M1: I Was Wrong

I am very sorry to do this, but when one has made a serious mistake in public, one must make a public admission.  M2 has grown, in addition to M1:

It is only growing from a much larger base, so that proportionally the change is smaller and I did not notice it on casual inspection.  I should have been more careful.

What does this mean?  What it means is that the monetary aggregates are increasing because of new lending.  The accumulating bank reserves which have caused so much consternation are finally being lent out.

To most people, this will be a hopeful sign.  It means that markets are returning to 'normal.'  To me, this is a scary sign -- that inflation may have finally made its return.  But I suspect we'll all be scared by the prospect of 'recovery' in due time.

Raining on the Deflationist Parade

Vox Day is a Worldnet Daily opinion columnist and host of the blog Vox Popoli.  He is also an economics enthusiast with a penchant for the Austrian school, and a deflationist.

Like most deflationists, for some time he consistently danced around the issue of exactly why he believed deflation could occur.  He did not seem willing to lay his cards on the table and lay out exactly what mechanisms or scenarios or accounting would or even could result in deflation.  I even bought and read his book Return of the Great Depression, hoping to find the answer in there.  It was a decent read, with some sections I found quite insightful and some I thought did not make much sense, but with respect to the subject of deflation it failed to deliver the goods I was looking for.

Several weeks ago, however, he finally did lay his case out pretty well in a column for WND.  Up until this point, I was ~99% sure the deflationist scenario would not play out and that the deflationist argument was incorrect.  Having read this, I'd have to call it ~99.99%.  And since Vox has a pretty good reputation as an avid detail-monger who gets his facts straight, often able to articulate his opponents' stated positions and theories better than his opponents themselves, I think he probably represents the deflationist case pretty well.

It therefore came as some surprise to me to find that, to my understanding at least, the column contains several major errors, most of them centered around the functioning of the FED and what constitutes money.  I suspect that it is these misunderstandings that are the principle division between the inflationist and deflationist camps, and a bit of discussion might help to clear up any confusion in the minds of those who can’t quite decide what to make of this debate.

Several important mistakes can be found in these few sentences --

Moreover, this substitution of public debt for private debt is unsustainable beyond the very short term because the federal government cannot issue an unlimited amount of Treasury securities, which is how it borrows money, and expect to find buyers for them. Nor is the oft-expressed notion that the Federal Reserve can buy an infinite amount of its own loans a reasonable one because the Fed is a private bank, and its owners aren't about to destroy the value of their holdings to bear the full weight of the American economy. While they have clearly been willing to try papering over the recent gap in demand for U.S. debt, there is absolutely no chance they will attempt to fill in a permanent chasm by altruistically falling on an inflationary grenade for the benefit of the American people. As I have written before, the Federal Reserve can print paper, but it cannot print borrowers. There is no question that if the USA was on a true paper system, the politicians would print money until the presses overheated, but that is not an option under the present monetary regime.

First of all, you cannot buy what you already own, and the FED has no authority to issue its own debt which it could buy back from buyers.  So either interpretation of "the FED buying an infinite amount of its own loans" is incorrect.  Both transactions would be nonsensical.  A central bank issues debt as a sterilization measure - to counteract inflation, not to instigate it.  An observer of monetary statistics really should see through this supposed inflationist argument pretty quickly.  The FED might get the authority from Congress if it asked nicely, but it would never do so just to buy its own debt back.  To do so would not cause inflation or deflation.  It would be a wash.  It would be buying and selling the same asset at the same time and have no effect on anything.  The FED also does not need debt to buy in order to increase the money supply.  It can buy whatever it wants.  It has bought gold bullion in the past; I see no reason why it couldn't buy other such physical assets in the future.  Why not the Hoover Dam or Manhattan real estate?  Theoretically, it is supposed to buy only highly liquid assets, but in buying the "toxic waste" of the banking system, it seems to have disregarded that convention.

That brings up another fallacy.  The FED cannot be bankrupted, so it doesn't matter that its balance sheet has been destroyed by its recent activities.  The banks who "own" the FED don't need to worry about its solvency, let alone its profitability.

Such an analysis completely misunderstands the position of the FED.  The FED is a mostly-private bank, at least about as private as any large-institution-grafted-to-government-at-the-hip is in this country anymore, however, it does not exist to make a profit.  It pays out salaries to its employees every year, plus overhead, plus a fixed dividend to the banks that own it, and the rest of its income, which is most of it, it returns to the Treasury.  Not the behavior you'd expect of a profit seeking venture.  Yes, the FED is owned by the banks, but is more or less forbidden from making a profit.  This odd ownership/unprofitability juxtaposition is probably the place to begin to understand the FED's purpose.

As owners of the FED, the major banks pack the FED's various boards with their own representatives.  Like the rest of our government-financial complex, the whole thing is inbred, riddled with incestuous relationships.  For one thing, it really ought to strike one as peculiar that entities which should be competitors have joint ownership in the entity which is supposed to regulate their activities.  It should bring to mind the word "cartel," which is as accurate a description of the relationship as any. 

Think of the banking system as a criminal syndicate or a crime family.  (I know, it’s not that difficult…)  The FED is The Godfather.  The Godfather doesn't get his hands dirty in the day-to-day operations of the family business.  He keeps things in line, enforces family discipline, takes care of the cops, and makes sure nothing interferes with "the take."  In short, the FED doesn't exist to make a profit, it exists to make sure that Goldman Sachs, Citigroup, J.P.Morgan-Chase, and the other big boys of the banking system make a profit.  In return, the FED and its employees enjoy a cushy existence and lots and lots of power.

But all of those are side issues.  On the inflation/deflation front, he appears to take a very literal, very simple, "all debt is money" stance, with which I'll have to disagree:

Contrary to the assumptions inherent in the series of estimates, guesses and outright fabrications that go into the magic formula that produces the current measure of an economy, Gross Domestic Product, most spending, be it consumer, corporate or government, does not come in the form of money proper. This should be obvious to anyone who has ever used a credit card, signed a mortgage or read a government budget…

… As you can see, total debt in the American economy absolutely dwarfs both of the money supply measures. It is 30.9 times more than "the total of all bank reserves that are physical currency plus total demand accounts," M1, and 6.2 times more than "M1 plus savings accounts, money market accounts, retail money market mutual funds and small denomination time deposits," M2. This indicates that an increase in either the M1 or M2 money supplies is not going to be inflationary if Z1 is decreasing, because in a debt-based monetary system, total debt is the real money supply.

