Many people today see the Fed’s Quantitative Easing as money printing. They remember what happened in the 1970’s, and they instantly jump to conclusions. However, we live in a different world. To illustrate this, consider the following story about Joe, a promising and eager young manager in a struggling manufacturing company.
Joe excitedly walks into the boardroom and pitches his idea. “Let’s borrow a billion dollars. We can use it to build a massive warehouse and to buy massive quantities of our raw materials!”
The senior management team stares at him. The CEO demands, “Why?”
“We need to have a stockpile at every level. We should start with 3 months of raw materials, and a three-month buffer of work-in-progress in between every one of the 27 steps of our manufacturing line. And even better, we need to warehouse finished product. We shouldn’t ship anything that hasn’t been sitting for at least 4 months. Ideally six, but we can start with four.” Joe has the bit in his teeth now.
He rushes on. “Bernanke has printed so much money, and Yellen is going to continue. We already have massive inflation and it’s going to get worse! By borrowing to buy stuff that is only going up in price, we can make extra profits and protect ourselves from supply shocks as the cost of commodities rises out of sight!”
The CFO leans over to whisper in the ear of a young assistant, Bill. Bill does a quick Google search and finds the price of copper, which is one of the most important raw materials the company buys. Bill puts the copper chart up on the screen. It has fallen a third over the past few years.
Joe will be lucky to remain employed when he leaves the room. To be fair to him, his mistake is simply to try to implement a business strategy around what most casual observers and many economists believe.
Sometimes, the best way to debunk an idea is to take it seriously.
Though it makes no sense today, holding inventory was not the crazy idea of a young fool back in the 1970’s. It was how many businesses conducted business. In that era, the game was to accumulate inventories. The more, the better. First people were trading excess cash for inventories. I can recall my parents stockpiling things like canned tuna fish. It was better to keep one’s wealth stored in a durable food product than in a bank account. Consumer prices were rising about 20 percent per year.
Next, companies began selling bonds to finance inventory growth. This pushes down the bond price, which is the same thing as pushing up the interest rate. And of course it pushes up prices.
In the 1970’s, cash was trash. Inventories rose relentlessly in value, at least as measured in terms of the dollar. This, by the way, is a great example of how irredeemable money distorts the economy. You aren’t producing any more, or creating any kind of new wealth, and yet, you are rewarded with a profit.
Now we have the opposite condition. Since the interest rate began falling in the early 1980’s, companies have been finding ways to reduce inventory accumulation. The Lean manufacturing movement began to gain acceptance at this time. Lean, also known as the Toyota Way, defines inventory—such as work-in-progress sitting on a shelf—as waste. Lean is all about eliminating waste.
Today, cash is king. Excess inventory quickly become obsolete.
Companies are not borrowing to hold inventory, but to expand production when they can make a profit above the cost of capital. Since the interest rate keeps falling, the hurdle to get over for minimum acceptable profit keeps going lower.
Think of it this way, if you manufactured handheld electronic devices, would you want to keep inventory a minute longer than you had to? Of course not, because your competitor is about to release a new model that will make your product less desirable, or even unsalable. How about clothing? Cars?
In the 1970’s, the interest rate was rising. When a worn-out plant needed replacing, it may not have been feasible to borrow to replace it. That’s because the new interest rate was much higher than at the time when the plant was first acquired, a decade or more earlier.
This is the connection between the rate of interest and the rate of profit. It’s impossible to borrow at a higher rate than the profit one hopes to earn. A rising rate will therefore lead to rising margins, and a falling rate to falling margins.
Other than the problem of financing plant replacement, business was easy. Sleepy conglomerates had travel policies that allowed managers and executives to fly first class, even for domestic travel. With the cost of borrowing rising all the time, profit margins were expanding. And there was the kicker, holding inventory before selling it fattened margins further.
Business had a lazy pace to it, as I look at it today (though business managers at the time might not have agreed with that characterization).
In comparison, today it is the opposite. Limitless oceans of dirt-cheap credit issue forth, like effluent from the world’s central banks. The problem is not replacing worn-out plant when the cost of capital is higher. The problem is that every competitor has ever-cheaper cost of capital. The challenge is that rapid product cycles are driving rapid obsolescence. It is harder and harder to recoup design and tooling expenses. Inventory that sits for a week may have to be liquidated at a massive discount. Profit margins are under constant pressure.
