Tag Archives: deflation

Deflation is the Name of the Game

You are worried about your job. There are rumours of layoffs; your in-laws’ pensions might be at risk because the company they worked for for years is teetering on the edge of bankruptcy. Meanwhile, as the malls empty, sale prices abound. Sitting there on the table in front of you is a pile of credit card bills, mostly priced at something over 18% interest …

Is it any wonder you’d be taking any spare cash, and any “stimulus cheques” (like the carbon tax offset in BC, or the ones sent out earlier this year in the US), and paying down that debt? That you’d be cutting back on your own spending (“it’ll be cheaper still in a bit”) and, after years of not worrying too much, socking upward of 15% monthly into your own personal rainy day fund?

Now, tell me: if Jack Layton’s beloved “ordinary Canadians” are smart enough to figure all this out, why can’t professional economists and politicians?

This morning I arose to find the Prime Minister’s musings on opening our wallets to spread cash around. As with most “professional” economic thinkers, the answer to deflation is deemed to be ever more liquidity and cash injected into the system, to get people to spend. Slightly more sensible — but note the word slightly — was the view of the economists working for those paragons of greed, the banks. The sensible part is building infrastructure for the future; the really silly part is using borrowed money to do it, rather than doing what Joe and Jane Canadian are doing: cutting out unnecessary expenditures, making choices between this and that, getting in the black and conserving cash.

Ah but, Monty Python style, the Sensible Party has morphed into the Silly Party overnight — with the Really Silly, Outrageously Silly and Perpetually Offended and Deeply Silly Parties sniping from the corners. I don’t know what the headline writers will do with Prime Minister the Rt. Hon. Tarquin Fintimlimbimlimbimwhimbimlin Bus Stop Ftang Ftang Olay Biscuit Barrel, but that’s where we’re headed. Probably call him Oil of Olay for having slid one by us all in the last election or something.

One would think that eighteen years of experience in Japan since 1990 might have provided a note of caution before Canadian policy makers had rushed to the “throw money at the problem and worry tomorrow about how to pay for it all” school of economics — the real Keynes would rise up in righteous anger at this misuse of his ideas if so many experts weren’t piled higher and deeper upon his grave — but after all, if you’re liberal in your thinking, history is bunk and means nothing. (Besides, didn’t Japan recently call on the rest of the world to copy their 0% interest rate and 180% of GDP debt ratio policy on the grounds that “it hasn’t worked for us, but maybe in 2008 it’ll work now for no good reason”? Don’t they call it insanity when you try the same thing again and again in an unchanged environment and expect the results to differ “this time”?) The words of others, however, loom large: “they’re doing it, so we should, too”.

Lemmings walking off a cliff into the sea couldn’t do a better job. Or are our political figures all locked in their high-school years, where peer pressure can outweigh almost any consideration of rational and moral behaviour?

What is far more likely to happen, should we walk off this cliff, is the sort of thing James Howard Kunstler has often written about in his blog, Clusterfuck Nation. People praise Franklin Delano Roosevelt for the New Deal: they forget that the Great Depression was intensified as he spent the US Treasury bare, didn’t get results, and was forced to trim back and increase the tax bite simply to stand still back in 1937. We have been suffering from an excess of money creation via credit and prices and M3 (money in circulation including credit) must reset for the economy to improve. We can try to forestall this, in which case the deflation drags on and on, the damage gets worse and worse, our public finances go back into the toilet and down the drain, Canadians become ever-more impoverished … or we can change the way we live to recognize that the era of excess finance we have lived through is gone forever.

Government, as we know it, to survive, will shrink — or we’ll just end up doing away with it. Money, as we know it, to survive, cannot be inflated to a fraction of its current value — or we’ll create some non-government money and go “off the books”. Communities will have to be more local and more self-reliant: big corporations, big unions, big governments and big continental scale anything is a function of cheap and abundant resources, and while there’s lots of resources left the cheap and easy to get ones are mostly used up. (Don’t be fooled by the recent collapse in oil prices — that was the blowing up of the bubble in commodities as yet another haven in the markets from the last destroyed bubble in real estate — look instead at the supply and demand situation.)

In a deflationary period — common in the nineteenth century, rare in the twentieth, and now present in the twenty-first — you keep real interest rates high enough to make savings and investment pay; you minimize unnecessary expenditures, you focus your resources, you encourage initiative and new sources of economic activity rather than prop up old ones and you make money into a stable store of value.

Unfortunately, for those who drew the lesson that you flood the system with ever more bail out money and “liquidity” when the problems are ones of insolvency, radical misallocation of resources and too much unproductive activity draining the real economy, ramping up the printing presses and dropping bales of cash by helicopter is just too tempting. Besides, for the power-lovers, who gets the handout, and on what terms, holds far more reward than does their own restraint.

In the words of W.B. Yeats, in his poem The Second Coming:

Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

Sauve qui peut!

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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.