What's It Going to Be: Inflation or Deflation?

October 9, 2007, marked the day when the Dow Jones reached a peak at 14,198.83. On October 10, 2008, the Dow reached as low as 7,882.51 which is a decline of about 45%. These are tough and humbling times to be an investor or simply someone trying to save for retirement or a down payment on a house.

A 45% decline in the Dow over 1 year does not happen often. When we take a longer term look at investing, we can appreciate that we'll have years when we won't have gains, but at the same time, we'll have years when our gains will be terrific and we'll have years when our gains will be average. But ultimately, the goal of investing is to have gains and not lose them, and that makes years like this tough.

America and the world have seen massive wealth destruction both in real estate and business/stock wealth over the past 12 months, especially over the past month and a half.

This kind of wealth destruction is normally deflationary like what happened in the early 1930s: Falling prices for goods and services, falling house prices, falling stock prices, falling commodity prices.

Deflation:

Deflation is the opposite of inflation. Therefore, under the usual contemporary definition of inflation, 'deflation' means a decrease in the general price level.

Deflation is considered a problem in a modern economy because of the potential of a deflationary spiral and its association with the Great Depression, although not all episodes of deflation correspond to periods of poor economic growth historically.

I'm mentioning this because the topic of whether we will have a deflationary recession/depression or inflationary recession/depression will have very big consequences on our investment strategies.

It is and has been my belief that we are likely to be getting a more inflationary recession/depression over the next few years. So, as we are seeing the signs of deflation happening, commodities falling, house prices falling and stocks falling, we can take a look at what our Fed Chairman had to say about this.

He has provided us with his take on deflation and how it affected America in the great depression of the 1930's. He does not want America to have deflation and has provided us with his views on how to prevent deflation if it was to occur from a speech he gave in November of 2002 known as his "Helicopter Speech." Here are some samples from that speech that bear reading now as this credit crisis and wealth destruction occurs.

The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. (ME: That's inflationary) We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).

Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, (Me: At 1.5% now and may very well go to 0% as he suggested) the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. (Me: Buying $700 billion of toxic mortgage backed securities and now taking equity stakes in banks directly) Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. ( ME: AIG) Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

(Emphasis with underline and bold all mine.)

Our Fed and Central banks around the world are doing all they can to both alleviate the credit crunch and perhaps, without saying it, inflate away some of the debts outstanding via their actions.

So what's it going to be: Inflation or deflation?

Let's look at where we are now. Inflation in September showed year over year CPI increase in the US at 4.94%. This is down from 5.6% in July. If you have been holding anything yielding less than 4.94%, you have lost purchasing power. The hidden tax of inflation has eaten into your wealth.

US Treasuries maturing 3 years or less are all currently yielding less than 3%. It's no wonder Warren Buffett is selling his treasuries and buying stocks in great American businesses as per his recent Op-Ed in the NY Times. The world's greatest investor is not interested in negative rates of return, especially given the actions of the Treasury and Fed to print money and flood the system with ever more dollars that will likely lead to higher inflation.

In Warren's Op Ed to the NY Times, he states, and I think this is important, "Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts."

So what is an investor to do to protect his or her wealth in an inflationary recession/depression when real rates of return are negative? Here is a starting point.

1. Invest in business that have strong franchises and can earn high returns on capital or don't need to invest in a lot of capital each year just to stay in business. These businesses should be able to pass off the higher costs of production to their consumers and still make high returns on capital. Many of these businesses pay dividends whose rates are now far higher than money market and treasury yields.

2. Consider having silver or silver mining shares in your portfolio. Or, own physical silver, if you can find any as there is a big shortage at retailers currently. Precious metals have always been considered a hedge against inflation, so it only makes sense that under current conditions, one has some precious metals in their estate, even if it's just 2% - as much as 15%.

One of the most interesting things about silver that makes it so compelling now is the price in relation to gold. About 160,000 tons of gold have been mined in the history of the world of which nearly all of it is still around today. That's close to 5 billion ounces of gold out there. It's been estimated that there have been 44 billion ounces of silver mined in the history of the world. Modern industry has used up a lot of silver through its various uses and some has been lost to simple abrasion. So, it's been estimated that there may be only about 25 billion ounces of silver left in the world. That includes all silverware, jewelry, medals and of course, coin and bullion. Also, industry uses more silver than gets mined every year so the above ground supply can continue to shrink.

So, 5 billion ounces of gold in the world and perhaps as much as 25 billion ounces of silver make the ratio of gold to silver 1 to 5. Yet as I write, gold is 782.90 an ounce and silver is 9.35 an ounce making gold over 83 times more than silver! This means that silver is either drastically undervalued to gold or gold is simply way overvalued. I think the price of silver is drastically undervalued Vs gold and that is why I own shares of iShares Silver Trust (SLV) and for more speculation, shares of Silver Standard Resources (SSRI).

Source for this info about silver came from here and other sources I've read over the years in either books or articles.

Disclosure: Long SSRI and SLV.

Comments

[User 282433:]

Jason,

JP Morgan can loan "your" SLV silver to any hedge fund it wants. Odds favor, it would be to someone wanting to short it (borrow it from good ole JP Morgan and sell it). Since it's now common/accepted knowledge that hedge funds can drop like flies and bury themselves...there is simply no guarantee your silver "backing" will be in Morgan's vaults in a world of ever-escalating silver prices.

2008 Oct 20 08:28 AM

[User 282433:]

If inflation wins, Uncle Sam will be brutalized by dramatically higher borrowing costs. Simply stated, if the risk-free borrowing rate goes to 8,9, 10%...do you really think any asset is going higher?

