Gary North

Dec. 28, 2009

John Maynard Keynes was the most destructive economist of the twentieth century. Political conservatives know this, although they have not read The General Theory of Employment, Interest, and Money (1936). But, then again, almost no one has. I have. It is an incoherent defense of big government. It swept the non-Communist world, 1945 to today.

Oddly enough, Keynes' arguments have persuaded a group of non-economists in the hard-money camp. These men are known as deflationists. They predict inevitable deflation. They use Keynes' arguments. Yet they are so poorly informed on economic theory that they are unaware that they are Keynesians. I call them Keynesians in drag.

Keynes argued in 1936 that the private capital markets cannot always allocate capital by means of the interest rate. He said there can be permanent economic stagnation under some conditions. This means falling prices.

Deflation must be stopped, he said. It can be stopped, he said. The solution is for the government to run large deficits. It has to spend. Lenders will lend if the government is the borrower.

Then Milton Friedman added his fiat two-cents' worth in 1963 in his co-authored book, A Monetary History of the United States. It argued that prices fell in the U.S., 1929-33, because the Federal Reserve failed to inflate. That argument won him the Nobel Prize. At last: a conservative's justification for Federal Reserve inflation!

Combine these two arguments, and you get today's Federal Reserve policy: inflationary to the core.

The deflationists have taken Keynes' argument one step beyond. They say that we are about to enter an economy in which lenders will not lend at any price. Friedmanite inflation will not save the capital markets this time. Borrowing from the FED will not help. Nothing can prevent a deflationary collapse, because bankers will not lend, and borrowers will not borrow, at any price.

In short, price -- the interest rate -- does not allocate capital. This is Keynes' argument, re-packaged for hard-money investors. Sadly, a lot of them are buying it. They don't understand where it came from.

Deflationists are Keynesians in drag and on steroids.

I have devoted considerable space to showing why Mish Shedlock doesn't know what he is talking about concerning deflation.

Now it is Karl Denninger's turn.

WHO IS KARL DENNINGER, AND WHY SHOULD ANYONE CARE?

He operates a popular Web site on investing. That is just about all anyone knows about him.

I have searched the Web to see if he has written a book on monetary theory. I cannot find one. What about a book on the history of money and banking? No luck. What about a self-published book? No go.

I really did not want to write this article. My time is valuable. But a subscriber has been impressed by the arguments of Mr. Denninger. He asked me what I thought.

This is what I think. Karl Denninger is a crackpot on the issue of deflation. For my definition of crackpot, read my critique of Keynes, who was also a deflationist crackpot.

In a recent post, Denninger makes the traditional case for price deflation by appealing to the increase in debt.

Back in 1973, John Exter made this same argument. I said he was wrong at the time. The money supply always rises to matches the increase in debt. Prices follow along.

Exter's argument is the key in the case for deflation. Deflationists return to it, as the Bible says, like a dog to its vomit. Year after year, decade after decade, they repeat this argument. Deflation is coming Real Soon Now. For my critique of Exter and the other deflationists on this point, click here:

Deflation never comes. It came the last time in 1955, when prices fell by less than 2%. Prices have not fallen by more than this since 1933. The New Deal created the FDIC in 1934 to stop bank runs, which it did. When the banks runs ceased, the fall in the money supply ceased. That ended price deflation. But the deflationists, not being economists, and not understanding monetary theory, go on and on, as if their predictions have not proven wrong ever since.

If you listen to any of them, you are going to be misinformed. There are no exceptions.

THE DECEPTION BEGINS

Denninger is self-deceived. I do not think he is a liar. I think he is a Keynesian in drag. But self-deception leads to active deception of others. Let me show you how badly deceived he is.

He offers a graph on the increase in debt since 1980. Why not since 1970? Or 1950? Or 1940? Simple: because it would weaken his case. There has been no price deflation since 1940, yet debt has climbed relentlessly upward. Always, the debt could be sold to investors, if only to the FED. Always, any prediction of deflation based on the non-marketability of debt has been proven to be utter nonsense.

