Deflationist Karl Denninger Praises Keynes, Rejects Hard Money, and Says Mises and Rothbard Lost the Argument on Inflation.

Gary North

Dec. 29, 2009

Some people learn best by reading a detailed critique of a line of reasoning that is wrong. If this line of reasoning is also popular, all the more reason to critique it.

Other people think, "I don't have to eat a whole rotten apple to know that it's rotten." These people get bored with long, detailed critiques on obviously -- to them -- preposterous arguments. "Why kick a dead horse?"

I am writing this for the first group. The others can skip it.

Yesterday, I published a detailed critique of Karl Denninger, a deflationist. I classified him as being part of the hard-money camp. I also said that he advocates a bizarre form of Keynesian economics -- as do all deflationists. This bizarre theory teaches that there is no escape from massive price deflation. The Federal Reserve System can do nothing to avoid this. Keynes at least thought government spending could avoid it. Not today's crop of deflationists.

In his reply to me, Denninger explains that I got him all wrong. He is not a hard-money advocate. He wrote: "Among other things I'm not a 'hard money' guy; I have never advocated such."

My apologies to him. I made this mistake because he is quoted widely on pro-gold sites. There, he is perceived as an expert on on the economy. I therefore retract my categorization of him as a hard-money man who has ignorantly adopted a bizarre form of Keynesianism.

He is, however, an economic illiterate who has adopted a bizarre form of Keynesianism. Never having read the Austrian School economists, he dismisses them as conceptual losers who do not know how to define inflation.

As you will see, arguing with Karl Denninger is like punching your fist into a bowl of Jello. But I will examine his response to me line by line, just to show readers how the man argues.

I do this for these reasons:

1. He has a Web reputation as an expert on money.
2. His arguments are representative of deflationism generally.
3. I want my readers to see how weak these arguments are.
4. He thinks Keynes was wiser than Ludwig von Mises.

DENNINGER DEFENDS KEYNES

North seems to be unaware that Keynes called for governments (and central bankers) to inexorably rebuild their Treasuries (that is, stuff 'em full of actual savings) during times of economic prosperity, thereby allowing them to spend that excess to level out recessions.

That was Keynes' position. He died in 1946. His disciples universally have refused to call governments to use tax revenues to purchase national debts. Keynes' most prominent biographer, who generally supports Keynes over Hayek, has conceded this much.

On the other hand, Hayek was right to point out -- after Keynes's death -- that, by destroying the rules which restrained government economic intervention, Keynes had opened the door to a hubristic form of Keynesianism which took no account of Keynes's own self-imposed limits.

Denninger adds:

Nobody bothers with that part of Keynes theories -- but that doesn't negate them. Quite to the contrary; they are the essence of Keynes' economic principles: the application of counter-cyclical forces to the markets by governments (and by extension central bankers); a beautiful principle in theory but one never practiced in the history of the markets.

When an economist or anyone else proposes a theory that no one bothers with, including his disciples, this negates the theory, if it was proposed as a guide to policy. Keynes' theory was a guide to policy. He was the chief economist for the British Treasury. He was an adviser for the Bretton Woods meeting that drew up the plans for the International Monetary Fund.

He goes on:

Keynes economic theories are mathematically able to be proved correct.

First, no one has offered such proof. Second, there is very little mathematics in his theory. Third, his theory is wrong. Stating an incorrect theory in simple mathematical form does not make the theory accurate. It just impresses the gullible.

That's irrelevant since there is no government, now or ever, that will implement them as-written. As a consequence arguing over the validity of Keynes theories is akin to arguing over whether Christianity is a valid religious path while taking a big fat Sharpie Marker to the 10 Commandments!

If Denninger thinks this is a sound, relevant argument, then he is a lot less sharp than that Sharpie Marker than his followers imagine.

He is saying that it is irrelevant to argue over Keynes theories -- the theories of the most influential economist of modern world, whose ideas undergird the entire world economy.

This is to intellectual integrity what horse apples are to apple butter.

HIS ATTEMPTED REFUTATION

He quotes me:

The deflationists have taken Keynes' argument one step beyond. They say that we are about to enter an economy in which lenders will not lend at any price. Friedmanite inflation will not save the capital markets this time. Borrowing from the FED will not help. Nothing can prevent a deflationary collapse, because bankers will not lend, and borrowers will not borrow, at any price.

In short, price -- the interest rate -- does not allocate capital. This is Keynes' argument, re-packaged for hard-money investors. Sadly, a lot of them are buying it. They don't understand where it came from.

