Excessive money printing will lead to inflation.  We are at risk of a Weimar Republic style hyper-inflationary crisis!

Tightening credit markets put us at risk of deflation.  Deflation was the true culprit behind the Great Depression.  We are on the brink of another deflationary collapse!

If you’ve spent any time reading economic news and blogs both the above arguments are probably familiar to you.  Both arguments seem to have at least some merit.  Which is correct?  How will the crisis unfold?

Indeed one of the questions I received on my last post, Bondpocalypse, essentially boiled down to: In the battle between inflation due to loose monetary policy and deflation due to tightening credit markets, which wins?  Stated differently, if the bondpocalypse occurs and massive debt monetization is unleashed, could the economic slowdown reduce the total money supply such that inflation is held in check or we even get deflation?

I’ve wrestled with these questions continuously over the last several years as I’ve tried to make sense of the craziness that passes as economic policy these days.  Here’s my take.

The Deflation Argument Holds Water

The premise of the argument, that economic slowdowns cause deflationary pressure, makes a certain amount of logical sense.  After all, recessions and depressions are associated with a tightening of the credit market which, in our fractional reserve system, directly reduces the money supply.

How?  Well, in a fractional reserve system only part of the total money supply is controlled by the central bank.  On top of this base central bank money, additional money is loaned into existence by the banks.  The amount of money the banks loan into existence is bounded by the reserve ratio.  This reserve ratio effectively sets a hard upper limit on how much money the banks can loan into existence.  But there’s no corresponding lower bound: People can’t be forced to borrow and banks can’t be forced to lend,

The rate at which money is created in this fraction reserve system can be measured by looking at a metric called the ‘Velocity of Money’.  The higher the velocity of money, the more leveraged money the banks are loaning into existence.

Here’s the key: If bank lending slows for any reason, the rate of growth of the total money supply will decrease and the velocity of money will fall.  If the total impact of this decrease in the money supply exceeds the new money being injected into the system, deflation results.

Thus looking at the velocity of money gives us a clear indicator of how much deflationary pressure exists on the money supply:

It couldn’t be more obvious: Velocity of money has plunged since the 2008 financial crisis.  There has been no recovery either.  Instead, in the last couple of years, the velocity of money has decreased to well below historical norms.  Banks aren’t lending (or aren’t able to lend).

The conclusion is that there must then be clear deflationary pressures on the economy.  I would conclude that the premise of the argument used by the deflationists is valid.  Clearly the ongoing economic slowdown is putting extraordinary deflationary pressures on the money supply.

So Where’s the Deflation?

Given the drastic reduction in the velocity of money, one might expect we’d already be experiencing deflation.  This is not the case.  Here’s what the money supply looks like:

The overall trend is clear – total money supply continues to increase even in the face of a drastic slowdown in the velocity of money.

The reason: Quantitative Easing (QE).  Since the onset of the economic crisis the Federal Reserve has been pouring money into the economy.  Even with a lower velocity, the printing by the Fed has served to keep the system slightly inflationary.

Government Debt

As I covered in my last post, the major use of QE is to allow for the monetization of the exponentially growing government debt:

You can read that post for all the details but the conclusion is that government debt has gone critical.  Massive interest required to service such a massive debt load.  Increasing bond yields.  Increased government expenditures.  Government debt will continue its alarming upward trajectory at an ever accelerating pace.

Inflation Versus Deflation

At last we have all the pieces to attempt to answer the question we set out with: Will it be deflation or inflation.

My belief is that, while the deflationists may at first appear to be correct, in the end inflation must win.

It comes down to two opposing forces at work:

1. Deflationary pressure from economic downturn causing tightening credit markets and decreasing velocity of money.
2. Inflationary pressure from debt monetization and QE.

The key is that the acceleration of these two pressures is fundamentally different.

There is a lower bound to the deflationary pressured resulting from the decrease in the velocity of money.  Once banks stop lending completely and credit markets freeze up, the deflationary impact of a decreasing velocity of money is exhausted.  I would argue further that this deflationary impact initially has a large effect which diminishes over time i.e. the curve decelerates.  The longer a crisis goes on, the less of an impact is made by tightening credit markets since those markets are already stressed.  Regardless, even if the impact on money supply is linear, it is still bounded which is the key.

