THERE’S DEFLATION, AND THEN THERE IS DEFLATION

In Hugo Stinnes [legendary speculator of the German hyperinflation] were combined all the prerequisites for an inflation profiteer. He had the wealth, founded before the war and much enlarged during it, as well as the ability to read the signs of the times and so see how to swim safely and successfully through the turbulent waters of the Inflation. He recognised before his contemporaries the phenomenon born of the Inflation that industrial shares, commercial enterprises, all kinds of assets were cheap, and that their owners, confused and frightened by the prevailing conditions, could be persuaded to part with them at bargain prices. He pounced on these changes like the accomplished asset-stripper of our days, reforming, transforming, and combining these acquisitions with great profit. . . .

In addition, he had the most precious fuel for the money-making machinery: Devisen, Valuta – in other words, foreign currency. . . . In a dollar starved Germany this raised Stinnes to commanding heights, a position comparable to that of an Arab oil sheikh in an energy crisis. Profits were there for the taking.

Last month I wrote “More Taxis, More Prostitutes” to try to explain a widespread fundamental error. Many acute analysts look into the future and correctly foresee a massive business contraction that will inevitably entail writing off huge amounts of debt. However, in likening the last great depression in the 1930s to our time, they make a fundamental error. They forget that since 1971, no currency in the entire world is backed by anything but debt. Every currency in the world is a fiat currency, that is, its value is determined wholly by politics.

That was not the monetary world of the 1930s. Back then, every currency was backed directly or indirectly by gold or silver or both. Now read that last sentence once more, just to fix it in your mind. 1930s, no fiat moneys –- 2000s, no backed moneys.

Therefore in the 1930s, when governments inflated their currencies, it also lowered the purchasing power of gold. Why? Because the gold formed but one element in a currency system composed of gold, government notes, bank notes, and silver. Therefore, when the money supply deflated, through the removal of the various notes, the purchasing power of gold and of all the paper currencies, too, increased.

Compare that to today’s world. In today’s world, gold and silver form no part of the official monetary system, except that gold contributes a very remote theoretical “backing” or “reserve” to the currency supply. That is, central banks own big piles of gold, but only as window dressing to make their fiat currencies appear valuable. The piles of gold are just the point upon which the pyramid of credit and money creation rests. In fact, no one can redeem those currencies for gold. Therefore in today’s system, gold is just one currency competing with many others. Unlike all the other currencies gold is not simultaneously somebody else’s liability.

Understand clearly this difference: in the 1930s, gold and silver formed part of national monetary systems. Today, in 2002, they form competitors to national monetary systems.

I see another error lurking what I read. Even those “hard money men” who see the debt deflation and depression looming on the horizon accept the money manipulators’ model. The friends of paper money --- central banks and their lackey politicians and media – run a propaganda machine to maintain public confidence in their essentially worthless currencies. The propaganda machine harps ceaselessly, ‘Gold is a barbarous relic. Gold is only one more commodity among many.”

Then, even though these hard money men have freed their thinking from the rest of the manipulator’s propaganda (aimed at making us think that trusting them will make us all wealthier and better looking forever), yet they cannot jump over this gold propaganda lie. They share the presupposition that gold and silver are merely commodities among many others, with no qualitative difference.

Gold and silver are not “mere commodities.” By their nature they are money – scarce, fungible, portable, standard of value, means of exchange, store of value, having none-contingent and original value.

What difference does that make? Just this. By definition a “deflation” means that money is becoming more scarce, and hence more valuable. Viewed from a standpoint of prices, that means that the price of everything is dropping – the value of all other commodities is falling.

Here’s where they make their mistake. When they see a “deflation” of debt in process, they infer that the price of commodities will drop – and then they include gold and silver among those commodities.

In fact, just the opposite should occur. As the errors of the Bubble Era surface, more and more bankruptcies occur. Creditors must write off debt forever. Where once money was easy to borrow, now scared lenders are hard to convince. And since all our money is borrowed into existence, the destruction of debt ought to reduce the money supply. Other things being equal, even the value of paper money would rise and the price of things would fall.