Then he adds: "It is here that North completely flies off the rails into the realm of pure fancy."

The issue is not whether interest rates allocate capital (they do), it is what happens when the marginal productivity of debt disappears.

The marginal productivity of debt is irrelevant if the Federal Reserve System is willing to monetize this debt. This is what Denninger and all other deflationists do not understand. This is the essence of their blindness -- ever since 1933.

He goes on:

To review, there are three uses of borrowed funds:

Productive: The use of borrowed funds to purchase something such as a CNC machine that then produces more in output than it's acquisition cost (including interest) over the lending term. The net GDP contribution to such lending is positive.

Consumptive: The use of borrowed funds to purchase something that is consumed (housing, food, etc.) While there may be productive components to consumption this use of borrowing is differentiated from the first by the primary character of the consumed good or service.

Denninger comments: "That is, only the first use of lending is productive for society as a whole." Wrong! There is nothing necessarily unproductive about consumer debt. But he denies this.

That he does not understand free market economics is obvious. He thinks people reduce wealth when they consume. But free market economic theory teaches that people gain their goals when they consume. They must consume. If you stop consuming, you die.

He then gives use #3 for borrowed funds.

Ponzi: The use of borrowed funds to purchase an item that has as the essence of ownership the intent to sell to someone else at a higher price. The purchase of stock in the open market (but not in an IPO) is in this category; the company gets no tangible benefit from this transaction, and the intent of the purchase is simply to sell to a "bigger sucker." The same is true for a home purchased with the intent to flip it, not live in it, or where the intent is to extract equity to spend on consumer goods (the essence of the transaction is that it is able to be completed as agreed only if the "price" of the house rises.)

Denninger opposes Ponzi schemes. Good for him. So do I. But the question is this: Can the central bank keep them going if it is willing to destroy the currency? The answer is yes.

His list is woefully incomplete. Let me suggest some additional uses of borrowed funds, as illustrated by the U.S. government, the #1 borrower on earth. The borrowed funds can do the following:

1. Serve as the legal backing for a nation's currency.

2. Fund government boondoggles of all kinds.

3. Bail out big banks, big companies, and big labor unions.

4. Inflate the currency to keep big banks from going bust.

5. Stimulate the economy to become a boom.

A central bank-funded boom can keep the Federal government's Ponzi schemes going, decade after decade, generation after generation. It has done so. The price for this policy is rising consumer prices and the misallocation of capital. This is what we Austrians have been saying ever since Ludwig von Mises wrote The Theory of Money and Credit (1912). But Denninger does not mention any of this.

If the Federal Reserve ever decides not to continue to fund the U.S. Treasury, and if it stops buying all other debt, there will be a depression and deflation. This is not the issue. Here is the issue: Can the FED inflate even more, thereby avoiding deflation until black market money and barter replace the official currency unit? The Austrians say yes. The deflationists say no.

Austrian economists have 75 years of evidence that they are correct regarding Federal Reserve policy. Deflationists have one year, 1955, when prices declined by 1%. Take your pick.

DENNINGER MUDDIES THE WATERS

He tries to move the issue away from the central issue, namely, "Is price deflation inevitable?"

The issue is not whether interest rates allocate capital, it is whether and how the balance of activity with lent funds changes -- and whether those activities are of net benefit to the economy.

This has nothing to do with the question at hand, namely, whether price deflation is inevitable because of imploding debt. He has shifted to a side issue for the deflationists' case: net benefits to the economy. The issue is whether the FED can continue to raise prices by debasing the dollar. That was what my original critique was all about. He refuses to deal with this issue.

This is because he cannot deal with it.

North, having failed to make his primary case, then turns to the ridiculous to try to buttress a lost argument:

He begins with a crucial error. It is the same error that misleads Keynesians and Chicago School economists. He defines inflation incorrectly.

I see. I cling to a lost argument. Poor Mises. Poor Rothbard. They lost the argument. They did not know how to define inflation. But Denninger knows the right definition. It is what Keynes and Friedman said it is.

You think this man isn't misled? You think he isn't standing on the shoulders of pygmies?

He continues:

(Me) - Now remember: The definition of "inflation" in the monetary sense is the growth of money beyond the growth in goods and services. Deflation is the opposite.

This is the standard Chicago School/Keynesian definition. It conceals central bank policy as the source of the boom and the bust. It fails to alert investors that malinvestment is taking place. On this, see Rothbard's book, America's Great Depression (1963).

