By Alasdair Macleod
June 13, 2019
This article is a wake-up call for those who do not understand the true purpose of monetary inflation, and do not realize they are the suckers being robbed by monetary policy. With the world facing a deepening recession, monetary inflation will accelerate again. It is time for everyone to recognize the consequences.
Introduction
All this year I have been warning in a series of Insight articles that the turn of the credit cycle and the rise of American protectionism was the same combination that led to the Wall Street crash in 1929-32 and the depression that both accompanied and followed it. Those who follow statistics are now seeing the depressing evidence that history is rhyming, though they have yet to connect the dots. Understandably, their own experience is more relevant to them than the empirical evidence in history books.
They would benefit hugely from a study of the destructive power of the Smoot-Hawley Tariff Act combining with the end of the 1920s credit expansion. The devastating synergy between the two is what crippled the American and global economy. And as we slide into a renewed economic torpor, contemporary experience tells us the Fed and all the other central banks will coordinate their efforts to restore economic growth, cutting interest rates while accelerating the expansion of money and credit. The current generation of investors argues that this policy has always worked in the past (at least in the past they have experienced) so the valuation-basis for financial assets and property should stabilise and improve.
This brief summary of current thinking in financial markets ignores the fact that a catastrophic tariff-cum-credit-cycle mixture is baking in the economic cake. Crashing government bond yields, reflecting a flight to relative safety, are only the start of it. If the 1929-32 comparison is valid, today we have the additional problems of excessive government debt coupled with consumer debt, and hundreds of trillions of over-the-counter derivatives adding to systemic risk. The banking system all but collapsed in the 1930s, as banks desperately dumped collateral assets into falling markets. This time, the debt is not confined to industry; a debt contraction will hit consumers directly and threaten domino defaults in OTC derivatives as well.
Obviously, this cannot be permitted to happen. Whatever it takes to prevent a debt-deflation spiral developing is de facto official policy. The only solution central bankers have is to flood the economy with a tsunami of interest-free money, which will be in addition to the monetary expansion which has continued since the Lehman crisis.
As our tariff and credit cycle mixture bakes in the economic cake, infinite monetary inflation will be the response. At some point, financial markets will wake up to the consequences. It could be sudden and relatively soon. The chart below, of the euro-dollar exchange rate warns us that the two most important fiat currencies are about to experience a sudden change in their relationship, likely to have far-reaching consequences.
For the last ten months, the euro has been falling in the
confines of a triangular pattern. It resembles a falling wedge, from which a
substantial up-move for the euro could develop. However, falling wedges usually
last no more than a few months, and this one is nearly a year old. It could
also be a descending triangle, but a purist would argue the pattern should be
more horizontal. That would be sharply bearish for the euro, which is easy to
imagine, given the political, economic and systemic issues faced by the
Eurozone. Time will tell which interpretation is correct, but either way there
appears to be imminent currency volatility when the pattern breaks. With such a
warning, we must expect consequences.
This could be an important clue on timing: we shall see. Besides assessing the
immediate implications for financial assets around the world, we must also look
at the consequences of the increase in monetary inflation about to be inflicted
upon us. It is a subject of which there is widespread ignorance, not just at
street level, but in the highest levels of finance as well.
Keynes described aptly the extent of this ignorance in his The Economic Consequences of the Peace, published one
hundred years ago today with the following quote:
“There is no subtler, no surer means of overturning the existing basis of
society than to debauch the currency. The process engages all the hidden forces
on the side of destruction and does it in a manner which not one man in a
million is able to diagnose.”
The younger Keynes appeared to understand the consequences of inflation four
years before the collapse of the German mark in November 1923. The older Keynes
changed his mind and argued in favor of inflation’s powers of economic
restoration. He became one of the clueless million in his earlier
statement.
This article is for the millions, who like the older Keynes do not understand
the consequences of what will hit them. It is for those who do not appreciate
the hidden forces of economic destruction driven by the acceleration of
monetary debasement, which, thanks to the developing slump, now seems set to be
unleashed.
The true purpose behind monetary expansion
A government with an exclusive licence to print money will always use it as a source of finance. All hyperinflations have had their origin in spendthrift governments with fiat currencies to hand. There was a time when every credible economist knew this, but now and then someone comes up with a theory that encourages governments to abandon the constraints of sound money and for state-sponsored economists to revise their opinions.
The first modern exponent of fiat currency was Georg Knapp of the Chartalist school in Germany, who published his State Theory of Money in 1905. He encouraged Bismarck to believe he could finance the newly unified Germany’s growing status as a military power without raising taxes. The consequence was the Great War and the continuation of this monetary policy led to the mark’s final collapse in 1923.
