Celebrating at Halftime

Reminds me of that fella back home that fell off a ten story building…as he was falling people on each floor kept hearing him say ‘so far so good, so far so good.’

  • Steve McQueen, The Magnificent Seven (1960)

One of the most memorable football matches in the last 10 years took place in Istanbul on the evening of May 25, 2005. That night, the final of the European Cup was contested between AC Milan and Liverpool. Both clubs boasted a great pedigree in the competition, having won it 10 times between them. Despite the glorious history of both clubs, the teams on that night couldn’t have been more different. AC Milan’s starting 11 contained three members of the Brazil team that had won the World Cup three years earlier, and three members of the Italian team that would win the World Cup one year later. Jaap Stam, Clarence Seedorf and Paolo Maldini had won the European Cup 8 times between them. Hernan Crespo and Andriy Shevchenko were one of the best forward partnerships in football, and the latter was the reigning European Footballer of the Year. None of the Liverpool players, bar captain Steven Gerrard and perhaps Xabi Alonso boasted the decoration of the Milan players. As such, Milan were expected to make quick work of their English opponents.

The match began conforming to the pre match expectation. In the first minute, Maldini scored from a free kick to put the Italians ahead. The match then evened out, with both sides occasionally threatening. Milan then found another gear and hit Liverpool with a devastating blow – two Hernan Crespo goals in the final six minutes of the first half meant a half time lead of 3-0 to AC Milan. The nature of the goals were particularly devastating for Liverpool supporters to watch. Both of Crespo’s goals – and indeed Maldini’s opener – were expert displays of football, carving open a Liverpool team which didn’t look anywhere near the level required to cope with, let alone fight back against, opposition of such pedigree. There was a rumor that the AC Milan players could be heard celebrating in the changing room during the half-time interval. Liverpool defender Jamie Carragher vehemently denied this rumor in his autobiography, but stated that:

Even if they did, privately, believe they had both hands on the cup, who could blame them?

Fast forward to the fall of 2008. In a vastly different arena, a vastly different sort of match was about to unfold. The two contestants were Global Central Bankers, and their sworn enemy, Deflation. In the United States, deflation had made its presence known over the preceding 18 months or so, after the height of the housing bubble had come and gone. The fall of 2008 brought the issue to a head, with the failure of Lehman Brothers precipitating a panic not seen since the Crash of 1929. In response, the Federal Reserve cut its benchmark rate to 0% and embarked on an asset purchasing program, Quantitative Easing, which has persisted in different iterations through the time of this writing. The response in financial markets was the cessation of declines and ultimately a rebound in asset prices almost universally. One nil to the central bankers.

Similarly, Deflation loomed over the Eurozone in the shape of a Sovereign Debt Crisis that threatened the viability of much of Southern Europe. In response, the European Central Bank put forth an acronym cocktail of programs intended to prevent interest rates from rising materially for many countries on the edge. If that wasn’t enough, ECB head Mario Draghi put his foot down during a September 2012 speech in London, declaring that the ECB was ready to do ‘whatever it takes’ to support the Euro, underlining it by declaring ‘it will be enough, believe me.’ Since these measures, markets for European sovereign debt have been comparatively calm, and many speculators have made great profits buying debt from countries pegged for depression just months before.

Most recently, the Bank of Japan, frustrated with twenty years of oscillation between periods of slightly rising and slightly falling prices, announced that it would embark on a doubling of the money supply in an effort to double the target price level increases. Thus, the central banks of the three largest western economies had now embarked on explicit, unprecedented tactics to prevent falling prices. The immediate reaction in financial markets has been undoubtedly positive. Equity, debt and commodity markets the world over have risen in the wake of these monumental actions by the central bankers. As such, the result is seemingly 3-0 to the central bankers. To echo Carragher, who could blame anyone for thinking, as the supporters of the central bank policies do, that the central bankers have got it right, and people in the opposition are clueless?

