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We occasionally read that deflation is inevitable
because the total amount of debt in the system is so huge.
The point will eventually be reached, according to those who
are forecasting a deflationary outcome, when the amount of
debt carried by the average person and the interest burden
associated with the debt is so large relative to his/her income
that he/she will be unwilling or unable to take-on additional
debt; and at that time the total amount of money and credit
in the system will begin to contract. That is, deflation*
will occur.
No one can predict the future with certainty,
but we would be extremely surprised if the uninterrupted inflation
of the past 70 years were followed by a period of genuine
deflation (a prolonged decline in the total supply of money
and credit). One of the reasons this would surprise us is
that there IS so much debt in the system. The high debt levels
actually make deflation LESS likely, not more likely, because
the current monetary system -- the world's greatest-ever Ponzi
scheme -- could not survive a bout of genuine deflation. That
is, deflation will never be a viable policy option regardless
of how bad things get. Instead, the central banks of the world
will likely risk destroying their currencies and obliterating
the values of their bonds before they will permit deflation
to occur.
The question then becomes: central banks may
well WANT to avoid deflation at all cost, but will they be
ABLE to avoid it? Will they be able to implement policies
that cause the currency to lose its purchasing power in an
environment where almost all potential borrowers are 'tapped
out'?
We don't really understand why this is even
a question because it's such a basic economic truth that someone
with the ability to increase the supply of some 'thing' by
an unlimited amount also has the ability to push the price
of the thing down by as much as they desire. This is true
regardless of whether the thing in question is a dollar or
an apple or communications bandwidth. Central banks have the
ability to create currency in unlimited amounts so they have
the power to reduce the purchasing power of currency under
any and all circumstances should they choose to do so.
But assuming the central banks don't just print
currency and then drop it out of helicopters, how would new
currency be brought into circulation at a time when most individuals
and corporations were cutting back on their borrowing/spending?
One option would be for the government -- an
entity that will always be able to borrow more currency into
existence regardless of its current level of indebtedness
-- to shoulder the entire burden of keeping the supply of
money in an upward trend and the purchasing power of money
in a downward trend. But even if the government decided not
to go down this path the central bank would have other options.
It could, for instance, start monetising the mortgage debt
held by private banks.
There is a chance that monetising debt (buying
debt with newly printed currency) would not be effective because
it would simply shift debt from the balance sheets of commercial
banks to the balance sheet of the central bank. The debt would
continue to exist and the borrowers -- the people who mortgaged
their houses -- would be in the same financial situation;
it's just that they would owe money to the central bank instead
of owing it to private banks.
There is, however, a surer way to get more money
into circulation and reduce the purchasing power of the money.
Taking the example of the US, instead of monetising debt the
Fed could monetise assets. That is, rather than buying mortgages
from commercial banks the Fed could buy houses. Furthermore,
to achieve the desired purpose -- a reduction in the dollar's
purchasing power -- the number of houses that would actually
have to be bought might not be that great. The reason is that
if the Fed came out and said something along the lines of
"for the next 90 days we will use newly printed dollars
to purchase anyone's house at a price equal to today's market
value or the amount owing on the mortgage, whichever is the
higher" there's a good chance that there would immediately
be a substantial devaluation of the dollar relative to houses
(and every other tangible asset).
The time when the Fed needs to resort to such
drastic measures in order to keep the inflation going is probably
many years away. The point is, the Fed does have the power
to keep the inflation going and the fact that debt levels
have become so high means it has no alternative other than
to keep the inflation going. Our view, therefore, is that
the inflation will continue until the dollar and all other
fiat currencies become so devalued and discredited that they
cease to function as mediums of exchange, or, at least, until
inflation fears become great enough that the current monetary
system is abandoned in favour of something else.
As we've said many times in the past, keeping
the inflation going is not the real challenge for the Fed;
rather, the real challenge for the Fed is to keep inflation
EXPECTATIONS in check. In our opinion, the next time inflation
expectations spiral out of control will be the last time because
doing what Paul Volcker did at the end of the 1970s (pushing
interest rates to astronomical heights) is no longer a viable
policy option. This is why the Fed's biggest fear is an uncontrolled
rise in inflation expectations.
*Prices go up and down for many reasons,
but a price decline is only associated with deflation if it
is CAUSED by a contraction in the total supply of money and
credit. In other words, a price decline that has not been
caused by a contraction in the total supply of money and credit
is not related to deflation in any way.
*****
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