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Guest Post: Where To From Here?
Originally posted by Gerardo Coco at The Cobden Centre,
We face one of the deepest crises in history. A prognosis for the economic future requires a deepening of the concepts of inflation and deflation. Without understanding their dynamic relationship and their implications is difficult to predict how things might unfold. The economic future depends on the interplay of both these forces. From the point of view of their final effects, inflation and deflation are, respectively, the devaluation and revaluation of the currency unit. The quantity theory of money developed in 1912 by the American economist Irving Fisher asserts that an increase in the money supply, all other things been equal, results in a proportional increase in the price level [1]. If the circulation of money signifies the aggregate amount of its transfers against goods, its increase must result in a price increase of all the goods. The theory must be viewed through the lens of the law of supply and demand: if money is abundant and goods are scarce, their prices increase and currency depreciates. Inflation rises when the monetary aggregate expands faster than goods. Conversely, if money is scarce, prices fall and the opposite, deflation, occurs. In this case the monetary aggregate shrinks faster than goods and as prices decrease money appreciates.
Inflation is a political phenomenon because monetary aggregates are not determined by market forces but are planned by central banks in agreement with governments. It is in fact connected with the monetary expansion to fund their deficits. Inflation raises the demand for goods and decreases the demand for money; it increases aggregate spending and money velocity as the ratio between GDP and the amount of money in circulation which expresses the rapidity with which the monetary unit is spent and respent until it remains in existence.
There is no such things as demand-pull inflation or cost-push inflation. Provided that the quantity of money does not increase, if cost or demand for some goods changes, demand for other goods must necessarily adjust, leaving unchanged the amount of spending and the money aggregate in the economic system. If some people spend more, others have to spend less, thus leaving the purchasing power unaltered. The cause of inflation is nothing but money manipulation.
Inflation is a tax affecting all real incomes. While this is obvious for the fixed ones, it is less so for the variables ones such as business income. Inflation, in fact, overstates profits by making final sale prices to rise as compared to historical sale costs. When the moment arrives that businesses renew their capital assets, the higher price they will pay for them due to inflation will absorb the extra nominal profits. Since taxes are calculated on them, real profits will be insufficient to either replace or increase capital. Hence by decumulating capital, inflation penalizes economic growth and innovation.
As an economic stimulus, inflation sets the stage for deflation. By increasing the nominal taxable economy, it reduces the real one.
Likewise, subsidies and bailouts produce the same inflationary effects because most of them are financed through monetary expansion: a money supply growing faster than the productivity of capital and labor impairs both.
If inflation accelerates and becomes extreme, hyperinflation sets in: the demand for money tends to zero and because everyone hurries to spend it to avoid the loss of purchasing power, its velocity accelerates rapidly. The monetary aggregate and prices tend to infinity and the value of money to zero. Money loses the character of a medium of exchange and the credit-debit system collapses. Because money is the prerequisite of the division of labour, its destruction implies the destruction of the latter. To avoid barter the monetary system must be redesigned. In this catastrophic state of affairs it is small comfort to acknowledge that the overall debt of a nation is repudiated.
Inflation is a precondition of extreme deflation: depression.
Deflation in itself, however, is an economic phenomenon. Economic progress has a natural tendency to lead to falling prices. By increasing production and productivity, prices decrease, signaling that the economy grows faster than the money aggregate, which means that with the same volume of expenditure more things can be bought – i.e. money has a higher purchasing power.
Because depression usually is accompanied by deflation, central banks interpret any incipient downturn in prices as a sign of crisis and try to prevent it with monetary stimulus. But a depression occurs not because the price level falls but because real output, expenditure and all incomes on which aggregate expenditure is based fall. Regardless of the causes and confusing them with the effects, central banks always inflate, opening the door to evil that they claim to cure.
True and false money
There are many definitions of monetary aggregate. Strictly speaking it is the aggregate in the narrow sense which reveals inflation because it includes only the effective means of payment excluding short term redeemable financial assets. In fact, by definition, something that must be converted into money is not itself money. No one pays necessities with short term securities. Money is only the stock or base money needed to buy goods and services. If the public holds 50 in his pocket and banks 1000 in their reserves, the monetary base equals 1050. It’s called “base” because is the foundation upon which the banking system builds a pyramid of money and credit. Whenever central banks purchase government securities either directly from governments or from banks they increase bank reserves and the monetary base setting the pace for credit expansion.
