Tweet
http://www.safehaven.com/showarticle.cfm?id=8507&pv=1
September 28, 2007
Can We Have Inflation And Deflation All At The Same Time by Antal E. Fekete
Antal E. Fekete
Gold Standard University Live
aefekete@hotmail.com
Executive Summary
Very few people understand the "continental drift" that threatens with a fracture
of the U.S. (and hence, the world) monetary system. There are two tectonic
plates: one, the supply of Federal Reserve notes (FR notes), and the other,
the supply of electronic dollars in the form of an inverted pyramid that rests
on the supply of FR deposits. The fault line between the two tectonic plates,
like San Andreas fault in California, is a worrisome source of unpredictable
earthquakes that could cause massive and permanent damage to the U.S. and world
economy.
The monetary fault line exists because of the different statutory requirements
the Federal Reserve has to meet in order to increase the supply of "high-powered
money":
- FR notes must be collateralized by gold or by U.S. Treasury bills and Federal
Agency securities. The Federal Reserve does not print FR notes (still less
can it air drop them); it gets them from a government official called Federal
Reserve Agent against pledging appropriate collateral. - FR deposits may simply be collateralized by the note of the borrower who
borrows from any of the FR banks. Thus the Federal Reserve can increase FR
deposits on its own authority, without reference to the government. The banking
system then builds its own pyramid of deposits upon the fractional reserve
of FR deposits
Thus there is a serious obstacle in the way of increasing the money supply
by increasing the volume of FR notes in circulation, giving the lie to Chairman
Ben Bernanke's promise to air drop them from helicopters. The obstacle: falling
interest rates. For example, if the T-bill rate dips into negative territory,
then the market value of T-bills exceeds their face value and the Federal Reserve "cannot
afford" to buy them in the open market. The shortage of eligible collateral
will restrict the inflation of FR notes in circulation. By contrast, FR deposits
can be created out of the thin air in unlimited quantities at the click of
the mouse.
Herein lies the danger of monetary earthquake along the fault line. The outstanding
issue of FR notes as of September 20, 2007, was a paltry $760 billion (note
that a sizeable fraction is being hoarded by foreigners overseas), see: www.federalreserve.gov/releases,
which is less than two tenth of one percent of the notional value of derivatives.
Just a drop in the ocean of potential bad debt.
It is possible for the tectonic plate of hand-to-hand money, the FR notes
to deflate, while that of electronic dollars to go into hyperinflation. The
decoupling has frightening consequences for the financial and economic future
of the world.
The curse of electronic dollars
Helicopter Ben has just made a most unpleasant discovery. Earlier he has promised
that the Federal Reserve will not stand idly by while the dollar deflates and
the economy slides into depression. If need be, he will go as far as having
dollars air dropped from helicopters.
Time has come to make good on those promises in August when the subprime crisis
erupted. To his chagrin Ben found that electronic dollars, the kind he can
create instantaneously at the click of the mouse in unlimited quantities, cannot
be air dropped. They just won't drop.
For electronic dollars to work they have to trickle down through the banking
system. The trouble is that when bad debt in the economy reaches critical mass,
it will start playing hide-and-seek. All of a sudden banks become suspicious
of one another. Is the other guy trying to pass his bad penny on to me? In
extremis, one bank may refuse to take an overnight draft from the other
and will insist on spot payment. A field day for Brink's. The clearing house
is idled, and armored cars run in both directions up and down Wall Street delivering
FR notes and certified checks on FR deposits.
Under such circumstances electronic dollars won't trickle down. In effect
they could be frozen and, ultimately, they may be demonetized altogether by
the market. How awkward for Helicopter Ben. His boasting of air drops is an
empty threat.
Northern Rock and Roll
The Northern Rock and Roll fever may spill over across the Atlantic from England
to the United States. Northern Rock is a bank headquartered in Newcastle with
lots of branches in the Northern Counties. It was a high-flyer using novel
ways of financing mortgages through conduits and other SIV's, instead of using
the more traditional methods of building societies through savings. (SIV or
Structured Investment Vehicle is euphemism for borrowing short, lending long
through securitization). Now a run on the bank has grounded the high-flier.
As long queues in front of the doors of branch offices indicate, a world-wide
run on banks may be in the offing. Bank runs were thought to be a pathology
of the gold standard. In England they haven't seen the like of it since 1931
when the bag lady of Threadneedle Street went off gold. Surprise, surprise:
bank runs are now back in vogue playing havoc on the fiat money world. Depositors
want to get their money. Not the electronic variety. They want money they can fold.
