Sir John Tenniel’s famous cartoon of 29th March 1890 shows the young Kaiser Wilhelm II “dropping the pilot” — the veteran Chancellor (1862-1890) Otto von Bismarck – and heading Germany into new and dangerous waters. Like Bismarck a towering figure, retiring Fed Chairman (1987-2006) Alan Greenspan, to be “dropped” Tuesday, has run U.S. monetary policy for decades. Less cautious than the Kaiser, on March 31 the Fed will also drop the compass – by ceasing to report M3 money supply figures.

http://www.erziehung.uni-giessen.de/studis/robert/bismar4.html

Bismarck’s period as Chancellor was very highly regarded at the time of his retirement. Only later did the dangers inherent in his policies become apparent, of excessive militarism and German expansionism, dangers that eventually led to the immense human tragedy of World War I. Like Bismarck, Greenspan goes out on a high note, though in Greenspan’s case there is no suggestion that the retirement is other than voluntary. Like Bismarck, Greenspan may be less highly regarded by distant posterity when the long term effects of his policies are assessed.

At the American Enterprise Institute Tuesday, panelists Charles Calomiris, of AEI and Colombia University, Lawrence Lindsey, former President of the National Economic Council and Kevin Hassett of AEI agreed that incoming Fed Chairman Ben Bernanke would have a difficult first few months. Since all panelists agreed that resurgent inflation was currently a danger, they believed that Bernanke would have to show hawkishness on inflation as quickly as possible, both by speeches, notably at his Humphrey-Hawkins Act testimony to Congress February 15 and by action in continuing in the short term the recent Fed program of ¼ percent Federal Funds rate increases. However, when asked where they thought the Federal Funds rate increases might end, the consensus of the panel was in the 4¾-5¼ percent range, less than 1 percent above the current level of 4¼ percent.

Sorry to rain on the parade guys, but at current levels of inflation 5¼ percent isn’t going to do it. U.S. inflation as measured by the Consumer Price Index rose by 3.4 percent in the year to December 2005; the Bureau of Economic Analysis announced Friday that the price index for gross domestic purchases, which had risen at a rate of 4.2 percent in the third quarter of 2205, rose at a rate of 3.3 percent in the fourth quarter. In other words, when you look at the prices U.S. consumers and businesses are actually paying for goods and services, a 5¼ percent Fed Funds rate represents a real interest rate of less than 2 percent per annum, so would still be somewhat expansionary and would do nothing to bring inflation down.

It’s worse than that however, because U.S. price indices have since 1996 been calculated on a “hedonic” basis, used by none of the other major world economies. This purports to adjust for quality improvements in the tech sector, but uses the huge increases in chip capacity as a proxy for these modest improvements, which is clearly incorrect. I have written previously that because of this change reported price indices since 1996 have been around 1 percent lower than their equivalent before that date, so 2005’s consumer price index inflation of 3.4 percent is equivalent to a rate of about 4.4 percent in 1985 terms.

This differential can be validated further by looking at index-linked government bond yields, which in each country where they are offered give investors principal and interest linked to the local consumer price index, thus “inflation-proofed.” If capital markets are open, and there is no particular reason to believe one currency markedly overvalued against another, then long term yields on inflation-proofed bonds in each country should be about the same. If long term yields are exceptionally high in a particular country, capital will flow in from abroad, will raise bond prices and will thereby equalize yields with those of other countries. Thus if index-linked bonds have a markedly different yield in two different markets, the cause is likely to be differences in definition between the two price indices.

In current market conditions, British index-linked bond yields are markedly below those in the United States. The British 30 year index-linked “gilt” closed Thursday night at a yield of 0.83 percent, whereas the U.S. 30 year index-linked bond closed Thursday at a yield of 1.98 percent. Since the bonds have conditions that are in other respects similar, and the British consumer price index, while fudging house prices in a similar way to the U.S. index, is in other respects close in definition to the pre-1995 U.S. CPI, it therefore follows that the “hedonic” fudge factor in the U.S. CPI is about 1.15 percent, the difference between the two bonds’ yields. In other words, U.S. inflation, when stated on a British basis (which still suppresses increases in house prices) is not 3.4 percent but 4.55 percent. A 5¼ percent Fed Funds rate thus represents a real yield of only 0.7 percent, and is still thoroughly expansionary.

