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Guest Post: Inflation: An Expansion of Counterfeit Credit
Submitted by Keith Weiner
Inflation: An Expansion of Counterfeit Credit
The Keynesians and Monetarists have fooled people with a clever sleight of hand. They have convinced people to look at prices (especially consumer prices) to understand what’s happening in the monetary system.
Anyone who has ever been at a magic act performance is familiar with how sleight of hand often works. With a huge flourish of the cape, often accompanied by a loud sound, the right hand attracts all eyes in the audience. The left hand of the illusionist then quickly and subtly takes a rabbit out of a hat, or a dove out of someone’s pocket.
Watching a performer is just harmless entertainment, and everyone knows that it’s just a series of clever tricks. In contrast, the monetary illusions created by central banks, and the evil acts they conceal, can cause serious pain and suffering. This is a topic that needs more exposure.
The commonly accepted definition of inflation is “an increase in consumer prices”, and deflation is “a decrease in consumer prices.” A corollary is a myth that stubbornly persists: “today, a fine suit costs the same in gold terms as it did in 1911, about one ounce.” Why should that be? Surely it takes less land today to raise enough sheep to produce the wool for a suit, due to improvements in agricultural efficiency. I assume that sheep farmers have been breeding sheep to maximize wool production too. And doesn’t it take less labor to shear a sheep, not to mention card the wool, clean it, bleach it, spin it into yarn, weave the yarn into fabric, and cut and stitch the fabric into a suit?
Consumer prices are affected by a myriad of factors. Increasing efficiency in production is a force for lower prices. Changing consumer demand is another force. In 1911, any man who had any money wore a suit. Today, fewer and fewer professions require one to be dressed in a suit, and so the suit has transitioned from being a mainstream product to more of a specialty market. This would tend to be a force for higher prices.
I don’t know if a decent suit cost $20 (i.e. one ounce of gold) in 1911. Today, one can certainly get a decent suit for far less than $1600 (i.e. one ounce), and one could pay 3 or 4 ounces too for a high-end suit.
My point is that consumer prices are a red herring. Increased production efficiency tends to push prices down, and monetary debasement tends to push prices up. If those forces balance in any given year, the monetary authorities claim that there is no inflation.
This is a lie.
Inflation is not rising consumer prices. One can’t understand much about the monetary system from inside this box. I offer a different definition.
Inflation is an expansion of counterfeit credit.
Most Austrian School economists realize that inflation is a monetary phenomenon. But simply plotting the money supply is not sufficient. In a gold standard, does gold mining create inflation? How about private lending? Bank lending? What about Real Bills of Exchange?
As I will show, these processes do not create inflation under a gold standard. Thus I contend the focus should be on counterfeit credit. By definition and by nature, gold production is never counterfeit. Gold is gold, it is divisible and every piece is equivalent to any other piece of the same weight.
Gold mining is arbitrage: when the cost of mining an ounce of gold is less than one ounce of gold, miners will act to profit from this opportunity. This is how the market signals that it needs more money. Gold, of course, has non-declining marginal utility, which is what makes it money in the first place, so incremental changes in its supply cause no harm to anyone.
Similarly, if Joe works hard, saves his money, and gives a loan of 100 ounces to John, this is an expansion of credit. But it is not counterfeit or illegitimate or inflation by any useable definition of the term.
By extension, it does not matter whether there are market makers or other intermediaries in between the saver and the borrower. This is because such middlemen have no power to expand credit beyond what the source—the saver—willingly provides. And thus bank lending is not inflation.
Below, I will discuss various kinds of credit in light of my definition of inflation.
In all legitimate credit, at least two factors distinguish it from counterfeit credit. First, someone has produced more than he has consumed. Second, this producer knowingly and willingly extends credit. He understands exactly when, and on what terms, with what risks he will be paid in full. He realizes that in the meantime he does not have the use of his money.
Let’s look at the case of fractional reserve banking. I have written on this topic before. To summarize: if a bank takes in a deposit and lends for a longer duration than the deposit, that is duration mismatch. This is fraud and the source of banking system instability and crashes. If a bank lends deposits only for the same or shorter duration, then the bank is perfectly stable and perfectly honest with its depositors. Such banks can expand credit by lending, (though they cannot expand money, i.e. gold), but it is real credit. It is not counterfeit.
