Why Choose Sides on Inflation/Deflation? I

Contradictions do not exist.  Whenever you think that you are facing a contradiction, check your premises.  You will find that one of them is wrong – Ayn Rand

The question of inflation, deflation, and re-sets is being discussed ad nauseum in the media, in research reports, and even in many social interactions yet I rarely encounter arguments that reflect a deep understanding of the issue.  Gold bugs, crypto traders, globalists, progressives, conservatives, preppers, and market strategists all pontificate about what is going to happen without understanding that most of their expectations are impossible.

The global economy is like a Boeing 747 flying 45,000 feet in the air with three bad engines out of four while experiencing hurricane winds.  The global banking system is sitting on a Mt. Everest of debt – over $337 trillion as of 2Q25 according to the Institute of International Finance.  

The Covid years led to a blow-off spike in debt creation which concurrently let the inflation Genie out of the bottle in the West.  In retrospect, by allowing Covid to spread to the world, the Chinese Communist Party created the conditions for the global economic wipeout and financial dislocation that is coming.  If you think about it, there is a certain irony in China being the nation that destroys the global economy since an emerging China was supposed to raise the global economy into permanent expansion. 

Gold Standard

The inflated imitations of gold and silver, which after the rapture are thrown into the fire, all is exhausted and dissipated by the debt.  All scrips and bonds are wiped out.  At the fourth pillar dedicated to Saturn, split by earthquake and flood, vexing everyone, an urn of gold is found and then restored – Nostradamus

Personally, I’m sympathetic to the Austrian School of Economics.  I revere von Hayek and Rothbard but I don’t want a reincarnation of either at the controls of the plane that’s at risk of crashing.  I’m happy to follow them after I’m safely on the ground and can look to the future.

This is because any attempt to restore “sound money” in the short run would cause the global economy to crash instantly.  We’ve created a Frankenstein’s monster of a global financial system that is so intertwined that everyone would be poor before long. 

If you force an addict to go cold turkey, you often do more damage than if you maintained the addiction.  Think of it as the remedy being worse than the disease.  I would prefer a pilot that will do whatever necessary to bring the 747 in for a safe landing.

Physical gold and silver are nice in theory but they represent a nightmare for personal security.  If the criminals don’t get you, the government eventually will.  Despite the limitations, I’m a believer in gold and silver as it does represent “true money” but only as part of our portfolios.

The ‘re-set pontificators’ tell us that we’re going to wake up one morning to learn that the US dollar has been devalued versus gold just like the Roosevelt Administration did after the 1933 gold confiscation.  It sounds plausible until you realize that we’re not on a gold standard.  Devaluing versus gold does nothing today.  Besides, gold has moved from $35 per ounce in 1970 to its current price above $4,000 per ounce.  It’s already rising versus the dollar while skyrocketing versus other currencies.

We will eventually get some form of a ‘re-set’ but it will happen after we’ve experienced an asset liquidation event.  I’d argue that the global expansion of debt during Covid where governments around the world injected liquidity into their economies was an attempt to “print” out of the problem of excess debt.  It failed spectacularly.  We learned that you can’t devalue something that you can’t quantify in the first place.

Money Supply

If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand – Milton Friedman

Neither the Federal Reserve nor the US Treasury knows how much money is in circulation.  This is especially true of the Eurodollar market which are US dollars held outside the US banking system.  They’ve lost control over the past 50 years.  It’s the same for euros, yen, yuan, pesos, rubles, and rupees; all of the issuers of these currencies have followed the same debasement model.

The problem is that the US Congress has allowed the inmates to run the Insane Asylum since the fall of the Glass-Steagall Act in 1999.  Glass-Steagall, passed after the 1929 stock market collapse, acted as governor on Wall Street’s worst inclinations.  The result was that finance and banking turned into the Wild West, and continued despite the near financial collapse of 2008.  It was supposed to be modernization but the result has been a party of epic proportions, encompassing the entire world with few safeguards apart from price manipulation.

The core of this debasement has been the focus on constant expansion of central bank reserves, debt, and ultimately, asset prices.  The increase of “money in circulation” is a function of expanded government spending and the wealth-effect that comes with playing a no-lose casino.

To maintain momentum, the game had to be expanded across the globe, encompassing nations that lack the institutions and social mores to evolve into modern economies.  Think of it like a balloon with a tiny hole that needs to constantly add air over and above what escapes through the hole.

Then came Covid which hit the global economy like pulling the safety brake on a car travelling 100 mph.  Suddenly, all the air was at risk of leaving the balloon, so the US, China, and the rest of the world’s governments flooded the world with money created by government borrowing.  Global debt exploded by 30% in five years. 

The amount of money created at one time was so vast that it has obscured global economic fundamentals for four years.  As I wrote above, they also unleashed the sleeping inflation Genie on the developed world.  Therein lies the problem, past fiscal excesses are preventing the Federal Reserve from slashing interest rates even as those past excesses slow economic momentum. 

We can already see evidence of weakness in the US in employment, logistics, retail, and housing.  It’s going to get worse.  When it happens and if the decline is bad enough, money supply is going to contract.    

