CWC - Interview with Terry Coxon: Inflation vs. Deflation

Casey Research economist Terry Coxon, Interviewed by Louis James, Editor, International Speculator

L: Terry, when I asked Doug about the ongoing battle between those predicting inflation and those predicting deflation, he said he relied heavily on your judgment on these matters. That makes sense, since you literally wrote the book on inflation-proofing investments. So, can you explain in simple terms why Casey Research expects inflation? With some prices falling, it must seem to many that we’re simply off our rockers…

Coxon: We might have something that looks like deflation for a while, but inflation will win out in the end. It’s like being in a game in which one side always has one more move, until it finally wins. The government’s response to any whiff of deflation would be a restart of rapid growth of the money supply. That growth would be just as vigorous as the feared deflation seemed to be. The Federal Reserve would just keep piling on the cash, until deflation lost.

L: And presumably, with the government creating massive amounts of monetary inflation, masked by a period of average price deflation, by the time they realize they’ve gone too far, they will have gone way, way too far.

Coxon: That’s right. Administering monetary policy is like driving a bumper car, in which the feedback is very slow and has a lot of noise in it. At any given moment, the Federal Reserve – or any other monetary authority – doesn’t really know what the demand for cash is. They can only guess. If they are worried about deflation, they guess on the high side, creating more cash to satisfy what they think the demand for money is. If they overdo it, or if they underdo it, they won’t know they’ve gone too far for months, maybe years.

In running a central bank, there is a long time delay in seeing the results of what you’ve done. Milton Friedman’s famous expression was: “The lags in the effects of changes in the money supply are long and variable.”

L: Indeed. Let’s be clear here: when we talk about changing the money supply, are we talking about printing paper notes, are we talking about electronic ledger entries, are we talking about changing interest rates that govern multiplier effects, or some or all of the above?

Coxon: Two out of three. The mechanism is that the Federal Reserve purchases something. It’s usually the Federal Reserve Bank of New York that does the chore. What they most commonly buy is U.S. Treasury securities. In the last go-around, they bought a lot of other things, particularly a lot of junk debt, which is of grave concern to many, but is immaterial to the effect on changing the money supply. It’s how they pay for it that expands the money supply, and they pay for it by crediting the seller’s account at one of the banks maintained by the Federal Reserve. That makes more cash available to the seller’s bank. If the ultimate seller is a commercial bank, then it has more cash available to it.

L: Why does it matter if the seller is a commercial bank?

Coxon: Because the seller’s response to having more cash varies. Until the end of 2008, the result was pretty clear and straightforward. If the seller was a commercial bank, it would have more reserves than it was required to have, so it would lend or spend that extra cash, and keep doing so until it no longer had excess reserves. Under the rules that went into effect at the end of 2008, the Federal Reserve started paying interest on deposits that commercial banks have with Federal Reserve banks. They set the rates sufficiently high compared to what’s available on the money markets, so that the commercial banks are leaving their excess reserves on deposit, rather than redeploying them. Sellers other than commercial banks are not eligible to receive such interest payments, so they do redeploy the cash they get from sales to the Federal Reserve.

L: Hm. But why would the Fed do that? If the purpose of the bailouts was to increase liquidity in the markets and get the banks lending again, why would they pay the banks to leave their excess reserves on deposit with the Fed?

Coxon: Well, the operations that began in late 2008 have about doubled the monetary base. It was very roughly a trillion dollars. Nothing like that had ever happened before. Most of the new cash went to buy troubled assets from commercial banks. The first goal was to prevent the commercial banks from collapsing. If the Federal Reserve had done nothing else, the result would have been a doubling of the money supply within a few months, and we would have had South-American-style price inflation.

L: So they changed the rules so they could create a huge amount of money to keep the banks open, while trying to avoid hyperinflation.

Coxon: Yes. The money supply grew by about 20%, which, I suppose, they thought would be enough. To keep it from growing any further, they started paying interest on excess reserves, effectively sequestering those excess reserves.

L: That’s a lot of sequestered cash. But the U.S. government has done more than directing or allowing the Fed to buy toxic paper. There’s cash for clunkers and all sorts of other insane ideas coming out of Washington, with Congress seemingly willing to spend “whatever it takes” to get Boobus americanus to imagine he’s rich enough to start spending again.

And yet, the average Joe in the street doesn’t see inflation. Life hasn’t really gotten any cheaper, but gas is still way below its previous $5 high-water mark. Joe is worried about losing his job, and cutting his expenses, which is price-deflationary. Why isn’t he seeing more inflation?

