Are Financial Markets Portending Deflation?
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Mathematics tells us that prices, economy-wide, cannot continually increase without additional money entering the economy. “Prices” includes not only consumer prices, but the prices of stocks, bonds, commodities, real estate, oil, gold, and even aggregate corporate revenues and GDP. The new money which pushes prices up is created by the central bank(s) and its member banks in the form of credit. This new money, the foundation of which is debt (credit), is pyramided on top of previous money supported by previous debt. There is, therefore, an inherent and continuous tendency for a credit contraction, i.e., an implosion of debt. To prevent such a contraction, the central bank is constantly creating new money and debt.
When too much new money is created too quickly, the result is typically a large amount of unprofitable investments because the newly created artificial money competes with real savings for a limited number of profitable real investment opportunities –like playing a variation on musical chairs with more and more people, but with the same number of chairs. Having too much money chase too few profitable investments means that much of the money invested will never be recouped once the music has stopped playing. Unprofitable investments result in business losses which in turn spur bank losses. Bank losses culminate in a decrease in the value of bank assets, a contraction of deposits, bank failures, and therefore credit implosion: money is destroyed and vanishes from thin air, just as it was created out of thin air.
We have witnessed these types of mass unprofitable investments and the resulting credit contraction most recently in the form of the housing market collapse, and prior to that in the form of the 2000 NASDAQ collapse, the 1990 real estate collapse, the 1997 Asian currency crises and Russian debt crisis, and the now 18-year implosion of credit in the Japanese economy, among others. We have also recently seen U.S. and U.K banks going bust and the threat of quasi-governmental agencies Fannie Mae and Freddie Mac going bust. For fear of these events resulting in widespread credit contraction, the Federal Reserve is trying to paper over current credit losses with yet new money and new debt. When we witness negative growth rates for GDP, which is mostly a reflection of the amount of money in the economy and not a measure of economic growth, what is being registered is that money has been destroyed and that deflation of the money supply is in progress. Usually, of course, the central bank comes along and prints enough money to raise GDP once more. The question at hand is whether or not the Fed can print enough money to prop up prices in our economy, and whether or not new money being created will be outpaced by old money being destroyed. As was the case in 1929 and in Japan in 1990, so it could be the case now that the imbalances in the economy are large enough to cause such a destruction of real savings and capital that the amount of credit which is collapsing is simply too large to be outweighed by the new money being created. Should this indeed be the case, then we could imagine that in the intermediate future, not only would there be nothing to push all prices higher, but a falling quantity of money would take prices lower.
The possibility of a falling money supply presently occurring may be suggested by recent movements of world asset prices. Since, through time, credit is expanding and not contracting, ordinarily there are at least several asset classes on the rise and making new highs, even while other asset classes are falling. For example, while the world’s stock markets were imploding from 2000 through 2002, commodity and real estate prices were in bull markets. Now, by contrast, though developed-world equity and real estate markets have already rolled over into bear markets (with emerging markets teetering on the edge), other asset classes still in bull markets have recently all fallen from their highs; commodities, natural resources, oil, and gold have all declined substantially (though they did all have large previous gains which warranted a retracement). “Safe Haven” government bonds are still holding up, but not making new highs, and corporate bonds are looking rather weak. And, most interestingly, in the last few weeks, while stocks have fallen, gold and commodities have not moved in the opposite direction from stocks, as they have previously. So, one would have to wonder whether the fact that no asset classes are moving higher means that either not enough new money is being created to push them higher, or worse, that more money is being destroyed than is being created (money supply contracting), thus taking down all prices in the process (demand is declining).
The focus of the discussion thus far has been on asset prices because of the fact that credit is created within in the financial system. Thus, new money created and new money destroyed is usually first reflected in asset price movements, which typically lead the movements in the economy at large by six to eight months. Falling money supply would not take only asset prices lower, but also consumer prices, business revenues, and GDP. Many pooh pooh the notion that this deflation could happen to us today and dismiss as doom -and -gloom crackpots those who claim that it could. But our “leaders” are taking the risk seriously: Ben Bernanke, the Federal Reserve Chairman, is certainly worried that we could see a debt implosion, which is why he and Treasury Secretary Hank Paulson are desperately trying to prop up the banking system. It is, of course, a contraction of the money supply which caused the stock market to continually decline between fall 1929 and spring 1932 (but the money supply and stock market fall were not responsible for turning an otherwise short recession into a 10-year depression! - our politicians were), as shown in the chart below.
