The nightmare after Christmas

Christmas motive

Image by 10incheslab

 The pathetic state of the global financial system was again on display this week. Stocks around the world go up when a major central bank pumps money into the financial system. They go down when the flow of money slows and when the intoxicating influence of the latest money injection wears off. Can anybody really take this seriously?

On Tuesday, the prospect of another gigantic cash infusion from the ECB’s printing press into Europe’s banking sector, which is in large part terminally ill but institutionally protected from dying, was enough to trigger the established Pavlovian reflexes among portfolio managers and traders.

None of this has anything to do with capitalism properly understood. None of this has anything to do with efficient capital allocation, with channelling savings into productive capital, or with evaluating entrepreneurship and rewarding innovation. This is the make-believe, get-rich-quick (or, increasingly, pretend-you-are-still-rich) world of state-managed fiat-money-socialism. The free market is dead. We just pretend it is still alive.

There are, of course those who are still under the illusion that this can go on forever. Or even that what we need is some shock-and-awe Über-money injection that will finally put an end to all that unhelpful worrying about excessive debt levels and overstretched balance sheets. Let’s print ourselves a merry little recovery.

money raining down on umbrella

Image by Salvatore Vuono

How did Mr. Bernanke, the United States’ money-printer-in-chief put it in 2002? “Under a paper-money system, a determined government can always generate higher spending…” (Italics mine.)

Well, I think governments and central banks will get even more determined in 2012. And it is going to end in a proper disaster.

Lender of all resorts

Last week in one of their articles on the euro-mess, the Wall Street Journal Europe repeated a widely shared myth about the ECB: “With Germany’s backing, the ECB has so far refused to become a lender of last resort, …” This is, of course, nonsense. Even the laziest of 2011 year-end reviews will show that the ECB is precisely that: A committed funder of states and banks. Like all other central banks, the ECB has one overriding objective: to create a constant flow of new fiat money and thus cheap credit to an overstretched banking sector and an out-of-control welfare state that can no longer be funded by the private sector. That is what the ECB’s role is. The ECB is lender of last resort, first resort, and soon every resort.

Let’s look at the facts. The ECB started 2011 with record low policy rates. In the spring it thought it appropriate to consider an exit strategy. The ECB conducted a number of moderate rate hikes that have by now all been reversed. By the beginning of 2012 the ECB’s policy rates are again where they were at the beginning of 2011, at record low levels.

So why was the springtime attempt at “rate normalization” aborted? Because of deflationary risks? Hardly. Inflation is at 3 percent and thus not only higher than at the start of the year but also above the ECB’s official target.

The reason was simply this: states and banks needed a lender of last resort. The private market had lost confidence in the ability (willingness?) of certain euro-zone governments to ever repay their massive and constantly growing debt load. Certain states were thus cut off from cheap funding. The resulting re-pricing of sovereign bonds hit the banks and made it more challenging for them to finance their excessive balance sheets with money from their usual sources, not least U.S. money market funds.

So, in true lender-of-last resort fashion, the ECB had to conduct a U-turn and put those printing presses into high gear to fund states and banks at more convenient rates. While in a free market, lending rates are the result of the bargaining between lenders and borrowers, in the state-managed fiat money system, politicians and bureaucrats define what constitutes “sustainable” and “appropriate” interest rates for states and banks. The central bank has to deliver.

Eurotower in Frankfurt

Unlimited Euros!, photo by Florian K.

The ECB has not only helped with lower rates. Its balance sheet has expanded over the year by at least EUR490 billion, and is thus 24% larger than at the start of the year. This does not even include this week’s cash binge. The ECB is funding ever more European banks and is accepting weaker collateral against its loans. Many of these banks would be bust by now were it not for the constant subsidy of cheap and unlimited ECB credit. If that does not define a lender of last resort, what does?

