Modeling Our Fiat World
Deflation is the only place to go from here.
In a fiat world, money is printed into existence by the central bank - the Fed, in the case of the US. Given there's nothing backing up this money, it's inherently worthless. However, one thinks of it as real.
In addition to the aforementioned money supply, fractional reserve lending allows credit to be extended by banks and financial institutions on top of that inherently worthless money. Indeed, banks and financial institutions have leveraged credit to base money at ratios of 30-1, 50-1, or even higher.
It's pretty amazing if you think about it: Credit is extended with 30-50 times leverage on inherently worthless paper.
Borrowers have to pay interest on the amount borrowed. However, the interest and the debt cannot possibly be paid back - except by an ever-expanding Ponzi scheme of lending. That scheme can last only as long as everyone believes the debt can be paid back and the market value of that debt keeps rising.
It's a faith based system in which banks extend loans and hold the credit on the books (or in many cases off the books in various structured instruments). The banks are thought of as being well capitalized as long as the value of credit on the books in relation to their reserves meets some ridiculously low minimum set by the Fed.
This is how the system works - using the term "works" loosely, of course.
Day of Reckoning
The day of reckoning comes when asset prices start falling, defaults soar, and the value of credit on the books starts plunging. That day of reckoning has arrived.
And if leverage is high enough, as it was with Bear Stearns and Lehman, the institutions are wiped out overnight. Citigroup (C), Bank of America (BAC), Fannie Mae (FNM), Freddie Mac (FRE) and AIG (AIG) are essentially in the same position that Lehman was - except the taxpayers are funding the bailouts.
Conditions today are essentially the same as during the great depression. I talked about this in Humpty Dumpty on Inflation. When I wrote that piece, I listed 15 conditions one would expect to see in deflation; the score was a perfect 15-15. I recently added a sixteenth: bank failures. Click on link to see the conditions table.
Those who stick to a monetary definition of inflation pointing at M2, M3, MZM, or base money supply, as well as definitions that involve prices are selecting a definition of inflation that makes absolutely no practical sense.
The destruction of credit -- coupled with the fact that what the Fed's printing isn't even being loaned -- is what really matters - not some Humpty-Dumptyish academic definition that has no real-world application.
I have long been arguing we're experiencing deflation, based on the following definitions: Inflation is a net expansion of money and credit. Deflation is a net contraction of money and credit. In both definitions, credit needs to be market to market.
I can express the above mathematically.
Fm = Fb + MV(Fc)
Fm = Fiat Money Total
Fb = Fiat Monetary Base
Fc = Fiat Credit, the amount of credit on the balances sheets of institutions in excess of Fb
MV(Fc) is the market value Fc
Inflation is an expansion of Fm
Deflation is a contraction of Fm
If only base money was lent out (no fractional reserve lending), MV(Fc) would equal zero. The equation ensures we do not double count credit in Fm.
MV is a function of time preference and credit sentiment (i.e. Belief that one can be paid back). As long as that belief was high, banks were willing to lend.
Because (at the moment) Fc (credit) dwarfs Fb (base money), the system can only hold together as long as there is belief credit can be paid back and as long as there are not defaults. Needless to say, the perceived belief that Fc can be paid back is under attack, both by rising defaults, and by sentiment. That's why MV(Fc) is collapsing.
In other words, the mark-to-market value of credit is contracting faster than base money is rising.
What About Deposits?
Some may point out that base money isn't the only real money out there. Deposits are real.
Most deposits are fiction, borrowed into existence via an accounting entry and repeatedly lent out with the miracle of fractional reserve lending. Moreover, savings accounts have zero reserve requirements, and the bulk of checking accounts is swept nightly into savings accounts (so that they too can be lent out).
However, the FDIC guarantees those deposits up to the FDIC limit, now at $250,000 per account. Because of FDIC it might seem that deposits up to the guarantee limit should accounted for in the above equation. One could do that by adjusting the right side of the equation to allow for FDIC guarantees. This would result in a peculiar formula of adding credit extended with 30-50 times leverage on inherently worthless paper to guarantees promised on that which does not really exit.
From a practical standpoint, however, the economy seems to be acting as if base money and FDIC guarantees are irrelevant, and the only thing that matters is the market value of credit.
Let's explore why that is using a magical printing press as an example.
Magical Printing Press
Assume for a moment you invent a magical printing press. Your machine can print hundred-dollar bills so good that the US Treasury cannot distinguish them them from the real thing. The bills are perfect in every way. Now assume you print $5 trillion worth of those bills and bury them in your back yard. Is this inflation? Surely not. Would it be inflation if $5 trillion in bills were spent and entered the economy? You bet. The key then is not how much the Fed prints, the key is how much of that money makes its way into the economy.
Please consider this audio with Austrian economist Frank Shostak, discussing recent actions by the Fed.
Will this printing create (price) inflation? This is dependent very much on what money will do next. If banks will not lend and banks sit on that cash forever and ever like the great depression because the risk is too high and the banks do not know if the lending will end up in good assets or bad assets, and because banks are in so many bad assets now they probably will not lend at all.
That's the observation that Murray Rothbard made: During the Great Depression, banks chose not to lend because the risk of accumulating bad assets was far too high. So they were sitting on massive reserves. That's what's developing right now.
A good example is what happened in Japan in 2001-2002 where the Bank of Japan pumped 300% at one stage and lending continued to collapse. I expect similar things to happen here. If lending won't increase, we can conclude this won't be inflationary.
I agree wholeheartedly with Shostak and suggest we are following the Japanese model. This has been my thesis for years.
