To understand the consequences of the credit cycle, we must dismiss pure opinion, and examine the evidence rationally. This article assesses the fate of the dollar on the next credit crisis, a subject of increasing topicality. It concludes that the late stage of the credit cycle has important similarities with 1927, when the Fed eased monetary policy, following evidence of a mild recession.
Contemporary financial markets are inherently emotional, mainly because they are awash with government-issued currencies. Investors and speculators would never be as careless with sound money as they are with infinitely-elastic fiat. Instead, they are ready to gamble with it, partly because they know that standing still guarantees a loss of purchasing power and partly because rising asset prices, which is actually the reflection of a falling currency, makes selling currency for assets an appealing proposition. Furthermore, credit for speculation is freely available through futures and options.
Financial markets are also irrational due to modern economics, the explanation for it all, having become a belief system. If all central banks pursue economic beliefs, as an investor you will probably do so as well, otherwise, you are out of step in a world that follows trends. That works until it doesn’t. Central bankers pursue policies which are a mishmash of neo-Keynesianism and monetarism, the balance between the two setting the fashion of the day, with an overriding assumption that unregulated markets are the source of all our economic and systemic troubles. But there is one element of monetary policy that does not change, and that is a conviction that everything can be cured by monetary inflation.
Is this condemnation of monetary policy over the top? Well, only last week Mark Carney, Governor of the Bank of England, was authorized by the UK Treasury to issue a further £1.2bn of capital, which according to press reports will allow the Bank of England to create further loans totaling more than £750bn.[i] Nice work if you can get it: create some sterling by a few strokes on a keyboard and gear up on it by issuing a further 625 times as much, only backed by the myth that the central bank’s capital is real. What is the purpose? To banish all risk emanating from the private sector, of course.
You can only justify monetary policies of this sort by supposing they are the right thing to do. But it tells us something important: deflation, however you define it, is not the problem.
Deflation is ill-defined
Commentators and analysts appear to be in general agreement that deflation is the greatest risk facing us today, and every time a statistic falls short of market expectations, the walking shadow of deflation flits across the financial stage. We are all becoming nervously aware of the accumulation of debt, and the risk that consumers and businesses are teetering on the edge of another credit crisis.
In 1933, the economist Irving Fisher described how when loans start to go bad, banks liquidate collateral, thereby driving down asset prices and leading to widespread bankruptcies. According to Fisher, a cycle of debt liquidation and falling asset prices interact in a vicious self-feeding collapse, suppressing demand, resulting in falling commodity prices and unsold goods. Nearly everyone is terrified of this risk, forgetting it is something that can only happen with sound money because sound money retains its purchasing power. In the 1930s, the dollar was exchangeable for gold, until Roosevelt made gold ownership illegal for US citizens and devalued the dollar. Today the monetary landscape is vastly different: gold has been banished from the fiat money system and today’s government-issued unbacked currencies are as unsound as they get.
Therefore, deflation is an inappropriate way of describing any economic condition when central banks are prepared to pump unlimited fiat currency into their economies at the first sign of trouble. Wrongly, deflation has become the catch-all description for nearly all forms of economic failure. Instead, we should understand that economic failure, short of wars and plagues, is always associated with monetary inflation, and the undermining of a currency’s purchasing power.
Consider the economic effects of an inflationary monetary policy, such as that of the Argentinian central bank. The government presides over an economy where price inflation is officially running at 26%, but prices are estimated to be actually rising at three times that, based on estimates of purchasing power parity.[ii]
Argentina’s economy is growing at 2% in 2018, according to a recent report from the OECD.[iii] But realistically, the Argentine economy is contracting severely when you take into account the true loss of the currency’s purchasing power, in which GDP numbers are measured. So, from the OECD we have a neo-Keynesian commentary claiming marginal economic growth when the reality can also be described in today’s loose economic parlance as intensely deflationary, because real GDP growth adjusted for inflation is strongly negative.
It is not deflation. Argentina is suffering from severe price inflation, the consequence of monetary policy. The inflationary situation in the US and elsewhere is no different, just less intense. Like the Argentines, the US through official statistics underreports inflation, in this case at only 2.8%, and even that is ignored by the Fed. A more realistic rate of price increases, according to Shadowstats.com, currently exceeds 10%.[iv] This leaves the real Fed Funds Rate adjusted for an approximation of actual price inflation at minus eight per cent, which by any sensible definition is not deflationary.
Despite the monetary reality, the financial community, with an eye only on the overhang of debt, persists in thinking that deflation, not inflation, is the greater risk. This conclusion can only be the result of imprecise economic definitions, which allow the monetary establishment to fool itself along with us all into accepting their inflationary monetary policies are valid.