In the latter part of 2007, continuing into 2008, credit outstanding in the broad economy began to contract. This has not happened before -- indeed, it had not happened on a broad basis since The Depression.

The credit contraction is barely visible. This indicates a huge "So what?"

It is this that made this recession different from the other recessions -- and market movers -- that we have experienced during our lifetimes.

Talk is cheap. Providing evidence is more expensive. Offering a consistent economic theory is most expensive of all. He offers no economic theory to explain this tiny blip.

He begins with a crucial error. It is the same error that misleads Keynesians and Chicago School economists. He defines inflation incorrectly.

Now remember: The definition of "inflation" in the monetary sense is the growth of money beyond the growth in goods and services. Deflation is the opposite.

The correct definition was offered by Ludwig von Mises and his Austrian School followers: inflation is an increase in the supply of money. We can debate how best to define and measure money, but to discard this definition is to discard the foundations of economic analysis.

HE MISUNDERSTANDS MONEY AND BANKING

Denninger quotes Bernanke's 2002 speech, in which he praised Milton Friedman's explanation of the Great Depression: a fall in the money supply, which he blamed on the FED. Bernanke said:

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Then Denninger adds a rhetorical grabber: "Really?"

Yes, really. The only question is whether the FED will do it. But Denninger, as with all deflationists, doesn't believe this. This is because he makes a fatal error. He thinks that the U.S. government cannot absorb all the fiat money that the FED wants to create. He thinks the credit markets do not have enough borrowers, including all governments.

We inflationists argue that the U.S. government can absorb every dime the FED wants to lend to it, plus every dime commercial banks want to lend to it. But the deflationists reject this argument. This is why I think they are, to a man, nuts. Stark, raving nuts.

Certainly Ben didn't forget that very few paper dollars are actually in circulation, did he? Indeed, virtually all "money" in circulation is nothing more or less than credit - blind promises to pay from future production the principal and interest that has been borrowed!

No, he did not forget, nor did anyone else who watched debt grow since 1933 -- without price deflation and without any unwillingness of banks to lend.

Realize this folks: The dollar bills in your wallet were borrowed into existence. Treasury sold debt (Bonds) against which The Fed issued paper currency!

Paper currency is irrelevant in the U.S. Most of it is exported to third world nations and used there as a black market currency. Denninger probably knows this. If he doesn't, then he truly is an economic babe in the woods. But he is trying to prove the preposterous, and everyone without a logical case uses rhetoric to fool the rubes. Denninger is such a non-logician.

So do we have inflation or deflation here?

Yes, we have inflation, just as we have had since 1933.

Well Ben certainly asserted in 2002 that he could prevent "it", and prevent "it" he did. Credit outstanding went from some $30 trillion when he gave that speech to $53 trillion at its peak (!) That ain't deflation folks - indeed, it is massive, pernicious and ridiculous inflation.

Notice that he refuses to discuss M1, which is by far the best predictor of CPI price movements. If you doubt that M1 is not the best predictor of the CPI among the various Ms, see my detailed report. Click here. But he keeps talking about credit, as if credit were money. Fact: we do not spend credit unless credit is money. The CPI is the result of supply and demand: money for resources.

This is part of his pea under the shell strategy. "Keep your eye on the pea" -- something called credit, not the M1 money supply.

I say: Don't keep your eye on credit. Keep in on M1 and the M1 multiplier. The M1 multiplier is down since 2008. M1 is up. They offset. Thus, prices have barely risen since December 2008. But they have risen, according to the CPI (1.8%) and the Median CPI (1.3%).

But the other assertion that Bernanke made -- that The Fed has control over this -- is only indirectly true. That is, The Fed can "credibly threaten" to print money like a madman and shower it from Helicopters, hopefully (for them) stimulating borrowing in the private sector. Since all money is in fact debt this is indeed the creation of inflation!

He has things backwards. This is not inflation because money is debt. This is inflation because there has been an increase in the supply of money.

