Does the ‘recovery’ matter?

green shoots among coins

Image: Graur Codrin

I was thinking of starting this blog with a cynical comment along the lines of, last week equity markets came off, I think we need another EUR1 trillion from the ECB! – Okay, maybe it wasn’t the greatest joke but you get the idea. But then the Wall Street Journal beat me to it, and they weren’t even trying to be funny. In an article on weaker data in the Euro Zone one could find this remark:

“The unexpected drop in the purchasing managers’ index survey suggests more stimulus from the European Central Bank through interest-rate cuts or additional bank lending may be required to protect the economy from a more severe downturn.”

Sure. And why not?

Over the past 12 months the ECB expanded its balance sheet by 54 percent. At around 30 percent of GDP that balance sheet is now the biggest among the major central banks. The ECB’s printing press is providing an ‘unlimited’ backstop for all those financial ‘assets’ that nobody in their right mind would buy with their own savings, and providing ‘unlimited’ funding for the European banks, which are now permanently in intensive care. And we have to admit the strategy is not without success: Your neighbourhood Greek bank is again a going concern and those Spanish governments bonds are once more highly sought-after investments, even at single-digit yields. So, why not print another EUR1 trillion to get the economy really going? Isn’t it time the ECB really put its back into this whole stimulus business?

What a great policy ‘stimulus’ was back in 2001 when the Fed also ‘protected the economy from a more severe downturn’ and kept rates at 1 percent and blew the biggest housing bubble ever and thus set the world up for an even bigger ‘downturn’ in 2007. If you think about it, all our present problems are the result of past ‘stimulus’ – of past efforts to keep interest rates low and to ‘stimulate’ borrowing and encourage leverage. Now the interventionists of every couleur tell us that we can only get out of this mess by depressing interest rates even further for even longer.

Einstein said that the definition of stupidity was to do the same thing over and over again and expect a different outcome. This makes me wonder if economic intelligence has already been a victim of this unfolding crisis.

Exit the exit strategy.

That may well be so. Last week I read somewhere that a hard-left candidate in France (not Hollande, someone even more to the left of him) demands that the ECB lends money directly to companies. I think that this idea is not that farfetched considering how quickly and easily today’s consensus has embraced extreme policy intervention. Only five years ago it would have been unthinkable that the world’s major central banks would become the biggest marginal buyers and single largest holders of their countries’ sovereign debt, or that they would offer unlimited free loans to their banks with multiple-year maturities against the dodgiest of collateral. These used to be the type of irresponsible things that responsible central bankers scoffed at. Today, this is standard practice in most of the highly industrialized world. What was crazy five years ago is now merely ‘unconventional’.

And this evolution should not come as a surprise. As I explained in Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, what we are seeing is indeed the logic of the state fiat money system taken to its natural conclusion. The raison d’etre of the system was to not leave the setting of interest rates and the availability of credit to the free market. On a free market the level of interest rates and the availability of credit are naturally determined by the available pool of voluntary savings. The idea was always to massage interest rates to lower levels and to encourage additional money and credit creation. In a paper money system like ours, the banks’ ability to create deposit money and loans is largely the result of administrative decisions by the central bank – at least until the banks have OD’ed on cheap money and the central bank has to use its own balance sheet to keep credit growth going. This is where we are now.

As is true of all types of market intervention, once you fix one variable you have to fix others, and sooner or later you have to get involved in everything. As ever more sections of the economy become addicted to cheap money, the risk of higher yields and wider risk premiums becomes an ever more potent threat to the overbuilt house-of-cards. To avoid collapse, the central bank has to manipulate ever more asset prices directly.

The communist chap from France has simply anticipated the next step in the degradation of our paper money economy, the point where not only the government and the banks will be supported directly by the central bank but also the corporations and the consumer. What is good for the former certainly must be good for the latter. Why do Greek restaurants still face the risk of bankruptcy when Greek banks get limitless cash?

In any case, this development is much more probable than any kind of ‘exit strategy’ for the central banks. — You don’t hear about those exit strategies any more, do you? There is a reason for it. There are none. Every day that the present free-money-madness continues, the central banks are digging themselves a deeper hole. With ever more assets mispriced on cheap cash and with ever more balance sheets propped up by free loans, policy tightening is equivalent to pulling the rug from under the whole system. There is no way out.

On steroids.

But back to the title of this Schlichter file. What recovery am I talking about? In Europe there apparently is none. But data has been improving lately in the United States, if at a snail’s pace. The ‘interventionists’ assign a lot of importance to these developments. Being interventionists, they pay little attention to the reasons for why we were in a recession in the first place. There is never much focus on the root causes of the crisis or any debate about if those have been removed. Recessions just seem to happen, so do asset bubbles and excessive leverage. All that matters is that the government creates some growth, then, with a bit of luck, this growth may just lead to more growth, and sooner or later we may just grow ourselves out of this mess. Simples.

I think the chances of that happening are pretty close to zero. And I do not care much about what present data is supposed to tell us. It does not make much of a difference.

Take the drop in official US unemployment. Could it be attributed to a decline in labour market participation as many long-term unemployed – their numbers have been growing markedly in this recession – drop out of the official labour market altogether? Or, could it be the result of the mild weather recently? Or, as the optimists will say, is it the result of additional hiring? Frankly, I don’t know and I don’t think it matters much.

We know what the problems have been and still are: misallocated capital and misdirected economic activity on a gigantic scale as a result decades of artificially cheap money. The policies of the interventionists – first and foremost zero interest rates and quantitative easing – were aimed at sustaining these imbalances, sabotaging their liquidation, discouraging deleveraging and postponing the – admittedly painful – cleansing of the economy of the accumulated dislocations. This policy has to a large degree succeeded, maybe with the exception of parts of the US housing market, which has indeed been correcting from bubble-levels. Other than that, I believe policy has so far managed to sustain the unsustainable a bit longer and thus project a false image of stability. Congratulations.

