In a fiat world, money is printed into existence by the central bank - in the United States the Fed. Given there is nothing backing up this money, it is inherently worthless. However, one can think of as real. It was printed (even if only electronically), therefore it exists.



In addition to the previously mentioned money supply, fractional reserve lending allows credit to be extended by banks and financial institutions on top of that inherently worthless money. Indeed, banks and financial institutions have leveraged credit to base money at ratios of 30-1, 50-1 or even higher.



It's pretty amazing if you think about it: Credit is extended with 30-50 times leverage on inherently worthless paper.



Ponzi Financing



Borrowers have to pay interest on the amount borrowed. However, the interest and the debt cannot possibly be paid back except by an ever expanding Ponzi scheme of lending. That scheme can last only as long as everyone believes the debt can be paid back and the market value of that debt keeps rising.



It's a faith based system in which banks extend loans and hold the credit on the books (or in many cases off the books in various structured instruments). The banks are thought of as being well capitalized as long as the value of credit on the books in relation to their reserves meets some ridiculously low minimum set by the Fed.



This is how the system works, using the term "works" loosely.



Day of Reckoning



The day of reckoning comes when asset prices start falling, defaults soar, and the value of credit on the books starts plunging. That day of reckoning has arrived.



And if leverage is high enough, as it was with Bear Stearns and Lehman, the institutions are wiped out overnight. Citigroup (C), Bank of America (BAC), Fannie Mae (FNM), Freddie Mac (FRE) and AIG are essentially in the same position of Lehman except the taxpayers via the Treasury are funding the bailouts.



Deflation Economics



Conditions today are essentially the same as during the great depression. I talked about this in Humpty Dumpty On Inflation. When I wrote that piece, I listed 15 conditions one would expect to see in deflation and the score was a perfect 15-15. I recently added a 16th: bank failures. Click on link to see the conditions table.



Those who stick to a monetary definition of inflation pointing at M2, M3, MZM, or base money supply, as well as definitions that involve prices are selecting a definition of inflation that makes absolutely no practical sense.



It is the destruction of credit, coupled with the fact that what the Fed is printing is not even being lent that matters, not some Humpty-Dumptyish academic definition that has no real world application!



I have long been arguing that we are in deflation based on the following definitions: Inflation is a net expansion of money and credit. Deflation is a net contraction of money and credit. In both definitions, credit needs to be marked to market.



Mathematical Model



I can express the above mathematically.



Fm = Fb + MV(Fc)



Fm = Fiat Money Total

Fb = Fiat Monetary Base

Fc = Fiat Credit, the amount of credit on the balances sheets of institutions in excess of Fb



MV(Fc) is the market value Fc



Inflation is an expansion of Fm

Deflation is a contraction of Fm



If only base money was lent out (no fractional reserve lending), MV(Fc) would equal zero. The equation ensures we do not double count credit in Fm.



MV is a function of time preference and credit sentiment (ie. Belief that one can be paid back). As long as that belief was high, banks were willing to lend.



Because (at the moment) Fc (credit) dwarfs Fb (base money), the system can only hold together as long as there is belief credit can be paid back and as long as there are not defaults. Needless to say, the perceived belief that Fc can be paid back is under attack, both by rising defaults, and by sentiment. That is why MV(Fc) is collapsing.



In other words, the mark to market value of credit is contracting faster than base money is rising.



What About Deposits?



Some may point out that base money is not the only real money out there. Deposits are real.



Actually most deposits are fiction, borrowed into existence via an accounting entry and lent out with the miracle of fractional reserve lending time and time again. Moreover, savings accounts have zero reserve requirements and the bulk of checking accounts which are supposed to be available on demand are swept nightly into savings accounts so that they too can be lent out.



However, the FDIC guarantees those deposits up to the FDIC limit, now at $250,000 per account. Because of FDIC it might seem that deposits up to the guarantee limit should be accounted for in the above equation. One could do that by adjusting the right side of the equation to allow for FDIC guarantees. This would result in a peculiar formula of adding credit extended with 30-50 times leverage on inherently worthless paper to guarantees promised on that which does not really exit.



From a practical standpoint however, the economy seems to be acting as if base money and FDIC guarantees are irrelevant and the only thing that matters is the market value of credit.



Let's explore why that is using a magical printing press as an example.



Magical Printing Press



Assume for a moment you invent a magical printing press. Your machine can print hundred dollar bills so good that the US Treasury cannot distinguish them them from the real thing. The bills are perfect in every way. Now assume you print $5 trillion worth of those bills and bury them in your back yard. Is this inflation? Surely not. Would it be inflation if $5 trillion in bills were spent and entered the economy? You bet. The key then is not how much the Fed prints, the key is how much of that money makes its way into the economy.



Please consider this audio with Austrian Economist Frank Shostak on Mises on September 30, 2008 discussing recent actions by the Fed.



Will this printing create [price] inflation? This is dependent very much on what money will do next. If banks will not lend and banks sit on that cash forever and ever like the great depression because the risk is too high and the banks do not know if the lending will end up in good assets or bad assets, and because banks are in so many bad assets now they probably will not lend at all.



That is the observation that Murray Rothbard made, that during the Great Depression that banks have chosen not to lend because the risk of accumulating bad assets was far to high. So they were sitting on massive reserves. That is what is developing right now.



A good example is what happened in Japan in 2001-2002 where the Bank of Japan pumped 300% at one stage and lending continued to collapse. I expect similar things to happen here. If lending will not increase we can conclude this will not be inflationary.

Don't Ask, Don't Sell Policy

Confusion due to delays?

