Most Popular
1. Banking Crisis is Stocks Bull Market Buying Opportunity - Nadeem_Walayat
2.The Crypto Signal for the Precious Metals Market - P_Radomski_CFA
3. One Possible Outcome to a New World Order - Raymond_Matison
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
5. Apple AAPL Stock Trend and Earnings Analysis - Nadeem_Walayat
6.AI, Stocks, and Gold Stocks – Connected After All - P_Radomski_CFA
7.Stock Market CHEAT SHEET - - Nadeem_Walayat
8.US Debt Ceiling Crisis Smoke and Mirrors Circus - Nadeem_Walayat
9.Silver Price May Explode - Avi_Gilburt
10.More US Banks Could Collapse -- A Lot More- EWI
Last 7 days
Keep Calm and Carry on Buying Quantum AI Tech Stocks - 19th Feb 24
How to Profit from the Global Warming ClImate Change Mega Death Trend - Part1 - 17th Feb 24
Why Rising Shipping Costs Won't Cause Inflation - 17th Feb 24
Intensive 6 Week Stock Market Elliott Wave Training Course - 17th Feb 24
INFLATION and the Stock Market Trend - 17th Feb 24
GameStop (GME): 88% Shellacking Yet No Lesson Learned - 17th Feb 24
Nick Millican Explains Real Estate Investment in a Changing World - 17th Feb 24
US Stock Market Addicted to Deficit Spending - 7th Feb 24
Stocks Bull Market Commands It All For Now - 7th Feb 24
Financial Markets Narrative Nonsense - 7th Feb 24
Gold Price Long-Term Outlook Could Not Look Better - 7th Feb 24
Stock Market QE4EVER - 7th Feb 24
Learn How to Accumulate and Distribute (Trim) Stock Positions to Maximise Profits - Investing 101 - 5th Feb 24
US Exponential Budget Deficit - 5th Feb 24
Gold Tipping Points That Investors Shouldn’t Miss - 5th Feb 24
Banking Crisis Quietly Brewing - 5th Feb 24
Stock Market Major Market lows by Calendar Month - 4th Feb 24
Gold Price’s Rally is Normal, but Is It Really Bullish? - 4th Feb 24
More Problems in US Regional Banking System: Where There's Fire There's Smoke - 4th Feb 24
New Hints of US Election Year Market Interventions & Turmoil - 4th Feb 24
Watch Consumer Spending to Know When the Fed Will Cut Interest Rates - 4th Feb 24
Blue Skies Ahead As Stock Market Is Expected To Continue Much Higher - 31st Jan 24
What the Stock Market "Fear Index" VIX May Be Signaling - 31st Jan 24
Stock Market Trend Forecast Review - 31st Jan 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Deflationists Predicting Price Deflation Are Not Economists, They Are Journalists

Economics / Deflation Jan 14, 2010 - 11:13 AM GMT

By: Gary_North


Diamond Rated - Best Financial Markets Analysis ArticleIn Part 1, I replied to the issues raised by John Exter a generation ago:

1. The coming rush for liquidity
2. Gold as the most liquid asset
3. Currency and T-bills will do almost as well as gold
4. Gold as money, despite a commission
5. Asset prices influence consumer prices

In Part 2, I went on to deal with the myth of price deflation in Japan. First, there has been no monetary deflation. On the contrary, there has been mild monetary inflation (M2). Second, there has been price stability in Japan, despite massive declines in the real estate market and the stock market after 1989.

In response, I received a letter from Mike Rogers, a contributor to Lew Rockwell's site. He has lived in Japan for decades. He is the author of a book, Schizophrenic in Japan. Here is what he wrote.

I read your article. You are absolutely correct. There is no deflation in Japan. The average Joe-Blow on the street uses what we in Japan call the "Bento-index." Bento is those boxed lunches that Japanese people pack and eat. The price of a good cheap bento in 1996: about Y500–Y700 yen (maybe you can find a Y450 place – I knew of one. It was good too!) The price of a good cheap bento in 2010: about Y500–Y700 yen (maybe you can find a Y450 place – I know of one. I ate there last Friday. It was good too!)

He added this piece of evidence that I have seen nowhere else. There has been a change of consumer buying habits in Japan. Japanese consumers have become price-sensitive.

One thing you might want to know: It seems, as opposed to many years ago, only cheap things sell well in Japan anymore. So maybe people's perceptions have changed. A good example: There used to be no such thing as Dollar Shops or discount clothing (on the level of a K-Mart or something like that) in the late 1980's. Now, they are everywhere and they are booming. Because these places, and places that sell discounted goods are popping up all over the place, maybe this fuels the perception of deflation.

This is a major change. For decades, the Japanese government restricted entry of American firms, such as Wal-Mart, which are highly price-competitive. Price competition was regarded as a threat to traditional Japanese business standards. This attitude made possible political and social controls favoring wage stability, promotion by seniority, and the practice of lifetime employment. In short, it made possible government laws that in turn made Japanese corporations more like government bureaucracies.

