Goes for the Kill For edition of December 22, 2005
In the debate over whether inflation or deflation will eventually wreck the global economy, I’m always eager to take on a heavyweight. Gary North, for one. Let me say first that I have tremendous respect for the man, a writer with the kind of talent that other writers, including me, can only envy. North’s Reality Check is consistently one of the most readable freebies on the web -- a peerless source of wisdom, entertainment and money-making ideas that would be a bargain at any price. North is also a movie buff, and he writes just as engagingly about Hollywood’s glorious past as he does about the coming bankruptcy of the Social Security system.
In the latest edition of Reality Check, published earlier this week via e-mail, North’s topic was “‘Inflation vs. Deflation,’ Revisited.” It is a subject he has tackled many times over the years, always from the inflationist point of view. However, nothing that he has written – and I have read a great deal of his published work – has convinced me that the Fed will be able to prevent deflation. This is notwithstanding the fact that the incoming Fed chairman, Ben Bernanke, has left no doubt that he would consider flooding the banking system with printing-press money if deflationary forces were ever to approach critical mass. But no one in the inflationist camp seems willing to talk about how the only way for all of that funny money to enter the system is to have it borrowed into existence. This implies that, in the end, taxpayers would become major stakeholders in companies that investors now shun, including GM and Ford. They would also become guarantors of those companies’ pension funds and health plans.
Bernanke’s ‘Flat Earth’
Bernanke considers himself to be an expert on the Great Depression and the 1929 Crash, and he evidently has Wall Street convinced that under his watch the Fed will not repeat the monetary mistakes that supposedly triggered the deflationary collapse of the 1930s. I would argue that merely by harboring the belief that the Fed will be able to manage a global debt bubble amounting to hundreds of trillions of dollars, Bernanke has disqualified himself for the job. If you have any doubts about this, consider the following, from the December issue of The Privateer, a monthly newsletter published by William Buckler. He writes as follows:
“As has been exhaustively documented ever since he was nominated by President Bush to succeed Alan Greenspan at the end of January 2006, Benjamin Bernanke’s lifelong study, the issue upon which he has fixed his professional career, is the cause of the 1930s Depression and the Fed’s role in making sure that it never, NEVER happens again. From his studies, Mr Bernanke is sure that with proper Fed ‘supervision’, a credit expansion need never end. He is convinced that given the full powers of the Fed which he will have when he takes control, he can saw off the monetary branch and remain suspended in
mid air, impervious to the forces of economic gravity.
“Mr Bernanke, like the vast majority of his professional economist colleagues, has made very sure that his focus remains fixed on the ‘orthodox’ explanations for what happened to the world in the 1930s. He is a leading light of the economist’s version of the ‘flat earth society’, never letting any incontrovertible evidence to the contrary deflect him from doctrine. And such incontrovertible evidence abounds. The notion of a ‘flat earth’ was exploded more than 2000 years ago in Alexandria in Egypt, where a man named Eratosthenes derived the circumference of the globe to well within 1 percent accuracy using basic geometry. It was confirmed in 1522 when Magellan’s expedition returned to
Keynes Repudiated
“And although economic ‘booms and busts’ have an even longer history than the controversy about the shape of the earth, the modern ‘orthodoxy’ which purports to explain how to perpetually foster the boom while making sure the bust never happens has much more recent beginnings. The ‘bible’ of economic interventionism is Keynes’ The General Theory Of Employment, Interest And Money, published in the middle of Mr Bernanke’s “Great Depression” in 1936. One of the tragedies of the twentieth century is the fact that EVERYTHING in Keynes’ 1936 work had been conclusively refuted in the twenty-five years BEFORE his book appeared.
“This was the work of the Austrian economists in general and of their dean, the greatest economist of the twentieth century - Ludwig von Mises - in particular. Von Mises began the demolition in 1912 with The Theory of Money and Credit. He continued the process with the publication of Socialism in 1922. After that, von Mises wrote voluminously on the fallacies of controlling economic conditions by manipulating money and credit. His major contributions in this area were written between 1923 and 1933. They were collected in a book called On The Manipulation Of Money And Credit in the late 1970s.
