Why the Next Crisis Will be Deflationary

Miscellaneous Current Events
1

Reason #1, Record Low Yields:

The US 10 yr Treasury note yield recently hit an all-time record low of just below 1.5%. The 30 yr, just under 2.5% - also an all time record. Yields on 2 yr bonds are in negative territory in Switzerland, Germany, and Denmark. The persistently low yields are exactly the opposite of what should be happening during inflation.

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Reason #2, Excessive Debt:

The world is not so much awash in money, as it is awash in debt. Much of the new money created has merely gone to servicing debt. Our period of inflation has relied on continuous borrowing and continuous spending. Government cannot force people to borrow and cannot force people to spend.

Reason #3, Fear:

This is an excellent post by “lubbad” from the Kitco forums (boldface, underlining, and italics are mine):

“The problem with economies is that they are not machines. An economy is not controlled by the monetary policy of governments or central banks. Evidence of this is QE1 and QE2: the liquidity did nothing to free up credit markets. The QE did not work because, fear has taken center stage. People are not buying homes because it is hard to catch a falling knife-they are scared of depreciation and they are not secure in their jobs. Economies are controlled by people within the economy. People spend fiat when they are sure of their job security, and they have faith that the future will be secure. Fiat works well when people are secure. Machines do not have desires, and fears about the future…

…

Jim Powell explained velocity: And that brings us to what economists call velocity. Money responds to the law of supply and demand just as everything else does. Velocity is the speed at which money changes hands. When demand for the money is high, money changes hands more slowly, and velocity is low. This is deflationary…When demand for the money is low, velocity is high.

A key point is that velocity and money supply can act as substitutes for each other. A 10% rise in velocity has the same effect as a 10% rise in money supply. The biggest problem with velocity and money demand is they can turn 180 degrees overnight. If people trust the currency, and suddenly perceive some kind of big threat to their futures, money demand can shoot up.

If you don’t spend your money, that’s the same thing as taking it out of circulation. This can instantly cause the equivalent of a sharp deflation of the money supply by 10 or 20 percent, or more.

That’s what happened in the Great Depression. The Fed was inflating. In 1932, the money supply was $20 billion, and by 1940 it was $38 billion. But fear was so great that velocity was falling faster than money supply was rising. This is why Franklin Roosevelt said in his first inaugural speech, “The only thing we have to fear is fear itself.” People were afraid to spend their money, as they are now, and velocity was falling, which has the same effect as deflation, because if you don’t spend your money, it’s not in circulation.

These wild shifts in money demand and velocity have the same effect as massive, instantaneous shifts up and down in money supply. It’s like we’re having a huge inflation, then a deflation, every few hours — because our fears change every few hours — because the politicians have all this arbitrary power and we don’t know what they’re going to do to us!

It is important to see that the economy is not a machine. Machines don’t feel, they don’t have fear…But people, biological organisms, do have feelings. They do fear, and their fears can change instantaneously.”

https://www.kitcomm.com/showthread.php?t=93752

2

Reason #1. Interest rates are low because central banks are printing new money and buying those treasuries. New money means gobbling up resources by the printer of the money with no previous production on his part. Net result: Decrease in the pool of resources. Ineveitable byproduct sooner or later: Higher prices.

Reason #2: So the new money has gone to servicing debt. So what? Somebody gets that money, right ? It’s not tossed into a rubbish bin. And that someone [Hint: the creditor] will spend that moolah. See second sentence of Reason #1 and the continuation.

Now maybe the discussion is about phony money, meaning money created by fractional reserve banking in the form of a check issued to someone. By some complexity of the system which I forget, such money disappears when repayed to the bank. So indeed if everyone just pays their debts and nobody takes out new loans, then the money supply created by FRB will shrink. But this is not happening. nobody is repaying their debts; on the contrary, everyone is getting deeper and deeper into debt.

