Guest Post: The Sound Of One Hand Clapping - What Deflationists May Be Missing

Tyler Durden's picture

Submitted by Chris Martenson of and creator of The Crash Course

The Sound of One Hand Clapping - What Deflationists May be Missing

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 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 the 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 of '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?) 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 (from $26 to $52 trillion) that occurred between 2000 and 2008 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 a world exists where 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 in spades.

But let me ask this; what prevents the authorities from simply storing them out of sight in perpetuity? 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 have 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 to 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 consumer's 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.

About this process there can be no doubt, 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 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 as 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 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."


Chris Martenson is the creator of The Crash Course a free online video explanation of how trends in the Economy, Energy and the Environment are converging on a very narrow window of our future. Additionally at his website


* 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.

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nhsadika's picture

I believe the same.  The housing market is the lynchpin of this game, keeping prices up somehow and doing a massive transfer in the dark via asset purchases and cheap money.

What that says to me is STAY FAR away from Wall St - don't invest in banks, don't short the Fed.


What that also says to me is the MANIA won't easily jump the shark to the real world.  If you're a bear stay on Main St.


Long Fed, Short Main.

ghostfaceinvestah's picture

There is no dark conspiracy in the housing market - delinquencies are growing, you can look at any report - Fannie's monthly summary, private label remittance reports, etc.

These losses have not been "recognized" (i.e. houses liquidated) because of the government-imposed foreclosure moratoriums and the HAMP program.

Pretty soon these REOs will hit the market, they are already starting to.

Project Mayhem's picture

Chris Martenson is win.  So is Dada for that matter.

Anonymous's picture

What is the value of evidence if it goes unseen or unacknowledged ?

defender's picture

priceless if you act on it when no one else will.

SWRichmond's picture

No.  Being right at the wrong time is the same thing as being wrong.

Anonymous's picture

Seems that it shows up in the USD $ taking a dive and gold breaking out to all time highs and skying, both of which is happening.

Anonymous's picture

Interesting - couldn't the Fed then start to use 'selective' application of honest accounting as a knob to 'destroy' money in a controlled manner? If inflation starts up, just start leaking money back into the black hole...

Anonymous's picture

Yeah why not.

Harbourcity's picture

The problem is that foreign countries smell blood in the water.

bruce wayne's picture

Contracts for commodities are jumping through the roof though.  If we have a prolonged period of shrinking goods and services, these commodities will not need to be used but there is incentive to mine, drill, harvest, etc.; in general pull out of the ground.  At some point these commodities need to hit the market and there will be no way to keep prices up at that point.  Financial assets are skyrocketing in value because they are the only assets that have liquidity at the moment.  When this liquidity ends, i.e. when these goods are not a paper profit but a physical holding that cannot be stored somewhere the shell game must come to an end.

Mos's picture

Any chance they, the Fed, pull this off and avoid a total financial and social collapse of the US?  Seems to be working so far other than the dollar sinking, things getting worse for main street, and growing populist outrage.  If they can somehow control those three issues they may have a chance although I think the American people are starting to wise up to what is going on and I see a lot of incumbents getting voted out in 2010. Not to mention black swans that are likely to occur either domestically or internationally that the Fed won't be able to control.

Anonymous's picture

No chance, and it has nothing to do with incumbents, democrats or republicans. It has to do with the fact that the path we are on is not sustainable. Infinite growth is not sustainable in a finite world. Did you not read the article?

Anonymous's picture

Actually in the article Chris said that he expects inflation, which means exponential monetary creation to continue. It seems it is you that should re-read the article. Theoretically there is no need for the system to crash just because more money is required to pay off interests on existing loans. Just keep on adding zeroes, no biggie! Just add them slowly so the frogs don't jump out of the pot.

Noir's picture

Your icon cracks me up everytime I see it :-)

Yes, I'm wondering what will be the Black Swan for this situation. Some European nation goes under? Or is it gonna be the stonewall by the BRIC nations.

Daedal's picture

Dadaism, not to be confused with Daedal-ism.

Great post. I'd like to see if Mike Shedlock has anything to add.

Project Mayhem's picture

Mish would say go long the failbuck -- and there is no systemic corruption or collusion, only 'incompetence'

geopol's picture



mish the only living brain donor..

Hephasteus's picture

But they are about to finally get it figured out. This time it will be different?

Anonymous's picture

Off topic, however can anyone explain why the bid-to-cover of 6.29 was so high for the latest tbills auctioned?

Why is there so much demand from the primary dealers for 16 day paper?

koaj's picture

prices on things we dont need like houses and cars and boats are coming in yet prices on goods we need like oil and food are going up

fantastic. FTW American Middle class

RatherBFlying's picture

... except we're not. I'm buying gasoline cheaper than I did the entire past year, rents are going down, natural gas to heat my house is down, food in the grocery is down in price, eating out is cheaper (at least in my neck of the woods.)