Bad Debt and Money Supply

Debt is one person’s liability, but another person’s asset – Paul Krugman

The chart below is just a simple example of how banks create assets and liabilities.  Most of the assets at a commercial bank represent loans and bonds while their deposits represent the lion share of their liabilities.  Money is created when banks make loans and credit the dollar amount to the borrowers account.  Money is destroyed when the borrower reneges on the loan.

During the deflationary events of Y2K and the financial crisis, assets at bank flattened for a time before returning to growth.  Intervention behind the scenes and emergency monetary policy prevented declines in bank asset values.  Despite extraordinary monetary policy during those periods, consumer inflation remained muted while asset inflation resumed before long.

It wasn’t until Covid and fiscal “shock and awe” that consumer inflation returned.  I believe we’re at the starting point of a deflationary downturn and the fiscal moves made during Covid represent a nuclear bomb on a delayed fuse.  Consumer prices remain high, causing interest rates to remain high which has slowly sapped the vitality from the US economy.

We can already see where marginal borrowers are starting to fold – subprime auto lenders are going bankrupt.  Change occurs on the margin.  We also know that private credit is starting to weaken with increased use of PIK, or payment-in-kind, interest payments where the lender receives additional debt securities in lieu of cash when the borrower’s cash position is tight.  Rising PIK has been a sure-sign of credit stress for decades.

So how does bad debt impact money supply?  In theory, every charge-off of a bad loan reduces money supply.  In practice, it’s normally not a big deal because banks and non-bank lenders plan for bad loans.  It becomes a problem when the number of bad loans spike in a short period of time and overwhelm the safeguards of a banking system – equity capital and reserves.

US banks have an average 14.1% Tier 1 capital as a percentage of risk assets.  A bank needs at least 6% Tier 1 capital to be considered well-capitalized, suggesting that US banks are in very good shape.  In effect, they would need 8% of their loans and securities to go to zero value before they would, theoretically, need to stop lending and 14% before they would need to worry about insolvency.

Yet the average bank Tier 1 capital in 2006 was 9% which shows that things can go sour very quickly when it comes to bad debt.  If not for intervention, banks would have been forced to liquidate bad loans into an illiquid environment, which would have produced monumental losses for the banking system and strained the FDIC to the breaking point.  A systemic liquidation event is an extreme example of deflation, each booked loss representing a reduction in money supply.     

Perhaps not coincidentally, we have experienced spikes in bad loans when spreads between high-quality bonds and low-quality bonds have narrowed to extremely low levels.  Such narrow spreads indicate times of extreme confidence such as before the Asian Contagion in 1997, before the Great Financial Crisis of 2008, and today?

How can we reconcile the fact that banks appear well-capitalized at 14% Tier 1 capital with the indicator that tells us that we’re on the brink of a negative credit cycle?  The answer is non-bank financial companies, or what some call “shadow banks.”

When banks make a loan, they have the choice to keep that loan at the bank and book profits or losses each quarter over the life of the loan or they can sell it.  When banks sell their loans to shadow banks, they get to book an immediate profit while eliminating the credit risk attached to the loan.  Shadow banks typically “warehouse” the loan until they can combine similar loans together to create an asset-backed security that can be sold to investors like pensions, insurance companies, and individual investors. 

As a result, the loan’s risk is transferred from the bank to non-deposit taking financial institutions or NDFI’s, theoretically, making the bank safe.  If you take a closer look though, you’ll find that NDFI’s or shadow banks, represent $1.7 trillion or 13% of total bank assets.  Interesting, eh?

This means that banks have booked the gains and give the appearance of having no exposure to the loans they sold but in essence, they’re still lending against the same assets – through a middle man.       

Conclusion

We shall not grow wiser before we learn that much that we have done was very foolish – Friedrich August von Hayek

One prominent reason why GeoVest called the 2008 crash correctly is that we know that risk can’t be diversified away.  Someone is always on the hook to accept the losses.  At the time, leaders like Alan Greenspan would discuss how things were different because financial institutions had hedging tools to protect their balance sheets.  It was his way of justifying his lax policies for monitoring the financial system – policies that ultimately led to the crash in 2008.

This time around, the banking system has more buffers than in 2008 but asset values are extended while fundamentals are turning negative.  We believe that government agents are maintaining the stock market at very high levels to keep pressures off the credit market.  You can read more about this thesis in this piece we wrote earlier this year.  https://geovestadvisors.com/bizaro-world/

In addition, we believe the AI values in the stock market will prove ephemeral because AI is great technology without a purpose.  It is unlikely to produce positive operating cash flow until it satisfies a valuable need.  The technology isn’t there – yet.

In the next installment on this topic, we’ll look at the inflation side and yes, I believe we will experience elements of inflation as supply chains are fractured by a collapsing China.  We’ll also touch upon what governments can and can’t do to re-set the value of their currencies as well as the problems they’ll face in making a choice.   

If you’re interested in learning more, visit us at https://geovestadvisors.com/ and contact Paul Hurley. 

Philip M. Byrne, CFA