When price competition becomes prominent, consumer authority has more clout in the retail markets. This has forced changes in Japanese corporate policies. This pressure will continue to work its way up the corporate chain of command.

This brings me to Part 3: currency's role in the inflation vs. deflation debate.


A piece of paper money that is not a legal warehouse receipt for a specific quantity and quality of gold or silver is fiat money. All paper money systems today are fiat money systems.

The question is: How is a paper dollar issued? It has these words on it: "Federal Reserve Note." This tells us where the money came from.

Paper dollars are printed by the Treasury Department's Bureau of Engraving and Printing. The Treasury runs the BEP. You can see this on the BEP's site.

What is not generally known is that the Treasury does not issue currency directly, on its own authority. It acts as an agent of the Federal Reserve System. We read in the Federal Reserve's FAQ list on currency:

Does the Federal Reserve produce bank notes and coins?

No, the Federal Reserve does not produce bank notes or coins. The Bureau of Engraving and Printing (BEP) produces currency and stamps, and the U.S. Mint produces our nation's coins. The Federal Reserve issues Federal Reserve notes and places them in circulation.

How are coins and currency put into circulation?

Coins and currency are placed into circulation through depository institutions, which obtain coins and currency from their Reserve Banks. The Federal Reserve, the Bureau of Engraving and Printing (BEP), and the U.S. Mint do not provide coins and currency directly to the public for circulation.

This is crucially important information for understanding how currency affects the money supply.

There is relatively little paper money circulating inside the United States. It is well known that paper money is sent back home by immigrants. This money is withdrawn from circulation here. Estimates on the percentage of the total U.S. currency supply held outside the United States range from 50% to 70%. The Federal Reserve and the Treasury estimated that in 2005, this was about 60%. (

With this in mind, consider the words of a booklet produced in the 1970s by the Federal Reserve Bank of Chicago, Modern Money Mechanics. It is no longer in print, but it is on the Web. The booklet begins its discussion of currency with a widely shared fallacy.

Money has been defined as the sum of transaction accounts in depository institutions, and currency and travelers checks in the hands of the public. Currency is something almost everyone uses every day. Therefore, when most people think of money, they think of currency.

Yet relatively few transactions take place through the use of currency. That was true 30 years ago. It is far more true today, because of the use of credit cards. When the booklet was written, customers used checks.

Contrary to this popular impression, however, transaction deposits are the most significant part of the money stock. People keep enough currency on hand to effect small face-to-face transactions, but they write checks to cover most large expenditures. Most businesses probably hold even smaller amounts of currency in relation to their total transactions than do individuals (p. 14).

The booklet then describes what happens to the total money supply when currency is withdrawn from a bank by a customer.

When deposits, which are fractional reserve money, are exchanged for currency, which is 100 percent reserve money, the banking system experiences a net reserve drain. Under the assumed 10 percent reserve requirement, a given amount of bank reserves can support deposits ten times as great, but when drawn upon to meet currency demand, the exchange is one to one. A $1 increase in currency uses up $1 of reserves.

Suppose a bank customer cashed a $100 check to obtain currency needed for a weekend holiday. Bank deposits decline $100 because the customer pays for the currency with a check on his or her transaction deposit; and the bank's currency (vault cash reserves) is also reduced $100.

Now the bank has less currency. It may replenish its vault cash by ordering currency from its Federal Reserve Bank – making payment by authorizing a charge to its reserve account. On the Reserve Bank's books, the charge against the bank's reserve account is offset by an increase in the liability item "Federal Reserve notes."

The national money supply does not change immediately. "The public now has the same volume of money as before, except that more is in the form of currency and less is in the form of transaction deposits." Things do not remain constant, however. The withdrawal reverses the fractional reserve process.

Under a 10 percent reserve requirement, the amount of reserves required against the $100 of deposits was only $10, while a full $100 of reserves have been drained away by the disbursement of $100 in currency. Thus, if the bank had no excess reserves, the $100 withdrawal in currency causes a reserve deficiency of $90. Unless new reserves are provided from some other source, bank assets and deposits will have to be reduced (according to the contraction process described on pages 12 and 13) by an additional $900. At that point, the reserve deficiency caused by the cash withdrawal would be eliminated.

This means that the bank must call in loans. It has to get its new, lower reserves balanced by a reduction in its assets: loans on its books. Or maybe it refuses to make new loans as old loans are paid off. It may have to borrow money in the federal funds market until it can reduce its loans.

This means that the withdrawal of currency is deflationary. This usually does not matter, because the person with the currency spends it at a business establishment. The business then deposits the currency at the end of the day. As the booklet says, "When Currency Returns to Banks, Reserves Rise."

