Thursday, April 1, 2010

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. 

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