Guest Post: Taking On The Fed - What The Deflationists Are Missing

Tyler Durden's picture

What the Deflationists Are Missing
by David Galland, Managing Editor, The Casey Report

An interesting article by Ambrose Evans-Pritchard came my way the other day. It’s worth a read, if for no other reason than that he paints an appropriately dark picture of the current state of the U.S. economy. You can read it here.

While I very much share Mr. Evans-Pritchard’s view that the global economy is far from out of the woods, our views diverge in that he sees devastating deflation speeding our way down the tunnel. Casey Research readers of any duration know that we see devastating inflation. 

While we could both be right, with deflation first and inflation later, I’m not so convinced.
For starters, there is already a massive inflation operation being run by the Fed, evidenced in a historic spike in the monetary base over the last two years. 

And the Obama administration is far from done.

The Democrats’ reinvigorated focus on jobs – the single most important factor in this November’s elections – will soon translate into a flurry of new initiatives designed to put people back to work, most of it funded at taxpayer expense.

To believe in the deflationary case would seem to require believing that Obama and his minions are ready to forgo any further political aspirations by collectively putting their feet up on their desks for the balance of their sole term at the apex of global power.

Given Obama’s meteoric rise to power – evidence that he possesses a certain drive and competence in the game of politics – that seems highly unlikely. And so it seems safe to assume we’ll soon witness aredoubling of his efforts to keep interest rates down… to make it easy and cheap for strapped consumers and businesses to keep borrowing… and to otherwise flood the economy with money.  

In a deflation, the value of the money increases – which is actually a pretty desirable thing, if you ask me. Inflation, by contrast, means that pretty much everything you own in the local currency steadily loses value – forcing investors into a perpetual game of catch-up. It’s hard for me to calculate how the government can dramatically increase the money supply and yet have each of the currency units become increasingly more valuable over a sustained period of time.

Arguing against that point, Evans-Pritchard makes the case that the U.S. government is making much the same mistakes that were made in the first part of the Great Depression, i.e., being overly tight with the money. And that the velocity of money is falling.

There are a couple of key differences between now and then, however. First, the Fed didn’t actually know what the money supply was back then. They literally had no monitoring tools in place, mostly because no one thought it was important enough to track. Second, they didn’t have fiat monetary powers. Today, neither of those factors apply.  

Everyone knows what the money supply of the U.S. is and watches it keenly. Including our foreign creditors. And so it is not surprising to see the Fed publicly talking about tightening up a bit. But it’s just talk at this point.  

With the economy continuing to struggle, the only reasonable assumption that can be made is that the Fed – in cahoots with the entirely politicized Treasury – will keep shoveling money onto the economic embers, and continue to do so until economic activity again flares up.

That will, of course, require increasing the quantity of money that actually makes it into the economy – but that should be child’s play for Team Obama – with direct hiring and spending, continuing to buy mortgages and other loans to suppress interest rates, forgiving the bad debts of banks, or changing accounting rules so that banks can postpone reckoning day. And that’s just for starters, all of it packaged nicely in the name of the public good.

And once the money starts to flow, there will be a pick-up in economic activity, which will beget yet more money moving around. At first, this money will be a palliative for the economic worries, but then comes the inflation – a small trade-off, the politicians will decide, if it buys them enough of a recovery to make it through the November elections and get the president the second term you know he so strongly desires.

There is something else that I think the deflationists are missing, and that has to do with confidence in the currency. If the U.S.’s many creditors come to agree with our point of view – that the dollar is being led to the altar as a sacrificial lamb to political expediency – then they’ll further reduce their purchases of our Treasuries and start trading their dollars for stronger currencies and tangible assets, including precious metals.

At that point, interest rates will have to begin rising to attract new buyers. As you can see in the chart of long-term Treasury bond rates, a significant move off recent lows has already occurred, and rates are looking poised for a breakout to the upside.

Of course, the higher those rates ratchet, the more it will cost the U.S. government to carry its massive debt. While rising rates will continue to drive demand to the short end, suppressing those rates, in time the sheer quantity of paper that will have to be rolled over, and the rising tide of inflation, assures that short-term rates will have to rise too.