More aggregate expenditure follows, making nominal GDP grow. Because new credit corresponds to new debt, credit expansion by inducing more debt lowers the ratio between liquid assets and liabilities in the entire economy. When a deficit of liquidity follows to a credit crunch, debts repayment can only be made by deleveraging balance sheets and asset prices across the board sharply fall. Moreover part of the overall debt is cancelled by insolvencies and the combined effect of prices and debt reduction shrinks the monetary and spending aggregates triggering deflation in the form of recession. On the other hand the overall debt does not decrease because governments do not liquidate it as the private sector does. Quite to the contrary they increase debt to pay the outstanding so as to avoid default. As a matter of fact they must increase their debt to make up for debt deflation in the private sector.
Should in fact the overall debt collapse, there would be an extreme deflation or depression because the money aggregate would contract dramatically. In fact the money equivalent to the defaulted debt would literally vanish. It is for this reason that central banks monetize new debt at a lower interest rates, raising its value. Because lower interests raise also the values of all assets, the entire economy looks healthier. But debt monetization gives only the illusion of wealth. It produces inflation growing faster than GDP with the effect of diluting wealth. Real incomes fall not only because of money debasement but because by raising their nominal value, inflation pushes them into higher tax brackets. In this context only the financial sector thrives because in a context of ever growing uncertainty and unpredictability, instruments for averting risks proliferate.
All the financial bubbles and the mass of derivatives are just the consequence of debt monetization. By keeping interest rates extremely low, monetary expansion finances speculation at low cost, allowing it to shift huge amounts of money and earn risk-free profits by capturing price differentials between different markets, which, is the only way to gain returns and preserve purchasing power when interests are kept low or even negative. Because new money is dissipated through the process it must continually be recreated. Debt monetization result in a never ending process of creation and destruction of money. It discourages productive activities leaving the economic future at the mercy of speculation.
All this destabilizing process is the consequence of the creation of money out of the debt. Debt monetization is the exchange of new money for a promise to pay it in the future. Now, if money is a function of the debt it is impossible that we can settle debt permanently. Legal currencies are false money because they depend on the debt expanding and contracting accordingly. Real money cannot be a liability or a promise to pay unlimited debt of third parties subject to default.
The role of money can be discharged only by an economic good that is always in demand, preserves its value and is immune from the failure of third parties. The money with these characteristics is gold, the only financial asset which is not dependent on anybody’s promises and is not subject to debasement or default. As long as this truth is not fully recognised no structural reform whatsoever can overcome a crisis which is systemic precisely because it is immanent to an economic and financial system based on debt. Without sound money on the scene of the economic drama, inflation and deflation will continue to play their conflict until the final outcome: the monetary breakdown.
The currency cliff
In a context of false money, fiscal and monetary instruments are not only ineffective, but harmful. The first, trying to reduce the debt by increasing the tax burden results in draining resources when they are most needed. The second by refinancing the debt and boosting the monetary aggregate to prevent its collapse produces inflation. Hence debt cannot be tamed. Only hyperinflation or default can annihilate it. But the first would destroy the money system, the second would trigger a deep depression.
How will this all end? In history, debt monetization has always produced hyperinflation. As long as countries are enjoying credit, fiscal deficits through inflation work. But when they incur new debt to repay the outstanding they reach the point of no return because it becomes clear that they cannot repaid it. Thence hyperinflation has always been the consequence of the inability to service the debt. Investors start to lose confidence in the country and its currency and so citizens. At this point, monetary policy can no longer defend it and a collapse ensues.
In Western countries, despite the exponential debt a runaway inflation has not yet occurred. Monetary policy has only inflated the financial sector, starving the private one, which is showing a bias towards a deflationary depression: here the demand for money increases, the velocity and prices fall but the monetary aggregate holds as long as debt monetization works. According to the quantity theory it is the money actually spent on goods and services that causes inflation. As long as liquidity is parked in the bank reserves or finances speculation it does not flow into the real economy and inflation progresses slowly. If money were suddenly released it would have the same destructive impact of a dam breaking and overthrowing water downstream. Central banks in fact control the quantity of money but not its velocity, which depends on social forces.