“If there is ONE work on economics which the Captain and crew of The Privateer urge our subscribers to read - especially NOW - it is this work. Please note that the main part of the work was written in the midst of the boom years of the 1920s. Everything that would happen to the world during the 1930s Depression was laid out in these essays - YEARS BEFORE IT HAPPENED. So were all the reasons why the end outcome which was the Depression was inevitable. Mr Bernanke has never and will never read this book. Its message to him would be simple: ‘RESIGN - and take the Fed with you as you go!’ You should read it. It is the best preparation for what is to come in 2006 and beyond that you can make.”
Now, to Gary North’s essay; and to my comments -- which, to repeat, are bracketed in italics:
INFLATION VS. DEFLATION, REVISITED
One question that keeps coming from readers is this one: Are we heading for deflation or inflation? If you are concerned about how well your investments will perform over the next year or even decade, you had better come to an answer and then act in terms of it. Therefore, it is time, once again, for me to deal with this one. I have been dealing with it in print for over 40 years. (For the record, this was in a 1964 pamphlet, "Inflation: The Economic of Addiction." I republished it as a chapter in my book, "An Introduction to Christian Economics, 1973.)
To answer this question accurately, we must first define our terms. "Inflation" is an increase in the money supply. "Deflation" is a decrease in the money supply. Monetary inflation produces price inflation. Monetary deflation produces price deflation.
[True enough. But this time around it is not wages and prices that have become grossly inflated, but rather whole classes of assets, including real estate and financial derivatives. If it were only consumer inflation that we needed to worry about, the problem wouldn’t be such a big deal, since the total value of the world’s goods and services economy amounts to no more than $40 trillion. However, the financial economy has a notional value more than six times that size, resting as it does on leveraged financial instruments with a face value estimated by the BIS at $250 trillion. The clear implication is that there is not much tangible collateral to support all of the financial wheeling-and-dealing. Think of the $250 trillion financial edifice as a deflationary juggernaut about to topple. Considering that we barely squeaked through a sub-trillion-dollar S&L debacle in the
North continues:
The most important money supply charts are found here. I implore you: click this link.
Click the first three links on the page. If you refuse to do this, then you are not really interested in the inflation vs. deflation debate. Where is there any evidence of monetary deflation in the
[These charts tell only part of the story. But the more important part concerns how much bang we’ve gotten for each new borrowed dollar. In fact, while U.S. private credit and M3 have expended by a little more than 9 percent over the last two years, economic growth has been less than half that. Seen another way, it now takes more than $4 of borrowing to create $1 of economic growth. This means that credit must continue to expand at an increasing rate just to keep the economy afloat. If you believe that this trend can be sustained forever, then consider yourself a member in good standing, of the inflationist camp. Ditto for another trend, huge foreign purchases of
For the evidence of either looming inflation or deflation, I use the Median CPI, published by the Federal Reserve Bank of
Every time you hear an argument for deflation, come back to these charts: the money supply and the price indexes. They will help refresh your memory. [Again, the focus is wrongly on the relatively puny goods-and-services economy. But it is the $250 trillion financial economy that we should be concerned about, since it rests entirely on collateral that has been artificially inflated via credit stimulus.]
MY PREDICTION
We are heading for more price inflation. [I tend to agree – but only until such time as asset deflation begins to precipitate out. A falling stock market could be the catalyst, but in any event, a catastrophic deflation is going to draw irresistible power from an increase in the real burden of mortgage debt. That does not mean nominal mortgage rates will necessarily have to rise; in the event, even a small downtick in housing values would have the same effect. I say more about this below.]
I have been predicting this since 1963. I have been right every year since 1963. [The very same inflationist rationale has been used to justify buying homes in my old
I bought my first silver coins in July, 1963, with my first paycheck from the Center for American Studies. I was a summer intern. I went to the local bank and started buying. I was earning $500 a month. By the end of the summer, I had bought over $1,000 in silver coins. I sold this to my parents. I used the money for graduate school. In September, 1963, the silver coin shortage began. Toll booths in the
Guilty as Charged
I had known the silver coin shortage was likely ever since the summer of 1962, when Professor Hans Sennholz predicted it at a two-week seminary attended by college students at
In June, 1963, the
So, I have been correct every year since 1963. Consider this when considering the arguments of anyone who predicts deflation. How many years has he been predicting
this? He has been wrong for that number of years.