Legitimate lending begins with someone who has worked to save money. That person goes to a bank, and based on the bank’s offer of different interest rates for different durations, chooses how long he is willing to lock up his money. He lends to the bank under a contract of that duration. The bank then lends it out for that same duration (or less).
The saver knows he must do without his money for the duration. And the borrower has the use of the money. The borrower typically spends it on a capital purchase of some sort. The seller of that good receives the money free and clear. The seller is not aware of, nor concerned with, the duration of the original saver’s deposit. He may deposit the money on demand, or on a time deposit of whatever duration.
There is no counterfeiting here; this process is perfectly honest and fair to all parties. This is not inflation!
Now let’s look at Real Bills of Exchange, a controversial topic among members of the Austrian School. In brief, here is how Real Bills worked under the gold standard of the 19th century. A business buys merchandise from its supplier and agrees to pay on Net 90 terms. If this merchandise is in urgent consumer demand, then the signed invoice, or Bill of Exchange, can circulate as a kind of money. It is accepted by most people, at a discount from the face value based on the time to maturity and the prevailing discount rate.
This is a kind of credit that is not debt. The Real Bill and its market act as a clearing mechanism. The end consumer will buy the final goods with his gold coin. In the meantime, every business in the entire supply chain does not necessarily have the cash gold to pay at time of delivery.
This problem of having gold to pay at time of delivery would become worse as business and technology improved to allow additional specialization and thus extend the supply chain with additional value-added businesses. And it would become worse as certain goods went into high demand seasonally (e.g. at Christmas).
The Real Bill does not come about via saving and lending. It is commercial credit that is extended based on expectations of the consumer’s purchases. It is credit that arises from consumption, and it is self-liquidating. It is another kind of legitimate credit.
For more discussion of Real Bills, see the series of pieces by Professor Antal Fekete (starting with Lecture 4).
Now let’s look at counterfeit credit. By the criteria I offered above, it is counterfeit because there is no one who has produced more than he has consumed, or he does not knowingly or willing forego the use of his savings to extend credit.
First, is the example where no one has produced a surplus. A good example of this is when the Federal Reserve creates currency to buy a Treasury bond. On their books, they create a liability for the currency issued and an asset for the corresponding bond purchase. Fed monetization of bonds is counterfeit credit, by its very nature. Every time the Fed expands its balance sheet, it is inflation.
It is no exaggeration to say that the very purpose of the Fed is to create inflation. When real capital becomes more scarce, and thus its owners become more reluctant to lend it (especially at low interest rates), the Fed’s official role is to be the “lender of last resort”. Their goal is to continue to expand credit against the ever-increasing market forces that demand credit contraction.
And of course, all counterfeit credit would go to default, unless the creditor has strong collateral or another lever to force the debtor to repay. Thus the Fed must act to continue to extend and pretend. Counterfeit credit must never end up where it’s “pay or else”. It must be “rolled”. Debtors must be able to borrow anew to repay the old debts—forever. The job of the Fed is to make this possible (for as long as possible).
Next, let’s look at duration mismatch in the financial system. It begins in the same way as the previous example of non-counterfeit credit—with a saver who has produced more than he has consumed. So far, so good. He deposits money in a bank, and this is where the counterfeiting occurs. Perhaps he deposits money on demand and the bank lends it out. Or perhaps he deposits money in a 1-year time account and the bank lends it for 5 years. Both cases are the same. The saver is not knowingly foregoing the use of his money, nor lending it out on such terms and length.
This, in a nutshell, is the common complaint that is erroneously levied against all fractionally reserved banks. The saver thinks he has his money, but yet there is another party who actually has it. The saver holds a paper credit instrument, which is redeemable on demand. The bank relies on the fact that on most days, they will not face too many withdrawal demands. However, it is a mathematical certainty that eventually the bank will default in the face a large crowd all trying to withdraw their money at once. And other banks will be in a similar position. And the collapsing banking system causes a plunge into a depression.