At the present fiscal and monetary policies try to preserve a precarious status quo, balancing inflation and deflation, a state of affairs which allows the debt perpetuation. But this balance can not be maintained for long because sooner or later inflation will be translated from the financial into the real economy via the general currency debasement taking place worldwide. It must not be forgotten that not only are currencies depreciated by debt monetization and fiscal deficits. Governments debase their currencies, destabilizing their trading relationships too by correcting trade deficits to boost exports. Hence a currency downtrend might eventually trigger a systemic collapse, because speculation causes further debasement through currency short-selling .
Ultimately the combined action of low interest rates and currency depreciation would drive investors away either from financial securities or currencies on behalf of tangible assets, notably commodities, whose prices would escalate. Demand for money would fall and so velocity and aggregate expenditure. At this point the market value of the debt securities would fall, bringing the interest rate to astronomical levels. The value of the whole debt would collapse while the price increases of critical commodities would hit the entire economy, pushing up the consumer prices dramatically.
All this process is not linear but oscillatory: massive flows of money would alternatively inflate and deflate financial and real sectors, causing vibrations in the economy that superimpose, eventually reaching a magnitude sufficient to bring down the whole economic structure. It is impossible to predict whether defaults would occur through hyperinflation or depression and where they would start first. Probably the first countries to be affected would be the ones with the weakest currency and the most fragile political setting. The outcome will also depend on the geopolitical situation. The prospect of the extension of a war would certainly make for hyperinflation. Floating currencies would disappear as suddenly as they appeared a little more the forty years ago. It is very hard to imagine the social cataclysm that it would ensue.
Managing deflation
If all the disruptive effects of inflation were understood it would be prevented. The fact is that its effects are confused with real economic growth while inflation is pure and simple currency debasement via increasing currency supply destroying money gradually and systematically. Inflation cannot be controlled. Once the currency loses value it is lost forever. Deflation, by contrast, can be controlled – avoiding its deepening into depression. The latter is like a purge whereby the economic organism expels the poisons accumulated previously with inflation. A gradual deflation induces the recovery because it realigns values with the economic reality, reducing the inflated money stock at level that makes the debt sustainable and repayable. The currency appreciation which ensues is just the antidote to depression itself. In fact, when the quantity of money tends to be measured in terms of absolute purchasing power, it corresponds to more money and therefore to more liquidity.
Note, here, the difference between the true and the false money: defaults make money disappear, while gold, the real money, never does: once in circulation it will remain – it cannot be eliminated by default. The criticism that gold causes depression is unfounded; on the contrary avoids it.
Inflation and its effects can be contended by managing deflation, and this is a political task.
First, to avoid a systemic collapse reciprocal debts have to be either renegotiated or condoned. It must be recognized that their current dimension makes it impossible to repay them, opening the way to uncontrolled defaults.
Second, government spending must be reduced as well as taxes. At the same time, all banks’ bad debts recorded in the accounts as sound credits should be written down. Without this adjustment banks will never be able to operate normally, resuming their credit activity and financing the economy, neither will they be able to attract new capital. The recognition of their losses is the prerequisite for their financial reconstruction. In order to be able to provide new credit banks must first receive it. No investor is willing to lend them funds with the fear of covering losses disguised as gains.
All this restructuring would last a few years and would give a positive signal to markets that facing true values can restore the lost confidence in the economy. Currencies would appreciate again and money would start to flow again without inflating. However, problems would not be solved and crisis would recur with a debt based money. Hence a process of readjustment must contemplate the return of the real money, gold. Since 2010 central banks have become net importers of gold. Why keep it in their coffers? It has to be used immediately to recapitalize banks, and remonetized straight after.
Unfortunately governments and banks will go for more inflation. It is well known that both usually make not only the wrong choices but the exact opposite of the right choices. As history teaches, besides money the freedom of citizens can also be the victim.
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I hoard and my relatives want me to give up my stuff. I need it to sell when all my current revenue streams go BK. I'll be selling my stuff for pennies on the dollar, mostly for scrap value.
robertocarlos Southern Caribean/ or Northern Pacific
I'lL walk through the Jungle with ya.
got room for 1 more?
Tyler, we love you. You have earned trust/ Advertising/skime Good Idea in some ways.
http://www.youtube.com/watch?v=fnOY6BMgifg
Richard Wolf On The Crisis In Capitalism
.
full version
Typical Austrian economist, strong start, weak finish. Sorry to say. Sad-------
Except for Philipp Bagus.