[Guilty as charged. My first byline on the subject, in Barron’s, was 14 years ago, followed shortly thereafter by a deflation-headlined think-piece in The San Francisco Examiner. But even if my warnings were premature, my deflationist logic was vindicated over the next seven years, when I was virtually alone in being un-fearful of inflation. In 1992, as we emerged from recession with the help of strong Fed stimulus, the monetarists were predicting that an epic inflationary spiral was right around the corner. In rebuttal, I wrote that nascent deflationary forces were already too powerful by then to permit inflation. I was right. And I stuck to my guns even when Fed governor Lyle Gramley fired a warning shot across the monetarists’ bow. Here is what I wrote, in July 1966, under the headline “Fed Insider Dead Wrong": Fed governor Lyle Gramley predicted on CNBC yesterday that the Open Market Committee would vote to raise short-term rates by 50 basis points at its August 20 meeting. He said they didn't do it at the July 3 meeting because there wasn't enough evidence to prove that the economy is starting to overheat. But by late August, he predicted, we'll have seen two more months of statistics for the PPI, the CPI, and the purchasing managers' index, and they should provide ample justification for effecting the long-feared rate hike.
Excuse Me, Mr. Gramley
"I am predicting otherwise. About the only thing that will look overheated come late August will be the equity averages. I'd bet against a rate hike, notwithstanding either Mr. Gramley's insider status or the purportedly bullish look of
[That's a bet that most economists would have taken, and they'd probably have given me odds. But as we now know, inflation remained subdued, and the Fed, rather than raising interest rates, lowered them over the next several years with 13 consecutive cuts. That's how K-Wave autumn manifests itself: inflation fears slowly recede, as easier and easier money has no discernible effect on consumer prices. With inflation seemingly (if mystifyingly) in check, the Fed continues to ease even more aggressively, oblivious to the "good" inflation that is pushing financial asset values into the cosmos.
The party was just beginning back then, but it was plain to see that
Gary North’s letter continues:
The main arguments on each side of the debate never change. Only the believers change. Believe no one -- I mean NO ONE -- who predicts deflation until he supplies you with information about when he first began predicting deflation. He won't supply this information unless you ask. It is just too embarrassing. [I’m not the least bit embarrassed, especially in light of the above. Premature, but not embarrassed. Yes, I thought we’d had it in 1991, and you should read Jim Grant's account of how Citibank nearly went down to understand just how close we came to financial catastrophe toward the end of the statistically mild recession of 1990-91. In retrospect, I erred in predicting back then that deflation was about to swallow up the economy because I had been unable to imagine the cosmically vast scale of the credit inflation that was yet to come. But merely because I underestimated the limits of mass insanity more than a decade ago does not mean I will necessarily be wrong about the likely disastrous effects of the exponential increase in insanity since then.]
North continues:
CNBC Lunatics
Those forecasters who predict deflation do so year after year, attracting a new crop of subscribers from the general population. Why do they keep doing this, if they are wrong, year after year? Because it is their chosen niche in the newsletter market. They supply a counter prediction in order to get new subscribers. There are always newcomers who know nothing about investing who are happy to send in money. They keep sending money for a few years. Then they finally quit, having heard the same inaccurate song for several years. New subscribers replace them. [Rick’s Picks trades both sides of the market and was just as bullish on stocks during the late 1990s as the lunatics on CNBC. But we parted company with them in the spring of 2000, when I told my subscribers it was time to reef the sails. We nailed the top in one of the era’s high-flyers, Micron Technology, to within a few pennies. Anyway, I didn't choose the deflationary "niche"; it chose me.]
