Remnant Review (November 24, 2012)
There is ongoing confusion about my scenario about what the United States faces over the next decade, and possibly even longer. This confusion may stem from a misunderstanding of my terminology. In previous articles, I have attempted to define my terms, but I find that some subscribers do not understand my definitions. They confuse my terminology with words that they have heard on other websites, or which I used in my writings prior to Ron Paul's candidacy for the Republican nomination in late 2007. So, let us begin at the beginning. Let us begin with the Austrian theory of the business cycle.
THE AUSTRIAN THEORY OF THE BUSINESS CYCLE
This was first articulated by Ludwig von Mises in his 1912 book, The Theory of Money and Credit. In that book, he described the combined effects of central bank monetary inflation and commercial bank monetary inflation. He discussed the effects of this policy on interest rates.
He argued that central bank expansion of monetary reserves leads to an increase of fiat money issued by the fractional reserve banking process. There was nothing new about this aspect of economic theory. This had been known for at least a century prior to the publication of this book.
What distinguished Mises's theory was this: he said that the increased supply of central bank reserves, which leads to an increased supply of fiat money, is issued through commercial banks in the form of commercial loans. These commercial loans are used by the banks to increase their interest income. Commercial enterprises use these borrowed funds, newly created by the banks, to invest in productive activities.
Using the concept of the structure of production that had first been presented by Mises's teacher, Eugen von Bohm-Bawerk, Mises argued that this increased investment has to lengthen the structure of production, which means that the money will be used to buy capital goods, which will in turn increase the division of labor in the economy. This increased division of labor leads to greater productivity. But there is a looming problem. Future consumer demand at the end of the structure of production may not be sufficient to reimburse capitalists for their expansion of investment in capital goods.
The problem with credit that is issued by fractional reserve banks is this: it creates an illusion. The illusion is this: there has been increased saving on the part of future consumers. They have supposedly reduced their demand of present goods in order to turn over their money to banks. The bankers then use this money to lend to commercial enterprises, which in turn go into the production of future consumer goods. Producers assume that consumers want future consumption more than they want present consumption, which is why they put their money into the banks. Instead, banks had used newly created fiat money to make these loans. In order to lure borrowers into more debt, banks lowered the rate of interest. There was newly created money to lend (supply) and a fixed number of borrowers (demand). This lowered the interest rate: more supply, fixed demand (at yesterday's higher rate).
The problem comes when producers discover that consumers did not want to increase their level of savings, which means that they did not want to decrease present consumption for the sake of future consumption. There was no increase of thrift on the part of consumers. Instead, there had been an expansion of fiat money by the fractional reserve banking system. So, Mises argued, when it becomes apparent that consumers have not increased their rate of saving, businesses will have to scramble for additional loans in order to complete their various plans to increase output. Prices of present goods go up, because consumers are still bidding for these prices in the marketplace. When they are paid newly created fiat money by their employers, they go out and spend it. This increases the rate of consumer prices.
Entrepreneurs find that they are competing against each other for scarce economic resources. They had thought that there had been an increase of thrift on the part of consumers, but they had been misled by the artificially low interest rates. So, in order to cover increased wage demands on the part of workers, and in order to cover increased demands by owners of raw materials, owners of land, and orders of other production goods, businessmen find that they have to readjust their plans. They had thought that goods and services would not be immediately demanded, because they thought that consumers had increased their rate of savings. That was an illusion fostered by the expansion of fiat money, first by the central bank, and then by the commercial banks.
Businessmen find that their plans were based on a miscalculation. They want to finish their various projects, and they have to borrow more money than they had expected in order to complete them. This drives up short-term interest rates, because of the increased demand for bank loans. This begins to produce business losses. The losses spread through the economy. Businesses begin to shut down production. The result is a recession. If the cutbacks are very serious, we call it a depression.
This theory of the trade cycle, which was unique to Mises at the time, is based on an understanding of the effects of increased central bank inflation, increased commercial bank inflation, and the way in which new commercial loans affect the overall economy. It was written at a time when consumer loans were rare. There was no massive welfare state. The governments did not spend large amounts of money, which had been borrowed from the central banks, in order to vastly increase the government's overall influence in the economy. Civil governments were small in 1912.
In 1914, World War I broke out, and that changed everything. Governments became the major borrowers, not commercial enterprises. Governments abolished the gold coin standard. The modern era of mass inflation, and then hyperinflation, began in August of 1914 in Europe.
The Austrian theory of the business cycle provides insights into the choices available to policymakers. It does not tell us which choices those policymakers will make. It only tells us that certain kinds of results will take place if policymakers adopt one policy rather than another. It also does not tell us what everyone in the economy will do in response to the new policies. People can change their responses to these new policies. This is why Austrian school economists do not think that precise prediction is possible by means of looking at statistical aggregates produced by government bureaus. People still can do unpredictable things.
