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<font face="Verdana" size="1"><span id="lblStoryTitle">http://www.mises.org/fullstory.aspx?control=1579</span></font>
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<font face="Verdana" size="2"><span><font size="5"><strong>Debt and Delusion</strong></font></span><span id="lblStoryText">
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<h4>By Robert Blumen</h4>
<p class="MsoBodyText">[Posted August 12, 2004]
<p class="MsoBodyText"><img alt src="http://www.mises.org/images3/debt.gif" align="right" border="0" NOSEND="1" width="226" height="271">Since
the last serious outbreak of inflation in the 70s, central banks have
conquered this pestilence and have practiced a responsible stewardship over
national monetary systems ever since. Due in no small part to the benign
inflationary environment that has followed their victory, stocks and bonds
have outperformed historical averages. This reflects a high degree of
confidence in future monetary stability and prosperity.
<p class="MsoBodyText">Or so we are constantly told.
<p class="MsoBodyText">That this consensus view is a twisted mirror of reality
is the theme of an undeservedly obscure work of financial economics, Peter
Warburton’s Debt
and Delusion: Central Bank Follies that Threaten Economic Disaster.Â
Published in 1999, the work rapidly went out of print but has since become a
cult classic among financial contrarians.<a id="_ftnref1" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn1" name="_ftnref1"><span class="MsoFootnoteReference">[1]</span></a><sup>,</sup><a id="_ftnref2" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn2" name="_ftnref2"><span class="MsoFootnoteReference">[2]</span></a>
Although not written from an Austrian point of view, the argument parallels an
Austrian view of money and banking in many aspects. My purpose in
writing this article is to present Warburton’s main argument and to
interpret it through an Austrian lens.
<p class="MsoBodyText"><strong>The Demise of Inflation</strong>
<p class="MsoBodyText">During the developed world’s flirtation with
hyper-inflation in the 70s, wage and price increases were driven by a rapid
expansion of the money supply created by central banks to fund government
deficits. The upward spiral was finally stopped when Fed Chairman Volker
raised short-term interest rates enough to slow down monetary growth.
<p class="MsoBodyText">The mechanism of the last major bout of inflation was
the sale of government debt to commercial banks. In this process, called
"monetization," banks or the Fed create the money out of nothing
with which to purchase the bonds.<a id="_ftnref3" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn3" name="_ftnref3"><span class="MsoFootnoteReference">[3]</span></a>Â
This is often referred to as"printing money," although in modern
times, the money is usually created electronically rather than through the
manufacture of paper notes.
<p class="MsoBodyText">After suffering through one episode of runaway prices,
public opinion had turned against inflation by the early 80s. The political
parties associated with the inflationary period had been voted out of office
in the <ST1:COUNTRY-REGION>
<ST1:PLACE>
US</ST1:PLACE>
</ST1:COUNTRY-REGION>
and the <ST1:COUNTRY-REGION>
<ST1:PLACE>
UK</ST1:PLACE>
</ST1:COUNTRY-REGION>
. Chairman Volker had been appointed to head the Federal Reserve, a post
from which he embarked upon a painful campaign of raising interest rates
sufficiently to slow money supply growth.
<p class="MsoBodyText">Warburton’s story begins in the aftermath of
Volker’s triumph. The conundrum facing governments at the time was: how to
enable governments to continue to live beyond their means, without suffering
inflationary consequences? In this climate, a new outbreak of inflation
would have contained the seeds of its own demise, for the following reason.Â
Lenders require a positive real return in order to lend; interest rates must
then exceed the rate at which the currency is losing value, by some margin.Â
Having recently been burned by inflation, bond buyers would have resisted any
signs of rising prices by insisting on higher bond yields. Such a
market-driven rise of interest rates would have given the central bank little
choice but to follow with rate increases of its own to slow down money growth,
or else risk a total destruction of the currency through accelerating
inflation.