After holiday periods, currency returns to the banks. The customer who cashed a check to cover anticipated cash expenditures may later redeposit any currency still held that's beyond normal pocket money needs. Most of it probably will have changed hands, and it will be deposited by operators of motels, gasoline stations, restaurants, and retail stores. This process is exactly the reverse of the currency drain, except that the banks to which currency is returned may not be the same banks that paid it out. But in the aggregate, the banks gain reserves as 100 percent reserve money is converted back into fractional reserve money.

The money supply then increases: "Since only $10 must be held against the new $100 in deposits, $90 is excess reserves and can give rise to $900 of additional deposits" (p. 17).

So, if there were a run on the banks for currency, this would be deflationary. This was why the U.S. government created the Federal Deposit Insurance Corporation (FDIC) in 1934. It created a similar agency for savings & loan associations. Ever since 1934, there has been no threat to the total money supply from currency withdrawals. The Federal Reserve can use open market operations to offset any decline in the money supply. It can buy assets. As Modern Money Mechanics says,

To avoid multiple contraction or expansion of deposit money merely because the public wishes to change the composition of its money holdings, the effects of changes in the public's currency holdings on bank reserves normally are offset by System open market operations.


Robert Prechter is the most widely known promoter of the Elliott Wave theory. He is a deflationist. He has been consistent, unlike most deflationists, who promote gold ownership. In 2004, he said that gold at $450 would be the top.

I turned bearish early but I also said the upper limit was the low US$400 [per ounce] and that is where it stopped and so far I am very comfortable with everything we have been saying.

He also said this:

Gold is in a bear market so it's not a good thing to own, but I think everyone should have some. In a bear market governments get desperate and it's happened many times in history that they will seize gold, they will make it illegal so people can't buy it, so if you already have some you are in much better shape.

Why owning gold would be better than owning paper money, which the U.S. government has never outlawed, he did not say. Gold falls in price in price deflation. Paper currency appreciates, income tax-free: more real wealth, no taxes.

On December 18, 2009, he wrote the following article: "The Fed's Presumed Inflation Since 2008 Is Mostly a Mirage." In this article, he did not mention excess reserves deposited at the FED's regional banks by commercial banks. These reserves came close to offsetting the increase in the FED's holdings of assets in its monetary base, which was the result of the bailouts in the fall of 2008. Instead, he said that the FED has offset its own policy. He did not say how this was possible.

When the Fed buys a Treasury bond, net inflation occurs, because it simply monetizes the government's brand-new IOU. But in 2008, in order for the Fed to add $1.4 trillion new dollars to the monetary system, it removed exactly the same value of IOU-dollars from the market.

This is not true. The increase in its assets still is listed in its balance sheet.

Prechter continued:

It has since retired some of this money, leaving a net of about $1.3 trillion.

This is also not true. The FED does not "retire money," as if money were some aging race horse put out to pasture. It sells assets, which destroys money in a fractional reserve banking system. It has not done this, as its balance sheet indicates.

Prechter then brings up the issue of currency.

In currency-based monetary systems, the creation of new banknotes causes – indeed forces – inflation.

This is irrelevant. The United States operates in terms of debt money created by its purchases of debt. Very little currency circulates inside the United States. When this increases, the money supply falls, due to the reversal of the fractional reserve process.

Likewise, the monetization of new government debt creates permanent inflation practically speaking. (Theoretically, the government could retire its debt, but it never does.) But when the Fed simply swaps money for previously existing debt, there is no net change in the amount of dollar-based "purchasing power" on the planet.

What does he mean, "swaps money"? The FED swapped assets at face value: liquid Treasury assets for illiquid toxic assets. That did not change the money supply because money was not involved. When the FED swaps money for a previously issued debt, it must create the money used to swap. It does not have "money" in reserve.

By the way, the phrase "net change in the amount of dollar-based 'purchasing power'" is meaningless. The issue is this: Does the monetary base increase when the FED "swaps money for previously existing debt"? The answer is yes. To deny this is to deny both money and banking practice and theory.

So investors, who previously held $1.3t. worth of IOUs for dollars, now hold $1.3t. worth of dollars. They are no longer debt investors but money holders. The net change in the money-plus-credit supply is zero.

This is incoherent. This is why you cannot follow it. It is not your fault.

Investors are not money holders unless they hold currency or a liquid account in a bank. The total of these is M1. There was no increase in bank reserves held by the public. That is because of excess reserves. So, this leaves currency. There was not $1.3 trillion in currency to hand over to them. Currency is held by the public or in bank vaults as reserves. Conclusion: there was no offsetting swap by the FED of money for previously existing debt.

Prechter went on:

The Fed simply retired (temporarily, it hopes) a certain amount of debt and replaced it with money. In fact, if the Fed is to be believed, it desperately wants to sell the rest of these (in)securities and retire the new money. I doubt it will happen, but it doesn't much matter to inflation either way.