2008 Oct 20 08:32 AM

[brewtul:]

We will have deflation THEN inflation. While falling commodity prices have cheered the mainstream financial press they have scared the bejeebus out of Bernanke et al. They prefer not to have prices falling when monetary policy is already HIGHLY accomodative (i.e. negative real rates). SO... entere the non-traditional means of putting money into the economy. If banks won't lend and borrowers won't borrow the Fed (and it's wall street owners) can simply juice asset prices directly. Buy real estate, stocks, long term bonds, anything you want. The exchange stabilization fund and treasury are authorized to do it and even if they weren't they'd simply change the rules. Only those with eyes to see what happens to purchasing power when ALL currencies decline in tandme will be able to protect their wealth. That's the problem. Asset inflation does not create wealth - just the illusion of wealth as your nominal accounts inflate. That is why the authorities are trying to crush gold - it is the only alarm left in the system.

2008 Oct 20 10:08 AM

[sickofthehype:]

7 trillion in 'new' money across the globe with more to come..
Inflation will be HUGE, so look out above...
Real estate will once again be a good thing to own in the near future.

2008 Oct 20 10:43 AM

[ozzy43:]

An interesting analysis - I wonder what would happen if the author would use a more realistic basis for calculating inflation than the outrageously fraudulent CPI. Same goes for the equally fraudulent GDP.

I agree with brewtul - near term deflation then long term (probably hyper)inflation, thanks to both the feds and the Fed. The history of fiat currencies is pretty stark in this regard - we have centuries of history to rely upon for clear lessons. Just look at any chart of *real* inflation (i.e. increase in money supply) noting 1933 and 1971 and what happens to money supply afterward. A good primer:

www.chrismartenson.com...

Sections 6 to 10 are relevant to this discussion, but all are worth watching and thinking about.

2008 Oct 20 10:53 AM

[JasonC:]

Inflation indexed treasuries currently yield 3% real, 2-3 times a year ago. They are within 1-1.5% of unadjusted treasuries. Anyone who thinks there will be strong inflation ahead is clearly disagreeing with the market consensus, and can buy those. The risk is practically non-existent.

Better investments for those who believe deflation is much more likely are high quality bonds trading at distressed levels, (up to 15% for banks the government has made clear it will not allow to fail e.g.), loan participation closed end funds at double digit discounts to net asset value (with senior creditor positions, and profitable over the last year despite the turmoil), AAA senior tranches of private MBS on prime credits, yielding 6-7% above treasuries, etc.

It is outright crazy that these assets are being dumped at prices this attractive, while central banks make unlimited credit available at 1-3% rates. Nobody has the stones to step in an arb the spread. All the usual players who did such things in the past blew out, or had their short term financing costs spike, or banks pull their credit lines, forcing them to dump.

There is no fundamental reason for those spreads. It is a pure capital panic. Since the authorities are simply not going to allow that panic to cause systemic collapse, it is objectively entirely safe to buy all these classes of assets.

Those worried that interest rates will go higher in the medium term can hedge credit positions by owning TIPS as mentioned above, or use floating rate securities - some are available on financials that will yield twice the short rate forever with an 8% floor (because they are selling at half issuance price), and they are going begging.

These inducements to save, or to take on credit risk, are the highest in my lifetime and likely the highest any of us will ever see. Everyone brave enough to act on them is going to make a killing.

2008 Oct 20 11:25 AM

[derryl:]

Mr. Bernanke is being a little disingenuous in stating, "Normally, money is injected into the economy through asset purchases by the Federal Reserve." This is the "normal" way the Fed implements its monetary policy by direct manipulation of the money supply (as contrasted with the indirect/market approach that involves interest rate adjustments via the Fed rate to make new money cheaper or more expensive to rent from private commercial banks: you have to repay the loan; you don't "own" the money. You rent it.).

In fact the "normal" way money enters the economy is via private commercial bank loans, not via Fed money. When a bank makes a loan to a business or a consumer or an investor the bank is not lending out someone else's savings. The bank is creating new financial credit which is new "money". That's what "banks" do. Various kinds of "mutual funds"--including guaranteed investment certificates sold by banks--invest people's savings, but "banks" as formally defined create the money in the first place.

Prior to 1913 many private banks issued their own money. In 1913 both the US and Canada passed their Bank Acts (England passed its own in 1914; other countries in other years). Federal governments have the Constitutional obligation to provide their nation with appropriate institutions for the creation and administration of money and financial credit. On the one hand the Bank Acts prohibited banks from issuing their own money (e.g. Bank of Nova Scotia dollars in Canada). On the other hand they formally gave chartered banks authority to issue and administer credit denominated in the national currency (US dollars, Canadian dollars, British pounds). The US Federal Reserve Act created the Fed in 1913, but Canada's Central Bank wasn't created until 1936. Britain's central bank, the Bank of England, was created in 1694 and was nationalized in 1964.

If central bank injections were the "normal" way money enters our economies, how did money get into the US and Cdn economies prior to the establishment of our central banks?

It is a simple fact of financial economics that bank loans are the creation of new money. When the loan principal is repaid, that money ceases to exist. In a modern economy only about 2% or less of the money supply in any currency exists as the coins and paper currrency that we carry in our wallets. Almost all "money" exists as numbers in bank accounts.

To make a "loan" of $1000, the bank adds $1000 to the credit balance in your bank account which you can then withdraw in cash or debit or write checks on. The bank also adds $1000 + interest to your "debt" account--you have to give the money back. The bank circulates money to borrowers, and the borrowers circulate the money into the economy. Eventually the borrower has to withdraw $1000 from the economy to repay the loan principal. You deposit the money in your account to restore your credit balance to at least $1000 and when the principal is repaid the bank reduces your account credit balance by $1000 and writes off your debt principal balance to $0 and the "money" no longer exists as either a credit or debt.

