As a survivor of graduate school, I have to say I have seen the whole “debate one issue into the ground” thing before, and this saying likely applies to the debate between so-called “deflationists” and “inflationists.” So I hate to beat a dead horse, but I would like to point out the problematic nature of the dichotomy between inflation and deflation as often advanced in numerous forums. I would go so far as to say that it is a false choice. This is especially true when viewed through the prism of past economic depressions, where deflations and inflations happened simultaneously.
Depressions, like bad weather, can’t be planned or legislated away
The Great Depression of 1928-1933 was the worst global economic contraction in the twentieth century. Pretty much across the world, stock markets, real estate values, and farm prices declined over 75%, and global GDP fell by something like one quarter. However, it was not the first worldwide economic contraction (the best definition of a depression) and, unfortunately, it will not be the last. Even as a lover of gold, I have to admit that there was at least one depression under the gold standard, the “Long Depression” of 1873-1896. This was a similar kind of global contraction as that of the 1930s (and today?) and may have actually been longer. The “Long Depression” arose from excessive speculation and unstable banking practices associated with the rise of the railroads. I take it as a given that global economic contractions happen. I view them as a force of nature that can no more easily be legislated or managed away than hurricanes, floods, or earthquakes. How human beings- especially investors- deal with these depressions is another issue.
The Fallacy of Central Planning, or “Pride Goeth Before the Fall”
The Great Depression of the 1930s came as a surprise to some because it occurred less than twenty years after the creation of the Federal Reserve, an institution supposedly created to stop severe banking panics (such a those in the 1890s and, in particular, 1907). This bank was intended to be an effective lender of last resort, and yet it could not stop the Depression of the 30s. However, not long after the Great Depression of the early 1930s occurred on the Federal Reserve’s watch, there were hundreds if not thousands of economists who wanted to rescue central planners and the economics profession from obsolescence by asking for a second try. Somewhat ironically, these professional economists subsequently went about explaining all of the supposed mistakes made by the Federal Reserve that somehow caused the Great Depression. Few of these economists ever seemed to wonder about the logical problem of asking people to trust the institution supposedly responsible for exacerbating the depression with a second chance to ameliorate another one, but oh well.
One of most famous examples of the effort to explain how the Federal Reserve could have avoided the Depression came from Milton Friedman, an economist who spent the Depression working for the government as a supporter of the New Deal. Yet Friedman later tried to reconcile his private free market leanings with an acceptance of the need for central planning in an economy. He did not like Keynes emphasis on fiscal policy, or the demand side of the economy, because Friedman characterized Keynes’ views as too friendly to the advocates of state control of the private sector. Instead, Friedman focused on the monetary policy of the Federal Reserve, meaning that the central bank had failed to increase Friedman’s definition of money in the period from 1929 to 1933. Friedman’s definition of money supply contracted by over 25% from August 1929 to October 1930, and he believed that the Fed was therefore to blame for the tightening of credit in the banking system.
It may or may not come as a surprise, however, that Friedman’s monetary causes for the Great Depression not only have been criticized by Keynsians, but even by people loosely defined as Austrians, who have felt that Friedman was still defending the viability of bureaucratic manipulation or control of the economy. These Austrians dissent from at least two aspects of Friedman’s thinking. First of all, there is the issue of Friedman’s quantity theory of money and his portrayal of it as a potentially potent tool by the Fed that the bank stupidly just forgot to use. Friedman’s money supply included demand deposits (things like retail bank deposits) in addition to simple base money. Friedman included demand deposits into his definition because there was NO base money deflation in the period from 1929-1933, only deflation brought about by people calling in loans from banks, or banks going bust. So one could criticize Friedman for neglecting to tell the whole story regarding what kind of money was inflating or deflating between 1929 and 1933. Second, even if we believe that it is important to define money as Friedman did, we have to remember that the authorities at the time were hardly sitting on their hands and watching banks going under and deposits evaporate. Far from it. For one thing, in October of 1929 the Federal Reserve did provide 160 million dollars of liquidity to the banking system, in addition to another 210 million the very next month. But there was concern that too much of this medicine would further destroy investor confidence, therefore reinforcing the depression. I hope this predicament sounds familiar to you. Yet, at the same time, the concern of some bankers for moral hazard did not stop other foreign central banks from lending more money to insolvent entities, such as the loans made by the Bank of England in early 1931 to Austria after the failure of its version of Lehman Brothers, called the Creditanstalt. Moreover many foreign central banks- again led by England- also turned to devaluation as a solution to the Depression (again- sound familiar?) Beginning in September 1931, Great Britain went off the Gold Standard, followed quickly by Japan, Scandinavian countries, and, in early 1932, by Germany. Most famously, the great British Pound fell about 35% in less than one year (!!), but the Depression proved hard to shake. (Note where the dollar may be headed soon....) So it is completely untrue that devaluationists were not engaged and working after 1929, even if some people today think that there should have been more devaluation, and lament how the United States waited until 1933 to go off the gold standard.
