Liquidity drowns meaning of 'inflation' By Henry C K Liu
The conventional terms of inflation and deflation are no longer adequate for
describing the overall monetary effect of excess liquidity recently released by
the US Federal Reserve, the nation's central bank, to deal with the year-long
This is because the approach adopted by the Treasury and the Fed to deal with a
financial crisis of unsustainable debt created by excess liquidity is to inject
more liquidity in the form of both new public debt and newly created money into
the economy and to channel it to debt-laden institutions to reflate a burst
debt-driven asset price bubble.
The Treasury does not have any power to create new money. It has to borrow from
the credit market, thus shifting private debt
into public debt. The Fed has the authority to create new money. Unfortunately,
the Fed's new money has not been going to consumers in the form of full
employment with rising wages to restore fallen demand, but instead is going
only to debt-infested distressed institutions to allow them to deleverage from
toxic debt. Thus deflation in the equity market (falling share prices) has been
cushioned by newly issued money, while aggregate wage income continues to fall
to further reduce aggregate demand.
Falling demand deflates commodity prices, but not enough to restore demand
because aggregate wages are falling faster. When financial institutions
deleverage with free money from the central bank, the creditors receive the
money while the Fed assumes the toxic liability by expanding its balance sheet.
Deleverage reduces financial costs while increasing cash flow to allow zombie
financial institutions to return to nominal profitability with unearned income
and while laying off workers to cut operational cost. Thus we have financial
profit inflation with price deflation in a shrinking economy.
What we will have going forward is not Weimar Republic-type price
hyperinflation, but a financial profit inflation in which zombie financial
institutions turn nominally profitable in a collapsing economy. The danger is
that this unearned nominal financial profit is mistaken as a sign of economic
recovery, inducing the public to invest what remaining wealth they still hold,
only to lose more of it at the next market meltdown, which will come when the
profit bubble bursts.
Hyperinflation is fatal because hedging against it causes market failures to
destroy wealth. Normally, when markets are functioning, unhedged inflation
favors debtors by reducing the value of liabilities they owe to creditors.
Instead of destroying wealth, unhedged inflation merely transfers wealth from
creditors to debtors. But with government intervention in the financial market,
both debtors and creditors are the taxpayers. In such circumstances, even
moderate inflation destroys wealth because there are no winning parties.
Debt denominated in fiat currency is borrowed wealth to be repaid later with
wealth stored in money protected by monetary policy. Bank deleveraging with Fed
new money cancels private debt at full face value with money that has not been
earned by anyone, that is with no stored wealth. That kind of money is toxic in
that the more valuable it is (with increased purchasing power to buy more as
prices deflate), the more it degrades wealth because no wealth has been put
into the money to be stored, thus negating the fundamental prerequisite of
money as a storer of value.
This is not demand destruction because decline in demand is temporarily slowed
by the new money. Rather, it is money destruction as a restorer of value while
it produces a misleading and confusing effect on aggregate demand.
Thinking about the value of any real asset (gold, oil, and so forth) in money
(dollar) terms is misleading. The correct way is to think about the value of
the money (dollars) in asset (gold, oil) terms, because assets (gold, oil, and
so on) are wealth. The Fed can create money, but it cannot create wealth.
Central bankers are savvy enough to know that while they can create money, they
cannot create wealth. To bind money to wealth, central bankers must fight
inflation as if it were a financial plague. But the first law of growth
economics states that to create wealth through growth, some inflation needs to
The solution then is to make the working poor pay for the pain of inflation by
giving the rich a bigger share of the monetized wealth created via inflation,
so that the loss of purchasing power from inflation is mostly borne by the
low-wage working poor and not by the owners of capital, the monetary value of
which is protected from inflation through low wages. Thus the working poor
loses in both boom times and bust times.
Inflation is deemed benign by monetarism as long as wages rise at a slower pace
than asset prices. The monetarist iron law of wages worked in the industrial
age, with the resultant excess capacity absorbed by conspicuous consumption of
the moneyed class, although it eventually heralded in the age of revolutions.
But the iron law of wages no longer works in the post-industrial age in which
growth can only come from mass demand management because overcapacity has grown
beyond the ability of conspicuous consumption of a few to absorb in an economic
That has been the basic problem of the global economy for the past three
decades. Low wages even in boom times have landed the world in its current
sorry state of overcapacity masked by unsustainable demand created by a debt
bubble that finally imploded in July 2007. The whole world is now producing
goods and services made by low-wage workers who cannot afford to buy what they
make except by taking on debt on which they eventually will default because
their low income cannot service it.
All the stimulus spending by all governments perpetuates this dysfunctionality.
There will be no recovery from this dysfunctional financial system. Only reform
toward full employment with rising wages will save this severely impaired
How can that be done? Simple. Make the cost of wage increases deductible from
corporate income tax and make the savings from layoffs taxable as corporate
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com.