He adds: "What part of reading comprehension did North fail? Inflation is the increase in 'money' beyond output." Yet, so far, he has re-stated exactly what I said he says. He says it clearly. He's wrong, but he says it clearly. He is a Keynesian in drag.

Then he critiques the Austrians.

The Austrian School (and Mises) look at a statis system in terms of output and then define inflation in terms of that. This is a perfectly legitimate exercise for academic purposes but of course output is never static.

This man is -- how can I put this politely? -- conceptually challenged. The heart of the Austrian School's unique approach to economic theory is that it does not look at a "statis system." [Note: the word "statis" is not in an dictionary I know.] Austrian economic theory categorically denies the existence of any such "statis". Austrians break with the entire system of "static" economics, whether neoclassical or neo-Keynesian. Austrians rely on a theory of entrepreneurship: men's attempts to overcome the inherent uncertainty of economic life -- the antithesis of "statis."

This is news to Denninger. If he knew what he is talking about, it wouldn't be.

Yet he writes with such confidence, such authority! It is confidence based on ignorance.

The error that North (and most of the rest of the crooners make) is to define "money" for the purpose of inflation (or deflation) in terms of Mx, where "x" is whatever you choose -- M1, M0, M', M2, M3, whatever.

That's wrong and it takes an extreme level of willful blindness to continue to tout that which every person in the United States and indeed the Western World knows for a fact from their personal experience is wrong.

No rhetoric here, of course. He says I am willfully blind because I deny what "every person in the United States and indeed the Western World knows for a fact from their personal experience." Right. Every person. In the whole world.

I used to be a debater in high school. We were taught this rule: "If the opponent uses rhetoric to advance his argument, you're in trouble. If he uses nonsense to cover his lack of argument, he's in trouble."

Denninger is in big trouble.

However, I accept this critique: as a fan of Bing Crosby, I don't mind being called a crooner.

DENNINGER'S EXPLANATION OF MONEY

He continues to attack my view of M-1 as the most accurate definition of money for forecasting consumer prices.

I'll prove it right here and now for you.

Go get your wallet and value every item in it for its maximum purchasing power -- that is, what you could spend right now should you choose to do so.

If you're like most people there is a small amount of paper currency. Perhaps $100 or so?

You probably have an ATM card in there that is also a debit card. That is, you can spend the entire contents of your checking and/or savings accounts using that electronic piece of plastic.

But you also probably have in there one or more credit cards which provide you access to many times the amount of money you have in your checking and savings accounts. Right now, right here, on (your) demand.

So what is the supply of money?

It is in fact that which you both can and will borrow plus the total of your actual stored funds.

The supply of money is what I can and will borrow. Oh, yes, there are are stored funds. He glides over these stored funds. They are called bank accounts.

But what happens to money if I will not borrow it? Why, it goes into money heaven, I guess.

Money is money because it is in a bank account, whether or not anyone spends it. By holding it, the deposit owner has spent it. It is a backed by a debt. Someone has borrowed it from the depositor's bank.

This man is really without any understanding of money. The more you read, the more this becomes clear.

Is his confusion clear to you? I hope so.

As I have repeatedly stated: When you put forward a false premise as the foundation of your argument everything you do from that point forward is wrong.

You've got it, Karl!

Now let's examine the rest of North's premise:

On the contrary, there was no price deflation occurring. That is why the CPI rose. Yes, rose. The deflationists have kept predicting a fall in prices (CPI), and they have been wrong.

Oh really? So now we turn to an intentionally-cooked number that excludes the largest single component of every person's spending - housing - from influencing its reading - and then claim that "CPI rose"?

That's ridiculous.

Let us follow his argument. When the Consumer Price Index says that his prediction of rising prices last year was wrong -- and has been for 75 of the last 76 years -- then this number is "intentionally-cooked." This means that he can make his always- wrong prediction year after year, and when it does not come true, he can blame it on cooked numbers.

This is not logic. This is desperation.

"THE CPI DOESN'T COUNT!

What does his prediction of deflation mean, if not a declining CPI or similar index of all national consumer prices? It means nothing. It means he can predict deflation, and when it is not confirmed, he can say his prediction was accurate; it's the index that's wrong.

Heads he wins; tails, his critics lose -- in his fantasy world, anyway. Not in yours or mine.

Next, he appeals to a "true" index, not the crummy CPI, which keeps showing that his prediction was wrong. He appeals to housing.