From this argument, in order to produce a reduction in inflation that is clearly necessary if it to be reduced to the 2-3 percent per annum genuine inflation that is the maximum tolerable, the Federal Funds rate will have to rise to give a real yield of 3-4 percent above 4.5 percent inflation, in other words a nominal rate of 8 percent. Nobody, but nobody is expecting this, certainly not in the effervescent current stock market, so we can for 2006-07 expect a further surge in inflation, inevitably to be succeeded by a panic increase in nominal interest rates that will throw the U.S. economy into deep recession, with despair in the stock and housing markets

The very low yields on long term British index-linked bonds (a 50 year issue was launched Tuesday on a yield of a mere 0.46 percent) indicate another disquieting feature of the current world economy: the extraordinary, indeed unprecedented glut of investment capital worldwide. Real yields on long term British “gilts” in the gold standard 19th century bottomed out at 2.1 percent in 1897, the year of Queen Victoria’s Diamond Jubilee. While yield trends in the 20th and 21st centuries are less clear, because of the fluctuating value of money and the lack of a solid inflation benchmark, there is no example of real yields significantly below this level having persisted for a significant length of time.

We are thus in uncharted waters, with real long term yields less than half the previous benchmark lows. Optimists have hailed the emergence of India and China as providing an enormous new pool of labor, yet a sharp increase in the relative supply of labor should increase the cost of capital, not decrease it. Further, multi-factor productivity statistics, released with ever-increasing delays and minimal fanfare by the U.S. Bureau of Labor Statistics, suggest that the productivity of capital in the U.S. economy has reached historic lows, far below any level reached since statistics began to be kept in 1947, and fully 40 percent below its peak of 1966. This, together with the exceptionally low spreads on junk bonds both domestic and international and the record level of private equity and hedge fund investment, suggests that the world’s economic system is seriously out of kilter and must be re-stabilized through painful deflationary policies.

Very cheap money may appear an unmitigated boon, but in reality it is neither benign nor sustainable. First, it causes all kinds of boondoggles and crooked schemes to get financing, as well as leading stock markets and real estate markets into bubble mode – investment banks and providers of funds fail to do proper “due diligence” because capital is cheap and all investment apparently profitable. Eventually, the crooked schemes and fly-by night propositions go bust, the stock market and real estate markets return to earth, and most people find themselves a great deal poorer than when they started out.

Cheap money leads governments to dream up new money-wasting schemes, since debt is easy to raise and tax revenues rise from the buoyant economy. Cheap money drives pension funds towards bankruptcy and makes saving for old age and other long term needs very difficult, since real yields on investment pools are so low they barely if at all outstrip inflation. Finally, cheap money corrupts society morally; the spendthrift are benefited at the expense of savers, inequalities in society widen, and youthful corner-cutting “entrepreneurs” are benefited at the expense of those who have spent decades acquiring valuable skills that society needs.

To assign blame for the world liquidity glut, one comes back to Bismarck, or rather Greenspan. It is he who has allowed M3 money supply to grow at a rate of 8.2 percent per annum in the last decade, compared with 5.4 percent per annum growth in nominal Gross Domestic Product. Had M3 only kept place with nominal GDP since January 1996, it would today be $7,921.2 billion, compared to its actual $10,254.1 billion – in other words, there’s a spurious $2,332.9 billion sloshing around the place that shouldn’t be there (monetary conditions were not especially tight in January 1996, rather the opposite.)

This is where the compass comes in. We are only able to determine the magnitude of Greenspan’s monetary sloppiness through using the Fed’s weekly statistics on M3 money supply (which includes new monetary instruments such as money market funds – M2 doesn’t.) Doubtless it is annoying to the Fed, as it bows graciously to the plaudits of Wall Street and the mainstream media, that there are a few old fashioned monetarists issuing catcalls from the wings. The Fed has therefore (it hopes) silenced its monetarist critics by a simple expedient – from March 31 it will no longer calculate and report M3 money supply, a statistic it has been reporting since 1959. Even the St. Louis Fed, itself somewhat monetarist, relies on the Fed for M3 figures, and so will stop reporting them in its FRED data system.

In other words, to silence criticism from the passengers, the Fed has discarded not just the pilot but the compass.

Where’s the $2.3 trillion in excess M3 money? In the foreign currency reserves of China, Japan, Taiwan and other Asian central banks, of course, where by the magic of multipliers it has caused bubble conditions to appear in all those countries except Japan (where the Bank of Japan has itself pursued an admirably cautious monetary policy) and, through the banking system, in spurious financings all over the globe. The huge U.S. trade deficit is primarily a mechanism for exporting inflation and sloppy monetary conditions from the U.S. all over the world, leading the world as a whole, not just the United States, to the edge of a yawning economic precipice.

The ill effects of Bismarck’s policies appeared only 24 years later in the mud of Flanders; in the meantime Wilhelmine Germany had a period of considerable contentment and wealth creation. We are unlikely to be so lucky with Greenspan’s legacy.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.