The Abolition of Deflation

Modern economics has been a great experiment:

Economic history can be broadly divided into two eras: before Keynes, and after Keynes. Before Keynes (with precious metals as the monetary base) prices experienced wide swings in both directions. After Keynes’ Depression-era tract (The General Theory) prices went in one direction: mildly upward. Call that a victory for modern economics, central planning, and modern civilisation: deflation was effectively abolished. The resultant increase in defaults due to the proportionate rise in the value of debt as described by Irving Fisher, and much later Ben Bernanke, doesn’t happen today. And this means that creditors get their pound of flesh, albeit one that is slightly devalued (by money printing), as opposed to totally destroyed (by mass defaults).

But (of course) there’s a catch. Periods of deflation were painful, but they had one very beneficial effect that we today sorely need: the erasure of debt via mass default (contraction of credit means smaller money supply, means less money available to pay down debt). With the debt erased, new organic growth is much easier (because businesses, individuals and governments aren’t busy setting capital aside to pay down debt, and therefore can invest more in doing, making and innovating). Modern economics might have prevented deflation (and resultant mass defaults), but it has left many nations, companies and individuals carrying a great millstone of debt (that’s the price of “stability”):

The aggregate effect of the Great Depression was the erasure of private debt by the end of World War 2. This set the stage for the phenomenal new economic growth of the 50s and 60s. But since then, there’s been no erasure: only vast, vast debt/credit creation.

As I have long noted, in the end the debt load will have to be erased, either by direct default (or debt jubilee), or by indirect default (hyperinflation). Deleveraging in a credit-based economy, is very, very difficult to achieve, without massive damage to GDP (due to productive capital being lost to debt repayment). The irony is that the more central banks print, and the more the Krugmanites advocate for stimulus, the tetchier creditors (i.e., China) become about their holdings being debased, when the reality is that the only hope that they have to see any return on their debt holdings is for governments to print, print, print.

How long can America and the world kick the can? As long as the productive parts of the world — oil exporters, and goods manufacturers — allow the unproductive parts of the world — consumers and “knowledge economies” — to keep getting a free lunch. Keynesian economics didn’t abolish defaults in the long run — it just succeeded at making mass defaults much less frequent. My hypothesis is that it also made these moments of default much more catastrophic.

This is akin to the effects of dropping rocks on humans: drop a hundred 1-pound-rocks on a man over the course of 50 years  (at the rate of two per year) and he will most likely be alive after those years. Drop one hundred-pound-rock on him after fifty years and he will more likely be dead aged 50. Perhaps in reality it is not as extreme as that, but that is the principle: frequent small defaults, small depressions, and small contractions have been abolished, in favour of occasional very, very big depressions, contractions and defaults.

Where does that leave Keynesian economics?

Well Keynes was right that intervention can save lives, families and businesses. What Keynes and Fisher were wrong about is that stabilising credit markets and prices (resulting in the abolition of deflation) is completely the wrong kind of intervention. Government’s role during depressions is to preserve and stabilise the productive (i.e. physical) economy, to prevent the needy from starving, to prevent homelessness, and create enough infrastructure for the nation to function (and eventually, to thrive). The financial economy (and all the debt) should go the way nature intends — erasure, and resurrection (in a new form).

32 thoughts on “The Abolition of Deflation

  1. Nice work. The end of deflation graphic is a good one.

    So, in this and other pieces you mention that oil and goods producing countries are accepting paper for value. In other pieces, you point out that the US is voluntarily paying to secure the world.

    I wonder if those two cancel … The US is securing the world in exchange for goods and resources. The true value of our security is some fraction of the cumulative GNP differences between the Cold War East and West plus a fraction of world GNP growth after the Cold War assuming the growth rate was higher after the Cold War ended.

    If this thesis ends up looking like a fair trade, we can unwind a lot of problems by dealing with it transparently.

    • I think the real solution is ultimately diversification: the US does more to produce its own goods and resources, and the rest of the world does more to ensure global stability. Getting there requires every party to acknowledge the current reality (problematic — look at Mitt Romney on one hand, Vladimir Putin on the other, etc) and recognise the virtue in working toward a less fragile world (tough — global fragility has evolved out of free lunches and quick payoffs).

      I get the feeling that only the threat of imminent (palpable) disaster will bring the world to its senses. The art lies in avoiding that disaster.

      • You didn’t quite get where I was going.

        Step one … Determine a fair price for the services (security) rendered.

        Step two … Pay us for those services .. you can use treasuries that you have accumulated or dollars.

        Step 3 … Stop all the insanity in the future … No more oil for paper or defense for free … Sung to the tune of Dire Straits’ ‘Money for Nothing’ (both the group name and song title deliciously apropos)

        • It comes across as America post-hoc determining a price for something that other nations never agreed to pay for (although they benefit from it).

          The problem is that America is dependent on the provisions of these other nations (or at least, more dependent than vice verse) and cannot really expect to make such demands with impunity (trade war).