This is also incoherent. The FED cannot "retire debt" and thereby "create money." The only way that it can create money directly is to buy debt. Indirectly, it can create money by lowering the legal reserve requirement or by imposing a fee on excess reserves. So, the only two ways for the FED to offset its own actions in 2008 are these: (1) increase legal reserve requirements; (2) sell all of these assets. It has done neither.

The economic effect of the commercial banks' voluntary increase in excess reserves is the same as an increase in the legal reserves. But the banks determined this; the FED did not.

Prechter is clearly confused about how the FED works or what the FED has done. Yet he has been publishing ever since 1979.

He then compounds his error.

The theory among monetarists is that these new dollars are hot money that creditors can now re-lend. Thus, it will multiply throughout the banking system. At first it might seem that new money in banks' hands should be more powerful for creating inflation than the previously-held FNM mortgages. But this is not the case, because the main thing for which the Fed wants banks to lend out the new dollars is new mortgages.

Monetarists and Austrians and all other schools of economic opinion say that banks can legally lend any reserves made available by central bank purchases of debt – new debt or previously existing debt. (The word "re-lend" has nothing to do with anything.)

The banks did receive the money spent by the FED when it purchased assets in 2008. Bankers have decided not to lend this money. This stopped the fractional reserve process, just as an increase in the reserve requirement would have stopped it.

The FED has no policy of banks' buying mortgages. It buys Fannie Mae and Freddie Mac bonds for its own account, but it has remained silent on who banks should or should not lend to. In any case, banks can legally lend to any borrower they choose. Raising the issue of mortgages merely confuses the issue. What issue? The issue of excess reserves: the bankers' fear of buying anything, including T-bills.

Today, bankers and other creditors are afraid of mortgages, and they don't want new mortgages any more than they want the old ones. In the mortgage-intoxicated, pre-2008 world, there would have been little significant difference in the paper, because banks were creating new dollars any time they wanted by taking on new mortgages. In the mortgage-repelled, post-2008 world, guess what: there is still little significant difference in the paper, because virtually the only thing banks can use it for is to fund mortgages! The only other outlet for the Fed's new money is to fund market speculation, which is one reason why the stock and commodity markets rose.

Got that? ". . . virtually the only thing banks can use it for is to fund mortgages!" This is not true. The exclamation point makes it even more untrue.

It is very important that people who talk about Federal Reserve policy understand how money and banking work, both in theory and practice. Prechter does not.


The forecasters who predict inevitable price deflation, yet do not predict inevitable monetary deflation, do not understand monetarism, or Austrian School economics, or supply-side economics. They are not economists. They are journalists.

There can be monetary deflation. That could result from deliberate FED policy: increased legal reserves or sales of assets. It could result from the collapse of banks, due to the unwillingness of the FED to intervene to provide Congress with the fiat money necessary to fund the FDIC. Neither policy is inevitable.

    Gary North [send him mail ] is the author of Mises on Money . Visit . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .

    © 2010 Copyright / Gary North- All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

© 2005-2022 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


14 Jan 10, 16:34

I hate mises To pieces

15 Jan 10, 04:12
Hurray for an alternative explanation!
Hurray to Gary for providing a credible alternative explanation! (I dare not make a judgement that this is THE explanation, although it could well be, as this subject is complex and I'm not a "student" nor someone with a Permanent head Damage on this subject). You are Great, Gary. It would be great to circulate this more widely so that those who have been fed with just the Prechter's expalantion do not get hoodwinked and lose their shirts....
15 Jan 10, 17:21
. Inflation and deflation are a psychological phenomenon

Always look at both sides to things.

Another point of view:

By Al Coryell


Why does the value of stuff diminish? What makes something worth less today than it was yesterday?

Short answer, you do. Inflation and deflation are a psychological phenomenon. It is all about your perception of the worth of something. If you believe that you are getting a good deal on a product and you are willing to continuously pay rising prices for the product, you are contributing to inflation. For example, let’s say you are willing to buy a car this year for $10,000 dollars. In a few years you trade in the car and now you are willing to pay $10,500 for basically the same model. That is inflationary. Nothing has significantly changed about the car except the price. Conversely, if you are not willing to pay the asking price anymore, and neither is anyone else, the manufacturer must lower the price point until you are willing to purchase it. If, then, you buy basically the same car for $9500, that is deflationary because, again, nothing has significantly changed about the car except the price. In both of these circumstances, you, the consumer, were the determining factor as to the value, and thus the price, of the product. As simple as that sounds, it is this very notion regarding the consumer’s willingness to spend that Keynesian economics fails to correctly handle, and why a Keynesian controlled economy is doomed to failure.

Which brings us to the next set of questions:

How long can an economy continue to deflate? What will make it stop deflating?

Two factors determine how long the deflation process will take. One, the greater the size of the bubble the longer it takes to liquidate all the bad credit and mal-investment. That statement should be self-evident. Two, the longer you try to maintain the bubble by keeping it artificially inflated, the longer the deflation process will take.

