The Event

by Eric Andrews | September 21, 2009

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Since at least 2000, there has been a heated debate over the **BIGGEST FINANCIAL ISSUE OF ALL TIME**: “will there be Inflation or Deflation?”

And so far the answer has been “Yes”. Since 2000 we have had both Inflation and Deflation, each measurably so. Never deterred, the argument has now shifted to: “Which way will it ULTIMATELY go, in the final analysis?”

The key arguments include those listed below:

...And so on, day after day, board after board. As one writer quipped, “When I read one side, it seems conclusive and irrefutable...until I read the other side, which is just as convincing.”

Which to choose? Why not both? It is true that on the Inflationist side, that the money supply has increased, that government can change the rules at any time, that they have the power to destroy their currency at will, and will do everything it can to keep asset prices high. The Deflationists are correct that by debt-GDP, ability to service debt, etc, money—which includes credit—is mathematically unmanageable and is already contracting at a pace overwhelming the additional money supply, and this contraction is showing itself in falling GDP, stocks, bonds, and housing prices.

Since both are correct on their individual points, it follows that both must happen. But how?

For one, it's clear to me that we're already in Deflation. Even the Inflationists can't dodge the issue that the supply of money includes some form of credit. Under our peculiar system, Money isn't separate from credit, Money equals credit. In the words of Robert H. Hemphill, Credit Manager of Federal Reserve Bank:

"We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is."

He is correct that this happens when you abandon an objective, commodity-backed money, but neglects to mention the most important point. Because all of our debt-based fiat money is borrowed into existence, the money does not exist before the loan in a savings account somewhere, and therefore the loan is backed with the promise inherent in each individual loan, a 1=1 equation. However, the important part and the very reason for the loan is that it requires interest. So the full equation is $1=$1 + 5% or whatever the rate is. This always creates a synthetic dollar short position, by definition. If every loan were repaid, every dollar would disappear, strange but true; but what's more, the last dollar would disappear long, long before the last loan was repaid—the interest would still be outstanding! Only the principle is what is borrowed, not the interest. For the interest to be paid, ever-increasing quantities of money must be created, via extending ever-increasing volumes of loans. For where would we get the interest to re-pay existing debts? It would have to be borrowed into existence! And how would we do that? With yet-more interest. This does not happen on a commodity standard such as gold, which can extinguish debts with finality, not more debt. But we are not on such a system. Our debt-based fiat system must increase at an increasing rate forever within the context of a finite planet.

Like this, an ultra-modest 2% interest rate, compounded:

(Courtesy Mish Shedlock, http://globaleconomicanalysis.blogspot.com )

It cannot continue forever in a finite system, therefore it must collapse. And once any bubble trend collapses, it has never been reflated before all the previous unfounded credit has been wiped out, and the system comes to represent reality again.

This is an important pillar of the Deflationist argument. Our money is not “printed”, and it is a terrible mistake to say that it is. Even monetizing Treasury debt—the classic example—is not monetizing the debt in the same way that Weimar Germany printed notes on one side with spiraling zeros. Our “monetizing” is borrowing money from and owed to the Private Fed and her member banks, which not only must be repaid with interest eventually, but there is an ongoing interest charge due each month. And at this point, that interest is neither a minor accounting entry, but 1/3 of the Federal budget. If they cantruly print actual paper currency to pay the national debt, the fact is that right now they are not, and have no existing mechanism for doing so. Even our paper currency, printed by the Engraving Department by the US Treasury, only represents money borrowed and owed with interest.

Nevertheless, this is clearly absurd as our good Fed Manager declares: how is it possible that a nation could not be able to destroy their own currency if they wish to do so? How is it possible that they could not inflate it to a hundred, a thousand, a million should they wish to do so? The answer as both Inflationists and Deflationists will tell you is that they can. Even if they have no mechanism to do so now, Congress could extend their violation of the Constitution that only gold and silver are money, seize the Engraving Department or the Private Banks, and either print paper currency or transfer electronic cash to each individual bank account. They can and many nations have done so.

This is the key issue between the two camps. Not that what is happening is not happening. The “money” supply is increasing, no argument. The credit supply is decreasing, no argument. The contraction in credit (deleveraging) has reflected itself in a reduction of asset values to as much as -40%, just as a change in the money and credit supply should cause it to. The question for both camps wishing to be ultimately right, is “what now?”

