Deflation vs Hyperinflation after QE2 the debate still rages.
Let us delve into this topic and lay out a course of where the economy might head in the next several years.
Defining the terms
Before we begin let us define the terms, because there is a good chance that many people, depending on which economic school they come from might have different definitions.
Inflation - Increase in money supply and credit, not price. Credit is expanded via the Federal Reserve and the Fractional Reserve Banking of the banks. Will explore in detail below.
Price Inflation - A specific sector increase in prices, as a result of inflation.
Hyperinflation - A societal and cultural event where people lose confidence in the currency. This forces increased consumption as a means of protecting one's holdings resulting in dramatic price increases. This in turn results in printing to keep up with the prices. Ends in either abandonment of currency or significant reform.
Deflation - Opposite of Inflation.
Price Deflation - Opposite of Price Inflation.
What is happening now?
OK, this one is a bit tricky and can be answered in an easier fashion by asking, what was happening up to a few years ago? Answer: We had extremely significant inflation and price increases. This was achieved by low interest rates, a willingness to lend and a willingness to borrow. The reason for this kind of environment resulted in relaxed lending policies of the Federal Reserve after the DotCom bubble burst. In 2007-2008, the willingness to both lend and borrow quickly diminished resulting in deflation and a broad price deflation across housing, stocks and commodities (oil, metals, food).
Once again Ben Bernanke a "student of the Great Depression" and hopeless Monetarist, decided to intervene one more time. Through a combination of zero percent interest rates, TARP, emergency lending vehicles, swaps and QE1 he expanded the money supply. This is where the details matter quite a bit. Yes, Bernanke expanded the money supply, but there was one thing missing - credit. Let us look at a few charts, because charts are fun! The following is a chart of some popular money supply measures. It is not important to understand the definitions, just that they measure some combination of money in the economy (not credit).
Some things worth observing. Just how rapidly the money supply expanded starting in 2000 up until now including the past 2 years. And the fact that the MZM had an unprecedented dip down since it's inception. Still, through the efforts of our illustrious Fed Chairman, it would appear that the money supply is continuing it's march upwards. It now sits at just under 9-10 Trillion. (M1 is roughly currency in circulation)
But of course there is another component to our economy, credit. Presenting, below, America's livelihood:
Disturbed? You should be! This is our economy, in a nutshell, pretty pathetic. To say that we are a credit nation is a bit of an understatement. This graph can be best described, as unsustainable, despite all the machinations of the crooks at the Federal Reserve. But of course one thing should jump out as obvious, the parabolic ascent has stopped and in fact reversed. For the first time in 60 years, even as as it sits at a whopping 50+ Trillion!
The money supply is the foundation that allows for the expansion of credit. Credit flows into the economy and creates price inflation. Critical to understand. Whether you bought a TV with cash or a credit card, you still bought it and the merchant got paid, right? If demand exceeds supply, prices rise, regardless whether this demand was fueled by cold harsh cash or credit. The merchants do not care.
What we are seeing now is the slowdown of credit. This is the crux of the problem. The consumer (you) and the banking system (them) feel for whatever reason that no more credit can be created. A broad explanation and one that we covered previously, the economy is saturated. There are only so many houses, cars, TVs, computers, smart phones, clothing and junk one can purchase. Furthermore as unemployment rises and the ability to payback loans diminishes banks become unwilling to lend. This causes businesses of all sizes to contract and/or go out of business. This causes deflation.
We are now in a cross-current of deflation and inflation. Where the financial sectors and household have given up and the last major borrower is now the Government. One last credit graph showing the Financial Sector contraction, household contraction and government expansion.
These are subsections of the 50 Trillion in total credit, representing almost 75% of total credit outstanding. So let's take a look at how Fractional Reserve Banking allowed for this expansion in credit.
Fractional Reserve Banking.
