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