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Monetary Velocity & John Exter’s Inverse Pyramid

John Exter, Central Banker/Economist

If there was one person who could best explain the threat of deflation in 2014 despite massive amounts of money creation, it would be the late John Exter. He was a giant intellect who had all the mainstream credentials. He was Harvard educated, a Federal Reserve economist, a member of the Council of Foreign Relations and most uniquely among mainstream insiders, John was a gold bug. He was a personal friend of the great Austrian economist, Ludwig von Mises and I’m told by retired stockbroker Barry Downs who married John’s daughter, that he and von Mises debated the inflation/deflation argument all the time with von Mises of course taking the inflation side of the argument.

I doubt Exter would buy the government’s current massively understated levels of inflation.  But he would not at all be surprised that we have not yet entered a hyperinflationary period of time because he understood that the more debt money that is created, the bigger the drag on macroeconomic demand.  He did not buy the argument that other Austrian economists feared, namely that deficit spending by government would automatically lead to hyper inflation. Instead he argued that the more debt money is created, the more severe would be the ultimate deflation because in a fractional reserve fiat system debt is the raw material from which money is created.

To illustrate his view of the dynamics of deflation, Exter drew up an inverse pyramid shown above. Up to a point, as money is created the system does in fact inflate. People become overly optimistic and they buy and invest in illiquid, speculative and often times unnecessary luxury items. As the system expands these illiquid, speculative and luxury items become massively overvalued, but the debt from which they were financed does not disappear. Ultimately, as the system expands and becomes ever more insolvent, a tipping point is reached in which the system turns into reverse as it did in the 1930s and more recently in 2008-09. When that happens the speculative overvalued, unnecessary items at the top of the pyramid are sold with people first rushing down the pyramid into Treasury Bills and Federal Reserve notes (currency).

In my view, after many years since 1971 of more and more liability money being created at a faster and faster pace, the 2008-09 Lehman Brothers event launched the start of the deflationary dynamics of Exter’s inverse pyramid. The massive and unconventional money creation by the Fed and other central banks staved off the problem for the time being. In the process we do see a leveling off of total debt as you can see by the red in the chart above. However, keep in mind private sector debt (aside from student loans) has declined while unproductive, non-cash generating government debt is growing very rapidly.

The Chart above right illustrates why we are in trouble. Note the rapid, exponential growth of debt (red line) compared to the growth of income (GDP - blue line). Debt has been growing almost exponentially while income is growing in a linear fashion if at all. John Williams, an economist who believes we are inevitably heading toward hyper inflation, believes if GDP (blue line) were adjusted for an honest cost of living as opposed to the current CPI, it would actually be heading dramatically lower. But the need to generate Keynesian “animal spirits” requires manipulation of the numbers to dupe the public so they keep spending to keep the system expanding.

Going back to John Exter’s inverted pyramid, once a set of dominoes is set in motion, one default begets another and another as the margin clerk requires payment of debt. As items are sold to repay debt, credit contracts and prices collapse as items are sold in mass to raise cash. Banks go into default as loans cannot be repaid because the value received for the sale of assets collapses below the value of the loans used to fund them. In this process business profits collapse. Workers are fired and default on their loans and a massive negative feedback loop is created. 

With all of these dynamics, people and businesses understandably hold on to the money they have in order to meet their most urgent life sustaining needs. In other words, monetary velocity (how rapidly money turns over) decreases.  One of the reasons I believe John Williams is right in suggesting that we never came out of the 2008-09 recession is because current monetary velocity is continuing to plummet as shown by the chart from the Federal Reserve Bank of St. Louis above on your left.  I believe this picture is consistent with statistics that show America’s middle class is very rapidly disappearing. We are even reading now that Americans are building up debt simply to buy food and gasoline for their cars. To the extent that trend grows and continues, the American economy is a train wreck waiting to happen.

The Turn from Treasuries & Federal Reserve Notes to Gold

At first, the result of Exter’s dynamics pictured above is to sell illiquid asset for the “safe” items like U.S. Treasuries and Fed notes. However, as the system goes into reverse, at some point a highly leveraged banking system topples over as it did in 2008-09 because asset prices collapse.

At some point, as banks default, people become ever more untrusting of the financial system at which point they swap their debt-based fiat money in favor of gold, which is not dependent on the solvency of the banking system for its value. It is at that point in time when gold begins to rise dramatically relative to cash and to all other assets in this deleveraging process. Indeed this began to happen with the 2008-09 collapse.  With a return to the “good times,” solvency appeared to return, gold lost much of the gains it made in real terms and mining profits declined in 2012 and 2013.

I suspect what is likely to happen is that we will go through a similar process once again such that U.S. Treasuries may actually gain to an even more outrageous overvalued status and the dollar could gain value as well while gold treads sideways or perhaps gains a bit relative to the dollar. But while that is taking place, you can bet the Fed will be printing even more money until such time as the world says “NO MORE!” When that happens I believe the ultimate destruction of fiat money will emerge as masses of folks, not just gold bugs trade in their paper for gold because its intrinsic value makes it safe unlike the fiat liability money we use today.

I don’t know what the catalyst will be to trigger a mass exodus from the dollar into gold. But the massive low interest rates and ongoing plunging velocity tells me people are still confident the dollar has value. Any number of triggers could emerge. It could be a severe military defeat of the U.S. or it could be a slower continuous drain on America’s power as the rest of the world becomes sick and tired of an America that abuses its client states. There is growing unrest now even among our strongest allies. Germany, for example, just expelled a CIA operative out of their country. France is expressing anger about the U.S. fining a major French bank billions of dollars for disobeying sanctions. And I learned last week that the Portuguese Parliament is investigating a possible CIA assassination of its leader back in 1980 relating to the shipment of arms through Portugal in the 1980 “October Surprise.” We may well see a European revolt against a repressive Anglo-American empire, especially if U.S.-imposed rules are seen by Europeans as leading to economic decline in Europe.

The main point however is that the underling global economy is becoming weaker and weaker as policy makers are increasingly turning their backs on free markets (including the markets for money and capital) and endorsing socialism.  Socialism is a guarantee for poverty over the longer term. What I do think is most important is to watch various measure of monetary velocity. As long as monetary velocity continues to plunge, that is a sign that most people still have faith in the dollar and the Exter’s deflationary process will remain a distinct possibility.  That could happen fairly quickly with another financial system meltdown or some other factor that causes the masses to run from the dollar to gold which sits at the bottom of Exter’s inverted pyramid.

Jay Taylor



Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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