Really?  Because I took my credit card bill to the grocery store the other day and they wouldn't let me use it to pay for anything. Wouldn't take the bill for my house payment either. They thought I was crazy. 

What's that you say?  That's obviously not the way credit works?  Seems obvious to me, too, but that's the only aspect of credit instruments that has anything to do with Z1!  So why in the world would the absolute level of Z1 have any effect on inflation?  How would my shrinking credit card balance, the balance I already owe, cause prices to fall?  If anything, other things being equal, it might even cause prices to rise since I have less debt to service, and can even think about running up a little more debt and expanding the money supply in the process.

The credit part, the part that actually pays for things for which a drastic rise or fall could reasonably be expected to influence prices, is not drawn from Z1 but from someone's cash balance somewhere who has chosen to lend money to me. New credit may only be extended from an existing cash balance, not from existing debt.  Credit fueled price inflation can only be spurred as a function of increasing cash balances, i.e. money supplies. These cash balances would therefore appear in M1 or M2, not Z1. M1 and M2 have an impact on pricing, not the supply of credit already extended which has yet to be repaid.  Z1 is money already spent, not money waiting in the wings to be spent.  Its magnitude is irrelevant. 

Oh, and no, I didn't actually attempt to buy groceries with debt.  Just trying to illustrate a point…

What is more relevant as far as debt is concerned is that new borrowing is taking place.  New borrowing from banks increases the money supply.  Under most circumstances, then, a rising Z1 would indicate money creation and an inflationary environment. However, the converse does not hold.  I have been over the rules of the creation and destruction of money before.  The rules of debt creation and destruction are intertwined with the rules governing the creation and destruction of money and somewhat related, but completely different with respect to effects on pricing.

There are basically two ways to create new debt -- borrowing from a bank, and borrowing from a non-bank.  Borrowing from a non-bank has no effect on the money supply or on purchasing power.  The lender forfeits his money and therefore his immediate purchasing power to the borrower, who spends the money into the economy.  No change in the money supply, no change in price levels.  Pretty simple.

Borrowing from a bank has a different outcome.  The borrower receives and spends the money into the economy, while the lender retains his money and purchasing power.  This is because of fractional reserve accounting, as explained before.  The ultimate lender is not the bank, but the bank's depositors, who retain control of their deposited funds even after the funds have theoretically been lent away.  The inflationary increase of the money supply has come because of the accounting, not the lending itself. 

Deflationists!  Pay attention!  The following paragraph is the most important of this insignificant essay!  It might be the most important thing you read in the next five minutes!

The bank might try to trade the loan as an asset, but this is not inflation any more than products coming off an assembly line and into the market constitute inflation.  Any attempt to trade the debt is likely to result in the seller being forced to accept a discount, precisely because the debt is not money.  Money does not trade at a discount precisely because it is money.  Money is the economic calculation and accounting device -- all other goods are discounted against it.  This is why it is so important to distinguish between actual money and any other form of debt if one is going to insist on thinking about money as debt.

And nobody is going to trade the monthly payment for anything, except maybe a smaller monthly payment.  In any event, trade itself is irrelevant to absolute price levels, except in its role of increasing efficiency as part of the division of labor.  But that, clearly, is an entirely different issue.

Debt can be destroyed in four ways.  It can either be repaid or defaulted, and this can occur to a bank loan or to a non-bank loan. 

In the case of default or repayment to a non-bank lender, the debt is destroyed in both cases and money destroyed in neither.  If you are the lender, obviously you would prefer to be paid back, but for the economy as a whole, Z1 declines and the money supply is unchanged.  Either outcome is inconsequential except to the actors involved.

When a bank is involved, however, the situation changes.  If a bank loan is repaid, both debt and money are destroyed, assuming the money is not re-lent.  This is deflationary not because total debt has declined, but because the money supply decreased.  If the loan is defaulted, however, the money supply remains unchanged, while the total debt is reduced.  The money created by the loan and the money in the deposit account are still completely spendable.  That is just how the accounting works.  If enough loans are defaulted, the bank will eventually fail because it will be forced to default on its liabilities. 

In such a case, the money supply would be reduced because the money held in its deposit accounts would disappear, however, the FED and FDIC prevent this by seizing banks before the failure and covering over the looming default.  This is accomplished by selling FDIC "securities" a.k.a. adding to the national debt, kind of like Social Security accounting, new money being produced in the process because it is the banking system buying the "securities," i.e. debt instruments, i.e. loans with new fractional reserve money.  So, the failure of fractional reserve accounting is covered over by more fractional reserve accounting, and the destruction of money is compensated for by creating new money through the same process. The impact of defaulted debt is absorbed by adding to the national debt.  In general that is how "bailout" works.  Make sense?

If you ever investigate the "deflation" of the beginning of the Great Depression, you will likely at some point encounter a graph like this --

It comes from a book by Milton Friedman, (well, the data, not the graph itself) tracing the causes of the Great Depression back to monetary policy.  In his view, the FED did not inflate enough at the onset of the downturn, which was what caused all the trouble.  Friedman is a monetarist, perhaps The Monetarist is more precise, so he does not subscribe to the Austrian view of things.  However, the graph is revealing in that the AMB remained more or less inflationary over the entire period, while the M1 and M2 aggregates fell dramatically early on, and later recovered their inflationary trajectory.

What you are seeing is the destruction of deposit accounts as banks failed early on in the event.  Defaults set off a chain reaction that took down thousands of banks, as default led to bank failures, which led to more default, etc, and despite the FED's vigorous expansion of the monetary base the deflation of monetary aggregates could not be stopped.  This uncontrollable cycle led to the establishment of the FDIC in 1934, after which you can see the deflation stopped.  There is as clear a picture of what a change in accounting can do as any. 