At that point, the train begins to leave the track.

As the train wreck approaches, the government is going to have to find creative new ways to fund its social contract with impatient voters. Perhaps, for instance, pegging everyday fines and assessments to the amount of income a person makes. Executed brashly, such policies might even allow the government to charge a person of means, say, $290,000 for a speeding violation.

I know what you’re thinking: C’mon, let’s be realistic – that could never happen. Think again…

Europe slapping rich with massive traffic fines


The Associated Press

Sunday, January 10, 2010; 11:30 AM

GENEVA -- European countries are increasingly pegging speeding fines to income as a way to punish wealthy scofflaws who would otherwise ignore tickets.

Advocates say a $290,000 (euro203,180.83) speeding ticket slapped on a millionaire Ferrari driver in Switzerland was a fair and well-deserved example of the trend.

Germany, France, Austria and the Nordic countries also issue punishments based on a person's wealth. In Germany the maximum fine can be as much as $16 million compared to only $1 million in Switzerland. Only Finland regularly hands out similarly hefty fines to speeding drivers, with the current record believed to be a euro170,000 (then about $190,000) ticket in 2004.

The Swiss court appeared to set a world record when it levied the fine in November on a man identified in the Swiss media only as "Roland S." Judges in the eastern canton of St. Gallen described him as a "traffic thug" in their verdict, which only recently came to light.

"As far as we're concerned this is very good," Sabine Jurisch, a road safety campaigner with the Swiss group Road Cross.

Full story here. 

Or maybe the government will force you to convert some or all of your IRA or 401(k) into Treasuries, perhaps packaged up in an annuity. You’d be given the choice of making the switch or making a withdrawal and paying all outstanding taxes at that point. This is something that Doug Casey has warned about for several years now. 

The seeds of that possibility may be headed for the soil: the following article from BusinessWeek reveals that the Treasury is now looking very hard at the trillions in retirement accounts and trying to figure out new ways to “help” the owners of those accounts.

In my view, what’s important in this little dissertation can be summed up as follows:

  1. The current administration and its congressional allies have powerful political motives to soak the economic soil with fresh dollars. The Christmas Eve announcement that the Treasury is removing the $400 billion cap on losses it will cover for Freddie and Fannie is a classic example of how far they are willing to go to keep the money moving.
  2. Unlike the Great Depression, the U.S. is now on a fiat money system – which is purpose-built for the current scenario. Open the taps, and if that doesn’t work, open them even wider. Failing to do so would be political suicide, and Obama and his team are just not into the idea of serving a single term.
  3. Given the size of foreign holdings of U.S. dollars, the nation is faced with a “rock and a hard place” situation, where a sharp loss in confidence on the part of our creditors would likely lead to a currency crisis that drives the value of the dollar quickly lower, at the same time that it drives interest rates higher.

    Something will have to give. We think that something will ultimately be the U.S. dollar, as it’s politically more acceptable to have a failing dollar than a smoking hole where the economy used to be.

    Before this thing is over, I would not be surprised to see a new currency regime adopted that introduces exchange controls and a different category of dollar to be issued for the purpose of paying back foreign creditors. Such a dual-track currency system is nothing new but has been used by desperate regimes numerous times throughout history.

Forecasting the future is actually impossible, as there are just too many variables. But that doesn’t mean that we can’t step back and make certain logical assumptions about the policies the politicians are most likely to deploy in their efforts to retain power.

In the case of today’s world, the only politically logical decision will be to keep on spending until that spending itself becomes a pressing problem, at which point the politicians will turn their attention to “solving” the newest in a long list of problems they have created.

At which point they will no doubt find some creative way to blame the inflation on speculators, profiteers, and the free market.