These kinds of catastrophes don’t crop up over night. They can take decades to culminate. In my Dead Cat Bounce article I showed the above chart of the Dow Jones Industrial Average since 1973. Note that the Dow’s average in 1975 was only 570 points and that the Dow never rose above 1,000 until 1983 when President Ronald Reagan and the Congress began to spend money on national defense that the Treasury didn’t have. The Federal Reserve was given carte blanche to inflate the money supply to pay for the deficit. Recall that in Part 3, the CPI charts began to reflect the results of that monetary inflation around the same time that the GDP chart began to show a slow but steady deflation in the worth of our stuff. However, the government data did not reflect either the money supply increase or the GDP decrease. Government data led us to believe that our economy was humming along nicely.

But no matter how you compile the statistics, deficit spending results in inflation. The combined messages of the charts revealed the ugly truth that the Reagan administration, and every subsequent administration, has simply spent whatever it wanted and the Fed would make up the difference by inflating the money supply. The current administration’s spending makes previous administrations look like amateurs. Our national debt has increased from less than 5 trillion to over 12 trillion in less than a decade and over 2 trillion in the last year and a half. The biggest difference is that the current administration is not hiding the increase and, in fact, is bragging about it’s successful ’stimulus’ programs which it claims are saving the economy from disaster. But are those programs really saving us? Or are they simply prolonging the agony?

With no gold standard to limit the amount of monetary inflation, the Federal Reserve has been able to print as much fiat money as it wants to keep up with the growing deficit. As the above chart makes visibly evident, since the 1980s, the stock market, the barometer of the economy, skyrocketed with inflation. You can see that by 2007 the Dow had inflated, with debt-laden dollars, to 14 times its value in 1983. The 1929 stock market bubble which brought on the Great Depression, only ballooned by a factor of five during it’s period of asset mania. Still, it lost 89 percent of its value when the bubble burst. I would expect this bubble to experience something similar in terms of percentages, maybe worse this time. What goes up must come down as we are certainly witnessing today.

So in 2008 the Fed finally capitulated and admitted there was a crisis. Their buddies in the financial industry were in trouble. That was the crisis. The financial institutions were going to inevitably collapse. Something had to be done to help them out. But what?

Before we go any further, let’s stop and look at how the Austrian’s would handle this situation. Bear in mind, in an Austrian School economy, the magnitude of this problem would never have occurred. You don’t mess with the thermostat in an Austrian economy (interest rates and the money supply), because on a gold standard you must have reserves available for every dollar in circulation. The fiat money simply would not have been available to finance questionable dot com companies or sub-prime mortgages or high limit credit cards.

In an Austrian School economy, interest rates are set by the market, not by a central monetary authority. Before the creation of the Federal Reserve, any bank could start up anywhere and set it’s own interest rate and service charges. Bank patrons could decide with their feet which banks offered the best combination of services and rates. Banks competed with each other just like retail stores. The more competitive banks won the most customers. But this was a major problem for the large banking institutions owned by the financial elite like the Morgans and the Rothchilds and it was the impetus that prompted them to create the Federal Reserve System in 1913. The little banks were far too competitive and they were stealing market share from the major players and thus a cartel needed to be formed to bring them under control.

The Austrians don’t believe in interfering with markets, so in today’s economy the failing banking institutions would have simply been allowed to fail. Goldman Sachs, Bank of America, AIG… none of them would have been bailed out with taxpayer money or any other kind of money except private capital. Ron Paul observes the absurdity of the governments assertion that the major institutions had to be bailed out because their assets were “illiquid”. As he so astutely notes “They are illiquid because nobody wants them [at the asking price].” Paul would just let the institutions fail and see what the free-market is willing to pay for them. “But wait…” I can hear you saying “They were a systemic risk. The President and Treasury Secretary Paulson and Ben Bernanke came on TV and said the whole financial system would collapse if we didn’t bail out the ‘too big to fail institutions’“. Yes, they said that. But, the truth is, many of those institutions are going to fail anyway with or without your bailout money. They are no longer solvent, they are “zombie banks” as Nouriel Roubini puts it. It is not fiscally possible for many of those institutions to survive the coming collapse. Their survival depends on being repaid for all the outstanding loans they have issued against residential housing, commercial real estate and other consumer credit. That’s not going to happen and the banks know it and the Federal Reserve knows it and the government knows it. The urgency of the crisis was a drama contrived so that you, the taxpayer, could be legally swindled into bailing out the financial friends of the Federal Reserve and their congressional cronies.