Reason #3. First of all, that analysis of the Great Depression is highly questionable. See Friedman and Schwartz’s famous work, which concludes that the Great Depression began when money inflation ended. Even Austrians acknowledge this, merely insisting that continual printing might have delayed the Depression, but would have resulted in destruction of the value of the dollar. Also, that the root cause was not stopping the money inflation, but it’s increase in the first place, which caused malinvestments.

In any case, who exactly is slowing the velocity of money? The govt is spending at an unprecedented rate. The average household is $40,000 in the red. The average college student is 100 grand in the hole. These people are spending huge amounts.

I’ve seen Kel Kelly argue that in a large economy, like the USA for example, velocity cannot really change by that much.

Finally, an Austrian analysis of price inflation concludes that it is a function of an increase in the money supply, meaning that a few people [heads of central banks] can actually control whether there will be inflation or deflation, by deciding whether to print more money or not. So the analysis of what will happen no longer depends on what anybody else is doing, or what is happening in the economy, but rather on one simple question, to wit, what most benefits centarl bankers and their masters, inflation or deflation? That’s what will happen. And of course, the govt being the world’s largest debtor, it is clear that inflation is what they want, and that’s what we will therefore have.

3

The Fed Chairman said he would dump money from helicopters to get people to spend it. If the Central Bank creates enough money then eventually the rest of the actors in the economy will go into a spending frenzy. And the people at the Fed can and these crazy maniacs WILL create as much money as they want to without regard to consumer behavior.

It does not matter if people are afraid, eventually they will realize that other parties are dumping their currency for physical assets so they will too.

4

Hyperinflation is itself a form of deflation. For one thing, it’s the result a massive deflation in the demand for the given currency. For another, it involves massive consumption of capital - in other words, massive deflation of the capital stock. Finally, it involves a massive collapse (deflation) in the division of labor.

This whole deflation vs. hyperinflation thing is kinda moot, if you ask me. That’s because the end effects are pretty much the same. The main reason I side with hyperinflation over deflation is because central bankers, as a rule, fear deflation more. This is because the name of the game is to keep profits rolling in for banks, especially the big banks. This requires expanding the supply of money and credit.

If the end-the-Fed movement gets hijacked by greenbackism (which I think has a fair chance of happening), leading to Congress reverting the Fed’s functions back to the Treasury, then I think the probability of hyperinflation approaches one.

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The difference is Austrians correctly believe that the money supply shrank because of private hoarding, while Chicagoans believe the Fed did not try to inflate, which it did.

Reason #3. First of all, that analysis of the Great Depression is highly questionable. See Friedman and Schwartz’s famous work, which concludes that the Great Depression began when money inflation ended. Even Austrians acknowledge this, merely insisting that continual printing might have delayed the Depression, but would have resulted in destruction of the value of the dollar. Also, that the root cause was not stopping the money inflation, but it’s increase in the first place, which caused malinvestments.

6

People were hoarding money (storing it for future use) that they withdrew from a hosed up over managed banking system that was collapsing because the structure of the whole system was designed to protect certain banks at the expense of consumers and other entrepreneurs.

And the other reason for hoarding rarely mentioned is that when the Fed began inflating, especially after leaving the Gold Standard, consumers had to hold more cash to maintain the same purchasing power that they had on hand previously.

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The difference is Austrians correctly believe that the money supply shrank because of private hoarding, while Chicagoans believe the Fed did not try to inflate, which it did.

From America’s Great Depression, by Rothbard:

Alarmed at the burgeoning boom, and at the stock prices that rose about 20 percent in the latter half of 1927, the Fed reversed its policy in the spring of 1928, and tried to halt the boom. From the end of December 1927, to the end of July 1928, the Reserve reduced total reserves by $261 million. Through the end of June, total demand deposits of all banks fell by $471 million. However, the banks managed to shift to time deposits and even to overcompensate, raising time deposits by $1.15 billion. As a result, the money supply still rose by $1.51 billion in the first half of 1928, but this was a relatively moderate rise. (This was a rise of 4.4 percent per annum, compared to an increase of 8.1 percent per annum in the last half of 1927, when the money supply rose by $2.70 billion.) A more stringent contraction by the Federal Reserve—one enforced, for example, by a “penalty” discount rate on Reserve loans to banks—would have ended the boom and led to a far milder depression than the one we finally attained. In fact, only in May did the contraction of reserves take hold, for until then the reduction in Federal Reserve credit was only barely sufficient to overcome the seasonal return of money from circulation. Thus, Federal Reserve restrictions only curtailed the boom from May through July.