And as I pointed out recently, the ECB’s self-imposed limit of EUR20 billion in weekly government bond purchases (an exercise in market manipulation and subsidization of spendthrift governments but shamelessly masked as an operation to allow for smooth transmission of monetary policy) is hardly a severe restriction. It would allow the ECB to expand its balance sheet by another EUR1 trillion a year. (The ECB is presently keeping its bond purchases well below EUR20 billion per week.)

Deflation? What deflation?

It is noteworthy that there still seems to be a widespread belief that all this money-printing will not lead to higher inflation because of the offsetting deflationary forces emanating from private bank deleveraging and fiscal austerity.

This is an argument I came across a lot when I had the chance in recent weeks to present the ideas behind my book to investors and hedge fund managers in London, Edinburgh and Milan. Indeed, even some of the people who share my outlook about the endgame of the fiat money system do believe that we could go through a period of falling prices first, at least for certain financial assets and real estate, before central bankers open the flood-gates completely and implement the type of no holds barred policy I mentioned above. Then, and only then will we see a dramatic rise in inflation expectations, a rise in money velocity and a sharp rise in official inflation readings.

Maybe. But I don’t think so. I consider it more likely that we go straight to higher inflation.

The deleveraging in the banking sector is the equivalent of austerity in the public sector: it is an idea. A promise. The reflationary policy of the central bank is a fact. And that policy actively works against private bank deleveraging and public sector debt reduction.

Consider this: The present credit crisis started in 2007. Yet, none of the major economies registered deflation. All are experiencing inflation, often above target levels and often rising. In the euro-area, over the past twelve months, the official inflation rate increased from 2 percent to 3 percent.

From the start of 2011 to the beginning of this month, the U.S. Federal Reserve boosted the monetary base by USD 560 billion, or 27 percent. So far this year, M1 increased by 17.5 percent and M2 by 9.5 percent.

Below is the so-called “true money supply” for the U.S. calculated by the Mises Institute.

True money supply chart

From the Mises Institute Website

As the Mises-Institute’s Doug French pointed out, total assets held by the six biggest banks in the U.S. increased by 39% over the past 5 years. Maybe this is not surprising given that in our brave new world of limitless fiat money, credit contraction is strictly verboten.

In the UK the official inflation reading is at around 5 percent, but nevertheless in October the Bank of England embarked on another round of “quantitative easing”. It has so far expanded its balance sheet by another £50 billion in not even three months, which constitutes balance sheet growth of about 20 percent.

What we have experienced in the UK in 2011 provides a good forecast in my view for the entire Western world for 2012: rising unemployment, weak or no growth, failure of the government to rein in spending, growing public debt, further expansion of the central bank’s balance sheet, rising inflation.

Death of a safe haven

And what about Switzerland? Here the central bank expanded its balance sheet by 40 percent over just the first three quarters of the year, and almost tripled the monetary base over the same period of time. Most of this even occurred before the 6th of September, the day on which Mr. Hildebrand, the President of the Swiss National Bank, told the world and his fellow Swiss countrymen and women that the whole safe-haven idea was rubbish and that Switzerland was now joining the global fiat money race to the bottom.

Book cover for Paper money CollapseDeflation has become the bogeyman of the policy establishment. It must be avoided at all cost! Of course for most of us regular folks deflation would simply mean a tendency toward lower prices. It would mean that the capacity of the capitalist economy to increase the productivity of labour through the accumulation of capital and to thus make things more affordable over time (a true measure of rising general wealth) would accurately be reflected in falling nominal prices. The purchasing power of money would increase over time. This, however, would require a form of hard and apolitical money. Instead we are constantly told that our economy needs never-ending monetary debasement in order to function properly. We are constantly told to fear nothing more than deflation, which can only be averted by a determined government and a determined central bank. And the never-ending supply of new fiat money.

Appropriately, there is no talk of exit strategies any longer.