The point is, the "deflation" of the early Great Depression was largely the result of deposit account destruction that accompanied bank failure, not mere destruction of debt.  I'm quite sure that defaults continued after 1934, and even some more bank failures, yet no more uncontrollable deflation occurred because the cause had been remedied.  Financial markets have encountered the effects of this kind of debt destruction before, and steps have been taken and accounting rules changed to ensure that such a deflation cannot happen again.  Those deflationists that point to the Great Depression as a model for what will happen this time around had better come up with a reason why the FDIC will suddenly not be up to the task when it has been perfectly adequate for upwards of 70 years.  Since the inception of the FDIC, for all intents and purposes, there has never been any significant deflation whatsoever.  So long as it is not allowed to fail by Congress, I would expect that trend to continue.  And if the government was not willing to let the too-bigs-to-fail collapse this time around, why would it let a full blown federal agency?

Remember, this is a numbers on paper game.  The government can cheat, has cheated, and will cheat all it wants to ensure that this type of thing does not happen again.  Instead, it will be something else that happens.

If you've been keeping up with this blog, you already knew most of that.  The major point is this -- Z1, the total debt level, can fall, even at drastic rates, while at the same time new loans are created and the money supply increases.  The destruction of old debt and the creation of new debt are two completely different processes, and only a fraction of debt destruction, the repayment of bank loans, results in any destruction of money.  Obviously, if bank loans were being repaid, the banks wouldn't be in trouble, and in case you haven't been paying attention, a certain borrower has been borrowing at a $1+ trillion per year clip, namely, Uncle Sam.  Any of this debt financed by a bank is monetary inflation, just like any other debt financed by a bank.

I will say it is a bit unusual historically to see falling debt levels and monetary inflation, but this is only the result of a peculiar set of circumstances.  There's been an ongoing boom for 20 years or so and it's easy to become accustomed to things looking a certain way.  But so long as new bank lending exceeds bank debt repayment, the magnitude of Z1 or how it is changing is irrelevant.  The money supply is increasing.

Therefore, the inflationist who insists that “only money is money” and consumer prices are tied to money supply proper has no problem predicting inflation in a collapsing debt market, so long as the collapse is primarily a result of defaults, there is a deposit insurance system in place, and there is still some level of bank lending going on.  The “all debt is money” deflationist, on the other hand, has some 'splaining to do when debts are being wiped out left and right but consumer prices remain stable.

The only deflationist argument I can anticipate is that my credit card bill example is just a contrived and disingenuous argument that distorts the real situation.  I never would have guessed that the deflationist opinion was really as simple as "all debt is money, period."  I thought for certain that there was more to it, because it seems strange to me that anyone would be persuaded by such an argument, but I suppose I was wrong.  My example is not contrived and seems to me to reflect the deflationist's case quite accurately, if in a rather harsh light.  If it appears absurd, well, what is there to say?  I do not subscribe to the theory.

Nevertheless, I will offer one more line of reasoning to dissuade anyone with deflationary sympathies.  If one truly believes that accumulating debt levels drive up prices, one cannot also simultaneously believe that the banking system, fractional reserve banking, and monetary inflation is the cause of the business cycle.  In fact, the notion that "inflation is always and everywhere a monetary phenomenon" goes out the window as well.  For even in the absence of a banking system and any amount of monetary inflation altogether, non-bank lending and debt would still accumulate.  If "debt is money" and causes price inflation, and therefore mispricing, malinvestment, and the business cycle, the deflationist must argue that the business cycle is not caused by the deceitful accounting practices of the banking system at all but is a natural phenomenon of any economic system that allows the extension of credit.  He must insist that the only stable market is one that forbids the lending of money at interest altogether.  He might find a place for himself in Muslim economic circles, but he certainly cannot subscribe to the Austrian school, as Vox Day and many other deflationists claim to.

I really dislike advancing this argument, however.  I'm not one to much like arguments resting on demonstrations of internal inconsistency, as they sound too much like shrieking "hypocrite, hypocrite!" to me.  For persuasive effect, I'd much rather just show or be shown where an argument is wrong, as I am not overly concerned with mere internal consistency in favor of getting as much right as possible and being mostly at peace with the knowledge that I'll always be a screwed up human being in many respects.

Yes, it is important to seek harmonies and consistencies across systems of beliefs and ideas.  It can lead to insights into unfamiliar regions of inquiry, and point out areas that might need some hammering out.  But in my opinion, making it an overriding concern is a mistake for a limited being such as a human because the only way to get everything consistent within himself is to be in harmony with what he naturally is -- broken, limited, and prone to error.  In other words, obsession with internal consistency will not push one toward perfection, but away from it and towards consistency with his broken self.  It results in either believing nothing or being wrong about everything.  You are never going to get everything right because you are a human being.  Better to accept the tension of inconsistency between your failings and the things you have managed to get right than to allow the failings wipe out everything else.  At least get some things right!

Besides that, it seems rather narcissistic to me.  Isn't one being persuaded by little less than an argument that shows that a particular belief is in conflict with your own "perfect" reflection in the philosophical mirror?  Maybe others do not see it that way, but I do and I really do not like it.  Is there a man alive who is in no way a hypocrite?  I say, show me a man, and I'll show you a hypocrite.  You might as well insult a person by calling him a human as use the word hypocrite. Or inconsistent. Perfection is not man's to have.  That is pretty well common knowledge.  So why is it that this argument/accusation alone seems to carry so much weight where others usually fail to make any headway?  And why does the observation of inconsistency draw such loathing?  Isn't it to be expected?

Anyway, I've gotten way off track here.  Suffice it to say, I'll settle for plodding along and picking up what little bits of wisdom that I can scrounge together.  I don't usually find the "hypocrite, hypocrite!" argument to be very persuasive.  But for whatever reason others seem to respond better to this form of argumentation, so I offer it up.  I actually preferred the negative example argument and explanation I started with.

To sum up, it seems to me that any talk of deflation had better be accompanied by a demonstration of collapsing money supplies, not just debt levels.  Graphs like the falling debt-to-GDP ratio are interesting (thanks Aaron!), and it is certainly true that debt has been put to more productive uses than $7,000 plasma televisions and other uses of so-called “consumer credit.”  But I still say that a TV is a capital good, just a very foolish “investment” in most cases.  Might even call it a malinvestment, eh?  Economists of the 19th century would roll over in their graves to see what we will borrow money to do these days, and it certainly must have implications for the economy.  However, I do not think that one should get overly concerned with falling debt levels, or think that inflation is somehow good for the average guy and bad for the banking system, and that deflation is on its way. 