<p class="MsoBodyText">Central bankers offered a program to solve this dilemma,
the centerpiece of which was a change in the method of financing government
debt. Â Deficit finance bonds would be sold to private investors through
existing financial markets. This would place the bonds in the hands of
investment funds, rather than on the books of commercial banks as would have
been the case had they returned to the old style of monetization. The
subsequent explosion in the size and breadth of bond markets is illustrated by
a few snapshots of gross issuances: less than $1 trillion in 1970; $23
trillion by 1997<a id="_ftnref4" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn4" name="_ftnref4"><span class="MsoFootnoteReference">[4]</span></a>
and nearly $43 trillion by 2002.<a id="_ftnref5" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn5" name="_ftnref5"><span class="MsoFootnoteReference">[5]</span></a>
<p class="MsoBodyText">A second part of the central bankers’ program was to
reign in government deficits so as to reduce the need for borrowing.Â
This advice has been mostly ignored. Borrowing to fund government deficits
exploded under Reagan, continued to soar in spite of the phony"surpluses"
of the <ST1:CITY>
<ST1:PLACE>
Clinton</ST1:PLACE>
</ST1:CITY>
years, and has reached stupefying levels under George W. Bush.<a id="_ftnref6" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn6" name="_ftnref6"><span class="MsoFootnoteReference">[6]</span></a>
It is the interaction between this explosion of debt and what Warburton calls
"the capital markets revolution" that has produced a new and
deceptive form of inflation.
<p class="MsoBodyText"><strong>The Interest Rate Anomaly</strong>
<p class="MsoBodyText">Scarcity requires that when a good is demanded in
increasing quantity, the price paid by the buyers will be successively higher.Â
This must happen because the sellers who value a good the least are the first
in line to sell. As buyers continue to search out a greater quantity of
the good, potential sellers who place an increasingly greater valuation on the
good must be recruited to supply it.  Buyers then bid up the price
of a good up by demanding more of it.
<p class="MsoBodyText">Under a sound monetary system where credit cannot be
created out of nothing, credit can only be the supply of savings by a lender.
If credit is demanded in increasing quantities, borrowing must take place at
ever-higher interest rates because savings are necessarily scarce; a higher
interest rate is necessary to draw more marginal savers into parting with
their cash. There is an inherent limit to the amount of borrowing that
can occur: the point where savers cannot be enticed to part with any more
present goods at any rate of interest. The reason that the pool
of savings cannot expand indefinitely is because people only have so many
assets that they can save, and everyone must engage in some consumption in the
present.<a id="_ftnref7" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn7" name="_ftnref7"><span class="MsoFootnoteReference">[7]</span></a>
<p class="MsoBodyText">Yet, as the fire hose of government bond issuances has
flooded international capital markets with debt issues, interest rates have
not risen much, are now lower than in the 70s (a time of less borrowing), and
for the last year have been at or near generational lows.  It is
dubious to maintain that the gargantuan volumes of bond purchases in recent
years could have been funded out of savings when the <ST1:COUNTRY-REGION>
<ST1:PLACE>
US</ST1:PLACE>
</ST1:COUNTRY-REGION>
personal savings rate has also dropped to long-term lows.
<p class="MsoBodyText">This anomaly has not attracted much attention or
investigation. Instead, most analysts now find this state of affairs to
be utterly normal. An alleged quote attributed to Vice President Dick Cheney
that"deficits don’t matter" perfectly summarizes the prevailing
attitude.<a id="_ftnref8" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn8" name="_ftnref8"><span class="MsoFootnoteReference">[8]</span></a>Â
Notes Warburton,"the incongruity of the massive accumulation of
government and corporate debt with a low inflation environment no longer
provokes much curiosity, even among professionals."<a id="_ftnref9" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn9" name="_ftnref9"><span class="MsoFootnoteReference">[9]</span></a>;
and,"a stratospheric stock market has become accepted as the normal
state of affairs, requiring no special explanation."<a id="_ftnref10" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn10" name="_ftnref10"><span class="MsoFootnoteReference">[10]</span></a>
<p class="MsoBodyText">As he wryly noted:
<blockquote dir="ltr">
<p class="MsoBodyText"><em>Periodic bouts of price inflation, the tell-tale
signs of a long-standing debt addiction, have all but vanished. The
central banks, as financial physicians, seem to have effected a cure....
Few have bothered to ask how the central banks have accomplished this feat,
one which has proved elusive for more than 20 years. As long as inflation is
absent, who really cares exactly what the central banks have been up to</em>.<a id="_ftnref11" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn11" name="_ftnref11"><span class="MsoFootnoteReference">[11]</span></a>
[/i]
<p class="MsoBodyText">The solution to this puzzling anomaly is to identify
the source of demand for government bonds. For this, we must examine"what
the central banks have been up to."
<p class="MsoBodyText"><strong>Financial Assets and Price Inflation</strong>
<p class="MsoBodyText">Â
<div>
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<td>
<h4>We cannot all be day traders: someone must produce the goods
that are consumed.
