We are currently going through battles of inflation vs. deflation, fiat money vs. precious metals, government spending vs. austerity, etc. There are so many hard positions being taken by all of our “experts”, and they are so diametrically opposed – in a similar manner to our politicians – that an ordinary investor feels almost frozen in his tracks.
So let’s try and shine a light on these issues and try to come to what the ultimate truth of what is going on in this rather confusing financial world that seems to continually reward the “haves” on the backs of the “have-nots.”
Fiat Monetary Systems
We have all heard that our monetary system is based upon “fiat”. What does that really mean?
Since 1879, the United States’ monetary system had been on the gold standard, wherein its currency was actually backed by gold held by the government. On June 5, 1933, the United States went off the gold standard because the public was so frightened during the Great Depression that they began to hoard gold, thereby making the gold backed standard untenable. As part of a process to “correct” this problem, all gold was ordered to be turned into the government in return for money, for a fixed price per ounce of gold.
On August 15, 1971, the United States ceased converting US dollars into gold at a fixed value, which effectively ended the entire era of the gold standard.
So, at this point, if you are coming to the conclusion that the US dollar is not backed by any asset whatsoever, you are 100% correct. This now brings us to our definition of the word “fiat” - an authoritative or arbitrary order or decree.
Fiat money is currency that cannot be redeemed for a commodity with intrinsic economic value, such as gold. Therefore, it only has the value given to it by government order or decree. Hence, as long as the public has confidence in the government that has made that order or decree, the fiat money system will hold the value to which the public will allow.
So effectively, our dollars are only as valuable as the confidence of our citizenry in our financial system, as orchestrated by our government. However, the law of supply and demand also comes into play. In our fiat currency system, the fact that the government can create more “money” through credit expansion also has an effect upon the US greenback. As the amount of the printed greenback remains relatively stable, the amount of credit in our monetary system has fluctuated, which also has an effect upon the value of the greenback.
Therefore, during inflationary periods, when our economy is engaged in credit expansion, the relative value of the greenback decreases. Alternatively, when our economy is experiencing credit contraction, the relative value of the greenback increases.
Can there truly be deflation in a fiat monetary system?
The question is more aptly put as can an authoritative body, that can control the amount of “money” in a system, prevent deflation?
Theoretically, you would think that any authoritative body that can control the amount of “money” in a monetary system can control inflation and deflation. However, we do not live in a vacuum, nor does our government run a utopian society.
The main issue with this premise is that it works on the presumption that all the credit created by our government will be gladly accepted by the public. Clearly, this ignores the law of diminishing returns.
Let me give you an example. If the demand for computers started getting a little sluggish, and the government wanted to attempt to boost the demand for computers, it would decide to subsidize the sales of computers by 10%, thereby offering computers to the public at 10% discounts. Initially, demand may rise. But, after a certain amount of sales, demand will fall off again. The government then subsidizes sales by 40%. Again, demand spikes, but then falls off. The government ultimately will fully subsidize these computers and the provide free computers to the public.
Now, assume you buy a computer when they were discounted by 10%. Then you decide to buy one for the children when it was discounted by 40%. Then when the government started giving them away, you took three more. But, how many computers are going to be in your home before you say “no more.” There comes a point where you don’t want any more computers, since there are only so many computers you can actually use for ANY purpose.
This is the realistic issue that we are now grappling with in our economy regarding debt. The demand for credit started to get sluggish, so the government reduced the “cost” of such credit. They continued to reduce such cost, until such cost is now close to nothing. Yet, credit is not relatively expanding.
For the last 30-40 years, we have seen prolific increases in credit within our system. However, I believe that our society is finally at a point where it is saying “no more” to credit. We are saying “no more” to private credit, as households are deleveraging. We are saying “no more” to public debt, as calls for austerity and deficit reduction are being made from sea to shining sea. We are simply saying “no more” to credit of all kind, despite the government’s willingness to offer us more and more credit.
When a society is at a point where it is saying “no more” to credit, and it then begins to deleverage, this is simply what we call deflation.
As public sentiment has clearly grown fearful of further debt, the only “card” that our government can play would be to sway public sentiment.
In hindsight, the powers-that-be recognized – only behind closed doors - that the signing into law by Bill Clinton of the Gramm/Leach/Bliley Act, which effectively repealed the Glass-Steagall Act, directly contributed to the severity of the financial crisis we experienced during 2007 to 2009. They viewed this as one of the main causes for the public backlash against credit, which was further exacerbated by the unregulated proliferation of credit default swaps, which placed our financial system at tremendous risk.