The only part of Chris's analysis I see above is that the Fed isn't buying the worthless loans from the Banks... they are taking them on to their books, but they can exchange them back anytime they want. The Banks know that and that's why they aren't restarting lending. These aren't really "reserves" in the traditional sense. They are window-dressing that allows the FDIC to not execute their legally mandated duty to liquidate insolvent banks, which would wipe out equity and bond holders like the Pension Funds.


lovejoy's picture

One of the best explanations I have seen for those large bank reserves. Thus if real estate tanks more, the FED may decide that it longer wants to hold the collateral. I would think that the FED steps in before FDIC if any goes wrong. I can also see why the FED is against any audit. I don't think think they are worried who they money to -- they gave money to everyone. They don't want the public to know that FED that generally only takes AAA collateral has taken junk collateral. That would destroy the FED. CAPUT.

perfectlyGoodWhiteBoy's picture

I thought we were a credit economy, not a money economy.  Does MZM include credit?

SWRichmond's picture

Astute.  It appears the author conflates money and credit.

In a fractional reserve system, what is being loaned?  Capital?  Money?  Credit?  If capital starts off being real store-of-value money capital, then is loaned out at 10:1 in a fractional reserve system, what exactly are you borrowing?  This is not merely a semantic question, because when the loan defaults, exactly what has been lost?  1/10 of the capital?  Mathematically, how can you measure capital destruction in a fractional reserve system?  I've never seen this discussed anywhere, all discussions conflate money and credit.  Is money capital?  Is fiat money capital?  Is borrowed capital, in a fractional-reserve system even capital at all?

I think we would all agree that capital cannot be printed, yet that is what Bernanke is trying to do.  The whole inflation/deflation debate is a red herring.  You cannot understand the impact of printing trillions of thingies and pouring them into a hole that is tens of trillions of thingies deep and try to figure out what will happen.  It makes no sense at all, because what were the thingies that were lost into the hole?  What are the thingies that are being printed?

Fractional-reserve credit / lending affects price.  If we hadn't been loaning out "credit" at 10:1, would house prices have gone as high as they did?  Of course not. 

So when house prices fall, what is lost?  If we can merely print up replacement tokens, what are the tokens worth?  Why don't we print up enough to make everyone millionares?

Harbourcity's picture

Don't forget the hole that is tens of trillions of thingies deep is still getting bigger as we speak.


SWRichmond's picture

If we can't even define what the thingies are, why does the size of the hole matter?  People say Bernanke can't print it up fast enough to fill the hole; they say that like the thingies are more than mere tokens, like they have value.  If they have value, how can Bernanke just print them up?  And if he can just print them up and they ARE valuable, why doesn't he just print up a shitload for everyone and then we all quit work?  If they DON'T have value, then what is the point of printing them, and who cares how many we print, or how many have fallen into the hole?

Anonymous's picture

Best lines ever... I'm stealing this thank you!

Anonymous's picture

If you guys are relying on "Limits to Growth," you are going to look very, very foolish. The big story in the 21st century will be the decline in the human population, not because we've reached some sort of resource "wall," but because people are not having children.

economicmorphine's picture

That's only true in the west.  If one looks at global population, it is going parabolic.  If we have a population decline it will be because we outproduce the world's ability to sustain that population, resulting in a massive die off the likes of which we've never seen.  The present environment suggests a genocide the likes of which we've never seen may occur as well.  I hope your comment was satire.  It's incredibly naive if it isn't.

Galois's picture

I'm currently reading this book concerning the sustainability of the world population (you may download it for free):

It will probably get very ugly in a few years :-( Especially if you read about the problems the big powers India and China will be facing and consider how desperate they might become. 


BobPaulson's picture

Which is why he cited Malthus in the previous article. The Malthusian end is not pretty, and that is an understatement of the most diabolical kind.

snorkeler's picture

We hit the "resource wall" quite a while ago. I would estimate 50 to 60 years ago.

Now we are beginning to realize what the true cost of feeding and housing this planet is going to be.

It is unaffordable, especially in light of what the climate change issues are going to cost.


As Bob says a "Malthusian" scenario.  The resource wars (no longer disgused by political bs as has been the case to date) begin very soon.

Anonymous's picture

There is a lot of contrivance on the whole Malthusian resource shortage perspective. For example, Haiti was a variegated agricultural country that was able to feed its population, but than through globalization, transnational agri-business undersold local agriculture, which drove farmers off the land and into work for the transnational corporations. The country became a transnational mono-culture agriculturally. Thus Haitians have been eating mud cakes to ward off starvation. This is contrived Malthusian, which doesn't occur if Haiti is left to its agricultural history. So, the same is true for globalization in other countries.

