Having written 2 in-depth articles about the rationale behind the Federal Reserve and US Govt plans to bail out the financial system some readers of the last couple of Occasional Letters may well have wondered if I was about to change my outlook. This article should put paid to any such thoughts. 

Previously I looked at the evidence that supported the view that the Fed and US Govt (along with the Bank of England) are following a monetarist approach, adapted by GB Eggertsson , to attempt to re-inflate the economy through non traditional means. As we have seen, especially recently in the UK, all the mechanisms required for the plan are in place and are being instigated.

In this article I want to look at why the monetarist approach will fail and what the results of that failure will be. (Yes, this is the article you have been waiting for). In doing so, I may quote from others but I shall make it clear when I am doing so.

First and most importantly, I must stress that my long term outlook remains unchanged:

• A recap of the scenario: bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse…….Deflation.

Now the next bit might sound a little patronising for which I apologise in advance, I know my readers are a clever bunch and this could be seen as pointing out the obvious.

Read the scenario again. Within it is a wisdom that could form a theory all of its own (I know, I’m getting carried away) and would explain many of the observations about the economy and stock/bond markets.

Here is the patronising bit. To circumvent the final outcome of the scenario, which is the biggest fear of the Fed et al, the central planners have a “cut out”. Simply put, when they judge circumstances may lead to the dreaded conclusion; they stop the process by resetting it to the beginning. They rewind the tape.
Is this my way of saying that the deflation will not happen? No, it will occur when the tape snags and breaks. What we are living through now is an attempt by the Central Banks, in cooperation with their Governments to reset conditions back to “easy money”. In other words every attempt to avoid a deflationary period results in a series of actions that make the requirement for the same actions to reoccur, the only difference being that the size of each “action” has to be larger than the previous one.

It is the infinite Ponzi scheme. Whereas a normal Ponzi scheme requires investors to keep ploughing in new money, the infinite scheme is only regulated by the pace of newly created money introduced to the scheme as the fiat system guarantees supply.

Let us see this in action by examining other periods when the tape was rewound.

Firstly here is a chart of inflation/deflation swings from Jan 1914 – Mar 2007. Although a year behind, it shows well the current long term trend (Dept of Labor/BLS):

Most noticeable is the smoothing of inflation peaks and deflation lows, with the elimination of deflation by the mid-50’s. This remarkable achievement is even more apparent in this chart (using McCusker to 1913 then as per previous chart):

 Never has the elimination of deflation or such a sustained period of inflation been seen in the past 350 years. We truly are in an age of innovation. Without doubt, it is the elimination of deflation that is the Fed mandate, accomplished by a continuing inflation which is controlled in its acceleration by the application of interest rate policies:

FFR 1954-2008Now for most that read my Letters none of this is particularly earth shattering news, for the uneducated public though this would come as a shock. The recognition that the past 50 years are aberrant, not the norm, is like saying the deflationary outcome of the 30’s crash was “unexpected”. There is no doubt that the deflationary period in the Great Depression was not unusual. What is unusual is the persistence of inflationary conditions since the mid-50’s.Some will say that it was the loss of a gold or silver backed currency that caused this unusual inflation, others that the social and economic ills of the 30’s made episodes of deflation unacceptable to the politicians and public.

Although both points could offer contributory causes to the current inflation, it would not explain the acceptance and appearance of both inflation and deflation prior to the mid-50’s. What may explain the disappearance of deflation is the rapid and innovative use of debt.

Who initiates and allows the accumulation of debt?

Gross Federal Debt 1938 – 2007The above chart show recessions marked with gray columns. You can now see why I compared the current Fed conundrum to 1937 and not 1933. Notice the acceleration of debt at each recession. The one time that debt accumulation slowed, in the very late 90’s, it led to the closest meeting with deflation since….the mid 50’s.It is the increase in debt, the enabling of “easy money” coupled with a falling real interest rate environment that allows a new wave of inflation to begin. The trigger is any threat that a deflationary period might occur, regardless of the cause of the recessionary events.

Why, in the face of such evidence, do I then hold onto a deflationary outcome? Am I saying “its different this time” ? Or have you already forgotten that the current conditions have only existed for the past 50 years?