</h4>
</td>
</tr>
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<p class="MsoBodyText">Economists have long known of a general correspondence
between changes in the quantity of money and its purchasing power. A naïve quantity
theory of money would have all prices moving by the same proportion in
response to a change in the quantity of money. According to the quantity
theory, if apples cost $1 and bananas $2 today, then after an increase in the
quantity of money, their new prices should still be in the ratio 1:2, perhaps
$2 and $4.
<p class="MsoBodyText">Debt and Delusion argues that the
institutional changes described above have confined the price adjustments
resulting from monetary expansion to the financial system.  The
character of the 80s and 90s inflation differed from that of the 70s. In
recent decades, price changes following money quantity changes have been in
stocks and bond prices, rather than wages and consumption goods prices.
<p class="MsoBodyText">How can inflation sometimes affect financial assets and
other times mostly consumer prices? The monetary framework of Ludwig von Mises
can explain this. Mises accepted a general relationship between money quantity
and money prices, but he argued that introduction of new money into a
community will not affect all prices uniformly. Relative as well as
general price changes will result.<a id="_ftnref12" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn12" name="_ftnref12"><span class="MsoFootnoteReference">[12]</span></a>Â
The particulars of magnitude and goods depend on where the new money enters
the economic system, and what the initial recipients spend it on.
<p class="MsoBodyText">The initial owners of new money, Mises noted, find
themselves with a surplus of cash relative to their needs for immediate
spending. They are in a position to increase their demand for the goods
or assets that they wish to purchase, which will bid up those prices.Â
The sellers of those goods then receive the money second-hand, putting them in
a position to demand more of some other goods, and so forth.  In
essence,"variations in the value of money always start from a given
point and gradually spread out from this point through the whole community".<a id="_ftnref13" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn13" name="_ftnref13"><span class="MsoFootnoteReference">[13]</span></a>Â
In this way, monetary expansion will affect some prices more than others.Â
<p class="MsoBodyText">Mises showed why after an inflation, the relative price
of apples in terms of bananas might no longer be 1:2, for example, the apple
might now cost $2 and the banana $6, a ratio of 1:3. Price ratios are
not stable under inflation. Suppose that, instead of comparing to
bananas, the prices of apples relative to stocks are compared. If today
apples cost $1 and the Dow Jones Average is at 5,000, and then money is
created and used by the initial recipients to buy stocks, the apple may still
cost $1, while the Dow might have attained 10,000. Â
<p class="MsoBodyText">With financial assets absorbing most of the impact of
new money, the outbreak of inflation into wages and consumption goods that
proved so unpopular in the 70s has been (at least for a time) repressed. Â
Newly created money was injected into capital markets, where it was initially
spent on the purchase of bonds. The low yields in government bonds have
made low-yielding corporate bonds more attractive and equities with low
dividend yields in competition with bonds an increasingly good buy. The
inflationary price adjustments have leaked out of government bonds into other
financial assets.
<p class="MsoBodyText">But over time wouldn’t the second or third recipients
of the money spend it on cars or food, causing the inflationary to leak out of
financial markets into consumption goods? The answer is no: in recent
years, money has been injected into financial markets and the resulting price
effects contained there. The greater part of Debt and Delusion
deals with the mechanisms of this containment.  They are interest
rate arbitrage, gearing through financial derivatives, the attraction of
private savings from banks into capital markets, and management of public
opinion about inflation. More will be said about each one of these below.
<p class="MsoBodyText"><strong>Interest Rate Arbitrage</strong>
<p class="MsoBodyText">The rate at which commercial banks can borrow from the
Fed for short-term loans is fixed by the Fed itself. In the current
institutional framework, interest rates do not rise with increased loan demand
to reflect actual scarcity.  To hold the interest rate below the
market-clearing level, the Fed must create whatever amount of money borrowers
wish to borrow in order to prevent the natural rise of rates that would occur
if credit were restrained by savings.Â
<p class="MsoBodyText">Without central bank price fixing, interest rates of
different maturities would tend to be the same. Deviations could arise
in one direction or another, but if, for example, 5-year bonds consistently
yielded more than 1-year bonds, that would imply the existence of different
rates of return not just for different bonds but also within the productive
structure of the economy, something that could not persist permanently.<a id="_ftnref14" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn14" name="_ftnref14"><span class="MsoFootnoteReference">[14]</span></a><sup>,</sup>
<a id="_ftnref15" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn15" name="_ftnref15"><span class="MsoFootnoteReference">[15]</span></a>
Some empirical research by Paul Kasriel suggests that the long and short bond
yields tended to be more nearly equal prior to the existence of the Fed than
afterwards.<a id="_ftnref16" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn16" name="_ftnref16"><span class="MsoFootnoteReference">[16]</span></a>
<p class="MsoBodyText">As long as a rate differential between short term and
long term bonds remains, an essentially risk-free profit opportunity (known as
the"carry trade") will persist no matter how much"arbitrage"
occurs. Banks or their favored clients borrow from the Fed at short-term rates
to purchase bonds of longer maturity, when there is a sufficient price spread
between them. For example, when the interest rate on a 90-day T-Bill is 1% and
the 10-year Treasury yields 5%, there exists a profit opportunity of 4% for a
borrower who has access to these rates.