We live in a society of fiat (paper) money and a banking system that can grow credit through a term called fractional banking. This essentially means that a large sum of loans can be generated on top of a very small number of actual dollars provided a small reserve is kept. Depending on the school of economics, one might accuse this system of counterfeiting or one might accept this system as acceptable.
Here is how it works:
The major variable is the reserve requirement. That is, what percentage of the deposit must remain on the books. With a 10% reserve requirement, Bank A can loan out $90 from an initial deposit of $100. Bank B can then loan out $81, so forth and so on. As you can see, by the time $100 starts in our banking system it can turn into $900! Now imagine several hundred billion starting at the top of the banking chain, at the Fed. As this trickles down to the Commercial banks, county banks, regional banks, community banks, etc this sum can balloon into trillions of dollars. As you saw in the total credit chart, it did. If the interest rate on the loans are manageable, then people consume this credit and purchase. This creates a very happy chain of banks getting paid interest, businesses selling their wares and consumers enjoying a higher standard of living. Unfortunately this expansion cannot sustain itself because as we discussed up above, there will come a time when consumption has to stop and doing so will unravel the entire happy chain.
Although our banking system technically operates using 10% reserves, this varies dramatically on the type of bank, type of deposit and Federal Reserve rules. Please consider reading the following material which explores how the Federal Reserve through various schemes lowered the reserve to virtually 0%! As you can see from the above graph, the difference between 10% and 0% can result in a significant increase in total credit. This would also explain how America managed to create, in just 20 years (from 1990) almost 35 Trillion in credit!! The reserve requirement plays a major role.
The Great Depression and the Great Recession
What happened in the banking system in the 1920s, leading up the great Depression is precisely what has happened in our modern banking system over the past 40 years. Although public schools have completely dropped the ball in explaining the Great Depression, Milton Friedman found the explanation behind the Great Depression. He accurately explained that the Federal Reserve contracted the money supply and thus brought about a major deflation, which resulted in bankruptcies, unemployment and misery (We can see now why a major credit contraction can be disruptive). Ben Bernanke is a disciple of Milton Friedman and that particular school of economics known as Monetarism. The problem with Monetarism and Friedman is that for all the wonderful and sometimes ingenious endorsements of the free market, Friedman was still a Keynesian at heart. He therefore concluded that it was the contraction to blame and has stigmatized the term deflation from that day forward.
What Friedman missed and what Murray Rothbard understood, it was not the contraction that caused the Great Depression, it was the expansion! The very same expansion that we are living through now. In fact, Rothbard argued quite effectively in his must-read book, America's Great Depression, that the Fed did not actually contract at all despite Friedman's claim to the contrary. In fact, the Fed tried to expand further, but was overwhelmed by market forces. It is Bernanke's views that the Fed in the 1930s simply did not expand enough.
There was a catch in the 1920s, a limitation to the powers of the Federal Reserve. This catch was gold. Every single dollar issued had a certain amount of gold that backed it or at least such was the claim. Each holder of paper dollars could go to any bank and demand payments in specie (get their gold back). Since money *has* to have value, the system worked as long as the issued paper could be exchanged for value. People exchanged their paper dollars for gold when they got worried about the economy and if the worry was contagious it resulted in a run on the bank. Previously through the 1800s whenever this happened, it resulted in banking panics where everyone scrambled to collect their gold. Because banks issued paper money in excess of their gold holdings on a regular basis, bank runs were common and so were bank bankruptcies. Many historians and public educators to this day blame the system, not the expansion of paper money for these bank runs.
The Federal Reserve was supposed to prevent banking panics, though a system of regional reserve banks (12 around the country) throughout the nation to act as the lender of last resort. But in the 1920s, the credit expansion was so dramatic that the deflationary forces of people pulling their money just 9 years later overwhelmed the system resulting in the shutdown of the Fed!
