This is Not the 1930's...
and that means a Whole Lot of
Inflation to Come, Part
1
Truly Different this Time
Michael Pollaro
posted May 12, 2009
Many comparisons have been
made between today's financial and economic crisis and the Great
Depression, none more than the specter of deflation. Well, contrary
to what happened during the Great Depression and contrary to
the deflationary forecasts of government leaders, central bankers
and economists, deflation, while always possible, is, in this
man's opinion, highly unlikely. Why's that? Because the monetary
and political framework of today is nothing like that of the
early 1930's. In fact, it's nothing like anything seen, ever.
Quite simply, today's monetary and political framework is built
for inflation, as much inflation as the government, the Federal
Reserve and their banking partners want. And inflation, and a
whole lot of it, is exactly what we are about to get.
Inflation and Deflation Defined
Let's begin with some definitions
to help us through this discussion. Today, when most people talk
inflation, they mean generally rising prices, and when they talk
deflation, they mean generally falling prices. This leads to
endless consternation because it confuses cause and effect. For
the purposes of this essay, inflation will be defined as it was
in yesteryears, as an increase in money and money substitutes,
which, holding all other things constant, brings about higher
prices. The former we will call inflation, the latter we will
call price inflation. Deflation will be defined as a decrease
in the supply of money and money substitutes, which, holding
all other things constant, brings about lower prices. The former
we will call deflation, the latter price deflation. Why are these
distinctions important? Because they focus attention on the driving
force behind price inflation and price deflation; that being,
the Federal Reserve and the fractional reserve banking system.
Today's Monetary and Political Framework,
Truly Different this Time
Now, what is so different about
today's monetary and political framework versus that which existed
on the eve of the Great Depression? Simply put, all the checks
on inflation, all the deflationary holes in the system that brought
on the deflation of the 1930's have been removed. In so doing,
the government, the Federal Reserve and their banking partners
have given themselves all the tools necessary to create as much
inflation as they like. What we have today is a fiat based monetary
system at the discretion of politicians and bankers bent on printing
and spending our way to supposed prosperity (not to mention helping
a few campaign reelections and banking interests along the way).
That is not what we had on the eve of the Great Depression, not
even close.
Let's take a closer look:
- On the eve of the Great Depression
and until 1933, there was nothing to protect banks from prudent
depositors wanting their money, that being currency or gold,
or conversely, to assure depositors that there money was safe
when they feared for their savings. Fractional reserve banking,
where banks are permitted under law to loan out depositor money,
while pretending the money is still in their vaults redeemable
on demand, is an inherently unstable system, always susceptible
to a bank run. (1) Murray Rothbard, the great
Austrian economist and expert on the Great Depression (Ben Bernanke
isn't the only one), taught that it's this fear, the fear of
a bank run that keeps the banking system in check. To paraphrase
Rothbard, there is nothing like a bank run to squeeze inflation
out of the system. So when things started going wrong in 1929
and worsened thereafter, true to form, scared depositors, fearing
for their savings, withdrew their money from the banking system
en masse. Deflation, via a contraction in bank loans and deposits,
engulfed the early 1930's. To make sure this never happened again,
the government in 1933 created the FDIC giving the US banking
system federal deposit insurance. Today, back-stopped by the
Federal Reserve's printing press, the FDIC insures all bank deposits
up to $250,000. (2) And when and where FDIC
insurance falls short, both the government and the Federal Reserve
have shown they will stop at nothing to provide trillions of
dollars in asset and or debt guarantees, even equity capital
to any and all banks to keep depositors in the banking system.
I ask you, when's the last time you saw a bank run? That's right,
the Great Depression. Today, the banking system can inflate without
fear of a bank run.
.
- On the eve of the Great Depression
and until 1933, the US was on a gold standard, whereby domestic
and international dollar holders could redeem dollars for gold.
Gold redemptions, and the ever present threat of those redemptions,
limited the amount of money the Federal Reserve could create.
Today, there is no gold standard. FDR ended the right of US citizens
to redeem their dollars for gold in 1933, and Nixon did the same
to international holders of dollars in 1971. Did dollar holders
avail themselves of the right to redeem their dollars for gold
before 1933 and international holders before 1971? Yes they did.