Of course, we can never exclude that this policy may also generate some additional activity here and there. Super-cheap money may not only stop the much needed deleveraging and cleansing but it may even encourage additional borrowing and additional investment. Who is to say that the trillions of new currency units will not cause some more balance sheets to get extended a bit further?

Fact is that none of what we see right now can be taken at face value. Not the equity rally, not yield levels, not headline economic data. Everything has to be taken with a sizable pinch of salt given the distortions from an outright surreal monetary policy stance.

But we can be sure about one thing: None of this should be taken as an indication of improving health. The patient is still sick but made to run laps around the track with the help of steroids, amphetamines and massive amounts of caffeine. The economy will not get fundamentally better until the underlying imbalances have been addressed and that is only possible if money printing stops and the market is again allowed to set interest rates and other prices.

I am not sure if the mainstream economists do really take a lot of encouragement from the manufactured asset price rally and the occasional green shoots in an economy that remains freakishly unbalanced and fundamentally sick. I don’t know what the economic data will tell us over coming months or quarters. I am confident that we are far from closing the book on the present depression.

In the meantime, the debasement of paper money continues.

 

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Please don't call this capitalism!
What gives money value, and is fractional-reserve banking fraud?

Comments

  1. Chase says

    Asset bubbles do just seam to happen according to Bernanke, who recently scoffed at the notion that the Fed had anything to do with the housing bubble.

  2. Lex says

    I am a regular reader of this blog and find it a refreshing and unique perspective on economics. I am not an economist, so I have some questions:

    1. The Austrian narrative of the business cycle, recessions and paper money make more sense to me intuitively (which does not necessarily mean it is correct). Why do you think that Austrian economics are viewed as heterodox and Keynesiasism is the dominant form taught in schools and universities and written about in the media?

    2. Recently Bernanke has been giving some lectures. As an agnostic on economics and economic policy I found these graphs that he presented to be intriguing. What’s your take on them? http://www.businessinsider.com/bernanke-lecture-charts-compare-the-great-recession-to-the-great-depression-2012-3

    • says

      Thank you, Lex.
      ad 1): There are a couple of reasons here that are interrelated. Ludwig von Mises is rightfully credited with deriving the Austrian Business Cycle Theory (ABCT) in 1912. He never called it the ‘Austrian’ theory but the monetary theory of the business cycle, and he considered his work to be a further elaboration and an improvement of the monetary cycle theory that the Currency School had developed in Britain in the 19th century. Mises improved that theory as he was the first to apply the new theoretical approach of Carl Menger, in particular Menger’s methodological subjectivism, to the field of money. I am just stressing this to show that Austrians such as Mises did not consider themselves to be working outside the scientific mainstream or outside scientific traditions. They had disagreements with other schools of thought but they were not and did not want to be a scientific sect, which is how they are often treated today. Between 1912 and 1930, ‘Austrian’ ideas got noticed in other parts of the world and began to spread. That they did not spread faster may be the result of language (they were written in German and translations into other languages took some time to appear) and of the dominance of other schools of thought in academic establishments abroad (academia in Britain was completely dominated by the economics of Alfred Marshall at the time.) I think it is fair to say that by the late 1920s the Austrian School was on the rise. Then something peculiar happened: the so-called Keynesian revolution in economics in the 1930s. Although Mises had not only explained the Depression, he had in fact forecast it many years earlier, when the depression finally unfolded, nobody was looking for explanations but solutions, and Keynes promised a quick guide to recovery. His ‘General Theory’ was not so much a ‘general theory’ but very much a book for the moment. Keynes did away with all the Classical Economics, he didn’t bother with the Austrians, and came up with a scientific but largely neo-mercantilist justification for government action, although this was the type of action that politicians have a penchant for anyway and which they had already commenced years before Keynes published his book. Keynes provided a scientific-sounding legitimization of popular government action. For the remainder of the 20th century, economics was dominated by the English-speaking world and increasingly by the US, and here a certain interpretation of the Great Depression became generally accepted, namely that the Great Depression was the failure of unregulated capitalism, of laissez-faire, of the gold standard, and that a modern and stable society needs ‘managed capitalism’, and this requires management of ‘aggregate demand’, astute central banking and occasionally stimulative government spending. Keynes’ work fit the zeitgeist and simultaneously shaped the zeitgeist. Of course, the political establishment but also the academic and media establishment loved it. Under laissez-faire, politicians do not run much, academics can’t advise them on the little they do, and the media have little to report about the little that gets done. All that changes under ‘managed capitalism’: the politicians have loads to do, they intervene constantly; there are plenty of jobs for academically trained economists (central banks, IMF, World Bank,); and journalists love to mingle with all those powerful politicians and bureaucrats (think World Economic Forum in Davos!). But there are other reasons: Keynes’ book is fairly dry and even unstructured. It is also without graphs. But then John Hicks devised the IS/LM model and Keynesianism entered basic economic education. I believe that since the 1940s, whoever received a basic education in economics and particular macroeconomics (which is the kind of economics people like to discuss at dinner parties) received an education in Keynesianism. Add to that the bestselling economics textbook of the past 40 years: Paul Samuelson’s book, which is a massive Keyensian tome. You see the reasons were manifold: historical, accidental, cultural, political, sociological. Bottom-line: most of economics has been running up a cul de sac for 80 years. But in the history of human knowledge that is not such a long time after all. It happened in other sciences. It can and will be corrected. Ultimately, the better theories will prevail.
      ad 2: These charts don’t say anything. The question is: what happens next? Do we really think that was it? The crisis is over? I don’t think so. Nobody ever denied that with his helicopter money Ben could arrest the correction for a while. Sure. But postponing the correction does not mean avoiding it. The central banks are producing trillions of currency units to paper over the cracks, to sustain the unsustainable a bit longer, to maintain the system in a state of suspended correction. That is all they have done and all they ever can do. — It ain’t over yet.