Hank Paulson begrudgingly allowed the banks that caused the problem to accept significant infusions of capital so that the markets would feel more confident in the system. The banks had no choice but to take the government money since they had to keep the “confidence game” going so that the public would not lose faith in the system, which would cause a run on the banks!
Ben Bernanke and the Fed then bought Treasuries and directed the additional debt created by this Fed “monetization” into the stock market so that stock prices would rise. He was trying to raise the public confidence in the financial system by directing money into the equity markets. He surmised that if people see the market going up and feel as though they have more value in their pockets/accounts, they would be willing to have more confidence in the system and leverage up again, which would be inflationary.
In effect, both Paulson and Bernanke were playing a high stakes game of chicken. They were trying to “trick” people into having confidence again so that they would be willing to accept more debt, thereby avoiding a deflationary spiral. However, ultimately, this is not a game they can win.
“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by such credit expansion”
Luwig Von Mises, 1949
So what happens when the public begins to lose confidence in this monetary system?
I propose that the answer will come in stages. At first, the public will deleverage. They will reduce the credit they have outstanding either by choice or by default. This will ultimately lead to deflation.
Asset prices that have been rising over the last 30-40 years due to the increase in availability of credit will fall due to the lack of ability to pay those higher prices because there is a lack of credit in the system. As prices spiral downward, this will cause a snow ball effect wherein the public that owns assets that were paid at the higher prices, which now have debt greater than the value of the underlying assets, will simply walk away from those assets, as there is no residual value to them. The longer this lasts, the more people will be effected by this deflationary spiral.
Since demand for goods during this deflationary period will plummet, the need for supply will also plummet. This will result in higher and higher unemployment as the demand for goods and services continually drops. This will ultimately lead to another reason for asset sales, which will put further downside pressure on asset prices.
In the financial markets, with credit contraction abound, and lack of trust pervasive through the system, margins will be reduced further and further by brokerage houses. This will put further downside pressure on asset prices as well.
The purpose of all of these actions by the public will be to raise cash. As I explained before, due to the credit contraction, the value of the US dollar will rise during this period. Therefore, the buying power of the dollar will increase. Hence, the public will want as much of the greenback as they can possibly get.
As our Fed sees this happening, of course, they will attempt further QE3, 4, 5, and anything else they can throw at us to stem the tide. However, at this point, it will be analogous to placing 3 feet of sandbags on the beachhead to prevent a 200 foot tidal wave. It will have the same effect as QE1 did in the face of its oncoming tidal wave.
“The Fed has run out of the strong tools, and is turning to weak ones. When you’re fighting in a foxhole and you’ve used up the machine guns and hand grenades, then you pull out the sword and start throwing rocks.”
- August 31, 2010, Alan Binder, Vice Chairman of the Board of Governors of the Federal Reserve System from June 1994 to January 1996.
(Please also see this article for a more in-depth discussion of this effect.)
The Fed will probably attempt QE-type of infusions for several years before the public will realize that the Fed is unable to prevent deflation. Ultimately, the public will demand that the Fed be disbanded. This will clearly put a halt on any further actions by the Fed, which will allow deflation to further ravage our economic system while the government is busy managing the Fed “issues.” When it is already too late, the government, which always acts too late, will finally authorize the Treasury to print more greenbacks, which is the other manner in which a government entity under a fiat monetary system can battle deflation. However, by the time the government actually engages the Treasury to print, we will most probably be at the end of the normal course of our deflationary period.
As deflation subsides, the system will now have to deal with a significant increase of “money” in the system. This will act like a sling shot in the opposite direction, the result of which will be inflation, and, most probably, hyper-inflation. Since the government will be so battered by the deflationary effects that have ravaged the system for years by this time, they will simply not stop printing until such time that their significantly lagging indicators tell them that we are already in a hyper-inflationary rise.
As you can see, theoretically, our government should be able to exert enough control over our fiat monetary system to avert any form of deflationary period. However, due to the fact that our government is not the only actor within our economic system, this “theory” is an unworkable one in reality.
In reality, we have been on the periphery of “The Perfect Storm” for the last several years. We are now heading right into the eye of the storm. The casualties of this storm will be a significant amount of the public’s investment and bank accounts. The effects of this storm will potential change the psyche of the public for several generations to come. We are heading into the heart of a storm from which the government will not be able to rescue us. And, when it is too late, the government will only cause more problems, as governments usually do.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.