Why We Are Facing an Inflationary Depression

Zimbabwean Bank Notes, 2008

Is the global ‘recovery’ faltering? Is the United States economy heading for a ‘double-dip’? These are the headlines after recent disappointing economic data releases, in particular the weak employment report last Friday.

Truth be told, there never was a proper ‘recovery’, if the term is to denote a process of true healing, of fundamental betterment.

Recessions occur because of economic imbalances – and the imbalances that caused the financial crisis and the following recession are predominantly still with us. The few imbalances that somehow have dissolved or improved have been replaced with new ones. The reason for this is the misguided policy of ‘stimulus’.

Why is the economy weak?

The allocation of capital and the direction of economic activity were, to a considerable degree, misdirected in the preceding boom, which was, as is now painfully apparent, in no small measure an artificial boom based on easy money and cheap credit. At the end of that boom the economy had accumulated various dislocations, from artificially high real estate prices to overextended bank balance sheets. At that point a meaningful recession had become unavoidable. It had to unfold with inescapable necessity.

High levels of debt are not necessarily bad in themselves but presently they are simply not supported by current and prospective real income streams, or by the willingness of the public to save and thus provide the means to allow asset prices and debt levels to remain at these elevated levels.

The recession is the inevitable cleansing process by which economic structures and prices get realigned with the underlying preferences of the public, in particular the public’s propensity to save which sets the speed limit to sustainable capital formation.

Painful? –yes. Necessary? – definitely.

Why is ‘stimulus’ not working?

What is usually discussed under the misleading term ‘stimulus’ is entirely ineffective in solving the problem. Indeed, it is counterproductive. Suppressing interest rates further and injecting more money into the banks and – to some degree – the economy again creates an illusion of high savings-availability. This may – for some time – delay the deleveraging process and the dissolution of capital misallocations, and to some degree it may even encourage new capital misallocations – new projects funded with printed money rather than true savings. Such a policy is designed to mask the extent of the problem and project an illusion of stability.

Ben Bernanke (Photo by U.S. Federal Reserve)

Furthermore, this policy systematically distorts asset prices. In fact, with QE1 and QE2, it has now become the declared goal of the United States Federal Reserve to manipulate asset prices in order to generate near-term boosts to the GDP-statistics, as explained by chairman Bernanke here. This has “worked” in recent months and quarters in the sense that it has partially arrested the cleansing process and sustained the mirage of normalcy. Not for the U.S. housing market which is truly beyond saving but for the extended financial sector which is subsidized with zero-percent interest rates and the debt monetization program (“quantitative easing”). However, such a policy is constantly pitted against the accumulated dislocations, which are urgently pressing towards a resolution – that solution would be achieved through asset price deflation and debt reduction, mainly through defaults.

The policy of ‘stimulus’ through government spending is, if that is possible, even more absurd. Government spending does not add anything to the economy that wasn’t there before. No new resources are being added. What the government spends it has to take from the private sector. If the government taxes the private sector, that is self-evident. If the government borrows the money it taps into the existing pool of savings, taking money that would otherwise have gone to private sector borrowers, such as corporations. Remember that what is being saved does not drop out of the economy. In order for the saver to receive any interest income or dividends the money has to be invested with someone. Even more troubling is the fact that government spending is now predominantly or fully funded by the central banks and their printing presses – either directly or indirectly via the banking sector. This is now the case in the United States, in Britain, in Japan and in the Eurozone. Not only does this policy increase overall debt-levels and the system’s dependence on ever more money creation, but it also increases – via artificially low rates – the very dislocations that were the cause of the downturn in the first place.

All that fiscal policy ever does is replace the private control over society’s resources with governmental control over those resources. By running deficits and accumulating debt the state obtains more control over resource employment than it already obtains via taxation. Forget the childish New Deal myth – no country has ever furthered its economic wellbeing by handing control of its resources to the state bureaucracy.

As I explained before, the mainstream has adopted the Keynesian concept of “aggregate demand” and thus believes that what matters is that somehow the sum of recorded economic transactions over a given period of time be maintained at some predetermined level, that therefore any activity counts for as much as any other, whether it is voluntary and occurs on free markets, or whether it is directed by government dictate.

Accordingly, the interventionists – the government officials, central bankers, and the mass of economists and commentators who cheer them on – always claim victory whenever their policies lift the aggregate GDP statistics. But all they are doing is treating the symptoms while making the underlying disease worse.

What I described here – in terms of problems, mainstream misconceptions and adopted policies – does not only describe the situation in the United States but also in Britain, the Eurozone and Japan. There are marginal differences but the problems – and the misguided policy responses – are essentially the same.

It should therefore not come as a surprise that the forces of contraction, which emanate from the accumulated dislocations, will from time to time regain the upper hand over the forces of inflationary expansion, which emanate from ever more aggressive and desperate ‘stimulus’ policy.

What’s the endgame?

Who will ultimately win in this tug of war? There can be no doubt that it will be the forces of contraction. The present structures are unsustainable. There must and will collapse.

Image by Salvatore Vuono

Those who share this view sometimes tell me that I am therefore too negative on the prospect of paper money’s survival and too concerned about the inflationary meltdown. Should you not hold paper cash to wait for asset prices to collapse in the deflationary correction and then buy cheap assets? Maybe you could even park some money in government bonds, which usually benefit in a deflation. Is the gold price not too high? I think that all of this is incorrect. We will get a depression AND inflation. The present structures will collapse, banks will fail and states default, but in the process our present paper money system will be destroyed.

We are facing an inflationary depression.

As so often, Ludwig von Mises put it best:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

In short, what we are facing is less Great Depression of the 1930s, and more Germany 1923, Argentina 2001 or Zimbabwe 2008.

