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PONDERING INFLATION
AND DEFLATION
Before we contemplate
the future at all, it is good to remind ourselves that God has
hidden the future from us. We cannot know it, so whatever
expectations we might form, no matter how good our reasoning, they
remain just guesses. We can overlook fundamental forces that
completely foil our expectations. Having heard and digested that
warning, let’s consider first inflation versus deflation,
and then present conditions.
INFLATION vs.
DEFLATION
My first reaction to
this debate is somewhat irritably to cast the whole thing aside as a
ridiculous waste of time. The monetary authorities (Federal Reserve
and US Treasury) have at their disposal only one weapon:
inflation. The political system survives only by bribing its
constituencies: inflation. The monetary system, which
borrows all money into existence, must continually grow or die:
inflation. The political structure, built brick by brick in the
70 years since the Great Depression, has proclaimed itself Guarantor
of Universal Prosperity. The whole building has been constructed to
fight the devil deflation by inflation. That is their
sole weapon, other than blarney.
Overwhelmingly, the
existing monetary and financial institutions exist for one identical
purpose: inflation. There is a reason for this. Their
world view was formed in the 1930s, during an intractable
deflation. “Intractable” means “not to be handled; unmanageable;
ungovernable; stubborn, obstinate, refractory, ungovernable;
untoward.”
Stripped down to its
skeletal strategy, every plan of the Roosevelt administration shared
one solitary goal: inflation. Why? Because prices for
everything were dropping, the money supply was shrinking (as banks
called in loans, loans defaulted, & the public refused to borrow or
spend), wages sank & unemployment reached 25%, and economic activity
shrank while no government action could break the nose dive.
OVERINDEBTEDNESS
The deflation was
intractable for two reasons: overindebtedness then and
cowardice now. In the Twenties’ boom the Federal Reserve had
puffed up the money supply. As always, that artificially lowers
interest rates (“artificially” here means, “contrary to the market’s
genuine direction”). That makes money look cheap, so people borrow
more than they otherwise would. Low interest rates make speculating
cheap, and so encourage it. The speculative money finds its way
into stocks, bonds, and real estate, creating bubbles.
COWARDICE
Then the bubble of
overindebtedness bursts. That’s where the cowardice comes in
– well, not really “cowardice” but a radical reversal of outlook.
Society’s expectations suddenly turn 180 degrees from “optimistic”
to “pessimistic.”
Not only must the bad
debt be written off, but debtors find that no lenders will lend them
more. Deflation is worsened by the drop in money’s velocity. No
longer optimistic, both consumers and businesses save their money
rather than spend. While before money might have turned over five
or six times a year, now it only turns over twice.
Around the world the
irresistible, inexorable process of writing down and writing off the
bad debt will continue until it wrings every last bit of folly out
of the economy.
In the late 1980s and
early 1990s John Exter kindly befriended me. Mr. Exter had seen his
father lose almost everything in the Depression, and in the late
1930s had attended Harvard graduate school. After the war he went
to work for the Federal Reserve, briefly leaving to set up a central
bank for Ceylon, then returning to the New York Fed as VP for gold
operations. In the early 1960s he worked for First National City
bank. As he became aware that the Fed and the US government were
adopting an inflationary policy, he began to advise anybody who
would listen to buy gold. He left banking and became a consultant,
advising his clients to buy gold and gold shares, well in time for
the wild ride of the late ‘60s and ‘’70s.
Travelling around the
country, Mr. Exter would make essentially the same speech. He used
an upside down pyramid to depict the financial system, with layer
after layer of increasingly shaky debt built on a tiny point of
gold. His point was that when it began to break down, the junk
bonds and dicey assets would all evaporate: deflation. (You
can read my interview with Mr. Exter at
The Moneychanger > Articles >Money, Markets & Metals >
The Economy, “John Exter, Simplex Munditiis.”)
But John Exter never
claims that gold will suffer from this deflation. Just the
opposite, in fact.
INFLATION OR DEFLATION
It sounds contradictory,
but every inflation creates a deflation. By that I mean that as
inflation erodes purchasing power, it simultaneously shrinks the
money supply’s real size. Although the numbers of money
units in circulation grows, what they will purchase shrinks.