Inflation vs. Deflation: The Verdict

We've come to the conclusion of this series. I hope that everybody who was interested in doing so has been able to follow my arguments and the logic of how everything works without my confusing things too much for you. We've pretty well reviewed the mechanics of a fiat money system and the economic quandary that the FED has put itself in. So, if you've managed to follow it all, you are pretty much up to speed, as least on the basics. In case you missed a post or two, here is the full list:

• Inflation: What It Is and What It Is Not
• Banking and the Money Supply I: Inflation
• Banking and the Money Supply II: Deflation
• Interest Rates and the FED
• The Symbology of Money
• The Origin of Economic Bubbles: The FED and the Business Cycle

I trust that, external to all of this, most folks are familiar enough with the political situation to know about the gargantuan fiscal deficits that are presently being run up by the federal government. I also trust that most will understand that, despite all the promises of the political class to the contrary, this deficit promises to widen further as our government appears to have taken on the role of insurer of every financial asset known to man. Based on our discussion of the business cycle, I hope it is clear that it is a foregone conclusion that even more losses are on the way, so we are sure to see ever more "claims" filed with our "insurer," and ever larger deficits to cover them. Simply put, the FED has put the entire economy and financial system in a position of being completely dependent on a constantly increasing money supply coupled with near zero consumer price increases and low interest rates. To anyone with a modicum of common sense, this is clearly unsustainable, yet without these three ingredients, the pricing regime we presently enjoy comes to an end. As we saw last fall, and even as far back as 1998-2000, the beginning of the end appears to be upon us. For an excellent alternative discussion of how all this works, see the latest installment of the series Leo directed us to a few weeks ago. And just as the economy is addicted to monetary inflation, the federal government is addicted to subsidized interest rates as a result of the FED purchases of Treasury debt, as well as purchases by foreign central banks such as China, Russia, and Japan to subsidize their own export markets and suppress their currencies. It has run up deficits far and away beyond any reasonable level thanks to this cheap financing which looks about to dry up. How will the FED respond? What is the likely fate of the dollar and our economy? In case you haven't yet surmised my conclusion my answer to the inflation/deflation debate is a resounding inflation. What the FED Has Been Up To In response to the financial crisis of 2008, the FED did precisely what we would expect it to have done: attempt to prop up capital prices and protect the banking system by inflating the money supply without initiating undue consumer price inflation. Thanks to the unfolding economic chaos in response to its temporary monetary tightening that clearly revealed the mistakes of the preceding years, the FED could safely assume that resumed monetary inflation would not lead to immediate consumer price increases since money would not make it down to average Joe consumer. It would stay locked up in businesses and the financial system, which had suddenly become much more worried about improving their hemorrhaging balance sheets than with aggressively expanding market share and beating out the competition. Survival was at stake, costs were slashed, and employees tossed overboard. As you now well know, the FED was completely correct and this has been exactly the case. The unprecedented explosion of the monetary base is clearly visible in the following graph, which has become rather famous of late: However, before this occurred, several other events took place which were quite revealing with respect to the character of Ben Bernanke and the fiscal propensities of the present governors of the FED, and are worth taking a look at. The 2008 Rate Cuts and the Alphabet Soup Initiatives The 2008 Rate Cuts, as mentioned in my last piece, were a bizarre response to the looming fiscal crisis that was already visible to the more observant market watchers. The FED began a policy of lowering interest rates in the face of skyrocketing oil prices and other signs of heady and imminent price inflation, but also in the face of market weakness. Major indices were already significantly off all-time highs, and a market slowdown loomed. Yet the oil price squeeze had the FED in a bind. It clearly, clearly had no room for the slightest bit of monetary loosening. (Biographical side note: this was the singular event that led to my conversion to the Austrian school of economic thought. Having been an amateur enthusiast of all things economic for a few years at this point, I looked at this scenario and realized that there was something very, very wrong with the way I understood monetary policy to work. I finally realized that the problems I had encountered in trying to digest the contortions of mainstream Keynesianism and monetarism were not my problem. They were Keynes' and Friedman's. And so my search for a correct theory began...) The ace up Bernanke's sleeve was that despite his rate cuts, he was not increasing the monetary base as is the usual response of the FED to the onset of a recession. Despite maintaining an outward appearance of monetary accommodation, he was actively, willfully encouraging recession! The next step Bernanke took in fighting off the financial crisis was to initiate the various "alphabet soup" programs, beginning with TAF, and moving on into TSLF, TARP, etc. This was another strange and unexpected move, but the effect is fairly easy to explain. Simply put, the FED traded its good assets (the ones it purchased to create the monetary base, remember?), for the bad assets held by banks, supposedly on a temporary basis. You know, all those bad loans everyone has been talking about. Yes. They were traded for the FED's Treasury debt. The mortgage debt that has been so affectionately termed "toxic waste" is what is now backing your currency! It is important to note that while these activities degraded the quality of the assets held by the FED, they did not increase the monetary base. Once again, the FED chose to act in such a way as to "take action" while avoiding any increase to the monetary base. It wasn't until TARP came along that the monetary base finally began to increase. At this point, the FED had already traded away most of its good debt, and was forced to begin making outright purchases in order to remove the toxic waste from the banking system's balance sheet. You can see the effects of these transactions in the following chart: Note the similarity in shape to the Monetary Base graph above. Note also how "Traditional Security Holdings" began to disappear and were replaced with things like "Securities Lent to Dealers" and "Term Auction Credit" long before the monetary expansion began in September-October 2008. These were the asset swaps. Before resorting to monetary expansion, Bernanke attempted to "solve" the problem through book-keeping. But if he wasn't increasing the monetary base to try and "stimulate" the economy out of recession, why would Bernanke do this? To answer this question, lets take another look at the banking system's T-account calculus. The Effect of the Crisis on the Banking System The main problem the FED is trying to solve is saving the banking system. The banking system is in jeopardy because their assets have become devalued while their liabilities, i.e. deposits, have remained constant: No matter how many defaults, repossession losses, etc. should befall a bank, it must still honor its obligations to repay depositors. Further, the eroding value of assets prevents the banking system from improving its situation by unwinding its positions through monetary contraction, i.e. selling assets, because this doesn't substantially improve their balance sheets: Meanwhile, asset prices continue to