Business executives routinely fly coach, even for international travel.
If the word for the 1970’s business environment was lazy, the word for today’s climate is frenetic.
Neither is the ideal behavior for a rational enterprise. They are the direct fault of the regime of irredeemable paper money.
Everyone’s attention is misdirected towards prices. Is the Consumer Price Index rising? Is it rising more than expected? How about the producer price index? Is that dropping into the dread D-word—deflation?
It’s the greatest economic sleight of hand ever perpetrated.
Instead of zeroing in on prices, we should be looking at the enormous distortions of our centrally banked irredeemable currency. We have bubbles, malinvestment, insolvencies, volatility, with exponentially rising debt and derivatives outstanding.
Interesting article, Keith.
You’ve characterized how business works during 1) high interest rates and high inflation, and 2) low interest rates and low inflation.
I think it would be interesting to contrast this with a proper gold standard, in which I presume we would have moderate interest rates (3-4%?) and moderate (2-3%?) deflation. Would you be willing to write an article about that?
Thanks for your comment and question.
First, while I realize most people define inflation as rising prices I don’t agree. There are many reasons why prices may rise, other than monetary. For example right now, draught and disease are driving up the price of beef and pork. I define inflation as counterfeiting (see my article: http://www.forbes.com/sites/keithweiner/2014/05/03/inflation-is-counterfeiting/) Rising prices is one possible result. Another is falling prices.
Second, while the interest rate was high in the 1970’s it was also rising. A high rate is one thing, but a rising rate is much worse and the cause of the phenomenon I describe in this article. Starting around 1981, the rate began to fall. It was not what anyone would call low, not for a long time, but falling interest causes all manner of problems. Different problems than rising rates.
I have written a short paper on how the rate of interest is regulated in the gold standard. It’s short because the mechanism is simple. https://keithweinereconomics.com/2012/06/06/in-a-gold-standard-how-are-interest-rates-set/
I have written a 7-part series of papers giving my theory of interest and prices under irredeemable paper. It’s long because it’s much more complicated. The article above looks at one aspect of the full theory. https://keithweinereconomics.com/2013/12/28/the-theory-of-interest-and-prices-in-paper-currency/
I’ve often wondered what the difference was between the recession of the 70s and the recession of 2008-present that resulted in such different outcomes in price inflation and rates of interest. It is a very important question and one in which not many free market thinkers have addressed to my limited knowledge. I agree with your logic for most of this article, but I am puzzled as to why the selling of bonds to buy more inventory necessarily pushes down the price of the bonds and raises interest rates. Doesn’t this depend on the supply and demand characteristics of any particular bond market? Also isn’t that exactly what the US shale industry has done and the opposite effects can be seen? I’m 31, so I wasn’t around to witness events of the 70s for myself, but this is my opinion for what it’s worth.
Since the economy was a bit healthier in the 70’s (Nixon had only recently severed the last shred of accountability in government finance), and not quite so distorted in favor of the wallets on Wall Street, more money made its way into the hands of us common folk, who used it to bid up ordinary products on the market. The resultant price inflation in turn resulted in an increase in interest rates as more and more recognized the falling value of the dollar. I believe interest rates were rising very rapidly in the Wiemar Republic in Germany during their hyper-inflationary crises.
The current recession in contrast, and massive credit expansion by the Fed and other central banks, has landed most of the windfall on Wall Street, and so we’ve seen massive asset price inflation and not a huge rise in the CPI (government cooked number though it may be). Rapid consumer price inflation is not taking hold because primarily the rich have the newly created funds at their disposal and they only need so many TVs and other consumer items. Those with money invest it in the only place they can see a return in this interest rate repressed economy – Wall Street. Also many common folk are still leveraged to the gills from the previous Fed induced debt binge that they can’t afford to lend the money out of the banks even at very low rates, meanwhile the costs of living keep rising if slowly and wages continue to lag behind.
