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Let me say early on that I am not in the deflation camp. Yes, I understand that in a fractional reserve banking system, as deflationists say, "debt is the raw material from which money is created”. Yes, I understand that more inflation must, by definition, mean ever more debt. Yes, I understand that this situation is unsustainable. And yes, I understand that mounting debt could very well sow the seeds of deflation. But, it could also sow the seeds of more inflation. For there is clearly two ways to liquidate debt: The first is through deflation, a contraction of money and debt; the second is through the willful, concerted attempt to inflate that debt away through inflation, with the end result being a flight from money; i.e., hyperinflation. Under today’s fiat-based monetary system, I find it hard to believe that politicians, concerned only with the next election, government bureaucrats, concerned only with their next pet project, and special interests, conspiring with both to secure the next government handout, will not team up with the mother of all government protected cartels – banking, to use their power to inflate the nation out of debt. I dare say most, if not all deflationists would agree that they will certainly try. But to the deflationist it will be to no avail. Deflation is inevitable, they say. Sooner or later all this debt will overwhelm income, and despite the best efforts of everyone, debt will be liquidated in a sea of bankruptcies and bank failures. Money; i.e., banking deposits will collapse - Deflation, in all its glory. Could we get deflation? Well, yes. In fact, as deflationists often site, we have, many times in the past. But it is by no means inevitable. In fact, I won’t count on it. Why? Because the political and monetary framework of today is nothing like that which brought us the great deflations of the past. Not even close. I’ll admit; I wasn’t always this confident. I was one of those confused observers; that is, until I checked in with the great Austrian monetary theorist and historian, Murray Rothbard. So what does Rothbard have to say on the inflation vs. deflation debate? Let’s start with his America’s Great Depression, where after a thorough analysis of the causes and consequences of the classic boom bust cycle [1], he concludes: Thus, bank credit expansion sets in motion the business cycle in all its phases – the inflationary boom marked by expansion of the money supply and by malinvestments; the crisis, which arrives when the credit expansion ceases and the malinvestments become evident; and the depression recovery, the necessary adjustment process by which the economy returns to the most efficient ways of satisfying consumer desires. [2] And what are the critical features of the depression recovery? Wasteful projects…must either be abandoned or used as best they can be. Inefficient firms, buoyed up by the artificial boom, must be liquidated or have their debts scaled down or be turned over to their creditors… Just as the boom was marked by a fall in the rate of interest, i.e. of price differentials between stages of production… as well as the loan rate, so the depression-recovery consists of a rise in this interest rate differential. In practice, this means a fall in the prices of the higher-order goods relative to prices in the consumer goods industries… Since factors must shift from higher to the lower orders of production, there is inevitable “frictional” unemployment in a depression but it need not be greater than any unemployment attending any other large shift in production… [3] Then a shocker for the deflationists: There is no need… for deflation (lowering of the money supply) during a depression. The depression… begins with the end of inflation, and can proceed without any further change from the side of money. [4] No need for deflation! Then maybe it’s not so “inevitable.” He goes on: Deflation has almost always set in, however. [5] Why? In the context of the monetary framework of the Great Depression, this is Rothbard’s answer (brackets mine): In the first place, the inflation took place as an expansion of bank credit; now, the financial difficulties and bankruptcies among borrowers [at the onset of the depression recovery phase] cause banks to pull in their horns and contract credit. Under the gold standard, banks have another reason for contracting credit – if they had ended inflation because of a gold drain to foreign countries [Rothbard later adds US citizens]. The threat of this drain forces them to contract their outstanding loans. Furthermore the rash of business failures may cause questions to be raised about the banks; and banks, being inherently bankrupt anyway can ill afford such questions. Hence, money supply will contract because of actual bank runs, and because banks will tighten their position in fear of such runs. [6] In short, faced with the threat of a bank run, banks, in a position to make good on only fraction of their depositors’ money, get scared, “pull in their horns and contract credit.” Worried depositors mean worried banks and worried banks don’t lend or invest. The result is deflation. No argument here. But is it inevitable? According to Rothbard, deflation is a “secondary feature” of depression recovery. Its genesis is to be found in the structure of the banking system itself, the “shortfalls” of a gold-based, fractional reserve banking system on the downside of a cycle. The banks greatest fear, the “dreaded” bank run, is really a manifestation of those shortfalls. As a consequence, maybe the system can be “improved” to address those shortfalls, to ease the worries of depositors and banks, to ward off deflation and ensure perpetual inflation? In other words, maybe deflation is not inevitable. With that as background, let’s have a look at the “big one” – America’s Great Depression. To repeat, the deflationists’ case rests on the assumption that despite the best efforts of everyone, inflation will fail, that debt will overwhelm the system and bring on a deflationary collapse of the money supply. Hey, didn’t the Fed try to inflate its way out of the Depression by running the printing press, and fail? Well, yes. Beginning immediately after the 1929 stock market crash and up through the 1933 Depression bottom, we see a series of failed attempts by the Fed to inject reserves into the banking system, to get the banks to reflate the system. The question is why the Fed failed? Rothbard provides the answer (brackets mine): The answer… is… that the inflationary policies of [the Fed] proved to be counterproductive. American Citizens lost confidence in the banks