• The Debt/Inflation Ratchet

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    We are all
    familiar with ratchets. A bar with a tapered end locks into place
    a gear, so that the gear cannot move backward. Then force is applied
    to the gear in order to move it in one direction. Click by click,
    the ratchet system prevents the gear from moving backward. Click
    by click, the system governed by the ratchet moves in one direction.

    This
    is the monetary condition of the world’s economy today. A few items
    are so price competitive through innovation that they continue to
    move down in price. We see this anti-ratchet effect in computers
    and computer-related equipment. Moore’s law is actually accelerating.
    The chips are now doubling in capacity every 12 months, not every
    18. This is not fast enough to speed up the boot-up process of the
    latest Microsoft operating system. (“Intel giveth, and Microsoft
    taketh away.”) But, once booted, the computer is faster.

    COMPUTERS
    VS. PRICE INFLATION

    There
    is a kind of war between the price effects of computerization and
    the price effects of monetary inflation. I personally experienced
    this last week. I installed, and then removed, an ancient Hewlett
    Packard Laserjet III printer. I thought I needed it to make a decade-old
    program on my computer function properly. I was wrong. A Laserjet
    III was a real improvement over the predecessor, which I also owned,
    but at 300 dots per inch, it’s not up to par today. Most important,
    it is heavy. I mean really heavy. I can hold an HP 1100 (now several
    years old) in one hand. It puts out 600 dpi. It doesn’t hold a tray
    of paper that the Laserjets III and IV did — a liability —
    but it is cheaper and far more convenient. So, I have compromised.
    I reinstalled my old Laserjet IV, which holds its price in the used
    printer market because of the tray.

    The
    improvement in desktop printers has been constant. Prices have fallen;
    quality has improved. These are tangible benefits. Consumers are
    now used to this in printer technology. We expect advances. But
    in few other areas of life are there comparable examples.

    Last
    week, I also experienced first-hand the other side of the coin.
    I watched a Rhino video of what was my favorite TV show fifty-two
    years ago, “Space
    Patrol
    .” The budget was low even for those days. The sets were
    actually cheaper looking than the even older “Captain Video” program,
    which seems inconceivable. (I was never a “Captain Video” fan.)
    How I could have been a fan of “Space Patrol,” yet also think that
    Jos Ferrer’s “Cyrano
    de Bergerac
    ” and Alistair Sim’s “Christmas
    Carol
    ” were great movies — which they were — escapes
    me. I had the entertainment aesthetics of an adult co-existing with
    those of a child.

    “Space
    Patrol” in its TV and radio versions created the original market
    for Wheat Chex and Rice Chex, allowing Ralston Purina to replace
    the never-popular Hot Ralston cereal. The show was incredibly popular
    among pre-teen boys. It ran for five years (daily: 15 minutes),
    plus a twice-a-week radio show, plus a weekly half-hour. It was
    a phenomenon.

    http://www.grapevinevideo.com/space_patrol.htm

    Even more
    incredibly, after the show went national, polls indicated that
    60% of the audience was adults.

    http://www.sundaycomicsonline.com/space_patrol.htm

    Rhino wisely
    retained the show’s original commercials, which are far more interesting
    today than the scripts. Nestle was an alternative sponsor. The
    actors came on-camera to promote Nestle’s products. The candy
    bars — Crunch, etc. — sold for a dime. My wife’s comment
    was “This will prove to our children that candy bars really did
    sell for a dime.”

    The
    product line hasn’t changed. What has changed is the price. Also,
    the bars looked bigger on-screen, which I suspect they were. So,
    the manufacturer reduced the quantity in order to forestall price
    increases. We rarely get an opportunity to compare the same product,
    without improvements, over time. Food products are among the few
    whose formulas don’t change much, and candy especially. Taste matters,
    so manufacturers are afraid to tamper with the formulas. They prefer
    to reduce sizes or change packaging. They resist passing along price
    increases. So, when we can compare today’s prices with prices a
    half century ago, we can see what has happened to the purchasing
    power of the dollar.

    When
    the show first aired, in 1950, on the local ABC TV station in Los
    Angeles, the actor who played “Cadet Happy,” Lyn Osborn, was paid
    $8 per show, meaning the pre-tax equivalent of 80 Nestle candy bars.
    I have no idea how he paid his rent.