Now, the ultimate bank run, that being a run on the Federal Reserve
itself, has been "outlawed." The dollar is redeemable
into nothing. As a consequence, the Federal Reserve is free to
expand its balance sheet and print money to its heart's content.
.
- On the eve of the Great Depression,
the Federal Reserve's monetization activities were essentially
limited to Treasury securities, banker's acceptances and direct
loans to member banks, the latter largely consisting of rediscounted
business paper. In 1932, the government greatly expanded those
monetization tools by broadening the assets eligible as collateral
against Federal Reserve loans. Today, with the passage of the
Monetary Control Act of 1980 and several other "tweaks"
along the way, the Federal Reserve can pretty much buy anything
it wants, from any bank or non-bank that it wants, by writing
a check on itself. And it can pretty much loan money to any bank
or non bank that it wants, virtually with whatever collateral
it deems worthy. Think Ben Bernanke's alphabet soup of funding
programs. Think the defacto nationalized of AIG.
.
- Until the establishment of
social security and unemployment insurance in 1935, there was
no large scale federal social safety nets through which money
could be injected into the economy. Today, we have a plethora
of long standing, and deeply imbedded safety nets, overseen by
politicians able, willing and ready to use them, especially when
they are funded, not by taxes, but stealth through the printing
press of the Federal Reserve. Think about that. The ability to
inject an unending stream of newly printed money to needy recipients
sure to spend. How big is this stream of money? Given that the
unfunded liabilities of social security, medical insurance and
other trust funds are some $55 trillion, about 3.5 times nominal
GDP, and growing rapidly, very big indeed.
.
- Hoover, FDR, indeed all subsequent
administrations have given us all sorts of bailout packages over
the years. But I think we can agree that we have never seen anything
like this before. Some $30 trillion in bailout money has been
advanced or guaranteed by the Treasury, FDIC and Federal Reserve
in response to this crisis. And it's likely not over. Simply
unprecedented. Combine government bailout packages and social
nets with the Federal Reserve's printing press, and throw in
a few government make-work programs for good measure, and what
do you get? A huge and determined spender of last resort, with
bottomless pockets. This year's federal deficit, the one the
Federal Reserve is now telling us it plans to increasingly monetize,
is likely to surpass $2 trillion. And by the looks of it, we
are only getting started.
.
- On the eve of the Great Depression,
the US was a nation of savers and a creditor to the world. Today
we are the largest debtor in the world. Given that inflation
favors debtors, vote seeking politicians can be "excused"
if they see the "value" in inflation; and voters, neck
deep in debt, with little savings to boot, can be "excused"
for voting them into office. And if foreigners take dollars in
return for their mercantilist toil, only to deposit those dollars
in US government IOU's wholly denominated in currency they know
is coming off a printing press, then hey, what's not to like
about inflation. Sure the US is paying off its foreign obligations
in deflated dollars, but foreigners don't vote, right.
.
- During the Great Depression,
there were numerous voices, even inside the Federal Reserve,
calling for free markets and advising against government intervention.
Who today argues against an active government and for free markets?
Very few. Think no further then the highly respected Federal
Reserve Chairman Ben Bernanke. This is a man who has waited his
whole career to prove that it was the Federal Reserve and its
tight monetary policy before and after the stock market crash
that gave us the Great Depression, that the correct policy response
by the Federal Reserve post the stock market crash was to print
money and to continue printing money until economic recovery
was assured. Unfortunately, the opposite is the case, and it
is why a Bernanke led Federal Reserve virtually guarantees inflation.
Contrary to what Bernanke thinks, the Great Depression was caused
by the low interest rate and loose monetary policies of the Federal
Reserve in the 1920's. These policies created the 1920's boom
which NECCESITATED the stock market crash of 1929 and economic
bust of the early 1930's. You see, by lowering interest rates
and increasing the money supply, you create economic and financial
distortions - mal-investments, which eventually must be liquidated.
Sooner or later, the Federal Reserve induced boom of the 1920's
REQUIRED a bust, and there was nothing the Federal Reserve could
have done to prevent it. (3) Does this have
a familiar ring? It should, because it's the same policies that
caused today's economic mess. So how can more of the same "fix"
the current economic and financial crisis? It can't. Indeed it
will make matters worse. And when it does expect a clueless Bernanke
to respond with yes, even more inflation.
