Can we Have Inflation and Deflation All at the Same Time?
Very few people understand the â€žcontinental driftâ€? that threatens with a fracture of the U.S. (and hence, the world) monetary system. There are two tectonic plates: one, the supply of Federal Reserve notes (FR notes), and the other, the supply of electronic dollars in the form of an inverted pyramid that rests on the supply of FR deposits. The fault line between the two tectonic plates, like San Andreas fault in California, is a worrisome source of unpredictable earthquakes that could cause massive and permanent damage to the U.S. and world economy.
The monetary fault line exists because of the different statutory requirements the Federal Reserve has to meet in order to increase the supply of â€žhigh-powered moneyâ€?:
- FR notes must be collateralized by gold or by U.S. Treasury bills and Federal Agency securities. The Federal Reserve does not print FR notes (still less can it air drop them); it gets them from a government official called Federal Reserve Agent against pledging appropriate collateral .
- FR deposits may simply be collateralized by the note of the borrower who borrows from any of the FRÂ banks. Thus the Federal Reserve can increase FR deposits on its own authority, without reference to the government. The banking system then builds its own pyramid of deposits upon the fractional reserve of FR deposits
Thus there is a serious obstacle in the way of increasing the money supply by increasing the volume of FR notes in circulation, giving the lie to Chairman Ben Bernankeâ€™s promise to air drop them from helicopters. The obstacle: falling interest rates. For example, if the T-bill rate dips into negative territory, then the market value of T-bills exceeds their face value and the Federal Reserve â€žcannot affordâ€? to buy them in the open market. The shortage of eligible collateral will restrict the inflation of FR notes in circulation. By contrast, FR deposits can be created out of the thin air in unlimited quantities at the click of the mouse.
Herein lies the danger of monetary earthquake along the fault line. The outstanding issue of FR notes as of September 20, 2007, was a paltry $760 billion (note that a sizeable fraction is being hoarded by foreigners overseas), see: www.federalreserve.gov/releases, which is less than two tenth of one percent of the notional value of derivatives. Just a drop in the ocean of potential bad debt.
It is possible for the tectonic plate of hand-to-hand money, the FR notes to deflate, while that of electronic dollars to go into hyperinflation. The decoupling has frightening consequences for the financial and economic future of the world.
The curse of electronic dollars
Helicopter Ben has just made a most unpleasant discovery. Earlier he has promised that the Federal Reserve will not stand idly by while the dollar deflates and the economy slides into depression. If need be, he will go as far as having dollars air dropped from helicopters.
Time has come to make good on those promises in August when the subprime crisis erupted. To his chagrin Ben found that electronic dollars, the kind he can create instantaneously at the click of the mouse in unlimited quantities, cannot be air dropped. They just wonâ€™t drop.
For electronic dollars to work they have to trickle down through the banking system. The trouble is that when bad debt in the economy reaches critical mass, it will start playing hide-and-seek. All of a sudden banks become suspicious of one another. Is the other guy trying to pass his bad penny on to me? In extremis, one bank may refuse to take an overnight draft from the other and will insist on spot payment. A field day for Brinkâ€™s. The clearing house is idled, and armored cars run in both directions up and down Wall Street delivering FR notes and certified checks on FR deposits.
Under such circumstances electronic dollars wonâ€™t trickle down. In effect they could be frozen and, ultimately, they may be demonetized altogether by the market. How awkward for Helicopter Ben. His boasting of air drops is an empty threat.
Northern Rock and Roll
The Northern Rock and Roll fever may spill over across the Atlantic from England to the United States. Northern Rock is a bank headquartered in Newcastle with lots of branches in the Northern Counties. It was a high-flyer using novel ways of financing mortgages through conduits and other SIVâ€™s, instead of using the more traditional methods of building societies through savings. (SIV or Structured Investment Vehicle is euphemism for borrowing short, lending long through securitization). Now a run on the bank has grounded the high-flier. As long queues in front of the doors of branch offices indicate, a world-wide run on banks may be in the offing. Bank runs were thought to be a pathology of the gold standard. In England they havenâ€™t seen the like of it since 1931 when the bag lady of Threadneedle Street went off gold. Surprise, surprise: bank runs are now back in vogue playing havoc on the fiat money world. Depositors want to get their money. Not the electronic variety. They want money they can fold.