      • Lex says

        Thank you very much for your very informative answer. That has certainly made things clearer for me.

        You are right in saying that economic education today is focussed heavily on Keynes. You can look at the GCSE and A-level economics curricula taught in schools in the UK and the macro is very much Keynesian. At my secondary school, I heard from economics students (I didn’t take economics) that the Austrian school was sometimes discussed, but mainly a sideshow, to provide an alternative perspective; I doubt anyone was seriously interested in it, but at least it wasn’t ignored completely.

    • Bruno says

      Lex, an answer to your first question might be “timing”, an answer given by Tony Judt in his chapter on Austrian economists in “Ill Fares the Land” (if I recall correctly) and by Wolfgang Streeck’s “The Crisis of Democratic Capitalism” in the New Left Review (that I know Detlev doesn’t agree with in its entirety).

      Streeck writes, “in the years immediately after the Second World War there was a widely shared assumption that for capitalism to be compatible with democracy, it would have to be subjected to extensive political control — for example, nationalization of key firms and sectors, or workers’ ‘co-determination’, as in Germany — in order to protect democracy itself from being restrained in the name of free markets. While Keynes… carried the day, Hayek withdrew into temporary exile… The political-economic peace formula between capital and labour ended domestic strife after the devastations of the Second World War… For governments facing conflicting demands from workers and capital in a world of declining growth rates, an accommodating monetary policy was a convenient ersatz method for avoiding zero-sum social conflict. In the immediate post-war years, economic growth had provided governments struggling with incompatible concepts of economic justice with additional goods and services by which to defuse class antagonisms. Now governments had to make do with additional money, as yet uncovered by the real economy, as a way of pulling forward future resources into present consumption and distribution. This mode of conflict pacification, effective as it at first was, could not continue indefinitely. As Hayek never tired of pointing out, accelerating inflation is bound to give rise to ultimately unmanageable economic distortions in relative prices…”

    • says

      Well, luckily I am not quite the only one communicating this message but we are a minority. Yes, it is exhausting. Sometimes I wish I had a more optimistic message. I know that many people don’t even want to engage with the argument. There is a lot of ‘normalcy bias’ at work out there. But that is the way I see it. It won’t be the end of civilization but we are facing some very tough economic times, with huge social and political implications.
      What is enjoyable in what I am doing is to immerse oneself in the work of some outstanding economists. And to try and fully understand what is really going on in the world. There is enjoyment in that.

      • azazel says

        It is an optimistic message, as it is a message of justice, of consequences for immoral behavior. I relish the thought of this unfair system failing as that is what will bring change, change for the better I hope. I’m sure there are many people who listen even though they may not comment. Keep up the good work Detlev!

  3. vance says

    Well Detlev, when the balloon goes up you can say to all “I told you so!”..

    So can I ask, what is the main difference between the money printing frenzy as is happening now and the very lucrative seignorage business that governments enjoyed even before during the ‘good’ times?

    Aren’t they both money for jam?

  4. Rafael Wagner says

    Hi Detlev,

    There are some economists and analysts predicting recessionary conditions in the US (see Economic Cycle Research Institute for example) and others seeing Q3 still in play (US economist at RBC Capital Markets). Yet bond yields have been retreating somewhat lately and gold has been under pressure. I know your thoughts on the critical benefits of holding gold, but do you have any possible explanations on its recent price behaviour? And also, would you stay miles away or now sell inflation protected government bonds despite their built in CPI insurance? I see the latter as still an effective defense to the printing press but wonder what your thoughts are at this stage. Thanks so much for your continued writing, Rafael

    • says

      Gold has been moving sideways in a fairly broad range since October. Maybe we can call this consolidation. I have to admit I am a bit disappointed by the price action considering that the events of recent months have, in my view, confirmed, if confirmation was still needed, that the key driver behind the gold rally (first and foremost, fiat money debasement as a last-gasp policy tool of utmost desperation) is still in place and alive and kicking. The euro-crisis that flared up again in the summer and propelled the gold price to a new record, and beyond that the global debt crisis are not gone but have for now been papered over, as expected, with limitless free money from the printing presses: Only when the ECB opened the monetary spigot was some calm restored. The BoE and the BoJ have also renewed their commitments to QE in recent months. Maybe all of this was already priced into the gold market during the July-September bull run? Maybe it was all in the price? — I am not so sure. I think there is an alternative explanation for why gold has been moving sideways. There is an expectation out there that the central bankers will now be more reluctant to provide additional accommodation. As the central bankers SHOULD realize how dangerous and crazy this money-for-free game ultimately is, and SHOULD therefore be very reluctant indeed, this is not an unreasonable consideration. I have always said that there is a major political component to the scenarios discussed here. If central bankers accept that they cannot keep the prices of all assets artificially high forever and all banks and all governments afloat, and if they stop printing money, they can do massive damage to the gold market. In such a scenario, paper money gets a lease on life and gold goes down. (Of course, none of this affects the key premises of my book, namely that ‘elastic’ money is suboptimal, unstable and ultimately unsustainable. The final assessment of elastic money and its endgame are untouched by any of these short- to medium-term considerations.)