Coxon: Joe isn’t seeing inflation because, so far, the Federal Reserve has not allowed the money supply to grow enough to trigger inflation. You’re mixing apples and oranges when you talk about Congress and the Federal Reserve. All of the runaway deficit spending is not, in and of itself, inflationary. The government spending borrowed money does not increase the money supply – it doesn’t change the amount of cash people have.

L: Ah. You’re saying that out-of-control government spending isn’t inflationary, but sets the stage for future inflation, when money has to be created to pay the government’s debts?

Coxon: What it does is create a political motive and economic need for inflation. These huge deficits may have slowed the recession that began in 2008, but to keep the recession from worsening, the Federal Reserve will have to prevent interest rates from rising for months or years to come. And to do that, it will have to start printing money to buy up debt instruments whenever the economy starts recovering, to keep interest rates down to levels that will not choke off the recovery.

L: So more money creation will be necessary to keep interest rates low, but at some point, the foreigners holding dollars, believing it to be a sound currency, will have to get worried about all this dilution of the dollar – and that would tend to force interest rates up, as it will take more and more to convince those people to keep buying T-bills & such.

Coxon: The world outside the U.S. has become like a giant capacitor for U.S. inflation. The charge that’s building up is the accumulation of dollars and dollar-denominated assets in the hands of foreigners. When the outside world wakes up to the threat of inflation in the U.S., they will start unloading U.S. dollars, which will suppress the dollar’s value in foreign exchange markets, which will make prices of imports (including oil) go up, and that will be a separate vector feeding price inflation in the U.S.

I don’t think this will happen any time soon, because whereas every other currency is just paper, the U.S. dollar looks like cardboard by comparison. I don’t think there will be a run on the dollar until the game has been played out with all the other paper currencies.

L: So you’d expect the euro to fall apart first?

Coxon: Yes.

L: I think Doug would agree. Back in the U.S., to what degree would you say the apparent absence of price inflation is due to price destruction of certain asset classes, like housing, versus any actual contraction in the money supply?

Coxon: I wouldn’t call it an apparent absence of price inflation; there is an absence of price inflation. If there is any price inflation in the U.S. right now, it’s very tiny. What has held it at bay, in spite of a roughly 20% increase in the money supply, is a roughly 20% increase in the level of anxiety. That is to say, people are holding more cash, which they do when they feel more uncertainty. Uncertainty increases the demand for cash. If and when we have an economic recovery, the financial anxiety will ease, causing the demand for cash to decline, and at that point, the 20% increase in the money supply will have an effect on prices.

L: If even a recovery will spark inflation, that certainly supports your initial claim that inflation will win out in the end. This seems to sync with the conventional view that recessions are deflationary.

Coxon: That effect is real.

L: Even when there’s a lot of money creation?

Coxon: Yes, because the first effect of the money creation is to cure the recession, or at least to slow it. The effect on prices comes later.

L: Hm. Well, is there a way out for the U.S. and other governments around the world? Could their stimulus packages actually “prime the pump” as they say – get people spending again, get businesses going again, get tax revenues flowing again, etc., to the point that they could actually pay off their debts without creating more money and sparking massive inflation?

Coxon: No… There really isn’t. On the debt question, the debts are just too large.

L: Really? The U.S. has had a ridiculous national debt for a long time, and every time it reaches a new level of unimaginable ridiculousness, the statistically insignificant number of people who care are ignored and the party continues. Nobody cares.

Coxon: [Laughs] At some point, they’ll care. That’s what’s happened in Greece and Spain.

L: What point would that be? At what point does the buck stop working here?

Coxon: I can’t give you a number. It’s not like the temperature at which ice melts or water boils. It’s more like climbing out on a limb. You don’t know how far you can go before the limb breaks. But if you keep going, there is a breaking point out there somewhere.

There are two separate problems at work. One is the debt and what will the government be forced to do about it sooner or later. It will have to go back on part of it – probably Social Security. It will be done artfully, without anyone breathing the word “default,” but the Social Security promises are just so enormous, they simply cannot be kept. The likelihood that the bonded indebtedness in the U.S. would go into default, I think, is pretty low.

Separate from that problem is the desire to avoid recessions, or to cure them when they happen. If Dr. Keynes is writing the description, that means more deficit spending. If Dr. Friedman is writing the prescription, that means creating some more money. But the prescription gets taken to a pharmacy run by incompetent people. It’s one thing for an academic economist to say that the cure is a deficit of so many hundreds of billions of dollars. It’s another thing to see what happens once Congress gets hold of that prescription – they’re likely to do anything. It could be twice as much now, or half as much now and three times as much later. So, even if the prescription was the right prescription, there is no assurance that it will be filled correctly.