Yet, even so, the vigorous open market sales of securities and drawing down of acceptances hobbled the inflation. Stock prices rose only about 10 percent from January to July.40 By mid-1928, the gold drain was reversed and a mild inflow resumed. If the Federal Reserve had merely done nothing in the last half of 1928, reserves would have moderately contracted, due to the normal seasonal increase in money in circulation.

There’s more, of course, but that’s the essence. He makes no mention of private hoarding.

8

QE1/2 has not yet produced significant general price inflation primarily because of the introduction of the FED’s (relatively) new tool of monetary policy, namely the fact that it is paying interest on reserves. The FED is paying banks not to lend; it’s paying them to sit on that money, and this has, in fact, constricted credit and led to a contraction in velocity. It is not inflationary if the newly created sums do not enter circulation. The problem with this, of course, is that the FED cannot keep this condition going in perpetuity. It must, at some point, either withdraw those reserves from M0 or allow them to flow into circulation (where they will be multiplied via fractional reserve banking).

This is something that almost everyone seems to be unaware of.

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“the FED cannot keep this condition going in perpetuity.”

why can’t it?

10

This is why I have trouble with Ron Paul’s/Bob Murphy’s predictions on imminent hyperinflation. Even if it’s something like his haters taking his words out of context, which they usually are (ie “OMG he’s predicted it since the 1970s but it didn’t happen he’s wrong lolololol”), I don’t see any signs that massive hyperinflation will arise in the coming years.

11

Central banks are generally impotent in creating inflation in a debt-deflation environment. Banks aren’t lending because they are capital impaired and they don’t have qualified borrowers. If anything has been proven in this recession, it has to be that the money multiplier is total bunk. Bank reserves, in and of themselves, simply do not create inflation.

I think you can make an argument during inflationary periods that reserves act as a catalyst, hence the punchbowl effect that other central bankers have discussed. But central bank/monetary policy has major limitations, and it has nothing to do with paying .25% interest on reserves. Commercial banks are insolvent and there are not enough qualified borrowers to create the amount of loans to cause any sort of tangible inflation.

In this type of environment(debt-deflation) the only way to create inflation is through fiscal policy or unorthodox political involvement in monetary policy. Hopefully things don’t get that bad, and those idiots get involved.

Inflation may come in the future, but it won’t be until the balance sheets of the public and commercial banks are repaired,. Then, and only then will the excess reserves become an issue for the Fed.

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This is why I have trouble with Ron Paul’s/Bob Murphy’s predictions on imminent hyperinflation. Even if it’s something his haters are taking his words out of context, which they are (ie “OMG he’s predicted it since the 1970s but it didn’t happen he’s wrong lolololol”), I don’t see any signs that massive hyperinflation will arise in the coming years.

Agreed, somehow the libertarians missed the boat. Paul, Casey, and Rothbard have been predicting imminent hyperinflation for the last 30+ years, yet it hasn’t materialized. I don’t see any signs either. I am in Europe right now and everyday I see businesses folding and people holding back on purchases. People are worried about NOT having enough money. They are not worried about shortages. That being said, I do believe we’ll see hyperinflation, but it will be after the debt bubble has collapsed.

Reason #1. Interest rates are low because central banks are printing new money and buying those treasuries. New money means gobbling up resources by the printer of the money with no previous production on his part. Net result: Decrease in the pool of resources. Ineveitable byproduct sooner or later: Higher prices.

Japan has done just what you’ve described for two decades, yet no inflation.

Central banks are in a catch-22 situation. While they don’t want deflation, they are just as fearful of inflation, because it would force interest rates up. That would be suicidal, as just a small rise in rates would bankrupt governments along with the tens of trillions in unfunded liabilities. Ironically, that situation would end up being deflationary.