Then there are the roles of consumer confidence and fiscal (political) policy in the unfolding of the Depression. First, lets take consumer confidence. Peter Temin actually believed that the decline in spending preceded the decline in Friedman’s money supply from 1929-1933. The implication in Temin’s work was that the Federal Reserve could not have forced the broader society to borrow, lend, or consume. (ringing any bells??) Still other historians of the Great Depression focused on the policy of politicians. Whether it was tax hikes in the U.S. or Britain or the much maligned Smoot-Hawley Tariff (to which over 1,000 economists signed a petition of protest), central banks had (and have) NO CONTROL over the idiocy of politicians and the laws they pass which damage business and foreign trade. Once again, I am hoping this reminds you of the present.
I also want to point out that the narrating of history is skewed by the way we know subsequent events unfolded. What do I mean by this? Here is an example: some might claim that the Fed should have dramatically increased its open market operations in order to stave off a deflationary price spiral in the 1930s- above and beyond what the FED ALREADY DID. Those who say this have the benefit of hindsight of knowing the subsequent crisis in the early 1930s unfolded in a deflationary manner. But what if the Federal Reserve at the time threw caution to the wind and bought five or ten times as many securities, loans, or stocks than they did; and of course went to war with the evil gold-hoarders and somehow forced them to spend their money. I think the results would have been the same- if not worse. It makes perfect sense to me that if the Fed behaved in this manner, it would have further precipitated a crisis of confidence in the dollar or in paper money. People should be scared when they look to central planners emitting paper money with all the caution of a flame thrower operator. If this had happened in the 30s, wouldn’t that have only furthered the efforts of people to dump stocks and long term bonds, to hoard anything tangible (whether or not it was gold), and simply turn a deflationary depression into an inflationary one- if not a hyperinflationary collapse of the western banking system? I believe the dilemma facing the Federal Reserve in the 1930s is actually the same one today: namely, the moral hazard of doing anything radical that might further spook the markets, consumers, other governments, or all three to exit the U.S. Dollar.
Deflationary Depression or Hyperinflationary Depression? Tomato or Tomatoe?
This leads us back to the problem of trying to neatly parcel out what is inflation or deflation, since we all know that the two things happen at the same time. At the moment, real estate prices in many areas are deflating, while gold is inflating. To take an extreme example, in World War II Germans and Japanese people with productive farms or hoards of precious metals saw values skyrocket (albeit under terrible circumstances), even as the stock markets of those two countries more or less went to ZERO.
Historians tend to be particularists- which means they don’t like big generalizations or neat social scientific models. So in the spirit of trying to be as particular as possible, let me point out two obvious, particular facts from the present (at least to most of us). First there is a U.S. Dollar bubble, and, second, a long term Bond bubble. Both of these things will deflate eventually, but that deflation could certainly have inflationary consequences for certain other things in the economy. There are similarities here to the 1970s, though I think our present predicament is much more severe. But like the 1970s, as interest rates rise, the cost of borrowing goes up, and equities suspended in air with loans and debt come down to earth right along with the values of longer term bonds. So you have deflation in certain securitized assets. But it hardly means that prices at the pump, food prices, or the price of gold deflate- instead they inflate. Why? Because among other reasons, damaged economies can’t keep up with demand, plus the fact that when people flee paper assets in search of something tangible they drive up their price.
There is no monetary deflation at the moment (even if M3 is backing off a bit), and there really wasn’t any during the crisis from 2007-2009. There also was no monetary deflation in the 1970s, but don’t tell that to someone holding certain stocks and bonds- many people lost money. In the most literal sense, then, there has not been monetary deflation since the U.S left the gold standard post 1933, or 1971 (whenever you think that happened), but there have been plenty of instances of asset deflation.
Thoughts on Robert Prechter, Asset Management, and Gold
“Precious metals are likely one day to become the most important asset class to own….Since the Fed came into being, [inflation] has destroyed the financial security of the working class, the middle class and retirees. Had modern money a tangible basis, then workers could have saved for their retirement in a true store of value, and retirees would have far more buying power in their golden years…. Gold also contributes to long-run productive stability. By setting up central banks with monopoly powers dedicated to paper money, governments traded that stability for an international casino in which money manipulators thrive at the expense of both producers and savers.”
Do you know who authored the above sentiments? Was it Ron Paul, Marc Faber, James Turk, or Jim Sinclair? No. It was none other than the Dean of Deflation studies, Robert Prechter, a man whose work has produced a firestorm of protest from goldbugs or commodity perma-bulls, if the tone of some of the complaints on the internet is an accurate barometer. Prechter’s precious metals-friendly quotes come from pages 206 and 207 of his best-seller, Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression. The title sort of speaks for itself. But in this book, Prechter seeks to caution people against assuming that just because certain definitions of the money supply grow (meaning they are inflating) this does not mean that price or asset inflation is a given. This point is well taken, then, because it may be worth being skeptical regarding the ability of central planners to simply order widespread price or asset inflation when they are facing a depression. The world tends to be a little more complex and harder to manage than central bankers- and many money managers- think, and investors should keep this thought in their heads as they run off and buy stocks in anticipation of the inflationary effects of “QE 2.”