It began its life as numbers added to your bank account credit balance; it ends its life as numbers deleted from your bank account debt balance. This is not controversial. Any financial economics textbook will confirm that this is the mechanics of "normal" money creation and circulation into an economy.

You will note that the $1000 bank loan simultaneously created 2 things: $1000 of "credit-money" and $1000 + interest of "debt-money". If it's a one year demand loan at 8% interest then after one year you have to give the bank $1080 of money to payout your principal + interest. To repay your principal + interest you have to withdraw $80 more OUT of your economy than the $1000 you put INTO the economy.

The $1000 you circulated into the economy may well have generated more than $1000 of new "economic" wealth, but it didn't generate any new "money". Only the federal government and banks can create new money. Anyone else who creates money is called a "counterfeiter". The real, physical industrial economy creates all the "real" economic wealth. But only banks can create the "money" that the economy needs to enable its productive and consumptive processes. Economic activity does not "make money". It makes goods and services. Only banks (and to a very minor extent government mints and printers) "make money".

Every country in the world that uses this system of bank-money is getting increasingly in debt for the simple arithmetic reason that banks always add more monetary debt into the system than they add monetary money. The world has become much richer in terms of real economic goods and services. All of these things--houses, cars, furnishings, food, etc.--have been built and everyone who contributed to building them has been paid. So why are we getting further in debt? "Really" we are much richer economically. "Monetarily" we are deep in debt.

This is a simple consequence of the arithmetic flaw in our system of money creation as bank loans with interest. Debt adds up fast. Every new loan adds more new interest obligation into the system without adding any new money to pay that interest, so borrowing new money to pay old interest just makes the problem worse.

Let's grossly simplify the situation for clarity. Let's say that Americans need $1 trillion per year of money to enable all the economic production, investment and consumption transactions they want to do in a year. On January 1 US banks add a total of $1 trillion of new credits to Americans' collective bank balances. At 8% interest the banks also add $1 trillion and $80 billion to Americans' collective debt balances. On December 31 when the loans are due Americans find themselves collectively $80 billion short of money to pay the interest. That's because the money to pay the interest was never created so it doesn't exist. When they repaid their collective $1 trillion principal their banks collectively wrote their principal debt balances down to $0 and that principal money ceased to exist. But the debt balance of $80 billion remains. ALL of the money is gone but $80 billion of monetary DEBT remains. And American industry cannot create the $80 billion by counterfeiting it. The only way to make new money is to get new bank loans. Or the government could print and spend/circulate $80 billion into the economy to allow the debt balance to be liquidated, but this is not the practice.

On January 1 of the following year Americans again collectively borrow a new $1 trillion for the coming year with a new $80 billion interest obligation. Let's assume the banks have carried forward the $80 billion interest debt from Year 1. Really, this is all they can do, because the money to pay that $80 billion does not exist because the banks haven't created it yet. The banks could force American businesses and consumers into a total of $80 billion of bankruptcies to write off the unrepayable debt and balance the banks' credit and debt accounts, and in fact this does periodically happen. But you see that destroying real economic wealth by forcing bankruptcies in the interest of balancing the national accounting system is, well, stupid.

So Americans start Year 2 with no money and $80 billion in debt, even though everyone working in the real economy has been paid and all of the year's economic output has been purchased (in this simplified economic picture) and people are enjoying the new economic wealth they created during the year. By the end of Year 2 when Americans repay Year 2's $1 trillion principal, they find themselves with no money and now $160 billion of accumulated debt. Actually it's worse, because in fact the unpaid $80 billion interest from Year 1 is charged to Americans' debt account as a new loan at a new 8% interest, so total debt increases with compound interest obligations.

You can do the arithmetic from here through Year X. Unrepayable monetary debts mount at a logarithmic rate. Americans are "economically" very wealthy and quite secure, but Americans are "financially" in deeply disturbing monetary debt.

Is this an appropriate way to operate a country's financial system? Bankers are generally very good at micromanaging the country's financial credit by screening borrowers. But the banking SYSTEM of debt-money at interest has a fatal arithmetic flaw: there is never enough money to pay all the principal + interest, unless you bankrupt people who don't need to be bankrupted as an excuse to write debt off bank balance sheets.

Congress enabled this system with the 1913 Bank Act when legislators were ignorant of how money works. Congress can fix this problem with new legislation based on understanding how money works. This is certainly not the only financial problem America is currently experiencing, but this is the cause of unnecessary financial insecurity in the midst of economic wealth.

2008 Oct 20 11:32 AM

[ignoramusma...:]

Econ 101:

Dump a whole bunch of something on the market, it's value ( the price you can get for it) drops. Keep on a printing boys . . .

The $ is toast.

2008 Oct 20 01:24 PM

[GoldWize:]

Jason.

-Money supply increase
-inflation pressure increases
-SEC valuation modification: we can't properly value equities
-leading to more uncertainty
-investors run to hedge their cash
-worldwide increase in the price of gold.

Gold Long, Inflation Long.

2008 Oct 20 02:39 PM

[ignoramusma...:]

The trouble with buying TIPS is the I is based on the gov't nos.

derrly's synopsis makes sense. So who holds all the debt? Whoever it is would have a vested interest in not seeing the US economy go bust if they ever expect to get anything out of that debt. I see countries propping up the $ - England, the EU, the Swiss, etc. Will they will want to hold that dollar denominated debt long term? Will anyone want to buy debt from anyone as fiscally irresponsible as uncle sam? Will they prop the $ up until they can cash in their treasury certificates and spend the money? Will they be able to spend the money anywhere but the US? Will prices of real estate and any other hard asset be on a shot for the moon? Isn't this called inflation?