Some would look at this and blame the gold for this event, but that is an incredibly shortsighted conclusion. Gold, or value, was the great decider and only because, not in spite of, was the great expansionary credit boom brought to a halt. I encourage you to explore more on the matter and discover how Benjamin Strong of the New York Federal Reserve teamed up with the English central bank and engaged in a coordinated inflation scheme to prevent gold outflows. Two men tried to outsmart the forces of the market and created one of the most earth shattering events in American history. Here I would like to make an important historical mention. The Fed started in 1913 and so did the monetary expansion. But the Great Depression's expansion began and created the Roaring 20s, because the first 7 years of credit expansion were wiped out in a nasty Depression. The 1920-21 Depression purged the excess credit and was the last time that the Government did not intervene in a credit bust caused by the Central Bank.
So why is this relevant? Because in 1971 Richard Nixon dismantled the last semblance of our gold standard, which was not really a standard at all. The system of Bretton Woods only allowed foreign banks to collect gold, predictably they began doing just so when the inflationary forces of America spilled over in Europe. Since then our currency's value has been non-existent and is strictly imbued with value by the backing of the United States Government. This is extremely convenient for the Fed because it allows him to act as the lender of last resort with ease and not worry about paying out in actual value. It allows for unbridled credit expansion as the State looks on approvingly - it is in full control.
Yet credit and debt is not wealth. It is just an illusion. You can certainly take out a huge loan and buy a fancy car, TV, jewelery, etc and one would think you are quite wealthy, but you are not unless you have the means to pay this debt. America has been on a credit cycle for a long time. Yet although the Fed can act as a lender of last resort, he cannot prevent credit from vanishing. He cannot prevent defaults. Understanding this is the heart of the debate. Because contraction of credit is the very same deflation that brought about the Great Depression Ben Bernanke the student of Milton Friedman will try do everything in his power to prevent it.
Credit Contraction
When banks make loans they demand collateral and a failure to pay results in the confiscation of this collateral, this is the value behind the loan. Fail to pay a mortgage? Lose a house. Fail to pay a car loan? Lose a car. Default on your loans and lose your credit standing. But what happens when the collateral loses value? If a bank issued you a 500,000 mortgage three years ago, but your house is now worth 300,000, what happens? Very simple - 200k just went up in smoke. Scroll up, look at the total credit chart. See that hook? That hook represents credit vanishing. The illusion of our wealth is starting to hit home, literally. This is despite fancy accounting rule changes that to this day is allowing banks to pretend their collateral has not lost value.
From another perspective, as you observe the contraction of credit below, think about what happens when the ability to pay one's debt disappears. Confiscation of collateral by the banks will immediately lead to lower prices. If for example a bank foreclosed on 1,000 properties, the next step would be to auction these properties to those willing to buy and this will invariable lead to lower prices, a lot lower because the original purchase price was never based on a real market condition in the first place. Additionally the consumer's inability to buy additional goods will create surpluses in the economy leading to price deflation.
This cycle of credit expansion and contraction is similar to the expansion of paper money on top of existing gold supplies. The Fed's major response to any kind of credit contraction since the 1980s has been to expand more credit. Look at the crash of 1987, Recession of 1990s and the Recession of 2000. All have been met with identical responses; lower interest rates and liquidity. Each time it has worked at the expense of diluting and destroying the value of the currency. Each time a credit expansion took place, it covered up the losses of the previous. The real contraction after the DotCom bubble never took hold, because Gerenspan prevented it from doing so. Not this time.
As you can see from the charts, the sheer amount of credit is not just the 800 lb gorilla, it is the 5000lb woolly mammoth that ate the gorilla. Ben Bernanke has exhausted his arsenal. We are at zero percent interest and even a 1.25 Trillion dollar purchase of bad loans (QE1) failed to inspire another credit expansion. That is to say, credit is being destroyed faster than our Fed can hope to create it! The consequence of Bernanke's action has resulted in asset bubbles, thus creating distortions in the commodity, currency and equity markets. But these distortions have no underlying fundamental reasons behind them and are doomed to fail. So now the Fed has turned to the one last sector of the economy that is willing to accumulate credit with the hope that a new credit expansion cycle will begin. While the attempt is silly and desperate, it is fraught with danger.