Only two of the major financial institutions were not bailed out, Bear Stearns and Lehman Brothers. Two of the oldest and largest financial institutions in the world were allowed to go bankrupt without a handout. Why? Because they were the largest competitors to the closest financial friends of the US government and the Federal Reserve — J.P. Morgan and Goldman Sachs, former home to Timothy Geithner, New York Fed governor at the time, and Hank Paulson, former CEO of Goldman. The Fed and the US Treasury protected their buddies at Morgan and Goldman. Once a $160 dollar stock, Bear Stearns was offered to surviving giant J.P. Morgan for just $2 per share, eventually negotiated to $10 per share. The pieces of Lehman were liquidated and sold off in bankruptcy. When AIG became insolvent and couldn’t raise the necessary reserves it needed, it sent chills through the halls of… guess what company? Goldman Sachs. So AIG was handed $150 billion dollars to pay off their creditors. There were no negotiations for a discount or lesser amount, all of AIG’s creditors received 100% of the debt they were owed. Guess who AIG’s biggest creditor was? Goldman Sachs, of course, who got 100% of its loans back. It didn’t lose a single penny. The financial system didn’t collapse when Lehman Brothers and Bear Stearns went under, nor would it have collapsed if AIG was liquidated and the system won’t collapse when many of the other institutions eventually suffer the same fate in the coming years. However, although the financial system will continue to function, many major institutions will collapse still owing you money that you will never see.

Now when I say the financial system won’t fail, I need to qualify that statement. The financial system is deflating fast and will eventually accelerate catastrophically taking your hard-earned tax dollars with it. Don’t expect that money back. The collateral damage will be bad and it will be bloody but it won’t be Armageddon. Natural Darwinian forces will prevail. At some point the market will stabilize once the debt liquidation has run its course. In the mean time, no amount of stimulus or manipulation will save the institutions. The constituent pieces of the bankrupted companies will be liquidated, sold for pennies on the dollar at market prices offered by the most solvent institutions at the time, just like Lehman Brothers was. Ultimately, the market itself will decide what each bank is worth, not the central monetary authority. And many of the acquiring institutions won’t be headquartered in the United States anymore. Don’t be surprised if Bank of America is one day owned by the Bank of China.

The longer the Fed and the US government try to prop up this phony economy, the longer it will take to start a real recovery and the deeper the depression will be. Consider this fanciful analogy:

Imagine yourself trying to re-inflate one of those floating air mattresses for a swimming pool. Somewhere it has developed a leak and is deflating. The size of the leak is bigger than your ability to keep the mattress inflated. Still, you keep blowing on it, but no matter how hard you blow, your lungs do not have the capacity to maintain the size of the inflated mattress. It continues to slowly deflate, with you still blowing as hard as you can getting more and more tired with every breath until, finally, you give up and allow the mattress to completely deflate. You then repair the mattress and start again to blow it up. Had you simply quit blowing and allowed the mattress to deflate as quickly as possible, you could have completed repairs and gotten started re-inflating mattress that much sooner. Your lungs would not be nearly so tired. How quickly you will now be able to inflate the newly repaired mattress will depend on how worn out your lungs have become after working so hard to keep the damaged mattress inflated.

Such is the difference between the way the Austrians would handle this crisis as opposed to the way the Keynesians have chosen to do it. Economic collapse is inevitable. The Austrians would just let the mal-investment and bad debt liquidate as fast as possible and get on with it. The sooner housing prices finish collapsing and the sooner the banks go under, the sooner we can start to rebuild and the sooner we put people back to work. There is no such thing as a jobless recovery. Austrian economists would not keep trying to prop up a failing system.

As an example, there was a very severe Depression of 1921, right after World War I. There are always recessions after wars because the economy must transition from military to domestic production. A significant part of the economic difficulty we will experience in the coming years will be the direct result of winding down the military industrial complex in operation today as we rein in our globally deployed armed forces. We aren’t going to be able to afford to maintain our empire around the world with the domestic economy in shambles. Public opinion will demand we bring the military home and use the savings from the armed forces reductions to repair our damaged industrial base.

During the 1921 recession, the decline in GDP was the largest in the previous 120 years, almost 18%, greater than the Great Depression itself which only declined by 11.8% in the third year. (Glance back at the GDP chart in Part 3 and picture where a negative 12% or 18% would be on the chart. As you can see it would be off the chart by a significant factor. It is likely the GDP from the coming depression will bottom somewhere between those two numbers). Further, wholesale prices deflated over 42%. Unemployment was nearly 12%. But at that time, the US was still on the gold standard and the Fed was not yet influenced by Keynes (not until 1936) so it took no action relative to the money supply, nor did it try to manipulate or stimulate interest rates or anything else. The economy collapsed badly over a 12 month period then began to rebuild and was back on track just over a year later. The point being, the free-market was allowed to self-correct. The Austrians contend that the economy can have rather violent, sometimes painful swings from time to time, but it will quickly repair itself if left alone to do so. But if the government tries to control economic conditions artificially by manipulating interest rates or the money supply, it can and will create credit (debt) bubbles of major proportions. The end results will always be catastrophe and the associated pain and suffering will not only be more severe than free-market corrections, but they will last much longer, lingering until the effects of any stimulus or monetary interference has been totally and completely abrogated.