But the increase required to the money supply for debt monetization has quite a different characteristic.  Clearly, as more and more debt exists, more and more money is required to service that debt.  The curve grows at an accelerating rate.  We can clearly see this already happening in the above chart of government debt.

It makes logical sense.  The amount of money required to service ever growing debt goes to infinite.  Money velocity can only slow to an absolute bottom of one which would represent a system with 100% bank capitalization and no fractional reserve. In the battle between printing and economic slowdown, printing wins.

Here’s how I visualize this tug of war:

At any point up to T1 (the point where the lines intersect), deflation can win out.  After T1, inflation dominates.

Thus, I feel that, in the end, inflation is still the lion in the corner of the room.  We are going to get mauled.  The question is how close are we to the point of intersection.  This I don’t know – and don’t believe anyone who claims to with certainty.  The reality is we could still be earlier in the above graph in which case we may see a period of deflation.  But, eventually we will cross the intersection point and enter a period of high inflation.  You can’t print money without inflation.

Recovery Won’t Save Us

Even if the economy magically recovers prior to the intersection point (fat chance), that very recovery would cause money velocity to return to ‘normal’ levels i.e. increase.  At that point all the money printing of the past would show up in the money supply as inflation.  So even recovery is, at this point, a catalyst for inflation.  There’s no way out here.  Recovery or no recovery the beast of inflation bites sooner or later once you’ve fired up the printing presses.

Conclusion

We’ve unleashed the inflation monster.  The collapsing economy has served to delay the inflationary impact of loose monetary policy.  It will not continue to do this forever.  At some point, recovery or not, we will have to pay the piper.  Common sense, in this case the fact that printing money leads to inflation, wins.

If I were to single out what for me would be the biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally, for any one of a variety of reasons. We have seen shades of that over the last two or three weeks. Let’s be clear, we have intentionally blown the biggest government bond bubble in history. That is where we are, so we need to be vigilant to the consequences of that bubble deflating more quickly than we might otherwise have wanted. That is a risk.

-Andrew Haldane, Executive Director of Financial Stability at the Bank of England, June 2013

You know it’s serious when the central bankers start preparing the public for the inevitable bondpocalypse.  For Max Keiser acolytes the ideas explored in this post will be old news.  For the rest, the goal is to shed light on what is arguably the largest systemic risk to the global financial system that exists.  Indeed, the bond bubble that has been building over the last 30 years is arguably the largest bubble ever inflated and if it pops, which history indicates is inevitable, the financial carnage will be biblical.

Tale of Two Bond Bubbles

For reasons I’ll get to later, most major bond issuers have created bubbles.  Let’s look at a couple of example bubbles to get a feel for the magnitude of what we’re talking about:

First off, outstanding U.S. government debt (which exists as bonds) not adjusted for inflation:

And, adjusted for inflation, the picture is still scary:

Next up, the outstanding U.K. government debt (also known as gilts):

Inflation adjusted, the picture doesn’t get prettier:

These examples show what has happened in two of the largest bond markets that exist: U.S. and U.K. sovereign debt.  In general, the markets for most other bonds have exhibited a similar explosive growth over the last few decades with marked acceleration in the last five years.

Clearly, the amount of total outstanding bonds has exploded.  On the surface these bond markets certainly look like bubbles.

A 30 Year Bull Market in Bonds

How did things get to this point?  For these bond markets to grow there needed to be two things: supply and demand.

Understanding the additional supply is easy.  Governments have been increasing in size for some time and are engaged in never ending and costly foreign entanglements (think Iraq, Afghanistan, Libya, soon to be Syria).  To finance all this while servicing the interest on the pre-existing debt, governments have turned to issuing bonds like crazy.  The financial crisis of 2008, which saw governments around the world take on huge debts to bail-out insolvent banks (signing up Joe Taxpayer to the banker’s gambling debts in the process), simply accelerated the growth of government debt.

Understanding the demand side requires a little more nuanced thinking.