There's the rub. Pity Helicopter Ben. It looked so simple a couple of weeks
ago. The promise of an air drop should stem any run. It sufficed to tell people
that he could do it. No reason to mistrust the banks since they are backed
up by air drops. Now people have different ideas. The air drop is humbug. Can't
be done. Ben is bluffing. He has no authority to run the printing presses as
he sees fit. He's got to have collateral. Moreover, as calculated by Alf Field
writing in Gear Today, Gone Tomorrow (www.gold-eagle.com,
September 6, 2007) if only ten percent of the notional value of derivatives
is bailed out by dropping $500 FR notes the pile, if notes are stacked upon
one another, would be nearly 9000 miles high. Helicopter Ben hasn't reckoned
that FR notes do not exist in such quantities. They will have to be printed,
not to say collateraliyed, before they can be dropped. It is true that the
Federal Reserve has an additional $225 billion in unissued and uncollateralized
FR notes, just in case. However, before the air drop they have to be collateralized,
and that is easier said than done. There is not enough of T-bills and agency
securities to be used as collateral.
Devolution
What does it all mean? At minimum it means that we can have inflation cum deflation.
I am not referring to stagflation. I refer to the seemingly impossible phenomenon
that the money supply inflates and deflates at the same time. The miracle
would occur through the devolution of money. This is Alf Field's admirable
phrase to describe the "good money is driven out by bad" syndrome a.k.a. Gresham's
Law. Electronic dollars driving out FR notes. The more electronic money is
created by Helcopter Ben, the more FR notes will be hoarded by banks and financial
institutions while passing along electronic dollars as fast as they can. Most
disturbing of all is the fact that FR notes will be hoarded by the people,
too. If banks cannot trust one another, why should people trust the banks?
Devolution is the revenge of fiat money on its creator, the government. The
money supply will split up tectonically into two parts. One part will continue
to inflate at an accelerating pace, but the other will deflate. Try as they
might, the government and the Federal Reserve will not be able to print paper
money in the usual denominations fast enough, especially since the demand for
FR notes is global. Regardless of statistical figures showing that the global
money supply is increasing at an unprecedented rate, the hand-to-hand money
supply may well be shrinking as hoarding demand for FR notes becomes voracious.
The economy will be starved of hand-to-hand money. Depression follows deflation
as night follows day.
Decoupling tectonic plates
Next to deflation of hand-to-hand money there will be hyperinflation as the
stock of electronic money will keep exploding along with the price of assets.
You will be in the same boat with the Chinese (and the son of Zeus: Tantalus).
You will be put through the tantalising water torture -- trillions of dollars
floating by, all yours, but which you are not allowed to spend. The two tectonic
plates will disconnect: the plate of electronic dollars from the plate of FR
notes, with lots of earthquakes along the fault line. No Herculean effort on
the part of the government and the Federal Reserve will be able to reunite
them. At first, electronic dollars can be exchanged for FR notes but only against
payment of a premium, and then, not at all.
The curse of negative discount rate
If you think this is fantasy, think again. Look at the charts showing the
collapse of the yield on T-bills. While it may bounce back, next time around the
discount rate may go negative. You say it's impossible? Why, it routinely
happened during the Great Depression of the 1930's. Negative discount rate
means that the T-bill gets an agio, the discount goes into premium even
before maturity, and keeps its elevated value after. This perverse behavior
is due to the fact that T-bills are superior to FR notes in that they earn
a yield while they are just as acceptable (if not more acceptable in very large
amounts) as are FR notes. Yes, people will clamor for money they can fold,
the kind that is in demand exceeding supply, the kind people and financial
institutions hoard, the kind foreigners have been hoarding for decades through
thick and thin: FR notes. Thus T-bills are a substitute for the hard-to-come-by
FR notes. Mature bills may stay in circulation in the interbank market, in
preference to electronic dollar credits. Why, their supply is limited, isn't
it, while the supply of electronic dollars is unlimited! The beauty of it all
is that we have an accurate and omnipresent indicator of the premium that cannot
be suppressed like M3: the (negative) T-bill rate. It is an indicator showing
how the Federal Reserve is losing the fight against deflation.