Why abandon a marketing strategy that keeps working, decade after decade? Also, these poor souls really believe their own advertising copy. I know most of them. One of them is a second-generation promoter of the "deflation is coming soon" prediction. He is rich, yet he and his late father have been predicting deflation every year since 1967. I debated the man on Joe Bradley's subscription tape service in 1982. [I am not rich, owing in part to the fact that my promotional efforts have avoided disingenuousness like the plague it is.] Using the Bureau of Labor Statistics Inflation Calculator, which understates inflation, we learn that it would take $2,047 today to buy $1,000 worth of goods in 1982. Yet this man has created a newsletter publishing empire based on predicting deflation.
THE CASE FOR DEFLATION
The debate between deflationists and inflationists surfaced in 1973. The best-known deflationists were John Exter and C. Vern Myers. Myers is dead. I don't know about Exter. [I interviewed Vern Myers at his
This is the crux of the coming deflation – that every penny of the world’s hundreds of trillions of dollars of debt must ultimately be paid by someone. If it is to be paid by creditors through the mechanism of hyperinflation, as North implicitly believes it will be, the financial collapse that must inevitably follow will in every respect describe a deflationary world – one with little lending or borrowing, almost no capital investment, no bond markets, and a stock market with thousands of issues trading for pennies on the dollar.]
Exter's argument was coherent. Myers's wasn't. [See Myers quote, above, and judge for yourself.] Exter argued that gold would go up in price even though fractional reserve banking would collapse because of a lack of secure collateral. Gold is the ultimate collateral, he argued. The inverted pyramid of debt at some point will no longer be sustainable. There will be a flight to liquidity. The fractional reserve banking system will implode. Consumer prices will fall. But not gold's price.
Is this scenario plausible? Not then, not now.
Is it possible? Yes. [I agree.] The problem will most likely come from the leveraged futures markets -- specifically, the derivatives market. If there is a major default in this $300 trillion market, inter-bank payments could cease. Bank A would not settle its daily payments with bank B until bank C pays bank A. Greenspan has called this scenario cascading cross defaults.
If it ever comes, the international division of labor would collapse. If credit ever ceases, then the modern world ceases. It would be like a nuclear World War III. No one could settle digital money accounts, including gasoline stations. How would you buy gasoline? How would the local station pay the regional distributor? The modern world is like millions of long, interrelated rows of dominoes. Nobody can see where the rows are. If they topple, everyone will suffer. At that point, only well-armed Amish farmers would survive. Problem: they are unarmed.
Collapse of Civilization?
This is not a case for deflation. This is a case for the collapse of civilization. [Actually, it is a case for deflation. I surmise that North is too keenly aware of the short odds of “cascading cross-defaults” to develop the point any further.] Short of a bank gridlock, what is the case for deflation? If you cannot easily jot down the case for deflation, don't subscribe to anyone's letter until you can. If you don't understand the theory, don't invest in terms of it. [If you understand the quote from C.V. Myers, you know everything you need to know.]
There is one thing that governments can do: order their central banks to buy more government debt. When the central bank buys debt -- or any asset -- it creates new money. The government then spends this money. That money will be spent: by the politicians, by the defense contractors, by the welfare recipients, by everyone who receives a government check. [Bernanke has already fooled everyone once with this drivel, but don’t let North do it again. Both men must surely understand that the only true source of wealth and prosperity is capital investment. If everybody on North’s unconvincingly short list were to be gifted with a million dollars, would any of them be so foolish as to invest it in…what? Autos? Steel? Consumer electronics?]
Here is why there is no logical case for 2% or 5% or 20% price deflation. It relies on a totally implausible theory: governments will not spend money. Governments will ALWAYS spend money -- more than they receive through taxation. [Again, you should ask: Spend money on what?? Government spending is synonymous with waste. Pouring tens of trillions of Monopoly dollars into…whatever is hardly a path back to prosperity. If it were otherwise, FDR’s WPA giveaway would have pulled the
The case for PRICE deflation is the case for MONETARY deflation. [Don’t waste your time trying to imagine what MONETARY deflation might be. Think of deflation in precisely the way it will come knocking on your door: i.e., as an increase in the real burden of debt. Which is to say, having to pay real rates of 9 or 10 percent to service a mortgage on a home worth less than you paid for it. Or having the rate on your $15,000 of credit card debt boosted from 4% to 12% overnight.]