Given the size of the already accumulated imbalances I think a stop to this madness of fiat money creation would be painful at first but hugely beneficial in the long run. I am the last to say that no risk of a very painful deflationary correction exists. But a correction is now unavoidable in any case, and every other policy option will make the endgame only worse. Even if I am wrong on the near-term outlook on inflation and even if all this money-printing does not lead to higher inflation readings imminently, it will still be a hugely disruptive policy. Money injections obstruct the dissolution of imbalances and invariably add new imbalances to the economy, including new debt and capital misallocations, that will make even more aggressive money printing necessary in the future.

The nationalization of money and credit


Self defense asset!

Herein lies a fundamental contradiction in our present system: The desire for constant inflation and constant credit expansion requires that the banks be shielded from the effects of their own business errors. Allowing capitalism’s most efficient regulators, profit and loss, to do the regulating, would mean that banks could face the risk of bankruptcy – this is, of course, the ultimate disciplinary force in capitalism. This could then lead to balance sheet correction and thus periods of deflation. Ergo, banks cannot be capitalist enterprises at full risk of bankruptcy as long as constant credit growth and inflation are the overriding policy goals. The constant growth of the banking sector must be guaranteed by the state through the unlimited provision of bank reserves from a lender-of-last resort central bank.

That banks get ever bigger, that they routinely hand out multi-million dollar bonuses, and that they frequently get bailed out, is not a result of the greed of the bankers – a stupid explanation anyway, only satisfactory to the intellectually challenged and perennially envious – but is integral to the fiat money system.

Banking under state protection ultimately means banking under state control. In the end it means state banking. And this is where we are going.

Last week the Federal Reserve and the Bank of England announced plans to tighten the control over the balance sheet management and the risk-taking of private banks. This is just the beginning, believe me. The nationalization of money and credit will intensify in 2012 and beyond. More regulation, more restriction, more control. Not only in defence of the bankrupt banks but also the bankrupt state. We will see curbs on trading, short-selling restrictions and various forms of capital controls.

A system of state fiat money is incompatible with capitalism. As the end of the present fiat money system is fast approaching the political class and the policy bureaucracy will try and defend it with everything at their disposal. For the foreseeable future, capitalism will, sadly, be the loser.

The conclusion from everything we have seen in 2011 is unquestionably that the global monetary system is on thin ice. Whether the house of cards will come tumbling down in 2012 nobody can say. When concerns about the fundability of the state and the soundness of fiat money, fully justified albeit still strangely subdued, finally lead to demands for higher risk premiums, upward pressure on interest rates will build. This will threaten the overextended credit edifice and will probably be countered with more aggressive central bank intervention. That is when it will get really interesting.

We live in dangerous times. Stay safe and enjoy the holidays.

In the meantime, the debasement of paper money continues.







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"When they stop buying bonds, the game is over."
Adam Smith Institute lecture: paper money collapse


  1. says

    So well written, Detlev. I have worked in broadcasting and journalism since the 1980s and have covered big financial stories yet I have learned more about the economy in under a year from reading your blogs. But you are up against an entire Keynes-oriented financial-economic commentariat throughout the West. Merry Christmas !

  2. Kevin Dawes says

    Hi Detlev,

    many thanks for your inputs on deflation/inflation. At the momeent I’m trying to think what could be the factor that causes the base-rate to rise and what comes to mind is the Bond Markets. Right now the likes of the UK and USA have ultra-low yields but we know this is not due to them being seen as a safe haven but due to the BoE and Federal Reserve buying up their respective government debt thus suppressing yields and driving up prices. In addition the reigning sentiment in the markets seems to be fear as opposed to greed which is making investors rush for these.
    However this can not last forever and I’m wondering what underlying factors may influence these bond investors to bail out, I mean with bond prices of USA and UK treasuries and gilts being artificially high in value and such tiny yields now would be a good time as any to cut-loose. I would have thought rather than waiting it out and seeing those bonds potentially drop in value along with investor invested capital, it seems common sense to pull out now and atleast retain their capital exposure. Why is this not happening yet and what could trigger it?