If you read my articles regularly you have seen this quote by the famous Austrian School economist [Ludwig von Mises] several times:

“There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.”

Mises is talking about a credit implosion, a deflationary collapse, not inflationary. He understood that interference with the operation of the free market always results in an exaggerated boom/bust business cycle. In his writings he warns that providing “easy money” (credit expansion) creates unrealistic price inflation which inevitably causes the formation of asset bubbles of exorbitant debt. When those bubbles burst, the debt must be completely liquidated before normal economic stability can return to the economy. He is telling us that we have a choice. We can elect to stop the futile stimulus attempts (which are nothing more that further credit expansion), and let the debt get written off as quickly as possible so we can begin the healing process right away, or we can continue to expand credit (by adding more and more stimulus (debt) to the system) thereby throwing good money after bad and thus prolonging the inevitable collapse as well as increasing the pain and suffering that accompanies deflation.

Here is some further evidence of the deflationary forces currently impacting our economy:

■Banks are tightening real estate lending standards and often refusing to lend at all. Tighter standards means fewer home buyers. Deflationary

■Homeowners are increasingly walking away or strategically defaulting on their homes. Deflationary.

■Businesses are defaulting on their commercial loans. Deflationary

■Just like the homeowners they criticize for doing it, hypocritical banks like JP Morgan are strategically defaulting on their own commercial loans. Deflationary.

■Consumers are paying off their debts and avoiding spending on their credit cards, once a major resource engine for banks. Deflationary.

■Moody’s has warned that 6 of the 10 largest leveraged buy outs (LBOs) since 2007 are in distress, four have already defaulted. Deflationary.

■The FDIC is broke and wants to tax banks for additional revenue thus reducing banks cash on hand. Deflationary.

■Many states are broke and on the verge of bankruptcy. California will probably have to default on its bond debt in 2010. More states will follow. Deflationary.

I hear economists and media pundits talking as if the the worst of the economic crisis is over. Unfortunately, I believe the worst is just beginning. The next few years will be awful. Certainly, the amount of deflation we have experienced from the three bubbles which have already burst (savings and loan, tech or dot com, and sub-prime) has been bad enough. But the really big stuff remains ahead of us. Three more asset bubbles loom on the horizon: a consumer credit (credit card) bubble, a commercial real estate bubble and another round of residential real estate consisting this time of 5yr ARM resets from 2005-06 and ALT-A loans, a grade higher than sub-prime. The contagion is spreading to markets once thought immune from trouble.

In addition, rising unemployment has caused many people to have to live off of their credit cards. As they reach their limits and can no longer make their payments they will begin to default, not just on their credit cards, but on their home loans, car loans, student loans and other loans as well. Unfortunately, rather than walk away from their houses and other credit loans, many many people will try to pay their mortgages and other debt with their credit cards for as long as they can, a disastrous mistake. Defaulting on their homes and using their remaining credit for food and clothing would be a much wiser use of the dwindling resource. But that is a subject for a future article. 2010 and 2011 will be devastating years for the financial industry as more and more home owners go into default, foreclosure rates will skyrocket yet again and banks will continue to fail, now in massive numbers. The current lull in the collapse of housing prices, as well as the rest of the economy, is just a temporary respite on the way to new calamitous lows. I have described deflation before as an insidious monster. It sucks the life out of an economy and has historically been accompanied by untold suffering, particularly of the poorest among us, those who can least provide for themselves. Without jobs to provide an income and with limited government support available (because of lost tax revenue at both the federal and state government levels), millions of people will suffer greatly.

So what will the near future look like? My research has me convinced that there will be massive civil unrest, increased homelessness including camps and cities of displaced refugees, marches on Washington to protest economic policies and conditions, perhaps marshall law if the protests turn violent, a rise in crime fueled by desperation and a tax revolt greater than any in American history. The tax revolt will be a galvanizing factor which will trump the two-party political polarization that currently exists and create a revolutionary third party which will sweep Congress and reconstruct the U.S. monetary system. The Internal Revenue Service and the Federal Reserve System will probably be abolished or at the very least, completely revamped before this is over. When will it end? I can’t put a precise timeline on it (4-10 years?), but things will only get better once the massive debt of the American consumer has been completely liquidated, i.e., either paid off or defaulted on (remember the words of Ludwig von Mises). And a new economy, a new wave of productive businesses will have to replace the current false economy dominated by the Keynesian philosophy of borrow and spend and promulgated by the financial industry, Wall Street, the government service entities (GSEs – Fannie Mae, Freddie Mac, FHA etc.), the Congress itself and the Federal Reserve. A return to the Austrian School philosophy of free-market production and saving will eventually put people back to work, reducing unemployment and re-invigorating and restoring the U.S. economy. In the end we will be a very different but better off nation.

