Why the Fed Can't Prevent a Deflationary Depression

In June of 1966 (similar to the warm sunny days of summer in 1929 and 2007), Brian Wilson produced the Beach Boys’ single “Good Vibrations.” Capturing the positive feelings of the day, it quickly became a number one hit. But something had changed in 1967 when the Beach Boys moved on to their next album: Smile. They just couldn’t do it. With discord among the band members (Mike Love reportedly called Smile ‘acid alliteration’), Smile was simply shelved. Unable to deal with the pressure, Brian Wilson experienced an emotional meltdown. The next single released by the Beach Boys was titled “Heroes and Villains.”

click to enlarge

Just compare the image of the Beach Boys of the early 60’s to their appearance in the single “Don’t Go Near the Water” produced in 1971. The later single comes from the album Surf’s Up. Oddly, the artwork of that album depicts the End of the Trail by James Earle Fraser. This kind of ragged exhaustion is laughable now, but remember we aren’t down in the depths quite yet. Clearly the downward shift in social mood, as evidenced by the inflation adjusted Dow Jones Industrial Average (chart above updated to 2005), had made an impact.

Lew Rockwell, Money and Our Future:

Consider what it means to live through our times in the light of (Ed Note: Austrian or Psychological) economic understanding. Even in the face of calamity, there is no mystery and hence fear is reduced…In many ways, it is like watching the movement of stars and planets with the scientific knowledge provided by astronomy, or observing the effects of a plague with medical knowledge…Without the understanding, the events look mysterious, like a curse from the gods, and their patterns appear random. With the knowledge, with the understanding, we can make sense of the events. Patterns of cause and effect emerge. You see events before they happen, like turning the page of a script before the movie catches up to you. This gives you a sense of intellectual coherence and inner peace – even in the midst of calamity.

Surprise Losses

We would like to recommend to all of our readers Russell Napier’s Anatomy of the Bear: Lessons From Wall Street’s Four Great Bottoms. His analysis suggests we may have another 55% decline in the S&P by 2014. How could that much more downside in the market be realized?

Russell Napier, "Anatomy of The Bear":

There [were] some signs of economic stability in early 1931, but this resulted in only a modest rally in the equity market…Even at this stage, the magnitude of the decline in the index was only marginally in excess of the 1907 and the 1919-1921 bear markets. It was now that the second bank crisis hit. An investor committing funds to equities on Feb 24, 1931, almost 16 months after the October 1929 crash, would witness a 79% drop in the DJIA in the next 17 months. It was this period of decline that marked out the bear market as clearly different from anything before.

The banking crisis of 1931 (the second wave of Panic after 1929) was triggered by a surprise loss at an Austrian bank named the Creditanstalt. Earlier in the Panic, the Creditanstalt had been merged with a weaker bank:

Charles Kindleberger, The World In Depression: 1929-1939:

In 1929, the Bodenkreditanstalt (the ‘monarch of Austrian industry’ according to Rudolf Notel, “Money, Banking and Industry in Interwar Austria and Hungary”) was fused overnight with the Creditanstalt. The Bodenkreditanstalt brought to the Creditanstalt large loans to industrial concerns which could be maintained only by the device of ignoring market values…When the Creditanstalt took over the Bodenkreditanstalt, it acquired 80 million shillings of capital. But it also acquired 140 million of accumulated losses, as it learned later when a British chartered accountant revealed the truth…the announcement of the support operation on May 11, 1931 started a run, partly foreign, partly Austrian.

Weaker banks have been rescued by stronger banks all over the globe. So far, Bank of America (BAC) has already been surprised by losses from its Merrill Lynch merger. Others are sure to follow.