First of all, the primary enabler for this explosion of debt has been the interest rate policies of the central banks.  That policy has been to gradually lower interest rates over the last 30 years.  These interest rate policies get reflected directly in the interest (or yield) on government bonds.  Here’s the U.S. 10 year bond yield from the 1960’s until today:

As you can see interest rates (set by the Fed) have been steadily falling since 1980.  And, as bond yields fall, the price of bonds rise (see here for a good explanation of the inverse relationship between bond prices and yields).  What does this mean?  Basically, older bonds become more valuable and increase in price since they pay higher interest compared to new bonds being issued.

For the average investor holding a bond to maturity this change in price is irrelevant.  After all, the investor will still collect the same amount for the bond when it matures.  But large financial institutions, pension funds etc. often don’t hold their bonds to maturity.  Instead, these bonds are traded on the open market with older, higher interest bonds fetching a premium over newer, lower interest bonds.

Thus, in a climate of lowering interest rates one can earn a profit by simply buying a bond, waiting for interest rates to fall, and then selling the bond.  Indeed this is what the bankers have been doing over the last several decades.  As long as rates continue on a downward trend, you’ve got yourself a bonafide money-making machine.  The 30 year bull market in bonds has lead to a huge demand for bonds and allowed governments to get away with ever-larger debt bubbles.

But, at a certain point one of two things happen which stop the party:

1. The market is leveraged as high as possible and not able to generate a further increase in demand.
2. Interest rates reach zero and cannot be reduced any further.

If either of these conditions occur, the money-making machine stops working.  And, if either of these conditions reverse (interest rates rise or demand falls), bonds will enter a bear market of falling prices and increasing yields.  The bubble pops.

Central bankers and government are, understandably, desperate to keep the wheels on the wagon.  The problem is that, as it stands today, both of the above conditions have been breached.  It’s likely that the bond market is, at this point, fully saturated.  And, with the Federal Reserve already holding interest rates at less than 1%, there’s simply not room left to goose the markets with further interest rate cuts.

The Hail Mary Play: Monetize the Debt

But the central bankers have one last tool they are using to try and keep the bond market from collapsing: Debt monetization.

In general it’s frowned upon for central banks to simply outright purchase and hold government bonds.  The reason is simple: Such a monetization of the debt essentially gives the government a free-reign to raise all the funds it desires.  In our short-term, highly corrupt political system this is obviously a very dangerous tool.

But this kind of outright debt monetization is exactly what’s been happening for the last several years.  Various incarnations of Quantitative Easing (QE) have occurred which all basically boil down to the same thing: The Fed buying U.S. bonds and mortgage backed securities and holding them long-term on its balance sheet.  Here’s what the Fed’s holdings look like for the last 10 years:

As you can see, the Fed’s balance sheet has quadrupled in size in just five years.  And, the Fed is continuing with their QE3 (aka QE-Infinite) program of buying $85 billion a month of U.S. bonds and mortgage backed securities.  As a result, the scary looking QE3 slope can simply be extrapolated into the future.  It’s not hard to see where we’re going.  This represents the outright and long-term monetization of the debt not to mention the absorption of toxic mortgage backed securities left over from the subprime crisis.

What Happens If the Fed Stops

Clearly the Fed’s QE programs have injected huge amounts of artificial demand into the bond market.  This, coupled with near zero interest rates have allowed the party in the bond market to continue just a little while longer.  But the Fed is playing with fire and they know it.  The danger: Inflation.

The Fed can’t simply keep increasing the monetary base forever at this pace.  At some point all the digital money printing must show up as inflation.  Up until now the decelerating velocity of money as credit markets tighten has masked the underlying increase in the supply of money.  But at some point this will change.  And, if history tells us anything, it’s that once the inflation genie is out of the bottle it can be very difficult to put back in.  In the late 70’s and early 80’s Fed chairman Paul Volcker had to jack interest rates north of 20% to tame runaway inflation.

So what happens when the Fed stops QE3?  Or worse, what happens when the Fed starts to unload the assets on its balance sheet back into the open market (which it assures us it’s going to do)?

Simple: The bond bubble will burst.  There’s just no way around it.  Once the conditions that created the 30 year bull market in bonds are stopped, demand for bonds will fall.  At the same time governments are saddled with truly historic debt loads that must be serviced (requiring the creation of an ever larger supply of debt).  Increasing supply and decreasing demand for an asset will inevitably cause the price for that asset to plunge.  Pop goes the bubble.