Thereâ€™s the rub. Pity Helicopter Ben. It looked so simple a couple of weeks ago. The promise of an air drop should stem any run. It sufficed to tell people that he could do it. No reason to mistrust the banks since they are backed up by air drops. Now people have different ideas. The air drop is humbug. Canâ€™t be done. Ben is bluffing. He has no authority to run the printing presses as he sees fit. Heâ€™s got to have collateral. Moreover, as calculated by Alf Field writing in Gear Today, Gone Tomorrow (www.gold-eagle.com, September 6, 2007) if only ten percent of the notional value of derivatives is bailed out by dropping $500 FR notes the pile, if notes are stacked upon one another, would be nearly 9000 miles high. Helicopter Ben hasnâ€™t reckoned that FR notes do not exist in such quantities. They will have to be printed, not to say collateraliyed, before they can be dropped. It is true that the Federal Reserve has an additional $225 billion in unissued and uncollateralized FR notes, just in case. However, before the air drop they have to be collateralized, and that is easier said than done. There is not enough of T-bills and agency securities to be used as collateral. Â
What does it all mean? At minimum it means that we can have inflation cum deflation. I am not referring to stagflation. I refer to the seemingly impossible phenomenon that the money supply inflates and deflates at the same time. The miracle would occur through the devolution of money. This is Alf Fieldâ€™s admirable phrase to describe the â€žgood money is driven out by badâ€? syndrome a.k.a. Greshamâ€™s Law. Electronic dollars driving out FR notes. The more electronic money is created by Helcopter Ben, the more FR notes will be hoarded by banks and financial institutions while passing along electronic dollars as fast as they can. Most disturbing of all is the fact that FR notes will be hoarded by the people, too. If banks cannot trust one another, why should people trust the banks?
Devolution is the revenge of fiat money on its creator, the government. The money supply will split up tectonically into two parts. One part will continue to inflate at an accelerating pace, but the other will deflate. Try as they might, the government and the Federal Reserve will not be able to print paper money in the usual denominations fast enough, especially since the demand for FR notes is global. Regardless of statistical figures showing that the global money supply is increasing at an unprecedented rate, the hand-to-hand money supply may well be shrinking as hoarding demand for FR notes becomes voracious. The economy will be starved of hand-to-hand money. Depression follows deflation as night follows day.
Decoupling tectonic plates
Next to deflation of hand-to-hand money there will be hyperinflation as the stock of electronic money will keep exploding along with the price of assets. You will be in the same boat with the Chinese (and the son of Zeus: Tantalus). You will be put through the tantalising water torture ? trillions of dollars floating by, all yours, but which you are not allowed to spend. The two tectonic plates will disconnect: the plate of electronic dollars from the plate of FR notes, with lots of earthquakes along the fault line. No Herculean effort on the part of the government and the Federal Reserve will be able to reunite them. At first, electronic dollars can be exchanged for FR notes but only against payment of a premium, and then, not at all.
The curse of negative discount rate
If you think this is fantasy, think again. Look at the charts showing the collapse of the yield on T-bills. While it may bounce back, next time around the discount rate may go negative. You say itâ€™s impossible? Why, it routinely happened during the Great Depression of the 1930â€™s. Negative discount rate means that the T-bill gets an agio, the discount goes into premium even before maturity, and keeps its elevated value after. This perverse behavior is due to the fact that T-bills are superior to FR notes in that they earn a yield while they are just as acceptable (if not more acceptable in very large amounts) as are FR notes. Yes, people will clamor for money they can fold, the kind that is in demand exceeding supply, the kind people and financial institutions hoard, the kind foreigners have been hoarding for decades through thick and thin: FR notes. Thus T-bills are a substitute for the hard-to-come-by FR notes. Mature bills may stay in circulation in the interbank market, in preference to electronic dollar credits. Why, their supply is limited, isnâ€™t it, while the supply of electronic dollars is unlimited! The beauty of it all is that we have an accurate and omnipresent indicator of the premium that cannot be suppressed like M3: the (negative) T-bill rate. It is an indicator showing how the Federal Reserve is losing the fight against deflation.