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Shiznit Diggity's picture

In a similar vein, the latest from Van Hoisington and Lacy Hunt:

Crime of the Century's picture

+1 - a much better offering than Galland's essay. I generally like Casey's outfit, but sometimes it is rolleyes city over there. There is a massive paper (electron) fire burning in the background, and currency crisis hyperinflationists should pay attention to what is, instead of jumping ahead to where they are positioned. It's like they're playing checkers on a chess board (with a nod to The Wire).

Chopshop's picture

major, major boo. 

this cannot be called "research".

this is a college essay and a C minus at that.

Anonymous's picture

Agreed. Assumptions of economic outcomes based on assumptions are nothing more than ones own opinion.

What we do have is concrete evidence of deflation.

Seems so many are wishing for hyperinflation based on simply looking at money supply and ignoring credit losses on asset devaluations or velocity of money.

I'd give this article an F.

Anonymous's picture

I agree with your point, ignoring credit losses AND asset devaluations. By comparison the increase in money supply is a drop in the bucket.

jeff montanye's picture

my question is, given that the most similar historical period to the current is the early '30's and during that far more deflationary time (banks failing and deposits disappearing instead of being insured, unemployment at 20% and no unemployment insurance or food stamps, etc.) the price of gold rose, the share prices of gold miners quintupled, government bond yields rose (sidney homer, a history of interest rates) and stocks declined.  so what investment tips are we to draw from the deflationary hypothesis?

Zro's picture

Seriously. I stopped reading after this: "In a deflation, the value of the money increases which is actually a pretty desirable thing, if you ask me."

Worthless research, if you ask me.

DoChenRollingBearing's picture

I won't give it an F, nor can I predict the future any better than almost anyone else.

I do think that the deflationists are likely right in the short term.  MUCH more money has been lost (value as assets) than has been printed or guaranteed into the system.  CRE and other looming problems seem to me to be bigger than the amount of money they can force into the system to be spent and/or borrowed for now.

But, a determined inflation policy can always win in the end.  If they REALLY WANT to print FRNs of $1000 (Bernanke would be a good choice) and then FRNs of $10,000 (Obama could get this one), well that would get everyone to spend the paper as fast as possible: more money supply * faster velocity = hyperinflation.

dnarby's picture

From what I have read, it seems like deflation first, then inflation, then currency crisis, then "hit the reset button".

Chopshop's picture

such is what i'm intellectually married to as well, dnarby.

prefix a few uber(s) of varying Grand Supercycle degree in there and i'll sign it for it.

WaterWings's picture

Hopefully you're not married married. Going long on Colombians pays excellent dividends. From what I've heard:

john_connor's picture

More money supply does not necessarily mean faster velocity.  For velocity to increase, banks have to start lending and there has to be willing, credit worthy borrowers.

Without money velocity, you could still have selective hyperinflation in imported commodities if other countries lost confidence in the dollar.

Other than that, the US could cause hyperinflation if it printed its OWN money, not FRN's, and handed it out.  Of course they wouldn't do that because the banking cartel owns the government and currency must be issued thru their counterfeiting operation.

Anonymous's picture

Any loss of confidence in the dollar that causes a significant drop will be immediately felt by export dependent countries, which in turn stabilizes the exchange rate. This is my 'race to the bottom' thesis, and gold is the only thing capable of measuring the falling value of fiat currencies worldwide. If the dollar drops too low it will be the rest of the world that suffers more than we do. This can be seen in the recent larger drop in GDP among exporters like Japan compared to consumers like the U.S. China is a price taker, not a price maker, because they have massive overcapacity for world demand that doesn't exist.

john_connor's picture

Agree.  My contention is that gold's price will actually fall initially, but it will fall less than everything else.  At some point, gold's *price* will stabilize and at that point it will be as *valuable* as ever.

BTW, Japan's default is not matter of if, it is a matter of when. 

Anonymous's picture

Japan's default is a black swan that is going to hit investors like a ton of bricks (or should I say gold bars). Demand for the only real risk-free asset, gold, will go astronomical after Japan defaults.

Eternal Student's picture

Well said. I have noticed that the unuseful articles usually don't define what they mean by "inflation" or "deflation". Instead, they sort of assume everyone knows what they are talking about. And usually, they get the meaningful definitions wrong.