      It appears to me that this explains to some extent what is going on right now. Whether correctly or wrongly, the market took the recent announcements by the Fed as an indication that further stimulus (QE3) may not be forthcoming. Of course, I have no special insight into what policymakers think or will do but I remain of the view that they will not sit still for long and allow the system to get cleansed. The dislocations are too big and the painful but necessary correction is politically still unacceptable. QE3 will come, and QE4 and QEn. Therefore, I expect that gold may go down in sympathy with other assets for a while but at some point that should stop and the gold price should again decouple from the prices of other assets as the market readies itself for another policy-push in response to the meltdown. That is how I see it at the moment. The big picture has not changed in my view. There is no meaningful self-sustaining recovery out there. Policy has obstructed the liquidation of imbalances and whenever policy retreats, even marginally, or whenever the prospect of policy retrenchment becomes a factor, markets fall apart again. The forces of deflation and liquidation will then occasionally depress the gold price as well, at least until another desperate policy initiative is started.

      Most governments are bankrupt and I will not buy their bonds, including inflation-protected bonds. Debt-levels are too high to be inflated away. Any attempt to inflate this debt away will end in complete destruction of the currency and on top of it, for good measure, government default. TIPS offer no protection in this scenario. Alternatively, money-printing stops and a deflationary correction is allowed to unfold (see above). In this scenario governments will default for sure, and you lose again. My personal view is that I want to stay from government bonds altogether.

  5. Rune K. Svendsen says

    I’m in the process of reading your book right now, Detlev. I’m really surprised by how simple the explanation actually is. I thought it would be a lot more complicated, but it seems that when we understand the basics correctly (what really constitutes money, for example), the conclusion that money injections can only confuse the markets and not help them seems obvious.

    Have you considered teaming up with a movie producer to make your book into a film, thus reaching a wider audience? If Charles H. Ferguson can explain the market of credit derivatives to the average moviegoer (the movie “Inside Job” from 2010), surely the two of you would be able to explain the concepts behind the inherent instability of paper money, as they seem much simpler to me than CDSs and CDOs. The graphical aids available in this media will also help in explaining the concepts. If used rightly, I think the viewer can obtain an almost intuitive understanding of why systems like these cannot function properly, ever.
    Like depicting the flow of new money into the economy: first as it is created, and instantly absorbs a bit of value from all the other currency in existence, in order to attain value. Then, as it moves out into the economy, reducing in spending power with each market participant it passes through.

    • says

      I agree that the argument is in the end not that complicated and I like to think that this is the case with many correct and fitting expositions. Once you see the explanation it becomes somewhat obvious and you wonder why you did not see it like this right away and why others still fail to see it.
      It has occasionally been suggested to me that this would make a good movie. I love film so I started to think about this a bit more but haven’t yet pursued this in earnest. On the one hand, it would be nice to reach a larger audience. On the other hand, I am still somewhat unsure if it is the right medium for this topic. As I said, I love film but film always mixes the intellectual with the emotional. That is why movies are so powerful and also, when dealing with topics like politics or economics, potentially so dangerous. Of course, one could make a movie with lots of ‘talking heads’ and charts and visuals that aim to explain and educate. One could make a predominantly educational movie. But good movies also want to entertain, and few things can entertain as well as movies! And here is where I see the danger. Most documentaries, if they are not about individual people or specific incidents but if they are about big, big topics that are essentially abstract, such as global warming or the financial crisis, are somewhat sensationalist and want to arouse an emotional response. They have a message. My book is about crisis and a fairly bleak outlook but that is not its central idea. The objective is to challenge established ideas about our monetary system. I tried to keep the book as matter-of-fact and as scientific and even academic as I could and not yield to the temptation to “sex it up” by stressing the element of disaster and crisis. I sometimes wonder if I should have gone for a more neutral (boring?) title. I don’t want people to just see the bleak forecast I have but I want them to engage with my economic argument. They should leave their emotions out of it and follow a fairly abstract and conceptual line of reasoning. I think that could be very difficult with a movie. When I watch movies I do want to have emotions. When I want to understand economics, I read a book.