The Austrian theory of the trade cycle always held to this position: there will be price deflation at some point after the expansion of the monetary base, and after the expansion of commercial bank credit or other forms of bank credit. This expansion of the money supply initially leads to rising prices, or at least it distorts the market's assessment of the value of capital goods. When the recession comes, some banks will fail. When banks fail, this contracts the money supply. So, the Austrian theory of the trade cycle insists that inflation of the money supply through the central bank and fractional reserve banking system will ultimately lead to a contraction of the money supply, falling prices, and either recession or depression.
WHY DEFLATION IS INEVITABLE
Every theorist of hyperinflation believes that, at some point, the hyperinflation must end. Mises called the hyperinflation phase the crack-up boom. During this phase, the government's currency unit falls in value to something approaching zero. Prices rise rapidly. During this phase, individuals shift from the using the government's currency to barter, or maybe the use of other foreign currencies, or the use of gold and silver coins. Over time, the policy of hyperinflation leads to destruction of the currency unit. During this process, the currency unit ceases to be the primary means of purchasing those assets that most people want to buy. When money dies, the markets that were based on that money also die.
I want to make this perfectly clear. Every theory of hyperinflation is also a theory of ultimate deflation. Every theory of hyperinflation is also a theory that hyperinflation must end at some time. There is no such thing as a theory of hyperinflation that argues that hyperinflation can be permanent. Every argument for the inevitability of hyperinflation is an argument that hyperinflation is inevitably temporary. It is temporary because hyperinflation by definition means the destruction of the existing money system. When the existing money system is destroyed, because nobody is making exchanges by means of the currency in question, the public will abandon that currency. At that point, the entire price system that had been denominated in terms of that currency also disappears. The government knocks off a dozen or more zeroes, or people convert their accounts to a new currency system, and this currency system knocks off a dozen or more zeros.
So, no matter who is talking about hyperinflation, he ultimately has a theory of deflation. He has this theory, precisely because hyperinflation cannot go on. This means that Herb Stein's law is applicable: "Things that cannot go on have a tendency to stop."
Whenever anybody thinks the word "hyperinflation," he should simultaneously think "ultimate deflation." Every hyperinflation has to end. When it ends, prices are adjusted downward in a new currency system.
This means that hyperinflation produces the crack-up boom, as Mises called it. The crack-up boom eventually ends. The economy shifts to deflation. This is the Austrian theory of the trade cycle, and it has not fundamentally changed in the last hundred years. Here is what Mises wrote in Human Action (1949).
The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them (p. 425).The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system (p. 552).
After hyperinflation ends, there is no depression. The destruction of the division of labor is so far advanced under barter that the new currency fosters economic recovery. But creditors are now wiped out. Debtors who paid off their debts with worthless money are ahead. There is a new distribution of wealth under the new system.
Therefore, whenever I have written about hyperinflation, I have either explicitly said or implicitly assumed that the hyperinflation must end in a currency reform. This will be deflationary, but it probably will produce a recovery, not a depression. The division of labor will increase.
THE SELF-INTERESTED FEDERAL RESERVE
Because of the effects politically of Ron Paul's candidacy for the Republican party's nomination for President, which he began in late 2007, the American public is now more familiar with the Federal Reserve System than at any time in its history. No longer will the Federal Reserve System's senior bureaucrats hide successfully from the public's wrath if they adopt a policy of hyperinflation. There is no way today that the central bank can successfully do what it did in Germany in 1923, namely, blame anybody else for the hyperinflation. Ron Paul's candidacy changed the political landscape with respect to the public's awareness of what the Federal Reserve does and what the economic effects are when it does it.
Because of this, I believe that the Federal Reserve will not adopt a policy of hyperinflation. It wants to protect the value of its retirement program, which is funded outside of the federal government. It is not loaded up with IOUs from the Treasury Department, unlike the Social Security system. If the Federal Reserve destroys the monetary unit, it will thereby destroy, or vastly reduce, the value of the pension fund which guarantees the comfortable retirement years of employees of the Federal Reserve System. We are back to that fundamental assumption of all economics after Adam Smith, namely, the self-interested behavior of decision-makers.
I have adopted the phrase "mass inflation" to describe the policies of the Federal Reserve up to the appearance of hyperinflation. I have defined mass inflation as follows: whenever the consumer price index is rising at a rate of something like 20% to 30% per year. I am arguing that I do not think it is likely that the Federal Reserve will continue to follow policies that result in a rate of consumer price increase much beyond 30% per annum. I do not think we will get anything like triple-digit price increases as measured by the consumer price index.