There are also instances where the saver is not willingly extending credit. The worker who foregoes 16% of his wage to Social Security definitely knows that he is not getting the use of his money. He is extending credit, by force—i.e. unwillingly. The government promises him that in exchange, they will pay him a monthly stipend after he reaches the age of retirement, plus most of his medical expenses. Anyone who does the math will see that this is a bad deal. The amount the government promises to pay is less than one would expect for lending money for so long, especially considering that the money is forfeit when you die.
But it’s worse than it first seems, because the amount of the monthly stipend, the age of retirement, and the amount they pay towards medical expenses are unknown and unknowable in advance, when the person is working. They are subject to a political process. Politics can shift suddenly with each new election.
Social Security is counterfeit credit.
With legitimate credit, there is a risk of not being repaid. However, one has a rational expectation of being repaid, and typically one is repaid. On the contrary, counterfeit credit is mathematically certain not to be repaid in the ordinary course. This is because the borrower is without the intent or means of ever repaying the loan. Then it is a matter of time before it defaults, or in some circumstances forces the borrower to repay under duress.
Above, I offered two factors distinguishing legitimate credit:
1. The creditor has produced more than he has consumed
2. He knowingly and willingly extends credit
Now, let’s complete this definition with the third factor:
3. The borrower has the means and the intent to repay
Every instance of counterfeit credit also fails on the third factor. If the borrower had both the means and the intent to repay, he could obtain legitimate credit in the market.
A corollary to this is that the dealers in counterfeit credit, by nature and design, must work constantly to extend it, postpone it, “roll” it, and generally maintain the confidence game. Counterfeit credit cannot be liquidated the way legitimate credit can be: by paying it back normally. Sooner, or later, it inevitably becomes a crisis that either hurts the creditor by default or the debtor by threatening or seizing his collateral.
I repeat my definition of inflation and add my definition of deflation:
Inflation is an expansion of counterfeit credit.
Deflation is a forcible contraction of counterfeit credit.
Inflation is only possible by the initiation of the use of physical force or fraud by the government, the central bank, and the privileged banks they enfranchise. Deflation is only possible from, and is indeed the inevitable outcome of, inflation. Whenever credit is extended with no means or ability to repay, that credit is certain to eventually become a crisis that threatens to harm the creditor. That the creditor may have collateral or other means to force the debtor to take the pain and hold the creditor harmless does not change the nature of deflation.
Here’s to hoping that in 2012, the discussion of a more sound monetary and banking system begins in earnest.
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agree, it makes it a Silly Game, makes me wonder what the Fed really fears in a major repricing of everything? They claim to fear and combat deflation, meaning a system wide lowering of prices....when in reality they could just do what they've been doing and what you suggest in that New Risk Sharing Mechanisms will work closely with Accelerated Revenue bla bla bla to hide losses anyway! What is the difference other than to continue the sharade?
agree, it makes it a Silly Game, makes me wonder what the Fed really fears in a major repricing of everything? They claim to fear and combat deflation, meaning a system wide lowering of prices....when in reality they could just do what they've been doing and what you suggest in that New Risk Sharing Mechanisms will work closely with Accelerated Revenue bla bla bla to hide losses anyway! What is the difference other than to continue the sharade?
More deconstructivist nihilism? Now the Keynsians and the antithisis of the Keynsians, the monetarists are being lumped into the same bag. Like they say in New York, go figure?
Not sure if anyone is still reading this post but the comments were awesome, learned a lot. Might have to read some again....
A hope for a sound monetary and banking system is wasted dreaming of a Libertarian mind.
The spigots of investment liquidity, carry trade lending and central bank easing have been turned off and are now running toxic. Insolvent sovereigns and insolvent banks cannot support investment expansion or economic growth. Fiat currencies are dying. The seigniorage of fiat money is being replaced by the seigniorage of diktat, as evidenced by the rise in power of the EU ECB IMF Troika, as well as by the appointment of technocratic government in Greece and Italy. Fiat money is being replace by the currency of diktat. The global investment, economic and political tectonic plates have shifted, and an authoritarian tsunami is on the way; political capital is replacing investment capital.
Out of sovereign armageddon, that is a credit bust and global financial collapse, regional global governance will be established; this having been called for by the 300 elite of Club of Rome in 1974.