Unlike any period since the 30’s we are now living with a credit contraction, were even extraordinary measures carried out by Central Banks and Governments are only able to keep the status quo. Expansion of debt from its originator is now used to shore up positions (the Bank of England has forbidden any new positions be taken with Treasuries borrowed from the latest scheme) rather than initiate a further velocity of lending, a fractional enlargement of debt. Current debt is being rolled over, with the new collateral provided by the Central Banks. The acceleration of debt has been massively retarded, if not stopped completely.

It is this that has caused such extraordinary manoeuvres to have happened over the past 8 months, leading to a socialisation of the capitalist system. It is not bank losses or even closures that worries the Fed, it is the breakdown of the benign inflation mechanism by the withdrawal of credit mechanisms from the economy.

The following excerpt is from the August 2000 FOMC minutes (pg 82):

• “MR. JORDAN. Thank you. I agree that leaving the funds rate unchanged at this point is the right thing to do. I am also sensitive to the communications issues involved; it would not be desirable to communicate the expectation that we are not going to raise the funds rate in the foreseeable future or to imply that the next change might be down rather than up. But it is a challenge as to how to avoid communicating that.Regarding the language on the balance of risks, part of me would like to say that the statement should always be that an unavoidable, permanent feature of a fiat money system is a balance of risks toward higher inflation. [Laughter] If it ain’t going down it’s going up.

Some readers might remember the Mogambo Guru published a similar extract in one of his articles some time ago. It was I who sent it to him.

You noticed the laughter. It is poignant as much as alarming. It shows that the committee accept the words of Mr Jordan as a truism. It also means that any threat to an inflationary environment is seen as a threat to the very existence of a fiat money system.

The Fed is no inflation hawk, it is no defender of inflationary expectations. Inflation is a necessary tool to keep the monetary system alive. The Fed is a fighter of deflation, not inflation.

Inflationists are even now pointing out that all the Fed/US Govt needs to do is create new money or nominal interest rate bonds (as put forward by Eggertsson/Bernanke/Friedman) to allow new credit to be created. Indeed I fully expect such measures to be taken in the future.

There is however one difference between the current situation and that of the 30’s. I give you this as an example:

• “BANGKOK (Thomson Financial) – Japan has turned down 60,000 tons of rice from Thailand after the asking price nearly doubled in the space of a month, the Thai Rice Exporters Association said Wednesday.Chookiat Ophaswongse, president of the association, said Thailand on Tuesday offered the Japanese government 100 percent white rice at $1,300 per ton — up from the $720 it paid in March.”This time, Japan turned it down, saying that the price was too high for their budget,” Chookiat said, adding that Japan did not want to be seen as a country pushing up global rice prices.

The implications of such actions by importers cannot be under-estimated. This is Japan turning down a staple food requirement for its populace because the price is too high. The reasoning is not important, it is the action and the implications for other exporters of other commodities that is.

We are seeing the beginning of price controls by buyers. If Japan is successful and eventually gets its rice at a cheaper price, the lesson will not be lost on other purchasers and not just those buying food stuffs.

If such actions become commonplace, price inflation and therefore inflation expectations would decouple from the requirements of the Central Banks. If prices start falling price inflation measures, already at peak y-o-y readings would drop drastically, undermining the Feds inflation rhetoric and therefore its plan to raise inflation expectations would lose credibility.

It is this loss of a credible inflation threat that would make further debt issuance by the Fed untenable. I refer you to this from “The Future Actions of The Federal Reserve And US Govt Are Known”:

• “Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)”The third key result of the paper is that in a Markov equilibrium the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation.”

The private sector will not expect inflation in the face of declining prices, if buyers follow the actions begun by Japan. During a period of recession it would be politically unacceptable to try and stop prices from falling from their currently elevated levels. It would not matter that the public and private business did not recognise the difference between price inflation and monetary inflation. Because of the carefully nurtured confusion over the 2 forms, the Fed would have great difficulty explaining why it was attempting to raise (monetary) inflation in a recession.

The Eggertsson plan would fail and deflationary forces would prevail sounding the death knell for the infinite Ponzi scheme.

Unless, of course, the Fed entered the commodities markets and bought everything it could. Then again, I doubt the US Govt has the stomach to be blamed for mass-starvation.

Commentary by Mick Phoenix

on behalf of An occasional letter from The Collection Agency

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. The views in the article are for informational purpose only.