How Deflation Begins
The case rests on the theory that people will not borrow money at some rate of interest above zero. But they will. The modern world is addicted to debt. There can be some markets that experience deflation. Housing is one of them. [Let’s not beat around the bush here: If residential real estate values were to fall by as little as 3% to 5%, pushing real mortgage rates upwards of 10 percent, deflation would come on with the force of a planetary collision.]
But general deflation? No. General deflation that central banks cannot thwart by buying up the actual assets that are falling in price? No. [By now, I hope you can see the fallacy of this argument without my having to explain it to you. Hint: The quality of those assets, and their intrinsic value, cannot be conveniently left out of the equation.]
If a frightened owner of an asset that is falling in price is offered a check from the central bank to buy his asset, he will sell. The central bank is allowed to buy anything as a reserve asset. It can create new money at any time, using the purchased asset as a legal reserve. [If the day comes when the central bank is impelled to become my landlord, we will be in deeper doo-doo than most of us can now imagine. This crackpot scheme raises a dozen questions. Here are two that would be likely to cause immediate distress and consternation: At what value will the central bank carry these properties? And, who will actually “own” the house? My guess is, ultimately, the taxpayers. But the question is made more difficult by the fact that no one knows who owns the central bank. Books have been written about this, but there are no clear answers.]
The deflationary scenario assumes that central banks cannot overcome falling prices by creating money. Until you understand why a central bank cannot buy falling assets, don't take seriously anyone who predicts deflation. [Creating more and more credit money just to stay marginally afloat, is more like it. The biggest borrowing binge the world has ever seen has spawned an alleged economic recovery that by every statistical measure is the feeblest on record. When I wrote my piece on deflation for Barron’s a decade ago, it seemed worrisome that it took about $2.40 of new borrowing to create a dollar’s worth of GDP growth at the margin. These days, though, as I have mentioned above, it takes more than $4 of new debt to achieve a single dollar’s worth of growth. Clearly, this game cannot go on forever.]
Dr. Ben Bernanke, the newly named future Chairman of the Federal Reserve System, has made a prediction in 2002. Pay close attention: “Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”
In short, the U.S. Treasury could buy up every asset on earth by selling the FED its debt. This is socialism on the cheap. The government would own the capital of the world. Why won't this happen? Because the world would at some point stop selling assets to the Treasury for fiat money because of mass inflation -- the collapse of value of the dollar. This is the opposite argument: the inflation argument, not the deflation argument. [Agreed. But the phrase “at some point” offers precious little reassurance on the question of what shape we’d be in at that time. There is no evidence that once deflationary psychology germinates, its growth can be stopped. Keep in mind that
THE CASE FOR INFLATION
Let us start with a fundamental economic principle, one which I have been using since 1963:
It is cheaper for a fractional reserve bank to create unbacked fiat money than it is for
individuals to create wealth.
Computerization has made money creation a lot easier than it was in 1963.
There is also a fundamental political principle:
Incumbents will accept "a little inflation" rather than be defeated at the next election
because of a recession.
Are there any doubts about these two principles on your part? You don't need any further theoretical arguments for further inflation. These two are sufficient. For as long as the central banks of the world are allowed to monetize assets without political restraint, deflation is not a threat. [But there are restraints, since keeping this Ponzi scheme going requires debt to increase at an increasing rate. How do you think a $40 trillion global economy came to spawn a $300 trillion financial economy? If you truly believe this game can go on forever, then by all means, party with the inflationists.]
A complete bank payments gridlock is a terrible but inherently unpredictable threat, but that's not what deflationists are predicting. [Oh yes I am. Trying to keep short-term-debt rollovers sequenced amidst the collapse of a $250 trillion derivatives pyramid will be like trying to build a sandcastle with an avalanche in progress.] A bank payments gridlock would mean that no one could subscribe to newsletters. That would bankrupt all publishers. This would mean that existing subscribers would not be sent the promised newsletters. No deflationist dares to put that in his subscription offer!
There has not been price deflation in the