2008 Oct 20 07:03 PM

[Greg Pinelli:]

I must say..that "derryl" having been let out of mom's basement has cutt loose with the most indecipherable load of nonsense I've heard in the last week...and the dude didn't let up! Congrats..you really should write for Rolling Stone..
For everyone else who'se sober let me state and restate...deflation will NEVER happen...It means loss of political control and President Obama will personally come to your homes and give you lunch money and free mortage payments before he allows that to happen.
Deflation only works when it's laid on people with integrity..like those in the 1920s who endured the burden of the 1930s..and then fought a war! How could the entitled, weenie grabbing, whining mommy boys and daddy girls of the last 2 generations possibly handle that?? We'll inflate because the morons who weekend to Las Vegas will still have the illusion they matter.......

2008 Oct 20 09:21 PM

[NOWHEREMAN:]

Hey Geo, nice to see you writing up a storm.

Not that you need edification but there is a site with a writeup on "Deflation scare" which you may be interested in just to send others to if gor no other reason:

murkywaters.com

2008 Oct 20 10:14 PM

[NOWHEREMAN:]

for not gor but then Gore might ne a good euphemism too.

2008 Oct 20 10:16 PM

[NOWHEREMAN:]

Damn, I've got to stop writing so fast.

2008 Oct 20 10:17 PM

[directcommu...:]

Inflation

2008 Oct 20 10:36 PM

[NOWHEREMAN:]

agreed but for many the dollar's strength means importing lower priced goods which is deflationary pricing.

2008 Oct 21 01:08 AM

[EE:]

Check out butlerresearch.com. then silverstockreport.com Yes silver is the way to go in junior stocks that are or will mine in 2009 and in physical. NO ETF's or FUTURES unless you try for physical delivery through it. Good luck

2008 Oct 21 10:58 AM

[xsuddensam:]

Ashizashiz:

You're beating a dead horse. The need to buy un-needed things has been culturally embedded in the American psyche. Maybe you can convince some wayward hippies from the sixties to ride bikes and grow vegetables but you're not going to get Mr. & Mrs. Bling, nor their kids, to change their ways.

As long as we are going to go broke bailing out the financial system, it would only be fair to give us another stimulus check. Today, $600 would buy me about a half bag of pre-1964 U.S. silver coins. Now, that would certainly stimulate me.

2008 Oct 21 11:14 AM

[xsuddensam:]

Whoops, I meant about one 1/20 of a bag.

Sorry.

2008 Oct 21 11:19 AM

[deuxsous:]

Jason,

John Hussman addressed both the issue of Treasury real rates (TIPS) and commodity inflation/dollar strength in his weekly letter yesterday...and he also discussed Buffett's NYT op-ed piece at length:

www.hussmanfunds.com/w...

I think he's on the right track,,,as he ususally is.

Tom

2008 Oct 21 11:59 AM

[User 30121:]

I can only THANK you posters out there, because without you, I would go CRAZY!

The rationale I see in SOME of these posts makes me realize that my brain is STILL good and functional after all these years.

ashizashiz: You scare me, man! You need some oxygen, and get off the weed!

EE: You are spot on!

xsuddensam: Your posts are a joy to read, usually because they are so on target!

2008 Oct 21 12:08 PM

[bbowen7:]

The unstated disconnect in the international system is that US voters get to decide on the leaders/policies that rule the global financial system. Why should this be? Ultimately, we cannot stop spending, will not tax to pay for it, have nearly maxed out the credit card, and the only remaining outcome is inflation and the rest of the world saying "enough."

2008 Oct 21 12:25 PM

[David Roskoph:]

It's fairly simple math - 7 trillion lost in equities
- 3 trillion lost (so far) in real estate
- 1 trillion lost in everything else.
----------
11.0 trillion lost
Fiat so far 2.5 trillion
----------
Net deflation 8.5 trillion

The only way we could have inflation woud be an imbecillic attempt to reinflate the deflating assets and postpone the reset for a few more years. That would look a lot like Weimar Germany circa 1923.

Deflation is not going away and the dollar will reach parity with the Euro within 18 months.

2008 Oct 21 12:31 PM

[carey_jim:]

Economies are much more complicated than the economic models describe.

For instance, theoretically, you could put fifty percent of your savings in non-callable bonds and fifty percent in blue chip stocks and survive any inflation or deflation for obvious reasons.

But hyperinflation (even inflation of 20 to 30 percent a year) or serious deflation can send an economy (and any economic or financial model) into a chaotic state where people lose confidence in all investment vehicles except mattresses and hoard their money to to point of not consuming anything but necessities.

If economies become chaotic then money, and people that can afford it, tend to flow into more secure economies abroad and social disruption, revolution, food riots, etc. make life impossible.

I'm not predicting economic chaos for America which would be similar to crying "fire" in a crowded theater.

But I do smell smoke and I notice that quite a few people going to get popcorn :)

2008 Oct 21 01:17 PM

[derryl:]

Georealist:
You find arithmetic "indecipherable"? If you doubt that money is created as bank debt look it up in any financial economics textbook, like I did over 25 years ago long after I had moved out of mommy's basement. The consequences of creating money as debt at interest (ever-increasing debt) are arithmetic problems, not political or policy or economic problems. Until you understand what money is and where it comes from you cannot understand the sources of our financial problems and you cannot begin to figure out solutions that can realistically hope to correct the problems. Fiscal and monetary Bandaids have no hope of closing the ever-widening hole of unrepayable debt that is caused by creating money at interest.

