``Let's get to the bottom line. A deleveraging process is under way. It can happen against a background of bankruptcy, deflation, declining cash flows and bank bankruptcy or in a slower way against a background of inflation. Both reduce the debt burden, but one is socially jarring and led in the past to mass unemployment and arguably WWII. Democracies will choose the inflationary approach. This is not evident today, but it will be more evident soon enough as the BoJ, ECB, BoE and others realise that their current monetary policy is driving them not to slower growth and lower inflation but to deflationary calamity. Today, you can see the calamity of the deflationary disease but what will you see tomorrow, or the day after, if the monetary cure pours from the medicine jars of the global central banks?”-Russell Napier of CLSA (courtesy of fullermoney.com)
Not if you ask, Dr. Frank Shostak, ``We however, maintain that it is not the size of the debt that determines the severity of a recession, but rather the aggressiveness of the loose monetary policies of the central bank. It is loose monetary policies of the central bank that cause the misallocation of resources and the depletion of the pool of funding and in turn can be manifested in over-indebtedness. So to put the blame on the size of the debt as the key factor in causing depression is no different to blaming the thermometer for causing the high temperature.” (underscore mine)
Or Joseph Salerno in Austrian Taxation of Deflation, ``Bank credit deflation represents just such a benign and purgative market adjustment process.”
Many have cited the Great Depression as a prospective model of today’s deteriorating environment as having a deflationary character. Yet, the reason debt deflation transformed into the Great depression wasn’t due to the deleveraging process itself, instead it was debt deflation aggravated by economic policies which crushed profit incentives.
Again Mr. Salerno (highlight mine), ``Unfortunately such benign episodes of property retrieval have been forgotten in the wake of the Great Depression. Despite the fact that the bank credit deflation that occurred from 1929 to 1933 was roughly proportional in its impact on the nominal money supply to that of 1839-1843, the rigidity of prices and wage rates induced by the “stabilization” policies of the Hoover and early Roosevelt Administrations prevented the deflationary adjustment process from operating to effect the reallocation of resources demanded by property owners.”
Myths of Liquidity Trap and Pushing On A String
Deflation proponents have further used the Keynesian concepts of “liquidity trap” and or “pushing on a string” to advance their Armageddon theory.
The concept of “pushing on a string” suggests that US Federal Reserve policies will be rendered ineffective or impotent and won’t jumpstart the economy by stimulating lending.
While the US Federal Reserve have the boundless powers to add into bank reserves by purchasing assets (usually government liabilities), commercial banks might not lend money to take advantage of this. It’s like leading a horse to a pool of water, but doing so won’t guarantee that the horse will drink from it.
A liquidity trap environment is seen almost similar to the “pushing on a string” concept, but here, as interest rates nears or is at the zero regime, traditional policy tools might also be unsuccessful to spur lending (again!).
So should we fear these as media and Keynesian experts paint them to be?
We doubt so.
Why?
First is to understand how Central banks operate, according to Murray Rothbard in Man Economy and State (emphasis mine), ``The central bank can increase the reserves of a country’s banks in three ways: (a) by simply lending them reserves; (b) by purchasing their assets, thereby adding directly to the banks’ deposit accounts with the central bank; or (c) by purchasing the I.O.U.’s of the public, which will then deposit the drafts on the central bank in the various banks that serve the public directly, thereby enabling them to use the credits on the central bank to add to their own reserves. The second process is known as discounting; the latter as open market purchase. A lapse in discounts as the loans mature will lower reserves, as will open market sales.”
Next, Murray Rothbard in Making Economic Sense tells us why deflation isn’t likely to occur given the innumerable powers of Central Banks, ``What deflationists always overlook is that, even in the unlikely event that banks could not stimulate further loans, they can always use their reserves to purchase securities, and thereby push money out into the economy. The key is whether or not the banks pile up excess reserves, failing to expand credit up to the limit allowed by legal reserves. The crucial point is that never have the banks done so, in 1990 or at any other time, apart from the single exception of the 1930s. (The difference was that not only were we in a severe depression in the 1930s, but that interest rates had been driven down to near zero, so that the banks were virtually losing nothing by not expanding credit up to their maximum limit.) The conclusion must be that the Fed pushes with a stick, not a string.”
A dainty chart from dshort.com shows of the historical bouts of deflation in US history. Most of the incidences of deflation came on a post war basis after a massive expansion in money supply and artificial demand from a war economy resulted to massive adjustments during in the post war economy.