The rest of the article seems to strive to justify the implicit definitions without really illuminating anything. And unfortunately, like most inflationists, he completely left out what's been going on in the credit/debt side of things, which makes his view of the money supply nearly insignificant.

Until he gets those basics right, the author is going to be as shocked by what happens in the future as he probably was in September 2008. And as people were in October 1929.



jeff montanye's picture

october 1929 already happened in 2008.  that was the end of the credit cycle.  if we are anywhere in there, we are nearing march of 1930.

Eternal Student's picture

Unfortunately, the credit cycle appears alive and well, for the right people. The total amount of derivatives has increased this past year, and still stands at over $600 Trillion. IMHO, 2008 was just a wake up call.

Anonymous's picture

If by "research" you mean that wonderful stuff that the Banks did before handing out sub-prime loans or the wondrous models created for underwriting the commercial loans you are right. This only comes into the bracket of thoughtful rumination. Hmm no MBA would submit this as a college spreadsheets, no power point. No NO Wisdom is not "research" what a world!!

DavidC's picture

"Unlike the Great Depression, the U.S. is now on a fiat money system – which is purpose-built for the current scenario. Open the taps, and if that doesn’t work, open them even wider. Failing to do so would be political suicide..."

Yup, and continuing with HISTORIC low (Fed) interest rates and pumping HISTORIC high currency (not money) into the system is ECONOMIC suicide. It will not work.

I've read Ambrose Evans-Pritchard's piece and agreed with it. Now, the eternal optimists may say that people like him (and me, I guess) are naysayers, doom merchants and eternal pessimists. Perhaps, just perhaps, we're the ADULTS who are looking at this all unfolding from a REALISTIC (apologies for the continuing use of capital letters) viewpoint who can see (albeit from a more empirical standpoint) how this is all unfolding.

Look at the chart of the Dow since 1900 - there is NO reason to assume that we will NOT have a fall, exponential growth (particularly that we witnessed in the 1990s) cannot continue indefinitely, and we're still very much at the top of the range following that last 10 months' correction - or should I say nascent recovery?

I used to work with a very intelligent person who used to comment on things in a world-weary way (and with extremely funny humour!). I lost count of the number of people who told him not be so pessimistic - he was nearly always right.


BobPaulson's picture

Does your friend who is always right have a blog? Please post URL, could use a nice combination of humour and accurate predictions.

Anonymous's picture

Expanding the monetary base is one thing......but where is that "money" going? If it's simply going into a huge black hole of bad bank debt then it is unlikely to have an "inflationary" impact.

Just look at Japan to see what mass monetary "inflation" delivers. The global economy is in a period of severe deflation and with the financial economy ripped to shreds I cannot see how inflation will manifest in a destructive manner.

If a deflationary environment spells the end of the financialisation of economies then that may be a blessing in disguise. This really is a battle between the financial institutions and the real economy. Whilst the former have all the power the latter have maths on their side.

No amount of monetary magic can defeat the inexorable collapse of the corrupt money system.

Anonymous's picture

I agree, but if they start dropping bundles of fresh notes from helicopters then all bets are off. I think the Japanese govt left fresh bundles of notes in back alleys but you know how the Japanese are, the notes were returned to the lost and found. Does the American govt own that many choppers?

Nout Wellink's picture

When they start the helicopter money action, they are already too late and deflation has kicked in.

Anonymous's picture


Anonymous's picture

nicely said

Anonymous's picture

Well now....

TD....What about THIS....

The numbers for cumulative debt available ....and supposed
counted 2007 was far higher in 2006/7 than today....

Does anyone have the actuals/guesstimates ?

It is a fair estimate that 40/70s .....would be what is currently available....

Which means this....

Cumulative means it does not matter how the numbers add long as the numbers are broadly distributed throughout the system....

So what is the number of additional FIAT cumulative sums that could be printed away in order to make sum back to 70/70s....?