Ludwig von Mises; photo by mises.org

Our future is not predetermined, of course, but all signs point in this direction. We will see ongoing debt accumulation, predominantly by the public sector, and entirely funded by money creation. When the public loses confidence in the solvency of states and banks and the purchasing power stability of the state’s paper money, the following will happen: Banks will lose deposits; the velocity of money will accelerate; yields on government debt will shoot up. Inflation accelerates at the same time as the problems for banks and states mount. But banks and states are underwritten by the central banks, which now have a mandate to guarantee ‘financial stability’. In the collapse central banks will create ever more money ever faster to prevent the contraction – a futile effort.

Why is this the endgame?

What makes me so confident that this is by far the most likely scenario?

1) The zeitgeist. What Thomas Kuhn has described for science (“The Structure of Scientific Revolutions”) is even truer for economics and economic policy debate. Dominant paradigms exist and the mainstream finds it difficult or impossible to even consider alternative intellectual frameworks. The belief in the power of ‘stimulus’, either by monetary or fiscal means, is unbroken. Even those who occasionally argue that ‘quantitative easing’ has gone too far, or that it is not needed or not effective at present, usually argue from an intellectual position that maintains a role for ‘stimulative’ monetary policy in principle. It may be true that Bernanke yesterday poured some cold water on the hope for QE3. But just give the force of contraction a few more months and QE3 will surely be on the agenda again.

2) The central banks are already trapped. Even if all central bankers read Mises’ “Human Action” today, they would find it difficult or impossible to change course now. Without ongoing substantial support from near-zero interest rates and ongoing central bank balance sheet expansion, the fractional-reserve banking system and the public sector would collapse. Which central bank bureaucrat would want to put his or her name on that? The system is already fully underwritten by the printing press.

The Federal Reserve’s balance sheet expanded by 27 percent year-to-date (non-annualized!), and the Fed bought more than the entire new issuance of U.S. government debt for the past six months. Meanwhile, British banks bought more than 90 percent of the UK government’s new issuance over the past six months, no doubt helped by low funding rates provided by the Bank of England despite rising headline inflation.

The Easy B, photograph by Florian K

But the most telling example is probably the European Central Bank (ECB). In theory, the ECB should welcome the default of Greece as it takes pressure off the central bank to try to inflate the debt away. In a proper monetary union, as under a real gold standard, sovereign borrowers are just like private borrowers – at full risk of default, and thus required to live within their financial means. A Greek default could send a powerful message to sovereign borrowers and their lazy lenders. (There is a perfidious remark making the rounds in financial markets that private lenders are being opted in. What? They opted themselves in by lending to Greece in the first place!)

As Doug Casey has observed, default is simply an admission of failure. The failure of the borrower is that he borrowed too much. The failure of the lender is that he lent too generously. The whole matter is between these two parties. But, revealingly, this is not the position the ECB takes. Instead, the ECB is fighting default, or reprofiling, or restructuring, or whatever the Eurocracy deems to call it, tooth and nail. Why? Because thanks to the ECB’s pervious policy interventions, the central bank is now the largest holder of Greek debt. A default will hit its capital base hard. Secondly, the ECB is already underwriting the European banking system via its low interest rates and generous liquidity provision, under which it accepts all sorts of toxic waste as collateral. A Greek default will hit the banks and force the ECB to print more money to help them.

But the ECB has no alternative to the Greek default. The solution it proposes is essentially immoral and economically counterproductive: To make the productive part of the Greek population or the productive part of the German population pay higher taxes to pay for the reckless spending of Greek politicians and the reckless lending of German banks is wrong and ultimately not workable.

As I said in a previous Schlichter file, the ECB’s recent rate hike doesn’t mean anything. A meaningful rise in rates is out of the question. The ECB’s balance sheet, like that of the Fed, the Bank of England and the Bank of Japan, will continue to grow. These central banks are no longer disinterested bystanders, watching the economy and arguing when to withdraw the punchbowl. They are part and parcel of the state-bank alliance. Independent central banks? What a joke!

3) The mainstream underestimates the power of changing expectations and, in particular, of waning confidence in the system. There is still a widespread belief that states that control their own printing press can inflate their debt away. This is nonsense. It has never worked. The holders of government bonds and the holders of bank deposits are not going to sit patiently and let inflation erode their wealth. When the public wakes up to the fact that states and banks are only kept in business through ever more money creation and that rising inflation is not transitory, they will lose faith in the state’s paper money quickly. The fact that the wider money aggregates are not yet growing very rapidly is then of little comfort. When the public fears inflation and tries to reduce money balances, inflation will rise in any case. As explained above, the central banks will then be forced to print MORE money, not less. This is how all paper money systems collapsed.

What does it mean for investments?

Against this backdrop I consider it extremely dangerous to hold large cash positions in the hope that a meaningful deflationary correction would be allowed to occur and that one could than scoop up real assets at bargain prices, such as precious metals, other commodities or real estate. This would assume a substantial rise in paper money’s purchasing power when measured against these assets. I consider this exceedingly unlikely.

Bill Gross: Too early but still right

Even more suicidal, it seems to me, would be an investment in government bonds, such as U.S. Treasuries. A lot is being made in the mainstream media of the recent rally in Treasury bond prices. On this one I continue to be with Mr. Gross. Maybe he was early but he is still right. In the highly unlikely event that a deflation would be allowed to take hold, the U.S. government would certainly face bankruptcy. Remember that today nobody buys Greek bonds in response to weak economic data from Greece. Quite the opposite. As a government bondholder you ultimately face either default or inflation, probably both. You can’t win.

I am not underestimating the extent of the dislocations and the forces of contraction but I think the deflation camp may be underestimating the power of the paper money producers to destroy their creation.