The End Game

By: Steve Saville | Mon, Feb 6, 2006
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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.


Steve Saville

Author: Steve Saville

Steve Saville
Hong Kong

Steve Saville

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