<p class="MsoBodyText">Debt and Delusion locates the source of
financial inflation in the ability of large bond buyers to borrow volumes of
newly created money from the Fed at a fixed price. Because the interest
rate does not rise to meet increasing quantities of lending, this arrangement
generates volumes of"synthetic demand" for the government bond
markets at longer maturities. Enough bonds are purchased to maintain
their prices above and their yields below true market-clearing levels.Â
Warburton terms this"the illusion of an unlimited savings pool" and
notes that this illusion"has grown more and more powerful and is matched
by a new confidence among prospective bond issuers."<a id="_ftnref17" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn17" name="_ftnref17"><span class="MsoFootnoteReference">[17]</span></a>
<p class="MsoBodyText">When Austrians talk about entrepreneurial activity,
they are describing the activity of insightful actors who perceive profit
opportunities that others have missed, and are willing to risk their capital
to test their ideas.  The continuing rearrangement of productive
activity by entrepreneurs aligns production with consumer preferences.Â
Under central banking, financial markets are not real markets, although they
are similar enough in appearance to fool a lot of people. In this
environment, the term"arbitrage" is a misnomer because borrowing
and lending is no longer a market-driven price adjustment process.Â
Trading mainly recycles debt from the central bank to government borrowing.
<p class="MsoBodyText"><strong>Gearing</strong>
<p class="MsoBodyText">A second mechanism of financial asset inflation is the
use of derivatives to create additional purchasing power. Derivatives
are financial contracts between two parties. The value of the contract
is thus derived from another reference price. The value of a
derivative contract is determined by some mathematical relation to the price
of the underlying asset or commodity. For example, an option contract on
copper might reference the price of 25 tons of copper. Derivatives on
government bond interest rates are a large component of the total volume of
these instruments.
<p class="MsoBodyText">The important feature of these contracts is the ability
of one side to control a position whose value is that of a large volume of an
underlying commodity for a much smaller amount of money.
<blockquote dir="ltr">
<p class="MsoBodyText"><em>Derivatives are used to secure the control of a
more expensive asset from a much smaller commitment of capital. The
use of derivatives by hedge funds and the proprietary trading desks of large
banks in relation to government bond markets represents itself as a grossly
inflated demand for the underlying bonds. This acts as an artificial
support mechanism for both bond and equity markets, keeping yields lower and
asset values higher than would otherwise be the case. This synthetic
source of demand is critically dependent on the downward progression of bond
yields and on the slope of the yield curve. While there is a sense in
which all demand for financial assets are contingent on their expected
performance, this is especially true of geared and unhedged derivatives
positions.</em><a id="_ftnref18" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn18" name="_ftnref18"><span class="MsoFootnoteReference">[18]</span></a>
[/i]
<p class="MsoBodyText">Warburton explains how these leveraged contracts are
used to generate a synthetic source of demand for financial securities. A
hedge fund wishing to purchase $100 million of stock can put up $8 million and
borrow the remaining amount from an investment bank.<a id="_ftnref19" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn19" name="_ftnref19"><span class="MsoFootnoteReference">[19]</span></a>Â
Then:
<blockquote dir="ltr">
<p class="MsoBodyText"><em>It is possible to use unrealized gains in
financial assets (including derivative contracts) as collateral for further
purchases. The persistent upward trend in underlying asset prices has
amplified these unrealized gains and has enabled and encouraged the
progressive doubling-up of ‘long’ positions, particularly in government
bond futures. It is easy to envisage how the cumulative actions of a
small minority of market participants over a number of years can mature into
a significant underlying demand for bonds. While financial
commentators are apt to attribute a falling</em> <ST1:COUNTRY-REGION>
<ST1:PLACE>
<em>US</em></ST1:PLACE>
</ST1:COUNTRY-REGION>
<em>Treasury bond yield to a lowering of inflation expectations or a new
credibility that the federal budget will be balanced, the true explanation
may lie in progressive gearing.</em><a id="_ftnref20" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn20" name="_ftnref20"><span class="MsoFootnoteReference">[20]</span></a>
[/i]
<p class="MsoBodyText">The initial injection of new money into the bond market
explains why the effects of inflation would show up there first. The continued
containment of inflation within the financial sector as money is spent, and
then re-spent on financial securities, is created by the leveraging available
through derivatives. The funding of these derivatives is complex, but
again it ultimately relies on borrowing at fixed low yields from the central
bank. The process circulates the newly created purchasing power again
and again back into the financial sector, rather than allowing it to leak out
into wages or consumption goods.