The Money Printing Secret – A Collapse in the Money Multiplier

The Fed is printing money as fast as it can and cramming it into the vaults of the banks. This ‘printed money’ is known as the monetary base and includes Treasury Bills for bank reserves, currency, coins, etc. If we look at the broader measures of the money supply, we see that large portions of our money are actually private agreements created in the marketplace, such as deposits at banks, money market deposit accounts, and repurchase agreements. These private agreements are called commercial bank money. In a fractional reserve system, “new commercial bank money is created through loans.” We referred to these ‘money substitutes’ in March of last year.

In a banking crisis, these additional private agreements are not necessarily entered into. Instead, fearful bankers pile up excess reserves (monetary base) and refuse to lend.

The money multiplier, the rate at which bankers take the Fed’s printed money and multiply it into commercial bank money, collapses (chart below). This leads to a contraction in the money supply, which is deflation.

Therefore, the Federal Reserve is unable to prevent a deflationary Depression because the amount of money base it prints becomes less and less effective in boosting the money supply. More Fed printing at this point will lead to more fearful hoarding by bankers and the two opposing sides are locked into the deflationary spiral.

Comments

[mike4130:]

The bubble gets harder and harder to reinflate. The government is wasting its breath.

Feb 05 06:44 AM

[SW Richmond:]

Let us not ever confuse 'it is not working' with 'and so we will stop trying'. Is it so difficult to think beyond one step ahead?

Maybe I can get this author to explain why they will stop trying to reflate? In the face of vastly reduced tax revenues, many US states are beginning to flirt with BK. States cannot print. The US is similarly faced with both mounting debt (and the mounting debt service to go along with it) and reduced tax revenues.

Someone please offer me a rational explanation as to why this situation will be allowed to continue, why at some point the central banks and treasuries of the world will say 'it's not working, so screw it' and how it will be resolved in a deflationary environment.

What will happen to the debt?

How will it be paid?

If it is not paid, what happens to currencies in national defaults?

If you believe there will be a deflationary spiral and still no default, how will the defaults be avoided? Where will money come from to service debt?

I await this explanation with baited breath.

Feb 05 07:58 AM

[investor88:]

Good points made in the article. Printing money does not increase the money supply if there is no velocity ie people cannot and won't spend.

Feb 05 09:25 AM

[kelm:]

You are not considering the entire system nor the likely evolution.

The Fed is printing money willynilly and it is winding up in bank vaults. Interest rates will rise inexorably as the Treasury (and the rest of the world's treasuries) issue increasing and historic levels of bonds. Banks can't make money on loans at current interest rates, they can when rates rise. So two things are set to happen:
1) When rates get to some higher point bank lending becomes profitable and the flood of money that is penned up in bank vaults floods the system = inflation.
2) The perception of bond buyers on the financial stability and credit worthiness of the US degrades as record amounts of debt are auctioned backed by the printing press. This leads to the dollar declining and we import inflation (just like our strong dollar imported deflation during the1990's. Recall that we enjoyed importing deflation during those years as it kept the CPI near zero)

Feb 05 09:57 AM

[factsmatter:]

I don't think I understand the point of this article. Of course it is true that in this banking crisis the money multiplier/velocity of money has collapsed. But the Fed can add as much money to the system as it wants. It doesn't even have to print it, only a few keystrokes are required. Sooner or later the banks will start lending this money out as it starts piling up, even if initially the multiplier is near one. The Fed should in principal be able to always inflate out of a deflationary trend - of course, downstream there will be consequences to pay.

Feb 05 10:44 AM

[Allen Charles:]

The Worldwide DEBT is the problem.

The best solution for the present economic crisis would be a REBOOT or restart of the entire debt system for the ENTIRE WORLD.

1. A data base listing ALL DEBT, government, business and personal needs to be created. The list would need to list the debt and debt holder with a bank that could make an accounting of the debt. Included would be all national debt of all nations, all mortgages car notes and credit cards for individuals. All outstanding bond and other debt for corporations, The idea is to list ALL DEBT of any kind owed.

2. Every government on the planet would need to call a special session of its legislature.
Using the same authority that governments have to use or create FIAT CURRENCY the legislatures and Central Banks need to authorize the creation of ACCOUNT CREDIT in an amount equal to all the listed debts in the world.