Resource wars are nothing but self-fulfilling prophecy; mainly because those prophesizing are the ones who are going to start the wars. Consider refocus of finances into renewable energies and expending there instead of financing 18th, 19th and 20th century endeavors and the resource shortages are addressed by new paradigms rather than the same tried and failed course of most of history.

Malthusian situations arise as a direct result of empire building. Countries attending to their local populations can stave off mass starvation and, by the way, may also be the way to save the planet.

Anonymous's picture

Pretending debt does not exist? Congress is free to pretend they are not broke is the solution to all our problems? Inflation with huge tax increases, is that the misery index thingy? So the debtor is "off the hook" yet the "new" debt the Fed is sending the US Treasury DOES have to be repaid? The American people, not to mention most taxpayers of the world, are not going to swallow that one.

TumblingDice's picture

Yes. Pretending the losses aren't there is a sure fire solution. How can it possibly fail?

phaesed's picture

Excellent article and perhaps the best analysis I have read from anyone in the present crisis on the actual nature of the problem.

Anonymous's picture

Except for the indefinite part, nothing works indefinitely.

Anonymous's picture

So what will the impact be on the Fed when Ron Paul's bill gets passed and GAO finally audits them? I'm not sure "extend and pretend" will be able to continue past that point.

Anonymous's picture

I truly believe that the President will not sign any such bill. The best scenario (for the banksters) will be to have the bill arrive on his desk just before some holiday adjournment and exercise a nice little pocket veto, thereby having it look like he was not actually against it, just sort of a "hey, Congress didn't get it to me in time to sign - what could I do?"

Anonymous's picture

Great Post.

During the initial phase of the Great Depression there was no deflation. Then it started to take off (-12%-15%). Unemployment soared. Then in Oct 1933, Roosevelt devalued the dollar by 60%. This caused unemployment to fall, but created 5%+ consumer price inflation while assets were decreasing in value. Who isn't to say that the FED isn't going down the same path (get rid of the debt by allowing asset prices to fall, while they devalue the dollar). It's the double edged sword on how to get rid of debt quickly. But it also rapidly lowers the standard of living.

Anonymous's picture

Max Ernst!

Anonymous's picture

We have become an immature society by ignoring the consequences of our actions, instead we have chosen to cover them up and continue with our bad behavior.

HEHEHE's picture

Precisely what has happened.  Bernanke has created a bubble in trader bonuses.  You pay me a salary and tell me I don't have to pay my rent and utilities until 10 year from now and I'll look like Warren Buffet in the short term too.

Anonymous's picture

Wednesday, October 7, 2009
Chaos at Cobo: Detroiters turn out for federal help
Charlie LeDuff, George Hunter and Santiago Esparza / The Detroit News