<p class="MsoBodyText"><strong>The Management of Expectations</strong>
<p class="MsoBodyText">Mises’s investigations showed that the purchasing
power of money depends on the supply and demand for money itself. The
greatest determinant of the demand for money is public expectations of future
prices.<a id="_ftnref21" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn21" name="_ftnref21"><span class="MsoFootnoteReference">[21]</span></a>Â
If prices have been stable, people will expect them to remain stable and money
demand will remain about the same. If prices have been falling slowly
for many years, people will expect them to continue to fall. In spite of
accelerating money supply growth, if people do not believe that prices will
rise in the future, inflation expectations can remain low while the growth of
money supply proceeds.<a id="_ftnref22" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn22" name="_ftnref22"><span class="MsoFootnoteReference">[22]</span></a>Â
Rothbard has commented:
<blockquote dir="ltr">
<p class="MsoBodyText" dir="ltr"><em>On the other hand, suppose that people
anticipate a large increase in the money supply and hence a large future
increase in prices... . People now know in their hearts that prices
will rise substantially in the near future. As a result, they decide to buy
now—to buy the car, the house or the washing machine—instead of waiting
for a year or two when they know full well that prices will be higher. In
response to inflationary expectations, then, people will draw down their
cash balances…But as people act on their expectations of rising prices,
their lowered demand for cash pushes up the prices now rather than later.
The more people anticipate future price increases, the faster will those
increases occur.... Deflationary price expectations, then, will lower
prices, and inflationary expectations will raise them.</em><a id="_ftnref23" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn23" name="_ftnref23"><span class="MsoFootnoteReference">[23]</span></a>
[/i]
<p class="MsoBodyText">Recent history would also suggest that people attribute
more importance to the recent price changes of consumption goods in forming
expectations about the future trends in the prices of consumption goods.
Similarly, consumer's attribute more importance to price trends in financial
assets in forming opinions about the future price trends in financial assets.Â
For example, investor Marc Faber has observed that moves in asset price tend
to attract little interest from the mass of investors until a trend has been
in place for several years.<a id="_ftnref24" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn24" name="_ftnref24"><span class="MsoFootnoteReference">[24]</span></a>
<p class="MsoBodyText">To the extent that any price increases at all have
leaked out of financial assets into consumption goods, the deliberate
distortions in the measurement of the Consumer Price Index (CPI) have been
introduced in order to create a false consensus that"there is no
inflation."Â A variety of questionable price adjustment stratagems
have been instituted in the CPI computation: the exclusion of food and energy,
the use of lower"quality-adjusted" prices, seasonal adjustments,
and the replacement of home prices with rental rates. The index
incorporates only consumption goods, when most of the price increases are
showing up in financial assets.<a id="_ftnref25" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn25" name="_ftnref25"><span class="MsoFootnoteReference">[25]</span></a><sup>,</sup><a id="_ftnref26" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn26" name="_ftnref26"><span class="MsoFootnoteReference">[26]</span></a>
<p class="MsoBodyText">So successful has been the management of expectations
that inflation has disappeared from public discussion. Most of the public did
not view a succession of all-time highs in the stock market as in any way
relevant to the price they would have to pay for milk. Growth in the money
supply attracted no analytical attention from the mainstream financial media.
Some prominent"supply-side" economists even advanced the ludicrous
idea that the <ST1:COUNTRY-REGION>
<ST1:PLACE>
US</ST1:PLACE>
</ST1:COUNTRY-REGION>
economy was experiencing a deflation during the 90s stock market bubble, and
called upon the Fed to inflate even more.
