"Jaguar Inflation" - why the Fed can't create inflation at will

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switters's picture
switters
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"Jaguar Inflation" - why the Fed can't create inflation at will

I recently came across this article written by Robert Prechter in 2004.  It's very relevant to the raging "inflation/deflation" debate going on today.  In the article Prechter uses an analogy to explain why the Fed can't create inflation at will, no matter how much it prints.  

I am tired of hearing people insist that the Fed can expand credit all it wants. Sometimes an analogy clarifies a subject, so let’s try one.

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing Jaguar automobiles and providing them to as many people as possible. To facilitate that goal, it begins operating Jaguar plants all over the country, subsidizing production with tax money. To everyone’s delight, it offers these luxury cars for sale at 50 percent off the old price. People flock to the showrooms and buy. Later, sales slow down, so the government cuts the price in half again. More people rush in and buy.

Sales again slow, so it lowers the price to $900 each. People return to the stores to buy two or three, or half a dozen. Why not? Look how cheap they are! Buyers give Jaguars to their kids and park an extra one on the lawn.

Finally, the country is awash in Jaguars. Alas, sales slow again, and the government panics. It must move more Jaguars, or, according to its theory — ironically now made fact — the economy will recede. People are working three days a week just to pay their taxes so the government can keep producing more Jaguars. If Jaguars stop moving, the economy will stop. So the government begins giving Jaguars away. A few more cars move out of the showrooms, but then it ends. Nobody wants any more JaguarsThey don’t care if they’re freeThey can’t find a use for them. Production of Jaguars ceases. It takes years to work through the overhanging supply of Jaguars. Tax collections collapse, the factories close, and unemployment soars. The economy is wrecked. People can’t afford to buy gasoline, so many of the Jaguars rust away to worthlessness. The number of Jaguars — at best — returns to the level it was before the program began.

The same thing can happen with credit.

Full article.  Thoughts?  Comments?

Kurosawa's picture
Kurosawa
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Re: "Jaguar Inflation" - why the Fed can't create inflation ...

Assuming you support this, what's your arguement against the fact that the dollar has lost over 95% of its purchasing power over the century?  I certainly think the Fed's hands are dirty in relation to this.

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Re: "Jaguar Inflation" - why the Fed can't create inflation ...

I was going to write that I don't agree with Prechter's analogy but when I went and read the full article, I realized I fully agree with it.  What I disagree with is your characterization of it as "why the Fed can't create inflation at will, no matter how much it prints".

The article basically points out that the Fed can't expand credit indefinitely.  Credit moves future production to the present to be repaid later and at some point there will be no more demand for that.  It does not state that the Fed can't create inflation. 

My understanding of Prechter's position was that he does not believe that the Fed is printing as fast as credit is being destroyed, therefore the deflationary outcome.  I think any reasonable person believes that a Central Bank operating with a fiat currency, can create inflation if it wants to.  The examples such actions are too numerous to list.

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Re: "Jaguar Inflation" - why the Fed can't create inflation ...

Kurosawa,

I think the point is that the Fed achieved this 95% devaluation of the dollar by the expansion of credit via the Fractional Reserve Banking system. But if the population is "up to their ears" in debt (credit / jaguars), then the Fed's credit creation / inflation mechanism is no longer functional. Indeed there is ample evidence of this occurring today. The only hope that the Fed has in restarting the inflation machine is to propagate the fear of inflation/currency crisis in the market place, and even this seems unlikely to work given the balance sheet constraints of the banks, corporations, and consumers.

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Re: "Jaguar Inflation" - why the Fed can't create inflation ...

I thinik this analogy is broken.  The reason being that people don't take on debt for the sake of  debt.  They take on debt to buy other assets that may or may not be productive.  So the Fed can create more and more debt and as long as it is cheaper people will take it on to acquire assets.  As the debt becomes cheaper to acquire you end up with more dollars chasing goods and the price of those goods goes up (inflation).   Ultimately when you are awash in those dollars no one will take them in exchange for real goods (hyperinflation and end of currency).

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switters
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Re: "Jaguar Inflation" - why the Fed can't create inflation ...
JAG wrote:

Kurosawa,

I think the point is that the Fed achieved this 95% devaluation of the dollar by the expansion of credit via the Fractional Reserve Banking system. But if the population is "up to their ears" in debt (credit / jaguars), then the Fed's credit creation / inflation mechanism is no longer functional. Indeed there is ample evidence of this occurring today. The only hope that the Fed has in restarting the inflation machine is to propagate the fear of inflation/currency crisis in the market place, and even this seems unlikely to work given the balance sheet constraints of the banks, corporations, and consumers.