To put an exclamation mark on this consider what’s happened since May 2013 when Fed chairman Ben Bernanke indicated that a tapering of QE3 might commence towards the end of 2013:

This drastic increase from around 1.7% to 2.7%, a more than 50% rise, resulted from just the mention of a possible future tapering.  And, during this period the Fed artificially goosing demand by buying $85 billion a month in assets.  Just imagine the carnage if the Fed actually does taper and unload all the treasuries sitting on their balance sheet back into the market.

And what about the real impact of these increased yields?  It’s not just that prices will plunge hitting bank capitalizations, pension funds and the like.  These bond yields represents the amount it costs for governments to borrow.  If the yields spike up sharply so too does the amount of interest required to service all that debt that’s accumulated in the last 30 years.  This will very quickly become unsustainable especially for countries already teetering on the brink of insolvency (Spain and Italy leap to mind).

Watch Out For Bank Failures

It’s not just governments that are highly exposed to increasing bond yields.  Banks hold large quantities of ‘safe’ government bonds on their balance sheets.  These bonds contribute to the reserve requirements (capitalization) of the banks.  But, if the price of these bonds fall, banks can very quickly find themselves under-capitalized and at risk of failure.

This is something I believe we are going to see once the bubble pops: Systemic bank failures.  God help us if the governments do what they did in 2008 and bailout these reckless and over-leveraged banks using debt guaranteed and owed by the tax-payer.  Of course, the flip-side, a Cyprus style bail-in in which depositors are forced to pay amounts to the same thing.

In either scenario the little guy is going to have to bend over and take it.  Individuals would be well advised to take steps to protect their investments against the threat of inflation and confiscation.

The Bondpocalypse Come’th

The 30 year bull market in bonds is coming to an end.  Attempts to keep the financial system from collapsing over the last five years have merely set the stage for a larger collapse.  Government debts have exploded.  Central banks have desperately lowered interest rates to near-zero and resorted to outright monetization of the debt.  Recent events show us that the mere suggestion of possible future tapering is enough to cause an immediate and violent reaction in bond yields.

There’s no way out.  The bondpocalypse come’th.  With it will come a one-two punch of a massive increase in the cost to service national debts coupled with massive losses in the financial system which could well lead to wide-spread bank failures.

Rather than let the system collapse or institute the deep structure reforms necessary, governments will likely resort to ever increasing debt monetization.  The result to these debt based policies must be inflation.

Protect yourself.  Prepare yourself.  Things are going to get ugly.

Every time we go through a major economic upheaval the pundits appear on cue heaping scorn upon capitalism and the evil free market.  It is the greed and instability inherent in these systems, say the critics, that have caused the our current crisis.  We must prevent future instability with increased regulation and by placing shackles upon the evil free market!

This is complete nonsense.  The premise on which these critics are basing their arguments is completely wrong.  Free markets can’t be the problem since we, at a fundamental level, don’t have them.  In fact the opposite is true.  It’s precisely because we don’t have free markets that we’re living through a slow motion economic train-wreck.  Attempting to solve problems rooted in the bastardization of the free markets by further interfering with and regulating those markets is utter folly.

In my previous post I both defined free market capitalism and also showed how government interference with the price discovery mechanism necessarily leads to inefficient markets.  Today I want to apply that discussion to what’s arguably the most important price that exists in an economy (especially an economy that purports to be capitalist): Interest rates.

Interest Rates – The Price of Capital

Most non-economists don’t think of interest rates as a price.  They are.  In fact, interest rates are arguably the most fundamental price that exists in a capitalist system: The price of capital or money.

Like any other good or commodity money has a price.  That price is interest rates.  If an individual or company wants to obtain money to buy a house, invest in a new factory, etc., they need to borrow money or capital.  We all know that borrowing money is never done for free – the lender needs to be compensated both for any risk and also for forgoing access to their money for the duration of the loan.

In a free market interest rates are the quantitative expression of:

1. The premium the borrower willing to pay in the future to have access to money today.
2. The profit the lender demands in compensation for the lose of access to their money for the period of the loan (and any risk).