3. The Various governments and Central Banking Systems then need to make an accounting change equal to the debt in the form of an ACCOUNT CREDIT or CREDIT zeroing out ALL THE DEBT in the entire world, and crediting all debt-holders in the world.

The following day the economy of the entire world would restart and the Stock Markets of the world would react to the new renewed capital in the banking systems, the Capital now available to restart all business and the disposable income to the individual people would restart and grow the retail sectors and the manufacturing sectors of the entire world.

Some have commented that if this was done in a very short time the exact problem would be repeated. My answer to this idea is history does recycle and repeat itself but some do learn and avoid making the same mistake. Europe learned after WWII and has avoided a major repeat for more than sixty years.

The other objection has been the possible inflation that would result would weaken the dollar. My answer to the weakened dollar is it may be a GOOD thing to help our ability to export manufactured products and also make our manufactured products more competitive in our own country. Jobs are needed for our own citizens especially the bottom forty percent.
Allen Charles Report
allencharlesreport.blo.../

Feb 05 11:00 AM

[Tony Daltorio:]

This article is "typical" of Wall Street thinking - no one thinks outside the box! Is there a law that the Fed and the Treasury must use the banking system to get the money out there? They could simply give money directly to corporations or consumers. Remember Ben's helicopter?
Also, many economists outside of Wall Street consider the whole concept of the velocity of money pretty much a discredited idea.

Feb 05 11:11 AM

[Jason Rines...:]

Since the U.S. is a debtee nation and the other nations the debt holders they won't comply when they know the debts held will increase in value as the U.S. dollar devalues and interest rates rise. It's an equation of amount of individual defaults vs. the increase in the aggregate paybacks with the larger percentage with the ability to repay.

Now outright default in there minds of the U.S. is very unlikely and I would agree with them so the point is, why would the debt holders do this? Answer, they wouldn't.


On Feb 05 11:00 AM Allen Charles wrote:

>
> The Worldwide DEBT is the problem.
>
> The best solution for the present economic crisis would be a REBOOT
> or restart of the entire debt system for the ENTIRE WORLD.
>
> 1. A data base listing ALL DEBT, government, business and personal
> needs to be created. The list would need to list the debt and debt
> holder with a bank that could make an accounting of the debt. Included
> would be all national debt of all nations, all mortgages car notes
> and credit cards for individuals. All outstanding bond and other
> debt for corporations, The idea is to list ALL DEBT of any kind owed.
>
>
> 2. Every government on the planet would need to call a special session
> of its legislature.
> Using the same authority that governments have to use or create FIAT
> CURRENCY the legislatures and Central Banks need to authorize the
> creation of ACCOUNT CREDIT in an amount equal to all the listed debts
> in the world.
>

Feb 05 11:39 AM

[Jason Rines...:]

That would be Congress issuing it's own currency. Note that Central Banking tends to react rather violently to that idea. Not saying the U.S. should issue Greenbacks again but right now the system too corrupt for this to occur. No Andrew Jackson, Lincoln or Kennedy and far more corrupt House of Reps/Lobbying network then in past depressions. It probably will come down to this but I don't expect it to happen very soon.


On Feb 05 11:11 AM Tony Daltorio wrote:

> This article is "typical" of Wall Street thinking - no one thinks
> outside the box! Is there a law that the Fed and the Treasury must
> use the banking system to get the money out there? They could simply
> give money directly to corporations or consumers. Remember Ben's
> helicopter?
> Also, many economists outside of Wall Street consider the whole concept
> of the velocity of money pretty much a discredited idea.

Feb 05 11:43 AM

[Mike Picone:]

I agree. I wrote an article in Seeking Alpha which suggested this as top priority for restoring the lending system on a short term basis. The government can use the banks to administer the loans without giving them access to the money. That way the government need not set up a new infrastructure; instead using the lending infrastructure that is already in place. The link is
seekingalpha.com/artic...