Wall Street has done fabulous in this “recovery,” and the central banks and their academic stooges pretend to be frustrated that they can’t achieve escape velocity and their beloved 2% CPI numbers, when their real goal of bathing the established elite in free money and consolidated power is achieved quite spectacularly… at least until the whole thing is exposed for the sham that it most certainly is and those responsible are held to account.
Good to have you on our side and God bless you and yours.
You could think of it as an endlessly increasing supply of bonds. Though I really don’t think one can get very far with quantity-based analysis of monetary topics such as the bond market.
I would recommend you read my theory of interest and prices (if you haven’t already) as well as what I have written on inflation. Inflation is not about rising prices, and prices do not move with the money supply and the dollar is not money anyways, it’s credit.
I have read your theory, and I remember agreeing and understanding most of it, but I confess I have not yet given it the full consideration it deserves.
I certainly agree with you that inflation is not rising prices, it is an increase in the counterfeit credit supply or supply of notes above what it redeemable in real money; I consider debasement of metal currency inflation as well. I also agree that inflation does not necessarily lead to rising prices. Like you said it also depends on productivity and time preference.
I’m not yet a seasoned veteran in some of the financial and economic jargon, so statements like “The arbitrager lifts the offer on his long leg and presses the bid on his short leg” can be a bit tough for me to comprehend. I do like your use of the term arbitrage as the primary objective of entrepreneurs. I never thought of it that way, but it makes perfect sense.
I like your insight that if savings rise it does not necessarily mean that the interest rate will go down (productivity could be increasing causing mild price deflation and an increasing reluctance for the average saver to part with his or her appreciating cash). I would humbly argue that the opposite situation is possible as well contrary to your theory. Savings and productivity could both decrease and the rate of interest would not go up (may even go down), because the lack of productive opportunity may suppress the average entrepreneur’s demand for the saver’s cash.
One more question about the 70s: How did Keynesianism survive???
WordPress apparently has a limit on nesting replies. So this reply is a new comment.
I don’t agree with defining inflation as any time when credit > gold. There’s no particular limit to how much legitimate credit can be based on X amount of gold. The defining characteristic of counterfeit credit is not how much total credit there is, but whether the saver is deceived or robbed, and whether the borrow lacks means or intent to repay.
I need to write up the theory in a more readable format, perhaps a book… It was good to get it down on paper but it’s hard to read.
As to Keynesianism, well people cling to their dogma (and let’s not forget, gravy train). It’s our job to discredit it where it matters. In the minds of the people. Anyone calling himself an alchemist, douser, witch doctor, or fortune teller could not get a respectable job. I look forward to the day when monetary witch doctors are similarly unemployable. 😉
I wholeheartedly agree with you. The real issue is theft vs non-theft.
I guess what I meant was if (BIG “if” I know) bank notes were redeemable in specific fixed weight of gold, any increase in the amount of notes above what is redeemable in said weight of gold would be inflationary (replace gold with any other market chosen commodity to act as currency). Imagine how fast bank runs would occur in today’s ridiculously interconnected world. Fraudulent banks wouldn’t stand a chance without government guns, boots, and apologetic intellectual flak.
Gravy train is right. Inflation is a genius way of stealing from people. Theft is bad (victim recognizes the theft); taxation is worse (victim recognized the theft but is hoodwinked into thinking its for his own good); inflation is worse still (victim doesn’t recognize the theft).
I think you just channeled Bastiat:
“Away, then, with the quacks and organizers! Away with their rings, chains, hooks and pincers! Away with their artificial systems! Away with the whims of governmental administrators, their socialized projects, their centralization, their tariffs, their government schools, their state religions, their free credit, their bank monopolies, their regulations, their restrictions, their equalization by taxation, and their pious moralizations!”
Have a good one Keith, and I’d be interested in any book you write.
Suppose you borrow $100,000 to buy a house. Can the bank come and check out your basement to see where you keep the money to repay?
No. You don’t keep cash on hand. You have a salary, an income. The income is your asset, in a sense. Your income is what backs your mortgage (the house is collateral, which is something different, it is not the house which somehow amortizes its own debt).