Deflation or Hyperinflation, the dark horse.
Not to burst Bernanke's credit bubble, but he will be unable to stop the 50 trillion dollar credit avalanche from falling, because he can't prevent defaults. But he can certainly prevent the default of the Federal Government (FG), at least in theory.
Right now our FG is borrowing about 80 billion a month to operate it's expenses. In about 6 or so months, the debt ceiling will be reached. Congress will vote on whether to breach this limit again and allow for additional borrowing. This borrowing is now falling exclusively on the Federal Reserve and the banks. Just like the Fed would act as the lender of last resort for a failing bank, the Fed is now acting as the lender of last resort to the spender of last resort. Each time the Fed extends a loan to the FG, we as Americans get taxed, through the debasement of our currency. The debate boils down to one simple question. Will the FG neutralize the contraction of outstanding credit and/or exceed it? As it stands, it cannot because the current debt holdings of the FG comprise only 15% of the total credit.
In other words, the newly announced QE2 the 600 Billion dollar "loan" is just 1% of the total debt.
This means that the destruction of credit will exceed the pace of the newly created money and will result in deflation, not that I am encouraging this reckless behavior.
But there is a catch. As of 2010, our FG has spent 3.4 trillion dollars. 1.5 Trillion of that is the deficit (borrowing). 190 billion of that are interest payments. In order to prevent a default, America simply has to pay the interest.
By 2015 the US Government has projected interest payments to be 571 Billion. Failure to pay the interest will result in a default and a default by a sovereign nation is price inflationary. Because paper money only has value through the backing of the Government issuing the money, a default by the Government destroys the value and the purchasing power of the dollar.
This projection is based on the amount of money borrowed and most likely interest rates at that time. An extremely difficult projection to make because it completely depends on the economy and the amount of taxable income. Additionally the Government understands that using the Fed as the lender of last resort will eventually cause the bond market to sell off, this will in turn raise interest rates and payments. So within a few short years the interest payment could double or triple. This will further increase the deficit if there is no increase in revenue. A vicious circle could arise.
But like I said before, unlike the banking system that we have no control over, Congress can stop this. By sharply and dramatically reducing the deficit the need to borrow large amounts drops and the possibility of a default diminishes. The difficulty arises with the fact that the government is the spender of last resort and so cutting spending will invariably result in higher unemployment, bankruptcies and welfare payments. Yet a refusal to do so raises the need to borrow thus placing the entire solvency of the US in danger.
What to look out for.
In conclusion, America as a whole is heading towards deflation. The sheer amount of impending credit default is not stoppable. However the dark horse is our Federal Government. If Congress continues to turn to the Fed for borrowing, the bond markets should respond by raising interest payments. Interest payments will further put the urgency of cuts upon Congress. Failure to do so could potentially trigger a very serious situation, where the government borrows money just to pay the interest. If this happens, it will be the beginning of the end of our current solvency. At that point investment strategies should change from a defensive cash position, to an accumulation of precious metals for protection. Rest assured, there will be time to react.
Even in that scenario I still believe that no hyperinflation will occur, but a default becomes much more likely. A default, just like a structured bankruptcy can pave the way for a recovery - whereas hyperinflation spells the end for everyone in power and civil unrest.
It would finally provide the opportunity for the impotent Congress to admit, once and for all, that programs like Social Security, Medicare, Medicaid and a military spanning the entire world are impossible to sustain. Perhaps it will serve as the wake up call for so many Americans of why we can't have valueless money, why the Federal government cannot bail everyone out, why we cannot have a central banking system, why States should be doing the bulk of the spending and why the Founding Fathers were so damn right.
Comments
Post a Comment