Unlike the Milan players in Istanbul, there is no question that the intellectual supporters of the central bankers and their policies have been popping the champagne corks over these developments. These declarations of intellectual victory over the ‘inflationistas’/goldbugs/hawks/Austrians/’inflation truthers’/etc. intensified in late spring and early summer. This seemingly vanquished group stands in opposition to the polices of the central bankers, on the grounds that said policies are ultimately the foundation for future problems, even as they may alleviate present discomforts. The sharp decline in gold, the appreciation of which seemingly defied the arguments of the central bank apologists, was the only source of real world evidence the ‘inflationistas’ could use to justify their claims, the argument went. Now, with gold seemingly in freefall, the last impediment to victory has seemingly been removed, and the apologists for central bank policy can begin to celebrate in earnest. And they haven’t shied away:

Joe Wiesenthal calls the fight, declares ‘economic elites’ winners:

So the collapse in gold is not about gold, but about vindication for a large corpus of belief and economic research, which has largely panned out. It’s great that our economic elites know what they’re talking about, and have the tools at their disposal to address crises without creating some new catastrophe.

Paul Krugman, in the wake of gold going down:

Well, the inflationistas/goldbugs are really, really annoying — all this air of having the secret wisdom when they actually haven’t a clue. And they have been a real destructive factor in policy debate, standing in the way of effective policy by raising fears of Weimar and Zimbabwe. So seeing the one thing they got right — betting on higher gold prices — turn sour is cause for a bit of celebration.

And again:

Maybe I actually am right, and maybe the other side actually does contain a remarkable number of knaves and fools… But can the debate really be as one-sided as I portray it? Well, look at the results: again and again, people on the opposite side prove to have used bad logic, bad data, the wrong historical analogies, or all of the above. I’m Krugtron the Invincible!… The point is not that I have an uncanny ability to be right; it’s that the other guys have an intense desire to be wrong. And they’ve achieved their goal.

You get the idea, but just in case, the likes of MattO’Brien, Noah Smith, and Jon Hilsenrath have all chimed in recently, expressing some variant of the same theme: the doves have been correct, and anyone in disagreement is now on the wrong side of history, to varying degrees. 

The issue with this declaration is the same issue that faced the (alleged) over exuberant Italians in Istanbul, and the sanguine fella from McQueens’ hometown: the story had not yet played out in full. Milan still had 45 minutes of football to navigate, and the fella back home still had the earths’ gravitational pull to navigate. Western economies are still yet to fully navigate the longer term, final effects of the easy monetary policies they have embarked upon. Declaring victory at this juncture is taking the risky step of celebrating at halftime.

The ‘Crank’ Argument Explained

In order to determine how wrong the ‘inflationistas’ are (if they are indeed wrong at all), it would make sense to outline what their argument actually is, and compare it against the data. In some of the celebratory pieces linked above, an attempt was made to differentiate between classes of ‘inflationistas.’ For clarity, I’ll be approaching this from a strictly Austrian angle, thus outing myself as a ‘crank,’ as per Matt O’Brien.

The Austrian argument, as it pertains to the issue of monetary stimulus, can be surmised from the following, oft referenced Mises quote from Human Action:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

The standard monetary stimulus programme espoused by the doves involves the lowering of the rate of interest and increasing the money supply, for the explicit purpose of facilitating credit expansion, which will ultimately support, and then raise prices. According to the above quote, it is this exact credit expansion which is the first step down an irreversible path to collapse. It is not that all credit expansion and lower interest rates are disastrous – the rub is in how that lower interest rate came into being. The interest rate in a market economy is ultimately determined by the supply of and demand for loanable funds. Financial crises and recessions are often characterized by a reduction of available credit and increased requirements to obtain loans, which result in rising interest rate. In other words, during a crisis, there is a short supply of credit, which can be replenished in one of two ways.

  • Societal time preferences change, induced by the higher interest rate, which leads to an increase in the savings rate and thus loanable funds
  • A central bank increases the money supply by purchasing bonds or other assets from financial institutions, thus increasing their reserves and thus loanable funds

The difference between the two methods is that the second way involves no changes in societal time preferences. With no central bank, the only way to increase the amount of savings (and thus loanable funds) is to reduce the amount allocated to consumption spending. In the second way, no such adjustment is required of society, as the central bank supplies the funds to replenish the loanable funds which lower the interest rate. The first method will lead to lower prices generally speaking, seeing as there is a reduction in the funds available to purchase consumer goods. The second method doesn’t require a lowering in consumption prices, as there is no need for society to lower its income allocation toward consumption goods.