          Maybe with enough brinkmanship (see my first response) the Pentagon can pull this off…

          I don’t know.

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  3. This is a thought exercise. I am not advocating a threat. No matter what happens, the holders of our printed matter end up with pennies on the dollar. Their choices are to wait for it to be inflated or defaulted away (leaving them embittered), forgive our debt (it might leave them feeling superior and us morally indebted) or return our paper voluntarily and thank us for enabling their prosperity (leaving an emotional level playing field … At least that can be rationalized.)

    The financial equation is the same, the emotional one is different in all three scenarios. The result of the emotional equation will determine how fast the world bounces back.

  4. Ted,

    That oil contracts are settled in dollars is all you need to know. If you go back to the last gold bubble, it was the Arabs (Middle East folk) who were the big buyers of gold (Atleast thats what the newspapers of the time claimed.)

    But a funny thing happened along the way, a bunch of wars and instability increased in the region. At some point the Oligarchies running the ME must have figured out that if the USA goes down, they go down. (Imagine being a neighbor of Saddam (I’ll gas anyone).

    I’m sure the (Rich) Arabs are well aware that the unofficial policy of the US is continually debase the dollar, but most likey view as a better alternative to being invaded by the next Saddam.

    • The interesting thing is that devaluation may (contradicting what I have said in the past) only be a relatively minor concern for dollar/treasury-holders. It’s not just the money-printing — the way the dollar and the American economy is being managed is an embarrassment, inflation or none. That they printed all that money and hardly achieved anything in the way of growth and jobs is almost tragicomic. I think a lot of dollar holders may have reached the conclusion that the world is better off under efficient Chinese and German statist management rather than mixed up and confused American military-financial corporatism. Now, I doubt anyone (else) wants to end up like Qaddafi or Saddam, but it’s not like anyone needs to rock the boat to create volatility and start a new middle eastern war — Israel seems dead set on a new middle eastern order, with Israel calling more of the shots. A lot of up-and-coming nations (Iran, China, Pakistan, Russia — let’s call them the “PRICSs”) see this volatility not as a threat, but as an opportunity to expand their power.

      If, in the near future, the Eurasian powers actually threaten to disrupt the global trade web on which the American empire depends, I expect the “hawks” in the Pentagon to accede to demands. Even with the support of Germany/Europe (not guaranteed — things look very 1917 in Europe right now) America can never win a conventional war with the PRICs. And hey presto, a new world order, denominated in gold (petro-bullion-yuan). Unless whoever is in charge of America is completely insane (Rick Perry, Mitt Romney) losing Fort Knox to creditors is cheaper than a full-blown oil shock, a new global war, and the shutdown of the global trade web.

      Of course I haven’t touched on the the really dangerous eventuality: Israel using nukes…. They didn’t develop second-strike capabilities for nothing.

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  6. This is a very good piece, but there is one glaring omission: you ignore the role of the state (and the banking system) in the causing of the deflationary recession in the first place.

    Unlike what modern economists would like you to think, recessions and deflations are not our destiny. They are not inevitable, and they do not have to happen if you have a capitalist economy. They are always and forever a result of increases in the money supply (via credit expansion or good old-fashioned ramping up the printing press). These expansions of the money supply would not happen if you had a truly free market in money and credit. If the government couldn’t print money and the banks weren’t protected with a lender of last resort, the money supply could not be expanded, and recessions would not happen.

    The true disaster of Keynesian economics is in its founder’s insistence that examining the cause of the depression was not a worthwhile endeavor; that we need to just focus on the solution. With this stroke of idiocy, generations of economists have been shielded from understanding what causes crises, and instead keep repeating, like robots, the importance of raising aggregate demand and preventing the deflationary collapse. The result has been, as you perceptively note, endless growth in debt and inflation, resulting in ever-more crises, which are then treated with more debt and inflation, and so on. Insanity, in other words.

    Hence, I agree with you that Keynes and Fisher were wrong that the role of the state is in reflating the bubbles and stabilizing credit markets and prices. But I disagree with you on the correct role of the government: It isn’t to clean up the mess and stabilize the markets, it is to NOT cause the mess in the first place.

    • Interesting response.

      I agree that the bubbles can be created and exacerbated by governments. Austrians have got right that central-banking-fuelled credit expansion and contraction creates malinvestment and bubbles. But by no means is government and easy money the only source of bubbles. Perhaps it looks like that now, but please remember that bubbles can form under the gold standard, too, or under any monetary system, especially ones which permit debt (of any kind, not just debt-based-money). That’s why pre-Keynes there were such huge contractions and expansions in prices. There are hundreds and thousands of examples of bubbles pre-central banking.

      Just as Keynesians cannot (in the long run) prevent recessions and deflation through print print print, Austrians cannot prevent recessions and deflation through sound money, competing currencies, etc.