If I am making this sound like it will be worse than the Great Depression it’s because I believe it will. This depression will be nothing like the Great Depression of the 1930s. Times are markedly different. There were very few home owners during the depression. During the hardest of times there were many homeless who lived in tent cities which were nicknamed Hoovervilles, but the majority of people rented, share cropped or worked as hired hands on farms and ranches so shelter and food were not the problem then that they will be now. In 1930, people didn’t have credit cards so they didn’t owe $14 trillion dollars of personal debt. Nor, as a nation, were we $12.1 trillion dollars in debt to foreign countries as we are today. Nor did we have $38 trillion dollars of unfunded government liabilities because there was no massive welfare system at the time. (While I am a believer in welfare, I am not a believer in government as the provider. In a future article I will talk about how we can correct the problems with welfare and social security, removing the greedy and incompetent government from the equation). In the 1930s we were a strong creditor nation with surpluses in both budget and trade. We were also a productive nation with an industrial manufacturing capacity second to none in the world. The situation is much different and far more concerning today.

In the next few years, tens of millions of people will lose their jobs and thus their homes and will have to find a place to go. Children will move back to their parents homes. Older parents will move in with their children. Extended families will share crowded homes and apartments. But for many there simply won’t be anyplace to go except a modern day Hooverville, probably an abandoned house, a storage unit or a government refugee camp of some kind (stay away from those if you can – remember Katrina). In 2010, we are in debt to every major country in the world, China, Russia, India, the gulf states and Japan predominantly. We will be forced to sell much of our property to foreign nations to repay the astronomical debt we have amassed… and continue to amass as I write this (remember the debt clock in Part 1 of this series? Until that clock starts ticking backwards instead of forward our problems are only getting worse). Most of the productive capacity we had in the past has been shipped overseas to the emerging nations, leaving us with very little in the way of a manufacturing or production base. We will have to start pretty much from scratch to create a new wave of competitive industries, perhaps focusing on alternative energy, mass transportation and infrastructure modernization, things we should have been working on for decades.

Before you completely despair, I want to note that I believe the Phoenix will rise from the ashes. America is a highly intelligent, advanced and technologically savvy nation. We will adapt and innovate and resurrect ourselves eventually. But we allowed ourselves to be dragged far too long down the unrealistic road to the promised land of social security, free medicine, ever-increasing retirement benefits and a house for everyone who wanted one. We were told all we had to do to earn this bounty was to borrow and spend because the government was going see to it we were amply provided for. Apparently, it doesn’t actually work that way. Apparently, the Austrians have been right all along… production and saving are the only paths to prosperity.

It will not be easy and the pain and suffering we will endure will leave scars on our national psyche for generations, just as the Great Depression did on our grand parents. But two decades from now our children will be reading about “The Greatest Depression” (as futurist Gerald Celente has dubbed it) and the hardships endured by their fore-parents will be relegated to history books and period movies. Only recently have the memories of the last depression faded as those born in that era are all but gone. Santayana’s prescient words ring as true today as always – “Those who can not remember the past are doomed to repeat it.”

If you remain skeptical and unconvinced that my vision of the coming years is accurate, I can very well understand that. It is not an easy thing to allow yourself to contemplate much less believe. Most of us would like to see the glass as half full and remain hopeful that somehow we can work through this crisis without the massive suffering I have described. But I am convinced of the likelihood that a severe depression is imminent and so I am warning as many people as I can of the impending possibility and explaining why I believe it is inevitable. I have tried to provide ample evidence for my assertions and references to my sources of information. I leave it to you to judge for yourselves how well I have marshaled my facts, formulated my opinions and whether or not I have done an objective job of it. If you are reading this, then I am satisfied that I have spurred your thoughts and made you at least think about the possibility of what I am saying. Whether or how you elect to prepare yourself for this kind of future is your business. All I am suggesting is that you make a plan for the worst possible event that you can foresee happening to you and your family given your particular economic situation. If you never have to use that plan, that would be the best of all outcomes.

This is the last installment of my series on Deflation vs Inflation. Hopefully you have gained a better understanding of how the economy works, how we arrived at the situation we find ourselves in today, and at least some idea of what to expect from the future. If my arguments and observations have caused you to recognize the possibility of what I have discussed in these pages, then I urge you to inform your friends and family to educate themselves as you have, and advise them to prepare a plan as well.

My next series of articles will be about money, banking, the banking industry and how it works, and how I believe the U.S. monetary system must eventually evolve. For those who are interested in further learning about Austrian School economics, Keynesian economics and the Federal Reserve, I recommend the following websites and books:

■The Mises Institute

■Austrian School Economic Theory

■Keynesian Economic Theory

■The Federal Reserve Website

■The Creature from Jekyll Island: A second look at the Federal Reserve

G. Edward Griffin

■G. Edward Griffin: Creature from Jekyll Island – Free Online Video Series

■Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression

(and other books relating to Elliott Wave Theory)

Robert Prechter, Jr.

■Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse

Thomas E. Woods

■End the Fed

Rep. Ron Paul, TX.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in