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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).
Stagnation Nation?
It has long been my view that most of the seeds of the West’s ills were sown in the 1970s: that was the decade when Western consumerism began to be sated by Chinese imports, and Arab oil, and the decade when America cut the link between the dollar and gold sparked the first flames of the great Keynesian debasement bonfire. Richard Nixon and Henry Kissinger were the chief architects, of all three of these innovations, and the internationalisation of the dollar as the global reserve currency.
In the 80’s, the United States’ trade balance flipped over and the U.S. became a net debtor, sending more and more dollars and debt out to the world as the free lunch got bigger and bigger. But something odd happened from the 70s onwards, as demonstrated by our graphic of the day:
Why QE Didn’t Cause Hyperinflation
Ben Bernanke, and the Keynesians were right: Quantitative Easing has not caused the kind of inflation that the non-mainstream Austrian economists claimed that it would. The theory was that a soaring monetary base, and the zero-interest-rate-policy would lead to easy money flowing like a tsunami, and creating such a gush that inflation on goods and services — the change in cost from month-to-month and year-to-year — would soar, making daily life impossible for those on fixed incomes, and in a worst-case-scenario — like Zimbabwe, or Weimar Germany — forcing consumers to use an armful or wheelbarrow of cash to purchase a loaf of bread. Let’s look at the monetary base:
That is a huge spike!The monetary base — also known as M0 — is the total amount of coins, paper and bank deposits in the economy. Quantitative easing injects new money into the monetary base, and as we can see above, has great increased it. So why can I still buy bread without a wheelbarrow? That is because the monetary base and the money supply are two different things. In a fractional-reserve banking system, deposits in banks can be lent, re-deposited, and lent again. Government policy determines the number of times that money can be lent — in the United States, total credit cannot exceed lending by more than ten times. The money supply — which accounts for fractional reserve lending — is known as M2. Let’s look at it:
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