Housing expense is typically 30 to as high as 50% of one's after-tax income. It is the single largest line item on virtually everyone's personal balance sheet. The price of houses has fallen by double-digit percentages in the last two years; in some parts of the country, like SW Florida, you can now buy a house for $50,000 that in 2005 sold for $500,000!

He speaks of "the price of houses." Which houses? He means a price index of houses. There are lots of these indexes. The government does not publish such a list. Statisticians guess about the price of houses because different neighborhoods and different regions are . . . you won't believe this . . . different!

Here is how he argues. (1) When the broad-based number (or numbers - - I prefer the median CPI) says "inflation," he says it is cooked. (2) When he picks an asset class that has declined in price, that's the real McCoy. So, his prediction of deflation cannot be disproved in his universe.

This is not logic. This is putting the shuck on the rubes.

CPI-U (or any of the other CPIs) willfully and intentionally ignored this on the way up in the housing bubble. They now ignore it on the way down.

This is outrageously dishonest and so is basing an argument on anything reported via CPI.

You decide who is willfully dishonest.

He then says that the government's statisticians have changed the CPI formula since 2007. He offers no proof.

If we went back to how CPI was computed before the government tampered with it (post-Carter) we would have seen double-digit inflation rates for the period from 2000-2007. Why? Because housing was rising at double-digit rates and that, plus the rest of prices, would have resulted in a CPI print in the teens.

But in 2008 and 2009 we would have seen massive negative CPI prints -- that is, price deflation -- for the same reason.

Why did the government change the reporting rules?

Simple: they are complicit in the bubble game but more importantly entitlement payments are linked to CPI; with an honest CPI Social Security would have instantaneously exploded in the 1990s and 2000s. They therefore changed the rules to exclude where the inflation was showing up -- which not coincidentally now excludes where the DEFLATION is showing up!

Where is the proof? Where is there evidence that the formula was been changed in 2008? I am aware of no such alteration.

The rest of North's sophomoric attack is unworthy of digital ink.

Which is to say, he cannot answer me.

For that reason I will stop here, and strongly suggest that anyone relying on someone's "analysis" that includes in their claims changes in "CPI" change horses now -- you're going to be bankrupted following the so-called path put forward, and that's a certainty.

What is a certainty is that Karl Denninger does not understand economics.

CONCLUSION

Denninger has made it clear that he is not a hard-money advocate. He has made it clear that he favors the economic theories of John Maynard Keynes.

If anyone in the hard-money camp wants to take this man seriously, that is his business.

If other deflationist spokesmen want to rely on Denninger to carry their intellectual water, I say, "you deserve him."

Karl Denninger has erroneously predicted price deflation for years, and then he dismisses as irrelevant the consumer price index, which shows that his prediction, and the same prediction by his predecessors, has been wrong for 75 out of 76 years.

He has not got the facts on his side. He has not got economic theory on his side. All he has is a vision of Keynes as a really first-rate economist, but whose ideas are not worth arguing about, because no nation has ever followed his real policy recommendations.

If this is the best that the deflationist camp can produce, we inflationists are safe.

It amazes me that anyone with so little understanding of economic theory could gain readers looking for economic wisdom. But the Web is open to all-comers, and the degree of economic ignorance by the general public is immense. Denninger makes lots of noise, rhetorically speaking. This impresses people with little economic knowledge. The fact remains that he doesn't know what he is talking about on money, banking, and prices.

If his arguments make no sense to you, then you are immunized. If so, then my efforts have not been wasted.

I am not here to persuade Denninger. Logic has no effect on him. Neither do facts. I am here to keep you from getting fooled by a man who does not know what he is talking about.

Denninger reminds me of a toy clown I had as a child. It was inflatable plastic. It had sand in its base. It kept smiling. No matter how many times I hit it, it bounced back, smiling. Then, one day, it popped. It deflated -- rather like what Denninger says will happen to prices. I tossed it out. But I never forgot how much fun it was for a while -- though fruitless.

[Beating up Karl Denninger is about as challenging as beating up a kid in the Special Olympics. After you do it twice, it does not prove anything to do it again in full public view. It might even gain sympathy for him. That is not my goal. So, I will post any future responses to him -- if he chooses to continue this exchange -- in the Articles department. I will not waste my subscribers' time by posting them in the Latest Articles section on the Home page. Google will pick up my replies, if any are required. That is enough for me.]