This may mean that an additional $10 Trillion plus sum of new snaps.....may still not make deflation go away...because the cumulative would be 50/70s....

Money flow is money flow....there are just different types....

There is SUSTAINABLE money flow....and NONSUSTAINABLE money flow....

Govt. impositions = NONSUSTAINABLE

Innovation/progress = REAL.....SUSTAINABLE

And money spent on UNSUSTAINABLE when there was a choice to restructure taxes and other moves that would have created SUSTAINABLE instead....

Is where current policies are in error....

Please comment on cumulative valuations before and after relation to perhaps giving the govt. some ideas on creating better days ahead....

delacroix's picture

how about deflation, with a simultaneus currency crisis, lose lose situation

Anonymous's picture

Weren't you guys on the "INFLATION!" story back in 2007?

Dead and buried. Admit when you're wrong.

Housing is 40% of the consumption basket. Certainly you dont think there is any housing inflation? Services are another 40%. With sky-high unemployment... you dont really think there is service/wage inflation?

Even if oil and other commodities go up 50% from here (still mainly below highs) isnt that just a natural market price phenomenon that helps push more resource investment into mining or farming and conservation tech?

I act think commodities go down from here. Oil is $60 asset. Gold is $600. Ten years from now. But even if I'm wrong and oil is $150, Gold is $2000/oz... if housing is lower and services lower. Its not really inflation, right?

strike for return to reality's picture

Starting a war with China would allow the US to cancel all obligations to China.

On the downside, pretty much everything is made in China, so you'd better win pretty quickly and be able to restart all those factories in time for the next Christmas.

Question: Would Obama fly to an aircraft carrier in jumpsuit with a codpiece to proclam victory about 2% (measured in time) into the war?

strike for return to reality's picture

War would also have an advantage for China.  As a result of the one child policy and bias towards male children, China has a surplus of males seeking a mate.  A war would fix this problem.


From the American perspective, the war machine doesn't really care whether the US wins a war or not with one caveat, the parasite must not kill the host.  (Drawn out wars (Vietnam, Irag, Afghanistan) sell more hardware provided that the US survives the war.)  However, a war with China is in no way winable. The American policy is only to attack countries without a viable airforce or navy or nukes.

john_connor's picture

Wake me up when the 3 month T-bill is not basically zero.  A roughly 0% 3 mo. T-bill, my friend, is cash running for the hills.

There are no willing borrowers, or at least not enough to even make a dent in recreating the leverage that existed prior to the crunch. 

Job creation?  Please.  They are making up numbers of "jobs saved."


tom a taxpayer's picture

The tragedy is that the U.S. and world are teetering on a precipice so dark and so deep we can not see if it is inflation hell, deflation hell, or some other hell.  Good arguments and evidence can be made for all these hells. The Mismanagers of the Universe (Goldman Sachs, Wall Street, Fed, Treasury, Congress) concocted a witches brew that poisoned the well of U.S. and world financial systems, markets, and economies.  

The diabolic nature of the poisoning is that it is so dark and deep and convoluted that is can not be definitively diagnosed.  No one, not even the witches of Wall Street, knows whether the patient will die of deflation, hyper-inflation, or some other hellish disease.

strike for return to reality's picture

Nobody knows to which hell the US is headed.  Merely that it will be hell.

Perhaps this is what is meant by "change" wrt Obama.  By doing exactly the same things as the Cheney Administration, Obama guarantees that there will be a substantial future change (from status quo to hell).  "Hope" will be kept alive until the threshold is crossed, and there it will be abandoned.

To think, a simple rewind in time to October 2008 or so, and neatly packaged bankruptcies of Goldman Sachs, JPM, Citibank, etc... along with a relatively short-lived recession (financial services industry is diminished to be replaced by some new industry, maybe even a useful one).  Oh for the days when we could just wish for a decent recession instead of trying to guess which hell is our due.

I need to stop writing now.  I've found some work repaving a driveway in Greenwich, CT.