We are getting close to the heart of the ancient incorrect argument that has led to 35 years of inaccurate predictions by deflationists. He says: But the other assertion that Bernanke made -- that The Fed has control over this -- is only indirectly true. He questions the FED's control over the money supply.

FACT: THE FED IS IN CONTROL

The FED does have control over the money supply. This is the heart of the Austrian School's position. This is why the deflationists are never Austrians. We argue that the FED inflates. The money is spent, with one exception: when banks place excess reserves at the FED.

Since 2008, the banks have increased their holdings of excess reserves by a trillion dollars, thereby offsetting the FED's increase in the monetary base. This has bailed out the FED. It kept M1 from doubling. This is great from the FED's point of view. The FED doesn't face price inflation.

If the FED wanted to double the money supply in one week, it would impose a fee for excess reserves. At some price (fee), all the excess reserves would be removed. The only way to remove them is for a bank to lend. It can buy T-bills. The Treasury will spend every dime.

Prices would double.

But Denninger and the deflationists never respond to this obvious argument. They think banks will keep excess reserves, no matter what fee the FED charges. They don't really believe that price allocates money and credit. Let me prove that this is the case with Karl Denninger.

But what Bernanke couldn't control is where the money went. In this case it "went" right into housing along with commercial real estate, blowing prices all out of proportion with reality.

So what? No economic school of opinion teaches that the central bank can control what the money is spent on. It is an irrelevant issue. Yet Denninger thinks it is somehow relevant.

He follows the deflationists' Party Line. They deny that fiat money will be lent into existence. Yes, it was before. They admit this. He admits this.

Now, faced with another crash, Bernanke tried to do the same thing. How is it working out?

Look at that chart again.

At no time in the 2000-2003 "deflation scare" did credit outstanding even credibly threaten to go negative.

Again, so what? Like the matador facing the bull -- a skeptical reader -- he has a red cape: "credit." A smart bull will keep his eye on the sword: "the M1 money supply and the M1 money multiplier."

They all deny that fiat money will be lent in the future. Next time, it will be different! We are seeing this now, he says.

But this time it did -- in early 2008, ex-Federal Government borrowing.

What does he mean, "ex-Federal government borrowing"? That is the heart of the matter in a world of trillion-dollar Federal deficits. The Federal Government borrows and spends.

Now you understand why The Federal Government, which is allegedly "separate" from The Federal Reserve, is in fact nothing more than Bernanke's handmaiden (and vice-versa.) The Federal Government did exactly as they were TOLD, and tried to "stimulate" private credit demand with various "borrow and spend" stimulus projects.

All this is economically irrelevant for the issue at hand. Then what is economically relevant for the issue at hand, namely the consumer price index? M1 and the M1 money multiplier. He refuses to mention this.

This prevented the deflation that was occurring from being recognized in the economy from the end of 2007 through the summer of 2009.

On the contrary, there was no price deflation occurring. That is why the CPI rose. Yes, rose. The deflationists have kept predicting a fall in prices (CPI), and they have been wrong.

Besides, with respect to an increase or decrease of 1% or less, who cares? Statistical error is greater than this. But these guys just cannot fess up. They have been wrong since 1933.

But last quarter, Bernanke and The Government lost their fight and total outstanding credit actually declined -- including The Federal Government.

He says that the government is fighting something called "total outstanding credit." Where is the evidence for this statement? I am unaware of it. I have seen no statement from any government of FED official regarding this. Where is a quotation? I'd like to see it. Yet Denninger has it front and center here. Why? Because it seems to point to an inability of the FED to control the M1 money supply and therefore control the movement of consumer prices.

Further attempts to "stimulate" private borrowing are doomed. Debtors are defaulting left and right, with Bank America (along with others) rumored to be planning to dump as many as six times as many foreclosures into the market as were processed in 2009 once the year turns over. Arrow Trucking appears to have collapsed as of this afternoon, prime jumbo loan delinquencies are skyrocketing and the FHA portfolio remains mired in trash with well over 20% of their loans delinquent or in foreclosure.

