Please, click here to read this article in pdf format: may-2-2011
Today we could discuss the most important developments that have unfolded since we last wrote on April 18th. We could discuss the rationale of Greeceâ€™s debt restructuring, the monetary policy of the ECB going forward, the slow acknowledgement that Spain will not be spared, the weakness of the USD or its counterparty, the unstoppable rise of gold. Our readers know that we warned about some of these issues (Spain, gold, stagflation) with fortunate timing and our thoughts on why the Euro has risen or why we are facing stagflation (i.e. jobless claims have suddenly began to stabilize and rise, GDP change has not met expectations) are on record for anyone to see. This morning however, we want to dig deeper. We donâ€™t want to discuss things you may already know, but want to suggest why mainstream economists, like Ben Bernanke, continue to believe (unlike us) that this crisis can be fixed. We think (unlike them) this crisis ends in a currency crisis of a magnitude never seen before, with a transfer wealth of unthinkable proportions.
When Ben Bernanke gave his press conference last Wednesday, he labeled the increase in commodity prices of a temporary nature and dismissed his responsibility in the depreciation of the USD. The Chairman of the Fed reiterated the Fedâ€™s mandate, as a natural way to shield himself from unwelcome questions. This mandate is dual, seeking to maximize employment, providing price stability. There is a popular perspective of this dual mandate, which is expressed in what is known as Taylor rule. The rule seeks to find an approximation to the changes in policy rate, driven by the rate of inflation and the level of activity (i.e. the other side of the unemployment coin) in a currency zone. The equation is written:
Or:Â Target short term nominal interest rate = Rate of inflation + equilibrium real interest rate + coeff a * (gap between current rate of inflation and target rate of inflation) + coeff. b* (gap between current GDP and potential GDP).
As you can see, mainstream economists (including Mr. Bernanke) believe that there exists: (1) a â€œtargetâ€ rate of inflation, (2) an equilibrium real interest rate, and (3) a potential GDP.
However, none of these three concepts exists. They are only the mental tools of economic planning. When you think that there is a â€œtargetâ€ rate of inflation, you assume that you can control the inflationary process and furthermore, it shows that you donâ€™t understand what inflation is. Why? Because inflation is nothing else than the non-neutrality of money expansion at work. Not all prices rise or fall at the same time. It is relative prices that changed, with QE1 or QE2. To believe that one can target a rate of inflation is to believe that one can manipulate this non-neutrality of money. This is false and absurd. Ignoring this point explains why Bernanke believes that the price in commodities is of a temporary nature. In his mind, inflation can be targeted.
The next misleading concept is that of the existence of an equilibrium rate of interest. We believe this is self-explanatory, for there isnâ€™t a single rate of interest, let alone equilibrium. If there was one, there would be no need for money as a medium of indirect exchange. This point was thoroughly addressed by Don Patinkin (ref. â€œThe Indeterminacy of Absolute Prices in Classical Economic Theory”, 1949, Econometrica)
The last error lies in believing that there is a known potential GDP. This is a mechanic, Marxist, view of human action. It ignores the role of relative prices. Does anyone believe that a firm will hold inventory or work below capacity at a loss, just out of stubbornness?Â When a firm decides to lower output, or the use of resources, that decision is rationally driven, to remain profitable. The relative prices between inputs (and only one of which is capital) and output tells the entrepreneur that the apparently under-potential output is the profitable choice at hand. A potential higher output represents a potential loss.
In summary, the dual mandate of the Fed assumes the correctness of the price level doctrine. But in fact the whole mode of reasoning behind the Taylor rule is a typical case of arguing in circle. Its equation already involves the assumption which it tries to prove. It is essentially nothing but a mathematical expression of the untenable belief that there is proportionality in the movements of prices, unemployment and interest rates.
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Mr. Sibileau currently works as Director for the Loan Portfolio Management team of a Toronto-headquartered financial institution. In his free time, he regularly writes on global macroeconomic developments at www.sibileau.com.
Since 1997, he has held various positions in the areas of corporate finance, strategy consulting, international banking, commercial banking and risk management.