The world of finance and investment, as always, faces many uncertainties. The US economy is booming, say some, and others warn that money supply growth has slowed, raising fears of impending deflation. We fret about the banks, with a well-known systemically-important European name in difficulties. We worry about the disintegration of the Eurozone, with record imbalances and a significant member, Italy, digging in its heels. China's stock market, we are told, is now officially in bear market territory. Will others follow? But there is one thing that's so far been widely ignored and that's inflation.
More correctly, it is the officially recorded rate of increase in prices that's been ignored. Inflation proper has already occurred through the expansion of the quantity of money and credit following the Lehman crisis ten years ago. The rate of expansion of money and credit has now slowed and that is what now causes concern to the monetarists. But it is what happens to prices that should concern us, because an increase in price inflation violates the stated targets of the Fed. An increase in the general level of prices is confirmation that the purchasing power of a currency is sliding.
According to the official inflation rate, the US's CPI-U, it is already running significantly above target at 2.8% as of May. Oil prices are rising. Brent (which my colleague Stefan Wieler tells me sets gasoline and diesel prices) is now nearly $80 a barrel. That has risen 62% since last June. If the US economy continues to grow the Fed will have to put up interest rates to slow things down. If it doesn't, as money-supply followers fear, the Fed may still be forced to put up interest rates to contain price inflation.
It is too simplistic to argue that a slowing of money supply growth removes the inflation threat. In this article, I explain why, and postulate that the next credit crisis will be the beginning of the end for unbacked fiat currencies.
The fictions behind price inflation
The CPI-U statistic is an attempt to measure changes in the general price level, defined as the price of a basket of goods and services purchased by urban consumers. The concept is flawed from the outset, because it is trying to measure the unmeasurable. Its mythical Mr. or Mrs. Average doesn't exist.
Not only is the general price level different for each individual and household, but you cannot ignore different classes, professions, locations, cultural and personal preferences, and assume they can be averaged into something meaningful. We can talk vaguely about the general level of prices, but that does not mean it can or should be measured. Averaging is simply an inappropriate construction abused by mathematical economists.
There is also a fundamental and important dynamic issue, ignored by economic statisticians. You cannot capture economic progress with statistics, let alone averages. The ever-present change in the human condition is the result of an unquantifiable interaction between consumers and producers. What a consumer bought several months ago, which is the basis for statistical information, can be no more than an historical curiosity.
It does not tell us what he or she is buying today or will buy tomorrow. Nor can the statisticians possibly make the value judgements that lead consumers to switch brands or buy different things altogether. In short, even if there was a theoretically justifiable price index, it measures the wrong thing.
The statisticians are simply peddling a myth, which leaves it wide open to abuse. The myth-makers, so long as the myths are believed, control the narrative. It is in the interests of the statisticians' paymasters, the state, to see price inflation under-recorded, so it should be no surprise that independent attempts to record price inflation put it far higher.
Independent estimates suggest that a price inflation rate of around 10%, depending on the urban location, is a more truthful assessment.[i] If this was officially admitted, the continuing impoverishment of the ordinary American would be exposed, because the GDP deflator would be large enough to record an economy continually contracting in real terms. And this appears to have been the situation since the Lehman crisis, as well as in many of the years preceding it.
You cannot, year in year out, take wealth away from consumers without crippling the economy. A continual economic contraction, which is the inevitable result of monetary debasement. It can never be officially admitted, least of all by the Fed, which has total responsibility for the currency and the banking system. The Fed does not produce official price inflation estimates, which is the responsibility of the Bureau of Economic Affairs, so the Fed conveniently hides behind another government department.
But if the Fed did admit to this statistical cover-up, what could it do? The whole concept of monetary stimulation would quickly unravel, and the debate would almost certainly move away from policies that rely on monetary smoke and mirrors towards the reintroduction of sound money. The Fed would be out of a job.
However, the government now depends on inflationary financing to cover persistent budget deficits, if not directly, then indirectly through the expansion of bank credit to finance the acquisition of government bonds. In the short term, President Trump has made things worse by raising the budget deficit even further, which will be financed through more monetary inflation. And in the long term the obligations of increasing welfare costs will ensure accelerating monetary inflation ad infinitum is required to pay the government's excess spending.
