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Bad Inflation Bets and Why They Were Bad



December 31, 2012 – Comments (7)

This is extremely well said by Cullen Roche. The last couple of years have been filled with some dire predictions, especially regarding inflation, none of which have occurred.

The responses to this are generally:
1) But it will happen, just you wait!, or
2) Actually the deflationary environment is so severe that the massive inflation is offsetting the deflationary tendencies

Both responses are completely incorrect.

If one wants to understand why events have unfolded the way they have, why the 'explosion of the monetary base' has not led to any meaningful increase in bank lending nor meaningful inflation, then an understanding of how our monetary system actually works is required. Bad models that do not account for operations of the banking system (which most don't) or bad models that assume gold-standard constraints (which most do) will produce bad predictions.

Analysts need to look honestly at their predictions, admit that they were completely incorrect, and try to understand why they were in error. Once this happens and people start talking from a place of knowledge regarding the monetary system then there can be open and productive discussions about what should be done in the economy.

Until that happens, people will continue to make bad recommendations and predictions based on incorrect models.


Bad Inflation Bets and Why They Were Bad

Brad Delong rightly slams Austrian economist Robert Murphy this morning for a bet he made in 2009 regarding inflation.  Murphy stated that headline inflation would hit 10% by January 2013.  Well, here we are with 24 hours to go and the latest monthly CPI reading is 1.8%.  I don’t want to just pile on Murphy with personal attacks.  Instead, I think it’s constructive to understand why this prediction was wrong because it’s at the heart of an important economics and finance understanding.

If we jump in the Google time machine we can see what was said back in 2009 that was so wrong.  Murphy was working from the same premise that many economists work from.  He saw the Fed flooding the banking system with reserves and assumed that this would cause inflation.  He said:

“In order to keep those reserves from working their way back into the hands of the general public (where they can start pushing up prices), the Fed will have to raise the interest rate it pays to persuade the banks to keep the reserves parked at the Fed. But this simply postpones the day of reckoning, as the troublesome stockpile of excess reserves grows even faster.”

This is not correct and it displays a huge flaw in the model that Murphy is working with.  It’s worth noting that Delong and others are working under a model that actually isn’t that different (though their “liquidity trap” theory has stated that the Murphy model is temporarily broken).  Both models are wrong.

Monetary Realism starts from an understanding of modern banking.  We understand that the US monetary system is essentially privatized.  In other words, the money supply is controlled almost entirely by private banks whose ability to create loans creates deposits which are the primary form of money we all use.  The money supply expands and contracts (mostly expands) in an elastic form based on the public’s demand for loans.

The flaw in the Murphy model is that he assumed that reserves are somehow related to a banks ability to loan money.  He specifically shows the scary chart of M1 going parabolic and then states in clear terms that this money will work its way into the public.

This is really important so I am going to cover this point again.  There are two types of money in our monetary system.  Banks deposits (the money we all use) are inside money because it is created inside the private sector (controlled by an oligopoly of private banks).  Outside money facilitates inside money and exists in the form of cash, coins and bank reserves.  This money comes from outside the private sector.  It is supplied by the government to facilitate the use of inside money.  Cash, for instance, is issued by the US Treasury to allows member Fed banks to stock vaults for customers who wish to draw down their bank accounts for transactional convenience.  Coins serve a similar purpose.  See here for more.

Reserves are a bit different.  Reserves exist solely because of the Federal Reserve System.  And they serve two purposes – 1. helping banks settle interbank payments; 2. helping banks meet reserve requirements.  Bank reserves are just deposits held on reserve at Fed banks.  You can think of reserves as existing in their own market that is totally separate and inaccessible to the non-bank private sector.  In other words, reserves are the money banks use to do business with one another.

But more importantly, banks don’t lend their reserves.  Banks lend based on their solvency or capital constraint.  Reserves are merely an asset of the bank.  When the Fed implements monetary policy like QE they don’t change the capital position of the banks.  They swap a t-bond or MBS for a bank reserve.  This doesn’t change the net financial asset position of the private sector.  The bank literally has the same capital position it did before this policy was enacted.  So, the bank can’t create more inside money than it could have before.  And we know that this outside money (reserves) doesn’t flood out into the private sector because it is used ONLY by the interbank system.  Anyone who understood this in 2009 (as many of us did) knew that Murphy was wrong because his understanding of the system was wrong.