    Also, I think its fair to assume now, for anyone following the economy for the past 4 years, that the base-rate of USA/UK are not going to rise and the fed. and BoE will just palm us off with another excuse to keep the base-rates at vitually 0% after 2013/2014 even. I think the reason for this, if I remember correctly, is that the higher the base-rate is the higher interest payments will be on the borrowing costs for the British and American government. Also couple this with the inflation produced as a result of Quantitative Easing then investors who see inflation rising in those currencies (dollar and sterling) are bound to factor this rise into the borrowing costs or interest payments they demand for lending to those governments.
    It just seems to me that the Central Banks/Governments can’t just keep doing new rounds of QE because this will cause inflation to rise as we’re seeing which will cause 2 things to become immediately worse i.e. high yields and an unhappy population faced with loss of purchasing power. So it seems like this is a juggling act at best and they’ve got to be really careful they don’t startle the Treasury/Gilt holders to prematurely redeem their bonds on the one hand and on the other, the population of UK/USA into social unrest due to extremely high inflation.
    So lets face it the government’s/CB’s can not raise base-rate because their interest rate payments for borrowing will become too high and they can only raise them when we start getting growth; but real growth can not take place until they write off the major portions of “unproductive debt” that has generated fake wealth. Then we would be left with the real savings and real capital that you say is necessary for us to stop the malinvestments. But, on a pessimistic view, this probably won’t happen (looks like fascism is rearing its head again) and therefore base-rates will remain low as government intervention is not going to allw markets to set these and neither to liquidate inflated assets to achieve price correction. I can’t understand how TPTB are willing to let this continue, do they not understand they are reliant on real productive wealth being generated to keep order and that these fake-measures will only shorten the status-quo instead of prolonging – albeit in a painful manner?

    Therefore base-rates will remain low for the forseeable future (until it collapses itself of it own accord) and I’m just wondering how this affects gold. Unfortunately I was a bit late to the party and I don’t own any gold yet because I am waiting for a price correction, I remember vaguely that gold usually drops when real interest rates are at 2% but anything above and below this does not affect the gold price. Anyways its likely to be a while until real interest rates becomes 2% again and when inflation does reall ramp up the base-rate will probably be kept at 0% anyway dropping us further into negative rates. I’m just wondering if you know what is so special about 2% (maybe something to do with amount of gold produced annually?) and also given that base rates are kept at 0% even when inflation does take-off can you see this causing gold to drop back a little to say $1000-1200 even? Or will gold just detach from the paper-gold market at this point and head to the moon?
    Speaking of paper gold, I’d imagine traders in this market cashing out enmasse would really drive down the price of gold, any ideas about when this might be likely to occur or what to look out for?

  3. John McCabe says

    Hi Detlev, I’ve only been reading your articles for the past month and have found it very informative. I have no background in Economics and up until recently paid little attention to markets, banks etc, but with all that’s going on in the world I’ve been on a steep learning curve.

    I tried speaking to someone who has worked in Banks in Ireland, Switzerland and London. I tried dismally to repeat some of what I had read (apologies I may have made a mess of that I can only refer back to the fact this is all new to me). I talked about there being too much money being printed, too much credit, gold standard etc. He just said if we had no credit you couldn’t buy a house! (maybe I should have clarified that by saying too much credit?). He then went on about Quantitive easing, that banks weren’t lending to each other, that people were nervous and therefore hoarding their money and that we needed to pump money into the system to get the money flowing and this would in turn filter down to the average Joe and Jane on the street. Then we could cut back on the printing and reduce supply of money out there to bring things back to normal. That’s the jist of what he was saying but again like when I tried to explain your theories/beliefs I may have done a hatchet job on what he was saying. . He thinks I’m paranoid and says ‘where were all this economist’s a few years ago, the truth is nobody knows what is going to happen not even the so called experts’. In the end I decided to leave it alone but was wondering what you thought about that.

    Hope you had a good Christmas and best of luck in the New Year.