So, we can say with confidence that the purpose of monetary policy has quietly changed from what is commonly stated, that is to foster the health of the US economy. Instead it is to ensure government spending can proceed without interruption and without asking the people's representatives permission to raise taxes.
Supply-side and time factors
The conventional neo-Keynesian view of price inflation is that rising prices are driven by excess demand. In other words, an economy that grows too fast leads to increasing demand for the factors of production.
This approach wrongly plays down the role of money. If the quantity of money is fixed, the increased demand for some factors of production can only be met by reduced demand for other factors of production. If the quantity of money and credit is increased the redistribution of factors of production is impaired, and common factors are bid up to the extent the extra money is available. The source of higher prices is clearly the extra money.
When a central bank, like the Fed, creates money and encourages the expansion of credit, it takes time for this extra money to work through the system. It is deployed initially in the financial, as opposed to the productive side of the economy. This is because monetary inflation is initially directed at the banks to stabilise their balance sheets. And once the immediate crisis is passed, the banks continue to extend credit to the government at suppressed interest rates by buying its bonds.
Suppressed interest rates and therefore bond yields lead to a bull market in equities, encouraging credit-backed speculation. Bank credit is then increasingly extended to businesses and also to consumers through credit card and mortgage debt. At this point, price inflation then begins to be a problem.
The eighteenth-century banker and economist Richard Cantillon was the first to describe how the new money gradually disperses through the economy, raising prices in its wake. To his analysis we must in modern times add the course it takes through financial markets to impact the non-financial economy.
The time taken for new money and credit to be absorbed into the economy governs the length of the period that separates successive credit crises. Cantillon also made the central point that the gainers are those that get the new money to spend first, while the losers are those who find prices have risen before they get their hands on the new money. In effect, wealth is transferred from the latter to the former.
This wealth transfer benefits the government, the banks, and the banks' favoured customers through the transfer of wealth from mostly blue-collar workers, the unemployed, retirees and those on fixed wages. The self-serving nature of the Cantillon effect is bound to influence monetary policy-makers in their understanding of the effects of their monetary policies. Blinded by self-interest and the interests of those near to them, they fail to understand exactly how the creation of extra money actually creates widespread poverty.
Monetary creation manifestly benefits the parties that control and advise the Fed, giving it and its epigones the rosy glow of institutional comfort and superiority. Everyone around it parties on the new money. And the licences to create it out of thin air given to the commercial banks are exploited by them to the full. They are temperamentally opposed to withdrawing the stimulus.
It is hardly surprising the neo-Keynesians, with their flexible economic beliefs, no longer believe in only stimulating the economy to bring it out of recession. Instead they continue to stimulate it into the next credit crisis, as the ECB and the Bank of Japan currently illustrate, because everyone in the monetary establishment wants the party to continue.
The link between monetary inflation and prices
There is no mathematical formula for the link between monetary inflation and prices. For modern economists, it comes down to their fluid mainstream opinion. Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomenon," but not everyone shares his conclusion. Central bankers note Friedman's dictum but ignore it in favour of their ad hoc interpretation of the effects of monetary policy. The result is that in the absence of a sound understanding of the relationship between money, prices and asset prices, they always end up shutting stable doors after a new financial crisis overwhelms them.
It is a policy that always fails. Central bankers think the difficulty arises in the private sector, so they address what they see as evolving market-related risks. They fail fully to understand it emanates from their own monetary policies. Besides going against the grain of their own vested interests, convincing central bankers otherwise is made doubly difficult because there is no empirical proof that links the quantity of money in circulation with prices.
Logically, Friedman was correct. If you have more money chasing the same quantity of goods, its purchasing power will fall. That was the lesson of sound money, when it was beyond the reach of government creation and interference. The purchasing power of both sound and unsound money also vary due to changes in the general level of liquidity desired by consumers.