God is effecting his sovereign will, Ephesians 1:1-11, Revelaton 2:26-27, and not any human action, He will bring forth a revived Roman Empire, that is a German led Europe. Fate will open the curtains, and out onto the world’s stage will step the most credible of leaders. Bible prophecy reveals this Little Authority will work behind the scenes in regional framework agreements to change our times. The rule of law will be replaced by his word, will and way, as he mandates sweeping economic and political changes, Daniel 7:25. The people will be amazed by this, and place their faith and trust in him; they will give their allegiance to his diktat, Revelation 13:3-4.
US Federal Reserve policies have finally caused currency devaluation worldwide. Bernankeism has upset the normal dynamics of sovereign debt. His central bank credit liquidity policies have closed the 40 year chapter of human history known as Neoliberalism. The Milton Friedman, Free To Choose, Banker Regime, where democracy and inflationism ruled, is finished, done and over. Currencies are no longer floating; they are sinking. The age of destructionism has commenced, and with it, the currency of diktat is coming into use.
No way, never, will there be a sound monetary and banking system. The Beast Regime of Neoauthoritarianism is rising out of the death rattle of fiat money. This behemoth of statism and regional global governance is a monster, having seven heads, that is rising to occupy in all of mankind’s institutions, and ten horns, that is going to rule in all of the world’s ten regions, Revelation 13:1-4.
I think he meant "quite lucid"
Keith Weiner
"Counterfeit credit" sounds alot like my term, counterfeit wealth ...i still prefer my term because at the core of the issue is productive wealth with the counterfeit wealth fabricated on top or riding on the back of that monopoly central banks and big retail banks create (to enrich/empower themselves)
These bankers are frauds (lazy greedy cheaters) in the economy as you rightly describe. With the power grab on the money supply they are able to fabricate wealth, it is criminal alchemy
the key for me regards deflation is when the productive economy starts to pack-up and leave. Greshams Law of how bad money drives out good. What that means in truth is bad people (cheaters) drive out good honest productive people from an economy (the 2% who drive business).
As the 2% start to wind-down or leave the economy the counterfeit wealth has less and less substance behind it or holding it afloat and it begins to implode. The economy is a social event, not a monetary event. Once the productive people leave, or are driven out by the economic frauds and cheaters, no amount of counterfeit wealth can hide the sewer or fake that it's a healthy economy (try as Benny and Tiny Tim might)
brilliant contrarian theory. counterfeit credit here can also mean capital or resources
that have been unfairly transferred (in the sense of mispriced or poached) or removed from
the economy. this is particularly bad for fractional reserve systems, since the system
assumes the assets stay in the country in order for creative destruction / innovation
to make good on their promise. if the assets disappear to tax havens, we're left with
bad debt from interest on fictitious future business cycles that will never materialize.
a proposal for the Corporate and Commons Capital Preservation tax restructure
by Archduke
First a quote from ZH: http://www.zerohedge.com/article/over-past-4-years-news-corp-generated-1...
This further highlights why there's something fundamentally wrong with our tax structures. Allowing funds to move freely between national fiscal barriers, and taxing only profits and actually indemnising refunds on alleged losses leads to this sort of abuse.
Offshoring: the real shadow banking, or profits are not made where you think they are, and nor are losses.
to paraphrase Treasure islands by Nicholas Shaxson: http://treasureislands.org/the-book/
First we consider that in modern fiscal theory we tax profits alone, while losses are credited. One of the keys here is understanding how both of these ideas are localised, ie within specific national jurisdictions, which the modern offshore multinational structure is designed to exploit. Some would say evade or bypass, but I use exploit because it actually leverages loss into gain. One fundamental problem is in identifying where the lion's share of the profits are generated. Was it at production in Honduras? At the broker's in Panama? In the FairFruit HQ in the US? Multinationals play with these numbers using the technique known as transfer pricing.
The corollary problem in offshoring is why are there losses at all if the banana retail nets a profit? Which is to say if that if the banana's retail sale flow generates a net profit, is it fair to construct artificial localised losses in high-tax areas and deduct these from the loop, thus multiplying by far the amount of money from the actual sale? Now recall the credit is money, and income tax credit is money just the same. So compensating a local loss with tax break is in fact a public subsidy.