Inverted pyramid of John Exter
The grand old man of the New York Federal Reserve bankâ€™s gold department, the last Mohican, John Exter explained the devolution of money (not his term) using the model of an inverted pyramid, delicately balanced on its apex at the bottom consisting of pure gold. The pyramid has many other layers of asset classes graded according to safety, from the safest and least prolific at bottom to the least safe and most prolific asset layer, electronic dollar credits on top. (When Exter developed his model, electronic dollars had not yet been invented; he talked about FR deposits and other bank deposits built upon them as fractional reserve.) In between you find, in decreasing order of safety, as you pass from the lower to the higher layer: silver, FR notes, FR deposits, T-bills, agency paper, T-bonds, other loans and liabilities of the banking system denominated in dollars. In times of financial crisis people scramble downwards in the pyramid trying to get to the next and nearest safer and less prolific layer underneath. But down there the pyramid gets narrower. There is not enough of the safer and less prolific kind of assets to accommodate all who want to â€ždevolveâ€?.
Devolution is also called â€žflight to safetyâ€?. An example occurred on Friday, August 31, 2007, as indicated by the sharp drop in the T-bill rate from 4 to 3%, having been at 5% only a couple of days before. As people were scrambling to move from the higher to the lower layer in the inverted pyramid, they were pushing others below them further downwards. There was a ripple effect in the T-bill market. The extra demand for T-bills made bill prices rise or, what is the same to say, T-bill rates to fall. This was panic that was never reported, still less interpreted. Yet it shows you the shape of things to come. We are going to see unprecedented leaps in the market value of T-bills, regardless of face value! You have been warned: the dollar is not a pushover. Electronic dollars, maybe. But T-bills (especially if you can fold them) and FR notes will have enormous staying power. Watch for the discount rate on T-bills morphing into a premium rate!
It is interesting to note that gold, the apex of the inverted pyramid, remained relatively unaffected during the turmoil in August. Scrambling originated in the higher layers. Nevertheless, ultimately gold is going to be engulfed by the ripple effect as scrambling cascades downwards. This is inevitable. Every financial crisis in the world, however remote it may look in relation to gold, will ultimately affect gold, perhaps with a substantial lag. The U.S. Government destroyed the gold standard 35 years ago, but it could not get gold out of the system. It was not for want of trying, either, as we all know. Gold remains firmly embedded as the apex of Exterâ€™s inverted pyramid. Incidentally, it is a lie that gold has been demonetized. Gold is still a collateral used for FR notes. What happened was that further monetization of gold was blocked by fixing the official price of gold at $42.22 per Troy ounce, and at that price nobody is offering gold to the Federal Reserve. If someone did, according to existing statutes the Federal Reserve was duty bound to monetize it. Shame on academia for spreading lies about the demonetization of gold!
Vertical devolution is not the only kind that occurs in the inverted pyramid. There are similar movements that can be described as horizontal. Nathan Narusis of Vancouver, Canada, is doing interesting research on the Exter-pyramid. He noted that in addition to vertical there is also horizontal devolution. Within each horizontal layer of the same safety class there are discernible differences. An example is the difference between gold in bar form and gold in bullion coin form, or silver in bar form and silver in the form of bags of junk silver coins. Franklin Sanders in Tennessee is an expert on horizontal devolution of silver and has a fascinating study how the discount on bags of junk silver coins may go into premium, and vice versa. There may also be differences between FR notes of older issues and FR notes of the most recent vintage. There are obvious differences between the CDâ€™s of a multinational bank and those of an obscure country bank. The point is that movement of assets horizontally between such pockets within the same safety layer is possible and may be of significance as the crisis unfolds and deepens.