  6. EStone says

    Hello Detlev,
    I have been reading your posts on-line and I plan to read your book. Like you, I am very interested in what is going on with the economy and the underlying problems with our monetary system. I know your basic argument from reading your blog and I happen to agree with it, but I do have some thoughts about our monetary system as well as some questions regarding inflation and hyperinflation that I would love to hear your thoughts about.
    First, I should say that I completely agree with you that our monetary system is fundamentally flawed in that money (or currency) is elastic, without limit to its creation. Additionally, I believe that since our currency is debt based, it is inherently inflationary because over time, progressively more money needs to be created to account for interest that is owed (which exponentially accumulates); otherwise, with less money injection (perhaps even if only money is created at a constant, non-progressive rate), recessions will occur with possible deflation as debts are settled (most importantly, national debts). Therefore, to prevent recessions and to compensate for needed corrections as a result of misallocations of capital related to manipulative monetary policy, money needs to be progressively increased which results in accumulated inflation (probably punctuated with recessions and perhaps some degree of deflation depending on politics and fluctuating monetary policy), and, eventually hyperinflation (perhaps followed by a deflationary depression) until the dislocations are corrected and/or the monetary system is fixed/changed.
    Additionally, the way I see it, on top of this inherently inflationary monetary policy, especially since we fully came off the gold standard in 1971 (with fluctuating, yet accumulating inflation), you have fractional reserve banking which allows for limited elasticity of currency (the degree of which is based on the fractional reserve lending ratio – that is, without additional central bank money creation) which probably is the underlying factor for booms and busts. In boom times, more money is lent out and the more lending cycles, the more money that is created by fractional reserve banking. And, when reaching the limit of elasticity from fractional reserve money creation, a bust will follow with slowing of lending and a contraction of money creation, unless of course, more money is injected into the system by the central banks during contractions to prevent them or to lessen their severity.
    In addition to the aforementioned, we have the use of margin lending and/or the derivatives market which can extend the elasticity of currency creation, by way of leverage/credit, potentially to a much larger degree than fractional reserve banking. It seems to me that this process is what happened before the Great Depression in the US – for a decade or so prior to the stock market crash, margin lending and credit creation was enormous until it finally reached a hard limit (where credit creation was at the limit of its elasticity without the addition of central bank money injection), and, because the central bank did not inject money, the system suffered a severe contraction to the extent that there was price deflation until the economy reset (dislocations were worked out as debts were settled one way or another, frequently through default).
    Now, it seems, we have a much greater problem than that faced prior to the Great Depression, not only in scale, but also in that it involves the entire global financial system. That is, the enormous derivatives market which had been created, with the help of loose monetary policy including artificially low interest rates that lured people and investors to take on large debts and invest in risky assets including real estate and equities. That the derivatives market should reach a limit in the near future, where after such limit is reached we will see defaults and eventual collapse, and that there is political pressure to at least limit the amount of deficit spending and quantitative easing (in the US) and monetary expansion by the ECB at this time (despite that it will likely continue in a limited or restrained manner), is why I have a problem seeing significant inflation (especially hyperinflation) within the next five to ten years.
    We saw the collapse of a small part of the derivatives market associated with housing (CDOs, CDS, and MBS) as subprime mortgages began to default which culminated in severe market turmoil beginning in 2008. The collapse of this credit market was highly deflationary and required massive central bank money creation to keep the system from severe deflation. Now we are teetering between inflation and deflation as the Fed alternates between suggesting more or no more monetization. Just recently, the Fed suggested no more easing which seemed to cause the decline in the equity markets and gold (we usually see a rise in both markets when the Fed suggests that there will be more quantitative easing).
    However, the entire derivatives market is estimated to be in the hundreds of trillions of dollars, many times larger than that associated with real estate, and there is simply not enough paper money (and digital entries on balance sheets, etc.) in existence (so to speak) to cover this. Eventually, the entire derivatives market (perhaps parts at a time) should also reach a hard limit where defaults and eventual collapse will occur, and this should be extremely deflationary requiring much much more central bank money injection to keep the global financial system from collapsing. And, there is also the potential for the US bond market to break down which would be highly deflationary unless the Fed prevents default by serving as the lender of last resort (which of course will have an inflationary force).
    Therefore, it seems to me that though the Fed will likely intervene much more in the future, especially if/when the bond market begins to collapse, we are still facing an enormous credit contraction (from ongoing housing deflation and the associated loss of home equity credit) with the potential for an even bigger credit contraction if the majority of the derivatives market falls apart (which, I assume is not only possible, but inevitable). If/when the derivative market begins to default, the result could be hundreds of trillions of dollars of credit contraction, which would make the recent unprecedented monetary expansion of 2008-2011 seem relatively very small and markedly ineffective.
    Moreover, though all past experiences of hyperinflation have resulted from various circumstances, the common thread seems to be massive money creation (usually as a result of high debt). From my understanding, the Fed has not even come close to the extraordinary money printing that took place during the Weimar Republic and in Zimbabwe (where there were 100 trillion dollar bills) even including the potential money supply that could be dumped into the US from overseas – in the case for US hyperinflation. Also, in the case of the US, as the economy slows and the housing crisis worsens (more foreclosures, etc.), there will be less currency for Americans to spend and this should put downward pressure on prices (most Americans are in debt or living from paycheck to paycheck).
    Furthermore, the Fed and the ECB, as reckless as they have been, are well aware of the history of Germany and Zimbabwe and it would seem that they are therefore not likely to allow for longstanding or extreme hyperinflation. Perhaps the Fed would begin to raise interest rates and trigger a severe deflationary depression if inflation even came close to noticeably high levels (say 10-15% officially reported inflation per year in the US). Moreover, with fractional reserve banking, couldn’t the Fed raise the reserve rate that banks hold in an attempt to keep at bay any significant degree of inflation before it got out of control (instead of raising interest rates which would be disastrous for our economy and the service of our debt)? Lastly, there is the possibility that new Federal Reserve and fiscal policy could stop (or limit) the debasement monetary policy for many years, which might result in something similar to Japan’s lost decades.

    Your response would be greatly appreciated.

    • EJ Stone says

      Sorry, I meant to space out paragraphs, but somehow I posted the above reply before I was able to edit it (I hit some key accidentally, but I did not click on “post comment”).