Anonymous's picture

Could we just have a come to Jesus moment where every employee / ex-employee of Goldman Sachs, JPM, Citi, and the various other ex-Masters of the Universe (AIG, BSC, LEH, etc..) who ever earned more than $500,000 per year (we'll use CPI numbers for earlier years) is sent to one of the prison camps that Halliburton built for the Dept of Homeland Security. Release will be conditioned upon, oh I don't know, how about when the inmates an Guantanamo decide that Wall Street has suffered as much as the people of Afghanistan, Iraq, East Timor, Vietnam, Cambodia, Palestine, Pakistan, etc...

WaterWings's picture


We "changed" a coked-up puppet for a narcissistic pinocchio. Still no hope.

anynonmous's picture

 tom a taxpayer or is it TS Eliot better still Edgar Allan Poe, whatever, a great post


"We are the Hollowmen"

Anonymous's picture

The Casey article itself reaffirms my own opinion -- deflation now. You need to survive deflation before you can even thing about hyperinflation.

Cursive's picture

Everyone knows what the money supply of the U.S. is and watches it keenly. 

FAIL.  There is a large debate about what constitues the money supply.  Most notably, the Austrian school says that credit should be included in the money supply metrics.  The official government measures of the money supply show growth, but with credit contracting, I and others believe that the money supply is contracting.  A lot.  Though he's not the author of this "research", Evans-Pritchard makes an excellent point about the slowdown in the velocity of money.  Print all you want, if people don't spend it, it effectively doesn't exist.

Secondly, we don't have a fiat currency.  A fiat currency will imply that it is backed by nothing.  In reality, the Federal Reserve Act has given us a debt-money system.  Our money is backed by federal debt.  That is the problem here and it's why we cannot move forward.  We would be better off with a strictly fiat currency so that we wouldn't be debt slaves to the bankers.  For those who would say that the federal debt is not tangible, I invite you to argue with the bond market.


APC's picture

Money is created out of credit, and destroyed when the credit is paid down, or defaulted upon.  If everyone repaid their loans, there would be no money in circulation.  A contraction of available credit is a contraction in the money supply.  Deflation by definition.

I seem to remember that 2 trillion $ of credit lines had been cut in 2008/9.  Could be wrong about the number, but that would require a whole hell of alot of printing to induce inflation, assuming you had the means to get the cash into circulation. 

delacroix's picture

the core problem, is debt service. without anymore debt, an interest rate rise, could end our ability, to service existing debt, and tax revenues, are in decline. the game is over, now we are just going through the motions.

Zexe's picture

when credit is defaulted upon money isn't destroyed, those money are still circulating, only that it eats at bank's capital which curtails it's future lending capacity.


Otherwise nicely said.

APC's picture

Quite right.  Thank you.

Anonymous's picture

This is exactly correct, well said

There is vastly more debt/credit out there (which cannot be repaid) than the government could ever counteract. America is choking on debt, and they are trying to fix it by getting people to take on more debt. It cannot work that way.

We saw a lot of debt deflation in 08, but there's plenty more to come.

Anonymous's picture

So your saying the best way to solve a massive debt problem is not ramping up more debt?? Crap. Someone call Obama and let him know.

P.S. He might not be happy with the news. Actually, he probably won't care. Nothing is going to stop a good liberal agenda.

Cursive's picture

If everyone repaid their loans, there would be no money in circulation.

This is true under our current debt-money system.  It is not true under, for example, a commodity-based system such as gold or a strictly fiat system.  Money does not have to be debt.  In fact, it shouldn't be debt.  Debt is poison that bankers produce and force on societies.

Nout Wellink's picture


And note that credit is not money. The world is choking on credit and doesn't want more. The Fed presumes it did the right thing to avoid deflation and therefore we will get it. My pick: a huge deflationary collapse starting with the first large sovereign debt, followed by panicking central banks trying to hyperinflate their way out.

Anonymous's picture

"And note that credit is not money."

I agree. The problem I have is that in this system some parties can create effectively unlimited amounts of credit at no cost to themselves and then use it to compete with money for real resources. Those who are competing with real money are bound to lose.