Inverted pyramid of John Exter
The grand old man of the New York Federal Reserve bank's gold department,
the last Mohican, John Exter explained the devolution of money (not his term)
using the model of an inverted pyramid, delicately balanced on its apex at
the bottom consisting of pure gold. The pyramid has many other layers of asset
classes graded according to safety, from the safest and least prolific at bottom
to the least safe and most prolific asset layer, electronic dollar credits
on top. (When Exter developed his model, electronic dollars had not yet been
invented; he talked about FR deposits and other bank deposits built upon them
as fractional reserve.) In between you find, in decreasing order of safety,
as you pass from the lower to the higher layer: silver, FR notes, FR deposits,
T-bills, agency paper, T-bonds, other loans and liabilities of the banking
system denominated in dollars. In times of financial crisis people scramble
downwards in the pyramid trying to get to the next and nearest safer and less
prolific layer underneath. But down there the pyramid gets narrower. There
is not enough of the safer and less prolific kind of assets to accommodate
all who want to "devolve".
Devolution is also called "flight to safety". An example occurred on Friday,
August 31, 2007, as indicated by the sharp drop in the T-bill rate from 4 to
3%, having been at 5% only a couple of days before. As people were scrambling
to move from the higher to the lower layer in the inverted pyramid, they were
pushing others below them further downwards. There was a ripple effect in the
T-bill market. The extra demand for T-bills made bill prices rise or, what
is the same to say, T-bill rates to fall. This was panic that was never reported,
still less interpreted. Yet it shows you the shape of things to come. We are
going to see unprecedented leaps in the market value of T-bills, regardless
of face value! You have been warned: the dollar is not a pushover. Electronic
dollars, maybe. But T-bills (especially if you can fold them) and FR
notes will have enormous staying power. Watch for the discount rate
on T-bills morphing into a premium rate!
It is interesting to note that gold, the apex of the inverted pyramid, remained
relatively unaffected during the turmoil in August. Scrambling originated in
the higher layers. Nevertheless, ultimately gold is going to be engulfed by
the ripple effect as scrambling cascades downwards. This is inevitable. Every
financial crisis in the world, however remote it may look in relation to gold,
will ultimately affect gold, perhaps with a substantial lag. The U.S. Government
destroyed the gold standard 35 years ago, but it could not get gold out
of the system. It was not for want of trying, either, as we all know. Gold
remains firmly embedded as the apex of Exter's inverted pyramid. Incidentally,
it is a lie that gold has been demonetized. Gold is still a collateral used
for FR notes. What happened was that further monetization of gold was blocked
by fixing the official price of gold at $42.22 per Troy ounce, and at that
price nobody is offering gold to the Federal Reserve. If someone did, according
to existing statutes the Federal Reserve was duty bound to monetize it. Shame
on academia for spreading lies about the demonetization of gold!
Vertical devolution is not the only kind that occurs in the inverted pyramid.
There are similar movements that can be described as horizontal. Nathan Narusis
of Vancouver, Canada, is doing interesting research on the Exter-pyramid. He
noted that in addition to vertical there is also horizontal devolution. Within
each horizontal layer of the same safety class there are discernible differences.
An example is the difference between gold in bar form and gold in bullion coin
form, or silver in bar form and silver in the form of bags of junk silver coins.
Franklin Sanders in Tennessee is an expert on horizontal devolution of silver
and has a fascinating study how the discount on bags of junk silver coins may
go into premium, and vice versa. There may also be differences between
FR notes of older issues and FR notes of the most recent vintage. There are
obvious differences between the CD's of a multinational bank and those of an
obscure country bank. The point is that movement of assets horizontally between
such pockets within the same safety layer is possible and may be of significance
as the crisis unfolds and deepens.
Dousing insolvency with liquidity
In a few days during the month of August central banks of the world added
between $300 and 500 billion in new liquidity in an effort to prevent credit
markets from seizing up. The trouble is that all this injection of new funds
was in the form of electronic credits, boosting mostly the top layer where
there was no shortage at all. Acute shortage occurred precisely in the lower
layers. This goes to show that, ultimately, central banks are pretty helpless
in fighting future crises in an effort to prevent scrambling to escalate into
a stampede. They think it is a crisis of scarcity whereas it is, in fact, a
crisis of overabundance. They are trying to douse insolvency with liquidity.
