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April 25, 2004 Greenspan's Choice: Scylla or Charbydis? |
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THE TWIN BEASTS
INTRODUCTION A great deal of discussion has been bandied about the media lately concerning whether deflation is going to occur or if hyperinflation will rear its ugly head. Many believe that deflation will be the end result of the present imbalances within the monetary system; others say hyperinflation. Then there are those who readily admit they do not know which is going to occur, but that either could occur; and that one or the other will occur: it is either Scylla or Charybdis - unless. Lastly there are a few wishful non-thinkers hoping to muddle through it all with their heads buried in the sand. DEFINITIONS Before attempting to offer an "unless" theory, the deflation versus hyperinflation issue should first be addressed; and to do so requires that we define the terms we are talking about. The classical definition of inflation and deflation is as follows:
And now the tricky part: a definition of hyperinflation. Supposedly they, whoever they are, have not decided on an exact definition. Most often it refers to the monetary condition where the supply of money cannot keep up with the rising demand for money, which in turn causes prices and interest rates to go up as well. But there is more to it than that. For now, suffice it to say that hyperinflation is inflation that has run amuck, the creature that is no longer under the master's restraint. The following discussion will examine the two beasts: Scylla and Charybdis: deflation; and hyperinflation; and if there is an "unless" scenario. In the above definition it is stated that inflation is "an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur." Fiduciary media - sounds pretty impressive but it's not. Fiduciary media is a fancy word for money substitutes: stuff that isn't actually money, but represents claims on money. All those checks we write would be an example; all those computer entries on the ledger would be another. But alas, it is debatable if what we call and use as money: federal reserve notes or dollars bills, is actually money or promissory obligations to pay money; as the United States Code does state that Federal Reserve Notes are redeemable in lawful money, which begs the question as to whether or not Federal Reserve notes are lawful money, otherwise, why would they be redeemable in lawful money if they were lawful money? So just what constitutes lawful money seems to be a mystery, although the Constitution does state that our money is supposed to be silver and gold coin; which raises another mystery - why isn't our money silver and gold as the Constitution states? Here is what the U.S. Code has to say: UNITED STATES CODE
I wonder what they give you at the Treasury Department if you try to redeem a Federal Reserve Note? Perhaps they'll give you a different note back or maybe even the same note, wouldn't that be cool - self-redeeming money. Almost sounds like a scam, but I digress - back to the deflation/hyperinflation debate. MONETARY INFLATION In the above definition of inflation, "need for money" refers to the demand for money. The quantity of money is the supply of money. The term, "so that a fall in the objective exchange value of money must occur" refers to the purchasing power or quality of money. So an increase in the supply of money, which is greater than the demand for money, results in a debasement of the currency - a fall in the objective exchange value or purchasing power of money. Such is the fate that paper fiat currency is condemned to - it must inflate or die. As the money supply inflates it debases or destroys its purchasing power: it destroys itself, much the same as a drug addict who requires ever-increasing quantities of drugs just to stay "even". This is why the dollar has lost 95% of its purchasing power since the Federal Reserve was created in 1913; the Fed has created or increased the supply of Federal Reserve Notes to a gargantuan disparity over and above the demand for them. Such is the way of life in paper fiat land. Federal Reserve Notes become worth less and less and less, until eventually they become worthless. So what's the big deal? So what if the Fed has created tons of paper money. Isn't that a good thing? Aren't we all richer, because we have a larger quantity of money? More money can't be bad for us, can it? Yes, a larger quantity of money can be bad for us. If the supply of money is much greater than the demand for it, then the objective exchange value or purchasing power of the money is falling. It is not important how many units (quantity) of money one has, but the purchasing power (quality) that the money has. The greater the purchasing power, the more stuff you can exchange a unit of money for; and that is all that money is good for: to procure or exchange for other goods. If the purchasing power (quality) of money is falling, then we can procure fewer goods for the same number (quantity) of units of money. This is monetary inflation and debasement of the currency. PRICE INFLATION A popular misconception is that inflation is the rising cost of goods and services. Rising costs means that more units (quantity) of money are needed to buy the same amount of goods. This is price inflation, which is a result of monetary inflation - price inflation being the effect, monetary inflation being the cause. The reason that prices go up is because the objective exchange value or purchasing power (quality) of money goes down. Continual monetary inflation results in the need to have an ever-increasing amount of money (quantity) coming in as income, to make up for the loss of purchasing power (quality). Loss of quality requires a greater quantity. We must work harder and earn more to have more units of money to make up for the loss of the objective exchange rate or purchasing power of our money. FINANCIAL ASSET INFLATION Another