The Deflation Nobody Understands

Courtesy of Peter van Coppenolle @ NASOE:


(But they will experience it first hand)

Professor Fekete has been studying and teaching the gold standard for over 40 years now. Unlike most ‘pundits’ Fekete has held a seat at the Winnipeg Commodities Exchange in order to study the gold market from every angle possible. And studying he has done so relentlessly since immigrating to Canada in 1957. He has used all his powers to educate people about gold. Part of that effort was to groom a ‘hard core’ which now, 2013, constitutes the faculty at the New Austrian School of Economics. Over the years we at the faculty have experienced the rewards that only educators can testify to: the joy when other people finally see some light. And sometimes we encounter detractors too. They are an amusing lot, put there for our entertainment, no doubt.

Professor Fekete, dissatisfied with the body of knowledge on economics, has been a writer and above all a supreme philosopher of economics. Ever since 1957, he has amassed so much old and new knowledge, that we at the faculty of NASoE have quipped that ‘if you want to understand nothing at all about the gold standard, you will have to read B. Goldwater.’ We know that is one offensive statement. But we also stand by our own insights, research and above all methodology, which is a Mengerian disequilibrium approach. Using a good compass does make a difference. The world collectively knows that traditional ‘economics science’ is (expletive) dismal, which is stronger than just ‘dismal’. It has reached the stage were this economic discipline’s own academics are mudslinging each other or hubristically refer to themselves as invincible. (E.g. Krugtron the Invincible, a neoplasm born from a bad ’80 movie.) Or in the Austrian camp, the same old boom and bust line is repeated, yet zero research has taken place, until now, either to correct for some untenable assumptions in the Austrian Business Cycle or to advance knowledge on some other aspect of credit collapse. Nor do they bother to dismiss the Quantity Theory of Money, according to which the more money is brought into circulation, the higher prices will go. “More money chasing fewer goods”, etc..

The question described in the title is the one people least understand. Perhaps I am too harsh. People who never attended or never listened to standard economics, have no problems assimilating my message. It becomes harder to grasp for those afflicted with the idea that inflation and deflation are mutually exclusive. They are not, puzzled looks and hurled insults notwithstanding. The term “hyper-deflation” was never coined nor did such a state ever occur in history and it full scope is unknown as yet. But using Mengerian disequilibrium and Aristotelian logic, I can paint the general idea.

Professor Fekete never subscribed to what he called the Quantity Theory of Money. It suffices to point to the very fact that it is possible to have a shortage of money simultaneously with the overworking of the printing presses. The reason why the QTM fails is that money is not one-dimensional. It is in fact two-dimensional. Quantity is one, and the velocity of circulation is the other dimension. Central banks control the quantity of production and the market firmly controls the circulation speed.

If velocity increases, we talk about inflation. If it decreases, we talk about deflation. In the extreme case the increase in velocity may start feeding upon itself and velocity could grow beyond any limit. People buy anything they can lay their hands on because they expect prices to rise further. Hyperinflation is the terminal velocity of money, wiping out the value of the currency unit. This is so because the velocity of the money being exchanged for goods or services is now firmly establishing a total distrust in money. In other words: nobody in his right mind wants to hold the currency and prefers anything else over holding it. It is an irreversible process: once fiat currency loses its value, it is lost for good.

But the opposite is equally possible: the decreasing velocity of circulation refuses to stop and the slowdown starts feeding upon itself. People postpone buying indefinitely because they expect prices to fall further. This happened when silver during the ‘Long Depression’ was demonetised worldwide. The work of gold and silver had to be done by gold only now. It increased the purchasing power of gold. Any criminal would have called this “the heist of the century”, although in political circles this was called ‘progress’. The paper currency in small denominations and overrated coins circulated for daily transactions, but only because of threats of the law.

In the extreme case there is hyperdeflation. It manifests itself in the ever rising purchasing power of the currency unit, whose velocity of circulation is drastically decreasing. Obviously, this is what people do not understand. There is money creation by the trillions. Question is: where is it? — Money can be created by the issuing authorities. But once created, it is the market who decides where it goes. The banking system, as the receiver of the newly created money, is pushing on a string. Some money is lent out. But most money goes into lucrative places. And that is not business, but bonds. Frontrunning the Fed, bondholders typically make a killing when interest rates are lowered. Why? Because, understanding actuarial arithmetic involves realising that lowering an interest rate on an existing bond, causes capital gains in the hands of the holder. And halving an interest rate can go on for a long, long time. Obviously, it is not the low interest payment due that is attractive. The capital gain is the attractive part.