    MARKET
    FAILURE OR ANALYTICAL FAILURE?

    A
    free market monetary system allows users of commercial banking services
    to impose negative sanctions against mismanagement. If they suspect
    that a bank has loaned out more money than the bank has immediately
    withdrawable reserves on deposit, thereby increasing the money supply
    and also the risk of a bank run, a bank run begins. The bank is
    forced to call in loans and restrict the issuing of new loans. The
    money supply then shrinks.

    The
    free market imposes restraints on the expansion of money. It does
    so bank by bank. It imposes restraints on individual banks, which
    in turn impose restraints on the commercial banking system as a
    whole. Micro-incentives to restrict the issuing of new loans with
    newly created credit money therefore impose macro-restrictions on
    the entire money supply.

    This
    is the classic characteristic of the free market. A positive result
    in the aggregate is attained by individual decisions. Out of the
    self-interested actions of individuals emerges an unplanned system
    that benefits most of the participants. In short, “out of many,
    one.”

    This
    self-regulating free market system of monetary management has never
    impressed Milton Friedman, who is famous for his attack on the gold
    standard and his suggestion that what society needs is a government-run
    monetary system that will increase the money supply by 3% to 5%
    per annum — a lot of flexibility there!

    This
    is a classic accusation of “market failure” by an academic economist.
    The free market has somehow failed to maximize consumer benefits
    by providing a system that restricts abuse. It has failed to produce
    an optimum money supply. Yet, unlike a gold coin standard, which
    encourages depositors’ runs on overextended banks to get the gold
    they are owed (deposits), as well as other commercial bankers’ runs
    on overextended banks to get the gold they are owed (checks), Friedman’s
    system has no independent, exogenous (outside) negative sanctions
    against fractionally reserved commercial banks’ self-interested
    inflating of the money supply. The government must provide guidance
    and sanctions for disobeying government guidelines.

    Friedman’s
    brother-in-law, Aaron Director, who was also a University of Chicago
    economist, took another view: a fixed money supply with falling
    prices due to increased production. Friedman’s recommendation has
    always had a wider appeal than Director’s among academic economists,
    although no one has suggested any way to get the government or a
    central bank to follow the 3% to 5% guideline.

    The
    result of government controls and central banking has been the disappearance
    of the ten-cent candy bar. Another result has been the creation
    of a debt structure that encourages further monetary inflation.
    I call this the ratchet effect.

    THE
    RATCHET EFFECT

    When
    new money unexpectedly is released into the economy by the central
    bank, those who get early access to the new money have a competitive
    advantage. They can buy at yesterday’s prices. So, new users of
    fiat money can buy a disproportionate share of the economy’s existing
    goods, not because they have become more productive, but because
    they have in their possession the newly created money. Nice work
    if you can get it!

    How
    do you get it? By going into debt. The central bank creates new
    money to buy government debt. The government immediately spends
    this money: checks. Those who receive these checks then deposit
    the money in their bank, or else they cash the checks and spend
    the money. Banks wind up with the new money. They lend out more
    money, which in turn gets deposited: fractional reserve banking.
    So, for two groups of people — recipients of government funds
    and recipients of bank loans — the inflation process makes
    them winners.

    What
    we see, year by year, is an increase in the money supply, an increase
    in government debt purchased by the central bank, an increase in
    government spending, and an increase in private debt. All of this
    takes place because the monetary system allows the central bank
    to use government debt (or any other asset) as the nation’s monetary
    base: the legal reserve for the commercial banking system’s deposits.

    Debt
    produces hope for a future income stream. People will pay money
    today to buy an expected income stream. They buy bonds: expected
    income streams. They buy real estate: expected income stream. They
    buy annuities: distantly expected income stream. Create an income
    stream, and you have created wealth. When people bid to buy this
    wealth, we call this process capitalization: the capitalization
    of an expected income stream.

    These
    income streams are monetary. But people’s goal in creating streams
    of income is the creation of consumable income, not digits or pieces
    of paper with dead politicians’ pictures on them. So, people’s expectations
    regarding future prices are important in establishing the level
    of present demand for monetary income streams.