In a free market interest rates, just like any other good, should be set through the price discovery mechanism.  The more people save, the more supply of money exists and the lower the interest rate.  The more people spend, the lower the money supply and the higher the interest rates.  On the demand side, increasing demand yields increasing interest rates.  Referring back to the standard supply/demand chart the situation looks like this:

Supply and demand.

In this particular chart P* would represent the free market interest rate.  Any deviation from that optimal interest rate would cause either a shortage or excess of available capital (see my last post for a discussion of price fixing).  Both results, a shortage and an excess, have detrimental effects on the economy at large and, among other evils, are the primary causes of bubbles and the boom/bust cycle.

What Happens When Government Fixes Interest Rates

Let’s take it for granted that neither the government nor any other entity could possibly select prices as correctly and efficiently as the free market.  It directly follows that under our current system the government must be setting interest rates sub-optimally above or below the equilibrium price.  Let’s look at the effects of each of these cases.

Interest Rates Set Too Low

Current interests rates have clearly been set artificially low.  Indeed, the current Federal Reserve discount rate (the special rate the Fed will lend money to banks at) is less than 1%.  The Fed has also given indication that the rates will remain artificially low through 2015.

What is the impact of such a policy?  Well, apart from turning banks into gamblers (since banks can borrow money from the Fed to invest in a range of vehicles earning returns well in excess of the loan’s interest rate), the impacts of such a low rate are entirely predictable by looking at the supply/demand models: Demand soars.

For normal goods, such an artificially low price would result in shortages as suppliers would be less willing to produce at such low prices while at the same time demand would be high.  But money, especially fiat money in a fractional reserve system, is not a normal good.  I don’t want to go off on a tangent so, for the purposes of this discussion, since the Fed also controls the quantity of money in circulation, let’s assume that the Fed in conjunction with the banks will simply ensure that sufficient money supply exists in the system to satisfy demand.  Thus, the result of the artificially low interest rates is simply a surge in borrowing.

This surge in borrowing and the abundant availability of cheap capital first and foremost creates an artificial boom in the economy.  After all, people borrow money to spend it. The higher the aggregate borrowing in the economy, the higher GDP is pushed.  In the short term life is good.

But this short-term boom masks the underlying imbalances that have been created.  Depending on other policies in the economy, asset bubbles can be created.  Probably the best recent example of this is the U.S. housing bubble (which popped memorably in 2008) and the Canadian housing bubble (which is about to pop).  These bubbles where created exactly because of the availability of cheap mortgages.  This did no favour to the average person since it simply caused housing prices to shoot through the roof.  Houses doubled in price but salaries did not.  Although the low interest rates meant you could now get approved for a $500,000 mortgage due to the low interest rates, this made the outstanding debt as a percentage of income much higher than ever before for the standard person.  A whole middle class has literally become debt slaves.

So these are the first effects of artificially low interest rates: Asset bubbles and higher consumer debt.  Neither of these are healthy for the long term economy.

Another effect of low interest rates is to make people more likely to engage in suboptimal or high risk investments.  Since money is so cheap people are more willing to borrow for things that they would not have under normal (higher) free market interest rates.

Low interest rates can also delay or prevent inefficient businesses from going under.  One of the keys to the capitalist system is that the most efficient producers in any given market are selected for while less efficient producers are forced to improve or go out of business.  This leads to the best prices for consumers and the highest aggregate wealth in the economy.  Cheap and abundant credit provides less efficient producers with a way of circumventing this economic natural selection: Issue bonds, lots of bonds.  Thus, these companies can temporarily stay in business due to the over-supply of credit.

Finally low interest rates hurt savers.  Savers are supposed to be the keystone in the capitalist system since it’s their savings that are used as the basis for the economy.  People who used to be able to earn a return at or above inflation relatively risk free now must chose between returns lower than inflation (i.e. a lose in purchasing power year to year) or chasing returns in more risky investments, using precious metals etc.  The oft heard argument that the loss to savers is more than offset by the savings on interest payements for borrowers is nonsense.  As I’ve mentioned, low interest rates tend to get expressed in increased prices (so borrowers aren’t really saving and instead taking ever larger debt burdens).  At the same time pension funds and individuals are forced into riskier investments.  The end result is much higher debt for borrowers, much lower returns for investors and an increasingly risk based economy.