Since the gold has come off the monetary standard in 1971, despite the strings of crisis during the period (Savings and Loans, Black Monday 1987, LTCM, & dot.com bust), there has been no incidence of deflation.
The Nuclear Option: Currency Devaluation
Another, US Federal Reserve Chairman Ben Bernanke in 2001 spelled out his unorthodox “helicopter” means of avoiding a deflationary recession.
The Fed has always the luxury to use its printing presses, this from Mr. Bernanke’s speech Deflation: Making Sure “It” Doesn’t Happen Here, ``To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”
Or even consider massive devaluation as its nuclear option (emphasis mine), ``Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”
About fifty years ago, in his magnum opus the Human Action, Mr. Ludwig von Mises presciently elucidated of the endgame option available to central banks wishing to escape a credit bubble bust, ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Our Mises moment.
In short, a government single-mindedly determined to inflate the system won’t actually need a functioning private credit system to do so. As we previously said, it only needs the bureaucracy and 24/7 operational printing presses, or it can simply invoke massive devaluation as its nuclear option.
Proof?
Zimbabwe should be the best living testament of such government driven tenacity.
From Albert Makochekanwa, Department of Economics, University of Pretoria, South Africa “Zimbabwe’s Hyperinflation Money Demand Model”
``Borrowing from Keynes (1920) suggestions, namely that ‘even the weakest government can enforce inflation when it can enforce nothing else’; evidence indicates that Zimbabwean government has been good at using the money machine print. Coorey et al (2007:8) point out that ‘Accelerating inflation in Zimbabwe has been fueled by high rates of money growth reflecting rising fiscal and quasi-fiscal deficits’. As a result of that, the very high inflationary trend that the country has been experiencing in the recent years is a direct result of, among other factors, massive money printing to finance government expenditures and government deficits. For instance, the unbudgeted government expenditure of 1997 (to pay the war veterans gratuities); the publicly condemned and unjustifiable Zimbabwe’s intervention in the Democratic Republic of Congo (DRC)’s war in 1998; the expenses of the controversial land reform (beginning 2000), the parliamentary (2000/2005) and presidential (2002) elections, introduction of senators in 2005 (at least 66 posts) as part of ‘widening the think tank base’ and the international payments obligations, especially since 2004, all resulted in massive money printing by the government. Above these highlighted and topical expenditure issues, the printing machines has also been the government’s ‘Messiah’ for such expenses as civil servants’ salaries.”
As you can see, no consumer or industrial or any sorts of borrowing-spending Keynesian framework. It's plain vanilla print and distribute, where money supply exponentially outgrows the supply of goods and services, hence hyperinflation.
So even as US government policy tools have seemingly been unsuccessful to stoke up on its much desired rekindling of the inflationary environment after coughing up about $4.28 trillion of taxpayers money (see The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…), to quote Asha Banglore of Northern Trust, ``The lowering of the Federal funds rate, the Fed’s innovative programs to provide liquidity to financial institutions – PDCF, TSLF, and other programs – and more lenient rules for borrowing through the discount window appear to have exhausted the gamut of possibilities routed through monetary policy changes to influence aggregate demand. The provisions of the Emergency Economic Stabilization Act of 2008 allow for recapitalization of banks. The FDIC is working on obtaining an approval for the anti-foreclosure plan to address the housing market issues that are central to the current crisis. In conclusion, the probability of a hefty fiscal stimulus package with the Fed buying these securities is growing everyday,” the nuclear option or our Mises Moment endgame seem likely a looming reality as the day goes by.
Conclusion: Preparing For The Mises Moment
Finally, as shown above deflationary fears under a Paper money standard seems unwarranted and is not a likely scenario, given the unrestricted powers of the central bank to either use the printing press or its nuclear option- massive debasement of its currency.
Debt deflation in itself is a salutary process which involves the cleansing of malinvestments or the excesses of “exchange of nothing for something” dynamics.
The Great Depression was a product not of debt deflation dynamics only, but was exacerbated by the adaptation of rigid economic policies by the incumbent leadership that crushed business profits and the economic system’s ability to adjust.
Governments determined to inflate don’t need a functioning private banking or credit system as the Zimbabwe experience shows. All it needs is a printing press and an expanding bureaucracy.
Once the inflation process starts to gain ground be prepare for the next bout of inflation!
