Deflation Begets Inflation

Most of economic stimulation provided by the governments of the industrialized nations has gone towards supporting the prices of paper products, namely stocks and bonds. The last of the dollars in the latest U.S. stimulus program were distributed at the end of March, 2010. Little of this money found its way into the fractional-reserve banking system in the form of private loans for business and mortgages. Banks were fearful of the economic conditions that they had created and were reluctant to take risks when they could borrow short-term paper at artificially created low rates and buy higher yielding long-term paper from the Federal Reserve. They could safely pocket the difference in rates and bide their time until economic conditions improved. It seems that the sole purpose of the so called “stimulus packages” worldwide was not to stimulate the economy, as many governments in the West claimed, but rather to save big banks and well connected bankers from failing. Not only did the stimulus packages save the big banks, but they made them even bigger as they gobbled up smaller banks. Big banks in the U.S. were allowed to keep the performing assets of their unlucky colleagues that went into receivership while unloading the toxic assets on the country’s taxpayers. The big banks were also allowed to mark-to-model their toxic assets so that when the time came to repay the loans to the government, banks could pretend to do so by repaying the loan of government securities with worthless Ponzi paper such as credit default swaps.

Some of the government loans to bankers have found their way into the stock markets of the world. Lacking the stimulus of funds from programs that ended in March, the U.S. stock market experienced its worst May decline in forty eight years. Markets worldwide swooned as well with most major markets experiencing significant declines.

The problems of the financial crisis of 2008 and 2009 were diverted, or perhaps more accurately described as postponed by governments who provided a backstop to the banking system. They kept the too-big-to-fail banks in business and kept the monetary systems functioning by injecting freshly created money into the banking system. The citizens of each country whose central bank provided bailouts were unwillingly obligated to owe money to the very bankers that caused the crisis. Now we have come to what perhaps can be called the second stage of the crisis, namely, “who will bail out the sovereign nations?” Now that the banks have been temporarily recapitalized by sovereign nations, the question is who is going to bail out the sovereign nations who could ill afford to bail out banks? Citizens of industrialized countries such as the U.S. and the U.K. are saddled with high personal debt, a burgeoning government debt that will be their obligation to repay, and rising unemployment. The answer to this question is no one knows.

In the world’s fiat currency monetary system, debt is money and money is debt. The inability of nations to expand the money supply through the fractional-reserve banking system is by definition deflationary. In the industrialized world, government borrowing to finance bankers has replaced private borrowing to finance business expansion and productive uses of capital. The money supply in the U.S. is currently contracting and the ratio of the change in GDP stimulated by a change in debt is negative. This indicates that no amount of monetizing (i.e., printing money) by the Federal Reserve Bank will produce economic stimulus.

As such, many governments will eventually have to default on their debts. However, for now, they will more than likely keep the wolf from the door a while longer by monetizing debt in order to keep deflation at bay. Therefore, we expect that each new wave of deflation will result in a new wave of inflation as debt monetization feeds back into the economy. As a general rule, assets that don’t require credit to purchase, such as stocks, will benefit while things that require credit, such as commercial real estate, will suffer. We expect that the current wave of deflation will end in 2010 and lay the groundwork for even greater inflation in the months ahead.

* With contribution from Bruce H. Pugesek, President of Voyageur Research

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