2008 Oct 21 01:59 PM

[xsuddensam:]

Deuxsous:

I read the Hussman article and it did not assuage my concerns over the economy, growing unemployment, and the government's monetary & fiscal policies. He does not address the very real possibility of crippling consumer loan defaults and more importantly, commercial real estate mortgage defaults. Nor does he address the trillions of dollars of credit default swaps.

In light of the fact that Treasury and the Fed are, for the most part, just throwing money at the current problems, I'm spooked by what appears to be desperate actions by desperate men.

Hussman appears to be just another stock market tout who, as he readily admits, is covering his ass with put options.

2008 Oct 21 02:24 PM

[xsuddensam:]

User 30121:

Looks like Ashizashiz's post got the hook; must have been his English ;-)

2008 Oct 21 03:09 PM

[Joseph Wechter:]

They don't have to increase the money supply enough to pay off all the bad debts. All they have to do is increase the money supply enough to cover the interest on all the loans they made.

2008 Oct 21 11:50 PM

[Lin:]

Georealist , I concur with you ! Carey Jim , Then why was the 3rd army brigade returned home to the US for " deployment in the US ? " Deuxsous , a very correct observation . Truly deperate men taking deperate actions , to ' prop up " the shadow economy until the elections " . Our foreign creditors are going to ' pull the plug ' on the US + PDQ , pretty damn quick ! Greenspan only postponed the collapse of the US with cheap money after the Dot Com bust . The financial debaucle we are now seeing is only in it's early stages . The fat lady is not only singing , she's screaming at the top of her lungs !

2008 Oct 22 01:11 AM

[pooramerican:]

The suggestion that foreign governments will let the dollar tank is absurd. They will do everything to support the dollar. The dollar is backed by the full faith of the US government and its might, so you better pay attention. They also hold LOTS of $ so to let it fall is basically to say they gave away all those natural resources and poisoned toys for free for so many years.
I think what is happening is that we are continuing to deflate and asset prices will fall till they become cheap enough for all those holding the $ to buy them. In the process Mom & Pops will go out of business, your silver inheritance will be listed on ebay or sold to kitco for pennies etc.
By the way, a Brigade is just too small for any thing worth mentioning.

2008 Oct 22 09:34 PM

[rwg:]

There will be blood ....

On Oct 21 01:59 PM derryl wrote:

> Georealist:
> You find arithmetic "indecipherable&am... If you doubt that money
> is created as bank debt look it up in any financial economics textbook,
> like I did over 25 years ago long after I had moved out of mommy's
> basement. The consequences of creating money as debt at interest
> (ever-increasing debt) are arithmetic problems, not political or
> policy or economic problems. Until you understand what money is and
> where it comes from you cannot understand the sources of our financial
> problems and you cannot begin to figure out solutions that can realistically
> hope to correct the problems. Fiscal and monetary Bandaids have no
> hope of closing the ever-widening hole of unrepayable debt that is
> caused by creating money at interest.

2008 Nov 04 06:28 PM

[rwg:]

it will be repaid and it is difficult for me to image that there will be no war/conflict as a result, especially if world history has is in consideration.

2008 Nov 04 06:34 PM

[rwg:]

Bretton Woods: 1944-1971

By Paul Nathan
Oct 30 2008 3:41PM

kitco.com



This article was first published in May of 1973 by the Foundation For Economic Education. It is as pertinent in today's world as it was then.

In 1944, as the world was recovering from the effects of World War II, the heads of state from over 100 countries met in Bretton Woods to create an international monetary system that would unite the western world, insure monetary stability, and facilitate international trade. Over the years since then the system has been plagued by dollar shortages and dollar "gluts"; chronic deficits and chronic surpluses; perpetual parity disequilibria, "hot money" capital flows, and currency depreciation. By 1968, a "two-tier" gold market was established in the midst of a gold crisis which, by 1971, culminated in the suspension of dollar convertibility together with a dollar devaluation against multilateral revaluations of most other major foreign currencies.

Bretton Woods is dead and an autopsy is called for to determine the cause of death. If meaningful international monetary reform is to follow, it is necessary to know what went wrong.

Fixed exchange rates, flexible rules.... Under the rules established by the Bretton Woods agreement, the gold values of a member nation's currency could be altered "as conditions warranted." This distinguishing feature of the Bretton Woods system exposed a drastic ideological departure from the gold standard.

Under the gold standard, no natural conditions would ever warrant a change in the gold value of a nation's currency. Under a pure gold standard, all the money in circulation would be either gold or claims to gold. Any paper money would be fully convertible into gold. There would be no difference between claims to gold and gold itself, since, if claims to gold circulated as money, the gold could not.

However, there are government-made conditions that could warrant a reduction in the gold value of a nation's currency. If governments have the power to artificially increase the claims to gold (e.g., dollars), they have the power to depreciate the value of the national monetary unit.

Bretton Woods was established with the intention of aiding governments in exercising their powers of inflationary finance. Government leaders knew that the gold standard prevented them from fully pursuing domestic goals that depended on deficit spending and prolonged, artificially induced "booms." They detested the gold standard for its fixed rules which brought adverse economic repercussions whenever they refused to adhere to them, and they detested flexible exchange rates that exposed the government's policy of currency depreciation.

The political temptations of artificially increasing the money supply in order to "stimulate the economy" prevailed against the gold standard and brought the beginning of a "new era": fixed exchange rates with flexible rules, the exact opposite of the gold standard.