Bernanke has said previously that a 1930’s style money supply collapse could not happen today because the Fed would print enough money to prevent it. This is questionable logic, however, because the same strategy failed in the 1930s. Contrary to popular opinion, the Federal Reserve did try to expand the money supply in the 1930s by pumping bank reserves into the system. As evidence of this attempt, the Fed’s holdings of bonds purchased from member banks for the purposes of expanding reserves increased by 300% between 1929 and 1931 . However, this maneuver did not stop the falling market and the collapsing economy because the money was not loaned out and did not enter the money supply. In order for the new money that the central bank creates to make it into the money supply, banks have to feel financially healthy enough to lend their excess reserves to the public, and the public has to feel financially healthy enough to borrow the new money. If either the banks or the public do not make use of the new funds, the money will not make it into the money supply to push prices up. Such has largely been the case in Japan for the last 18 years.
If the financial markets are indeed telling us that deflation might be at hand, we should expect the very nasty downward spiral we’ve all heard about from the 1930s, which involves the lack of access to credit that both businesses and individuals need to repay debts. Without new credit to keep debtors afloat, and with falling incomes and revenues, debt repayment becomes harder, resulting in debt defaults. The result is more bank losses causing more destruction of money, which sends prices even lower, which results in a new round of debt defaults, unemployment, lower prices, and diminished ability to repay debts. Those who have gotten by in recent years by borrowing heavily (and lending) will likely have a tough road, and some will sadly be wiped out.
To the extent that government tried to spend its way out of the recession, the result would be monstrous government debt burdens, and more capital consumed. The more capital taken from savers and from businesses to be spent by the government, the less production and greater impoverishment we would have. Japan has tried unsuccessfully to spend its way out of recession for 18 years. Its spending on bridges to nowhere resulted only in a debt to GDP ratio of over 195%, - the highest of any country in history, next to Zimbabwe. Just as the Keynesian spending multiplier did not work in Japan, it would not work here – it does not multiply incomes, it only raises aggregate profits .To the extent that government would try to keep wages (or any other prices) artificially high as they did during the great depression, instead of falling in line with prices and other business costs, the result will be unemployment, as it was during the great depression. To the extent government tries to prop up bad debts in the banking system, as in Japan today, or forces creditors to forgive debts they are owed, the result will be a savings- and credit-gridlocked economy.
Paradoxically, the best strategy for the government would be to allow prices to fall in order to wipe out the excesses which have arisen from credit creation. Misleading price signals from a central bank-distorted marketplace has altered the economy’s underlying structure of production from what it would otherwise be. Production which would take place in accordance with price signals given by consumers freely expressing their desires without government intervention would place labor, tools, and machinery in different locations producing different goods than they are currently. Contrary to popular opinion, falling prices that re-set the economy and allow the market to clear would not constitute a never-ending spiral.
Though falling prices caused by deflation would be hurtful, it must be understood that falling prices in themselves are a positive and healthy occurrence. Falling prices arising from an implosion of debt are in no way related to falling prices which occur from increased production in a free market. In an economy with a stable quantity of money, or more realistically, in one which has gold as money, the increase in production of goods and services is greater than the increase in production of money (of gold, in the latter case); such was the case throughout most of the 1800s. A given quantity of money supporting an increasing amount of goods results in lower prices for each good. With falling prices and constant wages, standards of living improve. Further, falling prices from increased production does not make debt repayment more difficult: though prices fall, aggregate business revenues and profits stay approximately the same since the decrease in selling prices of products is offset by the increase in number of units sold; more units are sold at lower prices. Debt repayment actually becomes easier because the prices of all consumer goods that debtors purchase go down as time passes, causing real after-debt incomes increase. It should be clear from this difference between deflation-induced and production-induced falling prices that recessions and depressions can arise only from a destruction of money created by the central bank, not from production which takes place with real, non-disappearing, money. The “lack of demand,” “under-consumption,” and “overproduction” fallacies we hear bandied about as causes of recessions can be associated only with artificial credit creation. Contrary to popular accusations, the means by which we grow wealthier – production – is not what causes us to periodically suffer economic impoverishment .
In sum, though the pain of deflation could be tremendous, the best possible scenario would be for government to allow the market to work. In this case, the pain would probably last for a couple of years, after which the economy would again be very healthy. On the other hand, if the government prevents the market from working, the pain could last for decades. During the many recessions of the 1800s, the government mostly left the market to work itself out, and recessions were usually short-lived. But in the 1930s, in Japan currently, and in many Latin American countries in recent decades, governments intervened and prevented the economy from rebalancing itself, with disastrous results. Markets will clear. We should let them.
Kel Kelly @ July 31, 2008