Thus the immediate effect of the first method is to reduce consumer prices, while replenishing savings and investment. The immediate effect of the second method is to maintain consumer prices, while replenishing savings and investment. Given the doves consider a general fall in prices to be a disastrous thing, it is no wonder they opt for method 2 every single time.

The Austrian argument is that ‘method 2’ kicks off a cascade of events. The increase in loanable funds leads to an increase in bank loans to businesses and individuals. This increase in loans leads to an increase in demand for capital goods, durable consumer goods as well as the labor associated with those sectors. This increased demand manifests itself as rising prices for capital goods, and increasing incomes to the labor in those sectors. With respect to the increased labor income, it is crucial to note again that from the outset, method 2 imposes no need for society to change how it divides its income between consumption spending and savings. The portion of that increased income set aside by labor towards consumption spending represents additional demand for those consumer goods. Furthermore, that increased demand is exercised at a time in which new supply is yet to come on to the market. An auto worker hired thanks to stimulus, for example, is paid and can spend that money well before any new goods actually hit the market. This effect, according to Austrian theory leads to consumer prices rising.


Above is the savings rate alongside the Fed Funds rate going back to 1995. According to theory, the story begins with the need to replenish investment and loans to business. As written above, this can happen via an increase in savings or through central bank stimulus. The economy responded to the bursting housing bubble and the need to replenish capital by the first method, increasing savings. The spike in the savings rate from mid 2007 through mid 2008 took the personal savings rate to its highest point in nearly 15 years. The ‘problem’ with this method (according to the doves) is the negative effect this method has on prices, which again was touched upon above. This prompts the ‘need’ for central bank stimulus, which came in the form of zero interest rate policy and quantitative easing, initiated in late 2008. Since the introduction of central bank stimulus, the savings rate has declined steadily, the blip at the end of 2012 notwithstanding.


The above is a closer look at the prior chart, with the addition of consumption expenditures. The near tripling in the savings rate is not well reflected, but it is clear that following that spike, consumption spending fell, as is expected. Fed stimulus beginning at the end of 2008 allowed the savings rate to be held in check, and then to reverse, which coincided with the formation of a bottom and renewed upswing in consumer spending. This illustrates is why central bank stimulus is appealing, at least in the short term. The low interest rate environment enables increased bank loans, while at the same time consumption expenditures do not have to take the hit it would if further increases in savings were necessary.

Austrian theory states that the central bank stimulus leads to an increase in the demand for capital goods and employment in those sectors, leading to an increase in prices of capital/producers goods relative to consumer goods prices. This is illustrated below:


The above is the Producers Price Index divided by the Consumer Price Index, alongside consumption of durable goods and orders for new durable goods, which is used here as a proxy for producers’ goods. All three measures bottomed in early 2009 just after the initiation of stimulus. From there, PPI rose faster than CPI did and the demand for durable goods steadily increased. In early 2011 the relative price acceleration reversed, with CPI growing faster than the PPI. This is also expected, as described above.

From the Austrian perspective, what has been described to this point is the replenishment of capital with the aim to push into an expansionary phase. The future contractionary phase is essentially the result of the inability of producers, on the whole, to effectively recover the increasing costs of production once the final goods hit the market. Consider the following charts:


Above is durable goods data from the prior graph, this time compared with consumption expenditures. As written before, central bank stimulus is attractive because it enables both consumption and investment spending to increase simultaneously, at least in the short term. Without stimulus, the only way for capital to be rebuilt would be through a decrease in consumption (increase in savings) which would then allow for the larger demand for producers goods. The graph above would display the blue line continuing to trend lower, which would be the tradeoff supporting the higher demand for producers goods.

The fact that consumption spending (and price level) is supported in the short term does not bode well for longer term spending, because as demand is exercised in the short term, the ability to afford further increases in prices are restricted as time goes on. This means that producers, once they actually finish producing the goods, will be bringing them to market just as demand wanes at the higher price level.