Inflationists believe the government will step in and actively devalue the dollar, both to increase the nominal (not real) value of assets, and to avoid delivering on their promises such as Social Security and Medicare. Deflationists believe the government and banks will not destroy their power base--the bond market and the currency--to do so, and will instead simply force defaults by everyone else and be the last man standing by simply hesitating.

And they have a point. If the government and banks are going to create money from thin air to avoid a meltdown, a Deflationary spiral, what are they waiting for? Shouldn't they have done this in January of '08 when there were warnings but before anything bad happened? Or in March of '08 when Bear Sterns fell? Or in September '08 when Lehman fell? Or any time from May of '08 to February '09 while the Dow fell 6,000 points, housing prices plunged, mortgage bonds, ABS, and municipal bonds collapsed, and world markets followed with a 50%-90% loss? Even now, GDP is arguably negative, 100 US banks have gone under, sinking the FDIC, the Case-Shiller 10-city price index has fallen 31%, the Dow remains 40% below its all-time high, and in excess of $50 Trillion had been lost worldwide? If they were going to inflate wouldn't they do it now? Now in these past nine months?

Which brings me to my point. While it's true that a country can always destroy its currency and cause inflation should it wish to do so, our country is notdoing so. Or not yet. We are in deflation, as represented by this chart:
(Courtesy Karl Denninger, http://market-ticker.denninger.net/ )

Deflation is a contraction in the supply of money and credit, and as we said, credit=money. Both asset values and consumer credit are falling, and in the nature of bubbles, perhaps irreversibly. Asset values on the books of banks and corporations are falling hard as well, even if they are hidden by illegal accounting games, as seen by the recent disclosure that AAA-rated Mortgage bonds are worth 22 cents on the dollar, exactly what they were when the crisis began. ...And that's good, as AA-rated bonds are worth 4c, with everything further down the tranches effectively worth zero. Banks taken over are showing a +30% further loss compared to what they were publicly admitting.

Note above that although the Federal borrowing has risen sharply in an attempt to maintain the overall level of debt (by shifting if from failed private entities to the public taxpayer) the government, large as it is, is still far smaller than the entire economy. To offset the contraction of all other parties, it would have to triple or more its present levels, without the dollar and bond market collapsing, and that would only offset today's losses and delay the issue, not cure it, as shown in Japan's continuing 20-year recession.

Actually, that's nothing in terms of trouble. Unfunded liabilities—and this is Federal alone, in Social Security, Medicare, debt, interest, and wars—is nearing $100 Trillion, or $1 million per non-poverty household. Add to that the roughly $45 Trillion presently owed Private sector debt, as well as the Corporate, State, and Local debt, and you get as much as $2 million owed per non-poverty household. I don't know about you, but I don't have that kind of money lying around my house...and if I don't have it, I can't pay it.

So if they're not going to inflate now, given the state we're already in, then when?

When? When they have to. When something happens, and not before. This is the key to my argument, a view held by both Bob Prechter of Elliot Wave and Eric Janzen of iTulip. The government, the Fed, the banks, they've had all summer to inflate, and during a positive, receptive environment. If there was ever a time to actively prevent Deflation, it was this past summer. Something around $23 trillion was offered in one program alone (TARP), so there is clearly no issue of money or expense, while previously unimaginable power was seized by the Federal Reserve and Federal Government, to force mergers, bailouts, nationalize, and upturn bondholders in violation of 200+ years of legal precedent, so what's stopping them is clearly no issue of law.

The issue, as seen by the “Audit the Fed” initiative, and the deep backlash to the bailouts, nationalization, and bonus scandals, is political. To inflate on the scale required to have any impact on the credit contraction would require the Government and banks to actively, openly, and publicly devalue the dollar say 50%, 80%, 99% overnight, in a Mexican or Argentine fashion. Their own actions have shown that despite a year's reprieve, they are not willing to do so preemptively, on their own.