    • says

      Sorry for the slow response. You raise two points that I think need correcting. Let me address those first before I answer your main question. The first point is one that comes up regularly in reader comments and it relates to money today being “debt- based”. Deposit money gets created through the lending activity of fractional-reserve banks but these banks create only the principal amounts that they lend at the point of loan-creation, not the interest that needs to be repaid in addition to the principal amount when the loan expires. Therefore, this seems to be the assumption of many readers, the banks, in order to avoid a shrinking of the money supply, not only need to create another loan when an old loan expires, they need to create ever more loans (or larger loans). I think that this is what you allude to when you write that “over time, progressively more money needs to be created to account for interest that is owed”. As I said, this is a point that is raised quite a bit. As another person put it, “debt eats up the money supply through the payment of interest”. I believe this point to be incorrect and the concern expressed unfounded. Before we look at money creation, let’s look at the broader economy first and please note that any given amount of money can facilitate any number of transactions. If new economic transactions take place, there is no need for anybody in the economy to create more money. When I pay my gardener, my gardener may use the money to pay the butcher who in turn may spend the same money to buy my book, etc, etc. The given supply of money simply flows through the economy. The same is true for the money that the bank receives as interest when a loan expires. The bank creates the principal loan amount when it extends the loan and thereby expands the money supply, and the bank cancels the principal loan amount when it is paid back and, if the bank does not extend another loan, the money supply will shrink again, but the bank will never cancel the interest payment. This is part of the money supply the bank will not cancel at expiry of the loan because this is the bank’s income. It will have to pay this to other people, and thus allow this money to continue to flow through the economy. The bank will have to cover its costs out of this money income. Anything beyond that is its profit and will go to the shareholders or into the bank’s bonus pool. Just as with the example above, with the gardener and butcher, this is money that continues to flow through the economy. Of course, the money creation privilege has allowed the bank to integrate itself into the economy’s money flow. The bank uses fractional-reserve banking to generate a monetary income but it has not created that money it receives as interest income and it will certainly not destroy it upon receipt.
      The second point you raise is the gigantic derivatives market. This is a phenomenon that is very different from fractional-reserve banking or the credit markets. Links between all three exist but they are not that straightforward, so we need to keep them apart. The notional amounts in the global derivatives market are mind-blowing but they do not represent money and usually not even credit, and the true capital at risk is usually much, much smaller than what these notional amounts suggest. A collapse of the derivatives market would be hugely deflationary, that is true, but not because these hundreds of trillions would disappear. Hundreds of trillions of what? – Of bets, mainly. Dislocations in the derivatives market have the potential to generate huge losses for banks which will in turn affect their ability to continue lending and thus to keep the broader money supply expanding. Big positions in the derivatives market are another reason why the central banks will remain extremely accommodating.
      Now back to your main point which I believe is this one: Given the accumulated imbalances out there, is a deflationary correction not more likely than an inflationary meltdown? — I always said that if we abolished the central banks tomorrow (as we should!), we would face a cleansing correction that would bring the economy back into balance but that would be painful and, most certainly, deflationary, at least for many financial assets and many forms of real estate. Yes, if you leave the market to itself, we would have such a correction. But this correction is now deemed politically unacceptable and it will therefore be countered with ever more aggressive monetary accommodation, i.e. money printing. You and I know that the market will ultimately win. The correction will occur. But that is not the question. The question is if monetary authorities will destroy their fiat monies in the process. To answer this question, you have to make a judgement call on politics. To say that they CANNOT destroy their money as the demand for cash in our deflationary environment will outstrip ANY supply of money, is nonsense in my view. The central banks are already underwriting the banks and many sovereigns and they will also underwrite the entire derivatives market. I acknowledge the massive deflationary forces out there but I believe that, for political reasons, we will also see ever more bizarre levels of fiat money creation.

      • EJ Stone says

        Thank you very much for your thoughtful reply, especially as I did not have a chance to edit my written thoughts (which were not well organized). I see your point regarding fractional reserve banking. And, I agree with your excellent analysis of the derivatives market (that the true capital at risk is probably low, that bank solvency is the main problem with its collapse, and that ultimately central banks will likely underwrite much, if not all, of the market).

        With respect to my mention of debt based money, I am referring to the fundamental creation of money through the banking system in the United States. Perhaps my claim is best demonstrated by first considering money created only by the Federal Reserve (ignoring other bank lending for now, though the same concept applies when other banks lend money through fractional reserve banking). Assume the Federal Reserve has a monopoly on creating US dollars. Compounded interest accrues on the money the Fed creates which is, in the aggregate, the national debt. And, the national debt, I think, is roughly proportional to the money supply (M3). Because the Federal Reserve (and other banks) only issues the principle (the money that is created) and not the interest, the sum of the principle and the interest will always be larger than all of the money in circulation (and thus debt, on average and over time, cannot be repaid without more money being created). Therefore, more and more money needs to be created to accommodate the growing interest (debt), otherwise there would be a contraction of credit/money (on average). And, because of the compounding effect, the US national debt (and the proportionally increasing money supply) should increase exponentially (as it has been doing), unless there are deflationary forces that are not countered (such as credit contraction, austerity measures, etc.). Perhaps this is what others are referring to, as well, when mentioning “debt based” money?

        I do believe that central banks can destroy the money (and probably will), but I question the timing. I suppose if the derivatives market were to collapse rather suddenly and the banks stepped in with huge (and effective) accommodation, this would probably quickly destroy the money (as confidence in money could decline very rapidly). On the other hand, whether there will be slow or fast collapse of the derivates market, if due to political pressure to restrain money creation, the monetary authorities keep injecting, but never quite enough for the need at the time, might we not see this play out for many years (similar to Japan’s easing which was persistent over many years, but less than what was needed to destroy the yen)? The other concern I had was that if collapse of the derivatives market was large and fast enough, might deflationary forces get out of control to the point were, at least initially (perhaps several years), even significant money creation is not helpful (kind of like slowly adding base to a buffer – eventually it will become acidic, but only when enough base is added)?