Interest Rates Set Too High

If the price of a good is fixed above the free market equilibrium price a surplus results. That is, there is more supply than needed to meet demand at the price.  Applied to interest rates the picture is again muddied due to central bank monetary policies.  High interest rates are often associated with tight monetary policy.  But regardless, the general result is still the same – the credit market dries up, investment opportunities dwindle and the economy slows.

In the real world it’s been a long time since we’ve seen above market interest rates.  Probably Paul Volcker’s stint as Fed Chairman in the late seventies and early eighties is the best recent example.  In order to reign in runaway inflation which had topped 13.5% in 1981, Volcker jacked interest rates north of 20%.  The plan worked but caused a spike in unemployment and slowed growth in the economy.

While I doubt we will see high interest rates at any point in the foreseeable future the lesson remains: Artificially high interest rates are also damaging to the economy.

Why Does Government Fix Interest Rates

Given the myriad of problems and inefficiencies caused by governments fixing interest rates, why do they do it?  Money.

You see, governments also undermine the free market when it comes to currency.  Legal tender laws, capital gains taxes required for any exchange of precious metals, and other laws all exist to ensure governments have a monopolies on their nations’ currencies.

While we can argue about motivations for why government has imposed such a currency monopoly on us, for the purposes of this discussion the why is irrelevant.  What is relevant is the fact that there does undeniably exist such a currency monopoly and that the value of the currency is being eroded continually by inflation.  This systematic debasement of the currency is intentional.  Central banks usually target around 2% annual inflation as being a good thing.  Using the U.S. as an example, even the official stats report the loss of over 95% in the purchasing value of the dollar since 1913.  Often inflation runs higher that the 2% target and in virtually all cases real inflation is under-reported due to the statistical games played in the way inflation is defined by the government.

Why is any of this important to a discussion about interest rates?  Simple.  You can’t have an inflationary currency and free-market interest rates without very quickly breaking the economy.

It all comes back to the definition of interest rates being the price of currency.  Assume there’s a free market in which there’s no currency depreciation and where interest rates, through the price discovery mechanism, are running at 5%.  Now introduce an expected 3% currency devaluation into this economy.  In a free market lenders would demand to be compensated the additional 3% in order to make a loan.  The lender understands that being paid back in devalued currency cuts into the premium they demand in compensation for risk and deferred payment on their loans.  The entire supply curve shifts up by 3% and interest rates in such a system rise to 8%.  At the new 8% interest rate there is less demand for borrowing and the economy slows.

This scenario shows that, in a true free market, currency inflation will slow the economy as lenders attempt to shift the burden of inflation onto borrowers.

The only way governments can reap the benefits of inflation without the detrimental impacts of such a policy being immediately visible in the economy is if the government also seizes control of interest rates.  Thus, currency and interest rates are the two necessary prerequisites to enable currency debasement.

Conclusion

Were governments to raise all funding through taxes the people would revolt.  Inflation provides a mechanism whereby people can be taxed without their knowledge or understanding.  This enables government to grow ever larger while the people, confused, grow ever poorer.  Conveniently, government also controls the education system and sees to it that a basic, common sense understanding of economics is not part of the curriculum; Instead we learn about magic multipliers, benefits of omnipotent government price regulation and the like.

But this currency debasement is only made possible due to the control of interest rates and the extent to which this is able to distort, obfuscate and manipulate the economy.  In the process a never ending cycle of booms and busts, crises and panics are created.  This is the inevitable result of a managed economy – an increasingly chaotic system that eventually implodes.  Just ask the Soviets.

And that, ultimately, is where our managed economies are heading – ruin and collapse.  We have allowed the State to eliminate the free market for the most important price that exists in a capitalist system: The price of money – interest rates.  In so doing we consigned ourselves to a permanently sub-optimal economy.

No, we don’t have free market capitalism.  Not even close.  Welcome to the managed economy.