misconception is that price inflation is the mandatory result of monetary inflation, but such does not have to occur. As has recently been seen within the U.S. markets, asset inflation can also be the effect of monetary inflation. Instead of the increase supply of money going into the prices of consumable goods, it goes into the stock, bond, and real estate markets - causing the price of assets to rise to extreme valuations. Some refer to such as a crack up boom or a bubble. Sir Alan isn't sure just what it is. We will be revisiting this topic shortly, as it is the crutch of the matter. WAGE INFLATION Wage inflation is usually one of the last of the inflation cousins to rear its ugly head, but when it does it can be a killer, as rising wages go directly into rising costs of goods - all other things being equal, which usually they aren't. Rising wages go directly into rising prices for goods, unless producers take the hit of rising wages out of their profit margin, but this can only be done for so long and to a limited degree, to do otherwise leads to a loss of all profit margin and one could be forced out of business. DEFLATION As quoted by Mises: "deflation (or restriction, or contraction) signifies a diminution of the quantity of money (in the broader sense), which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange value of money must occur." In other words, the quantity of money is being reduced while the demand for money is not going down commensurate with the falling supply of money. This results in an increase in the objective exchange value or purchasing power of money. Money is in shorter supply (quantity) compared to the demand for it; hence what money is available is deemed to be of greater value or purchasing power (quality). SAVINGS The accumulation of an excess production of goods, over the consumption of goods, is called savings or the accumulation of wealth. Money, as the common medium of exchange for all goods, is stored or hoarded for future use, to transfer from savings into income, to exchange for what is needed. As there is a limit to what man can produce, there is a corresponding limit of excess production over consumption - or savings that can occur. This is a very important point. CREDIT The word credit is derived from the Latin creditum (a loan) and from credere (to trust or believe in). As covered in an earlier paper, Gold: Sovereign of Sovereigns money fulfills several roles, one of them being the standard by which value is transferred through time. Individuals desire to borrow money on credit - the trust and belief that they will repay the borrowed money. Other individuals desire to loan money and to charge a fee for doing so. In an honest or sound monetary system, credit is taken from the pool of savings and lent out as a loan. The cost of borrowing money or the price of credit is the interest rate. Because the pool of savings is limited, the amount of credit that can be lent out from it is limited as well. The greater the demand for credit the greater is the interest rate that is charged to borrow the savings. As the savings pool is drawn down through lending, savings become scarcer, hence a higher rate of interest is needed to convince savers to part with their savings. But that is in an honest or sound monetary system, not in a fraudulent paper fiat system. THE CONUNDRUM Debt (amount of credit extended and owed) is at the highest levels in history; for both the public sector; the business sector; and the governmental sector. The United States has gone from being the largest creditor nation to the largest debtor nation in the world - a most infamous distinction. The savings rate of the United States is also at historical low levels, yet the amount of debt keeps increasing. If credit is lent out of the savings pool, and the savings pool is at the lowest levels in history, how is it that credit and debt can be expanding? This is a conundrum. Interest rates are also at historical low levels, another conundrum, as interest rates should be rising to attract scarcer savings into the credit markets. How is it that the credit and debt market keep expanding yet interest rates remain historically low? Not only is this a mystery, it is an anomaly as well. We do indeed live in interesting times. Up appears as down, and down as up. GOVERNMENT DEBT & THE BOND MARKET Governments love to live beyond their means and to run up deficits; and ours is no exception, as a matter of fact they are quite adept at it. Bankers love to loan money on credit and to create debt and the interest rate stream that goes with it. Government debt issuance and bankers go together like white on rice. International bankers are most ingenious when it comes to creating new ways of issuing debt. It's their job, and unfortunately for us, but fortunately for themselves, they are quite good at it. That's why they keep getting wealthier, and we keep getting deeper in debt. Our government finances itself in two ways: by collecting taxes and by issuing debt or government bonds. Since the public gets upset if taxes go up too much, the government chooses to issue lots of bonded debt instead - especially treasury bonds. The bonds were originally sold to commercial banks via the Federal Reserve. This process is referred to as monetization, as the Fed and the banks create the money to purchase the bonds out of thin air. Debt becomes money. When reserves are extended as credit, money is created. And since our system is a fractional reserve system of lending, they get to lend more than they have, which is probably why bankers like to be bankers. But the central bankers, being ever resourceful, dreamed up a new way to finance the government debt. Instead of selling the bonds to the commercial banks, the bonds were sold to private investors via existing financial markets, and to foreign investors and central banks, especially Japan and China. This placed the bonds in the hands of investment funds, hedge funds, and foreign central