This means that, at some point, the Federal Reserve will cease to inflate the monetary base. It will cease buying Treasury IOUs. It will cease buying any assets without simultaneously offsetting the effects of the purchase by means of the sale of some other asset in its portfolio. It will adopt a policy of dramatically reduced monetary base inflation.
This will trigger a major recession. I say this because of my commitment to the Austrian theory of the business cycle. I think all other schools of thought will admit the same thing, namely, that any attempt by the central bank to stabilize the growth of money after consumer prices are rising by 20% to 30% per year will trigger a major recession.
There is nothing unique about a scenario that predicts a major recession in the wake of the stabilization of the money supply, once consumer prices are rising at 20% to 30% per year. In fact, all schools of thought except the Austrian school will scream bloody murder if central banks revert to a policy of monetary stability in the face of the worst recession since the 1930s. They will all be saying that the Federal Reserve, or some other central bank, must return to its policies of monetary expansion, and buy the government's debt, in order to forestall Great Depression II.
This means that I am predicting a scenario in which central banks, especially the Federal Reserve, will not adopt policies of hyperinflation. They could do so, but this will only delay the ultimate deflation and depression. Hyperinflation cannot go on for very long. Not in an industrial economy, anyway. The longest period of hyperinflation that I'm aware of was in Argentina in the 1980s and early 1990s. That lasted almost a decade. But nothing like this has been experienced in any Western industrial nation. Hyperinflations last at most about three years. The last major ones in the West were in 1921-24.
So, what would be the purpose of the Federal Reserve adopting a policy of hyperinflation in order to purchase Treasury debt? The policy will ultimately be defeated by the effects of hyperinflation in the economy. There will be a reduction of productivity. There will be a reduction in the division of labor. Then, when people finally give up any hope in the future of the currency issued by the central bank, they will abandon the use of that currency. At that point, the central bank has to impose a currency reform.
When that takes place, the government is still stuck with all of its obligations. It has promised medical care and retirement subsidies to virtually all Americans. Those debts will not be canceled after the currency reform. So, the ultimate problem that is facing the government, namely, the threat of default, remains a threat after hyperinflation ends. So, from the point of view of politics, there is no long-term advantage for the central bank to inflate the currency to such an extent that consumer prices begin to rise more than 30% per year. The central bank could continue the policy, but why? What's in it for central bankers?
People hear the phrase "mass inflation," and they think "hyperinflation." This is understandable, because the two phrases have been used almost synonymously within the inflationist hard-money newsletter writers for over 40 years. I have adjusted my use of these terms because of my sense that the FED will not risk destroying the currency. So, when I use the phrase "mass inflation," I do not mean hyperinflation.
If the reader sees me use the phrase "mass inflation," he should immediately think of this scenario. First, prices will rise by up to 30% per year. Second, the Federal Reserve will adopt a policy of stable money after prices are rising at anything like 30% per year. When it does this, it will create a recession. If it adheres to this policy, there will be a deep recession. Thousands of banks will go under. When they go under, the money supply will shrink. This will exacerbate the process, leading to the worst depression in history.
The Federal Reserve at some point will go back to its policy of monetary expansion in order to stop this decline. But the psychological effects of the decline will condition people to believe that they had better get currency in their hands, and that they had better not go into deep debt. This will change the investment psychology of the entire West. So, when the Federal Reserve expands the monetary base, this will not lead to price increases comparable to the expansion of the monetary base. That is what we have seen since 2008, and we will see again.
I do not believe that the Federal Reserve will commit suicide. I believe the Congress will not kill it, unless Congress is attempting to start a government bank, which will then adopt policies of hyperinflation. So, I do not expect to see the Federal Reserve sit on the sidelines permanently, while the money supply contracts, while the economy goes into massive depression, and while major New York banks are threatened with bankruptcy. The Federal Reserve will re-enter the marketplace as the lender of last resort, and it will attempt to reverse its own policy of monetary stability, precisely because this policy will lead to a depression.
In other words, I am saying that the Federal Reserve will continue to do what it has done since 1914, namely, operate in between mass inflation and hyper-deflation. It will do its best to find some middle path that will enable it to keep the economy from going into a deflationary depression. In other words, it will continue its policies of monetary expansion in order to offset the results of that policy in the capital markets in the labor markets. It will not accept a free market policy of central bank suicide. It will not let the major New York banks go under. It will probably intervene to prop up the FDIC.