Bad money drives out good money - Gresham's Law. That is only half of the equation, since we're talking about bad money, after all. Eventually bad money won't spend. That's when folks start trading grand pianos for a side of beef or whatever. And good money will drive out bad. The truth is, a great many things we take for granted are in fact luxuries, not essentials. Air, water, food, clothes, shelter, that's about it. Just Sayin'.
Very funny your T-shirt "end the fed "...and quite peterpanesque, or childish . I write to you as a european admiring the USA rise to world power in the 19-20th cent.and quite afraid of your ongoing decline and coming demise in those last 20 years. So you want to end the Fed ? Please do ! Our great leader general de Gaulle played his hand in that game in 1966, and asked your Fed to give him your gold in exchange for your $ 35 .Very quiclky he won the uper hand, Germany too joined that game and in 1971 Nixon gave up.That was the real end of the Fed; what you have seen since 1971 are only mere attempts to reflate your currency, ans all those attempsts have failed.Now the next threat to your survival comes from Asia, your No.1 competitor.As soon as China will let its currency float, you and the US $ are doomed.The asian mega-currency might be a basket of JPY-CNY-SGD-INR etc.. plus some petro-producers like Iran to bring into some almost free energy.The immediate consequence of an Asian mega-currency is the US T bonds death spiral, and the parallel debasement of the US $: Why ? As soon as the Asian mega-currency takes out the US $ , your currency will be priced at its true value: the value of a country where 70% of GDP is extracted from consumption vs.30% extracted from production and export.So the US $ could face a contraction of its international value of near 50%, and every imported goods would skyrocket.Hene the hyperinflation.Actually the Fed is just your life buoy, and it allows you to float instead of sinking.This salvation comes with a cost ( defaltion + inflation ) but it is much better than definitive sinking.
So the Fed is essential to your survival as well as a strong US navy and air force, and a ever-present US influence on the Mid-east axis of oil-flow ( persian gulf + Suez canal ).I hope you get the strategic dimension of your survival which owes even more to the US Army capacity of intervention than to the Fed.If you want to find a parallel in hsitory the rise and fall of the spanish kingdom in the 16th-17th cent is the exact senario you and the USA are following.
The Fed has some semi-talented psyops fucks working for it.
For just a second there, as I read your manipulation, I was rooting for the Fed.
I'm better now. FUCK THE FED.
I tend to agree with your view that our military is the only reason we are still the worlds reserve currency. I do not agree with your view on Asia as they too along with Europe are doing the exact same thing with their currencies as we are. We are all basically in the same boat with one exception. The USA stores most of the worlds gold. The president under the emergencies powers act will confiscate all the gold.
This will lead to world war to cull the population. I do not like typing this at all because it is all based on greed and ink and paper.
The Fed isn't essential to survival of the US.
If (when) the US dollar loses world reserve status and we can't export our inflation it will all come back home as those worthless dollars are repatriated.
The Fed will essentially end itself. Bankrupt... full of irredeemable paper.
Revaluation to something of worth (gold/silver reserves) will be a horrible event as the illusion of 'wealth' disappears.
One big broke-ass country that consumed itself to death.
The Fed is a big bank, like gladman sucks,Skank of Americak, Shitttycorp, etc.. The same creditors that squueeze the majority of countries in the world into debt slavery. The derivatives they push are gvraeter than the the combined GDPs of all the countries. Asia has plenty of debt owed to these beasts just like the rest of the world. I am not sticking up for the banks, just saying the complexity of the web of debt is not straightfoward and simple.
Double post rage overflow. Appy-polly-lodgies.
The cliff analogy works well here because in reality once the cliff gets over so high, the fall will kill you the same, regardless of it is a mile high. The only real difference will be how long it takes to hit the bottom and never knowing for sure how much farther we have to go. Reading so many different perspectives on what is happening, what caused it and how it will end, leads one to believe that regardless it will eventually end and with life all we can do is enjoy the ride.
I am Canadian
We approved China and Indonesia taking over a couple Oilsands and Gas companies yesterday which is great becuase it shows Obama the big fat finger for turning down Keystone. It also shows that we accept foreign capital to push our agenda forward to be the largest exporter of oil and gas on the planet.
But it shows something else, It shows how far you Americans and Eurpoeans have turned left. It is truly scary that the bastion of free enterprise is nothing now but a soviet state of welfare bums from citizens to corporations.