Baloney. Sheer baloney. First, is the Federal government willing to borrow? Has he heard about the Federal deficit? Why this? "Further attempts to 'stimulate' private borrowing are doomed." Why only private borrowing? Because it seems to strengthen his case that national debt is too large, that a great default is coming, and this will produce price deflation. This is the same old argument, going back to John Exter in 1973. It has always been wrong.

The claims that Bernanke "averted a second Depression" are outrageously false. There was no "Depression" in 1929 and plenty of market callers in '29 and '30 claimed that "the worst was behind us."

You can always spot a deflationist without a logical case. He invoke 1929-33, before the FDIC. He invokes a falling money supply: Milton Friedman's bugaboo. He invokes a world of bank failures that led to falling M1. A pre-FDIC world.

Any time you see this argument, think: "deception!"

Dead wrong, and for the same reason -- lending collapsed as willing and able borrowers were simply nowhere to be found.

Deception!

If anything Bernanke has made the situation markedly worse with his "quantitative easing" programs, in that he has created a circumstance where banks can make plenty of money by engaging in "risk-free" trades by borrowing at zero and buying Treasuries! This of course beats lending to some small (or large!) business who might go under and not repay his or her debts.

Notice: here he has shifted his argument. He is now invoking Austrian School analysis: the FED as an agency of monetary inflation.

I wish he would make up his mind! Sadly, he cannot stick with one argument, one line of reasoning.

The opportunity to avoid the now-inevitable was in 2003 and perhaps in 2004. The SEC could have told Paulson to pound sand on the leverage limit removal. Bernanke could have backed not extraordinary easy policy by Greenspan, but rather a removal of excess liquidity and a zero credit expansion policy -- forcing malinvestment out of the economy -- until GDP began to grow on its own without credit system pumping.

Again, this is Austrian analysis. The reason why we Austrians said stable money would not happen is because we believe that the FED really does have control over money, and that the FED would inflate in 2008. We were correct.

Now it's too late -- the borrowing capacity of both business and consumers has hit the wall. There simply isn't the ability to "buy more, pay later" given the actual earnings output of actors in the economy - yet that is the prescription that is required to continue to produce and consume beyond our means.

Here we have the ultimate rejection of economics. What is missing from this discussion?

Think.

Think hard.

Price. He fails to mention price. This non-economist fails to mention the interest rate!!!!!!. This is the classic mark of the economic crank.

Any time anyone discusses any economic decision without mentioning price, his economic logic is suspect. This is as true of Karl Denninger as with John Maynard Keynes. It is the same argument. When the absence of price in the allocation system is systematically ignored by the analyst, you know you are dealing with a non-economist. That applies to Keynes as well as Denninger. They ignore the rate of interest. At a rate of zero, people will borrow.

THE FUNDAMENTAL DECEPTION

Denninger has bought into the most successful economic deception of the modern world. He has amplified it. Keynes offered hope to avoid deflation: government debt. Friedman offered hope: Federal Reserve spending. Denninger rejects both. Nothing can avoid deflation. But the argument is Keynes' argument: the inefficiency of capital markets to set a market-clearing price.

What about the unwillingness of consumers to borrow? The fact is this: the ratio of household debt payments to disposable income has fallen, though not by much, Americans have reduced their monthly payments. How? Because interest rates have fallen. It costs them less to maintain their debt load. This ratio rarely changes much, but these days, it's moving lower. It is not collapsing. It is in the mid-range of what it has been over the last 30 years: around 16%. You can see this here:

So, if interest rates fall, borrowing will rise. It always does. Lenders will lend, and borrowers will borrow. That is why deflationists never refer to this crucial statistic. It destroys their case. It means that there is demand for loans at some price. There has been no collapse of lending in this recession. This time, it isn't different.

Denninger may analyze other things rationally, but not money and banking. Here, he doesn't know what he is talking about.

You want more proof? Try this.

As after the '29 crash the "reprieve" will prove transitory, not durable. Employment, credit numbers and freight all say "unsustainable bounce" and the GDP release this morning underlined that in big bold black sharpie -- if you were paying attention.