decline. Eventually, when things at individual banks get bad enough, the FED steps in and seizes control. When the FED steps in, assets are sold off, depositors paid off, and the FDIC makes up the difference, as we discussed before. Note the net effect of all of this: far from shrinking the monetary base, i.e. causing deflation, bank failure and default locks in the inflation that results from fractional reserve banking. Thanks to the FED and the FDIC, we can rest assured that defaults and bank failures will lock in fractional reserve pyramiding of inflated money on top of the monetary base. No deflation occurs. Paying off loans without re-lending is deflationary, yes, and some of this is occurring. But this is not the case for default or bank failure. The FED can pre-empt this process, or at least delay it for a time, through the alphabet soup initiatives. By swapping assets, the FED props up the bank, accepting losses due to devaluation on its own balance sheet: The same is true for outright purchase of assets: The FED is doing all of this so that the banking system will not have to properly account for losses to the value of its loans. A substantial fraction of mortgage debt once held by the banking system is now replaced by Treasury debt, which trades at very near face value, while the mortgage debt the banking system traded away gets placed on the FED's books. Any further losses will take place on the FED's books. This protects the stock prices of banks, and also went some distance in preventing a loss of confidence in the banking system, which might have led to rapid withdrawals of currency. In this respect, in performing all these activities, the FED was just doing its job -- to protect the banking industry. The problem is that this is the job of the FED in the first place. Here we see why there is so much impetus for a FED audit. This behavior looks crooked because it is crooked. With this kind of book-keeping, its hard to see how federal agents can come along and accuse others of cooking their books. But in my opinion, the whole "audit the FED" movement misses the larger point: the FED should not exist in the first place. The problem is not that it is not doing its job properly. It can't do its job properly. There is no squaring of the circle and the entire reason for the FED's existence is to perpetuate a fraud. Whatever malfeasance might be going on there is small potatoes to the larger economic issues. The FED will never work, no matter who is in charge or what it decides to do. The FED's Magical Resolution Now that we know how and why the FED is propping up the banking system, we might ask: how exactly does the FED plan to eventually resolve all of this? After all, this is a very temporary solution. It appears that the FED believes that someday, the value of these assets will be restored, and they can be swapped back onto the balance sheets of the banks that owned the debt in the first place. Everything will be more or less back as it was in 2007. This will take place, someday, when the markets are magically restored, and the old price regime is back in place, and everything is just wonderful again. Someday. Somehow. I guess the thinking is along the lines of "If we all clap our hands enough, the economy will come back to life." As we have seen, the old economy isn't coming back. The old pricing system didn't make any sense. It still doesn't. Either capital goods prices must fall, or consumer prices must rise, or both. Either way, there are huge real losses that must be realized. But since only a tiny fraction of us understand that, and none of us runs the FED, we're all going to have to wait around to see which particular way this outcome actually takes place. What the FED Is Likely to Do In the meantime, before all the economic magic/economic catastrophe occurs, the FED doesn't want all the money it created to be lent out, end up in consumers' hot little hands, and drive up consumer prices. So it will likely begin any number of sterilization programs. What is sterilization? It is a process where a central bank re-absorbs the money it created so that it won't cause inflation. What? You heard that right. The FED will re-borrow the money that it creates, so that the public can't get ahold of it. One of these programs is already in place. The FED now pays interest on reserves held with the FED. Right now, the rate is not high, but with this new power in hand it can easily be raised. By paying interest on reserves, the FED incentivises the banking system not to lend money to the public, which might spend it, but to lend to the FED, which buries the money in a hole and sits on it. The FED has also discussed issuing debt certificates and offering "CD's" to the banking system. Both work exactly the same way. The FED borrows money, then sits on it, so that it can't enter the fractional reserve banking system and drive up prices. Another thing the FED could do is raise reserve requirements. By doing so, it limits the amount of inflation that can occur through fractional reserve lending. The maximum money multiplier of the fractional reserve process goes down. When the FED says that it is trying to "unfreeze" credit markets and encourage lending, don't believe a word of it. The FED could easily get banks to lend. The FED wants them to do no such thing. If they start, believe me, the FED will intervene. Bernanke the Tightwad I point all of this out to make a point that you won't hear often among people of my economic persuasion: Bernanke is actually something of a monetary tightwad, at least as far as central bankers go. Despite his bailouts and spectacular increase of the monetary base, he made every attempt to avoid doing so until his hand was forced, and he has taken great pains to keep the new money out of the fractional reserve system. It is my opinion that he will fight the inflation far more than many of us Austrians give him credit for, even as he tries to prop up the banking system. He will try to have it both ways, but he cannot. Eventually, his hand will be forced, and just as he eventually had to increase the monetary base to continue his alphabet soup activities, I expect he will find the same with respect to the rest of the economy. If he wants to prop up asset prices, he will have to continue to expand the monetary base. Money has to circulate to drive up prices, and it is nearly impossible to hermetically seal one market away from the others. Eventually, the money will leak out. Inflation will win. 'The Deflationists' There is a group of economists out there who, acknowledging all of this to be the case, would still claim that we are looking at serious deflation in our future. From what I can surmise, their basic position is "Yes, the FED will increase the monetary base, but it will fail in its attempt to cause inflation. We will have deflation despite the best efforts of the FED." Their position, if I understand it correctly (which I may not), rests on the idea that money created by the central bank cannot make its way into the economy if economic conditions are bad enough. The monetary contraction of banks trying to call in loans coupled with a general revulsion towards borrowing for fear of losses in such a bad economy will outweigh every attempt of the FED to pump more money into the system. The FED may increase reserves all it wants, flooding the system with money, but the banking system will simply sit on it. Fractional reserve banking will seize up and stop working. This is sometimes called "pushing on a string." To a degree, this has been true. For all that the FED has increased reserves of late, there hasn't been much lending going on. There also hasn't been much in the way of consumer price increases. So, might the deflationists be right? The Borrower of Last Resort The fly in the ointment for both Bernanke and the deflationists may well be President Obama and Uncle Sam. We all know that Washington is on a spending spree. We also know that Washington can't pay for what it is buying. Which means that Washington is borrowing, and in a big way. The deficit this year is on the order of $1.6 trillion, or a tad over 10% of both