Yet you voted this regime in again. You cannot complain - you created it. Thus you must wish communism for yoru future becuase it was crystal clear what that dictator was doing.
When Canada is the last bastion of free enterprise then you know some bad shit is coming. We don't piss off anybody normally, yet, showing OBama and trolls the finger was delightful I must say.
I understand what your saying, and agree with it.; however, Logically speaking, if a communist country owns a portion of your assets, then Canada is partially owned by the Communist country of China.
Eliminate the debt ceiling, sell about a trillion in treasuries, use the trillion to short the entire global market (leveraged up 20 or so times), then crash the market and unwind the short positions. Use the ill gotten proceeds to pay off the debt and recharge uncle sugar's credit card-put us all on welfare, enjoy the plentiful supply of cheap labor.
This is probably what the 'brainiacs' intend to do (or some version of it).
Then go ahead and use the unlimited debt ceiling for unlimited gambling, heck - it's not their money anyway (unless they bet right). What a bunch of chicken-shits.
Good article, and quite a few good comments, but i still believe "Nature" will give us a surprise...
For ME, since I have NO economy, economy is OFF...Fukushima is what we all will be very concerned about soon enough.
-a Quake triggered by Nature...or Man.
Fuku-Radiation will be hard to escape! (and another Big War is already priced in)
Still good to read that lotsa people ARE "Revved up and ready to go."
Hey Ho!
R_J
This has never been entirely true. Increasing the money supply certainly stands to increase consumer prices but not necessarily proportionally. And there are other unrelated things which can also affect prices. Including revaluation of the currency (upwards/downwards), a rise in import prices and -- as we have seen in recent times -- where the increased money supply has gone to. Much of the Banana Bernanke printing has gone into the markets to prop them up and improve wealth perception. *Only if* the increase in money supply leaks into the real economy do we see prices rise.
@.."Inflation raises the demand for goods and decreases the demand for money; it increases aggregate spending and money velocity as the ratio between GDP and the amount of money in circulation which expresses the rapidity with which the monetary unit is spent and respent until it remains in existence." ...
.
comment: this particular statement is incomprehensible
or incoherent. the author might consider re thinking
and re writing it. particularly the phrase "until it
remains in existence." this has no cogent interpretation
in english or any other grammar based language. but,
even so, the part "inflation raises the demand for goods.." is very interesting but incorrect. it is
the increase of aggregate "currency" or credit that
raises the demand for goods, the inflation decreases
the demand for goods as in "i can't afford that and
will not reproduce because i can't afford to feed
a child." never mind attract a mate ! also, inflation
doesn't decrease the demand for money, that would be
deflation.
.
many good points in the other parts of the piece
but this section is a mess. imho
the line of thought represented in this piece is
"pregnant", i hope the author sees it through
to the delivery room.
@.." The quantity theory of money developed in 1912 by the American economist Irving Fisher asserts that an increase in the money supply, all other things been equal, results in a proportional increase in the price level [1]. " ...
and this .." all other things being equal ".
that is the crux and nut of it, all other things
are never equal, never ! that is the problem.
legal tender laws make sanctified currency unequal
to everything else, superior by fiat and under the
control as to creation and distribution of the
few mastas. it is not science or math or anything
but control, as in slavery, through symbolic and
conceptual or meme implantation into the "minds"
of the experimental population.
If there's one thing I really hate it's having to pay Capital Gains taxes on income that is really just inflation. In other words I hate being taxed for losing value.
@.." There is no such things as demand-pull inflation or cost-push inflation. Provided that the quantity of money does not increase, if cost or demand for some goods changes, demand for other goods must necessarily adjust, leaving unchanged the amount of spending and the money aggregate in the economic system." ..
.
and this is false also as the velocity of money
is not taken into account, i still like this post
anyway.
@..condoned" ...
might read "condemned". ?
.
i say this author is too good a thinker
to not have a proof reader.
other people's money
Where to from here?
Defaults
Chaos
Riots
Flames
Migrations
Redistribution
Freedom
A.D. 500.
Be there, or be square.
If you are hoping for change, history offers basically 3 alternatives (and no, this time it isn't different, the people against the robber barons is nothing new)
You can either have religion do it, or the army. If you are really lucky, you can secede. Takes a lot of committed people to organise that.
I see no evidence of a groundswell from the peeple.
If this time was different, a free media would have exposed all the corruption and all of the fraud, all of the black-flag operations of the past 50 years at least.