Deception! He invokes 1929-33. But 1923-33 is irrelevant in the era of the FDIC and the Friedmanite FED.

The Stock Market may not be for now, but the bond market sure as hell is: [he provides a chart. Click here to see it and his entire article.]

Then he launches into a discussion of the bond market. You will find it incomprehensible. That's not because of your ignorance. It's because of his.

That's the 30 year bond yield and the pattern you're looking at is known in technical parlance as an "Inverted Head and Shoulders." It is complete, it is a multi-year pattern, and it projects a 30-year bond yield to around 6.7-7.0%. Not tomorrow, not immediately, but the probability of this target being reached went up dramatically when the pattern confirmed this morning. It is negated conditionally (but not decisively) by a fall under 3.9% in the 30 year bond yield, and voided if the yield should fall below by a fall in the 30 year bond rate to below the head, or 2.5%.

Deception!

First, anyone who uses a graph that says a future price will reach that level of accuracy but refuses to say when is faking it.

Second -- and this is crucial -- bond rates fall in times of price deflation. Why? Because the investor's real return increases as money appreciates. He can buy more with his money. So, he accepts a low interest rate. There can be a deflation premium in long-term loans, just as there can be an inflation premium in long-term loans.

If long rates rise, this points to price inflation. Either Denninger is a true economic ignoramus or else he thinks his readers are. Take your pick.

So long as 3.9% holds one must expect a 6.7% long bond yield, and so long as 2.5% holds (way down from here!) one must be wary of a 6.7% long bond yield.

He is incoherent. Re-read that paragraph. It's nonsense.

Now he moves to home prices. This ignores all other prices.

The impact of this sort of move on home values will be catastrophic. A move from today's rates to the 7s will instantaneously subtract a further 25% from the value of every house in this nation. It will do similar things to commercial property values. In addition such a move would likely more than double government borrowing costs, shutting off government "borrow and spend" attempts almost immediately.

A move of mortgage rates of that magnitude is impossible in times of price deflation. Home prices may fall -- will fall -- in times of general price deflation, but this will be accompanied by falling mortgage rates.

Karl Denninger does not know what he is talking about.

If this chart is correct the next part of what is to come is going to be the "big suck" part of our economic future, and last many years -- perhaps as long as a decade.

The chart is purely speculative. It is tea leaves for chartists. It has no predictive value. It is surely not an argument based on economic theory or monetary theory. That Denninger believes this chart points to his lack of credibility.

He ends: "Good luck."

If you think he understands what he is talking about, you'll need it.

Ignore this man whenever he writes on inflation or deflation. He understands neither.

If he were not being read by tens of thousands of well-meaning but economically ignorant people, I would have ignored him. Why bother with anyone this poorly equipped to discuss money and banking? But he is misleading a lot of people. There comes a time to blow the whistle on a man this poorly informed with this degree of influence.

CONCLUSION

The deflationists are Keynesian wolves in sheep's clothing. They do not understand free market economics. They do not understand what money is, how it is created, how it is manipulated by the FED, and why the FED is in full control over the money supply. They do not understand how prices are set by competitive bids.

In short, they are economically ignorant. They do not know the extent to which they are committed to Keynesianism -- a grim Keynesianism, without a way to avoid deflation: not through Federal debt, not through FED inflation. But it is Keynesianism on the fundamental point: the unwillingness of lenders to lend at any price, i.e., rate of interest. "The debt cannot be rolled over, as it has been ever since 1933. It must collapse in a wave of deflation, no matter what the FED does." They have been wrong for 76 years.

They do not know what they are talking about. But they keep on talking.

I suggest that you stop listening.

Do what the best-known deflationist did. Martin Weiss finally stopped listening to his own arguments after 27 years. He switched sides. He is now an inflationist. He was a very slow learner. You don't have time for Denninger and Shedlock to come to their senses.

If you find it difficult to understand my arguments, do what the deflationists refuse to do. Read Murray Rothbard's great little book, What Has Government Done to Our Money? It's free:

http://mises.org/books/whathasgovernmentdone.pdf