On Feb 05 11:11 AM Tony Daltorio wrote:

> This article is "typical" of Wall Street thinking - no one thinks
> outside the box! Is there a law that the Fed and the Treasury must
> use the banking system to get the money out there? They could simply
> give money directly to corporations or consumers. Remember Ben's
> helicopter?
> Also, many economists outside of Wall Street consider the whole concept
> of the velocity of money pretty much a discredited idea.

Feb 05 11:46 AM

[BlackyBlack:]

Jubilee, anyone?

Feb 05 12:14 PM

[ariel1935:]

Some banks are lending money to sure bets, there just aren't many of them. Many banks are not sure of their debt and consequent reserve requirements or even sure that old reserve requirements are sufficient.
Money velocity is easier for me to understand in a biological analogy. Credit is blood sugar; market constraints and regulatory agencies are insulin. We've been on a sugar high because of extremely low insulin. Suddenly with sugar cutoff we are indire danger from low blood sugar. Credit (money being loaned, spent, and repayed; ie money velocity) is essential to our survival and without it the economy is rapidly dying. If the banks are unable to provide credit we must bypass them until they are willing to accept a little risk.
Banning bank merges until full disclosure of debts is possible might also be helpful. I might then understand which bank stocks to buy.

Feb 05 12:19 PM

[Rob Viglione:]

Reduced velocity is causing a hoarding effect with USD. It is likely this will be temporary, and at some point the economy will be flooded with currency. No fiat currency in history has been able to print without causing inflation, with the tendancy of public officials to attempt to inflate away short term problems.

I think we're all being too academic in our approach, using big words and new concepts to justify printing as a solution to malinvestment and poor management. History books are replete with the consequences of this sort of behavior.

Feb 05 01:08 PM

[Paul J. Lamont:]

The Fed will not stop trying to reinflate. Why would it? However the money multiplier is showing us that for every $1 the Fed prints, the money supply only expands 95 cents. The Fed printing is behind the curve. Bankers can destroy the money supply faster. That is deflation.

The debt will still be there after all the deleveraging is said and done. These long term debts will hinder our economy for a long time.

Even if the Fed prints money and hands it out, consumers will pay off debt (reducing money supply) or deposit it with bankers, who will hoard it in their reserves (reducing money supply). No one can prevent systemic fearful hoarding.



On Feb 05 07:58 AM SW Richmond wrote:

> Let us not ever confuse 'it is not working' with 'and so we will
> stop trying'. Is it so difficult to think beyond one step ahead?
>
>
> Maybe I can get this author to explain why they will stop trying
> to reflate? In the face of vastly reduced tax revenues, many US
> states are beginning to flirt with BK. States cannot print. The
> US is similarly faced with both mounting debt (and the mounting debt
> service to go along with it) and reduced tax revenues.
>
> Someone please offer me a rational explanation as to why this situation
> will be allowed to continue, why at some point the central banks
> and treasuries of the world will say 'it's not working, so screw
> it' and how it will be resolved in a deflationary environment.
>
>
> What will happen to the debt?
>
> How will it be paid?
>
> If it is not paid, what happens to currencies in national defaults?
>
>
> If you believe there will be a deflationary spiral and still no default,
> how will the defaults be avoided? Where will money come from to
> service debt?
>
> I await this explanation with baited breath.

Feb 05 03:34 PM

[PROXIMO:]

I've probably seen at least 50 intelligent, well-reasoned articles in the past few weeks on why deflation is imminent. I've seen at least as many compelling articles on why inflation is inevitable. Heck if I can figure it out. The only thing I'm certain of is that we won't have inflation and deflation at the same time. And that the best case scenario either way is trouble.

Feb 05 03:48 PM

[Paulo:]

So what happened to 'stagflation'?