No longer would politicians adhere to the discipline of the gold standard. No longer would they have to restrict their deficits or domestic money supplies. Government leaders would make their own rules and fix the nominal value of money by decree. And if "conditions warranted" a reduction in the nominal value of a nation's money, it was agreed that a nation could devalue up to 10 per cent after the formality of obtaining other nations' permission. This was called the "adjustable peg" system.

The great ideological distinction between the gold standard and the Bretton Woods system, then, is that the Bretton Woods system was ostensibly intended to stabilize exchange rates, but at the same time it anticipated that governments would not defend the value of their currencies. Worse, Bretton Woods institutionalized a method which allowed and condoned future currency depreciation.

Export or devalue: institutionalizing the devaluation bias....

Historically (and the Bretton Woods era was no exception) nations have seen fit to pursue a basically mercantilistic trade policy, i.e., a policy which maintains various regulations intended to produce more exports than imports.

The mercantilistic case is not a realistic one. For example, it would be impossible to develop a logical case advocating that all individuals should sell products and services at the same time. Obviously, some individuals must be consumers if there is to be a market for sellers.

There is no difference when it comes to nations trading in a world market. This is simply to say that not all nations can run trade surpluses at the same time.

An equally difficult case would be to try to convince some individuals that most of the money they receive from the sale of goods and services should be saved rather than spent on the consumption of goods. Yet this is the intent underlying all government policies that aim at increasing exports (sales) and restricting imports (consumption).

There is no logical reason why individuals should not be allowed to reduce their cash balances by buying goods from other nations if they believe it is to their benefit; that is what their cash balances are for. To penalize men or discourage them from importing by imposing licensing restrictions, capital controls, tariffs, or "import surcharges," only serves to limit the variety of their economic choices. This in turn only serves to reduce their standard of living. A nation's drive for export surpluses, together with its "protectionist" policies of restricting imports, leads to an increase in the domestic money supply. This influx of money, together with the money that governments feel they must artificially create in order to "stimulate the economy," leads to higher domestic wages and prices as more money chases fewer goods. These higher wages and prices create an illusion of prosperity, which explains the popularity of mercantilist-inflation... policies.

But higher domestic wages and prices lead to a dwindling trade surplus as a nation's goods become less competitive in world markets, and a dwindling trade surplus, unless corrected, eventually deteriorates into a trade deficit. This is the dilemma facing all governments that pursue the contradictory and self-defeating policies of mercantilism and inflationary finance.

Under a gold standard there is only one way to resolve this dilemma: stop artificially creating money, stop preventing money from leaving the country. The result would be a normal, self-correcting deflation — i.e., a contraction of the domestic money supply — which would lead to a fall in domestic prices and to equilibrium in that nation's balance of trade position.

But because governments hold an unwarranted fear of lower prices and favor higher prices that give the illusion of prosperity, the framers of Bretton Woods adopted a mechanism that would allow governments to inflate their currencies yet escape the process of a normal self-correcting deflation. By devaluing their currencies, governments could continue to inflate their domestic wages and prices while making their exports less expensive to the world.

The device of devaluation was established to allow nations to regain their competitive edge once their surplus deteriorated into deficit. Devaluation immediately lowers the price of a nation's exports, and in this way nations can more actively strive for export surpluses. Thus the framers of Bretton Woods found a way in which nations could continue both their drive for export surpluses and their domestic policies of inflation.

A nation would simply export its goods until its domestic inflation reduced or eliminated its trade surplus, then devalue. In this way the Bretton Woods system established an implicit code of conduct: export or devalue. It institutionalized a devaluation bias within the new international monetary system, which led to serious imbalances, ultimately resulting in hundreds of devaluations during the Bretton Woods era.

"Hot Money Blues."...

Because devaluations are completely arbitrary (at best mere guesswork), new problems arose in place of old ones. The problems centered around the pre-devaluation exchange rate: nations were committed to supporting the rate even when it was unrealistic.

Bright investors soon began to realize when a particular currency was overvalued and to shift their money from the weak currency to stronger ones. This caused further pressure on exchange rates and resulted in speculation — i.e., selling short on X currency, buying gold, or buying long on Y currency. Governments intervened in foreign exchange markets in order to preserve their unrealistic exchange rates, by accumulating massive amounts of unwanted weak currencies. But this could not continue for long.

Finally, when a government was forced to devalue, the action had repercussions on other currencies (particularly if a major currency were involved): it brought all other weak currencies under suspicion. This resulted in further devaluations as investors transferred their money into only the strongest currencies in anticipation of competitive devaluations and major currency realignments. This was called "hot money" and was attributed to speculators — not to currency-depreciating policies of governments.

Finally, under the Bretton Woods agreement, national currencies were not allowed to "float" and seek their own levels. The new "par value" of a currency was arbitrarily set by the IMF — and these were consistently either too high or too low. Like all forms of government price-fixing, the fixed exchange rate system was in perpetual disintegration. This resulted in further "hot money" flurries, further realignments of currencies, and an inherently unstable exchange rate system — the exact opposite of the goal intended by the framers of monetary reform at Bretton Woods.

The role of the dollar under Bretton Woods....

The role of the dollar under the Bretton Woods system was vastly different from that of other currencies. Because of the

United States' economic strength and Europe's economic weakness after World War II, the dollar was used by other governments as a reserve for their currencies. This meant the dollar was pegged to gold and supposedly committed to stability and convertibility. Thus the dollar was supposed to be "as good as gold," and therefore to be treated as a reserve asset just like gold.