Where did the money come from to pay operating expense deductibles in the banana republics of Honduras, Panama, and the deregulated havens of Ireland, the Channel Islands and Britain? Why, from the poor taxpaying sucker, the underclass, who thus have subsidized enormous profits that far outstrip the global retail sale of the bananas. Modern multinational corporations, you see, are not in the business of selling products. In fact the banana bundle is only a pretext, the special purpose vehicle to fleece the public. (but hey, keep the retail sale proceeds as well). The offshored multinational claims your cake and eats it too, and then taxes you for the crumbs.
Follow the Money, or money supply, fractional reserve, and debt as money.
Recall that in fractional reserve banking, every new dollar represents an unrealised asset,which is another way of saying a debt. Yet fractional reserve means every asset is recirculated and reissued as we find new wants (often) and needs (rarely) to exploit from the transformation of those same resources. a forest can represent wood from trees, printing paper from wood, or rent from adventure tourism. An asset value thus represents a forward in time of projected exploitation value. But it's still only the same forest.
Each asset or debt, creates new money in the form of profit or interest depending on which side of the asset you're on. Now the thing about interest is that it compounds. So while the monetary and debt growth is exponential, equivalent to interest on the issued tier-1 capital, the underlying resources are constant at best (sustainable) or for mining and extraction: depleting, minus depreciation, spoilage, and waste. Recall there is a limit to production and transformation: thermodynamics say that every step introduces waste and loss, so the underlying resources are more than likely trending to depletion than sustainability. Sustainability is a difficult constant upward battle.
One resource however is guaranteed to be ever-present within the system, because it is the basis upon which the system is predicated. That resource is human agency, which means labour and invention. It is this process that drives innovation and what Karl Marx called creative destruction (contrary to popular creed, not Alan Greenspan). When an asset is realised, and the debt of the forest netted by the sale of the trees, the fairy of innovation then can come into action and reprocess, realign, and rerecycle, spent capital into new opportunities. Innovation then, is what drives interest, and its sister inflation.
a Conflict of Interest: pricing resource depletion, taxation, and the monetary base.
So what happens to the interest implied by the asset when I export the asset? that is the million-dollar question. I can sell the forest at spot value, but the interest and inflation implied from the asset assumes that it stays within national borders, thus allowing it to compound with the invisible hand of potential innovation further down the road. when I export either the lumber, or even its flip-side when I export the proceeds by offshoring profits to a foreign subsidiary, I deprive this local economy of the future realisations of innovation, either with the same lumber, or by depriving the fractional re-injection of the monies back into the economy through reinvestment.
This is the fundamental epiphany: that exports ultimately cost the economy, and short of depleting all resources to make up for it the only guaranteed dependable resource to cover it is human capital. every export is a burden on the system and on human labour. (to mirror the current ZH article, inflation is a result of the imbalance in fractional debt whose underlying assets were wrongfully inflated, mispriced, poached, or transfered out of the domestic economy).
So the question is, how can you be sure the price of an export makes up for the loss in capital and fractional interest thereof? Hopefully an export sale brings cash value that makes up for it. But what if I undersell at discount? Worse, if instead of selling the lumber, what if I loan it to a foreign subsidiary for nothing. I've still deprived the local economy of the lumber, but more importantly also of all the forward gains that creative destruction would imply had the lumber stayed home. What if instead I send machinery? What about sending labour? How about sending money in the form of an injection of capital when I invest abroad? Note that if my accounting-fu is strong, these acts of goodwill may be claimed as deductible expenses back home, so not only do I deprive the local economy of an fractional interest-making capital asset, and implied tax revenues for the commons, but I may also further penalise the commons by claiming a tax-credit paid by the public.
the Tragedy of the Commons, or a tax should definitely not encourage inefficiency
We have to get rid of this idea that we don't tax foreign transfers and that we subsidize losses. That to me is the moral hazard of international corporate taxation. The old fiscal theory was intended to promote risky investment by choosing to tax only profits, but instead it's turned into an orgy of abuse as profit and loss are terms subordinate to an entity's fiscal jurisdiction. What we need to do is tax flows, specifically, flows that cost the commons missed opportunities.
