More on the inflation/deflation tug of war

“If the American people (or any other people) ever allow the banks to control the issuance of their currency, first by inflation, and then by deflation, the banks and corporations that will grow up around them will deprive the people of all property, until their children wake up homeless on the continent their fathers conquered. The issuing power of money should be taken from banks and restored to Congress and the people to whom it belongs. I sincerely believe that the banking institutions having the issuing power of money are more dangerous to liberty than standing armies.”
(Thomas Jefferson)


You of course all know I am squarely in the deflationist camp. To me the dynamic is clear and the reasoning is, so far, supported by empirical evidence.

However, many of you ask me why I think it is so important that we should know whether one economic condition or the other is prevailing. Most of you seem to think that nothing will change to your daily lives; you will still have to go to work or, at least, look for a job; you will still have to take the kids to school and shop for food; you’ll still make holiday plans and generally live your lives as you have always done in the past. After all, our lives are spent trying to figure out how to make ends meet and how to have a little surplus spending money for entertainment or retirement. So, why get worked up about finding out whether we’ll be living in a deflationary or inflationary world?

But this is not idle speculation. Correctly identifying what economic condition will prevail is vital to leading our lives in a certain degree of intellectual, physical and material comfort. I will tell you here and now that if indeed we should have entered a deflationary era, there will be social and economic upheaval and your daily lives will be affected physically as well as materially.

For all practical purposes, the West has lived in an inflationary period since the turn of the last century. This is not strictly speaking a correct statement but since all countries around the world progressively moved towards a fiat monetary system based on the US Dollar, effectively we all have to contend with an inflationary trajectory that dates back to the turn of the last century when the modern Dollar was conceived in 1913.

Fiat money has peculiar characteristics. As a monetary system based on some sort of intrinsic value is deemed to have a cost (the cost of locating, extracting, conveying, refining and distributing salt for example) fiat money is thought to have no such material or temporal limitations thus no intrinsic cost. In the absence of material cost limitations, fiat money is perceived to be “free” by the politician thus by the state.

But, even ” free” money is useless unless it is accepted for transactions by the people and, most importantly, by the government itself. If a government is successful in enforcing the mandatory use of the variety of fiat currency it creates, then a government would have unlimited political power and virtually unlimited spending power.

“Virtually” but not effectively.

Fiat money has no intrinsic cost but it has a cost that accumulates over time. This is what we refer to as inflation.

By choosing to adopt a fiat monetary system, a government awards itself the right to push inflation (defined as the expansion of credit and money supply) faster than the underlying economy. If this was not the case, then we could make do with a monetary system based on a value that is related to the economy like gold for example.

Fiat money is a clever concept. It is flexible and adaptable and could be instantaneously tailored to economic conditions thus  making it a far superior choice to a value based monetary system. The judicious use of inflation could help modulate the business and economic cycles thus smoothing out the peaks and troughs thereby alleviating the consequences of the natural cycles of the economy. The thing is that inducing inflation into a system engenders a rise in prices thus a rise in GDP. As GDP is the measure by which everyone seems to measure success, no politician would ever dream to modulate let alone moderate inflation to within reasonable limits. As far as politicians are concerned if a little inflation is good for GDP then lots of inflation is even better.

But inflation is a devious beast. Inflation is a dynamic that is exponential in nature thus it conforms to the law of diminishing returns. Therefore you always need more inflation in order to obtain the same rate of GDP expansion. Hence the reason that, for example, since 1980 debt has expanded by well in excess of 1200% but GDP has barely expanded by 100%. It follows that as we progress along the inflationary time line, it becomes increasingly difficult to inject inflation into a monetary system. So much so in fact, that at some point during the inflationary dynamic, aberrant practices become vital to the existence of the system thus to the existence of the issuer of the currency. That is because as the GDP number becomes increasingly more dependent on inflation, at some point inflation becomes the goal unto itself.

Graph: Federal Government Debt: Total Public Debt

Graph: Household Sector: Liabilites: Household Credit Market Debt Outstanding

Graph: Real Gross Domestic Product

(NB – above charts only show government and individual debt levels that, by themselves, already equal GDP  – corporate debt and the monetary base are not shown but of course if added it makes the picture even worse)

The point at which absence of inflation spells doom for GDP progression, hence for government, then stimulating inflation by any means becomes par for the course.

