Banks create money and then lend it to borrowers. The quality of projects that banks select will cause inflation, stable prices or deflation. The best quality projects would cause productivity to exceed the amount of money created, and so monetary expansion to be deflationary. If projects that banks select just equal the average quality of economic productivity then there will be neither deflation nor inflation. If banks consistently choose projects that are inferior to the average project with respect to productivity then there will be inflation.
This suggests that inflation can be viewed as a quality loss function (see discussion in Taguchi). The target loss should be negative. Economically, diminishing marginal productivity suggests that as more money is created losses will be greater. However, if banks are competently run and have adequate quality processes with respect to project selection, they can offer loans to projects and sustain zero inflation.
The management of banks becomes a critical problem to economic welfare if the banks themselves lack quality management capacity to select loans. This has been the case. It is impossible for outsiders to design quality processes that will improve loan selection because this depends on identification of borrower and project characteristics that are only known to lenders.
There is no literature on selection of entrepreneurial risk by lenders. This is not a topic that academics have treated and it is not a topic that bankers have carefully considered.
As a result of the absence of quality processes in making loans, the financial system has failed to make loans effectively. The current financial process results from quality losses, i.e., the Taguchi loss function among banks is large and so results in bad loans. Consistent inflation since the establishment of the Fed suggests that banks have failed to develop competent quality processes in lending.
Anecdotal evidence suggests that banks have consistently made loans based on incompetent criteria: to large institutions who cannot make good use of the funds; to firms with close connections to the banks and to firms engage in activities that loans other banks are making. This mimetic pattern suggests a financial system that is, in Deming's terms, "out of control". A competently run banking system would permit economic expansion coupled with stable prices.
The banking system requires restructuring to facilitate adoption of competent, quality driven practices with respect to lending. Banks must become competitive. Banks which fail to produce loans that generate net gains to society (i.e., deflationary loans) should be refused access to Federal Reserve bank credit.
Showing posts with label deflation. Show all posts
Showing posts with label deflation. Show all posts
Thursday, March 12, 2009
Tuesday, December 30, 2008
19th Century Land Policy and the Fed
The Land Act of 1796 allowed purchasers of public land a minimum of 640 acres, one square mile at $2 per acre with one half of the purchase price being able to be deferred for a year. The large size of the plots prohibited most Americans from purchasing public land. These minimums were reduced over the ensuing 66 years, resulting in an increase in agricultural output.
Under federal land policy, the minimum was reduced to 320 acres payable over four years in 1800. In 1820 80 acres could be purchased at $1.25 per acre, and in 1832 parcels of 40 acres could be sold. Especially after 1830 squatters were granted rights and in 1841 the "Log Cabin Bill" allowed squatters preemption rights of up to 160 acres. The Graduation Act put up land unsold for 30 years for sale at 12.5 cents an acre. During the Civil War, in 1862, the Homestead Act granted 160 acres and 320 per married couple as long as they lived on the land or cultivated it for five years. Thus, the population of the western states grew from about one million in 1810to about 14.8 million in 1869, or from 15% of the US population to 47.1%.*
From 1870 to 1890, corn output increased from 1.125 billion bushels to 1.650 billion bushels, an increase of 46.7%. Land used for corn increased from 38.4 million acres to 74.8 million acres, an increase of 94.8%. Because the newly granted land was less fertile than the land that settlers purchased first (since settlers chose the best land first) productivity fell from 29.3 bushels per acre to 22.1 bushels per acre. A slightly different pattern applied to wheat, whose output increased 76.8% between 1870 and 1890 and whose land increased by 75.5%. Because of expanding output, real farm income per capita rose by only .8% from 1869 to 1879 and .7% from 1879 to 1889.**
According to Walton and Rockoff***, "it is alleged that the rapid distribution of the public domain laid the groundwork for modern agricultural problems by inducing too much capital and labor into agriculture, thereby impeding the process of industrialization."
"...Partially as a result of this rapid addition of resources, the new West produced crops at such a rate that consumers of foodstuffs and raw materials enjoyed 30 years of falling prices. Furthermore, according to Robert Fogel and Jack Rutner, average rates of return on investments in land improvements, livestock, farm buildings and machinery equaled or exceeded returns on other contemporary investments, and real incomes in the new agricultural areas outside the South grew at rates comparable with those in manufacturing."