This is what I was getting at.  Prechter does say that the Fed isn't printing fast enough to offset deleveraging in the private sector.  But he (and other deflationists like Mish) also point out that consumers don't want any more debt and banks don't want to make loans, so even if the Fed was printing more it wouldn't lead to inflation or hyper-inflation.

As for my own beliefs, at this point I lean towards deflation but I am far from certain.  My current investment strategy reflects this - I'm prepared for both deflation and inflation, which is to say I own both dollars and gold.

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Re: "Jaguar Inflation" - why the Fed can't create inflation ...

I think we are currently in deflation. But what does that mean.

There is a good reason to believe that confidence in the dollar is dropping fast, whether we are in deflation or not.

Since (foreign) demand for treasury debt seems to rapidly decline, in normal circumstances the interest rates should go up. But they don't because the Fed is buying. Why is the Fed buying. I think because of the huge amount of interest rate derivatives held by the commercial banks. The Fed has two choices

1 Let Treasury auctions fail. Dollar up. Stocks down. Derivate banks bailed out. Deflationary depression

2 Keep stepping in and keep buying. Dollar down the toilet. Price inflation way up. I guess this is what will continue to happen.

Edwin

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Re: "Jaguar Inflation" - why the Fed can't create inflation ...

Sorry, little mistake there. I meant to say 'Derivate banks bailed out' in choice 2

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agitating prop
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Re: "Jaguar Inflation" - why the Fed can't create inflation ...

The U.S. govt. is facing a situation where they pretty much have to extend unemployment benefits. They are already printing then procuring their own fiat and distributing it at home and as a reserve currency, internationally.  They were merely weakening the currency through garden variety deficit spending before, now they appear to be engagedin pure counterfeiting.  Shedlock and the few remaing deflationists appear to be living on a tiny island together, trying to guage how islanders can afford a grass shack on incomes that are cratering or nonexistant, not realizing that the slight rise in sea levels from the recent stimulus packages, will be followed by a tsunami of unemployment benefit "money", while the international community abandons the dollar.

  The big story is going to be cost of day to day living....food, energy, etc...Housing prices may still drop in this atmosphere, unless foreigners start to buy up U.S real estate, en masse, at seriously depressed prices, with their much stronger currencies. This could put a floor under the prices. and turn the U.S. from a nation of home owners to a nation of renters with off shore landlords. I can see the Chinese sovereign wealth funds purchasing homes outright, through REITS, and pretty much buying up the U.S. residential sector.  What's the govt. going to do? Nuttin. They won't be able to.

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Re: "Jaguar Inflation" - why the Fed can't create inflation ...

I agree that individual and corporate appetite for credit is limited, even at 0% interest.  But doesn't the Federal Reserve have another means of producing inflation: the outright purchase of U.S. Treasury bonds?  The federal government "borrows" and then spends the cash into the economy, and this is for all practical purposes tantamount to permanent printing of money.  In a recent Martenson report (I can't recall the name), didn't Chris argue that the single most important predictor of inflation is government spending, for this reason?

At the moment, when the federal reserve conducts its operations, the money goes mostly to banks.  But if government officials were sufficiently afraid of deflation (and they seem to be) why would this framework necessarily need be retained?  As long as the federal reserve is willing to lend unlimited amounts of money to the U.S. Treasury on demand, which would be used to fund government programs consisting of subsidies, grants, or outright purchase of products and services, there is no end to the ways that money could be injected into the economy regardless of the individual consumer's appetite for credit.

Furthermore, the beauty is that as outstanding consumer credit is reduced by government-funded inflation, consumer appetite for credit can be rekindled as their dollar-denominated debts now stand in reduced proportion to their total dollar-denominated wealth.

It seems to me that the sole restraint on this process is legislative "sticker-shock" -- the instinctive human hesitancy of legislative representatives to approve debts which seem too "big" in proportion to the numbers they are used to dealing with.  But borrowing progressively and increasingly larger amounts of money is so easy when compared with the painful alternative.  When the chips are down, what representative could bring themselves to permit the destruction of the economic system that is responsible for their own success?

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