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Why Deflation is Still the Primary Trend

May 25, 2011 1:47 PM ET
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 Let me qualify the below with this: we are in uncharted territory in terms of monetary policy, fiscal policy, worldwide economic imbalances, etc and there are so many cross-currents that nobody can say definitely how this will play out. But, the very long story short is that I believe the larger, longer term trend remains deleveraging/deflationary.

Within that larger trend, we can have counter trend inflationary periods or periods where we experience both inflation and deflation simultaneously (things purchased with short money, like food, basic materials, etc are inflating now, whereas things priced in long term money like housing are deflating). The Fed is trying to create inflation, but the transfer mechanism (bank lending) is broken and there is no real private loan demand. With so much slack in the economy, there is no pressure on companies to raise wages and no real consumer lending, Thus, most of the monetary base they create just sits in bank reserves or flows to the
securities and commodities markets for lack of a better home.

The fed has been pumping an average of $5-6 billion a day into the economy for the last 6 months and the treasury is running a $1.6b annual deficit and we dont have much to show for it. The economy is addicted to massive stimulus, when it stops or its' growth rate slows, I think you'll see the deflationary forces reasserting themselves.

Why we will continue to deflate:

1. "Dollars" are really just promissory notes from the federal reserve bank. They are "redeemable" for US treasuries. Its a holdover from when the currency was backed by gold. The paper you held could be taken to any reserve bank and "exchanged" for a like amount of gold. After a while, the public gets enough confidence that the gold will be there if they need it, so the gold backed paper becomes the medium of exchange as people trust its ability to retain value. When Nixon cut off gold exchangeability in August, 1971, the dollar was then only exchangeable for a like amount of UST. Thus, you have debt backing more debt. It becomes easy to see why, under this system, fiscal and monetary discipline can quickly breakdown in the hands of short sighted politicians. This is what you call a "fiat" based system, as any central bank can issue new debt at will.
These federal reserve notes are "base" or central bank issued money.
2. We have what is called a fractional reserve banking system, which means that banks can lend out a certain percentage (let's say 80%) of the base money on deposit with them. Bank 1 takes a deposit of $100 of base money and lends $80 to a borrower, which is then credited or deposited to his account at Bank 2. Bank 2 can now lend $64 of those dollars out to its borrower, who then deposits those funds at Bank 3 and so on. Thus, depending on the reserve requirements, the system can create over $400 of "money" from that initial $100.
Individual Bank
Amount Deposited
Lent Out
Total Reserves:
This newly created money (like the base money) relies on the public's trust that it will be there if needed. The key distinction to remember here is that all of those credits sitting in accounts are not the same thing as a dollar in your hand. Because we have all grown up treating credits as dollars (and being willing to exchange things like houses for a transfer of credit from one institution to another), the system works.  Perhaps the best way to think of this is as a system of leverage. In a system where more and more money is lent into existence (to create growth), the base money underneath it must also expand to maintain the reserve ratio or else the system becomes one of ever increasing leverage where the less desirable claims (commercial deposits, debt and other future claims on base money, i.e. unfunded liabilities) are leveraged on top of the more desirable base money.
3.  Every debt that is created by this system must be "serviced" by way of payments on the interest or "rolled-over" by way of a new loan to refinance the old one. Once a society has reached the point where the debts cannot be serviced by production based income (income derived from real commerce and productive value creation/addition), then the continued expansion must be fueled by new lending and appreciating asset prices (so old loans can be rolled over into new ones and still secured by sufficient collateral). (Aside, we crossed this threshold perhaps 20 years or more ago, where now more and more of our “output” is now driven by debt-financed consumption and transfer payments).  At any rate, the expansion can theoretically continue until the economy becomes so saturated with debt that it 1. Cannot be serviced with productive income alone and 2. Cannot be refinanced because there are no willing borrowers or unleveraged assets left to finance or insufficient base money to reserve against such lending. 
It is at this point that the unsustainable debt begins to be liquidated that more and more demand is placed on base money. Rather than accept additional leverage or debt-denominated (and illiquid) assets, the society demands base money and liquidity. The system has the potential to break down when more people want to hold more base money than the system can give them. As more and more people prefer to hold base money (the liquidity premium), the banks must call in loans or sell assets to meet the demand. As this happens, the amount of total money in the system contracts as the fractional reserve chain described above unwinds.  The Fed’s original purpose was to step in at this point and temporarily provide enough base money to the system to satisfy the public demand and prevent bank runs by creating public confidence in the banking system’s ability to dispense base money if needed.
Where are we now?
As noted previously, the system is one of leverage where there are multiple layers of claims stacked upon base money. As we sit here today, we have created so many claims on base money that the gap between the base and the claims cannot possibly be bridged.  Either the claims must be liquidated or the base must massively expand. Said more simply, there are not nearly enough dollars to pay all that we owe as a society. We can either create more dollars or lessen the amount we have to pay.
Looking at the below, federal debt has expanded greatly over the past 20 years as we all know, but the private debt claims (mortgage, auto, consumer, corporate, state, and municipal debt, as well as unfunded federal obligations) have ballooned to an even greater degree. Effectively, our economy is now leveraged 26;1.

                                                     1994      2006      2011  
USD  Base (billions):                 $431      $842     $2,700  
Total Public Debt                       $4,692   $8,507 $14,519       
Outstanding USD denominated Claims:                                                                      $70,000    
Ratio Base to claims:                                               
26 :1
source: QBAsset Management 

This is where the fed steps in and thus my feeling that the fed must print for the forseeable future creating additional base money to satisfy the demand as debts are liquidated and to support the future level of claims against it. This gap must be (at least partially) bridged to a level where the only debt and claims remaining are those that are, at least roughly, supportable by productive activities.  This can be accomplished by 1. allowing the debt/claims to be liquidated or 2. Increasing the base.  There are downsides to both approaches, as liquidation will create contraction, bankruptcies and a downturn in economic activity as the economy re-sets to a sustainable level. This is SHORT TERM pain. The danger with taking option 2 is that you have the potential to destroy faith in the base money that supports the entire system.
As noted, the entire system is based on faith in the ability of base money to be used as a medium of exchange and preserve value for its holders. When the factors that secure that faith (the assets which back it and, importantly, its’ somewhat fixed supply) break down, the base money itself begins to lose its worth. It is at this point, where those engaged in commerce will not only no longer accept a transfer of debts or credit in exchange for its goods, services, labor and assets, but also now refuse to hold base money in any meaningful way or for any extended period of time, that the decline in confidence in the media of exchange serves to delever the broader economy forcefully as the government must restore faith in the base by fixing its supply or  backing it with something people trust and that cannot be diluted by political authorities (gold?).  As the base is now fixed by force of having gone over the “faith tipping point” the only remaining means to bridge the claim gap is to liquidate and destroy claims.

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