Thursday, October 30, 2014

Will the Fed's Fear of Deflation Lead to Rampant Inflation?

The financial pages these days it is easy to see that deflation is the major worry among the world's central bankers including the U.S. Federal Reserve.  The word "deflation" also turns up in articles and interviews with financial advisers.  The price of gold is down and few financial advisers are providing advice or strategies for dealing with inflation.

While there is no question that much of the world economy, including to some extent the U.S. economy and to a much greater extent the European economies, is suffering to some degree from deflation, there is an inflation time bomb lurking just over the horizon.

While I generally don't pay much attention to the doom and gloom concerns of Glenn Beck, I did find myself in full agreement with him this past Tuesday when, on the Sean Hannity show he made reference to the trillions of dollars worth of reserves the U.S. Federal Reserve and other Central Banks have been pumping into the world's banking system since the start of today's ongoing recession.

These trillions of dollars of reserves are new money created by central banks out of thin air and deposited into the world's banks.  While digitally created deposits, this money is basically no different than the massive amounts of paper money printed by the post World War I government in Germany.  The excessive printing of money by the German government resulted in  hyperinflation which led to the rise of Hitler and his Nazi party.

One other difference between the digital funds the world's central banks have deposited into banks and the paper money printed by the post World War I German Weimar Republic is that the digital funds are not circulating but are sitting on bank balance sheets as excess reserves.  So far banks have been hanging on to these funds and not loaning them out due to fear of another financial crises in which they might need these excess reserves to remain solvent.

While central banks intent at the start of the 2007-08 financial crisis was to shore up bank reserves with the injections, subsequent central bank efforts have been an attempt to increase the amount of money in circulation by providing banks with more money to lend.  However, banks have continued to remain cautious and have kept most of this new money as reserves.

The ongoing recession that has resulted from the financial crisis at the start of President Obama's term has been due to people being a fearful as the banks about a future crisis.  Just as the banks have kept the injected funds in reserve, people have been cautious about spending and have used much of their money to pay down debt and build up savings.  This has slowed the circulation of money which has led to fewer sales of goods and services.  This slow down in economic activity has led to layoffs and a reluctance to expand and hire more workers by employers.

This slowdown in the rate of spending by consumers has led to deflation which has prolonged the 2007-08 recession. Deflation is basically a reduction in the amount of money in the economy due to people hanging on to it rather than spending it.  They standard Keynesian policy response is to try to ignite some  inflation (the opposite of deflation).

According to a report on CNBC at the start of the financial crisis, the total amount of new money the world's central banks injected into banks as reserves exceeded the total amount of money in circulation in the world economy at that time.  Since then more money has been created and injected into bank reserves.

What central banks have been trying to do is get banks to move some of this money into the economies of their nations by loaning it out.  This injection of new money into circulation would result in some inflation which would off set or cancel out the deflation and get the world's economy moving and growing again.

However, the real problem is lack of confidence by consumers and business in the Obama Administration's tax and regulatory policies and fear that these will lead to another economic downturn.  In such a climate most people are being cautious and accumulating cash by cutting spending.

Creating money and putting it into the economy via the banking system is a traditional monetary tool for stimulating an ailing economy.  Central banks can also do the reverse and pull reserves out of the banking system which results in banks having less money to loan which forces economic growth to slow when the central bankers feel inflation is accelerating at to rapid a pace.  However, using monetary policy to stimulate or slow down an economy is not an exact science and considerable economic damage is frequently the result of these efforts.

The problem today is that if peoples confidence returns and banks respond by increasing lending there is the possibility that we will go from today's current deflation to rapidly increasing inflation.  If central banks stay focused on deflation and hesitate to act quickly, rampant inflation could result.  On the other hand, if central banks hit the monetary breaks too soon and too hard, the economy could fall back into a recession. 

Thursday, October 23, 2014

Political Risk that Threatens Retirees Social Security

It is campaign season and the airways are full of political commercials.  Fortunately for the politicians truth-in-advertising laws do not apply to campaign ads.  If political ad were held to the same standard as commercial ads, they would be scarce on television.

A recent television spot by the Democratic Congressional Campaign Committee supporting Arizona Congressman Ron Barber in his campaign against challenger Martha McSally is not only guilty of the typical distortion of an opponent but goes a step further by implying that Social Security is a retirement savings program.

In the ad a middle aged woman accuses McSally of trying to destroy Social Security by privatizing it.

In addition to taking a response by McSally to a reporter's question out of context, it goes on to say:

We worked hard. Played by the rules.  But then you have Martha McSally who wanted to risk ALL THE SAVINGS [emphasis mine] we earned over a lifetime.

Ad's Wording is Deceptive

This wording is very deceptive but it is also a deception that Social Security's supporters have been promoting to the American public since the Social Security legislation was passed in 1935.  While its supporters have always talked in public about Social Security as if it was a pension type retirement plan, the reality is that it has always been nothing more than a just another income transfer program. 

The lady in the Democratic Congressional Campaign Committee uses the words risk all the savings which implies that the Social Security taxes paid by workers and their employers are a form of retirement savings.  However, Social Security  payments to retirees are not like payments from a pension fund or a 401(k) or other type of retirement savings accounts. 

First, those who pay into and eventually  qualify to receive Social Security payments when they retire have no legally protected contractual right to Social Security benefits.  This is in contrast to the other sources of retirement income listed above in which participants have a contractual or ownership right to income from these plans.

In two separate cases (Helvering vs Davis in 1937 and Flemming vs Nesor in 1960) the U.S. Supreme Court  ruled in the first case that Social Security is NOT a retirement savings or pension plan but, instead, a simple welfare plan where one group (workers and their employers) are taxed to raise funds to give to another group (retired workers).  In the second case it ruled that people who pay Social Security taxes have no contractual right to the money taken from them by the tax or to any income generated by that money.

Secondly, the reference to savings in the campaign ad is deceptive since the money taken from workers' paychecks by the Social Security tax is not put into an account for each worker.  There are no savings to lose for the simple reason that the money taken from current workers and their employers is immediately transferred as payments to current retirees. 

When a worker retires, the Social Security payments that person receives comes from taxes on those still working and NOT from funds collected and stored in an account during that worker's working years.

Social Security Law Can be Repealed by a Simple Vote of Congress
Social Security is a law like any other law and, as such, can be changed or repealed by a simple majority vote by Congress.  Further, since the Social Security program, like any other program that requires the spending of money, relies on Congress to authorize funds for it to spend, payments can be stopped without actually repealing the law. 

A simple majority in the House of Representatives  voting NOT to approve it funding would halt Social Security payments to retirees for that year - however, existing workers would still have the Social Security tax deducted from their paychecks every payday.

What keeps Social Security from being repealed or not funded is the fact that millions of retirees depend upon Social Security for much of their retirement income.  Not only do these retirees vote but their voting age children and grandchildren also vote and these younger voters don't want to see their retired parents and grandparents thrown out into the streets.

Demographic Change Could Result in Repeal of Social Security

However, as I described in my article Social Security's Achilles Heel, I point out that the introduction of IRA and 401(k) accounts in the latter part of the 20th Century has made many retirees less dependent upon Social Security for retirement income. 

While these retirees probably won't advocate ending Social Security many of them won't be motivated to actively oppose repeal.  Meanwhile many younger workers who are struggling financially and want relief from Social Security taxes and whose parents or grandparents are not financially dependent upon Social Security will actively support repeal. 

Politicians, like other people, want to keep their jobs and, once a majority of voters want to have Social Security repealed, politicians will change their stand and vote to repeal.  This is the political risk that Social Security faces and this risk may come to the forefront sooner rather than later.

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