    If
    the process of monetary depreciation is slow enough, people tend
    to forget what is happening to the value of their locked-in streams
    of future monetary income. I think of those Nestle candy bars. I
    also remember going to a movie on Saturday morning in 1951: 15 cents
    each way for the bus, 25 cents for the movie ticket, and 10 cents
    for a Butterfinger candy bar. That bought me a day’s entertainment,
    10 a.m. to 4 p.m.: a western, six cartoons, a serial, a newsreel,
    and two adult features. Plus, previews of coming attractions.

    The
    Federal Reserve has acted to undermine the value of streams of monetary
    income. In response, voters have pressured politicians to establish
    cost-of-living escalators for Social Security payments. So, the
    government’s statisticians do whatever they can to juggle the data
    in such a way as to deflate the consumer price index. They prefer
    to include computers in the official basket of goods rather than
    candy bars. Moore’s law is their friend.

    The
    Median CPI, published by the Cleveland Federal Reserve Bank, is
    not subject to political jiggling, because it is not used to establish
    the government’s official cost-of-living estimate. So far this year,
    the increase in the Median CPI is moving at 3.7% annual rate.

    http://www.clev.frb.org/research/mcpi.txt

    We
    discount the future. Income received in the future is not worth
    what the same income is worth to us today. We also tend to have
    confidence that the future will take care of itself. This is the
    right attitude with respect to the bad things that might happen,
    but probably won’t. “Take therefore no thought for the morrow: for
    the morrow shall take thought for the things of itself. Sufficient
    unto the day is the evil thereof” (Matthew 6:34). This optimism
    encourages entrepreneurship. But there is a downside to this attitude
    in a world of central banking and government debt: neglect of the
    declining future purchasing power of money at the expense of looking
    at our net worth today.

    We
    look at rising prices for housing, and as home owners, we rejoice.
    We feel richer. We do not emotionally perceive that for every rise
    in our homes’ value, we must pay rising rent: the forfeited value
    of the income that we could receive if we sold the home and invested
    the returns. We think, “I’m rich!” We then think, “I could be richer
    if I borrowed money, bought another home, and got renters to pay
    it off.” If we buy right, this is true.

    http://www.johnschaub.com

    But leverage
    through debt is a two-way street. The debt meter keeps ticking
    even after the income stream dries up. If I pay $10,000 down on
    a $100,000 home, and I can sell it a year later for a net return
    of $110,000, I have made 100% on my investment, if I also rented
    it for what my costs were. But if I pay $10,000 down, and the
    price falls to $90,000, I have lost 100% of my investment, and
    maybe I could not rent it, either. So, in order to keep from getting
    hammered by the negative capital value effects of deflation on
    leveraged contracts — mortgages — debtors vote for politicians
    who promise to keep monetary income high, and thereby protect
    us from the risk of default.

    In
    my view, the housing market is the ultimate example of “moral hazard”
    that we face today. The housing market is too big to fail, meaning
    too big to be allowed to fail. Yet the only thing that the government
    and the Federal Reserve System can do to keep it from failing is
    to adopt a policy of money creation. This is what they have adopted.
    The voters want it.

    Eviction
    for non-payment of one’s mortgage is an immediate problem. Pension
    living is in the distant future. We look at today’s wealth, or the
    reduction thereof, and we make our political decisions accordingly.
    We discount the negative long-run consequences of today’s political
    decisions. We are willing for the Federal Reserve System to sacrifice
    the value of future dollars in order to sustain today’s monetary
    income stream, and hence the present market value, of our homes.

    This
    is the Great American Ratchet. We have borrowed money to capitalize
    our lifestyles. We have indebted ourselves to buy a consumer good
    that we pretend is a capital good. A house is a consumer good today
    — real income, not monetary income — but will become a
    capital good for us years from now: a salable stream of monetary
    income, but not necessarily real income. We buy real income today
    by going into monetary debt.

    Because
    we are present-oriented, we have made a risky exchange: real consumer
    income today in exchange for promised monetary payments (a mortgage).
    We justify this because we think that the government will keep the
    supply of fiat money flowing. It undoubtedly will do just that.
    But in pursuing real income now in exchange for making a promise
    to pay a fixed amount of money over the life of a mortgage, we are
    joining the nation’s largest pressure group for the politics of
    inflation. We are undermining our future stream of real income as
    retirees. We justify buying the home as a capital investment, yet
    this investment is no better than what the purchasing power of money
    will be when we finally decide to convert our consumer good into
    capital.