Keynes, as an occasional economic advisor to the British government, took on Knapp’s mantle in a different way, promoting the government’s use of money to stimulate the economy early in the business cycle by running a budget deficit, initially funded by government debt in a sound money context. In other words, he promoted the concept of the government being flexible in its finances but balancing its books over the business, or trade cycle.
In seeking a solution to the Great Depression, Keynes himself showed that after all, he was in the ranks the million who did not fully understood inflation. The error in Keynes’s approach was to believe the cycle was a trade or business cycle, when in fact it was a cycle driven by the inflation of the bank credit that he sought to stimulate. The solution was not to stimulate the expansion of bank credit but to stop banks from expanding bank credit in the first place and for the government to balance the budget at all times. But by encouraging governments to inflate money or have bank credit inflated in its place, Keynes was effectively promoting a modified version of Knapp’s disastrous state theory of money.
The result was that the bastion of sound, gold-backed money was fatally breached. Between 1934, when the dollar devalued against gold, and 1971, when the Bretton Woods Agreement collapsed, US broad money (M3) expanded considerably more rapidly than its gold backing, going from 5 times to 55 times. The issuance of unbacked fiat money was used to fight wars, while banks expanded credit, primarily to finance business expansion domestically and abroad. The collapse of the Bretton Woods Agreement reflected the fact that the dollar was then barely gold-backed, having become almost totally fiat. By coming up with his own, limited state theory of money in 1936, Keynes along with his fellow inflationists had led the way to casting currencies adrift from their golden anchor.
Since 1971, central banks, led by the Fed, have dealt with the gold issue by dismissing it. They adopted a full-on state theory of money, allowing the quantity of money in circulation to expand without limit. Gold was no longer available for exchange for dollars at the Fed, so its price was no longer tied to the dollar.
Following the ending of Bretton Woods, US broad money supply has increased by a further 21 times, an average annual compound rate of 6.6%, with much of the increase being in the wake of the Lehman crisis. Government economists in the Keynesian mold tell you that by managing the quantity of money, the economy can be optimized. While that opinion might have been honestly held by those duped by Keynes, it ignores one simple fact: in a market economy, the money deployed in it is a matter for economic actors, not the state.
Whatever Keynes’s original motivation, the state’s motive as issuer of state money is to use it as a source of free finance. Before the Lehman crisis, inflationary financing was predominantly in the form of the expansion of bank credit, but since the Lehman crisis, it has additionally been by the expansion of base money through the medium of bank credit. This new development was quantitative easing, justified as an emergency measure to stabilize the economy. But it is now becoming a common feature of inflationary government financing.
Government financing by inflationary means has been with us for a long time. Since 1971, when the Bretton Woods Agreement collapsed, net US Federal budgets have thrown up a total deficit of $13,738bn, which compares neatly with the parallel expansion of broad money of $13,782bn.[i]
While there is probably an element of coincidence in the closeness of these numbers, they carry a clear message about the true purpose of monetary inflation. Very few people understand it, but all the theories and claims about non-inflationary financing of government deficits are simply bunkum.
We now face a potentially devastating combination of American trade protectionism and a credit cycle which is moving America and the world into a severe downturn. The effect on government finances can only be guessed at, but with the White House’s own pre-recession forecast of a budget deficit for the current fiscal year of $1,092bn, the baseline is not good. Given the long-run relationship established in the previous paragraphs between monetary inflation and the deficit, clearly, we are in for another acceleration of monetary inflation.
Already, monetary policy is to throw as much new money and credit at the economy as it takes to generate recovery. As the economy slides, interest rates will be returned to zero, or even made negative as an inducement to consumers to spend, investors to invest, and their combined actions to keep the banks afloat. It won’t work, and why not is our next topic.
The drip-feed impoverishment of consumers
Whatever government economists say about the supposed stimulative effects of price inflation, if you debauch the currency you reduce the purchasing power of people’s salaries and the value of their savings. And the more rapidly you debauch the currency, other things being equal, the more rapidly you impoverish them.
This is a process that has been going on for a considerable time. It first became apparent when the Bretton Woods Agreement failed in 1971: the accumulated monetary inflation since gold was revalued to $35 in 1934 until 1971 impacted prices over the following decade. Today, the dollar has now lost 97% of its purchasing power measured against gold, the people’s money, since the end of Bretton Woods.[ii] While some members of society have prospered by being borrowers and investors in financially leveraged businesses, the ordinary worker and consumer has fought a losing battle to maintain a standard of living.
It should therefore be evident that instead of being a universal benefit, monetary inflation creates winners and losers. Generally, savers lose and borrowers win. The poor lose and the better-off win by gaming the system. Otherwise, the winners are the issuers of new money, which are the government through its central bank, and the commercial banks who are given a licence by the government to create money in the form of credit. Commercial banks do this by lending money they do not have, and which did not previously exist. This money returns to the banking system in the form of new customer deposits to balance its creation.