The decrease in the rate of increasing consumption expenditures since mid-2011 is an indication of a reducing ability to afford goods at current prices. Should these trends continue, downward pressure on prices will lead to a cascade into the very crisis the stimulus efforts sought to prevent, or at least mitigate.

Unless more stimulus is applied.

Perma Stimulus?

Returning to the Mises quote:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

Textbook stimulus eschews the ‘voluntary abandonment of further credit expansion,’ explicitly attempting to increase credit expansion in hopes that loan-driven consumption and investment ensue. Austrians do not deny that, at least in the short term, this goal is met. The claim is that on the back end, the price increases that accompany the credit expansion will ultimately kill demand for goods at those elevated prices, prices which are necessary for producers to charge given the higher prices they had to pay to secure factors of production at the beginning of the productive process. Without further stimulus to bolster the demand for goods at higher prices, producers will only be able to sell goods at a loss, leading to bankruptices, layoffs and other unpleasantries.

Stimulus supporters tend to vehemently disagree with the implication of ‘perma stimulus’. Take Paul Krugman, writing in May:

Ending stimulus has never been a problem — in fact, the historical record shows that it almost always ends too soon.

Incidentally, foreign experience follows the same pattern. You often hear Japan described as a country that has pursued never-ending fiscal stimulus. In reality, it has engaged in stop-go policies, increasing spending when the economy is weak, then pulling back at the first sign of recovery (and thereby pushing itself back into recession).

So the whole notion of perma-stimulus is fantasy posing as hardheaded realism.

Krugman wrote in response to allegations that stimulus couldn’t be ended, as in a literal inability to ever stop stimulus. This is obviously not true – it can be stopped, but that’s not what is alleged here – which is that if stimulus is stopped, the recovery comes to a halt. Krugman’s comments go towards that point. In writing that stimulus ‘almost always ends too soon,’ and that pulling stimulus back is responsible for the push back into recession, he correctly implies that the stimulus is the backbone of the recovery. In other words, the stimulus has to be permanent or else we slip straight back to recession.

According to the Austrians, not only must stimulus be ever present for recovery to be sustained, stimulus must rise at an increasing rate as time progresses. Austrian economist Jesus Huerta de Soto, piggybacking a point Hayek made in Prices and Production (1932), explains why in the following passage, from the book Money, Credit and Economic Cycles (2006):

The need for this ever-escalating increase in the rate of credit expansion rests on the fact that in each time period the rate must exceed the rise in the price of consumer goods, a rise which results from the greater monetary demand for these goods following the jump in the nominal income of the original factors of production. Therefore, given that a large portion of the new income received by the owners of the original factors of production originates directly from credit expansion, this expansion must progressively intensify so that the price of the factors of production is always ahead of the price of consumer goods.

Bit of a long winded passage, so I’ll distill it. Remember that central bank stimulus is supposed to flow to businesses via the banks, and then to individual wage earners through employment. This increased income of wage earners then leads to increased consumption spending, driving up prices. If stimulus in each successive round does not increase by a greater amount, the income flowing through to wage earners for consumption will not be enough to drive prices up as much as it did in that last round of stimulus. This is known as ‘disinflation’ to the Keynesian mind.

In light of all of this, the Federal Reserve, while remaining ever present in its stimulus, has not increased the amount of stimulus by an increasing rate with each successive round. The QE beginning in December 2008 lasted for 15 months and injected $1.7 trillion into the economy, a monthly rate of $113 billion per month. QE2 began in November 2010 and involved $75 billion worth of asset purchases per month through June of 2011. The current QE is open ended, with $85 billion per month going into the economy. With many market participants believing that the Federal Reserve is poised to taper, reducing the current $85 billion per month in asset purchases, it is interesting to note the overall trajectory of asset purchases per month over the 5 year course of Federal Reserve expansion. In effect, the Federal Reserve has been ‘tapering’ since the end of QE1, increasing stimulus at a slower pace since. The effect on selected data points is shown below.