But other things are not equal. While bankruptcies mount and the economy shrinks, what will the government/central bank do? Since they have appointed themselves the guardians of everlasting prosperity, they must intervene to stimulate business conditions. By what means can they intervene? Only one way, because they have only one weapon: inflation.[2]

Now the history of the last Great Depression and the last 12 years in Japan show us that inflation will not loose the grasp of a deep seated depression. No, public confidence has been broken, along with the bubble mentality. So no matter how much money is pumped into the system, it won’t kick off new business activity. Rather, the writing off of bad debt and bad investments must proceed until the entire economy has been cleansed.

But meanwhile the authorities are printing more money, and cheapening the value of that money. On the one hand you have people spending less, which lowers demand, which ought to push down prices. But on the other hand you have inflation, which lowers the value of the money, which ought to push prices up. And because the business depression is affecting demand, the results of the inflation affect things differently over time and category. The inflation does not affect the price of everything evenly, ore necessarily ‘logically.” Thus the price of necessities may rise while real estate and stocks fall, since people are afraid to invest and lenders to loan. Or, as we saw in Germany and Austria in 1923, nominal prices of everything rose, including stocks and real estate, but the currency’s value and economic activity fell so fast that both real and financial assets actually lost value. (Try to wrap your understanding around this: I expect an ultimate Dow/Gold ratio of 2:1 or less. Mathematically, that can come at US$1,200 gold and a 1,200 Dow, or at US$12,000 gold and a 12,000 Dow. With gold at US$12,000, how much do you think the 12,000 would really be worth? Right, under either nominal outcome, gold’s real value would have risen sharply while the Dow’s value would have fallen sharply.)

Here recent events in Argentina give us some insight into what might happen here. Picture that in Argentina the US Dollar presently offers “the alternative currency” to the Argentine peso (compare this to gold in the 1923 German hyperinflation). The value of the peso was pegged for 10 years to the US dollar at one peso to the dollar. Then in December the fiscal and financial crisis broke out, and the government pulled the plug on the peg.

But if that’s so, then the price of everything in pesos ought to rise, right? Wrong.

The price of essentials (groceries, for example) and imported goods (paid for in US dollars) rose. Oh, then that means the price of real estate rose, too, right? Wrong. The authorities had closed access to money in bank accounts, whether the accounts were denominated in pesos or dollars. With less and less money in everyone’s hands (a “deflation” of the money supply available for spending) and less and less mortgage money available (because of lender fear and currency uncertainty), the price of real estate has dropped.

So the Argentines have been left in the worst of all possible worlds: the values of their assets (real estate and bank deposits and currency) are dropping, while the cost of daily necessities are rising. Meanwhile, they are losing their jobs as business activity continues to contract, after a four year recession.

This is an inflationary depression. Your money and your stocks and real estate lose their value while you lose your job.

Continuing the Argentine analogy, ask what has happened to the value of the alternative currency?. From the standpoint of the buyer holding US dollars, prices in Argentina have not risen, but dropped. Why? Because Argentine prices are denominated in pesos, and the peso’s value has dropped against the alternative currency, the US dollar.

Okay, now just change the terms and location of this example. Go back through the Argentine example above, and make some substitutions. For “Argentina,’ substitute “the United States.” Everywhere it says “Argentine peso,” substitute “US Dollar.” And everywhere the “alternative currency” is the US dollar, substitute “gold and silver.”

Gold and silver are not commodities like all other commodities. They are money – the peculiar commodity by which all other commodities are valued. Because they are money and not commodities, when deflationary economic conditions drive down the price of all commodities, they will not drive down the price of gold and silver. Rather, deflation will drive up the value of gold and silver.

There is, however, one temporary exception to this rule. As long as the fleeting supremacy of fiat currencies clouds the monetary picture, those fiat currencies will remain marginally more liquid than gold and silver. That is, it is easier to transact business in those currencies than it is in gold and silver.