Let's recap. A run on the banking
system or the Federal Reserve, what gave us the deflation of
the 1930's, is no more. The Federal Reserve and the fractional
reserve banking system have virtually no limitations on their
ability to inflate. The transmission mechanism through which
money can enter the economy isn't limited to just the banking
system anymore and its ability or desire to pyramid loans on
top of reserves. Not by a long shot. The Federal Reserve can
inject money directly into the economy, bypassing the banking
system altogether. And then there is the federal government as
the spender of last resort, perhaps at this juncture, the most
important inflation outlet in the new inflation toolset. And
to top it all off, we have a clueless Ben Bernanke at the inflation
levers, as the world cheers him on. Like I said, today's monetary
and political framework - it's nothing like anything seen, ever.
Do the Facts Confirm the Theory?
Let's have a look at the historical
record. First up, some monetary statistics from the Great Depression:
As articulated above, artificially
financed by the inflationary policies of the Federal Reserve
and its fractional reserve banking system, the 1920's boom-turned-bust
created massive economic and financial distortions - mal-investments,
which necessitated liquidation. The resultant business and in
turn bank failures eventually led to runs on the banking system
and on the Federal Reserve itself.
Now contrary to popular belief,
beginning with and in response to the stock market crash, the
Federal Reserve tried repeatedly, and in increasing intensity,
to pump money into the economy by expanding its balance sheet,
to halt the deflation and to get banks to reflate. Clearly hampered
by the burden of the inflation checks of yesteryear, it failed.
(4) Between 1929 and 1933, nothing but deflation.
M1 fell 25% and M2 fell 31%, as demand deposits collapsed by
35%.
Murray Rothbard explains, this
from his Mystery of Banking:
"After Fed inflation
led to the boom of the 1920's and the bust of 1925, well-founded
public distrust of all banks, including the Fed, led to widespread
demands on redemption of bank deposits in cash, and even of Federal
Reserve notes in gold. The Fed tried frantically to inflate after
the 1929 crash, including massive open market purchases and heavy
loans to banks. These attempts succeeded in driving interest
rates down, but they foundered on the rock of massive distrust
of the banks." (5)
and this from Americas
Great Depression:
"If all other factors
had remained constant, and banks fully loaned up, the money supply
would have risen abruptly and wildly... Instead, and fortunately,
the inflationary policy was reversed and turned into a rout.
What defeated it? Foreigners who lost confidence in the dollar,
partly as a result of the program, and drew out gold; American
citizens who lost confidence in the banks and changed their deposits
into Federal Reserve notes; and finally, bankers who refused
to endanger themselves any further, and either used the increased
resources to repay debt to the Federal Reserve or allowed them
to pile up in the vaults. And so, fortunately, inflation by the
government was turned into deflation by the policies of the public
and the banks, and the money supply dropped..." (6)
Then, beginning in 1933, the
federal government and the Federal Reserve, realizing the deflationary
holes in the monetary system, began bulking up. As noted, of
special import, in 1933, the creation of the FDIC and the termination
of domestic gold redemption. And it worked. Between 1933 and
1937, M1 rose by 55% and M2 rose by 42%. After a brief respite
in 1937 and 1938, driven by the Federal Reserve's attempt to
mop up excess reserves in the banking system by doubling reserve
requirements, the money supply kept right on growing; right up
through the end of the Depression and into World War II.
So is deflation a thing of
the past? Fast forward to our current crisis and let's find out.
First, have a look at the Federal Reserve's balance sheet:
Simply the biggest balance
sheet expansion in history. Should we have expected less?
Now let's see how this Federal
Reserve largesse is impacting the money supply:
Other than a minor setback
in M1 in 2007, on the heels of the housing bust, no deflation,
anywhere.
Finally, note the surge in
M1, M2 and MZM from their 2007 lows. Depending on the measure,
year over year growth rates are now running 10%, plus. Unlike
the early 1930's, Federal Reserve largesse is having its intended
effect.