      The key thing is that I never actually said that its the government’s job to stabilise markets: quite the opposite — let the failing failures fail. Let the market destroy itself. The government’s job in this instance is to prevent people from starving, becoming homeless, and the nation and society from collapsing. Nothing more.

      I view economies like organisms: they have a kind of ecology. Cyclical expansions and contractions are natural. They can be worsened by government intervention, but that is far from the only source. Their cause is more likely than anything else to be over-exuberance followed by panic. The modernist push to abolish the natural economic ecology is very foolish, and is having dire consequences.

      • “But by no means is government and easy money the only source of bubbles. Perhaps it looks like that now, but please remember that bubbles can form under the gold standard, too, or under any monetary system, especially ones which permit debt (of any kind, not just debt-based-money). That’s why pre-Keynes there were such huge contractions and expansions in prices. There are hundreds and thousands of examples of bubbles pre-central banking.”

        Recall my point: bubbles and recessions only form because of expansion of the money supply. To the extent that the gold standard (or any other monetary system) prevents the expansion of the money supply, bubbles will not form. Whenever, under a gold standard or any other monetary system, you have an expansion of the money supply, bubbles will form.

        The gold standard, for the vast majority of its history, did not serve the function it had been intended to serve: prevent the money supply from expanding beyond the quantity of gold. Combining a gold standard with fractional reserve banking necessarily increases the money supply beyond the quantity of gold. Having a fiscally incontinent government think it can fool its people by printing a small bit of money and hoping no-one notices also increases money beyond the quantity of gold. In both these scenarios, the money supply rises, a bubble forms and a crisis follows.

        Whether you have a central bank or not is immaterial; what matters is whether the money supply is constant or not. If it’s increased, it’ll cause a bubble and recession. Even before central banks, there were many ways through which governments and banks could expand the money supply. And whenever they did, a crisis followed.

        You cannot prevent crises with a gold standard, as a gold standard is an invitation for governments to abuse it. The only way they can be prevented is in a truly free market in money and credit, where no coercion is involved in people’s choices in money and credit at all. My contention is this: Under this system of individual freedom, the only moneys and banks that will survive are the non-expansionary ones. No one will want to transact in a currency that is being Bernanked, because it will continue to lose value. No one will want to deal with a bank that engages in fractional reserve banking because it would always be at risk of collapse and will also cause its currency to lose value. As such, in a truly free market the only money that survives is non-expansionary money, and the only banks that survive are full-reserve banks. The ideal non-expansionary money would be one whose quantity is never expanded. But no such thing exists, and the closest thing is gold, whose quantity can only increase at very tiny increments.

        • Although the competing currencies scenario you portray is valid and could play out, in all honesty I suspect that in an open market, currency-users will — for money as the unit of exchange — go wherever there is the most liquidity. For money as the store of value they will go for the best preserver of purchasing power, which is historically gold and bonds. This is uncannily like what we see now.

          I expect the next phase of monetary history to include some form of sound money — namely, that America’s creditors will cease to accept fiat and demand Fort Knox instead. The global reserve currency will become gold, and gold backed yuan (poor Qaddafi did not live to see his dream). But I expect that in time this new order will be debased by fractional lending, and new exotic derivatives.

          The truth is that the wealthy and powerful love fractional money (and its expansions and contractions), because they can ride the wave and get rich(er) off it. The poor and the weak love fractional money (at least superficially) because the monetary-issuer can print more of it and helicopter it. It’s hard to get rid of a system like that.

  7. Liquidity does not come from the ‘technology called the printing press’, it comes from people’s willingness to accept a money as payment. The whole point of money is that it allows for exchange at any scale and timeframe. In a free market monetary system, people’s choice of what’s attractive as a medium of exchange will be heavily influenced by the choice of what’s attractive as a store of value: it’s far more convenient to just have one money rather than switch around. It is a coordination game that can only really produce one winner. Once a money has an advantage over others, it becomes the optimal strategy of everyone to start using it.

    But that, let’s remember, is in the la-la-land of a free market monetary system, which is a place we probably won’t see anytime soon thanks to decades of mainstream economic garbage brainwashing most people. Government coercion will likely continue to play a very important role in the foreseeable future, so it’ll always be more complicated and we’ll continue to stumble along from one idiotic flawed system that’s a catastrophe-waiting-to-happen to another.

    I agree with you that it’s hard to get rid of this system, but this is strictly because it’s hard to get a free market in money and credit. In such a free market, it doesn’t matter how much the rich and poor like funny money and funny banks, they cannot survive. Any Keynesian who wants to live by their convictions and put their wealth in such money and banks would see it all evaporate and that would be a wonderful example of poetic justice and karma and comprehensive proof that god exists.

    So while it’s tough to predict how the moron-nerd-overlords will try to design the next monetary system, it seems highly likely that as we move forward, the monetary role of gold will continue to grow, while the value of paper currencies continues to shrink.

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