It’s the same with a bank. The bank must have an asset to back every liability. Gold is the highest quality asset, but not the only asset and that’s no way to run a bank to keep 100% of all assets in gold. Gold has no yield.
I suppose consensual non-cartelized fractional reserve banking could exist in a free society; this is what you are alluding to by pointing out that an income stream can be used as an asset correct?
I see a bank in a free society acting as a warehouse with investment options. Gold or another market chosen commodity acts as the real money and notes may be issued for convenience redeemable in money in an environment where no note or money is mandatory to accept as payment of debt. These free market banks would process payments and protect an individual’s money for a service fee. Individuals warehousing their money at a bank may choose to invest in a particular venture and may rely on the expertise of said bank to any extent agreed upon by both parties. If the bank offers a loan with no collateral it is committing fraud; I suppose that the bank may bring future earnings from other loans outstanding to the table as collateral, but this would have to be understood and consented to by both parties.
Also I don’t see why gold wouldn’t have a yield necessarily. In an environment of a slow growing money supply such as gold, and no coercive restrictions on enterprise, productivity may bring about price deflation that results in greater gains in the appreciation of the money than the warehousing and service fees charged by the banks. Arbitrage! Of course, it is impossible to predict whether this sort of situation will actually happen in a free society, but unless I am mistaken, it is logical to assume that it could.
When an income stream is standardized to payment schedule, maturity, and other terms it is a bond. A bond trades in a relatively liquid market. There is nothing wrong with buying a bond, or holding it as an asset. Therefore, there is nothing wrong with raising capital from depositors to buy a bond and earn a profit on the spread.
I don’t agree that a warehouse is a bank. A warehouse is a warehouse. People should, of course, be free to pay to warehouse their gold. However, most people choose banks for a variety of reasons. A positive yield being one (a warehouse has a negative yield, as you noted, you pay to store your metal).
I agree there should never be a law to force people to accept something as payment. People have a right to choose what they want, within the choices available in the market.
I don’t agree that falling prices constitutes a yield. Prices in a free market would always be falling, as industry is always cutting costs and becoming more efficient. A yield is when you make money on your money.
You may be interested in my series on the unadulterated gold standard:
Falling prices may not constitute a yield in the formal sense, but it does afford one more purchasing power. This is better than our current situation with bank account yields impoverishing depositors under a financially repressed environment of negative real interest.
I like that your version of banking is (1) voluntary, that (2) credit must come from savings, and that (3) no bank or currency would enjoy monopolistic (state intervention) privileges, but I don’t see how fractional reserve banking would exist without (3) or how it is consistent with (2). How is this not counterfeit credit? If a bank issues more notes immediately redeemable in gold than it has in demand deposits, how is this not money creation ex nihilo? Currently banks enjoy the cartel privileges afforded to them by the Fed and the use of a currency redeemable in nothing of value, so the market has no teeth against it aside from the business cycle. This was not the case in the 19th and early 20th century, as I’m sure you know, and bank runs would have certainly destroyed this practice if it were not for the protective and coercive arm of the state. Even with the Fed, the bank runs of the Great Depression would have led to a paradigm shift in banking practices were it not for the state.
How does FRB square with your version of the free market, when it has continually needed the protection of the state to survive into the present?
“then one is opposed to any credit expansion and hence any banking. Without realizing it, one finds oneself advocating for the stagnation of the medieval village, with a blacksmith, cobbler, cooper, and group of subsistence farmers. Anything larger than a family workshop requires credit.” – A peculiar non sequitur. Banking can exist without fractional reserve credit expansion. The banks simply use money (gold) from consenting depositors to provide credit to a borrower. This credit is based on real savings, like you advocate.
Your assertion that the FRB money creation “process works if and only if each borrower spends 100% of the money and if the vendors who earned their money deposit 100%” is demonstrably false. Even if each individual does not spend 100% of their loans, the 10% reserve system can still be used to create say $8000 or $2000 off a deposit of $1000 after the credit has changed hands and banks enough times. The assertion isn’t and has never been that it creates 10 times the deposit every time. The point is that it can, and that fact should strike one as ridiculous.
Don’t use the straw man to knock down Rothbard (of all people!). You’re better than that.