Here’s an example. I went into the feed store the other day and handed the fellow my credit card, with this remark: “Isn’t that amazing! You give me all these nicely sharpened chain saw chains and a hundred pounds of scratch feed, and I just let you fondle a worthless piece of plastic.”

“Shoot,” he answered, “that’s the only thing you can use in some places. They don’t want cash.”

“Let alone gold or silver,” I said, “If you offered it, nobody would even know they were money.”

He chuckled, but to make my point I reached down into the back of my wallet and pulled out a plastic coin sleeve containing one Dutch ducat and one British sovereign. (I carry gold coins for identification purposes. After all, I am a moneychanger.) I held them out to the clerk and said, “Here – would you take these instead of that credit card?”

He smiled sheepishly, but finally shook his head. “Naw, I can’t. I don’t know what they’re worth.”

Well, precisely. He doesn’t know what they’re worth, but he does know what US dollars are fleetingly worth, so he will take those rather than gold or silver. Investors act the same way, until the light dawns on them.

Economists call the cost of dealing with anything, the cost of negotiating it, the “transaction cost,” and you could define money as “that article with the lowest transaction cost.” So if you are in Huntsville, Alabama, the “money” with the lowest transaction cost will be the US dollar, because that’s what everybody knows and understands. If your wallet holds only Yen or Euro currency, you will first have to add the transaction cost of converting them to US dollars.

If you were in Buenos Aires, Argentina, the same thing would be true, even thought the official currency of the country is the Argentine peso. The US dollar would still be the most liquid currency. But then, if money is the “article with the lowest transaction cost,” then that makes sense. Why? Because the Argentine peso really does have a higher transaction cost, namely the risk that even while you temporarily hold it, its value will decline.

Once again, change the terms of our example. Imagine that the US public begins to see risk in holding dollars. That higher transaction cost will drive them to find a money with lower transaction costs, namely, gold and silver. But for a while, that is, as long as precious metals money have a slight liquidity disadvantage against fiat moneys, then in the initial stages of an inflationary depression the precious metals may stumble or even slide against a fiat currency. A rush for cash as bankruptcies climb might sharpen this trend, but as the fiat dollar’s value comes under attack that impetus for cash (safety) will turn to gold and silver.

Many analysts see the massive debt accumulated during the stock market bubble, and correctly infer that that debt and the huge malinvestment that easy money occasioned must be written off.. That implies that the US economy today will experience the lowered economic activity historically associated with a monetary deflation such as the 1930s accompanied by an actual monetary deflation.

But 2002 is not the 1932. Today the money supply has no meaningful or operating precious metal component. It is “backed,” insofar as it can be said to have any backing at all, by debt. The amount of money in circulation is not determined by economic conditions, but by political goals. The goal of the monetary authorities (the symbiotic federal government and Federal Reserve) is stability. Their only weapon is inflation. Thus they will inflate to combat recession or depression.

In deflations, commodity prices usually decline as money becomes more scarce. However, gold and silver are not commodities like any others. Gold and silver are money, and so do not behave like other commodities in a deflation. Rather, because they are money, they gain value in a deflation.

[1][1] The Great Inflation by William Guttmann and Patricia Meehan. London: Gordon & Cremonesi Ltd, 1975.

[2] All right, technically “liquidity” is the broader and perhaps more apt term. But all of the “liquidity” weapons only have one result, and that is inflation, so I call their weapon “inflation,” but you ought to understand by that the whole armoury of gimmicks the government/Fed uses to increase money supply, to wit, lowering interest rates, guaranteeing loans, subsidising businesses, creating loan pools through Government Sponsored Entities, welfare, corporate welfare, “printing money” (although the government doesn’t really do this any more), defense spending, giving away money to local governments, foreign aid, and all the sorry train that pumps up money supply and mounts up budget deficits when the government serves as “borrower of last resort.” Okay, they have one other weapon, too, blarney or propaganda, but if that isn’t obvious, you haven’t been paying attention.

Banks, Money, & The Dollar