Try to get a grasp on
how powerful the inflationary mechanism is. Not only does the
government have hundreds of outlets for inflation, from student
loans to GSEs to corporate and individual welfare, think about the
inflationary power of the banking system. For every $100 dollars on
reserve, the banking system right now is required to keep
seventy-five cents [sic] in reserve. Since the multiplier is
the reciprocal of the reserve requirement, for every $100
deposited in banking system, banks can create $13,279.10.
Now some will say, “Yes,
but banks will be afraid to lend and borrowers to borrow!” Right,
the ones with any brains will be, but after you remove that two or
three percent from the US population, there will be plenty of folks
lining up for that cheap money. Besides, if all else fails the US
government will drop hundred dollar bills out of airplanes. The
government itself will become the “spender of last resort.” It
already has, with Bush’s war in Iraq.
If you want to know how
the US ruling elite will react to deflation, look at Japan. They
will do all those things, and more, and all of them amount to
inflation.
Does anyone seriously
believe that the US ruling elite, up to and including Alan
Greenspan, would hesitate even a moment to destroy the US dollar if
they thought that the only way they could hold on to power? Of
course they will destroy the dollar.
HYPERINFLATIONARY
DEPRESSION
In August, 2002 I
published an article about the monetary and economic turmoil in
Argentina, “More Taxis, More Prostitutes.” I recommend you re-read
that article. If you are a new subscriber, send us $5.00 and a
stamped, self-addressed envelope and we’ll send you a copy (or you
can e-mail us a request, including your name and address, and
we will e-mail you a copy gratis.)
Why focus on Argentina?
Because their problem resembles the future problem here.
The Argentine disease
was massive foreign indebtedness and an overvalued currency.
The US disease today is
massive foreign indebtedness and an overvalued currency.
The US is the world’s
largest debtor nation. The US dollar is, according to expert
estimates from the last four years, 25% to 45% over valued. From
its 120 peak on the dollar index, a 25% drop in the dollar would
take it to 90; a 45% drop to 66.
Over the last year the
US dollar’s course has made one thing crystal-clear. The Bushites
have chosen devaluation as their tool to end US current account
deficits and stabilise the dollar – stand aside and let it drop.
Since 1945 the US dollar
has served as the world’s reserve currency, allowing the US to
export its inflation. That status was founded on confidence in
the dollar. Confidence translates into the willingness of
foreigners to hold dollars.
But if the dollar pays
almost no interest (thanks to Greenspan’s genius), and it drops 25%
a year, what foreigner in his right mind will continue to hold
dollars? Certainly the Chinese, exporting like crazy to the US, will
keep recycling their excess dollars into treasury bills, won’t
they? At some point, the pressure to abandon a corrupt currency
builds so high that central banks around the world capitulate. The
rats bail out of the sinking ship.
At that point, the
United States will be a country with massive foreign indebtedness
and an overvalued currency. Then the currency will drop.
The result in Argentina
has been the worst of both worlds, hyperinflation and depression.
The price of necessities rises, the value of assets (financial and
real estate) falls. Economic activity seizes up, while employment
plunges. Bankruptcies abound as debt is written off. The value of
the money, and all assets denominated in that money, evaporates.
And of course, there’s
the debt, all that debt in the US. The mortgages and the consumer
debt and corporate debt and government debt. Much of that will be
written off in a great debt deflation.
WHERE’S THE EXIT?
So, please, you tell me
– where is the exit? How do you protect yourself against
these trends? Get out of stocks (except precious metals stocks).
Get out of bonds, because the debt deflation and rising interest
rates will gut those. Get out of real estate, because it is another
bubble. For those of you reluctant or afraid to buy gold or
silvers, several years ago I recommended you buy 13 week US Treasury
bills from US Treasury Direct (800) 722-2678. However, you have to
remember that Treasury Bills is just another way to spell
U-S-d-o-l-l-a-r-s. Whatever wounds the dollar will make treasury
bills bleed.
I know that some very
intelligent and skilled thinkers, men like Robert Prechter, believe
that deflation lies in our future, an actual increase in the value
of US paper money before gold and silver take off. Because
of the overwhelming US institutional bias toward inflation that I
have sketched out above, I just cannot reach that conclusion.
I am still convinced
that the US government and federal reserve will continue to respond
to shrinking economic activity and even financial panic with the
same weapon they are already using, the only weapon they have (other
than Samson’s): inflation. The cure for that problem is to
shift your wealth into gold and silver, or real (not financial)
productive assets.
-- F. Sanders
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