Nevertheless, despite the Fogel and Rutner findings, it would seem that Populism was related to falling agricultural prices. Moreover, the culture of farming was likely one that included an element of speculation. As Richard Hofstadter points out in Age of Reform****
"Frequent and sensational rises in land values bred a boom psychology in the American farmer and caused him to rely for his margin of profit more on the process of appreciation than on the sale of crops. It took a strong man to resist the temptation to ride skyward on lands that might easily triple or quadruple their value in one decade and then double again in the next...The penchant for speculation and the lure of new and different lands bred in the American farmer a tremendous passion for moving--and not merely, as one common view would have it, on the part of those who had failed, but also on the part of those who had succeeded...Mobility among farmers had serious effects upon an agricultural tradition never noted for careful cultivation: in a nation whose soil is notoriously heterogeneous, farmers too often had little chance to get to know the quality of their land; they failed to plan and manure and replenish; they neglected diversification for the one-crop system and ready cash...In a very real and profound sense, then, the United States failed to develop (except in some localities, chiefly in the east) a distinctively rural culture...What differentiated the agricultural life of these regions...was that it was so speculative, so mobile, so mechanized, so 'progressive', so thoroughly imbued with the commercial spirit."
Moreover, increasing agricultural productivity put additional pressure on commodity prices. Walton and Rockoff point out that+
"Thanks to the research of Olmstead and Rhode we have a greater appreciation of changes in plant varieties, irrigation systems, fertilizers and other biological inventions that greatly impacted the use of land for planting. These changes worked along two lines: (1) the discovery of new wheat varieties (and hybrids) that allowed the North American wheat belt to push hundreds of miles northward and westward and (2) researchers and farmers who found new methods of combating insects and diseases, some of which came from experimentation with new varieties (seeds) from Europe and elsewhere..labor productivity grew dramatically in wheat and corn over these decades. According to Robert Gallman, labor productivity in these two crops grew at a rate of 2.6 percent annually between 1850 and 1900."
As well, point out Walton and Rockoff, mechanization due to McCormick's reaper as well as thresher, mowers, horse rakes, seed planters, grain cleaners, portable grist mills, corn-shellers and similar devices enhanced labor productivity on farm.
The result was of course increasing competition and economic stress on farmers, who had to adapt, "to run faster just to hold ground". Such rapid change creates anxiety, which in turn leads to the demand for political fixes. For farmers, this was Populism. Of course the alternative, retaining primitive agricultural methods, would have prohibited industrialization. "In 1870 Americans spent one third of their current per capita income on farm products. By 1890, they were spending a much smaller fraction, just over one-fifth...Thus, although the real incomes of the American population rose during the period, and although Americans did not spend less on food absolutely, the proportion of those incomes earned by farmers declined." On the other hand "the value of agricultural exports rose from $297 million in 1870 to more than $840 million in 1900.++
Added to this mix was the "rapid increase in the supply of agricultural products. All over the world, new areas were entering the competitive fray. In Canada, Australia, New Zealand and Argentina as well as in the United states, fertile new lands were becoming agriculturally productive."+++
The Fed was not established purely because of Populism, but Populism was certainly a contributing factor. Fed apologists like William Greider in his Secrets of the Temple emphasize agitation among farmers because of falling commodity prices. Greider neglects to mention that falling commodity prices were great for workers. But they were bad for farmers, including moderate-to-poor income ones, who were landholders or speculators. In his book, Greider does not mention the relationship of federal land policy to falling agricultural prices. He merely paints falling agricultural prices as a monetary issue--in other words he takes the Populists' economic reasoning at face value. Nor does he raise the question as to whether farmers-as-speculators or farmers-as-workers dominated the Populist movement.
As Walton and Rockoff point out:
"Farmers were not inclined to see their difficulties as the result of impersonal market forces. Instead, they traced their problems to monopolies and conspiracies: bankers (some thought that Jewish bankers were particularly to blame) who raised interest rates, manipulated the currency, and then foreclosed on farm mortgages; grain elevator operators who charged rates farmers could not afford; industrialists who charged high prices for farm machinery and consumer goods; railroads that charged monopoly rates on freight; and so on."++++
Greider's book provides an excellent example of the inability of the public to debate questions concerning money dispassionately. A good example is his discussion of the Populist movement.