<p class="MsoBodyText">The successful management of inflation expectations has
forestalled the eventual rejection of cash in favor of tangible goods that
ultimately results from excessive money printing. "The impressive
reduction of inflation," writes Warburton,"is a dangerous illusion;
it has been obtained largely by substituting one set of serious problems for
another."<a id="_ftnref27" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn27" name="_ftnref27"><span class="MsoFootnoteReference">[27]</span></a>
In the end, the public, intoxicated with the gains from stock market inflation,
had adopted a don’t ask, don’t tell policy toward central banks.
<p class="MsoBodyText"><strong>The Corruption of Savings</strong>
<p class="MsoBodyText">A peculiar feature of the social psychology of
financial asset prices is their self-reinforcing character.  The
upward trend in stock and bond prices has served to enhance the respectability
of capital markets and their perceived safety as repositories of capital,
which in turn has aided their cause of attracting even more of the meager
available savings from the private sector.<a id="_ftnref28" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn28" name="_ftnref28"><span class="MsoFootnoteReference">[28]</span></a>
<p class="MsoBodyText">Warburton documents a long-term trend of investment
funds essentially chasing price inflation: shifting their cash out of
low-yielding bank accounts, CDs, and money funds into bonds of longer
maturities, and eventually, equities.<a id="_ftnref29" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn29" name="_ftnref29"><span class="MsoFootnoteReference">[29]</span></a>
<p class="MsoBodyText">Some commentators reason that inflation must now be
quite low because the credit markets are patrolled by"bond vigilantes,"
astute traders ever alert to punish central banks for their inflationary
indiscretions, ready to dispense rough justice in the form of higher interest
rates. This analysis assumes that inflation is reflected primarily in
consumption goods, and that bond yields are free to move on their own to
convey meaningful information about changes in the value of the monetary unit.
These assumptions are more or less the reverse of reality: the funneling of
inflation into bonds as described above provides a floor under bond prices and
hence a ceiling on bond yields. The bond vigilantes have gone on an
extended vacation.
<p class="MsoBodyText">Another popular argument is a stock market that is
expensive measured by P/E ratios is cheap or at least fairly valued because
low interest rates justify higher multiples. Stocks appear to be cheap
in a dividend discount model that uses the current bond yields to discount
future earnings. This view fails to take into account that the bond bull
market is a symptom of high inflation, not low inflation. Inflated
prices for bonds might make stocks look relatively cheap in comparison to
bonds, but in the absolute sense both are inflated.<a id="_ftnref30" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn30" name="_ftnref30"><span class="MsoFootnoteReference">[30]</span></a>
<p class="MsoBodyText"><strong>Conclusions</strong>
<p class="MsoBodyText">But what does it matter if stock and bond prices rise
relative to consumption goods? As economist Paul Krugman once
wrote,"It's paper gains today, paper losses tomorrow; who cares?"
The problem with financial inflation is that investment decisions by
entrepreneurs are based on relative prices. When relative prices are
disrupted, as by financial inflation, the entire productive structure of the
economy is distorted. The movement of real savings into real investment
is stymied.  As Mises wrote,"The endeavors to expand the
quantity of money in circulation either in order to increase the government's
capacity to spend or in order to bring about a temporary lowering of the rate
of interest disintegrate all currency matters and derange economic calculation."<a id="_ftnref31" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftn31" name="_ftnref31"><span class="MsoFootnoteReference">[31]</span></a>
<p class="MsoBodyText">The"financialization" of the economy—the
expansion of the financial sector relative to mining, agriculture,
manufacturing, transportation, energy, transportation, and retail—is but one
example of these distortions.  Various measures of the size of
financial assets, such as the stock market capitalization to GDP ratio, and
Tobin’s"Q" ratio (which measure total stock market capitalization
to replacement cost) reached all-time highs in the late 90s and are still
above long-term average values.