the present accumulated debt (~$11 trillion and change) and GDP (~$14 trillion, give or take). Where is this money coming from? Private lenders, the FED, and the banking system. Washington is displacing private borrowers and absorbing all the available credit. State activities are displacing the economy. But you already knew all that. The point with respect to this discussion is that what Washington borrows, Washington spends. Uncle Sam writes checks, and those checks go into private deposit accounts, where the money can be spent into the economy and drive up prices. It does not matter that when the money is spent it re-enters the banking system, where Bernanke can siphon it off with his sterilization programs. He can't stop politicians from spending money. I am convinced that no force in the known universe can. So long as Bernanke is creating money, Uncle Sam will be trying to spend it into circulation. Bernanke will have to bid it away from Uncle Sam with higher interest rates on the FED's debt instruments, which only puts even more money into the hands of the banking system that lends him back the money he created in the first place. If nothing else does, government spending will shortcut Bernanke's monetary firewalls. As we speak, the government is buying up materials for its many projects and paying its employees to work (or not work, as the case may be). Bernanke cannot long prevent his freshly printed money from entering the money supply. The Deficit If nobody else will borrow and spend, you may rest assured that Uncle Sam will, inadvisable as it may be. And as if the on-budget debt burden were not enough at ~$11 trillion, this figure does not even include the gargantuan entitlement programs Social Security and Medicare, which constitute obligations many times this amount, variously estimated to cost anywhere from $50 to $100 trillion if discounted to present value. These programs are guaranteed to force government money into circulation as Uncle Sam writes so many checks to so many recipients, and will also require ever higher and higher deficits to finance. These two entitlement programs will eventually sink the government no matter what, as they require payouts that our economy simply cannot handle. Inflation and outright repudiation of government debt obligations are the only realistic tools available to deal with this massive overload of obligations. Before this happens, expect the off-budget deficits that constitute these two behemoths to be converted into on-budget deficits as Congress borrows the money to pay for them. What's that, you say, there is a large fund set aside to pay for these programs, composed of ultra-safe Treasury debt? I wonder how the value of those assets will be affected as inflation takes hold, interest rates begin to rise, and ever more government borrowing us used to finance shortfalls. Or when our foreign lenders finally decide that enough is enough and begin the inevitable sell-off of American debt. Slowly, or possibly not all that slowly, as deficits accumulate and interest rates rise, the mere interest payments on the accumulating debt will increase to such a degree that the FED will be forced to intervene if it is to prevent national bankruptcy. Right now, and unfortunately for most of the last 25 years, the government could borrow cheaply, and did so right up to its gills. Those days are coming to an end, and at some point the number of willing private buyers will be slim. It may seem a bit unrealistic to think of individual government actors "conspiring" to inflate the US out of its debt burden, but this is precisely what they will do, intentionally or not, simply in response to the situation they find themselves in. FED purchases of Treasury debt will most likely not be done with the explicit goal of repudiating the debt itself, but in order to continue government efforts to mend the economy. Even if the FED has no intention of inflating the US out of its debt obligations, it will be forced to do so to finance government spending "in aid of the economy" and to avoid outright national bankruptcy. Bernanke may chide government profligacy now, but his own FED is extending the financing that makes it possible. When there is little confidence in Treasury debt, you can bet that there will be little confidence in the dollar, though to some degree a substantial fall in the exchange rate may be mitigated by the equally disastrous policies of foreign central banks. The dollar is likely to fall against the broader market of currencies overall, but it may be difficult to predict whether it will rise or fall against any particular currency. At this point, virtually all of them look weak. Conclusion I see very little hope that the US can avoid substantial monetary and price inflation over the next several years. We likely face high inflation, high interest rates, high unemployment, government displacement of the private sector, and substantial wealth destruction for the foreseeable future. There is at least a reasonable probability that these conditions could emerge precipitously, become quite acute, and result in substantial political instability and strife. This is not to say that deflation is impossible. It is possible that the FED will choose a policy of monetary contraction, despite the damage that this would do to the banking system as it presently stands and the ability of the US government to repay its debts, at least on paper. Bernanke has shown that he is keenly aware of the effects of his policies on consumer prices, and if these prices begin to show strong increases in response to his actions, it is possible that he will tighten, again, despite the political damage he will do to the banking system and the government he is supposed to be serving. But this will likely be long after the "other" effects of inflation have already taken place, and the economic damage has already been baked in. Once the ball is rolling, I do not think he will be able to stop it easily, and price spikes on sensitive commodities like oil and food are highly likely, even if overall consumer price inflation remains fairly flat. But I do not think Bernanke would dare to attempt even a policy as meekly tight as this one. I think he is more likely to tread with caution, which means with inflation, and simply accept a higher level of consumer price increases and interest rates, and a general erosion of the standard of living over time. I do not think we will see deflation as a matter of the FED's inability to cause inflation. Over short stretches of time, yes, there might be small monetary contractions here and there, but I think the FED will fight these and that the larger trend will be inflation, at least over the short to mid term. For deflation to occur, I think it would have to be deliberate, and as I have said, this is not very likely. In the longer term, it is also possible that the FED may instigate substantial deflation at some fairly distant future point, as the inflation plays itself out and the FED attempts to "save the dollar" once it has achieved its objectives as it sees them, namely, that prices are now clearing markets on their own and the government is no longer in need of coercive financing. "Prices now clearing markets" is a polite way of saying that wages, standards of living, and privately held claims to wealth have been slashed to the point that constructive economic activity can take place spontaneously once again, which is basically how WWII allowed the US to escape the Great Depression. In summary, two major conditions are necessary for the US to escape the present crisis. The pricing regime must return to something reasonably approximating sustainable market prices, and government obligations must be repudiated. These two conditions will most likely be met through some substantial level of monetary inflation. This is not necessarily how the FED sees things; it will only be reacting to economic data as it understands that data, in a train of thought similar to what I have outlined here. But without resolution of these twin predicaments, there can be no real, sustained recovery. That is the bottom line.