Take regulation. Sometimes regulation actually comes about for reasons that are valid in terms of ensuring the safety of the public for example. Very often, regulation just comes about in order to create another level of expense thus multiplying the reasons money must be spent. Things like licenses, stamp duties, taxes, fees and sundry for example. Other examples are overseas aid and development programs. If you are now or have ever been in the past an expatriate in developing countries, you may well have come across some inane projects that have no rhyme or reason for being. And yet, you may have seen governments throwing untold hundreds of million Dollars towards these white elephants. Same with little wars in small remote backwaters in Africa, South Asia, South America or the Balkans for example. And though most often these ventures are wrapped in rhetoric that may have humanitarian/democratic connotations, the reality on the ground is quite different. Take the United Nations. The UN is THE prime example of an inflation play. Of course, the UN are not totally bereft of idealistic individuals that truly believe in their mission. But the fact remains that for all the fuss and all the circuses, the amount of good coming out of the UN is horrendously disproportional to the amount of money that is poured in. Besides; other than the fact that I have yet to meet a member of the UN that has any respect for the organization, it is also true that the moment the UN move into a situation, as if by magic a black market springs up.  Seriously! Have you ever seen so much lavishness and wasted food as at a UN meeting to discuss hunger in the world? How about the ridiculous salaries and even more ludicrous perks that UN employees receive? The truth is that the primary purpose of things like the UN is specifically to create a lot of activity and run at a loss just for the sake of churning money and spreading it far an wide in an attempt to keep inflation on an expansionary trajectory. The rationale of this seemingly perverse objective is to keep money circulating regardless of how, why and where.

In a fiat monetary system, money must circulate because that is the reason a government adopts the system. In an environment where velocity is low and savings are high, the utility of fiat money is lost.

Halas, as an exponential dynamic, inflation conforms to the law of diminishing returns. It couldn’t be otherwise. If that were not the case, then there could be some sort of direct relation between the quantity of credit and money generated and GDP progression. However, empirically, the three charts above show that debt and money creation must run at a far higher clip just to keep GDP pottering about in the low single digits.

As far as the reason why the mere mention of deflation should send a shiver down the spine of those politicians that understand the ramifications, it is because after so many decades of relentless inflation pumping in all economies of the world, we have built an infrastructure that is dependent on continued inflation. If for whatever reason inflation should abate or even become deflation, most human constructs will come apart. Things like mail delivery or public transport; things like fire fighting; things like road bulding and maintenance… things like pensions.

Deflation is not undesirable for those entities that have no debt. Provided you own all your possessions free and clear of any debt, deflation makes for a much more comfortable style of living. Your wealth as calculated by the value of the assets you own will diminish nominally, but, relatively speaking your expense burden decreases too thus leaving you whole. Not so if you are in debt. If any of the assets you “own” are pledged against a loan, in a deflationary environment the value of your assets diminishes but the loan remains outstanding at the original value. Thus your spending power is curtailed and the longer the deflationary bout the harder it becomes for your to hold on to the asset you pledged against the loan.

However, in 90 years of relatively successful inflation pumping, most people alive today have come to believe that government can induce any level of inflation at will. Indeed, this is what Bernanke stated in his famous speech “Making sure it does not happen”.

There is a fringe of independent thinkers nonetheless, that believe that is so much hot air. I happen to be in that fringe.

Essentially, I say that inflation is now dead and buried for quite a few years to come because underlying economic activity is not sufficient to service the debt we’ve built in the past 90 years.

As evidence that our inflationary efforts have now failed and, incidentally, as evidence of the exponential nature of inflation, I give you the following chart;

Graph: M1 Money Multiplier

That is the Money Multiplier. This chart is supposed to show what the multiplying effect of each unit of currency has on the overall economy. I look at this graph and I realize that not only has the effect of fiat money on the overall expansion of the economy been steadily declining for the past 30 years (hence the exponentiality of inflation) but it has now gone neutral; and that, despite the untold Trillions that have been paid out in cash and guarantees by our respective governments around the world.

Assuming you are convinced that deflation is at least a very real possibility, you may be wondering why that should lead us into a third World War.

The reasoning is as follows. Inflation brings forward and compresses in time the demand and production cycles. Excessive inflation pumping brings about excess industrial and commercial capacity. But as the beneficial effect of inflation wanes and as inflation becomes a goal in itself, financial value runs away from intrinsic value at ever increasing rates. The point at which the underlying economy no longer generates sufficient income to service the debt, deleveraging triggers a deflationary spiral.

The more pernicious consequence of deleveraging is a reduction in the tax collected by government. As tax revenue dwindles a government can no longer make good on its external obligations (debt service) and neither can it make good on its internal promises (public spending and pensions). Deflation also bares the various scandals and swindles that have been run sometimes with government acquiescence. So as more people are left without a job, without a home and with diminishing state assistance, civil disorder is sure to follow. If the condition persists, governments are sure to fall too.

Now. If you think that any Western leader could feasibly come out and declare that, effectively, we are bankrupt, then we have nothing to fear. But the historical record shows that the West will not do that. I mean, how likely is it that a Western “industrialized” nation could come forward and declare that, in fact, we are no more righteous or capable than your garden variety Mugabe?

So, in order to keep the masses occupied with problems that may or may not exist, the West is feverishly working towards building bogeymen that, ostensibly, threaten our way or life.

Judging by the feedback I get from people I talk to, the plan Western governments have concocted with the complicity of a pliable media seems to be coming together. I stand by my prediction of global war by 2013/2015

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