However, widespread use of sound money, gold or silver, also ensured that the price effect of changes in a localised desire for monetary liquidity were minimised through price arbitrage, so in those circumstances, the relationship between the quantity of money and the general price level was plain to see and unarguable.
Unbacked national currencies do not share this characteristic, and their purchasing power is dependent only partly on changes in their quantity, being hostage to consumers' collective desire to hold their own state's legal tender. In other words, if consumers collectively reject their government's currency, it loses all value as a medium of exchange.
In effect, there are two vectors at work, changes in the quantity and changes in the desire to hold currency. They can work in opposition, or together. Given the quantities of new currency and credit issued since the Lehman crisis, there appears to be a degree of cancelling out between the two forces, with the effects of a dramatic increase in the quantity of money being partially offset by a willingness to hold larger balances.
The result is the dollar's purchasing power has not fallen as much as might be expected, though as was discussed earlier in this article, the fall in the dollar's purchasing power has been significantly greater than official inflation figures admit.
It is very likely that people and businesses in the US have been persuaded to hold onto cash balances and deposits at the banks by misleading official inflation figures. If the authorities had admitted to rates of price inflation are closer to the figures from Shadowstats and the Chapwood index, consumer behaviour would probably have been markedly different, with consumers reducing their exposure to a more obviously declining dollar.
In that event, both the effect of a massively increased supply of broad money combined with falling public confidence in the currency would almost certainly have worked together to rapidly undermine the dollar's purchasing power. All experience tells us that unless a loss of confidence in the currency is nipped in the bud by a pre-emptive and significant increase in interest rates, a currency's descent towards destruction can rapidly escalate. Doing it too late or not enough merely undermines confidence even more.
The issue of confidence poses yet another problem for the Fed. The extent to which currency values depend on misleading statistics represents a great and growing danger for future monetary policy, when statistical manipulation by the state is finally revealed to the disgust of the general public.
The dollar has nowhere to hide in the next credit crisis
The history of successive credit cycles shows that the general level of prices rises as a result of earlier monetary expansion. Inevitably, a central bank is belatedly forced to raise its interest rates, because the market demands it does so by no longer accepting the suppression of time-preference values.[ii]
Higher interest rates expose the miscalculations of the business community as a whole in their individual assessments for allocating capital. A slump in business activity ensues, and the banks, which are highly-geared intermediaries between lenders and borrowers, rapidly become insolvent. A credit crisis then swiftly develops into a systemic crisis for the banking system.
In the past, the encashment of bank deposits has been the way in which individuals tried to protect themselves from a bank's insolvency. This created a demand for physical cash, which helped support the currency's value through the systemic crisis. However, this prop for confidence in the currency in a crisis has now been effectively removed.
Central banks regard the right of the general public to encash their deposits as a hinderance to their attempts to stop banks failing. Since the 1990s, governments have gradually restricted public ownership of cash, accusing cash hoarders of criminal activities and tax evasion. More recently, they have moved towards banning cash altogether, assisted by the spread of contactless cards and other forms of electronic transfer.
The removal of the physical cash alternative forces a worried depositor to redeposit money from his bank into another bank he deems safer. The central bank can compensate for the loss of deposits in a bank, which has lost its depositors' confidence by recycling the surplus deposits accumulating in the other banks. It allows the central bank to rescue ailing banks behind closed doors, instead of having to deal with the contagious loss of public confidence that goes with an old-fashioned run on a bank. That is probably the overriding reason why central banks want to do away with cash.
Now let us make the reasonable assumption that the next credit crisis is worse than the last: that is, after all, the established trend. An ordinary saver is locked into the system and unable to demand cash to escape the risk of being a creditor to his bank and the banking system generally. His only remedy is to reduce his exposure to bank deposits by buying something, thereby giving the systemic and currency headaches to someone else.
It is easy to envisage a situation where the marginal sellers of a currency held in bank deposits drive its purchasing power rapidly lower. All that is needed is an absence of buyers, or put another way, a reluctance to sell assets seen as preferred to owning the currency.