    • says

      John, I share your frustration. I had many similar conversations. Your friend just repeats the mainstream phrases. Of course, what he says is either incorrect, only half-true or self-contradictory. Firstly, the credit you get to buy a house should be backed by savings. Someone saves, gives the money to you as a loan, you buy a house and repay your lender over time. The problem starts if nobody saves and we just print the money to build houses. If that was such a good idea, why should we then not just double (triple?) the money supply tomorrow? We would get a lot of houses, no? Secondly, your friend is right that banks have been somewhat reluctant to lend (in particular to other banks!) and the private sector reluctant to borrow. So the problem is obviously not that there is too little money in the system. The money is there but doesn’t flow. So why is printing more money the solution? Should we not ask ourselves why the banks are reluctant to lend to other banks and why the private sector does not want to take on more debt? Maybe these banks know that what the other banks have on their balance sheets is a lot of toxic waste for which there is no ultimate buyer and which is being kept on these balance sheets at artificially high valuations. Maybe these banks correctly infer from their own dismal finances that other banks must be in dire straights. Maybe the private sector is reluctant to take on more debt because it feels it has already enough. Is the problem not that there is too much bad debt in the system and that the states in particular are accumulating ever more debt that will be difficult, if not outright impossible, to ever repay? So if that is the problem, does force-feeding the system with ever more money solve this problem? Artificially low interest rates and QE do not lower the debt load but increase it! So the problem is excessive debt, over-extended balance sheets and distorted asset markets, which lead to money not flowing but being hoarded. So the solution is pumping more money into the system, which encourages more debt accumulation, bigger balance sheets and further market distortions? — At this point, most bankers and mainstream economists simply stop listening.

  4. Cliff Hanger says

    “…We will see curbs on trading, short-selling restrictions”

    All except the continued naked short selling by JPMC of paper Silver to suppress the price (no doubt!)

  5. Paula says

    “That banks get ever bigger, that they routinely hand out multi-million dollar bonuses, and that they frequently get bailed out, is not a result of the greed of the bankers – a stupid explanation anyway, only satisfactory to the intellectually challenged and perennially envious – but is integral to the fiat money system”

    Oh so NONE of this happened, must have been a dream I had. You think I am envious .. I pity those who have to worship mammon and will do anything to get it..
    What is there to be envious of…you obviously never heard of the rich young ruler…

  6. Paul Marks says

    Intellectually we knew they (the Central Bankers and so on) would act like this

    But EMOTIONALLY I find myself unable to accept it.

    I do not know about you Sir (perhaps with your years in the market you have gotten used to the folly of these people), but I (year after year) keep expecting to wake up and find it was “all a dream” (or rather a nightmare).

    Or that they will suddenly say “what we were taught is plainly nonsense – we must STOP this”.

    But it just goes on – and on.

  7. Nour says

    Thanks Detlev!! Well written, makes it all very understandable…
    Also nice link to the balance sheet of the ECB.

    Would love to see you talking here on Dutch main stream tv, instead of all the nonsense they’re broadcasting now.
    It is sad to say, but 99% of the population doesn’t question the origin and mechanisms behind money, their overall consent is manufactured.
    These are dangerous but then exciting times, hopefully society won’t fall apart by the time we hit the stage of hyper-inflation. It’s all a bit scary.

    Greetings from the Netherlands!

  8. Martin says

    Hi Detlev,

    I studied a little economics at university, and I agree with most of what you say in this article, but I have one question regarding deflation.

    Naturally, falling prices are good for consumers in the sense that they make goods and services less expensive over time, raising the standard of living. However, don’t falling prices also discourage consumer spending and investment relative to inflation (rising prices)? i.e. does deflation not encourage people to hoard money more? It seems like this would have a negative effect on economic wellbeing.
    If people chose to invest the additional money they did not spend, it would be put to work. However, it seems that people would be able to earn a ‘return’ simply by hoarding money. It seems that idle money would be detrimental to an economy, which thrives with the volume of exhange.

    At the risk of answering my own question, the fact might be that increased hoarding wouldn’t actually occur, because a change from inflation to deflation would simply cause a change in the cost of capital, would would encourage people to invest/save that which they choose not to spend (i.e. clear the market). If so, deflation vs. inflation would simply cause a reduction in consumption, but an increase in saving and investment.