In 2007 professor Fekete furthermore reminded his audience to the existence of several types of fiat credit. In general, there is the tangible note that we all could carry in pockets or wallets and there is the popular intangible counterpart in electronic form, rendered useful through chip cards and accounts with banks. He also instructed all who wanted to hear in 2007 how fiat credit turns into bad debt overnight, once it reached critical mass. Banks will distrust each other so why should you entrust any of them with your savings? Than came 2008. The ensuing facts vindicated his conclusions, but in 2008 most people were too busy with damage control to pay any attention.

Critics may point out that the banking crisis was overcome thanks to the heros at the central banks, who resurrected the economy with a large dose of anti-dote: some 8 trillions worth on each side of the Atlantic, not the mention Japans’ efforts. We at NASoE we would say: duh! Professor Fekete warned again in 2007 that dousing the apparent insolvency with liquidity will only aggravate the situation of deflation. At this point, it may be useful to remind the reader about Greece, although that country is certainly not alone, as Spanish or Portuguese readers may well imagine. He said so because mathematically you cannot extinguish debt created in the modern monetary system with a substance that is incapable of that task.

Here at the New Austrian School of Economics we know that money is not a simple issue. Economics, being part of human sciences, are too complex to experiment with. Here we have yet another problem injected into the mix. The first problem professor Fekete touched upon was nothing more than Gresham’s revenge on the apologists for modern reserve banking. And the second problem was a stunning revelation that one cannot settle debt with these modern payment systems. Both concepts need working out for the non-academic reader.

Sir Thomas Gresham, a sixteenth-century financial agent of the English Crown in the city of Antwerp, explained to Queen Elizabeth I what was happening to the English shilling. Her father, Henry VIII, had replaced 40 percent of the silver in the coin with base metals, to increase the government’s income without raising taxes. Astute English merchants and even ordinary subjects would save the good shillings from pure silver and circulate the bad ones; hence, the bad money would be used whenever possible, and the good coinage would be saved and disappear from circulation.

In its modern version a paper banknote will in the scheme of good and bad money, act as the “better” one. This means that the foldable version of people’s money will be hoarded by the people or companies and even banks and electronic money will be passed on much faster.

Fast forward to today. Governments just about everywhere have passed legislation that criminalises the possession of certain amounts of foldable banknotes. One cannot enter a bank either and deposit a suitcase of money, without breaking some law. Off course, the bank also hoards the contents of that suitcase, so it will bend over backwards to accommodate you and offer you…all sorts of electronic credit and debit card arrangements. And there is more: The experience with Cyprus has proven so effective (read easy) that the EU has now legislation that will confiscate in the case of ‘emergency’ a flat 8% of all your bank savings, reminding anyone with basic monetary understanding a deeper insight into the meaning of ‘I owe you nothing’. Furthermore, hiding your money in, say Switzerland is no use. The Swiss will now report you to your fiscal authorities.

So what professor Fekete pointed out was the unexpected and sinister revenge of Gresham’s law on the apologists for fiat credit as money. Bad money drives out good money. In the modern fiat credit world, that means that foldable paper money is hoarded, contrary to the issuers wishes. Its circulation is dropping in both volume and velocity. And that happens together with an increase in the electronic variant, whose volume and circulation speed increases relative to the foldable version, so much that it exceeds the rate by which it is physically possible to issue a printed variant.

And that is not all. At the NASoE, we know we are dealing with a complex system on different levels with many variables and unexpected results. The process of quantitative easing, a euphemism for ‘we have lost control’, is a feedback loop ensuring vast amounts of ‘money’ are created and have to be created ad infinitum and in the process suppress interest rates asymptotically towards zero. In reality the issuing authorities have no other option but to create more fiat, since the interest payments need to be settled on an exponentially increasing principal amount, with a medium that is unsuitable to settle debt to boot. Making abstraction of the latter, according to the QTM, the theory we started this article with, a cup of coffee would set you back a very large sum by now. It is not. Baffled by reality, the traditional Austrian School pundits stick to their guns by saying that eventually, hyperinflation will happen. That falls short of scientific rigour. It is like saying that a broken analogue clock is right at least twice a day. It is the New Austrian School’s merit to introduce the description of the deeply flawed money creation process in which money loses value and at the same time, due to job (read income) destruction, is needed and hoarded for the settlement of necessities.

In other words: the bad money increased in supply, the ‘good money’ was hoarded. In short, authorities who are purportedly concerned with our well being are in dire need of the very money they have created and are looking in every nook and cranny to recover so called ‘lost revenue’ – as if it was theirs- from you. After manhandling everyone into obligatory electronic bank accounts, parts of your savings (for now that is) will be cancelled and possession of the paper variant is criminalised. All this would have to lead any first year student to ask: if the government creates its own money, why do we pay taxes?

Soon people will realise the scam and start using more marketable goods in their daily exchanges and in the process, they will speed up the ultimate marginalisation of paper money. Checkmate.


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