Supply and Demand Theory

Basic economics is based largely on supply and demand.  Simply stated this theory says that the higher the price of a good, the less demand there will be for that good.  The lower the price of a good, the more demand there will be for that good.  This is easily visualized as follows:

Price Discovery

In a free market system this linkage between supply and demand leads to price discovery – the process by which the market automatically adjusts supply until the optimal price is reached.  This is often referred to as the ‘equilibrium’ price.

If the price for a good is above equilibrium there is excessive profit to be made by producers of that good.  This will cause additional producers to enter the market to take advantage of the high profits which in turn increases supply and drives down price.

And the reverse is also true.  A price below equilibrium lowers profits and causes some producers to stop producing the good.  This supply reduction raises the price.

In this way, any time a price deviates from the equilibrium price, there will automatically be correcting forces which will push the price back to equilibrium.  This price discovery mechanism is the bedrock of a free market system and always leads to optimal prices for goods.

Government Mucks It Up

Almost all government programs are started with good intentions, but when you look at what they actually achieve, there is a general rule. Almost every such program has results that are the opposite of the intentions of the well-meaning people who originally backed it. – Milton Friedman

Left to its own devices, the free market system has an amazing ability to respond to shortages or surpluses in an agile manner.  Further, since no oversight or intervention is needed, this system incurs no overhead costs and does not require a wealth sucking bureaucracy.

Unfortunately, government cannot resist the temptation to interfere with the free market through a variety of mechanisms.  Subsidizes, rent control, interest rate setting and many other schemes all accomplish the same thing: They fundamentally break the price discovery mechanism of the free market and, in all cases, necessarily lead to inefficiencies and exacerbate problems.

The remainder of this post will go through a few examples of government interference in the price discovery mechanism and demonstrate the sometimes subtle ways these interventions exacerbate the existing perceived problem or transfer the problem to another sector or group within the economy.

Hurricane Sandy and Gasoline Price Fixing

Last October the eastern seaboard of the United States, including New Jersey and New York, took the full wrath of Hurricane Sandy.  In its wake, with millions left without power and unprepared, gasoline (as well as other essentially commodities) underwent a surge in demand.  The result was entirely predictable by looking at the above supply/demand chart: Prices rose.  First to $5/gallon and then within days into the $10-$15/gallon range.

At this point prices started to stabilize and even fall slightly.  But the respite was brief as Governor Christie and other economically illiterate officials started jawboning about prosecuting price gougers and warning against any price increases above the state mandated 10% permitted during a state of emergency.  This immediately drove the black market price for gasoline up to $20/gallon and the shortages deepened.

This government response was completely predictable and, most people would argue, necessary.  But, by interfering in the free market system which was already working automatically to resolve the crisis, this government imposition of price controls actually prolonged the crisis.  After all, what good is $4 gas if there’s none to buy?  This was exactly the situation in the aftermath of Sandy – artificially low prices and chronic supply shortages.

But now consider what would have happened if the politicians had allowed the free market to work.  The initial phase of the crisis would have been the same: Increased demand leading to higher prices.  But these higher prices would have attracted an immediate increase in gasoline supply.  Think about it: If you’re a supplier in a neighbouring state with a tanker full of gasoline would you sell it locally for $4/gallon or send it to a market where you could sell it for $10 or $15/gallon?

Thus, under the free market system, within days there would have been a massive influx of gasoline into affected regions from unaffected regions as suppliers chased profits.  This influx in supply would have reduced both the prices and shortages of gasoline.

This is not to say that prices wouldn’t have settled at an elevated level.  After all, these out-of-state suppliers are incurring additional overhead to deliver their product to a more distant market and are also incurring risk sending capital assets (i.e. the trucks) into storm damaged regions.  But, certainly the premium would not have been more than a few dollars a gallon and any shortages would have been eliminated in short order.

Hurricane Sandy provides one great example of how, despite their best intentions, government interference with the price discovery system inevitably exacerbates problems.

Rent Control

Another great example of the unintended consequences of government interference in the free market is rent control.  When the government imposes rent control it suppresses the price such that it is below equilibrium.  Visually, it looks like this:

Notice that this hard ceiling on price has resulted in the following:

1. High demand due to the low price.
2. Low supply due to the lack of profits.

These two forces act in opposite directions to force acute and chronic housing shortages.  In the above diagram we can quantify the shortage as Q2 – Q1.