There are several implications tied to the concept of a paper reserve currency. (1) Gold, the main reserve asset, was considered too limited in quantity to restore world liquidity or to provide sufficient wealth for rebuilding war-torn nations. (2) While gold could not be increased, a paper asset (U.S. dollars) could — consequently the reserves of the western world could be expanded. (3) Inflation could be implemented in a "more equitable" manner by an ever-increasing paper reserve. (4) A paper reserve currency "should not be devalued" yet it should be increased "as needed" to meet demand. This last blatant contradiction was the major factor in the disintegration of the IMF in later years.

Limited gold — unlimited dollars: a formula for disaster....

Since gold was limited, the vast majority of the assets on which foreign currencies were based to finance Europe's recovery was not gold but U.S. dollars — the second primary reserve asset. The demand for dollars came in two forms: (1) demand for foreign exchange to be used for importing goods, and (2) demand for reserve liquidity and replenishment.

The U.S. satisfied the demand for foreign exchange by inflating its currency and extending loans and gifts to Europe. These gifts and loans were used almost entirely to import goods from the U.S. Therefore, many of these dollars returned to the U.S. However, the demand for reserve liquidity and replenishment was met by continuing U.S. deficits that led to European "stockpiling" of dollars in the form of interest-bearing notes and demand deposit accounts. Demand for dollars between 1950 and 1957 continued and an excess of dollars began to build up in foreign central banks.

After 1957, and to this day, the foreign banks have been obliged to continue to take in dollars that were neither intended for imports nor needed for liquidity. This era has become known as the era of the dollar "glut."

Confidence versus liquidity — a two-tier tale....

During the 1960's the progressive supply and accumulation of dollars mounted and world central bankers found themselves confronted with a government-made monetary dilemma: the more dollar reserves they acquired, the more likely was the chance that their dollar surplus would depreciate in value. To state the problem another way, the more liquidity central bankers enjoyed, the less confidence they had in their most liquid asset — the dollar.

Gresham's Law prevailed and in 1968 central bankers and private speculators began to convert their dollars into gold. A gold crisis developed: the U.S. could not hope to convert the amount of dollars outstanding against its gold stock. A "two tier" gold market was set up to avert a dollar devaluation and the break-up of the International Monetary Fund (IMF), i.e., one free market for speculators and industrial users who would buy gold at the free market price, and an official market where governments would transact dealings at the pegged price of $35 per ounce. Finally in 1971, in a wave of "hot money" speculation, the U.S. was forced to devalue the dollar against gold and to suspend its convertibility.

Gold's limitations: a blessing in disguise....

The demise of Bretton Woods can be traced directly to an excessive supply of dollars. The anti-gold principles of inflationary finance practiced diligently under the Bretton Woods era, turned into a give-and-take fiasco: the U.S. became a faucet of wealth, supplying dollars on request to every corner of the world, while over a hundred countries drained the U.S. in the name of world liquidity and "reparations."

The result was a flood of dollars that swept over the world producing world inflation, numerous recessions, hundreds of currency realignments, disruptive trade, a gold crisis, and the final international monetary crisis that has left the world precariously groping for stop-gap measures to resume monetary and trade transactions.

Clearly the Bretton Woods vision of a stable and ever-expanding reserve currency was doomed from the onset. Had the governments limited their reserves to gold, the kind of monetary and credit expansion under Bretton Woods — and all of its disastrous consequences — could never have occurred. Gold places objective limits on monetary and credit expansion, and this in itself was enough for the framers of Bretton Woods to condemn it.

It is no accident that the kinds of limitations gold imposes on the extension of money, credit, and reserves is just what the world is crying for today in light of the "dollar glut." As a reserve currency, the dollar was supposed to be as good as gold. But monetary authorities never stopped to ask "what makes gold so good?" The answer is that gold is limited — the very point for which it was condemned.

The refusal of government leaders to adhere to the rules of the gold standard and their desire to create a monetary system based on their own arbitrary rules of whim and decree, failed as it has always failed. Once again, history has proved that a mixture of government whim with the laws of economics is not a prescription to cure world problems: it has always been and will always be a formula for world chaos.

U.S. balance of payments problems....

U.S. balance of payments deficits began in the early 1950's and have not ceased to this day. The cause of these incessant deficits can be traced to monetary and trade decisions made at the inception of Bretton Woods and reinforced throughout its existence.

The first straw....

When it was decided that the U.S. was to act as world banker and benefactor to those countries in need of help after World War II, it is doubtful that anyone really believed the U.S. would profit as world banker. On the contrary, the consensus was that war-torn nations needed more money than they could afford to pay back. It was argued that the

U.S. could afford to (and therefore should) extend foreign aid (gifts), loans at below market rates of interest (gifts), and military protection (gifts), to those countries in need.

What must be remembered is the precedent for this decision: the U.S. was committed to protect and finance the western world by virtue of its great strength and an ever-expanding stream of dollars.

It was assumed that this money would return to the U.S. via import demand, and in fact, during the years 1946 to 1949 most of it did, resulting in fantastic U.S. surpluses.

On selling one's cake and wanting it too....

But during the years 1950 to 1957, a turn of events took place. Europe by design curtailed its already abundant imports and concentrated on replenishing its national reserves. With conscious intent, the U.S. continued to supply the world with dollars through deliberate balance of payments deficits to accommodate Europe's demand for reserve replenishment. The refusal of the foreign governments to allow their citizens to use their constantly rising dollar surpluses for U.S. goods (by imposing trade restrictions) led to the dollar glut of the 1960's.

The blame for the chronic surpluses of foreign governments and chronic deficits of the U.S. must be shared. While the U.S. can be blamed for financial irresponsibility, the surplus countries must be blamed for economic irresponsibility. The U.S. could have stopped its deficits, but surplus-ridden countries could have stopped penalizing their citizens and discouraging them from importing. Instead, they decided to increase dollar reserves (dollars that for the most part were given or loaned to them) and to either exchange them for gold or hold them in the form of interest-bearing notes and accounts.