banks, which meant the bonds did not show up on the books of our commercial banks as before. This is the how historical debt levels have been issued without creating price inflation, which would have caused market interest rates to rise to make up for the loss of purchasing power of the currency. Instead of price inflation of consumer goods, the money has flowed into the bond market and other financial markets, including the stock market and especially the real estate market, bidding up the prices of financial assets. The United States has learned how to export inflation. You must admit they are clever. In place of price inflation we have asset inflation, as exemplified by the rise in bonded debt issuance from less than $1 trillion in 1970, to $23 trillion by 1997, to approximately $46 trillion by 2003 - a doubling in just six years. Such is not an increase in debt - it is an explosion of debt. But the money didn't just go into the bond market, it also went into the stock market, although some of that has been given back; but it has also flowed quite heavily into the real estate market, which is tied to the bond market quite closely. Nothing quite like a 30-year mortgage to get you to work your life away to earn enough to pay 3 times the original price of the house. Now that's progress - isn't it? THE MAKE BELIEVE WORLD OF PAPER FIAT The rate of interest that the Federal Reserve charges for short-term loans to member banks is the Discount Rate. They also have a similar Federal Funds Rate. In paper fiat land most credit does not come out of the savings pool, but is instead created out of thin air or nothing. If the credit came from the savings pool, interest rates would rise as the savings pool was drawn down. The Fed manipulates interest rates to keep them below the natural rate of interest that would exist if credit came from savings, which would limit the available amount of credit.
Some financial writers have misinterpreted this to mean that although the Federal Reserve influences the demand for credit by its interest rate policy, that the issue of credit is unlimited. They believe that creditors have the ability to issue credit or to stimulate the demand for it to a virtually unlimited degree. This is confusing influence with complete control. The Fed is manipulative, but it is not omnipotent. As has been said:
THE CARRY TRADE The bond markets have a short and a long end, referring to the length of time of maturity of the debt instrument. Shorter maturities usually pay lower rates of interest, and longer maturities pay a higher rate of interest. The longer that money is loaned out for, the more uncertain or the greater is the risk that the purchasing power of the money repaid in the future, will be equal to the purchasing power of the money loaned in the present. This involves the function of money as a store of value or purchasing power. If you lend out your hard earned money, you want to be repaid with money that has the same purchasing power as the money you lent. If you are repaid with money whose purchasing power has lessened or been debased, you will be surrendering wealth. The greater the risk, the greater is the rate of interest - to pay or make up for the additional risk. The difference between the lower rates of interest on the short end of the debt market versus the higher rates on the long end of the market essentially offer an almost risk free profit to those who can take advantage of it. Banks and large financial institutions can borrow from the Fed at a short-term rate of 1% and invest the money in the long end of the bond market that pays 5%. The difference or spread between 1% and 5% is 4%, which the player gets to pocket as profit. This is known as the carry-trade - the free ride da boyz get. Some refer to this as arbitrage. Others call it fraud. Free markets are not supposed to be manipulated in favor of a special interest or group. The market should determine the price adjustment or rate of interest between borrowing and lending according to free market principles of supply and demand - not by governmental or central bank intervention. DERIVATIVES Derivatives are financial instruments (paper) that derive their value from another source. The "value" of a derivative is based on the underlying asset that it represents. For instance, the Comex sells future derivatives on gold. These are mere pieces of paper that represent claims on physical gold. The derivative market is huge - with a total nominal value of over 100 trillion dollars. Just so happens that the largest derivative market is the interest rate market - gee, who would have guessed? The catch or trick to derivatives is that they are used to secure the control of a much larger value of the underlying asset using a much smaller commitment of capital. More bang for your buck mentality. The use of interest rate derivatives by hedge funds and other large financial institutions creates a huge inflated and synthetic demand for the underlying bonds, as the derivatives market dwarfs the actual bond market in size. To allow for such a huge disparity between the derivative market and the underlying bond market is utter folly and pure speculation - a disaster waiting for a time and place to happen. Some say that the derivative market helps to lessen the risk of financial markets, and makes things more stable and safe. Kind of like when a bookie offsets large bets to other bookies, so that they get to have some of the risk instead of keeping it all for himself. I guess as far as the original bookie is concerned, he feels safer. It's debatable if this feeling of safety extends to all players involved in the transactions, however. Re-insurers lay off risk much in the same way. PILLAGE & PLUNDER What is actually occurring within the markets is a form of wealth transference, from the producing sector to the financial sector, taking the capital of the former, and giving it to the latter, creating almost risk-free capital gains in the process. The productive sector of the economy is being pillaged and plundered by the financial sector of structured finance - by casino-style gambling running wild. The house has rigged the game and is collecting all the chips. Our greatest skill is now in pushing paper, especially paper debt, to the rest of the world. Dr. Larry Parks, head of The Foundation For Monetary Education (FAME), recalls that John Kenneth Galbraith, the Paul M. Warburg Professor Emeritus of Harvard University, had published a book in 1975 entitled Money, Whence It Came, Where It Went. In this book the professor wrote:
In paper fiat land, banks are permitted to carry assets, such as bets in the derivatives markets, off balance sheet. They do this in order to hide what is really going on from public scrutiny. But the accountants and bank inspectors know what's up, but that's a different matter, as they seem to find it in their best interest not to mention it. This is how Dr. Parks describes the fraudulent activity:
OUT OF SIGHT OUT OF MIND A hedge fund or other large financial institution can put up 10% or less of $100 million in bond derivatives and borrow the rest from an investment bank. In today's world of structured finance it is possible to use unrealized profits in financial assets, including derivative contracts, as collateral for future purchases. Such financial activity is self-reinforcing, it bids up the price of the underlying assets by creating a synthetic demand for them, which causes the momentum players to climb on board and ride the wave of bond speculation. This is the Greenspan put so often talked about. By creating a falling interest rate environment for as long and to the degree that he did, he basically subsidized the bond market. But once again, this is not how free markets work; it is how manipulated markets work by intervention. And such manipulation and intervention produces imbalances and pressures within the financial system that will flow to the weakest link. The result: pop goes the bubble. This is why Warren Buffet has spoken badly about derivatives; they are a ticking time bomb waiting to go off. HOW THE GAME IS PLAYED So here is how the game of real life monopoly is played in paper fiat land. Our money is paper fiat; it is irredeemable; it is no longer backed by gold and silver, nor is it the hard money silver and gold coin system of the Constitution. In such a make believe world of monetary policy, credit, debt, and money have morphed into one and the same entity. By monetizing government debt, Federal Reserve Notes, which are irredeemable promises to pay, circulate as the currency. When money, credit and debt are one and the same, such a system must inflate or die. The money supply must constantly increase to pay the ever-increasing interest rate stream on all the debt that is and has been issued. It is a vicious, never-ending circle. Because the money supply must keep expanding, debasement of the currency constantly increases, and purchasing power is continually lost. Since the Fed took over in 1913, the dollar has lost 95% of its purchasing power. This is monetary inflation; and in paper fiat land it is inevitable. Paper money is condemned to a life of inflation and debasement - it is inherently self-destructive. Eventually such a system comes to a fork in the road: one path leads to deflation, the other to hyperinflation. One of the two paths must be taken - unless. DEFLATION REVISITED The Fed may be able to increase the money supply to huge degrees, but they cannot determine exactly how it is used in the economy or where the money will flow. If deflation starts rearing its ugly head, the central bankers would like to see the money flow to the commodity markets, bidding up the price of goods. But they can't make the money flow in the direction they want, they can try to direct the flow, but even that is almost impossible. In a prolonged falling interest rate environment, the action is in the bond market, that's where the money is being made as interest rates keep dropping. The bond market sucks up the badly needed money for the production sector of the economy. Although interest rates are falling, business finds it difficult to extricate itself from the higher debt levels that they have previously borrowed money at. The bond market mugs the productive sector - wanting more chips to play with. More money supply further pushes down the rate of interest, which in turn puts pressure on producers to lower prices. This creates a vicious circle as the interest rate level and the price level are linked. A continued and prolonged interest rate falling environment makes the cost of servicing past debt used for business expansion to rise exorbitantly. As interest rates fall, the present value of debt rises. The cost of liquidating a liability rises in kind. These hidden costs all hit the bottom line of businesses - its profit margin. If such continues they will be forced to liquidate or go bankrupt. HYPERINFLATION REVISITED Inflation is the modis operandi of a paper fiat currency; it must inflate or die. Inflation is the increase of the supply of money (quantity) greater than the corresponding demand for money. Such results in a loss of the objective exchange value or purchasing power (quality). Many seem to believe that the Federal Reserve has all this monetary policy stuff under control. Call me a skeptic - I'm not convinced. Given the fact that on their watch the purchasing power of the dollar has lost 95% of its value; and that the United States is now the largest debtor nation in the world, when it used to be the largest creditor nation; and that within 20 years of its creation the Fed had to have the government confiscate all gold and silver currency because the banks were going bankrupt; it makes me a bit leery and dubious. The Fed has a lousy track record and an even more horrendous resume. Would you hire these guys to run your business, remembering that you can't print your own money as they can? And