Even worse, the establishment of a price ceiling below equilibrium has resulted in a situation where the profits for suppliers of housing (i.e. builders and landlords) is reduced. In this situation these suppliers have little incentive to build additional housing and thus the shortage becomes chronic.

Another unintended consequence is that because the cost per square foot is artificially low, individuals have less incentive to economize by taking less space.  Thus, the same aggregate square footage of available housing tends to be consumed by fewer and fewer people at lower and lower prices.  If the price was allowed to increase people would adjust by reducing their space needs, subletting, etc.

Notice that simply allowing the price to find the natural equilibrium would resolve the housing shortage.  Even if the equilibrium price is initially prohibitively high, this will simply cause a quick housing boom to occur as builders chase profits.  This housing boom will naturally solve the shortage and cause the price to drop.

Commodity “Stabilization”

But the government doesn’t just fix prices artificially low.  Often government intervenes to fix a price above the equilibrium price.  One example of this is for agricultural crops.  Let’s use corn as an example.

It’s inevitably argued that price fixing policies are required to ‘stabilize’ the price of corn.  This stabilization can be in response to certain market conditions or simply because at harvest time the price of the corn naturally falls for a period due to the increased supply.  It’s at these times, says the government, that the evil speculators step in and buy the corn at low prices to store it and sell later in the season once the price increases.

This evil speculator argument sounds good but, when analyzed rationally, is nonsensical.

First of all, the speculator is doing nothing that the farmer couldn’t do himself.  Nobody holds a gun to farmers’ heads and forces them to sell at harvest time.  Those farmers are free to store their corn in grain silos until the price goes up just as the speculators do.  The reason some farmers are willing to sell when the price is lowest at harvest time is because there are costs and risks to storing.  First of all there is clearly a capital investment required – you have to put all that corn somewhere.  Secondly, the farmers are deferring income which carries its own costs – namely risk (insurance, uncertain market conditions, etc.) and forgone investment potential on the money for the period of the delay.

The reason speculators are important is exactly because they are willing to incur these additional costs and risks for a future profit.  By doing so the speculators are performing an important function: They stabilize supply and with it price.  By buying during times of excess supply and selling during times of shortages the speculator is, in fact, stabilizing the market and reducing seasonal price fluctuations.

But alas, the government often doesn’t see the logic of this and, with the support of the agricultural lobby, enforces a price that during harvest time is less than the free market price.  The situation they create looks like this:

By setting the price of corn at an elevated level an oversupply is created.  This has a few effects:

• Inefficient farmers are not forced out of business as they would otherwise have been.  The natural free market mechanism of perpetuating the most efficient producers and forcing inefficient producers to improve efficiency or go out of business is broken.
• Consumers pay more and as a result they consume less (demand falls).
• Imports of corn must have tariffs applied or be otherwise restricted to maintain the high price.
• Unless production by domestic farmers is restricted, chronic and building oversupply will become a major problem.

Unless the government regulates all production to force supply to the Q1 level (i.e. production limits) something akin to an asset bubble in the corn market is created.  Unchecked, this, like all bubbles, must burst at some point leading to even greater price volatility.

The take away here is that, once again, government interference with the price discovery mechanism only serves to exacerbate problems that the free market is quite able to resolve in the most efficient manner possible.  In the case of setting artificially high prices the main result is that consumers get less of a good at a higher price.

Conclusion

The free market system always leads to optimal prices.  The price discovery mechanism will dynamically adjust to shortages, oversupplies or any other disruptions or changes in the market.  There is nothing government needs to do other than trust in the natural profit seeking behaviour of the individual and stay out of the way.

It is important to note that in most cases the government is attempting to act in our best interests with their free market manipulations.  But you can’t fix an optimal system.  Any attempt to regulate or control such a system will inevitably make the system less efficient.  That neither we as a citizenry nor our political leaders have internalized this fact and educated ourselves in basic common sense economic theory leads to misguided attempts to fix something which isn’t broken.

Finally, these ill-advised attempts at market rigging introduce additional overhead into the system in the form of the army of bureaucrats needed to draft and administer the regulations.  Government gets larger, the market gets less efficient, and the individual consumer pays the price.