Let's stop and think about
this for a moment. Despite the biggest financial and economic
crisis since the Great Depression, and contrary to all the deflation
warnings from the "experts" we have inflation. Yes,
we have had some close calls, with lots of banking mergers and
consolidations orchestrated, indeed back-stopped, by the Federal
Reserve / Treasury tag team. But in the end, no bank runs. Let
me repeat, an implosion in private sector credit markets, a de-leveraging
of monumental proportions, and we have inflation at double digit
rates. Do you think that these new inflation tools are working?
Doug Noland, author of the
Credit Bubble Bulletin at PrudentBear.com provides
some interesting statistics that show the power and reach of
these new inflation tools. In brief, and as we might have expected,
the federal government, its agencies and the Federal Reserve,
have all stepped up in size:
"The "Flow of
Funds" illuminates why the collapse of the Greatest Credit
Bubble in history has not yet translated into one of the greater
economic collapses. Despite financial panic and the freezing
up of Credit markets, Total Non-Financial Credit expanded at
a 6.3% annualized rate during the fourth quarter... Importantly,
this feat was achieved by the federal government expanding borrowings
at a 37% annualized rate...
"For all of 2008, Treasury
securities outstanding increased an unprecedented $1.239 TN,
or 24.3%.... Combined federal and quasi-federal securities outstanding
ballooned an incredible $1.955 Trillion in just one year. For
comparison, Treasury and the Agencies combined to increase debt
securities $1.146 TN during 2007, $514bn in 2006 and $390bn in
2005. This ramp up of government Credit growth is outdoing even
the historic surge in mortgage Credit during the Mortgage Finance
Bubble years...
"With the "moneyness"
of Wall Street finance having disappeared, the (offsetting) issuance
of government "money" has amounted to nothing less
than a historic explosion of debt issuance. For the year, Agency
debt expanded 9.0% to $3.459 TN. GSE MBS grew 11.2% to $4.965
TN. Over the past two years, Agency debt expanded $585bn, or
20%, and GSE MBS ballooned an unprecedented $1.128 TN, or 29%.
Combined with Treasury's two-year debt issuance of $1.477 TN,
one tabulates incredible 2-year federal government ("money")
issuance of $3.20 TN (28%). And this already incredible debt
growth is now poised to really accelerate. At the Federal Reserve,
Total Assets expanded an unmatched $729bn during the quarter
to $2.270 TN, with one-year growth of 139%..."
I'm not saying deflation can
be totally ruled out. We are talking about a severely distorted
economy, made so by years of inflation. We are talking about
a huge and growing debt load versus income, in many cases hedged
with extremely complicated derivative structures. Could a rogue
event bring on deflation? Sure. But, armed with these new inflation
tools, a determined government, backed by an equally determined
Federal Reserve, can fend off deflation. In this man's opinion,
deflation scares yes, bank failures yes, close calls yes. But
a system wide bank run and thus outright deflation? Not likely,
with a determined Federal Reserve making good on all banking
liabilities via the printing press. As Rothbard once penned,
the deflation case now rests with "the dubious hope of
Fed restraint."
In a recent missive, when contrasting
the experience of 1930's to today, Steven Saville, proprietor
of the excellent The Speculative Investor, hit
the nail on the head when he wrote:
"IMO the similarities
with the early 30s are more pronounced than the similarities
with the late 30s, but, of course, there are important differences.
This time round the government immediately snapped into action
to the extent that overall debt has continued to expand despite
the private sector retrenchment. As a result, rather than an
early-30s style monetary contraction we are seeing the greatest
private sector de-leveraging in more than 70 years alongside
accelerating growth in the money supply. I don't think anything
like this has ever happened before..."
Amen Steve. Now we know why?
Notes:
(1) In any other
industry they call this fraud, but alas not in our government
protected banking system
(2) Recently
increased from $100,000 in the midst of the current financial
crisis
(3) For complete
discussion see Part I and Part II in Murray Rothbard, Americas
Great Depression
(4) For detailed
account see Part III, Americas Great Depression
or alternatively Jeffrey Tucker's well chosen extracts here http://blog.mises.org/archives/007530.asp
(5) Murray Rothbard,
Mystery of Banking (First Edition 1983), page 250-251
(6) Murray Rothbard,
Americas Great Depression (Fifth Edition 2005),
pages 268-269
May 10, 2009
Michael Pollaro
email: jmpollaro@optonline.net
321gold Ltd
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