It is worth pointing out that Prechter is a man who owns gold and who claims to have purchased gold mining equities at bargain basement prices in 1971; but these purchases were done against the herd, which is Prechter’s modus operandi. He relates that his broker actually sent him a letter in 1971 telling him NOT to buy “dangerous” gold mining equities. So I read Robert Prechter as an advocate of contrarian thinking, humility, and caution in a world that often dismisses all three. He also seeks to remind people that there are few investors- mostly speculators. When you invest- especially in stocks and long term bonds- you are a speculator. This puts a different tinge on things and cuts against the grain of the conventional sales pitch made to American savers by the investment management or brokerage community. Prechter is someone who obviously is afraid of people being taken with any number of manias, or with dreams of quick riches. His views have been justified by the way in which the asset management profession has had egg all over its face for the last ten years, as it recommends stocks, bonds, and even commodity futures which are often simply suspended in mid air with unstable bank leverage, and which all behaved quite similarly in the 2008 crash. In other words, when you invest in a mutual fund, or with a money manager, you are really putting your money on a roulette table at a casino. I imagine Prechter sees the increase in what you might call “bubble mentality” (including the bubble in asset management) as an unhealthy manifestation of the excesses of the fiat currency system itself, and he sees himself as the gadfly reminding people that the casino might very well close down someday. I respect this, especially given the level of hot air that so often characterizes conventional views of fiscal issues, money, and investing.
My problem with Bob Prechter is that his prediction of deflationary collapse is overly dogmatic and one-dimensional. In his view, there will be an acute and total deflationary vaporization of asset values and that is that. Prechter believes in a swift, collapse of debt as the Tower of Babel of fiat money comes crashing down, likely in a matter of weeks or months. His model, at least in my eyes, seems to be the South Sea Panic of 1720 (and others tied to it), where values of most western European bonds/stocks tied to New World enterprises lost something over 90% of their value in a matter of months. It took over a century to recover their real value.
Perhaps even more strangely, Prechter believes that gold and silver will also get hit in the coming vaporization- primarily because these assets (at least at the COMEX) are traded on paper, with leverage, and are not as liquid as the US Dollar market. Of course, this lack of liquidity works both ways- hopefully you are aware of the exploding premiums on retail coins during the 2008 crisis as an example of scarcity squeezing prices higher. I do not agree with Prechter’s view that conservative investors should only have a minority of money in gold and silver, with the majority being in the very paper instruments I would think Precther would be worried about being defaulted upon by bankrupt governments, as well. (?) It is strange that someone so concerned about the collapse of the coming financial system is so comfortable with paper promises, or debt. (Prechter tends to recommend that savers spread their money around in the short term bills of the six or seven strongest paper currencies, such as the U.S. Dollar, Kiwi, Aussie, Swiss franc, Loonie or Norwegian or Swedish Krona)
I also have a problem with Prechter’s view of human nature when he claims that this Depression would be the first one where people did not scramble for gold. Going back to the case of the South Sea Bubble itself, we learn from no less of an authority than Voltaire how there were draconian laws put in place in France to punish “hoarders” of gold and silver, since everyone was scrambling for the best form of cash after the collapse of the bourse market. The same is true of the 1890s, when J.P Morgan had to bail out the U.S. government because gold was flying off the shelves during the tail end of the Long Depression mentioned above. And of course gold became scarce in the early 1930s, and was then revalued higher. Prechter likes to claim that contemporary investors are so unfamiliar with gold that they won’t turn to it in a depression, but this viewpoint is becoming more and more untenable with each passing day. It may be the case that American investors have forgotten about real money, having been lulled to sleep by a (formerly) strong dollar, but I highly doubt that this is the case with African, Middle Eastern, southeast Asian, or central or eastern European investors, many of whom have had direct, first hand experience with a currency collapse. These investors understand that in a depression cash is king, and the king of cash is gold. It may also be the case that other assets, such as select agricultural commodities (like cattle), farms, low-income and cash positive residential buildings, or rare earth metal investments, and certain types of energy investments may also be inelastic enough to move higher, even as other paper investments collapse. At the very least many of the aforementioned investments are actually owned by their owners and do not exist as some promise, susceptible to counterparty risk from bankrupt entities.
As an additionally mystifying example of Prechter’s view on gold from his book, Prechter reprints a graph from his own research on the relationship of the value of gold to the value of the American stock market since 1800 (which in earlier times was merged with what we would think of as the corporate bond market). What is fascinating about this graph is that it shows how the average value of stock averages to the gold price was more than inverse to what it was in the year 2000- where the S&P bought something like 7 ounces of gold. To extrapolate from his logarithmic graph, Prechter claims that in the early nineteenth century, one ounce of gold bought something like 15 or 16 shares of his composite stock index. In today’s terms, this would yield roughly a 15,000 dollar an ounce gold price. (These are my rough estimations.) Obviously, the United States is a much wealthier country than it was 200 years ago, but do not think for a moment that people will not DRAMATICALLY reevaluate the role of gold in our global monetary system. In fact the actions of central bankers, who are basically net buyers of the yellow metal for the first time in quite a while, already signals this change- if only in a small way.
And just remember what Mr. Prechter told us: “precious metals are likely one day to become the most important asset class to own.”
I always knew you saw things my way, Bob.