    Many thanks

    • says

      Concerns about deflation are entirely unjustified. Falling prices are a natural phenomenon in capitalism. Capitalism constantly works to make human labor more productive (via the intensification of the division of labor and the accumulation of capital), which means things become more affordable over time (that is why capitalism has been such a success and why we all – or at least most of us – accept its iron laws). If that were a problem for consumption, you would also have to argue against positive real interest rates, which also allow you to consume more in the future by postponing acts of consumption and saving and investing first. The reason why deflation is not a problem (and neither are positive real interest rates) is simply this: time preference. Time preference is not a psychological phenomenon but an integral part of human action. As George Reisman put it so well: To want something is to want it sooner rather than later, all else being equal. Here is a present-day example of time preference at work: we all know that laptops, blackberries and mobile phones get cheaper and better every year. Does that mean that we all postpone our purchases of these items into the future? Of course not. Wanting a mobile phone, laptop or i-phone means wanting it now and not in a year’s time, even if the item will be cheaper by then. And, of course, falling prices mean that over time more people can afford these things. Falling prices do not hinder consumption, they encourage consumption!

      Concerns about the hoarding of money are unfounded. Holding money involves opportunity costs. True, these costs are lower in a deflationary environment but they still exist. I could obtain a higher return by spending my money on investment goods, and I could obtain instant satisfaction of my consumption needs by spending it on consumption goods. Encouraging the reduction of cash balances by debasing the monetary unit may lead to a temporary growth spurt but, as I have shown in detail in my book, this must always lead to grave dislocations in capital allocation and resource use. In the long run, debasing money does not give you a healthier, faster growing economy but economic chaos.

  9. Zog says

    “Deflation has become the bogeyman of the policy establishment”.

    Of couse, a key unstated reason that governments hate the prospect of deflation is that inflation provides them with their only hope of trying to contain their deficit, by way of increasing taxes and inflating away the existing debt.

    Deflation, in contrast, reduces their tax revenue and magnifies national debt.

  10. Jag says

    Hi Detlev,

    Just wondering was recently going to purchase you’re latest book.

    Could you be kind enough to answer a few questions of mine?

    1) If we implemented gold wouldnt this limit our productivity to the amount of gold we have? Wouldnt this open nations to speculative attack?
    2) I agree with the notion of government being too big within Europe. However you talk about the free market and yes it has created wealth far greater than any other system. But what about policies such as Minimum wage, regulation and inequality in wealth. Dont we need a large government to tackle these issues? Or a more involved one to say the least. I am for public education & healthcare which leads to much of the involvement of government.
    3) Doesnt the fed buy assets when it prints out money?, Im sure it is not just printing money out of thin air it is backed with assets. According to the fed’s website.Although i am against the FED beign privately owned to clarify.

    Thank you.

    Look forward to your book.

    • says

      Jag, I hope that after reading my book you will have changed all of your opinions. Just briefly: 1) The available supply of money does not limit productivity. Productivity increases through capital accumulation, technological progress and intensive division of labor. Expanding the money supply does not boost productivity one bit. In fact, expanding money will distort interest rates, thereby disturb the process of capital formation, and this will hold back the growth in productivity that would take place otherwise. 2) Minimum wage policies, which are policies of price fixing, and regulation disrupt the working of the markets. This leads to suboptimal use of resources (unemployment or underemployment; misallocation of resources) and to lower incomes in general. These policies are entirely counterproductive and should be abolished without exception. I see no role for the state in the economy whatsoever. The inflationary policies of the past 40 years have certainly INCREASED income inequality (owners of financial assets and real estate have benefited disproportionately in the credit boom) but as a general rule I maintain that the distribution of income and wealth is none of the state’s business. 3) Buying an asset is the process by which the money gets into circulation. The money is still created out of thin air. Creating the money doesn’t mean you are creating an asset.


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