ready to Buy Debt

Their view of the economy tending toward deflation is what I'm seeing in the detailed CPI. Certain things are inflating, but in general, prices are decreasing. So, if you believe that the Fed will do more QE later in the year, and that it will stem the erosion of prices, then bonds may be a good deal. I wouldn't make that bet. I don't think we've seen the end of our financial travails yet. Friedman makes sense for many things, but I think Fed interventions need to be well telegraphed, thought out and implemented slowly to allow the market to adapt to the changes. I'm also with the Austrians on the nature of unintended consequences. Every positive action, raises the opportunity for an opposite negative reaction.