Archive for November, 2012

Deathmatch:- FED v MATH


Inflation is always and everywhere a monetary phenomenon

– Milton Friedman

Those of us who are concerned about the near doubling of the US dollar money supply over the last four years are sometimes asked “So where is this inflation you keep banging on about”. Good question.

The formula in classic economics proposed by Irving Fisher in 1911 is



M is the quantity of money or M1

V is velocity of money, i.e. the number of times each dollar changes hands each year on average

P is the price level, and

Q is the quantity of goods and services produced (inflation adjusted GDP, defined as Real GDP is used as a proxy)

What we are interested in here is inflation, or the increase of P in the formula above. If we rearrange the formula to isolate P, we get

P = MV/Q

So let’s take each of these terms in turn and let’s see what’s been happening to them these last four years, using the official government figures from the St. Louis Federal Reserve.

M1, the money supply has risen by about 70% since 2008 from $1.4T to $2.4T as can be seen in the graph below


This is entirely due to massive Quantitative Easing by the Fed. The next term is V, velocity of money which has slumped from 1.96 to an historic low of 1.56 according to the government chart below.

Velocitu of money

Lastly let’s look at Real GDP which is what economists use as the standard proxy for Q. Real GDP is the inflation adjusted value for GDP, which is entirely sensible. This has dropped and risen to essentially the same number since 2008. Let’s call it $13.2T to $13.5T.

Real GDO

Since we are interested in the change of price P, i.e. inflation over this time period let’s look at figures for each of the two years 2008 and 2012.

P2008 = (1.4 * 1.96) / 13.2 = 0.208

P2012 = (2.4 * 1.57) / 13.5 = 0.279

Percentage change in price P over 4 years (i.e. Inflation) is (0.279 – 0.208) / 0.208 * 100% = 34%

To annualise that to an annual average inflation over four years we get the fourth root of 1.34 which is 1.076 or 7.6% annual average inflation over the last four years.

The official Consumer Price Index (CPI) over these years has been –

2009:  -0.34%
2010:  1.64%
2011:  3.16%
2012:  2.14%

Multiply these out and we get (0.9966 * 1.0164 * 1.0316 * 1.0214) = 1.067 or a cumulative 6.7% over the four years. We can get the average over four years by adding each of these figures and dividing by four which gives (0.9966 + 1.0164 + 1.0316 + 1.0214) / 4 = 1.0165 or 1.7% pa

So there we have it, the classic formula predicts an annual inflation of 7.6% pa while the Fed reports an average of 1.7% pa.

If the classic Monetary Exchange Equation is correct then we have a large discrepancy to try to explain.

Has the Fed been under-reporting inflation by about 6% per annum since the start of the crisis?


The looming US debt crisis


One of the main reasons I’ve started this blog is my concern with the level of debt undertaken by the US government. Though I’m not a US citizen or resident, because the US makes up over a quarter of the world GDP and is the world’s reserve currency, anything that happens there will have a huge knock-on effect worldwide. This debt is currently at around $16 Trillion and it will be $22T or $24T by the end of the new Obama administration. This is unsustainable and according to Stein’s Law, “If something cannot go on forever, it will stop“.

My fear is that it will stop by hitting a concrete wall, sparking an economic collapse and the Second Great Depression (GDII). All of this new debt has to be financed from the bond market. US national debt is already at 100% of GDP and will rise to 150% within this administration. In a normal capitalist system, the banks and insurance companies that purchase the majority of government bonds would demand a higher rate of interest to hold these risky bonds. However, if the interest rates were to rise to the level that they should do to reflect the actual risk, the annual interest payments would far exceed annual government revenues from taxes, leaving nothing for day to day expenditure. No amount of tax increases can come close to covering the shortfall, and under the current administration, no cuts in spending will be allowed. The US has painted itself into a fiscal corner and there is only one way out:- Inflate the money supply so that the debts become payable in debased dollars. And I’m not sure even this will work.

It’s not politics, it’s maths.

Quantitative Easing 1 (Tarp), 2, 3 and 4 (to infinity), is Ben Bernanke pumping money into the system in order to deliberately cause inflation, while denying that that is what he is doing. And Wall Street says nothing because they are making a fortune in a stock market that is booming due to this printed money

This all started in the late 70’s when excess credit caused the stock market to boom. When this crashed in 1986, the Fed expanded credit which caused the second-to-last property boom which crashed in ’91. Further credit caused the stock market to boom again, feeding into the internet stock mania of the late 90’s, which in turn crashed in ‘01. Doubling down on more monetary expansion caused the stock market and property value superboom that ran from ’01 to ’07.

This should have been our wake-up call. But no, what was decided was that we should quadruple down on this insanity. This has caused the stock market to double again from it’s ’08 low leading us to where we are now:-

Way out on a fiscal limb with no way back and with the branch creaking in the wind.

And all the time the US national debt has grown and grown.

Unless we get somebody sane in the Federal Reserve to stop this endlessly repeating cycle, the stock market will crash again sometime soon. If the Fed continues with excess credit, this torrent of freshly printed money will surely find the only outlet left, which is gold and we will see a further and possibly final boom cycle in this last remaining market.

I believe we will see 1970’s levels of inflation at 20%pa or more (remember that 26% pa for 3 or more years is the academic definition of hyperinflation) starting shortly and lasting for a decade or more. And that is a best case scenario. We have already plainly seen this inflation in food, commodities and energy.

What the US is doing, is being done double in Europe, and Japan is a disaster waiting to happen.