So, as we’ve seen time and time again, misunderstanding modern banking and money has resulted in very bad predictions.  Unfortunately, I still don’t see many people agreeing on why Murphy and others were wrong.  That’s not progress.

7 Comments – Post Your Own

#1) On December 31, 2012 at 3:28 PM, ChrisGraley (28.68) wrote:

LOL, I would give a rebuttal but your opinion is made up. Honestly you would think you could at least wait 1 more day to at least be accurate when codeming someone's 4 year prediction.

Anyway Happy New Year. Watch for that step over the fiscal cliff, it's a dewsy. 

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#2) On December 31, 2012 at 4:19 PM, whereaminow (< 20) wrote:

Bad predictions abound. That's the downfall of making predictions, as Greg points out:

Randall Wray said the USA was in a “depression” in 1994 before one of the biggest booms in economic history.

MMT has also been predicting the collapse of the Eurozone since 1999. You only had to be wrong for 10 years before you were right. And then even in 2010 they predicted the Euro would “collapse”. This was totally wrong.

Mosler said we were in a depression in 2011. GDP was 3.1% last quarter.

Then you have Wray saying commodities were the “biggest bubble of all time” last year.

Then, best of all, you have Mike Norman telling Peter Schiff there was no housing bubble in 2006.

Bob Murphy's crime was not following Mises' advice, which is to understand the economy is too complex to make precise statistacal forecasts.  Since no one knows where prices would be without intervention, it's impossible to know with statistic precision where they will be with it.  All one can understand is that, ceteris paribus, quadrupling the money supply will lead to higher prices than they would have been without the increase.  

It should be noted that Bob may never be proven right, as part of the fiscal cliff deal is reportedly to change inflation measurements again, to screw SS recipients.

David in Liberty

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#3) On December 31, 2012 at 4:22 PM, MoneyWorksforMe (< 20) wrote:

"So, the bank can’t create more inside money than it could have before.  And we know that this outside money (reserves) doesn’t flood out into the private sector because it is used ONLY by the interbank system"

This is not true at all. These statements seem to be arranged and written in a way to misinform. Once the reserve requirment is met EXCESS reserves CAN be lent out into the private sector.

The reason why Robert Murphy was wrong is largely twofold:

1.) A significant underestimation of the size and scale of the European debt crisis.

2.) Suppressed loan demand and decreasing money velocity.

 M1 and especially M2 are definitely something to keep an eye on. If/when money velocity picks up, due to either decreased macro uncertainty, or decreased confidence in the stability of the USD, watch out.

Oh and the CPI of 1.8% is a joke. Even joe the plumber knows prices are increasing at a much faster rate than that...No it's not 10%, but it's much higher than 1.8%.

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#4) On December 31, 2012 at 4:30 PM, whereaminow (< 20) wrote:

The 1.8% is not even the source of the bet. The bet was headline CPI not core. Headline hit 4%. Which is laughable too, but that's a whole nother issue. If you're going to make a bet on econometric terms, you can't complain about econometric methods. 

Murphy failed because he broke with the Austrian School to make that bet, not becuase of his Austrian School analysis.

David in Liberty

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#5) On January 01, 2013 at 9:51 PM, outoffocus (24.03) wrote:

"The best way to rob a bank is to own one." -- Economics Professor William Black  

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#6) On January 02, 2013 at 10:49 AM, kdakota630 (29.36) wrote:

A great reply from Robert Murphy.

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#7) On January 02, 2013 at 2:18 PM, GNUBEE (< 20) wrote:

From Murphy's rebuttal

"The big thing is that I did not, and do not, trust Bernanke when he tells us there will be a gentle unwinding of the Fed’s balance sheet, and that if things ever started getting out of hand he has all sorts of “exit strategies.” I thought other investors would eventually agree with me that the Fed was simply printing money to buy time and temporarily stave off disaster, and they’d head for the exits."

Exactly what I want to know...or even be able to theorize.

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