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Japan has done just what you’ve described for two decades, yet no inflation.

No. See http://mises.org/daily/5170/

I agree about banks in catch-22.

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So indeed if everyone just pays their debts and nobody takes out new loans, then the money supply created by FRB will shrink. But this is not happening. nobody is repaying their debts; on the contrary, everyone is getting deeper and deeper into debt.

Could you provide some evidence to back this up? From what I can find, it seems you are incorrect on this point:

As you can see, since 2008 private sector debt as a percentage of GDP has been heading downward.

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Hyperinflation of a currency occurs when the demand for that currency collapses. As long as that doesn’t happen, there won’t be hyperinflation. That being said, I think persistently high inflation - what Gary North calls “mass inflation” - can trigger such a collapse in demand for a currency. According to John Williams of ShadowStats.com, actual inflation figures in the US are higher than before the Panic of 2008, at about 10% per year, but the official inflation figures are significantly lower. In any case, I’m not sure that the (presumably) actual 10%/yr. inflation being known to most people would lead them to lose faith in the US dollar. But I think they would if inflation was at 100%/yr. (i.e. prices doubling between one year and the next).

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I doubt that 10% figure. Anyway, I believe what we’ve experienced during the last three years was “reflation” - a rally in the prices of commodities, real estate, and stocks after getting beaten down so badly during the `08-09 crisis. Commodity and oil prices are still well below than their 2008 peak. Real estate are well below their peaks as well:

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Why do you doubt that figure? Have you looked at John Williams’ methodology? If so, how do you think it’s flawed?

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Because eventually the economy will recover; eventually there will be a restructuring and a liquidation of malinvestments. This must necessarily occur, even in the face of vast government intervention, and when it does, the risk associated with lending will fall and the demand for loanable funds will rise dramatically. This, in turn, will mean higher real interest rates.

The interest rate that the FED is paying the banks not to lend, therefore, will be way too low. In other words, the banks will decide to lend that money (putting it in circulation) rather than keeping it “parked at the fed” at a relatively lower rate. The FED, if it wishes to prevent that money from entering circulation, must pay a higher rate which, in turn, will lead to a more rapid acceleration in money supply growth.

In order to drain those reserves, the FED must sell the bonds that it has purchased (fed has tripled its balance sheet over the last 3 years) which would send interest rates through the roof, destroying the bond bubble it created, leading to massive capital-losses and interest rates that are way too high for most businesses, home-owners, etc. Foreign investors would dump U.S. bonds which would lead to a relative devaluation of the USD. This is, of course, something that the FED will try to avoid at all costs.

​The more the FED expands the supply of base-money, the more of a shock it will create when it begins to undo this process and remove the excess reserves from the banking system. Some people have said that this isn’t a problem because the FED can gradually remove the excess reserves over time so that it doesn’t produce a shock. This, unfortunately, will fail because investors will anticipate this and trigger a massive sell-off from the private market (people will want to get out before they take capital-losses or in order to minimize their capital-losses). The same way that today investors are purchasing government bonds en masse in anticipation of FED purchases in the future, they will sell en masse in anticipation of FED sales.

[EDIT]

The key, again, is that that money must eventually enter circulation, either via loans, the purchasing of securities, or the banks may just increase their own remunerations tremendously.

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Because eventually the economy will recover; eventually there will be a restructuring and a liquidation of malinvestments. This must necessarily occur, even in the face of vast government intervention, and when it does, the risk associated with lending will fall and the demand for loanable funds will rise dramatically. This, in turn, will mean higher real interest rates.

Agreed. But the period of adjustment and deflation will likely be more painful than anybody can imagine. At that point, you’ll see a real recovery.

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Because eventually the economy will recover; eventually there will be a restructuring and a liquidation of malinvestments. This must necessarily occur, even in the face of vast government intervention…

How do you explain the Great Depression then? It only ended when govt spending ended. But should a govt decide to spend forever, the economy may never recover.

What is your take on this?