Feb 05 04:16 PM

[Mayascribe:]

Let's see here: The Fed is printing money faster than it can buy the ink. The TARP banks are stashing it in their vaults, because Uncle Sam says they have to decrease their leverage and up their reserves. On the sidelines some 10 trillion stands in money markets, munis and treasuries.

Perhaps this should be called the Gridlock Dam!

But there's a leak in the dam. People and institutions are pouring money into one precious sector; that would be gold and gold mining stocks! The Canadian ETF (GLD) is buying bullion by the ton, making the Exchange Traded Fund the fifth largest holder of gold in the world, only behind the United States, South Africa, China and Switzerland.

Since the November 19th and 20th bottom of last year, the whole gold mining sector is up, way up. Some stocks like Yamana Gold (AUY), Barrack Gold (ABX), Newmont MIning (NEM), Jaguar Mining (JAG), New Gold Corp. (NG), Vista Gold ((VGZ), Northgate Mining (NGD) and Nova Gold (NG) are up nearly 100 percent. Many are up more than 100 percent.

For instance: If you bought Jaguar Mining on Dec. 5th, you would be up from $2.38 per share to $5.42 per share. A whopping 128% increase. and that's with a recent pullback from being over $6.00 a share.

If you bought Nova Gold on January 21st, you could have bought it for around $1.60 a share; now it's $3.70 a share, pretty much the same huge increase.

All the above names have gone up big.

If it's global deflation that's causing this "flight to gold" than I will take it. But I really believe it's a combination of how foriegn currencies are doing against the dollar, and, the future belief that all these dollars Uncle Sam is printing, is going to eventually result in inflation.

My thinking is that all the above stocks will double again before the years end. I hope so, I own all of them, except Barrack Gold.

Yes, there really is a leak in Gridlock Dam! No other sector is currently as rewarding to invest in than gold mining stocks!

Make sure you check out the corporate websites, read the the financials and latest transcripts, so you don't get stuck with a bum mining stock like Hecla Gold (HL).

A good place to start is miningnerds.com That's where I started (prices of stocks are in Canadian dollars, so don't be confused as I was when I first looked into this site).

Good luck!

Feb 05 05:07 PM

[firstproman:]

I concur with Kelm and Rob above. When we cut through all the theorizing what is happening is that Central Banks around the world are increasing money supply. At the same time, governments are heading into major deficit spending periods. While this is going on the world is REDUCING production capacity by shutting down factories, closing mines, cutting crude production, laying off workers etc How in the world can we imagine that we're goin to avoid a sharp inflationary surge when the cash on the sideline comes back into the market???

Feb 05 06:59 PM

[dieuwer:]

Debt denominated in dollar can be paid off by printing dollars. Therefore, deflation will never last under a fiat-money regime.
When comparing the current situation with that of the 30's you have to remember that back then debt was denominated in dollars as good as gold. Deflation occurred because there was not enough "gold" around to pay off all the debts.

The trick FDR played was to settle the debts with dollars and devalue the dollar against gold. The effect was that immediately, a large fraction of the debt was annihilated.

Feb 05 07:30 PM

[cyl:]

Fed should get rid of the concept of the national debt (just print money when the government needs money).The worth of a currency of a nation should be based on the wealth of the nation, not gold, silver, or negatively impacted by the national debt.The ultimate success of the stimulus plan depends on this concept of valuing money on national wealth or expected national wealth. For example, at a time of deflation, as we have now, the government should print money to create an inflation, but not to affect the bond market by competing with private business to buy bonds.
Low-rate-of-return projects did not work during the Great Depression. Society should invest in high-return project during high unemployment. However, the rate of return on a project can only be calculated from a solution of value. To predict, prevent, and cure future crises, we need the solution of value to prevent over-valuation. Funding priorities in the stimulus package should be based on the rate of return on investment, which can only be determined from correct valuation(regulations.gov 4810-25-P or search hugh ching).
Economists need practical experience in formulating the problem of value and mathematical rigor in obtaining an infallible solution. Being mathematically rigorous, the solution of value is a non-violable law of nature in social science, as gravitation is a non-violable law of nature in science. Nature teaches us through punishment by financial crises to learn its non-violable laws of nature, such as the solution of value. In general, the progress of society should be based on knowledge, not just money or politics.