Yet there are only two ways to purge un-payable debt levels: you can default, or you can inflate. A default will take out thousands of households, corporations, all non-bailed out banks, and most State and Local Governments. Inflation will cause the same thing, the same Depression and damage—there's no free lunch--but it will hide its true cause of Government and Wall Street excesses, and save those two groups at the expense of savers and foreign creditors, as well as sharply increasing life-giving revenue by taxing inflationary “gains” at home.

This is far too tempting for any government. Yet they have not.

This tells us the only thing we need to know as investors: the timing.

The Banks, Government, and the Fed, have shown they are NOT going to inflate—yet. They will stand back, piddle in the margins and hope, analyze, and hesitate until the Deflationary collapse happens for them. And it's happening now as we can see that consumers can NOT take on more debt even if they wanted to; they are slowly falling behind on servicing the debt they already have. The natural weight—if unaltered by a truly massive intervention—is Deflationary contraction. Contraction in employment, in sales, in GDP, in shipping, in debt issuance, in the payments, income streams and loan self-heals that we already see. This steady contraction will at some point suddenly be reflected in asset prices, as the delusional psychology breaks and the Dow falls to 5,000, 4,000, 3,000 or somewhere. Don't say it can't happen because of intervention. There was intervention all the way down from 12,000 to 6,000 and it couldn't stop it. Their intervention may be larger now, but so are the problems, beyond any possible containment.

After such a massive collapse and repudiation of manipulation, the Banks, Fed, and Government could, just like now, inflate on the truly massive, Biblical levels required, and thereby default on the debt using inflation instead of bankruptcy; they would finally have an excuse large enough to hide behind. ...But at that point the damage is also already done. Once the Dow has already fallen to 5,000 or below, and the next truly epic number of bankruptcies have already occurred, what would be the point of inflating? But they could at that time, truly inflate or hyperinflate at last. But then, they could now.

There is one other scenario: that the government will still actively and intentionally inflate, and will in fact plan or cause the event they will use as an excuse for their actions. For our purposes, however, this is the same thing—we will first look for the destructive EVENT, one which will drop the market and seize the banking and credit system, and then afterwards, see if they take real action to inflate.

This goes back to Prechter's timing; that Deflation will happen FIRST, before the government can or will react. And they're proving that with a whole year's insubstantial actions. But this is also Janzen's “Ka-Poom” argument, that Deflation will happen first, for a few real months as in Argentina in 2001, but that any modern government on a strictly symbol-based currency, will always inflate rather than allow Deflation to take its full course. In his scenario, the latent inflation finally takes the upper hand in a total loss of confidence, causing near-immediate hyperinflation. But on this one thing, both sides agree, both the King Deflationist, and the key Inflationists—inflation occurs during a boom as credit is expanding, then credit pops and contracts, it is repudiated, and then...ULTIMATELY...? Inflation or Deflation?

Which will it be? Despite arguments to the contrary, we can't know. Although no symbol-based modern currency has ever chosen Deflation, the world has never yet been on a global fiat standard during the downturn of the 70-year Kondratiev cycle. So we can't guess. Functionally it can go either way. To save themselves, banks and creditors could choose to foot-drag until the whole Deflation is over. Or to “save the people”, Governments could seize the real power of the printing press and thereby create a mechanism for true inflation that does not presently exist. Personally, I believe a third thing will happen instead: that accounts are so imbalanced and are such a mockery of reality that the present system will disintegrate to be rebuilt piece-by-piece, and the dollar will vanish in its present form, perhaps reformed in one or three world currencies, perhaps with a dollar backed by gold at a far lower rate.

Although that's my opinion, we can't know for a fact who will get the upper hand in that eventual struggle. I cannot tell you which side will ULTIMATELY be right, in the very long-term, for each will be right in their own time. Life is a story that doesn't have a neat endpoint, but goes on and on.

But by their own actions we now know one important thing: they are not inflating, even with such desperate realities as face us today, and there is no reason to think they will until something happens. How do we know? They've already told us with actions louder than words.

Wait for The Event. Position yourself for it. It will be Deflationary, for by public standards if it were Inflationary to assets, that would be called a “good” thing, not a crisis. Then, after the Deflationary economic or geopolitical event, then we will see.

But first things first. Wait for The Event.

Copyright © 2009 Eric Andrews
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As Eric states "Life is a story that doesn't have a neat endpoint, but goes on and on."

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