L: Okay, let’s return to the debt for a moment. Let me suggest a different metaphor: the principal on a maxed-out credit card can be carried for a long time, but if you run into trouble making the minimum payments, you’re in big trouble. Is there a point at which it gets like that for the government?

Coxon: For the bonded indebtedness in the U.S., I don’t think we’re near that kind of a problem. What’s referred to as the debt trap, that Greece appears to be in, happens when your creditworthiness appears to be shaky, causing the interest you have to pay to go up when the time comes to roll over your debt, causing your overall debt to grow even faster, causing your creditworthiness to look even worse, and there’s just no way out of this cycle. The U.S. isn’t there yet.

[Laughs] When you hear the politicians, and some of their politically-minded economists say that we “definitely have to deal with the deficit” – and that maybe five or ten years from now would be about right, you could see how the U.S. could drift into a problem with unpayable debt.

L: Could you see the U.S. actually going down the path of Mugabe? You don’t have to get to hundred-trillion-dollar notes before you realize that things are out of control.

Coxon: That’s right. In the developed world, the politicians would hit the reset button long before you got to million percent per year inflation. But you don’t have to get anywhere near that level to have a real catastrophe on your hands.

L: What does that mean, to hit the reset button?

Coxon: A leap to a completely different monetary arrangement. If inflation were to reach as high as 25 to 30%, I think a lot of politicians would suddenly get religion about the gold standard.

L: Wow, you really think so?

Coxon: Yes, I do think so – but the process of transitioning to a new gold standard would involve a truly horrible mess.

L: Why wouldn’t they just declare some sort of “New Dollar” and lop a few zeros off?

Coxon: [Laughs] New dollar – contains no sugar!

L: Biodegradable and made by native artisans living ecologically sound lifestyles in the Amazon rain forest.

Coxon: Well, remember that the politicians are not a single person. There are lot of them, and they are all competing, all scrapping. When we get to frightening levels of inflation, there’s political hay to be made by coming up with a solution.

L: But going back on the gold standard would derail the gravy train, because the government wouldn’t be able to spend gold it doesn’t have.

Coxon: No. The amount of revenue the government earns from creating money is really quite modest. That’s never been more than a tiny portion of government revenue, most of which comes from taxes.

L: That doesn’t seem to be the case in Latin America.

Coxon: It’s the same among the low-inflation countries. Things have to become extreme, a government’s ability to collect taxes has to break down – that’s when you get a Zimbabwe-type situation. They print the money to pay the policemen and soldiers.

L: So it sounds like you could foresee a possible scenario in which the global crisis is eventually resolved, and even sound money being reestablished, without the world crashing into serious social disorder – blood on the streets.

Coxon: Eventually, yes. But by the time the U.S. would go back onto the gold standard, the price of gold would be in five digits.

L: That could work out great for readers of Casey’s Gold and Resource Report, who should profit from such gains in the gold price, but it still sounds like you’re considerably less apocalyptic than Doug.

Coxon: [Laughs] You just watch and see just how untidy the process is! The only way out for Social Security, for example, is euthanasia. They’ll gradually move to raising the starting age, and keep raising it, until there is no more problem. This won’t happen until everyone, including the politicians, is terrified of inflation – and a world in which that is the case will not be pretty.

L: Okay, that leads to the 64-billion-dollar question (adjusted for inflation): when do you think the inflation will really start to kick into higher gear?

Coxon: First, we’ll have to see the second part of the double-dip recession in full swing. I think we’re sliding into that right now. Give the Federal Reserve another six months to panic and start to print money in earnest, and then a year or two for the economy to recover, and then all the excess money starts pushing up prices.

L: How sure are you that there will be a double dip, and not the recovery everyone so desperately wants to believe is already underway?

Coxon: The signs of double dip are: one, banks are still not lending money; two, there is virtually no increase in employment, outside of government employment; three, venture capital is dead; and four, housing prices haven’t finished falling.

L: The so-called jobless recovery is a lie.

Coxon: Let’s call it a wish.

L: You’re a gentleman. And a scholar. Is there a bottom line to leave our readers with?

Coxon: The heart of it is this: even if deflation wins nine innings, there will be a tenth inning. And an eleventh. There will be as many innings as it takes for inflation to win. That’s because the Federal Reserve always has the ability to create more cash.

L: And the incentive to do so.

Coxon: Yes.

L: You’re as cheerful as Doug – but still, I appreciate your time, and I think our readers will find your explanations helpful. Thank you very much.

Coxon: My pleasure.

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Jul 14, 2010