Feb 05 10:54 PM

[carlspackler:]

I think I understand what you're saying but could you explain it a bit more?
If the debt was denominated in $'s backed by gold & then the debts were settled w/$'s how did that devalue the $'s? You may think I'm disagreeing w/you. I'm not. I just don't understand. Did they print more $'s? Help me understand Obi Wan! Thanks


On Feb 05 07:30 PM dieuwer wrote:

> Debt denominated in dollar can be paid off by printing dollars. Therefore,
> deflation will never last under a fiat-money regime.
> When comparing the current situation with that of the 30's you have
> to remember that back then debt was denominated in dollars as good
> as gold. Deflation occurred because there was not enough "gold" around
> to pay off all the debts.
>
> The trick FDR played was to settle the debts with dollars and devalue
> the dollar against gold. The effect was that immediately, a large
> fraction of the debt was annihilated.

Feb 05 10:57 PM

[PROXIMO:]

Timely comment Mayascribe.


On Feb 05 05:07 PM Mayascribe wrote:

> Let's see here: The Fed is printing money faster than it can buy
> the ink. The TARP banks are stashing it in their vaults, because
> Uncle Sam says they have to decrease their leverage and up their
> reserves. On the sidelines some 10 trillion stands in money markets,
> munis and treasuries.
>
> Perhaps this should be called the Gridlock Dam!
>
> But there's a leak in the dam. People and institutions are pouring
> money into one precious sector; that would be gold and gold mining
> stocks! The Canadian ETF (seekingalpha.com/symbo...) is
> buying bullion by the ton, making the Exchange Traded Fund the fifth
> largest holder of gold in the world, only behind the United States,
> South Africa, China and Switzerland.
>
> Since the November 19th and 20th bottom of last year, the whole gold
> mining sector is up, way up. Some stocks like Yamana Gold (seekingalpha.com/symbo...),
> Barrack Gold (seekingalpha.com/symbo...), Newmont MIning
> (seekingalpha.com/symbo...), Jaguar Mining (seekingalpha.com/symbo...),
> New Gold Corp. (seekingalpha.com/symbo...), Vista Gold ((seekingalpha.com/symbo...),
> Northgate Mining (seekingalpha.com/symbo...) and Nova Gold
> (seekingalpha.com/symbo...) are up nearly 100 percent. Many
> are up more than 100 percent.
>
> For instance: If you bought Jaguar Mining on Dec. 5th, you would
> be up from $2.38 per share to $5.42 per share. A whopping 128% increase.
> and that's with a recent pullback from being over $6.00 a share.

>
>
> If you bought Nova Gold on January 21st, you could have bought it
> for around $1.60 a share; now it's $3.70 a share, pretty much the
> same huge increase.
>
> All the above names have gone up big.
>
> If it's global deflation that's causing this "flight to gold" than
> I will take it. But I really believe it's a combination of how foriegn
> currencies are doing against the dollar, and, the future belief that
> all these dollars Uncle Sam is printing, is going to eventually result
> in inflation.
>
> My thinking is that all the above stocks will double again before
> the years end. I hope so, I own all of them, except Barrack Gold.

>
>
> Yes, there really is a leak in Gridlock Dam! No other sector is currently
> as rewarding to invest in than gold mining stocks!
>
> Make sure you check out the corporate websites, read the the financials
> and latest transcripts, so you don't get stuck with a bum mining
> stock like Hecla Gold (seekingalpha.com/symbo...).
>
> A good place to start is miningnerds.com That's where I started
> (prices of stocks are in Canadian dollars, so don't be confused as
> I was when I first looked into this site).
>
> Good luck!

Feb 17 05:51 PM