The creators of new money are the obvious winners. The banks’ favored customers (traditionally big business) also benefit, because they get to spend the new money which has been loaned to them before it goes into general circulation. The new money then enters circulation, indistinguishable from that which already circulates. And with a relatively fixed quantity of goods and services being produced in the economy, the outcome should be clear: prices will rise. But they do not rise evenly; it depends on where and on what the money is spent.
As the newly-created money progresses in its circulation, it drives up prices leaving those yet to receive it disadvantaged. They find prices have risen without having seen an increase in their wages and with no compensation for their devalued savings. All they know is that prices have risen, and they have to make do with what they have or go into debt. They are not aware that their unconscious presumption, that money is the constant in all their transactions, has been undermined by monetary inflation. This is why not one in a million has the foggiest idea what has happened to their money.
[For evidence of the entireness of the inflation fraud, look no further than stock charts. No one in the finance industry even considers the possibility that the price of any financial investment has been affected by changes in the purchasing power of the currency in which it is measured. They automatically assume all the change is in the stock price. And these are the financial experts advising the general public!]
Relative preferences are of overriding importance to fiat money
So
far, we have commented on what amounts to the quantity theory of money. During
a monetary inflation, the rate at which the general price level increases is
also affected by its impact on savings. In a country like Japan, consumers tend
to hang on to the extra money rather than spend it, increasing their bank and
post office deposits. Prices tend to be more stable for a given rate of
monetary inflation as a result. The money accumulating in the banks is
available to be invested in extra production capacity and product development.
Fortunately for manufacturing businesses, in a savings-driven economy with a
strong currency they can source most of the components of production from
abroad, thereby keeping a lid on production costs in local currency terms. By these
means and with a general preference for saving money instead of spending it,
monetary inflation at the price level is subdued.
The difference between the savings-driven economic model, where monetary
inflation has less of an effect on prices, and the consumer-driven model, where
it feeds directly into consumption, reflects different preferences for money
relative to goods.
As long as the public collectively retains some sort of preference for money,
even if it is a nominal amount of cash, the currency will retain some
purchasing power. It is when the public collectively decides to get rid of all
money in preference for goods and services that it becomes worthless. In the
final analysis, it is this relative preference, not the quantity in circulation,
that determines a fiat currency’s value.
On the eve of a deepening recession, we now face an acceleration in the pace of
monetary inflation as governments seek to fund yawning budget deficits and
their central banks try to keep their commercial banks solvent. In the
consumer-driven economies that are most susceptible to price inflation, the
creation of new money will accelerate the rate of wealth transfer from ordinary
people to their governments. This is from a level of wealth which has been
already badly depleted by monetary inflation over decades and has not much more
to give. We will face the pig-on-pork of currency debasement, with each new
currency unit buying less than the last one. In short, the dynamics that lead
to a final currency collapse are now falling into place.
Our next challenge is to work out how this might happen in a modern context,
where personal liquidity is vested in credit cards and consumer loans instead
of bank balances and physical cash.
Who will liquidate their dollars?
In the original model of an economy, bank deposits were owned by businesses and private individuals, reflecting a mixture of profits, liquidity and savings. This is important, because it is the flight out of deposits that will determine the fate of the currency. The largest categories of deposit-holders will drive the process.
From being a mainstay of deposit business, consumers in America now have very little on deposit as a proportion of the total. Instead, they are often borrowers with credit card debt providing personal liquidity instead of money in the bank, and often have just enough credit available to finance their purchases between pay days.[iii] Their influence on relative preferences for money is therefore not as significant as in the past.
Of the total of $12,605bn deposits recorded in the FDIC-insured US commercial banks and savings institutions at end-March, [iv] we know from US Treasury TIC data that $4,905bn is owed by the banks to foreign depositors (38.9% of total FDIC deposits).[v] We also see from the FDIC numbers that commercial lenders have deposits of $4,960bn (39.3%). The balance of 21.8% is a mixture of deposits on the books of mortgage lenders, agricultural lenders and other miscellaneous categories. Deposits relating to consumer lenders is only 1.4% of the total.
There is almost certainly some cross-over between these categories. We can only assume that banks specializing in commercial lending and the other FDIC categories seek to attract deposits from related sources, in accordance with their expertise and connections. This being the case, there can be little doubt that it is the relative monetary preferences of foreign and domestic commercial depositors which will take the lead in determining the future purchasing power of the dollar.