even that power seems to have caused more problems than it has solved, and may not help them in the end. Do they really have the power to create an unlimited supply of money - even in paper fiat land? Are they really omnipotent - or impotent? During standard monetary inflation, which is the norm for paper fiat, the supply of money is increasing above and beyond the demand for it. It is said that the Fed has unlimited capacity to create as much money as needed. Therefore an unlimited supply of money is pared off against a limited demand for money, even if the demand is ever increasing. As monetary inflation occurs, debasement of the currency takes place and loss of purchasing power results. Our money is continually becoming worth less and less. It requires more units of money to buy the same amount of goods. Just put a kid through college or have a major illness and you will experience this first hand, face to face, up close; and it ain't pretty. Hell, some people can't even afford to die; others can't afford to live - another conundrum, as if we didn't have enough already. A funny thing happens on the way to the market. Because the purchasing power of our money has been going down, the demand for more quantities of money, to make up for the loss of purchasing power, suddenly increases. No problem says the Fed, you want more money, we will give it to you; and they do. But in the process of giving us more money, to meet the greater demand, more purchasing power is lost, which then requires more units of money (supply) to make up for the loss. Demand rises again for more supply. As can be seen, it's a vicious circle. As the purchasing power of money keeps lessening it creates a greater demand, soon it is discovered that the purchasing power of the money is falling faster and faster, faster than the demand is rising. What was an unlimited supply of money meeting a limited demand for money suddenly becomes an unlimited demand for money meeting a limited supply of money, as the money can't be created fast enough to keep up or make up for the loss of purchasing power. Suddenly interest rates start to rise, as do prices. But the rise in interest rates does not support the currency. The purchasing power of the currency falls in spite of higher interest rates. Slowly panic starts to set in. People can't spend their money fast enough - before it looses more purchasing power. Now the monetary beast of inflation turns upon itself, suddenly what was an unlimited demand for money meeting a limited (although ever-increasing) supply of money, now becomes no demand for money, as the market correctly perceives that no amount (quantity) of money can make up for the loss of purchasing power (quality) created by the debasement of the currency. The gig is up. The fraud is seen for what it is. The currency is no longer accepted as the common medium of exchange. The use of the currency ends. The creature they created destroys itself by suicide - by hyperinflation. Hyperinflation is the death-knell of paper fiat currencies. In truth, however, neither the supply of money or the demand for money was or is unlimited - both are mere illusions of the debt game - false perceptions the bankers would have us believe in, within the make believe world of paper fiat land. Sort of like the belief that more debt makes us wealthier, because we get to rent more and bigger cars and houses, which have not been paid for. We may have more stuff even if we don't own it - but we do own the loan for it - the debt. STARING INTO THE ABYSS Deflation and hyperinflation are different in form, but they are identical in substance - two opposite sides of the razor sharp edge of debt. On either side lies the abyss. Deflation destroys the value of debt through defaults and bankruptcies, hyperinflation by debasement and loss of purchasing power. The decision is no longer in the hands of the producers in the economy, as it should be, it now rests with the financial sector, with the bond market, as the bond market is the debt market; and in paper fiat land we live and breathe and have our being by debt. Which path we take at the fork is anyone's guess, but is does appear that the bond market will have a big vote in the choice. Will greed of profit prevail, or will fear cause them to cut bait and run? HISTORICAL REFERENCES History is replete with bouts of both hyperinflation and deflation. One distinction that history shows, however, is that hyperinflation ends the life of a currency - it no longer is accepted as the medium of exchange. Although deflation is wrought with pain and suffering, defaults, bankruptcies, job losses, depressions, etc.; the currency is not destroyed or ended. The slate of debt is wiped clean, and the game begins anew, another cycle of boom and bust in paper fiat land. Hyperinflation destroys the currency; deflation prolongs the life of the currency. The first ends the currency game; the second allows the game to continue. UNLESS So does it really come down to one or the other: deflation or hyperinflation: Scylla or Charybdis? No, not necessarily. But the time to make the correct choice is running out quite fast. What is the "unless" - the correct choice? It is to return to the Constitution and our original system of silver and gold coin - Honest Money, Part I: The Constitution and Honest Money, as opposed to the present fraudulent paper fiat debt system. Paper fiat is just a means of wealth transference, from We The People to those who control the money. Deflation and or hyperinflation are but different methods of the self-same wealth transference scheme. One or the other will occur unless Honest Money is restored to its rightful place as The Sovereign of Sovereigns. The choice is ours.
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Nelson Hultberg
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Nelson
Hultberg is a freelance writer in Dallas, Texas and the Executive Director
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