    This
    is a self-reinforcing process. It takes ever-more debt to buy a
    home, and any increase in the monetary value of the home (equity)
    serves as a lure for taking on more debt. Interest payments on homes
    are deductible from gross income for income tax purposes.

    The
    ratchet of debt and inflation continues upward, fueled by the public’s
    confusion. Home buyers do not clearly distinguish real income from
    monetary income, consumer goods from capital goods, and present
    real income from future real income. Man’s inherent present-orientation
    favors real income now over monetary income later. This favors real
    income now paid out of future income later: debt.

    THE
    MEXICAN STRATEGY

    Mexicans
    will do what the rest of Americans won’t: share rental space among
    more than one family. While this is illegal in most communities
    due to zoning laws, the Mexicans’ definition of a family is broader
    than the Anglo and African-American definition. So, they legally
    get away with it. “This is my cousin, Manuel.” His third cousin,
    twice removed. They pool their incomes to meet the monthly mortgage
    payment on one house. Thus, Mexicans are steadily buying up African-American
    housing. African-Americans for decades in California used the block-cracking
    technique to scare whites into selling at low prices. Now Mexican-Americans
    are using the multiple family technique to buy out African-Americans.

    Block-cracking
    is no myth. Almost 50 years ago, my grandparents were warned to
    sell by their long-term black housekeeper, who had cared for me
    as an infant for 6 months when my parents were in Washington, D.C.,
    waiting for my father to be shipped out by the Army. She came to
    them and said that their neighborhood had been targeted for transition.
    How she knew, I don’t know; maybe church members were involved.
    My grandparents refused to listen, and they lost a lot of the equity
    in their home. White flight can be used against home owners by organized
    African-Americans. But family pooling of funds can be used by Mexicans
    to gain their real estate goals, given the mortgage system.

    Meanwhile,
    Asians are using personal productivity to generate the income needed
    to buy up homes from the Anglos.

    Southern
    California is changing color. About 500,000 whites left the state
    in the 1990’s. They are being bought out: from below (block-cracking)
    and from above (higher bids).

    The
    American dream is to own your own home. It is a worthy dream, but
    government guarantees have subsidized this dream. The dream now
    guarantees the decline in purchasing power of the dollar. The only
    alternative to this scenario is a fall in real estate prices as
    a result of a wave of defaults. When monetary income no longer allows
    existing home owners to pay off their mortgages, the real estate
    market will break. But will it break? Not if Alan Greenspan has
    anything to say about it. Surely, he does.

    CONCLUSION

    The
    debt/inflation ratchet cranks ever higher. The central bank system
    subsidizes government spending and, by way of funding this system,
    universal debt. It has subsidized a gigantic consumer debt market
    that is incorrectly regarded as a capital goods market: housing.

    Investors
    say, “Don’t fight the Fed.” If this applies to buying stocks, then
    it is surely true of buying homes. But we must not be naive. The
    subsidized housing market is a dagger at the heart of people’s retirement
    plans. The golden years of retirement are now a myth. A declining
    dollar is going to destroy the dreams of a generation of baby-boomers.
    They will be joined in the long line of disillusionment by their
    grandchildren, who will not be able to get a down payment on the
    American dream.

    When
    governments control the money supply, you can be sure of one thing:
    the long-term depreciation of the value of official money. The politics
    of now, when coupled with the reality of long-term debt (payment
    tomorrow), guarantees the destruction of money. This is not a market
    failure. It is a government failure. There are more debtors who
    vote than creditors who vote. Even when the debtors (mortgage signers)
    are also creditors (pension asset owners), they discount the future
    at the expense of the present. The present political power of the
    economic present is far greater than the present political power
    of the economic future.

    The
    ratchet clicks upward, day by day.

    May
    6,
    2002

    Gary
    North is the author of Mises
    on Money
    . To subscribe to his free
    investment letter (e-mail), click here.

    ©
    2002 LewRockwell.com

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    North Archives

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