        • says

          I still consider the point about “debt-based money” and interest to be incorrect. In a growing economy, in which the number of goods and services sold and bought, and therefore the number of economic transactions, constantly grows, nobody needs to create more money. The available quantity of money is sufficient to facilitate any number of economic transactions. All that needs to happen – and it will happen automatically – is for the velocity of money to rise (each unit of money changes hands more frequently) or for the purchasing power of each unit of money to rise (secular deflation), or for a combination of the two to occur, and any number of economic transactions can be facilitated. There is never a shortage of money. If you agree with this point, and logically I cannot see how you cannot agree with it, the problem you describe disappears. In your example, the amount of debt outstanding has grown through money-creation. Now, more of the money that circulates in the economy will flow through the financial sector in the form of interest payments. But that is not a problem. There is still no shortage of money in the economy overall for the very reasons cited above.
          If we never need more money to trade more cars or more shoes, we do not need more money to pay more interest. In neither case does the money drop out of the economy once it is spent. The same is true of the money you pay as interest. The bank may cancel the loan and thus shrink the money supply by the principal loan amount that it created originally, but no bank will ever cancel the interest it receives. That is its money-income, same as with the car manufacturer or the shoe-manufacturer. This money will continue to circulate. The bank will pay it to its employees as income and they may use it to repay their loans. And some of the money will be paid to the bank’s shareholders and they will use it to repay their loans or spend it on something else, and so forth.
          You say: “the sum of the principle and the interest will always be larger than all of the money in circulation”. Yes, but where is the problem? The overall size of economic transactions in an economy is much larger than the money in circulation. Still, there is no shortage of money, and logically they cannot be a shortage. It is, however, true that the larger the debt outstanding the more onerous it will be to service the debt. Those who have to repay the loans have to earn the interest in the market. They cannot print it.
          Let me approach this point from another angle. Would it be possible to repay large chunks of the outstanding debt, or is it not possible because nobody printed enough money to repay interest? – The answer is certainly, yes, it is possible. As loans expire, the banks would not extend new ones. This would shrink the overall money supply, it would also shrink bank balance sheets. Large parts of the constant money-flow in the economy would be redirected towards the financial sector. This would certainly cause prices to drop in other parts of the economy – the supply of money shrinks and more money is needed to make interest payments, so the purchasing power of each money unit needs to go up to satisfy the demand for money. Still: there is no shortage of money! But – again – none of the banks that see the principal loan amounts come back to them with interest – interest, that their customers have earned in the market place – and that wipe these loan amounts off their books, would ever cancel any of the interest that comes back to them. These amounts of money would continue to circulate. They pay for the banks’ expenses, the staff, the shareholders, and so forth. These other parties will get hold of the money as income and spend it again.

          • EJ Stone says

            I agree with you that a fixed amount of base money is sufficient for a growing economy due to secular deflation as well as some elasticity within the banking system. However, I look at the debt-based money concept from a different angle. Let me try to explain it another way. I will use some extreme hypothetical scenarios at first to illustrate my point and then I will come closer to reality. The concept of debt-based money is not at all incompatible with your analysis of fiat money. Perhaps it might help explain the underlying reason behind why monetary authorities are compelled to inject more and more money into the system, specifically, that credit is contracting and most big banks and financial institutions are currently insolvent.

            Lets start by supposing, for simplicity, that there was no fractional reserve banking and only the central bank can create money (other banks just store and lend money with a full reserve). Furthermore, lets say that the central bank agreed that only a fixed amount of money is needed and, again for simplicity, injected 1 trillion dollars into the economy (we will call it the national debt) which began to circulate with normal economic activity. Now, lets say that there is interest accruing on the 1 trillion dollars at a fixed rate of 3.5% per year, but there is no attempt or consideration to pay back the debt. After 20 years, the amount owed back to the central bank (or government) would be 2 trillion dollars. 40 years later it would be 4 trillion, 80 years later it would be 16 trillion, and 200 years later, the debt would be 1.024 quadrillion. In essence, the problem is that even low interest rates increase the debt exponentially, such that over a sufficient amount of time (depending on the interest rate), the debt will become out of control. I should point out that the same is true for deflation: even a low rate of fixed deflation over time will shrink the available money until it quickly approaches zero.

            Now, let’s say 80 years after this system has been operating and the national debt is 16 trillion dollars, the politicians decide that we must pay down the national debt. And, lets say that they want to pay back 200 billion each year from the circulating money (only the central bank can issue money, so the interest must be paid back from the money in circulation). If successful, after 4 years there would be only 200 billion left in circulation (however, the debt would then be greater than 15 trillion) and there would be a severe degree of unanticipated and deepening deflation likely causing a very steep depression. After 5 years there would be no more money in circulation if it were possible to take it all back through taxes, etc to pay down the debt. In fact, in the above scenario, any time politicians want to begin to pay back the debt, recessions, if not depressions will occur; that is, anytime the debt does not grow at the exponential rate by which it would otherwise grow if left unpaid.

            Now add to this scenario fractional reserve banking. The fundamentals of the growing debt problem do not change. Now the banks can create money through fractional reserve banking and the limit to this money creation is set by the reserve ratio. At a 10% reserve ratio, 1 trillion dollars (as in the previous example) introduced into circulation through the banks could theoretically be expanded to 10 trillion dollars. As in the case for the national debt, there is interest owed on this money to the banks (private debt), but the debt problem is concealed when money is expanding and it is difficult to detect given that there has always been some form of central stimulus and that there are vast and complicated transactions, loans as well as loan repayments, and defaults all occurring simultaneously and staggered over time.

            Lets start by assuming, with a 10% reserve ratio, we can eventually reach 10 trillion dollars in circulation (with maximum money velocity, etc.) after the central bank deposits 1 trillion dollars total into various banks that loan out money (and no more central bank money or deficit spending is added to the economy). Now we have the problem of accruing interest; every loan from the bank that was associated with expanding the money supply through fractional reserve banking was loaned out with an attached interest rate. Money may circulate without adding or subtracting to the available money, such as when someone uses money received for some goods to buy other goods, but this does not affect the supply of money and can thus be ignored. As the 10 trillion dollar amount is approached, we are reaching a hard limit with respect to money creation (banks cannot loan beyond the 10% reserve ratio). At this point, the money in circulation can only contract as defaults and loan repayments occur. Active loans will continue to accrue interest over time. And, the total amount owed to the banks will exceed the amount of money in circulation.