Detroit -- Thousands hoping to get applications for federal help on rent and utility bills turned Cobo Center into a chaotic scene today.
They came by foot, wheelchair, bicycle and car. About six left by ambulance after tensions rose and people were trampled, according to a paramedic on the scene. One unfortunate soul got his car booted.
Detroiters were trying to pick up 5,000 federal assistance applications from the city at Cobo because Detroit received nearly $15.2 million in federal dollars under the Homeless Prevention and Rapid Re-Housing Program, which is for temporary financial assistance and housing services to individuals and families who are homeless, or who would be homeless without this help.
People in wheelchairs and others using canes were being leaned on by people too weak to stand. Emergency medical technicians on the scene said they treated applicants who were injured during the rush to get inside the venue.
That's what happens when a town full of broke people gets a whiff of free money, said Walter Williams, 51, who came before the sun to get an application and a shot at some federal assistance.
"This morning, I seen the curtain pulled back on the misery," he said. "People fighting over a line. People threatening to shoot each other. Is this what we've come to?"
Outside Cobo on Wednesday, some people reportedly were going through the crowd, snatching the necessary applications from those who'd already obtained them. There also was a constant din of screams from people insisting they be let inside.
LaTanya Williams, a 32-year-old Detroiter, quickly filled out her form because "people are stealing them."
"I am hoping to get any help that they will give me," she said. "Everybody needs help."
By early morning, the applications had run dry. But some hustlers got the bright idea to photocopy the original and sell the copies for $20 a pop. They were doing a brisk business. The desperate are easy prey. The white original applications stated clearly on the bottom: "Do not duplicate -- Must Submit Original Application."
By late morning, however, volunteers from the City of Detroit Planning and Development Department were handing out yellow photocopies themselves.
"I'm not even sure the government will accept those applications," said Pam Johnson, a volunteer. "But it's almost like they had to pacify people. There was almost a riot. I mean, they had to call out the gang squad. I saw an elderly woman almost get trampled to death."
John Paul, a 25-year-old Detroiter, said the crowd and chaos illustrates the need people have for help.
"We need it," he said of the money. "Whatever they have for me is great."
Detroit Police 2nd Deputy Chief John Roach said 150 officers on the scene got a handle on the situation. "There was some pushing and shoving, and some people have fainted," Roach said. "Given the fact that we have 15,000 people down there, I'm surprised things have been as orderly as they are."
It was difficult to estimate the crowd because lines snaked all through the convention center and outside along the building and down the parking ramp along Cobo Arena to the river. One police officer estimated the crowd at 50,000.
More than 25,000 applications were snapped up in less than three hours Tuesday at Neighborhood City Halls. That day, Karen Dumas, a spokeswoman for Mayor Dave Bing, said some people mistakenly believed they would receive cash on the spot.
"That is totally untrue," she said. "There is a process."
Response had been so great that Detroit police and fire officials considered shutting down the process because of the volume of people.
Kelley Turcotte, a Detroit dishwasher, was near the end of the line around 10:30 a.m. today. The 27-year-old just had a son and said he is only squeaking by on his bills.
"I hope the government sees this and realizes the city needs a lot more help than they are giving," Turcotte said.
Luis Irizarry, 35, drove from Flint for the chance he could get assistance. He later found out only Detroit residents are eligible. He said it was a shock to see this many people in need.
"This is ridiculous," Irizarry said about the thousands who showed up.
Tony Johnson came at 5 a.m. Johnson has not found a job in three years.
"If I could win the mega lottery, I'd be tighty-iddy. I wouldn't be here," Johnson said. "But there's no peace 'cause there ain't no jobs. Everybody's looking for the freebie, the hand-out. They don't count me as unemployed 'cause I ain't drawing a check. It's like I don't even exist. But I do. Look around. There's thousands ... millions of us."
Dan McNamara, president of the Detroit Firefighters Association Local 344, was looking down from his office window across from Cobo.
"This absolutely is representative of the struggling middle class in America," he said. "We've been betrayed by the government, Realtors and those who've got. The promise has been broken."

Detroit News Staff Writer Christine MacDonald contributed to this report.

Anonymous's picture

thank you sharing that stiff dose of reality.

a couple quotes deserve another shot:

"This morning, I seen the curtain pulled back on the misery," he said. "People fighting over a line. People threatening to shoot each other. Is this what we've come to?"

"But there's no peace 'cause there ain't no jobs. Everybody's looking for the freebie, the hand-out. They don't count me as unemployed 'cause I ain't drawing a check. It's like I don't even exist. But I do. Look around. There's thousands ... millions of us."

"We've been betrayed by the government, Realtors and those who've got. The promise has been broken."

this is your pain america.
this is your burning hand.
it's right here.
don't deal it with the way those dead people do.
we are god's unwanted children, so be it!

Anonymous's picture

Should have told people Obama was giving out "free" money at the G20 in Pittsburgh. The cops there would have had 30-40K more upset people to deal with. Just a thought.

Anonymous's picture

"If nobody recognizes a defaulted debt on their balance sheet, does it exist?"

"...what prevents the authorities from simply storing them (toxic debts) out of sight in perpetuity? ... I am now wondering if they cannot keep this up indefinitely."

Lets say your rich in the pre-internet days, and you and your wife are on a cruise round the world. During this time your kid (home alone) crashed your sports car and destroyed your garage (it happens, ask Ferris) -- but has rigged the "spy-cam" to show you an old looping video image.

So, you believe with utter confidence that your sports car and garage still exist. Can your son keep this up indefinitely?

Nope. One day you will return and the SWHTF.

Likewise, the government cannot "keep this up indefinitely" -- eventually the money the banks are holding in their "excess reserves" WILL come out into the real world. Eventually that big shadow inventory of houses WILL be sold at auction (if not by the banks, then by the local gov'ts when the prop tax defaults happen).

Eventually, boomers WILL want (need) to sell their stocks and bonds.

Indefinitely is a long time.

Anonymous's picture

If the FED can create money out of thin air, with the push of a few keys on the magic FED computer. Why can't the FED make bad debt's disappear into thin air, with the few clicks of the delete button? No one knows what they are up to. No real authorities to answer to.

If I had a magic money computer, I could create some electronic cash. Buy all my friends and families mortgages, credit card debts, car loans, etc... from whomever was holding the notes. Then I could rip up the notes. I would give my friends and family the best Christmas gift of all time, a debt free life. Sure the magic money I created would make all the other money worth a little less, but think how much my friends and family would thank me for erasing all their debts.

Did I get the gist of the article? As I stare at a 10 trillion dollar Zimbabwe bank note above my desk, it's beginning to look alot like Christmas.