Banking and the Money Supply II: Deflation

Deflation vs. inflation: which is it going to be? We've looked at what the terms mean. We've looked at the mechanisms that bring about inflation and monetary statistics to describe the money supply. Now its time to look at the reverse process: deflation. We will also look at a few phenomena that have no influence on the money supply, but are sometimes blamed for one or the other.
  
Deflation

As you might have already guessed, deflation occurs principally through the reversal of the processes that lead to inflation. It can also be accomplished through a few other processes, which will also be discussed.  

Sale of Assets Just as when the FED buys assets money is created, when it sells assets money is destroyed. Because of these twin properties, I like to think of the FED as a something like an infinite capacity black-box: when assets go in, money comes out; when assets come out, money goes in. That's the easiest description I can think of.

In a more detailed analysis, the FED will sell assets into the market, withdrawing money from the deposit accounts of buyers. The FRN liability (Federal Reserve Notes, or US dollars for those of you who forgot) is redeemed and retired by the FED as it absorbs the FRN into its vaults and out of the banking system, and the asset passes from the vaults of the FED back into the market. The asset and liability columns of the T-account are wiped clean:
In the course of this process, bank reserves are reduced as those FRN leave the banking system. If the banks are comfortable with their reserves and reserves are above the legal requirement, nothing more need occur. In our example, the bank is in trouble as it has no reserves and will have to sell other assets to meet legal reserve requirements. Or go to jail. If banks choose to increase reserves for whatever reason, the process continues. By selling their own assets or calling in loans, banks increase money held in reserve, clear their T-accounts of assets and contract the money supply further:

Our example is a little extreme for two reasons. First, I am feeling lazy and did not want to draw out a whole new T-account chart. I just cut and pasted it. Normally, it would be a little strange for a bank to sell to its own depositor, but I suppose it might happen. But it does illustrate a good point. Selling assets also increases the reserve ratio by reducing liabilities, e.g. deposits, e.g. the money supply, not simply increasing reserves. It is an unwinding of the fractional reserve process. I could have had the bank sell to another bank or another private entity to simply increase its reserves. But that would have placed a strain on the buying bank, which would have lost reserves and would likely have had to shuffle things around even more. And I just can't stand the thought of having to draw out another and another of these durn things to explain all that.

The net effect overall from the banks' point of view is a transfer of assets out of the banking system and a reduction of bank deposit liabilities. From our point of view, it is a reduction in the money supply. Bonus question: what is the net effect when fractional reserve banking is used by banks to buy assets, then when the banks get in trouble and are unable to pay back depositors, the FED prints money to bail them out instead of forcing them to sell their assets to raise the money? Hmmm? Anyway, the point is that selling assets effectively reduces the fractional reserve multiplier, and the money supply. That constitutes the "desirable" deflationary routes engineered by the FED for control of the money supply, and autonomous contraction initiated by banks themselves. Incidentally, from a graph of the AMB, it is clear that the FED rarely deflates through the sale of assets. M1 and M2 indicate that the banks themselves are more likely to contract the money supply on their own, and at those times not by very much. For the most part, the monetary base is continually increasing, with short periods of stagnation. S0, there you have it, the two major forces of deflation: banks allocating more money towards reserves, e.g. decreased lending/selloff of assets, and the sale of assets by the FED. The exact opposite of inflation.  

Other Deflationary Forces

 The other routes for deflation are not nearly as important. First, depositors could withdraw currency en masse and hold it as cash outside of the banking system. This is deflationary because money held in physical cash is not on deposit with the banking system. It is held in deposit in your pocket, and cannot serve as reserves for the fractional reserve process while it is sitting in there. If enough cash is withdrawn, it will force banks to begin selling assets and call in loans in order to meet reserve requirements, or it will force the FED to purchase assets to provide banks with new reserves.

Of course, eventually the money that is withdrawn is likely to be redeposited and the effect reverses. Two exceptions exist. The first is that the withdrawn money is destroyed, as in, put into a pile and set on fire. Obviously, this is rare. As angry as some of us may get over inflation, we don't generally do this.

The second is not so rare. The money can be held permanently by private persons outside the banking system. This is most frequently the case for money that leaves the country. Many foreigners choose to hold paper US dollars as savings in preference to their local currencies as the purchasing power of the US dollar has tended to hold up better in the recent past, despite the inflation engineered by the FED. These dollars circulate in "bankless" black markets, or are simply stored up for a rainy day.

Central banks can (and do!) also hold US dollars as reserves, though they usually prefer Treasury debt. These dollars "back" their own currencies, just as our currency is "backed" by the Treasury debt and other assets held on the FED's balance sheet. By buying and holding dollars, foreign central banks create more of their own currency and reduce the quantity of dollars in circulation, artificially propping up the value of US dollars and distorting trade. But that is a long and involved topic of its own best left for another time... Imagine: there are banking systems out there even more screwed up than ours! In any event, this effect tends to tamp down the inflationary effect of printing ever more dollars, but could come back to haunt holders of US dollars in the event of a major devaluation. But I suppose that in a major devaluation this will be the least of our worries.  

Bank Failures and the FDIC

At one time, bank failures also resulted in deflation of the money supply. Bank failure occurs when financial strains cause the value of a bank's assets to be substantially less than the liabilities imposed by the bank's expenses, deposits, or depositors attempting to withdraw their funds all at once, e.g. a bank run. Over the past year or so, a few banks have failed almost every week. If you check Yahoo!Finance late on Friday afternoons, after markets have closed, you can usually read about them in the news stories. The FED closes them when markets are unable to respond to prevent panic. It's been happening like clockwork for some time, though most people pay little attention.

Since the introduction of the FDIC, bank runs have become virtually nonexistent, but at one time they were frequent. Note that bank failure is not the same as bankruptcy. Technically, banks are always bankrupt, in that they cannot possibly honor all their contracts simultaneously. They only stay in business because not all contracts are enforced, not to mention because the FED and the government cover for them when they get into trouble. This is different from a businessman who owes more money than his business is worth. The businessman is not obligated to pay his debts all at once; his debts are amortized, and as long as he can make his payments, he is still in business.