But what is safe to buy? Failing business models mean that non-financial assets fall in value and residential property prices, which are set by the interest cost and availability of mortgages, are likely to be in a state of collapse, at least initially. Equities will reflect these collapsing values as well. Government bonds are a traditional safe-haven asset, but government finances are certain to face a crisis with budget deficits rocketing out of control.
Prescient investors and savers are likely to anticipate these dangers in advance of the credit crisis itself and take avoiding action. That is how markets function. Now that the cash alternative has been effectively closed down, the only assets for which deposits are likely to be encashed in advance of the crisis are precious metals and cryptocurrencies. Therefore, it seems likely that safe-haven demand escaping falling currencies will initially benefit these asset classes. They will be, as the cliché has it, the canary in the coal mine.
Are we heading for the last conventional credit crisis?
This article has highlighted the deceitfulness of official US price statistics, and the way they have been used to fool both markets and consumers. The Fed's monetary policies are founded on quicksand and could face a different set of challenges from the last credit crisis: a general loss of public confidence in the Fed itself.
In the Lehman crisis, we looked to the Fed to rescue us from a complete systemic collapse. It succeeded by doubling base money in a year from September 2008, eventually increasing it nearly five times over the following five years. The fiat money quantity (FMQ), which includes all dollar fiat money and credit (both in circulation and reserves), increased threefold from $5.4 trillion to $15.6 trillion. These are measures of the massive monetary expansion, whose price effects have been successfully concealed by official statistics. The whole process of rescuing the economy from the last banking crisis and making it appear to recover has been a truly extraordinary deception.
When one stops admiring the undoubted skill the monetary authorities have displayed in managing all our expectations, there are bound to be doubts. The Fed appears to be normalising its balance sheet, presumably so it can do it all over again. But the ratio of FMQ to GDP was 33% in 2007 before the Lehman crisis, and is at a staggering 80% today. On any measure, we are moving towards the next credit crisis with far too many dollars in issue relative to the size of the US economy.
When the next credit crisis hits us, the Fed is likely to find it impossible to expand its balance sheet and support both the banks and the government's finances through QE in the way it did last time, without undermining the purchasing power of the dollar. A crisis that is demonstrably caused by an unbearable burden of debt cannot continually be resolved by offering yet more credit. Last time it worked without undermining the currency, next time we cannot be so sure. But the Fed has no other remedy.
The next credit crisis could therefore be the last faced by today's fiat currency and banking system, if the debasement of currency required to prevent a debt meltdown brings forward the destruction of the dollar and all other currencies that are linked to it. The credit cycle will therefore cease. We should shed no tears for its ending, but our rejoicing must be ameliorated by the political and economic consequences that follow.
The end of fiat money may not happen immediately, because the general public can be expected to hang on to the fond illusion their dollars will always be valid as a medium of exchange before finally abandoning all hope for it. That has been the experience of documented inflations in the fiat currency age, from the European hyperinflations in the early 1920s onwards. And since all currencies are in the same unbacked fiat-currency boat, the purchasing power for them is likely to collapse as well, unless individual central banks introduce credible gold convertibility.
We have well-documented individual monetary collapses, even regional ones such as those that followed after the First World War in Europe. In Austria it ended four years after the war, in Germany five. But a transcontinental monetary crisis leading to the end of the global fiat currency regime takes us all into unknown territory, whose timing and progression, if it occurs, is hard to estimate.
My best guess for the timing of the next credit crisis remains later this year, perhaps the first half of 2019 at the latest. The short time that is left is the consequence of the enormous monetary debasement throughout the credit cycle not just in the US but globally as well. And the small amount of headroom for interest rates before the crisis is triggered, due to the accumulation of unproductive debt since the last crisis.
Total fiat currency destruction should take at least a further year or two, perhaps three from there. But first things first: the current phase of the credit cycle must evolve into a credit crisis before we can feel our way through its developing consequences.
[i] See Shadowstats.com, 1980 series, and chapwoodindex.com.
[ii] Time preference is the difference between immediate possession of a good and the promise of its future possession and is the basis behind interest rates when set by free markets.
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