<p class="MsoBodyText">The increasing domination of the stock market
capitalization and economic activity by financial institutions is noted
by the New York Times:
<blockquote dir="ltr">
<p class="MsoBodyText" dir="ltr"><em>Â ... in recent years, financial
services companies have quietly come to dominate the S&P 500.</em>
<p class="MsoBodyText" dir="ltr"><em>Right now, these companies make up 20.4
percent of the index, up from 12.8 percent 10 years ago. The current weight
of financial services is almost double that of industrial company stocks and
more than triple that of energy shares.</em>
<p class="MsoBodyText" dir="ltr"><em>… It is also worth noting that the
current weight of financial services companies in the S&P is
significantly understated because the 82 financial stocks in the index do
not include General Electric, General Motors or Ford Motor. All of these
companies have big financial operations that have contributed significantly
to their earnings in recent years.</em>
<p class="MsoBodyText" dir="ltr"><em>… Financial companies now generate
about 30 percent of the profits, after taxes, of <ST1:COUNTRY-REGION>
<ST1:PLACE>
United States</ST1:PLACE>
</ST1:COUNTRY-REGION>
’ companies, [financial economist Andrew] Smithers said. That is up from 7
percent in 1982. In addition, profit margins at financial companies in the
first quarter of 2004 stood at 32.6 percent of all corporate output, around
11 percent higher than their average since 1929 [Smithers] said.</em>
[/i]
<p class="MsoBodyText">The economic purpose of capital markets is to provide a
nexus between savers and borrowers for the financing of productive investment. Â
Financial entrepreneurs, such as venture capitalists, traders, and speculators, are
essential in forecasting the best uses of available savings and bearing the
risk in an uncertain world.  But a society cannot prosper by
printing ever-increasing quantities of paper tickets representing claims for
real goods and drawing more of the population into trading these tickets back
and forth among themselves. We cannot all be day traders: someone must
produce the goods that are consumed.
<p class="MsoBodyText">Warburton calls the recent period"an excursion
into the realm of financial fantasy."Â The fantasy is that central
bankers have found a way to inflate without any negative consequences.Â
While the effects of money supply growth can be confined to stocks and bonds,
inflation is hidden in plain sight. The adjustment of relative prices
between financial assets and consumption goods cannot be postponed
indefinitely. The unwinding will not be easy or painless. Surely central
bank follies now threaten economic disaster.
<p class="MsoBodyText"><span class="234322613-12082004">____________________________</span>
<p class="MsoNormal">Robert Blumen is an independent enterprise software
consultant based in San Francisco. Send him mail at robert@RobertBlumen.com.
Comment on the   blog.
<p class="MsoNormal">NOTES
<p class="MsoNormal"><a id="_ftn1" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref1" name="_ftn1"><span class="MsoFootnoteReference">[1]</span></a>
Published by Penguin <ST1:COUNTRY-REGION>
<ST1:PLACE>
UK</ST1:PLACE>
</ST1:COUNTRY-REGION>
, 1999. Jim Puplava, proprietor of Financial
Sense Onlineis the foremost analyst who has built upon Warbuton’s views. See
some of Puplava’s writings on this subject: The
Last Wave, Debt
Valley, Rogue
Waves and Standard Deviations (part 1), and  Rogue
Waves and Standard Deviations (part 2).
<p class="MsoNormal"><a id="_ftn2" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref2" name="_ftn2"><span class="MsoFootnoteReference">[2]</span></a>At
the time of this writing, there is a single used copy for sale on Amazon.com
at an asking price of over $140 and one on Amazon.UK for around $180.
<p class="MsoNormal"><a id="_ftn3" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref3" name="_ftn3"><span class="MsoFootnoteReference">[3]</span></a>
Rothbard The
Mystery of Banking, explains this process on pages 105-08.
<p class="MsoNormal"><a id="_ftn4" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref4" name="_ftn4"><span class="MsoFootnoteReference">[4]</span></a>The
first two figures from Warburton, p. 3.
<p class="MsoNormal"><a id="_ftn5" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref5" name="_ftn5"><span class="MsoFootnoteReference">[5]</span></a>IMF,
Global
Financial Market Developments.
<p class="MsoNormal"><a id="_ftn6" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref6" name="_ftn6"><span class="MsoFootnoteReference">[6]</span></a>
Peter Eavis,   Spending
like a Drunken Democrat: Bush Drives the Nation Towards Bankruptcy.
<p class="MsoNormal"><a id="_ftn7" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref7" name="_ftn7"><span class="MsoFootnoteReference">[7]</span></a>Rothbard,
Man, Economy, and State, p 386.
<p class="MsoNormal"><a id="_ftn8" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref8" name="_ftn8"><span class="MsoFootnoteReference">[8]</span></a>If
this were true, then why tax at all? Why not just borrow or monetize the
entire amount? And even then why put any limits on government spending
at all?
<p class="MsoNormal"><a id="_ftn9" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref9" name="_ftn9"><span class="MsoFootnoteReference">[9]</span></a>Warburton,
p. 6
<p class="MsoNormal"><a id="_ftn10" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref10" name="_ftn10"><span class="MsoFootnoteReference">[10]</span></a>Warburton,
p. 6.