Also, the antiquated fiscal notion of the commons deserving a proportional share of your profits, which as we see is circumvented anyway, to me screams of injustice to liberal and libertarian principles. You shouldn't be charged more because you're better at your business, in fact the opposite should happen: For an identical set of inputs, the more efficient company should keep the higher return, while the less profitable should be discouraged because it wasting an opportunity for the commons to make good on the asset, and hence the implied savings interest rate.
a Reverse tax, or don't tell us how much you made, rather tell us how much you put in:
I think instead, we should tax investment, not profits. Recall that every dollar in the economy represents a forward on a real or imagined capital asset exploitation. Thus investing a dollar actually means you are consuming an underlying resource, ie chopping down a tree or hiring a brainy scientist's grey matter. This is what we should be taxing, because its consumption is at the expense of its better use by another investor or even by the commons. The tree may prove more useful in its capacity to provide ecological services like erosion control, co2 sinkage, etc, while the scientist's brain may have been more useful enlightening younger generations in public university. Thus we are taxing the opportunity cost of using or consuming a resource.
It's then up to the corporation, which pays a fixed cost for this asset use or resource depletion, to be efficient and make good on their use. The more efficient, the more profit they walk away with, and justly so. The caveat, is that offshoring strategies, for example "investing" in a tax haven, hence moving those dollars away from the local economy, would tacitly imply denying the exploitable potential of assets back home, and thus should be taxed equally. That is you are free to move funds to any more profitable foreign nation, but pay the tax on those funds first.
a Diligent tax, or all stakeholders have an interest in tracking the capital - the rest is your business.
The good news is that this tax need not be excessive. Forget even notions of 25% capital gains. I think the only way to fairly price the opportunity cost is to charge the base risk-free interest rate. That's right: good old LIBOR or whatever rate of return benchmark of choice for your country. This is actually a blessing in disguise. Instead of having to predict about how much profit you'll make as a business and plan a taxpool ahead of time, you'll know how much you owe from the get-go.
The other blessing in disguise is that all of a sudden the taxman aligns with shareholder due diligence instead of being at a polar opposite. All parties have an Interest to know where the money went. Imagine that, instead of the inefficiency of paranoid schemes to cook the costs and bake the books, companies can just pay down the meagre rate and get on with the business of making money. As much money as they can, and they can keep all of it, without having to tell any but their stakeholders. Unless they can't beat the LIBOR beta, in which case they have no business being, well, in business.
A possible side effect of that is that this will discourage high-leveraged ventures that misprice risk in lieu of savings. This is a very good thing. Instead of the current inflated opaque and volatile system which returns a pittance and fleeces the small investors for all their skin, this should imply a return to quality. Remember when the savings interest rate was something around 5%?
Capital Controls, or how Keynes intended the original World Bank and IMF to operate
Keynes argued that there is natural conflict between democracy and traditional capitalism. In the face of a recession or depression, one would be tempted to lower interest rates to boost a recovery of local industry. International investors, however, would be tempted to seek areas of higher return. This apparent conflict is quelled if we choose to tax investment flows instead of profits, especially for developed countries undergoing a recession. In such a case the labour costs and thus inputs would be considerably lower, and a greater return on investment would be generated. Such a system would form its own elastic safety net.
To solve the frivolous volatilty of capital flight, it was envisaged that transfers of capital between individuals and corporations of different nations would be controlled. Did you know old passports had a "foreign exchange authorisation" section which entitled or forbade currency transfers? These original Bretton Woods provision are all eroded now. While I certainly believe in the economic virtue and morality of free capital movements, to borrow a GNU quote this is free as in free speech, not free as in free beer I think the circulation need to be fairly priced (ie taxed). There has to be skin in the game to discourage the inefficient offshore predation, speculation, and volatility.
I'm going to call it the Corporate & Commons Capital Preservation tax
(or CCCP tax - heehee), though it really has nothing to do with socialism let alone communism. Rather it's a more sensible, efficient, purely marxist-capitalist, way to allocate risk and reward.