Don't Ask, Don't Sell Policy
The Fed tries to hide the contraction in the market value of bank credit by its Don't Ask, Don't Sell policy. See Fed and BOE Bail Out Insolvent Banks for more discussion of the aggregator bank shell game and the Don't Ask, Don't Sell policy.
Many point out that base money is rising at an amazingly high rate. However, as we have seen, base money is irrelevant until the money is lent. The key issue is that the market value of credit is collapsing at an amazing rate.
This is deflation.
One can choose to say, in strict Austrian terms, that there's no deflation, because money supply is rising. However, the money supply theory falls flat on its impractical face when it comes to accurately explaining what is happening in the real world.
The inflation model simply doesn;t fit. Conditions one would expect to see during inflation, stagflation, hyperinflation, and disinflation are nowhere to be found.
The US shows 16 symptoms of deflation for the simple reason that deflation is at hand.
Confusion Due to Delays?
Steve Saville chimes in on The Inflation-Deflation Debate with a thesis that suggests there are lengthy and variable time delays between changes in the monetary trend and changes in prices.
I agree wholeheartedly with Steve on the point that the Fed can print money at will. However, getting banks to lend is another thing entirely, as the following chart of Reserve Bank Credit shows.
Simply put, the Fed cannot force banks to lend or consumers and businesses to borrow. Congress can force the issue with TARP funds and other so-called "stimulus" measures. Then again, writeoffs of bad loans are going to increase at a massive rate, especially credit card defaults and foreclosures in conjunction with rising unemployment.
What About The Lag Theory?
Saville states "a lot of confusion on the inflation/deflation issue is caused by the lengthy and variable time delays between changes in the monetary trend and changes in prices."
Another way of phrasing this would be to say that growth in credit (and prices) follows the creation of money, with a lag. This is the money-multiplier model.
Money-Multiplier Lag Theory Is False
Please consider commentary from Steve Keen's Debtwatch, Roving Cavaliers of Credit.
"Two hypotheses about the nature of money can be derived from the money multiplier model:
1. The creation of credit money should happen after the creation of government money.
2. The amount of money in the economy should exceed the amount of debt, with the difference representing the government's initial creation of money.
"Both of these hypotheses are strongly contradicted by the data.
"...If the hypothesis were true, changes in M0 should precede changes in M2.
"Rather than fiat money being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and fiat money was then created about a year later... This contradicts the money-multiplier model."
Solid evidence that credit is created first and reserves later can be found by reviewing Fannie Mae's and Freddie Mac's Financial Problems.
Steve Saville points out that recent increase in base money has been many times greater than anything during the 1930s:
Note that the pattern leading up to the great depression and the pattern before the latest spike are nearly identical. There is no other similar pattern on the chart. And most certainly the recent spike, as Saville points out, is unprecedented.
Base money is indeed soaring. However, so is debt.
US Money Stock Measures and Debt
Here are some more charts and commentary courtesy of Steve Keen's Debtwatch.
"Measured on this scale, Bernanke's increase in Base Money goes from being heroic to trivial. Not only does the scale of credit-created money greatly exceed government-created money, but debt in turn greatly exceeds even the broadest measure of the money stock-the M3 series that the Fed some years ago decided to discontinue.
"Bernanke's expansion of M0 in the last 4 months of 2008 has merely reduced the debt to M0 ratio from 47:1 to 36:1 (the debt data is quarterly whole money stock data is monthly, so the fall in the ratio is more than shown here given the lag in reporting of debt).
"To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels."
I agree with Steve Keen with regard to money vs. credit, with credit being far more important, at the present time. Furthermore, rising unemployment is only going to exacerbate the problems of imploding credit. Expect to see massively rising credit card defaults, foreclosures, and walk-aways, all on account of unemployment that is soaring.
Finally, it's important to consider the role of attitudes going forward. Attitudes affect the willingness of consumers to take on debt and banks to extend it.
1. Boomers are heading into retirement. A significant portion of their retirement plan (home prices) has already been wiped out. Another portion of boomer retirement plans is being wiped out in the stock market crash. Toy accumulation is out. Fears of insufficient saving is in.
2. Boomers will be traveling and spending less than they planned.
3. A secular shift to frugality and risk aversion in all age groups has begun. Signs are everywhere. Children who have seen their parents wiped out in bankruptcy or foreclosed on are going to have a completely different attitude toward debt than their reckless parents did.
4. The lend to securitize model at banks is dead. So are toggle bonds where debt is paid back with more debt, and a myriad of other financial wizardry schemes.
In the US, banks are afraid of being paid back with cheaper dollar - or that they won't be paid back at all. Cash is being hoarded by banks and consumers alike. This is the opposite of what happened in the Weimar Republic and what's happening now in Zimbabwe.
Global Stimulus Kicker
There's yet another kicker to this model: the Eurozone, the UK, Japan, and virtually every other country worldwide are all attempting some sort of stimulus plan or other. This is bound to cause a major distortion at some point, as no country has anything remotely close to an exit strategy for this. What kind of distortion and when cannot be certain, because we are indeed in uncharted territory worldwide.
Political Will vs. Consumer Psychology
What happens next depends somewhat on the political will of the central banks and politicians. However, it depends more on the psychology of the borrowers. If consumers and businesses refuse to spend and instead pay back debts (or default on them along with rising unemployment), the picture simply is not inflationary, at least to any significant decree.
The credit bubble that just popped exceeded that preceding the Great Depression, not just in the US but worldwide. It's unrealistic to expect the deflationary bust to be anything other than the biggest in history. Those looking for hyperinflation -- or even strong inflation -- are simply looking at the wrong model.
At some point the market value of credit will start expanding again, but that is likely further down the road, and will be weaker in scope than most think.
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