In contrast, a bank is required to refund all of a depositor's money at any time. All the depositor has to do is ask. This is a basic problem of time mismatch: borrowing short and lending long. The carry trade. Whatever you want to call it, depositors essentially act as ultra-short term lenders or creditors, while the bank is busy making long term investments. The bank can't possibly fulfill the terms of its agreements, if they are enforced. The banks are fully aware of this discrepancy in expectations, and in many ways it is a sort of fraud.

This is precisely why deposits are listed under the heading liabilities. The bank is obligated to pay them back. In the old days, when a bank run would occur, word got out and depositors began withdrawing money until there was none left, then the bank was forced into liquidating its assets and repaying what deposit claims remained with the funds raised through asset sales. Naturally, there was not enough, and some depositors lost money into thin air. Money was destroyed in the process, and M1 or M2 would have reflected this loss as deposits evaporated and the money supply contracted. Hence, lost deposits due to bank failures results in deflation. With FDIC protection, accounts are insured up to $250,000. Most people are smart enough to spread out deposits so that they get full protection, but theoretically if a deposit was over this amount, the surplus would evaporate in the event of a failure.

You can simply accept that "deposits are protected" but it is instructive to look at the actual transactions to understand how money is conserved by this process. The FDIC does not actually have any money. It has assets in the form of Treasury debt, much like the FED itself. When the FED takes control of a failing bank, it begins the process of liquidating assets and paying off depositors. The remaining funds that must be raised are obtained by selling the assets held by the FDIC. These assets are sold to other banks, which buy them with money from reserves, initiating fractional reserve multiplication. So the money "lost" in the failure is made up for by fractional reserve multiplication. Pretty simple, really, but it took me awhile to get it.

The FDIC was created in 1933. Prior to 1933, bank failure resulted in deflation, but since that time it has not. So long as Congress continues to authorize funds for this agency, it will not. There is no need to fear a catastrophic deflationary spiral as a result of bank failures, which some claim occurred in the early years of the first Great Depression. Of course, it is still a political question, since the FDIC has already pretty well exhausted its asset base and Congress could theoretically refuse to provide any more funds, but I think it is a rather safe bet that Congress would not do that.  

Other Notable Absences: Deficit Spending, Default, and Falling Asset Prices

A few readers may not see their pet deflationary or inflationary forces at work here. Of course, I have missed some, as this is not exactly an exhaustive work. On the other hand, there are many events which have been attributed as inflationary or deflationary but in reality are not. I'll go through a few here.

Contrary to popular belief, deficit spending is not inflationary. Deficit spending is funded by issuing Treasury debt certificates. These certificates are bought by private investors and the money is transferred to the government and spent into the economy at large, passing back into private hands. No money is created in the process.

Deficit spending by the government is no different from the issuing of corporate bonds. The result is private transfers of money, not creation of money, and not inflation. Banks may buy the debt with depositor funds, yes, and in this case it results in multiplication by fractional reserve accounting. But the inflation is a result of the accounting, not the issuing of the debt itself. The FED may buy the debt directly, resulting in inflation of the monetary base, but again, that is as a result of the bank buying the asset, not the debt itself.

One way that deficit spending can get politically intertwined with inflation is that a large deficit can create a political incentive for the FED to buy the debt, increasing the monetary base in the process. Many, if not all, central banks engage in this nefarious practice regularly. By having the central bank buy debt, the government can obtain loans at interest rates far below market rates since the central bank supplies artificial demand for the debt. And when debts begin to pile up, it can be tempting to have the central bank simply buy up all of the debt and forgive interest payments owed by the government. This results in large-scale inflation for holders of the currency and repayment of debt in currency of depreciating value, effectively giving the governments creditors the shaft and allowing the government to default on its debts without legal bankruptcy. Nice of them, huh? I guess arbitrary authority is a good gig if you can get it...

This is called debt monetization, and though it will destroy a nations credit rating and its economy, it becomes a very real possibility as interest payments begin to absorb a politically unacceptable fraction of the budget, or fiscal deficits begin absorbing politically unacceptable fractions of GDP. The former will generally lead to the latter. Many nations are approaching these levels of debt, in particular the US and Japan, two of the largest economies in the world. A rise in interest rates to normal levels after years of suppression by central bank policy could effectively render the debt unpayable, especially for Japan where debt approaches 200% of GDP.

But, as I said, fiscal deficits in and of themselves do not cause inflation. It becomes inflation when central banks like the FED fund the deficit by buying debt certificates. Whether or not the central bank chooses to do so is a political question, not an economic question, though it does have economic consequences.

Occasionally, you will encounter the belief that default on a loan destroys money and results in deflation. You are especially likely to believe it if it is your money! This is not the case, however. The lender will not be paid back, and the price of his asset (the bond) goes to zero. But the money he lent to the borrower is still in the economy, whether or not he ever sees it again. Whether or not loans are repaid has no effect on the money supply.

 A fall in asset prices, like a stock market crash or the popping of a housing bubble, does not result in deflation either. The price of the asset in question simply falls. Your investment account or 401(k) does not "have less money in it." It is "worth less" (or just "worthless," as the case may be!) But the same amount of money is still floating around out there in the economy. A brokerage account contains assets, not necessarily money. A rising stock market does not create money and a falling stock market does not destroy it.  

Conclusion

Monetary inflation occurs principally through the purchase of assets by the FED and through fractional reserve banking. Fractional reserve accounting increases the money supply by counting the same money twice, once as deposits and a second time as money lent out. By lending money out which gets re-deposited into the banking system, fractional reserve banking can increase the money supply by up to ten-times reserves, which are the initial deposits provided by the FED through purchase of assets.

Deflation occurs principally through the opposite mechanisms: sale of assets by the FED and banks choosing to increase their cash reserve holdings by selling assets and calling in loans. A few other avenues of deflation exist, but these are more limited in scope. Deficit spending, market crashes, defaults and bank failures do not result in changes to the money supply. These forces, however, can exert political pressure for central banks like the FED to create inflation in order to "paper over" these problems and allow debtors to legally shirk their obligations.

Next up: how the FED influences interest rates!