Dousing insolvency with liquidity
In a few days during the month of August central banks of the world added between $300 and 500 billion in new liquidity in an effort to prevent credit markets from seizing up. The trouble is that all this injection of new funds was in the form of electronic credits, boosting mostly the top layer where there was no shortage at all. Acute shortage occurred precisely in the lower layers. This goes to show that, ultimately, central banks are pretty helpless in fighting future crises in an effort to prevent scrambling to escalate into a stampede. They think it is a crisis of scarcity whereas it is, in fact, a crisis of overabundance. They are trying to douse insolvency with liquidity.
I feel strongly that this aspect of research on the denouement of the fiat money era has been lost in the endless debates on the barren question whether it will be in the form of deflation or hyperinflation. Chances are that it will be neither, rather, it will be both, simultaneously. There is a little-noticed and little-studied continental drift beween the money supply of electronic dollars and that of FR notes. (Continental drift of the geological variety is invisible and can only be detected with the aid of high-precision instruments.) The tectonic plate of electronic dollars will keep inflating at a furious pace, while that of FR notes and T-bills will deflate because of hoarding by financial institutions and the people themselves. The Federal Reserve will be unable to convert electronic dollars into FR notes. Apart from lack of collateral, present denominations cannot be printed fast enough, physically, in times of crisis. If the Federal Reserve comes out with new denominations by adding lot more zeroâ€™s to the face value of the FR notes, Zimbabwe-style, then the market will treat the new notes the same way as it treats electronic dollars: with contempt.
Genesis of derivatives
Alf Field (op.cit.) is talking about the â€žseven Dâ€™sâ€? of the developing monetary disaster: Deficits, Dollars, Devaluations, Debts, Demographics, Derivatives, and Devolution. Let me add that the root of all evil is the double D, or DD: Delibetare Debasement. In 1933 the government of the United States embraced that toxic theory of John Maynard Keynes (who borrowed it from Silvio Gesell). It was put into effect piecemeal over a period of four decades. But what the Constitution and the entire judiciary system of the United States could not prevent, gold did. It was found that gold in the international monetary system was a stubborn stumbling block to the centralization and globalization of credit.
So gold was overthrown by President Nixon on August 15, 1971 by a stroke of the pen, as he reneged on the international gold obligations of the United States. This had the immediate effect that foreign exchange and interest rates were destabilized. The prices of marketable goods embarked upon an endless spiral. In due course derivates markets sprang up where risks inherent in interest and forex rate variations could allegedly be hedged. The trouble with this idea, never investigated by the economic profession, was that these risks, having been artificially created, could only be shifted but never absorbed. By contrast, the price risks inherent in agricultural commodities are nature-given and, as such, can be absorbed by the speculators.
This important difference between nature-given and man-made risks is the very cause of the mushrooming proliferation of derivatives markets, at last count half a quadrillion dollars strong (or should I say weak?!) Since the risk involved in the gyration of interest and forex rates can only be shifted but cannot be cushioned, there started an infinite regression as follows.
Let us call the risk involved in the variation of long-term interest rates x. The problem of hedging risk x calls for the creation of derivatives X (e.g., futures contracts on T-bonds). But the sellers of X have a new risk, call it y. Hedging y calls for the creation of derivatives Y (e.g., calls, puts, strips, swaps, repos). Now the sellers of Y have a new risk called z. The problem of hedging z will necessitate the creation of derivatives Z (such as options on futures and, with tongue in cheek: futures on options, options on options, etc.) And so on and so forth, ad infinitum. Thus the construction of the Tower of Babel is merrily going on.
We have to interpret the new phenomenon, the falling tendency of the T-bill rate. Maybe the financial media will try to put a positive spin on it, for example, that it demonstrates the newly-found strength of the dollar. However, I want to issue a warning. Just the opposite is the case. We are witnessing a sea change, tectonic decoupling, a cataclismic decline in the soundness of the international monetary system. The worldâ€™s payments system is in an advanced state of disintegration. It is the beginning of a world-wide economic depression, possibly much worse than that of the 1930â€™s. The falling T-bill rate must be seen as a sign of the government of the U.S. and the Federal Reserve losing their battle against deflation. We have reached a landmark: that of the breaking up of centralized and globalized credit, the close of the dollar system.