*Gary M. Walton and Hugh Rockoff, History of the American Economy Tenth Edition. South-Western-Cengage Learning, 2005, pp. 145-148
**Ibid, p. 288
***Ibid.
****Richard Hofstadter, Age of Reform: From Bryan to FDR. New York: Vintage Books, 1955
+Op. cit., pp. 290-1
++Op. cit., p. 294
+++Op. cit., p. 293
++++Op. cit., p. 294
Under federal land policy, the minimum was reduced to 320 acres payable over four years in 1800. In 1820 80 acres could be purchased at $1.25 per acre, and in 1832 parcels of 40 acres could be sold. Especially after 1830 squatters were granted rights and in 1841 the "Log Cabin Bill" allowed squatters preemption rights of up to 160 acres. The Graduation Act put up land unsold for 30 years for sale at 12.5 cents an acre. During the Civil War, in 1862, the Homestead Act granted 160 acres and 320 per married couple as long as they lived on the land or cultivated it for five years. Thus, the population of the western states grew from about one million in 1810to about 14.8 million in 1869, or from 15% of the US population to 47.1%.*
From 1870 to 1890, corn output increased from 1.125 billion bushels to 1.650 billion bushels, an increase of 46.7%. Land used for corn increased from 38.4 million acres to 74.8 million acres, an increase of 94.8%. Because the newly granted land was less fertile than the land that settlers purchased first (since settlers chose the best land first) productivity fell from 29.3 bushels per acre to 22.1 bushels per acre. A slightly different pattern applied to wheat, whose output increased 76.8% between 1870 and 1890 and whose land increased by 75.5%. Because of expanding output, real farm income per capita rose by only .8% from 1869 to 1879 and .7% from 1879 to 1889.**
According to Walton and Rockoff***, "it is alleged that the rapid distribution of the public domain laid the groundwork for modern agricultural problems by inducing too much capital and labor into agriculture, thereby impeding the process of industrialization."
"...Partially as a result of this rapid addition of resources, the new West produced crops at such a rate that consumers of foodstuffs and raw materials enjoyed 30 years of falling prices. Furthermore, according to Robert Fogel and Jack Rutner, average rates of return on investments in land improvements, livestock, farm buildings and machinery equaled or exceeded returns on other contemporary investments, and real incomes in the new agricultural areas outside the South grew at rates comparable with those in manufacturing."
Nevertheless, despite the Fogel and Rutner findings, it would seem that Populism was related to falling agricultural prices. Moreover, the culture of farming was likely one that included an element of speculation. As Richard Hofstadter points out in Age of Reform****
"Frequent and sensational rises in land values bred a boom psychology in the American farmer and caused him to rely for his margin of profit more on the process of appreciation than on the sale of crops. It took a strong man to resist the temptation to ride skyward on lands that might easily triple or quadruple their value in one decade and then double again in the next...The penchant for speculation and the lure of new and different lands bred in the American farmer a tremendous passion for moving--and not merely, as one common view would have it, on the part of those who had failed, but also on the part of those who had succeeded...Mobility among farmers had serious effects upon an agricultural tradition never noted for careful cultivation: in a nation whose soil is notoriously heterogeneous, farmers too often had little chance to get to know the quality of their land; they failed to plan and manure and replenish; they neglected diversification for the one-crop system and ready cash...In a very real and profound sense, then, the United States failed to develop (except in some localities, chiefly in the east) a distinctively rural culture...What differentiated the agricultural life of these regions...was that it was so speculative, so mobile, so mechanized, so 'progressive', so thoroughly imbued with the commercial spirit."
Moreover, increasing agricultural productivity put additional pressure on commodity prices. Walton and Rockoff point out that+
"Thanks to the research of Olmstead and Rhode we have a greater appreciation of changes in plant varieties, irrigation systems, fertilizers and other biological inventions that greatly impacted the use of land for planting. These changes worked along two lines: (1) the discovery of new wheat varieties (and hybrids) that allowed the North American wheat belt to push hundreds of miles northward and westward and (2) researchers and farmers who found new methods of combating insects and diseases, some of which came from experimentation with new varieties (seeds) from Europe and elsewhere..labor productivity grew dramatically in wheat and corn over these decades. According to Robert Gallman, labor productivity in these two crops grew at a rate of 2.6 percent annually between 1850 and 1900."
As well, point out Walton and Rockoff, mechanization due to McCormick's reaper as well as thresher, mowers, horse rakes, seed planters, grain cleaners, portable grist mills, corn-shellers and similar devices enhanced labor productivity on farm.
