Reality in the Economy

The central bank is an institution of the most deadly hostility existing against the Principles and form of our Constitution … Bankers are more dangerous than standing armies … (and) if the American people allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the People of all their property until their children will wake up homeless on the continent their Fathers conquered.
—Thomas Jefferson

The vast majority of Canadians are woefully unprepared for the world that is emerging around them. This is not simply because the savings rate in the country has fallen, year by year, nor is it because their financial assets have been shredded and diminished by the market meltdown taking place over the last five weeks.

Simply put, it is because they have never known an era where the value of money was not destroyed a little bit at a time. (We call this inflation.) As a result, the deflation which is now spreading is alien to them, and the moves they will make are likely to be exactly the wrong ones.

Worse still, even as deflation spreads, inflation continues to work its way through the system in a blow-off, so, unless you check your presumptions at the door, leave all ideology behind, and learn to actually look at the facts on the ground, you’ll miss what is happening.

Deflation: Killer of Debt

Our money supply need not be inflated by the Bank of Canada rolling the printing presses (despite the endless shots of sheets of currency coming off the press that the CBC — Newsworld and The National — have been using this week). Furthermore, since we are not running a deficit, and have not for years, we are not “printing” via the issuance of debt instruments of value greater than tax receipts (as are all our major trading partners).

Instead, inflation in the Canadian economy is created through the hidden magic of fractional reserve banking. In other words, that “so-called” friendly monolith found on all four corners of most major intersections in the downtowns of Canadian cities and towns are the agents of monetary destruction.

Here’s how: debt is used in the economy to jump-start activity, to allow asset growth to occur in advance of actually having the money to capitalise the start. Whether this is to allow you to buy a house, or whether it is to allow a business to begin and grow, debt is the accelerator.

When banks must maintain full reserves to pay off depositors, only a limited amount of lending can ever take place (loans of a duration less than the time depositors have committed their funds to the bank). Acceleration of debt creation occurs when fractional reserves are allowed: the bank must maintain only a percentage of its maturing deposits against its loan portfolio. Gearing ratios in fractional reserve banking today (depending on jurisdiction and strength of the institution) from 5-6% to as high as 11-12% (as is common in the USA and why it is in such trouble now).

Send too much debt into the market, and too much money chases productive economic activity. This in turn causes prices to drift upward — “too much money chasing too many real estate opportunities and not enough housing stock”, for instance, something we have lived through this decade — and for risk to be taken on and not acknowledged (high leverage mortgages, investments in marginal business plans, etc.). The resulting day of reckoning does help reduce the floating money supply and deflate things slightly, but in general this is not a universal situation. When it is, recession (if mild) or depression (if not) is the result, and deflation emerges into sight (cash becomes more valuable; prices drop to find buyers, etc.) for a while.

Central Banks Must Increase Debt

So, really, the only lever the Central Bank has is to increase debt, which it does through interest rate adjustments (as an indicator: for the actual interest rate the economy is using, see the treasury bill discount rate and the inter-bank lending rate — central banks cannot impose an interest rate despite all the rhetoric) and, less frequently but with more impact, by changing reserve requirements.

The reason a central bank — any central bank — wants more debt is because debt already taken out becomes a drag on the economy. A portion of earnings must now go into loan servicing (and, one hopes, repayment), plus, with a loan issued, a lender has restricted room to create new loans (and hence, new money). Today it takes between $5.00 and $6.00 in new debt to generate $1.00 in economic activity — activity which must provide for living expenses, continuity of on-going operations (both family and business), debt servicing, etc. In other words the crisis in Federal and Provincial Finances that led to revulsion at the thought of running a deficit was an early warning signal of the degree to which ordinary people and businesses are “tied down” now.

This is why Governor Carney of the Bank of Canada keeps dropping interest rates — he gets the effect of sinking the Canadian Dollar (and, eventually, even more takeovers of Canadian companies as they become “cheap”).

But eventually banks start to realise the combined risk their loan portfolio represents: typically, this comes as lay-offs begin and as more and more repayments default to interest only or monthly minima as inflation outpaces income growth. At first they raise their loan loss provisions, eating into earnings. When this becomes an unpalatable number — for the earnings per share of their stock is also an issue — they restrict further lending. This is why prior interest rate cuts in 2008 did not lead to looser credit, why the banks had to be jaw-boned into “passing on” the Bank of Canada’s changes, and why credit remains very tight.

Lag Times in Inflation

Price signals tend to lag policy changes by 9-18 months. As a result, even while the underlying economy is deflating (making existing debt more expensive in terms of the ability to service it) prices continue to escalate. Products and services which are easily avoided or substituted see this end sooner than those which are more difficult to move away from: this is why energy and food could accelerate, and why house prices crested but stubbornly fall only slowly. It is why financial assets (which, for many Canadians, are held in unit trusts, mutual funds and pension funds rather than directly) have remained invested in the market only to suffer the effects of rapid decline recently as other forced liquidations have moved the markets downward for lack of new buying.

This suggests that responding to the opportunity to take on new debt at this time is likely to be a very expensive, potentially ruinous move. The unwilllingness to borrow, of course, means that the inflation multiplier is also broken for a “lack of customers”.

Therefore, for a number of years to come, prices will fall, markets will fall, asset values will not recover, debt will be harder to service — and cash will be king.

An Interesting Knock-On Effect

Oddly enough, this supports another emergent situation: the end of cheap energy and easy-to-produce commodities. Our debt-based system depended on growing supplies of cheap, easy-to-extract and refine commodities to maintain its growth: take that away merely by requiring more expensive production and tightened (not reduced) supply and growth as we have known it becomes impossible. Environmentalists are right (but not always for the reasons they advance) in saying the environment controls the economy. A better way to put it is “nature always bats last”. Take the cheap stuff and consume it, and it gets harder to carry on.

With that in mind, we should be winding down our current financial system and moving toward one which allows for more of a steady-state environment, where growth comes slowly but from real production and advancement rather than from a “natural subsidy” (a robbing of the future to pay for the present no different in kind from running a deficit and leaving the cleanup to the next generation). Our policy makers do not always understand this: it means that firms must be allowed to die and be replaced with new kinds of work, for instance. All money thrown at companies to “keep them going” is lost money — debts that will never be repaid. Our Finance Minister got one thing right earlier this year in eliminating the 0% down/40 year mortgage (a debt creation engine designed to take on high risk, non-performing loans), just as he did in taxing income trusts. Other moves, though, have not been well-grounded. It is because the understanding of how reality works in the economy isn’t there; neither is the philosophical thinking to work out the interrelationships.

Now you are started on this journey. May it help you preserve yourselves and prosper. This transition will not be pleasant: there will be much pain. But working out the deflation and reinventing the system is what is needed. Nothing less will do.

We can start by closing down the Bank of Canada, before it impoverishes us all into decades of penury and recovery. More at a future date on what to do without it.

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