This is a piece that I wrote in response to a request for a guest
post over at ZeroHedge. It ran there yesterday garnering some nice
attention and a diverse range of comments beneath.
Based on some of those comments, this article represents nothing more
than my attempt to find an explanation that matches the data.
My central thesis to this crisis, developed a few years before it even hit, is that the economic troubles are the
symptoms, while the money system itself is the
cause.
My views on this are expressed in the opening of an article that I initially penned in 2006 but updated in 2008:
Within the next twenty years, the most profound changes in all of
economic history will sweep the globe. The economic chaos and turbulence
we are now experiencing are merely the opening salvos in what will
prove to be a long, disruptive period of adjustment. Our choices now are
to either evolve a new economic model that is compatible with limited
physical resources, or to risk a catastrophic failure of our monetary
system, and with it the basis for civilization as we know it today.
In order to understand why, we must start at the beginning. While it
was operating well, our monetary system was a great system, one that
fostered incredible technological innovation and advances in standards
of living, two characteristics that I fervently wish to continue. But
every system has its pros and its cons, and our monetary system has a
doozy of a flaw.
It is this: Our monetary system must continually expand, forever.
The article above provides the
big-picture backdrop that drives my long-term vision and thinking. I
raise it now so that you’ll understand that I principally view the
economic world through a monetary lens.
The hot topic of the day is “Inflation
or Deflation?” and the camps are firmly divided into groups of
inflationistas and deflationistas. When asked which camp I am in, I
reply “Yes.” Some would say that puts me in the
confusionista camp, but I actually have an explanation for why are living in a world encompassing both.
From a technical perspective, we are absolutely in one of the most
powerfully deflationary periods in history, yet, besides housing prices
and a few over-produced consumer goods, we find that stocks, bonds, and
commodities are all well-bid at the moment.
While we can ascribe some of this to the artificial wall of liquidity
(come to think of it, is there any other kind?) currently being thrown
into the financial market(s) by the Fed, it leaves hanging the question
of why that money is not being completely swallowed into the bottomless
black hole that the deflationist camp says lies at the heart of our
current financial system.
And they are right; there is a black hole at the center. If we treat
the credit doubling that occurred between 2000 and 2008 (from $26 to
$52 trillion) as a normal bubble that will follow the same pattern of
decline as numerous historical bubbles, then we might reasonably predict
that some $26 trillion of debt will somehow “go away” over the next 6
years. This is indeed a massive black hole.
Yet everything just keeps perking along. What gives?
The answer, I believe, requires us to ask a Zen-like question along
the lines of, “What is the sound of one hand clapping?” That question
is, “If nobody recognizes a defaulted debt on their balance sheet, does
it exist?”
Suppose, for the sake of argument, that there is a world in which
banks are allowed by their regulators to pretend their default losses
simply do not exist. And, even more outlandishly, some of these banks
are allowed to sell heavily damaged loans to their central bank at nearly their full original price.
What does “deflation” mean in such a world? Not much, as it turns
out. At least from a monetary perspective, because money is not being
destroyed at nearly the rate that would be expected or predicted by the
size and rate of the defaults.
This is the world in which we currently live. Trillions in probable
and provable losses quietly exist, out of sight, on the balance sheets
of the Federal Reserve
and other financial institutions. If they ever come out of hiding and
onto the books, I think the deflationists will be proven correct beyond
all doubt.
But let me ask this: What prevents the authorities from simply
storing them out of sight forever? Or at least long enough to allow the
wave of liquidity to work its inevitable magic? So far, much to my
great surprise, they’ve managed to do exactly that, with hardly a squeak
from the mainstream press (although the blogsphere is on the job, as
usual). I am now wondering if they cannot keep this up indefinitely.
So from a purely monetary perspective, money can only be “destroyed”
if banks and other financial institutions are compelled to recognize the
losses and take a hit to capital. If the loss is not recognized, no
money is destroyed. At least it is not recognized as gone.
Perversely, when a bank sells a ruined loan ‘asset’ to the Federal
Reserve, it is a double shot of money to the system – the money
initially created upon the issuance of the original loan, which is still
out there in circulation, and a second bolus when the Fed creates money
out of thin air to buy the failing ‘asset’ from the bank. One blob of
money into the system when the loan is made, another when it is bought
by the Fed. One loan, two blobs of money. Many have failed to
recognize this feature of the Fed’s asset purchase programs.
So from this perspective, we could even argue that by employing the
‘pretend and extend’ strategy, coupled with an aggressive Fed purchase
policy, it is possible that more money is being created than destroyed
right now. Which means that from a strictly monetary perspective, I am
not yet sold on the idea that money is being destroyed at the rates
sometimes implied by the deflationary arguments.
Also, the data is not really in support of that notion either:
Of course, this money needs willing lenders and borrowers, which brings us back to the matter of price deflation.
Out in the real world, where consumers and producers exist, the
bursting credit bubble has severely cut off consumers’ access to and
desire for new credit, and producers have dialed back excessive capacity
and cut their prices in order to attract business and survive.
There is no doubt about this process, but here I would argue that
falling prices are currently as much a matter of supply and demand as
they are a monetary issue. In other words, the price deflation that we
are currently seeing is not a pure monetary phenomenon.
Which means I think we are in a bizarre hybrid world, where deflation
should be the order of the day, but it currently is not, because its
impacts are being held in abeyance by the simple expedient of pretending
the losses do not exist.
My current outlook calls for productive capacity to continue to fall
out in the real world, even as the Fed conjures more money into
existence in the make-believe world of ‘high finance.’ (What are they
smoking over there?).
Is this not a recipe for eventual inflation? More money, but fewer goods and services? History says ‘yes.’
All that said, I would not disagree with the notion that there’s
another year or three of grinding along (where stock and bond prices are
concerned), possibly down, but maybe not, before the monetary/goods
imbalance comes charging out of the chute ready to throw off the unwary
and trample them in a blistering round of inflation.
But it could be sooner than that. Or later. The point here is that
we really don’t know, and because our monetary system operates on faith,
it means that we have to be prepared for the fact that a shift could
happen at any time. Nobody can predict when a school of fish will
suddenly turn to the left. Who knows what final trigger will cause a
critical minority to suddenly determine that they’d rather hold things
other than paper?
For now, while I understand and appreciate the deflationist argument,
the only thing that would convert me fully to that camp would be a
sudden return to rigorous application of honest accounting. If you
derisively snorted at that last sentence, then we share the same
assessment of the likelihood of that happening any time soon.
In order to answer the main question of this article, we regretfully have to turn to Dadaism* to develop an appropriately absurd non-sequitur:
“
What is the sound of one hand clapping? Insanely high stock and bond prices.”
* Dada was a protest by a group of European artists against
World War I, bourgeois society, and the conservativism of traditional
thought. Its followers used absurdities and non-sequiturs to create
artworks and performances which defied any intellectual analysis.
The founders included the French artist Jean Arp and the writers
Hugo Ball and Tristan Tzara. Francis Picabia and Marcel Duchamp were
also key contributors.
The Dada movement evolved into Surrealism in the 1920′s.