<p class="MsoNormal"><a id="_ftn11" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref11" name="_ftn11"><span class="MsoFootnoteReference">[11]</span></a>Warburton,
p. 4.
<p class="MsoNormal"><a id="_ftn12" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref12" name="_ftn12"><span class="MsoFootnoteReference">[12]</span></a>
Ludwig von Mises, The
Theory of Money and Credit. 8.2.2.
<p class="MsoNormal"><a id="_ftn13" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref13" name="_ftn13"><span class="MsoFootnoteReference">[13]</span></a>Mises,
Chapter 12, p. 238.
<p class="MsoNormal"><a id="_ftn14" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref14" name="_ftn14"><span class="MsoFootnoteReference">[14]</span></a>
Rothbard, Man, Economy and State, 6.7, The
Myth of the Importance of the Producers’ Loan Market.
<p class="MsoNormal"><a id="_ftn15" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref15" name="_ftn15"><span class="MsoFootnoteReference">[15]</span></a>
Rothbard, Man, Economy and State, 6.5, The
Time Market and the Production Structure.
<p class="MsoNormal"><a id="_ftn16" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref16" name="_ftn16"><span class="MsoFootnoteReference">[16]</span></a>Paul
Kasriel, The
Fed: A Failure to Communicate Or Communicated Only Too Well?
<p class="MsoNormal"><a id="_ftn17" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref17" name="_ftn17"><span class="MsoFootnoteReference">[17]</span></a>Warburton,
p. 136.
<p class="MsoNormal"><a id="_ftn18" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref18" name="_ftn18"><span class="MsoFootnoteReference">[18]</span></a>Warburton,
p. 191.
<p class="MsoNormal"><a id="_ftn19" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref19" name="_ftn19"><span class="MsoFootnoteReference">[19]</span></a>Warburton,
p. 121.
<p class="MsoNormal"><a id="_ftn20" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref20" name="_ftn20"><span class="MsoFootnoteReference">[20]</span></a>Warburton,
p. 120.
<p class="MsoNormal"><a id="_ftn21" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref21" name="_ftn21"><span class="MsoFootnoteReference">[21]</span></a>Rothbard,
The Mystery of Banking p. 46.
<p class="MsoNormal"><a id="_ftn22" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref22" name="_ftn22"><span class="MsoFootnoteReference">[22]</span></a>Rothbard,
p. 47.
<p class="MsoNormal"><a id="_ftn23" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref23" name="_ftn23"><span class="MsoFootnoteReference">[23]</span></a>Rothbard,
p. 46.
<p class="MsoNormal"><a id="_ftn24" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref24" name="_ftn24"><span class="MsoFootnoteReference">[24]</span></a>
Marc Faber, Tomorrow’s
Gold: Asia’s Age of Discovery,
<p class="MsoNormal"><a id="_ftn25" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref25" name="_ftn25"><span class="MsoFootnoteReference">[25]</span></a>Here
we see the relevance of Mises’s critique of inflation indices for failing to
capture the shifts in relative price and spending patterns changes brought
about by monetary injection. See Mises, II.11.7
<p class="MsoNormal"><a id="_ftn26" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref26" name="_ftn26"><span class="MsoFootnoteReference">[26]</span></a>
See the following BLOG items:Â 1,Â
2Â ,3,Â
4, 5,Â
6.
<p class="MsoNormal"><a id="_ftn27" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref27" name="_ftn27"><span class="MsoFootnoteReference">[27]</span></a>Warburton,
p 35.
<p class="MsoNormal"><a id="_ftn28" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref28" name="_ftn28"><span class="MsoFootnoteReference">[28]</span></a>Warburton,
p. 71.
<p class="MsoNormal"><a id="_ftn29" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref29" name="_ftn29"><span class="MsoFootnoteReference">[29]</span></a>Warburton,
p. 135, and see the following section for the second.
<p class="MsoNormal"><a id="_ftn30" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref30" name="_ftn30"><span class="MsoFootnoteReference">[30]</span></a>
Smithers makes the point that these models are flawed because they disallow
the possibility that both stocks and bonds can be wildly over-priced at the
same time. See Valuing
Wall Street, p. 282.
<p class="MsoNormal"><a id="_ftn31" title href="http://www.mises.org/fullstory.aspx?control=1579#_ftnref31" name="_ftn31"><span class="MsoFootnoteReference">[31]</span></a>
Mises, Human
Action<font face="Verdana, Helvetica">, 12.5.
</font></span></font>
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