For foreigners, the outlook for the exchange rate will be crucial. We know from Treasury TIC data that outflows have already begun, coinciding with the sudden slowdown in global trade.[vi] And if, as argued in this article, they begin to see a further economic deterioration, they will continue to liquidate dollar holdings, being surplus to their falling trade requirements. Their combined dollar holdings, including those of foreign governments, currently amount to more than America’s GDP, including investments totaling $18,463bn[vii] in addition to the bank deposits mentioned above of $4,905bn.
Therefore, we need to keep an eye these flows. Corporate depositors can be expected to be slower to act than foreigners, being primarily interested in accounting profits rather than matters of purchasing-power. This would change if negative interest rates are imposed by the Fed and passed on by the banks to depositors. Therefore, dollar weakness in the foreign exchanges, but more particularly against commodities and raw materials at a time of a widespread economic slump, is likely to be the first warning of an impending collapse in the dollar’s purchasing power.
This is not current thinking, with market commentators believing that indebted foreigners need more cover for their dollar denominated debts. The facts from the Treasury’s TIC data speak otherwise, and anyway, near-term debt obligations are routinely hedged by derivatives.
A flight out of the dollar is therefore much more likely than is generally believed and can be expected to undermine attempts by the Fed to maintain control over bond markets. For the moment, bond prices are rising, reflecting increasing signs of recession, but it is a phase which will shortly pass.
The US Treasury is anticipating the problem
In time, attention is bound to refocus towards the funding problems that will arise as a result of falling foreign participation in dollar-denominated markets. In TIC figures we have already seen early evidence of foreign dollar selling, threatening to undermine funding of the budget deficit if it continues. Since the ending of Bretton Woods (with the sole exception between 1998-2001, when there were three budget surpluses in a row) there has been a general presumption that foreigners would always fund most, if not all, of the budget deficit.
However, foreigners now appear to have stopped recycling their trade dollars, throwing the US Treasury funding burden onto domestic investors, who will also have to absorb sales by foreigners. The US Treasury will desperately need inward portfolio flows to counteract these problems, yet portfolio flows are destined to go elsewhere, such as into infrastructure-development in Asia.
Clearly, the US Treasury must be acutely aware of the problem. Unless the budding partnership between China and Russia is firmly quashed, global portfolio money will be sucked into financing their investment plans, particularly as they develop their non-dollar, Asia-wide currency bloc. Having been dependent on this money for decades, the US Treasury will expect a funding crisis in America rapidly materializing.
This is now the overriding reason behind America’s stance in the ongoing financial war with China and Russia. China and Russia are very much aware of these dynamics and are not going to roll over and submit. Our working assumption must be that over the next few years, not only will trade-related flows into the dollar reverse as the global recession deepens, but China will do its best to starve America of international portfolio flows as well in order to satisfy her own development needs.[viii]
The Fed will then have no alternative but to fund much of the government deficit itself through quantitative easing. Interest rates will return to the zero bound, or even be pushed into negative territory to stave off the government’s funding crisis. Lehman will look like a warm-up act for what’s to come.
There may be moves to support the dollar from sovereign wealth funds, while currency swaps between the leading central banks could be used to stabilise currencies. Perhaps a new plan involving SDRs will be hatched. A global reset might be claimed to be taking place, but it will not change outcomes. The reality is print, print, print.
Monetary inflation in the world’s reserve currency can only accelerate, because of an escalating budget deficit and the need to support banks which would otherwise fail. With a second leap in the inflation rate of the fiat reserve currency, and with sales of US Treasuries by foreign sellers to absorb, the dollar will lose credibility, first abroad and then domestically.
Prices of goods and services will rise in domestic dollars and any other fiat currency tied to the dollar, despite the slump in demand from a deepening recession. If you still think all the change in prices comes from the goods side in a transaction, you will be flummoxed at how it is possible for prices to rise in a slump. The explanation is the purchasing power of your fiat dollars, euros, whatever, is falling more rapidly than the deflating values of goods.
This could happen quickly once the slide begins. Central banks have been closing loopholes in the banking system, leaving depositors in aggregate trapped. The amount of physical cash they can withdraw from their accounts is limited today, and in real terms will be worth even less in the future. The only escape for a depositor is to buy things, anything. Gold, bitcoin even. But with a tide of depositors moving in the same direction, the price a seller will accept will rise very quickly, because sellers equally will be reluctant to hold currency.
Comprehend all this and you will understand how “…the (inflationary) process engages all the hidden forces on the side of destruction”. There have been many changes in the last hundred years since Keynes wrote The Economic Consequences of the Peace”, but the human desire for satisfaction, security, and an erroneous belief in the honest motives of government have generally remained the same. It never occurs to anyone that the state routinely robs them of the value of their wages and savings by the simple expedient of issuing money out of thin air.
Ignorance of monetary affairs and of the surreptitious inflation of the currency remains a mystery to as many people today as it did then. Hopefully, this will no longer include readers of this article.
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