It is clear that QE1 had the most effect, while subsequent, lesser rounds of QE have presided over a flat line at best in the growth rates of the four data points in the first chart. With respect to the S&P 500, which I will use as a proxy for assets in general, QE1 coincided with the largest increase in the index percentage wise. The other periods of QE provided less of a jolt to the index, and the circled periods in which there was no additional QE saw little to no increase or substantial declines.

This is in line with the Austrian theory as written above. Should the Federal Reserve embark on a more explicit tapering, growth will continue to remain flat at best, more likely growing at a slower and slower pace before actually declining. The same could be said of the S&P 500. In the face of that deterioration, the Fed will have to reverse course and actually increase the size of its asset purchases in order to avoid, or mitigate a crisis. That about-face should make it crystal clear that the Fed can never taper, let alone pare down its balance sheet or raise interest rates, without problems arising. To reference Krugman, it will always be ‘too soon’ to end stimulus, because the entire recovery rests on that stimulus. In tapering (particularly the explicit tapering so many expect at the September FOMC meeting), the Fed will be taking a step down the ‘voluntary abandonment of further credit creation’ path in a Misean sense. This path leads to crisis, which will be undoubtedly countered by the Fed accelerating stimulus, which in turn culminates with the ‘final and total collapse of the currency system involved.’

‘Hyperinflation? We Don’t Even Have Regular Inflation’

The ‘final and total collapse of the currency system involved’ is just a fancy way of saying hyperinflation. While it is true that many Austrian commentators have called for a hyperinflation which has not yet come to pass, it is not necessarily correct to extrapolate from that the idea that their theory is then invalidated. What those Austrians are guilty of is skipping to the end of a logical exercise that begins with the acknowledgement that deflation is the ultimate evil to policymakers and mainstream economists. Hayek touched on this in Prices and Production, writing [brackets mine]:

My argument is not that such a development [rapid rise in consumer prices] is inevitable once a policy of credit expansion is embarked upon, but that it has to be carried to that point if a certain result – a constant rate of forced saving, or a maintenance without the help of voluntary saving of capital accumulated by forced saving – is to be achieved.

Recall that the point of stimulus is to achieve constant capital replenishment without allowing an increase in the savings rate and the commensurate decline in consumer spending. Hayek is saying that in order to achieve this objective, rapid price increases are inevitable since only a constant increase in the rate of stimulus will do the trick. If stimulus isn’t large enough and results in disinflation, the response will be to increase the stimulus until it does achieve those results. Indeed, FOMC members Bullard and Kocherlakota have recently made rumblings to this effect. Once the effect of any increased stimulus wears off, yet another round will be needed to stave off the subsequent disinflationary or deflationary pressures. Again, only stimulus of an ever larger quantity will suffice.

The limiting factor that determines when these increasing rounds of stimulus would finally lead to the rapid price increases is psychology. The point at which people seek to spend all of their cash as fast as they can is unpredictable. What one can say is that the conditions for such an outcome are almost optimal, given the ideological preference of policy makers and mainstream economists for deflation avoidance at all costs.

Three Goals in Six Minutes

The second half began in Istanbul all those years ago in a quite innocuous manner, before Liverpool hit back with 3 goals in 6 minutes to level the score. Milan, shocked, was almost instantly rendered a spent force and labored into extra time and penalties where they went on to lose. It was a remarkable comeback by Liverpool, one their supporters will never forget. Only time will tell, but it could be possible that Ben Bernanke’s Congressional testimony on May 22, which kicked off the ‘taper tantrum’ across financial markets, is the first goal in the comeback by Deflation. Central Bankers are in a bind. They cannot withdraw the very stimulus upon which recoveries in debt dependent activities rely upon, given their predilection for avoiding deflation. At the same time, an increase in stimulus maintains, and even raises a level of prices the economy cannot sustain on its own. Hence, the Misean dictum of the inability to avoid catastrophe following a boom brought about by credit expansion. The idea that such a catastrophe can be avoided is pure fantasy, and this will be demonstrated in relatively short order. For the ‘economics of the elite’ to be proven correct, the Federal Reserve must actually exit with no problems. Exiting was always part of the plan, after all. Until that happens, any declaration of victory is celebrating at half time.

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