            Defaults will spread throughout the economy. If Bob owes money to Paul who owes Peter and Bob defaults, Paul will not be able to pay Peter; this scenario will play out in a very large and complicated manner commensurate with the intricacies of the economy, but nonetheless the money in circulation will be contracting as defaults and loan repayments outpace lending, exacerbating the problem, and it will manifest as a recession. If no further money is injected into the system at this point (including deficit spending), where people participating in the economy on average owe more than can possibly be paid back (due to accrued interest, a contracting pool of circulating money, and bank balance sheet problems), we would have an ongoing recession until no money is left in circulation. That is, unless the central bank (or government) steps in and stimulates the economy by injecting money or encouraging increased leverage with lower interest rates, etc. (think of the bursting tech bubble being covered by monetary policy that caused the transition into the housing bubble). Without additional money, even if the velocity of money can be maintained such that there were always near 10 trillion dollars in circulation (people were perpetually borrowing the maximum amount of money that can be loaned out with a fixed 10% reserve ratio), over sufficient time, interest (without a source for repayment) would eventually become many times the original principal.

            Now, ignoring the national debt for a moment, consider a more realistic example assuming that we are near the beginning of a business cycle and more money can be created through fractional reserve banking (velocity can increase). And, we can now allow for varying degrees of normal debt repayment. Debt will accrue on private bank loans and regardless of the average interest rate and duration of the debt, the aggregate loan obligation will exceed the amount that was loaned. As you point out, when the velocity of money increases, there is no problem with interest repayment (due to the elasticity of money from the fractional reserve system). The majority of people/businesses will have no problems paying back money with interest as more money is created and business and productivity increase. The problem occurs when the velocity of money slows down; for any reason, such as increased interest rates, but especially as we approach the practical limit of fractional reserve banking, when the velocity of money creation must slow down and eventually turn back as defaults and loan repayments begin to outpace lending while defaults spread through the economy (this can happen over many years) without any form of stimulus including interest rate reduction, deficit spending, monetizing the debt, and lowering the reserve ratio. Think of what could have happened during the Great Depression if the US did not have the relatively large deficit spending that occurred and note that there was significant national debt contraction over the decade or so preceding the Great Depression.

            In a different example, lets say that over the course of a 30 year loan, the amount paid back is double what was initially loaned (given the right interest rate). The money paid back to the bank in excess of the principal was pulled out of the economy. True, the bank will have earned the interest and this money will reenter the economy, but, unless more money is created through additional loans, there is no net gain (just money collected from others in the economy to pay back the interest which is then reintroduced into the economy), though the principal is pulled out of the economy as it is being paid back.

            This interest-debt accumulation condition applies to any amount of money in circulation, between the base amount (1 trillion in the above example) and the maximum amount in a fractional reserve banking system using any reserve ratio. Furthermore, this should hold true for a dynamic economy where varying degrees of money are circulating at different times (depending upon the velocity of money); varying degrees of money are being loaned out and paid back with different loan structures, timing, and interest rates; varying types and numbers of transactions are occurring; and there are varying degrees of full loan repayments and defaults, etc. I realize that some people may be successful with their loans and be able to pay them back completely while earning a profit (while the bank earns interest), but then others will necessarily default over time (given the limit on circulating money when the velocity can no longer increase, at least temporarily until stimulus is added).

            The fundamental premise that the total sum of the principle and interest will always be greater than the amount of money in circulation holds true, despite that various transactions occur without changing the supply of money and that loans will vary in duration, timing of payback, and rate of interest. While this may not be a practical point, in that money will never be all paid back at once in a dynamic economy (and there is usually some form of stimulus introduced), this condition exists at core, and its effect will be manifest during economic downturns. At the beginning of a business cycle when the velocity of money increases, there is no noticeable problem. But as the elasticity associated with fractional reserve banking approaches its limit (or interest rates increase, production decreases, etc.), there will be defaults and a shrinking money supply unless some form of stimulus is introduced to the economy. In fact, theoretically, if all loans are paid back, no money should exist (though I realize that this could never happen – the market and people would demand a new monetary system well before this could ever happen).

            So putting it together, the way I see it, at base we have an inherently inflationary central bank monetary system (so long as the debt or money supply expands at a sufficient exponential rate as described above) and modulating on top of this we have a fractional reserve banking system associated with expanding and contracting cycles (sometimes central bank and fractional reserve activity are occurring with an additive effect). Money creation through the fractional reserve system (as velocity is increasing) should temporarily conceal the deflationary pressure of not enough fiscal or monetary stimulus, but once money velocity begins to decrease (defaults, etc.), the contraction of the money supply associated with reaching the limit of fractional reserve banking (in a particular business cycle) will reveal the deflationary force of restrained central bank and/or fiscal policy.

  7. Rafael Wagner says

    Detlev,
    Your analysis and explanation of gold’s recent price behaviour sounds very plausible. It will be very interesting to see how economic activity and possible growth unfolds in the coming quarters. I also see the central bankers pausing their policy intervention (they are certainly hoping to move closer to ending and reversing it) in hopes of achieving growth, but it may truly be of the fictitious kind that you touched on in your book, or no material growth at all. Then it is back to the money machine levers.
    As a citizen, it feels difficult to play this game in the face of little modern precedent and constant meddling by central planners and government. Their power is awesome, yet also limited. But when do we see these limits finally begin to surface with their attendant consequences?
    I also agree with your concerns about inflation indexed govt bonds, but are some jurisdictions like Canada perhaps acceptable especially if one is dying to find some yield? Thanks again

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