The result was of course increasing competition and economic stress on farmers, who had to adapt, "to run faster just to hold ground". Such rapid change creates anxiety, which in turn leads to the demand for political fixes. For farmers, this was Populism. Of course the alternative, retaining primitive agricultural methods, would have prohibited industrialization. "In 1870 Americans spent one third of their current per capita income on farm products. By 1890, they were spending a much smaller fraction, just over one-fifth...Thus, although the real incomes of the American population rose during the period, and although Americans did not spend less on food absolutely, the proportion of those incomes earned by farmers declined." On the other hand "the value of agricultural exports rose from $297 million in 1870 to more than $840 million in 1900.++
Added to this mix was the "rapid increase in the supply of agricultural products. All over the world, new areas were entering the competitive fray. In Canada, Australia, New Zealand and Argentina as well as in the United states, fertile new lands were becoming agriculturally productive."+++
The Fed was not established purely because of Populism, but Populism was certainly a contributing factor. Fed apologists like William Greider in his Secrets of the Temple emphasize agitation among farmers because of falling commodity prices. Greider neglects to mention that falling commodity prices were great for workers. But they were bad for farmers, including moderate-to-poor income ones, who were landholders or speculators. In his book, Greider does not mention the relationship of federal land policy to falling agricultural prices. He merely paints falling agricultural prices as a monetary issue--in other words he takes the Populists' economic reasoning at face value. Nor does he raise the question as to whether farmers-as-speculators or farmers-as-workers dominated the Populist movement.
As Walton and Rockoff point out:
"Farmers were not inclined to see their difficulties as the result of impersonal market forces. Instead, they traced their problems to monopolies and conspiracies: bankers (some thought that Jewish bankers were particularly to blame) who raised interest rates, manipulated the currency, and then foreclosed on farm mortgages; grain elevator operators who charged rates farmers could not afford; industrialists who charged high prices for farm machinery and consumer goods; railroads that charged monopoly rates on freight; and so on."++++
Greider's book provides an excellent example of the inability of the public to debate questions concerning money dispassionately. A good example is his discussion of the Populist movement.
*Gary M. Walton and Hugh Rockoff, History of the American Economy Tenth Edition. South-Western-Cengage Learning, 2005, pp. 145-148
**Ibid, p. 288
***Ibid.
****Richard Hofstadter, Age of Reform: From Bryan to FDR. New York: Vintage Books, 1955
+Op. cit., pp. 290-1
++Op. cit., p. 294
+++Op. cit., p. 293
++++Op. cit., p. 294
Friday, October 31, 2008
Deflation? Unemployment?
Seasonally adjusted CPI
Someone just e-mailed that there is deflation in the making. The above table (in case of viewing trouble, the chart is located here) shows the Consumer Price Index over the past year. The numbers at the end, 2.6 and 4.9, indicate the inflation rate over the three months and twelve months ended September 2008. A 4.9% annual inflation rate is historically high. Note that there was recently a more than 50% fall in oil prices due to a speculative crash. Despite this, inflation in September was zero. Between 1913 and 2008 the CPI increased more than 4.9% only 19 times. That means that this year has had the 20th highest inflation in the past 95 years and represents the 21st percentile. I would call it above-average inflation. I am puzzling over how there can be deflation and inflation at the same time, but apparently today's economists and media pundits have figured out a way. It is true that the CPI deliberately excludes an element that ought to be counted toward inflation--house prices. The problem with including house prices now is that they were excluded since the 1980s and so inflation has been understated every year since 1983. If they add it in then inflation will have been 1/4 higher. It would seem that the Federal Reserve's regime has been one of price instability.
It is true that unemployment has been increasing. In February of this year unemployment was 4.8%. Unemployment is up 24%, from 4.9% in January to 6.1% in September. This would seem to reflect the decline in construction due to falling house prices.
In days gone by some economists claimed that unemployment implied deflation or reduced inflation and vice-versa. However, in the 1970s there was both high unemployment and high inflation, earning the appellation "stagflation".
Nouriel Roubini describes his fear of deflation in a Forbes article. Roubini argues that slack consumer markets, falling commodity prices, a global recession and unemployment will cause deflation. He notes that commodity prices are down 30% from their July peak. Also, inflation-adjusted treasury bonds are selling for more than non-inflation-adjusted treasury bonds. He argues that the federal government will not monetize (print money to cover) the trillion dollar bailout and that "central banks will mop up" the massive increase in the money supply in the past few months. These last points are speculative. Why would he think that a fifty percent increase in monetary reserves will be "mopped up" by the banking system? Banks are sitting on surplus reserves and they will eventually use them to make ever worse investments.