In other words, I think the Federal Reserve can continue to interfere with the free market for decades to come. I don't think we are going to see hyperinflation, nor do I think we are going to see a system of free banking which is tied to a gold coin standard. I do not think we're going to see liberty in money until such time as the entire moral and intellectual worldview of the nation's leaders is transformed. In other words, I don't think that Congress will adopt policies consistent with Ron Paul's legislative ideal.
TIMETABLES AND SEQUENCES
There are people who honestly believe that somebody is going to give them a timetable. These people are naïve to the core. They are going to lose all their money if they take seriously any such predictions on the part of some would-be guru. I realize that some investors honestly believe that such gurus know what they're talking about, and will continue to know what they're talking about, thus enabling the investors to beat the markets on a consistent basis. About the only way anybody could have done this was to have bought Berkshire Hathaway shares in 1960 and held the shares to the present.
We can make predictions about sequences, but I believe that only a charlatan will put dates on these sequences. If somebody puts a date on a specific day regarding what is going to happen in eight years, you will not believe it. I think the same is true of anybody who designates a specific month. Depending on how far out we are talking about, anybody who identifies particular year is a charlatan. Yet some investors desperately want to make risk-free decisions with their money, on a one-time basis, and so they go in search of gurus, who always turn out to be charlatans or else wildly overconfident.
I am saying as clearly as I can that I do not believe the Federal Reserve will ever voluntarily surrender its power over the economy. It can be taken away by Congress, but if it is, it will probably be replaced by a system that is worse than the Federal Reserve. I don't think that Congress is going to vote the Federal Reserve out of existence, and take back all of the gold that the Federal Reserve says that it is storing for the government, to be placed in Fort Knox or some other warehouse. I do not believe the federal government is going to adopt a gold coin standard which it will respect by refusing to expand the money supply, no matter what happens. In other words, I do not think we are headed back to anything like a free market in money in my lifetime. I think the Federal Reserve System will continue to operate as the enforcing arm of the bankers' cartel.
There will be a great default by the federal government before the Federal Reserve goes out of existence. In other words, there will be an end to the policy of hyperinflation, which will involve the refusal of the Federal Reserve to buy massive amounts of IOUs from the Treasury Department. This will force the Treasury Department to offer a very high interest rate to investors in order to persuade them to purchase the IOUs, or else Congress and the President will find a way to default on the political promises made by prior Congresses and prior Presidents. As to who will lose and who will win in this political bargaining, I do not know for sure. What I do know is that most people are likely to be losers, but it is still not clear to me whether this will be accomplished by raising the age of retirement and the age of Medicare to new retirees, or whether there will be a wholesale default across the board on the entire system.
I think Congress will do what it can to delay the day of judgment, which is why think it is more likely that Congress will vote to raise the retirement age and to raise the age of access to Medicare, which will become the major producer of red ink in the government's budget.
I do not think that we are anywhere near the day of reckoning for the central banks of the world. I have made this clear in the past, but apparently I have not made it clear enough, because I'm still getting questions about this. We are nowhere near mass inflation. We will not even have a hint of that until consumer prices are rising above 10% per annum. We are nowhere near that situation today.
So, when people ask me if I think there is going to be deflation, I tell them yes. I have told them this for over 45 years. The only thing that has changed in my thinking is the sequence. I no longer believe that it is likely that we will go through a period of hyperinflation as a prelude to the ultimate currency reform, which means monetary deflation, price deflation, and depression. I think central banks will continue to pursue the same kinds of policies that they have pursued since 2008. I think they will inflate. I do not think they will cease to buy assets, meaning I do not believe they will cease to expand the monetary base.
How long will they hold out? How long will they continue to expand the monetary base? I cannot tell you. I do think they will face the day of reckoning when consumer prices are rising at 20% per year or higher.
All inflationists are ultimately deflationists. I have never seen anybody write that hyperinflation can continue for a decade, two decades, or a century. Once the currency system no longer functions in the division of labor economy, is abandoned by the government and the central bank. The most recent case of this is Zimbabwe. It had hyperinflation, but that only lasted a couple of years. The economy ceased to operate in terms of the Zimbabwe currency system. This is the fate of all hyperinflations.
CONCLUSION
If anyone thinks I think there will be imminent monetary deflation, he has misunderstood my position. I do not believe that there will be long-term price deflation in the consumer price index -- that it will last for decades. I believe there will not be long-term monetary deflation. I believe that there will not be long-term price deflation. That would require the Federal Reserve to stop buying assets, stop bailing out New York banks, stop supporting the FDIC, and allowing Great Depression II.
I think there will be rising monetary inflation and rising price inflation until such time as we enter a phase that I call mass inflation. I do not think this is going to take place on Obama's watch. I am not saying that it is impossible to imagine such a scenario before 2017, but I think that scenario is unlikely.
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