Jâ€™accuse - said Zola when he assailed the French government for fabricating a case of treason against artillery captain Alfred Dreyfus in 1893. It is now my turn.
Jâ€™accuse - the government of the United States under president Roosevelt reneged on the domestic gold obligations of the U.S. in violation of the Constitution: it violated peopleâ€™s property rights in confiscating gold without due processes.
Jâ€™accuse - academia has been pussyfooting the government by failing to point out the economic consequences of gold confiscation, namely, the prolonged suppression of interest rates that was ultimately the cause of prolonging depression. (The causal connection between gold confiscation and the prolonging of the Great Depression should be clear. Gold must be seen as the main competitor of bonds. Once the competitor is forcibly removed from the scene, bond prices start rising or, what is the same to say, interest rates start falling. Linkage between falling interest rates and falling prices did the rest.)
Jâ€™accuse - the government of the United States under president Nixon reneged on the international gold obligations of the U.S. thereby globalizing the monetary crisis in 1971.
Jâ€™accuse - cringing academia failed to point out the consequences of trying to oust gold from the monetary system: price spiral of marketable commodities world-wide; roller-coaster ride of long-term interest rates, up to 16 percent per annum and down to 4 percent per annum or lower and back up again; and, last but not least, the fact that interest rates may take prices along for the ride.
Jâ€™accuse - foreign governments accepted Nixonâ€™s breach of faith without demur, apparently because in exchange for their compliance they were given the freedom to inflate their own money supply with abandon on the coattails of dollar inflation.
Jâ€™accuse - the banks have embraced the regime of irredeemable currency with gusto and greatly profited from it, instead of protesting that under such a regime it was impossible to discharge the bankâ€™s sacred duty to act as the guardian of the savings of the people, and to protect the value of the estate of widows and orphans.
Jâ€™accuse - the accounting profession for their compliance in accepting grieviously compromised accounting standards that allows the conversion of liabilities into assets in the balance sheets of the government and the Federal Reserve.
Jâ€™accuse - Ben Bernanke is lying to the people in stating that he has the authority to print and air dop FR notes in order to fight deflation; the notes must be collateralized.
Jâ€™accuse - the financial press is lying to the people in parroting the propaganda line that gold has been demonetized; gold is still used as collateral for FR notes.
In the words of Chief Justice Reynolds, in delivering the dissenting minority opinion on the 1935 Supreme Court decision that upheld president Rooseveltâ€™s confiscation of the peopleâ€™s gold:
"Loss of reputation for honorable dealing will bring us unending humiliation. The impending legal and moral chaos is appalling.â€?
No less appalling, we may add, is the impending financial and economic chaos.
Alf Field, Gear Today, Gone Tomorrow, www.gold-eagle.com, September 6, 2006
Antal E. Fekete
Gold Standard University
September 28,Â 2007
Gold mining shares are not eligible as portfolio insurance since they have an ambiguous correlation to traditional financial assets. While from time to time they may be negatively correlated, and there is no question of their ability to benefit from promising trading opportunities, long-term wealth preservation demands fully allocated, segregated, and insured gold bullion. The counterparty risk involved in owning gold mining shares is not zero. Worse still, the full extent of this risk is unknown. To complicate matters further, many a government (such as that of Ecuador) keeps a jaundiced eye on its gold mining industry and is trying to determine the most opportune moment to expropriate foreign shareholders. Gold bullion is not dependent on anyoneâ€™s promise, representation, or ability to perform (nor, if properly stored, is it dependent on the propensity of the government to expropriate), in a word: gold bullion is not someone elseâ€™s liability. Therefore it is the only agent that can provide the necessary protection against both contingencies: systemic collapse and slow monetary debasement, while incurring the lowest possible level of risk.
The author hereby wishes to acknowledge his indebtedness to various writings of Nick Barisheff of Bullion Management Services, Inc., Canada.