and demanded cash – Federal Reserve Notes - for their deposits… while foreigners lost confidence in the dollar and demanded gold…. The more that… the Fed tried to inflate, the more worried the… public became about the dollar, the more gold flowed out of the banks, and the more deposits were redeemed for cash. [7] The result: Banks “pulled in their horns and contracted credit.” In 1932, in the throws of unprecedented bank failures, banks became so worried that, for the first time, they did not fully lend out their reserves, preferring instead to accumulate excess reserves. Rothbard explains why: In the first place, Fed purchase of government securities was a purely artificial attempt to dope the inflation horse. The drop in gold demanded a reduction in the money supply to maintain public confidence in the dollar and in the banking system; the increase of money in circulation out of season was an ominous sign that the public was losing confidence in the banks, and a severe bank contraction was the only way to regain that confidence. In the face of this requirement for deflation, the Fed embarked on its gigantic securities-buying program. Naturally, the banks, deeply worried by the bank failures that had been and were still taking place, were reluctant to expand their deposits further, and failed to do so. [8] [9] Now this is important, exploding the myth that “unwilling borrowers” can bring on deflation. Not so, says Rothbard - deflation is to be found with the banks: A common explanation is that the demand for loans by business fell off during the depression, because business could not see many profitable opportunities ahead. But this argument overlooks the fact that banks never have to be passive, that if they really wanted to, they could buy existing securities, and increase their deposits that way. They do not have to depend upon business firms to request commercial loans, or to float new bond issues. The reason for excess reserves must be found, therefore, in the banks. [10] So there you have it. Much to the chagrin of the Fed founders, an inflation bent central bank alone was not enough to keep the banking system afloat, to ward off the bank run, to keep banks lending and deflation at bay. Perhaps the monetary framework needed some adjustments. Perhaps a few more obstacles needed to be removed to ensure perpetual inflation. And by 1933, at the Depression bottom, did government and big-banking ever know it. What did they learn:
From 1933 to 1935, Congress passed a series of acts - creating federal deposit insurance, eliminating the gold standard (domestically), further cartelizing the banks and centralizing the Fed’s power base solidly in Washington [11] - all aimed at enhancing the banking system’s ability to inflate, unchecked. Now here’s a legitimate question for inflationists. Will this be enough to ward of deflation and put an inflation bias in the system, indefinitely? Well, if you add in the fall of Bretton Woods in 1971, completely severing gold from the dollar, the passage of the Monetary Control Act of 1980, bringing all depository institutions under the Federal Reserve System and giving the Fed the ability to monetize any asset, and a populace that looks to government politicians to solve all their economic problems, I’d have to say yes. Still not convinced? When’s the last time you saw a real bank run? Not since the Depression, right? Do you think the new framework is working? I think so. Having said that, let’s do a mock bank run to see how it might play out: The housing bubble bursts. People walk away from their homes. The banking system is left holding the bag with a major bank running into trouble. The market value of the bank’s stock crashes, its debt downgraded to default status. People get scared and line up outside the bank, looking for their money. What do you think the response will be? Use your imagination, because the boys in charge most definitely will. Worried depositors, protected by their federal deposit guarantee, get their money – freshly printed Federal Reserve Notes. Meanwhile, the Fed orchestrates the bank’s merger with a “stronger bank”, maybe buying part of the bank’s balance sheet just to help out. Or, maybe the Fed teams up with the government to form RTC II, funded by the Fed’s printing press. Lots of turmoil, but problem solved. I can here the objections already, that this is not a sustainable policy. And I agree it’s not, because the endgame to this policy is surely hyperinflation. This is not to say that we won’t ever see another bank scare, that deflationary bouts will not checker our future. They have, and will continue to do so; that is, until we hyperinflate. You see, in the end, the market, the people are bigger than the government and the banking cartel. And if the people can’t beat these guys through deflation, they will beat them by exiting the dollar. When all is said and done, I for one can only think of one sure road to deflation in today’s environment. In Rothbard’s words “the dubious hope of Fed restraint.” I wouldn’t hold my breath! Notes [1] For complete discussion, see “The Positive Theory of the Cycle” in Murray Rothbard, America’s Great Depression (Fifth Edition 2005). [2] Murray Rothbard, America’s Great Depression (Fifth Edition 2005), page 13. [3] Ibid., pages 13-14. [4] Ibid., page 15. [5] Ibid., page 15. [6] Ibid., page 15-16. [7] Murray Rothbard, A History of Money and Banking in the United States (2002), page 294-295. [8] America’s Great Depression, page 303. [9] One can not overemphasize the importance of the gold standard during the Depression, in impeding the Fed’s ability to “protect” the banks by limiting the extent to which they could flood the banking system with money. Witness, in 1931, the last thing the Fed wanted was tighter credit conditions. Yet, precisely because of the gold standard, they were forced to tighten credit. From Rothbard’s, A History of Money and Banking in the United States, page 287-288 (brackets mine): When gold flowed out of US banks after Britain’s disastrous abandonment of their gold standard in late September, Meyer [then Chairman of the Fed] was able to force Harrison [Head of the New York Fed] - wedded to cheap money – to raise the discount rate from 1.5% to 3.5% in October reversing the gold drain by raising market confidence in the dollar. [10] America’s Great Depression, page 303. [11] New York vs. Washington control was a persistent problem in the early years of the Fed. See Murray Rothbard, “Part 3, Hoover to Roosevelt: The Federal Reserve and the Financial Elite” in A History of Money and Banking in the United States.
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