The 30% contraction in commodity prices to which Roubini refers follows a large increase in oil prices. The average oil price in 2007 was approximately equal to the current price. Thus, there was likely a speculative run up in oil prices over the past 18 months. The current oil price of $64.42 is almost triple the average price in 2002, $22.81. Comparing gold, which has fallen 26% from its 2008 high (which is the nominal all-time). In January 2001 the gold price was approximately $280 per ounce. It peaked at approximately $1,000 in March and is now about $736, 2.6 times higher than or almost triple its low in 2001. Might there have been excessive speculation in commodity markets that exceeded inflation and so caused a pull-back? These fluctuations would be greater than normal, but occur all the time in commodities markets.
The current banking problems have reduced new construction and are causing house prices to fall. However, this does not mean that there will be no inflation. The Fed's increase in monetary reserves of 60% is on top of several decades of healthy monetary expansion. Much of the monetary expansion was invested in worthless sub-prime and other real estate development. The Fed has already expanded the money supply to create unmarketable, worthless, investments to the tune of hundreds of billions if not trillions of dollars. It is difficult to picture how food, energy and commodities will not increase in price given the destruction of resources in which borrowers from banks funded through Federal Reserve Bank Credit have engaged since 1981.
Someone just e-mailed that there is deflation in the making. The above table (in case of viewing trouble, the chart is located here) shows the Consumer Price Index over the past year. The numbers at the end, 2.6 and 4.9, indicate the inflation rate over the three months and twelve months ended September 2008. A 4.9% annual inflation rate is historically high. Note that there was recently a more than 50% fall in oil prices due to a speculative crash. Despite this, inflation in September was zero. Between 1913 and 2008 the CPI increased more than 4.9% only 19 times. That means that this year has had the 20th highest inflation in the past 95 years and represents the 21st percentile. I would call it above-average inflation. I am puzzling over how there can be deflation and inflation at the same time, but apparently today's economists and media pundits have figured out a way. It is true that the CPI deliberately excludes an element that ought to be counted toward inflation--house prices. The problem with including house prices now is that they were excluded since the 1980s and so inflation has been understated every year since 1983. If they add it in then inflation will have been 1/4 higher. It would seem that the Federal Reserve's regime has been one of price instability.
It is true that unemployment has been increasing. In February of this year unemployment was 4.8%. Unemployment is up 24%, from 4.9% in January to 6.1% in September. This would seem to reflect the decline in construction due to falling house prices.
In days gone by some economists claimed that unemployment implied deflation or reduced inflation and vice-versa. However, in the 1970s there was both high unemployment and high inflation, earning the appellation "stagflation".
Nouriel Roubini describes his fear of deflation in a Forbes article. Roubini argues that slack consumer markets, falling commodity prices, a global recession and unemployment will cause deflation. He notes that commodity prices are down 30% from their July peak. Also, inflation-adjusted treasury bonds are selling for more than non-inflation-adjusted treasury bonds. He argues that the federal government will not monetize (print money to cover) the trillion dollar bailout and that "central banks will mop up" the massive increase in the money supply in the past few months. These last points are speculative. Why would he think that a fifty percent increase in monetary reserves will be "mopped up" by the banking system? Banks are sitting on surplus reserves and they will eventually use them to make ever worse investments.
The 30% contraction in commodity prices to which Roubini refers follows a large increase in oil prices. The average oil price in 2007 was approximately equal to the current price. Thus, there was likely a speculative run up in oil prices over the past 18 months. The current oil price of $64.42 is almost triple the average price in 2002, $22.81. Comparing gold, which has fallen 26% from its 2008 high (which is the nominal all-time). In January 2001 the gold price was approximately $280 per ounce. It peaked at approximately $1,000 in March and is now about $736, 2.6 times higher than or almost triple its low in 2001. Might there have been excessive speculation in commodity markets that exceeded inflation and so caused a pull-back? These fluctuations would be greater than normal, but occur all the time in commodities markets.
The current banking problems have reduced new construction and are causing house prices to fall. However, this does not mean that there will be no inflation. The Fed's increase in monetary reserves of 60% is on top of several decades of healthy monetary expansion. Much of the monetary expansion was invested in worthless sub-prime and other real estate development. The Fed has already expanded the money supply to create unmarketable, worthless, investments to the tune of hundreds of billions if not trillions of dollars. It is difficult to picture how food, energy and commodities will not increase in price given the destruction of resources in which borrowers from banks funded through Federal Reserve Bank Credit have engaged since 1981.
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