For many years we have been expecting inflation (growth in the supply of money) and nothing but inflation as far as the eye can see, but there have been times, such as the past 12 months, when we have felt more affinity with deflation forecasters than with most other inflation forecasters. The reason is that monetary inflation, when measured correctly, was minimal during the first half of 2008 and during the two preceding years, thus setting the stage for a US$ rebound and large price declines in the investments that had been bid up to astronomical heights.



Based on our observation, a lot of confusion on the inflation/deflation issue is caused by the lengthy and variable time delays between changes in the monetary trend and changes in prices. It will often be at least 2 years before the effects of a major change in the monetary trend start to become apparent in the prices of commodities and everyday goods and services. Consequently, during the first 2 years of a new monetary inflation cycle the outward evidence will often point to deflation (even though the inflation threat is rising), and for 2 years following the END of an inflation cycle it will seem as if the inflation threat is growing (even though it is falling). ...



Current Situation



We agree with much of the analysis presented by the well-known deflationists. The main point of contention revolves around the ability of the monetary authorities (the Fed and the Treasury in the US) to keep the total supply of money growing. Our view has been, and continues to be, that the Treasury-Fed tag team has the power to promulgate monetary inflation under almost any economic circumstances and will use this power. The bond market could eventually impose a practical limitation on the government's ability to inflate because increasing the money supply becomes counter-productive once the bond market begins to anticipate rapid currency depreciation, but if price-related evidence continues to favour the deflation view over the coming year then this limitation will not arise anytime soon.



The case is not yet closed, but the evidence presented to date supports our view. For example, the monetary base has expanded at an astronomical pace over the past five months. Mike Shedlock has attempted to counter this by pointing out that a sharp increase in the adjusted monetary base (AMB) also occurred during the early 1930s, but the St. Louis Fed's updated long-term chart of the AMB shows that the recent increase has been many times greater than anything during the 1930s. In any case, the overall monetary situation today could hardly be more different to the early 1930s. During the early 1930s the Fed increased the monetary base, but the total supply of money plunged.

Discussion On Points Of Contention

What About The Lag Theory?

a lot of confusion on the inflation/deflation issue is caused by the lengthy and variable time delays between changes in the monetary trend and changes in prices.

Money Multiplier Lag Theory Is False

Two hypotheses about the nature of money can be derived from the money multiplier model:



1. The creation of credit money should happen after the creation of government money.

2. The amount of money in the economy should exceed the amount of debt, with the difference representing the government’s initial creation of money.



Both these hypotheses are strongly contradicted by the data.



Testing the first hypothesis takes some sophisticated data analysis, which was done by two leading neoclassical economists in 1990.



If the hypothesis were true, changes in M0 should precede changes in M2.



Their empirical conclusion was just the opposite: rather than fiat money being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and fiat money was then created about a year later:



“ There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly. "



Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.

Solid Evidence Credit Is Created First

To make certain that the GSEs have adequate funds to cover potential losses, OFHEO (like all financial regulators) imposes capital requirements. At the end of 2007, the two GSEs had a $24.8 billion surplus over the regulatory capital requirement of $58.4 billion; they had a surplus of $50.8 billion over the risk-based capital requirement of $38.8 billion.



These amounts can be compared with the combined retained mortgages portfolios of $1.434 trillion and the $3.501 trillion in MBS that the GSEs guaranteed for a total of $4.934 trillion.



The regulatory capital surplus amounted to 0.50% of the $4.934 trillion and 1.03% of the risk-based capital surplus. If the GSEs were to face losses in excess of their income by these percentages, they would be forced to either reduce their capital requirements by selling mortgages and MBS from their portfolios or to raise new capital from investors.



The Secretary of the Treasury is authorized to lend the GSEs $2.25 billion each, but this is more a symbolic amount than a total solution. Based on Fannie Mae’s issuance of $1.588 trillion in short term debt in 2007, the $2.25 billion would have lasted less than 12.5 hours. Based on the $598.6 billion issued of short term debt that Freddie Mac issued in 2007, the $2.25 billion would have lasted just under 33 hours.





Base Money Yet Again

USA Money Stock Measures and Debt







Measured on this scale, Bernanke’s increase in Base Money goes from being heroic to trivial. Not only does the scale of credit-created money greatly exceed government-created money, but debt in turn greatly exceeds even the broadest measure of the money stock—the M3 series that the Fed some years ago decided to discontinue.







Bernanke’s expansion of M0 in the last four months of 2008 has merely reduced the debt to M0 ratio from 47:1 to 36:1 (the debt data is quarterly whole money stock data is monthly, so the fall in the ratio is more than shown here given the lag in reporting of debt).



To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels. That US$20 trillion truckload of greenbacks might enable Americans to repay, say, one quarter of outstanding debt with one half—thus reducing the debt to GDP ratio about 200% (roughly what it was during the DotCom bubble and, coincidentally, 1931)—and get back to some serious inflationary spending with the other (of course, in the context of a seriously depreciating currency). But with anything less than that, his attempts to reflate the American economy will sink in the ocean of debt created by America’s modern-day “Roving Cavaliers of Credit”.

Attitudes

Boomers are heading into retirement. A significant portion of their retirement plan (home prices) has already been wiped out. Another portion of boomer retirement plans is being wiped out in the stock market crash. Toy accumulation is out. Fears of insufficient saving is in.



Boomers will be traveling and spending less than they planned.



A secular shift to frugality and risk aversion in all age groups has begun. Signs are everywhere.

The lend to securitize model at banks is dead. So are toggle bonds where debt is paid back with more debt, and a myriad of other financial wizardry schemes.



Children who have seen their parents wiped out in bankruptcy or foreclosed on are going to have a completely different attitude towards debt than their reckless parents did. Expect to see more frugality from parents and their children alike.

What About Zimbabwe?

Global Stimulus Kicker

Political Will vs. Consumer Psychology