By accumulating excessive amounts of dollars that they refused to use, surplus countries helped foster U.S. deficits: some nations' chronic surpluses must mean that other nations are running deficits. The irony of the decision to run an intentional chronic surplus is that the purpose of selling goods is to gain satisfaction as an eventual consumer. The drive for both surplus reserves and surplus exports, and the refusal to consume goods with the money received, implies that a nation expects to sell a good and somehow derive satisfaction from it after it's gone.

The illusion of the last straw....

The increasing demand for dollars led the U.S. government and the Federal Reserve System to increase the amount of dollars and thus to depreciate the purchasing power of the dollar. As confidence disappeared in the dollar's ability to continue its role as a reserve currency, "hot money" flurries soon appeared. Thus, by the late 60's and early 70's, an enormous amount of dollars accumulated against a dwindling supply of U.S. gold. This caused both "runs" on the U.S. gold stock and "flights" from the dollar into stronger or undervalued currencies.

This speculative capital outflow caused the U.S. balance of payments deficit to increase in a pyramiding fashion. Finally, the conspicuously low amount of U.S. gold reserves, the disparity between currencies and interest rates, and a dwindling U.S. trade surplus, aroused a well-founded suspicion that the dollar might be devalued — and that other, stronger currencies might appreciate in value.

This justifiable suspicion then caused even greater U.S. capital outflows which led to even greater U.S. deficits. This was the "straw that broke the camel's back." But it was the haystack of straws before it, beginning with the first straw — i.e., the first U.S. inflation-financed gift abroad — that inexorably led to the progression of U.S. balance of payments deficits, international monetary chaos, and the disintegration of the Bretton Woods system.

The high price of gifts....

When the U.S. embarked on a policy of inflation-financed world loans and gifts, it surrendered all hopes of attaining a balance of payments equilibrium for itself or for the world. Between the years 1946 and 1969, the U.S. as world banker extended some $83 billion in grants and loans. Since 1958 some $95 billion has left the country. Most of these dollars were non-market transactions motivated by political and military considerations.

While many economists believe it is necessary for the U.S. to run trade surpluses to correct its balance of payments deficits, to expect normal exports to rise to the level of these abnormal capital outflows only makes sense if one stands on one's head — it is not a logical position to take.

These grants should never have been given to foreign nations. It was an economically unsound move and the grants were extended at the expense of the American taxpayers. Further, any additional loans and gifts made by the U.S. to satisfy nations who demand "free" military protection, such as Europe and Japan have been demanding for years, or "reparations" such as those now being demanded by North and South Vietnam, will only lead to further capital outflows... and this at a time when the world is plagued by depreciating dollar reserves and continuing U.S. deficits — the very cause of the international monetary crises which led to the demise of Bretton Woods.

Those who argue that the U.S. balance of payments deficits were caused by insufficient trade surpluses blind themselves to the fact that the U.S. has been running continuous trade surpluses for almost a century. They refuse to place the blame for U.S. balance of payments deficits where it belongs: on the U.S. government's inflationary policies of give-away finance.

On domestic dreams and international nightmares....

The notion that governments can divorce domestic inflation from international economics is fallacious. There is no domestic-international dichotomy in economic theory. There is a causal relationship between all economic activity, thus there can be no international immunity from unsound domestic policies and no domestic immunity from unsound international policies.

To the degree that nations practice sound domestic economic and monetary policies, the result will be stable economic progress in both the domestic and international economies. To the degree that domestic policies are unsound, distortions will occur that will be destabilizing and inhibit economic progress both domestically and internationally — the results being counter-productive in both areas. Bretton Woods was set up to accommodate various nations' domestic dreams. The dreams of post-war prosperity were financed by inflationary schemes that were incompatible with any sound international monetary standard. The Bretton Woods agreement established the contradictory system of fixed exchange rates with a built-in devaluation mechanism, in order to avert the monetary repercussions of not adhering to the exchange rates they fixed. The framers of Bretton Woods knew that governments had no intention of preserving the value of their currencies, that, in fact, they planned to deficit spend and inflate in order to pay for their domestic economic programs.

No international monetary system — not the gold standard nor any form of standard less fiat system, nor any combination thereof — can insure stability given unsound domestic policies. The fundamental economic issue today is not the kind of international monetary system that will replace the Bretton Woods system, but whether the domestic policies of the nations involved will permit any international monetary system to last. The pre-condition of any lasting monetary system is that it has integrity.

A monetary system that has integrity means a monetary system that is protected from government-created inflation, i.e., arbitrary and artificial increases in the supply of money and credit.

It is a moral indictment against today's political leaders and the public at large that the chances for a monetary system that has integrity are almost non-existent. For before a nation can have a monetary system of integrity, it must end all policies of inflationary finance. And this means that all those dreams a nation cannot afford must end.

The public has bought the politician's claim that they can get something for nothing; that all a government need do is print up money to pay for programs that satisfy national dreams. But there is no such thing as a free lunch — someone must inevitably pay the price of that lunch.

And so it is with domestic dreams.

The price for indulging in domestic dreams through government "something for nothing" programs is domestic inflation and international monetary crises with all their tragic and disruptive consequences.

If domestic dreams of nations today are pursued by resorting to the insidious schemes of inflationary finance, they will inevitably become the international nightmares of tomorrow.

This was the lesson learned from the Bretton Woods system. May it rest in peace!

Paul Nathan
October 2008



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Paul Nathan is a free lance writer who specializes in the field of economics.

2008 Nov 05 03:17 PM