I feel strongly that this aspect of research on the denouement of the
fiat money era has been lost in the endless debates on the barren question
whether it will be in the form of deflation or hyperinflation. Chances are
that it will be neither, rather, it will be both, simultaneously. There
is a little-noticed and little-studied continental drift beween the money supply
of electronic dollars and that of FR notes. (Continental drift of the geological
variety is invisible and can only be detected with the aid of high-precision
instruments.) The tectonic plate of electronic dollars will keep inflating
at a furious pace, while that of FR notes and T-bills will deflate because
of hoarding by financial institutions and the people themselves. The Federal
Reserve will be unable to convert electronic dollars into FR notes. Apart from
lack of collateral, present denominations cannot be printed fast enough, physically,
in times of crisis. If the Federal Reserve comes out with new denominations
by adding lot more zero's to the face value of the FR notes, Zimbabwe-style,
then the market will treat the new notes the same way as it treats electronic
dollars: with contempt.
Genesis of derivatives
Alf Field (op.cit.) is talking about the "seven D's" of the developing
monetary disaster: Deficits, Dollars, Devaluations, Debts, Demographics, Derivatives,
and Devolution. Let me add that the root of all evil is the double D, or DD:
Delibetare Debasement. In 1933 the government of the United States embraced
that toxic theory of John Maynard Keynes (who borrowed it from Silvio Gesell).
It was put into effect piecemeal over a period of four decades. But what the
Constitution and the entire judiciary system of the United States could not
prevent, gold did. It was found that gold in the international monetary system
was a stubborn stumbling block to the centralization and globalization of credit.
So gold was overthrown by President Nixon on August 15, 1971 by a stroke of
the pen, as he reneged on the international gold obligations of the United
States. This had the immediate effect that foreign exchange and interest rates
were destabilized. The prices of marketable goods embarked upon an endless
spiral. In due course derivates markets sprang up where risks inherent in interest
and forex rate variations could allegedly be hedged. The trouble with this
idea, never investigated by the economic profession, was that these risks,
having been artificially created, could only be shifted but never absorbed.
By contrast, the price risks inherent in agricultural commodities are nature-given
and, as such, can be absorbed by the speculators.
This important difference between nature-given and man-made risks is the very
cause of the mushrooming proliferation of derivatives markets, at last count
half a quadrillion dollars strong (or should I say weak?!) Since the risk involved
in the gyration of interest and forex rates can only be shifted but cannot
be cushioned, there started an infinite regression as follows.
Let us call the risk involved in the variation of long-term interest rates x. The
problem of hedging risk x calls for the creation of derivatives X (e.g.,
futures contracts on T-bonds). But the sellers of X have a new risk,
call it y. Hedging y calls for the creation of derivatives Y (e.g.,
calls, puts, strips, swaps, repos). Now the sellers of Y have a new
risk called z. The problem of hedging z will necessitate the
creation of derivatives Z (such as options on futures and, with tongue
in cheek: futures on options, options on options, etc.) And so on and so forth, ad
infinitum. Thus the construction of the Tower of Babel is merrily going
on.
J'accuse
We have to interpret the new phenomenon, the falling tendency of the T-bill
rate. Maybe the financial media will try to put a positive spin on it, for
example, that it demonstrates the newly-found strength of the dollar. However,
I want to issue a warning. Just the opposite is the case. We are witnessing
a sea change, tectonic decoupling, a cataclismic decline in the soundness of
the international monetary system. The world's payments system is in an advanced
state of disintegration. It is the beginning of a world-wide economic depression,
possibly much worse than that of the 1930's. The falling T-bill rate must be
seen as a sign of the government of the U.S. and the Federal Reserve losing
their battle against deflation. We have reached a landmark: that of the breaking
up of centralized and globalized credit, the close of the dollar system.
J'accuse -- said Zola when he assailed the French government for
fabricating a case of treason against artillery captain Alfred Dreyfus in
1893. It is now my turn.
J'accuse -- the government of the United States under president Roosevelt
reneged on the domestic gold obligations of the U.S. in violation of the
Constitution: it violated people's property rights in confiscating gold without
due processes
J'accuse -- academia has been pussyfooting the government by failing
to point out the economic consequences of gold confiscation, namely, the
prolonged suppression of interest rates that was ultimately the cause of
prolonging depression. (The causal connection between gold confiscation and
the prolonging of the Great Depression should be clear. Gold must be seen
as the main competitor of bonds. Once the competitor is forcibly removed
from the scene, bond prices start rising or, what is the same to say, interest
rates start falling. Linkage between falling interest rates and falling prices
did the rest.)
J'accuse -- the government of the United States under president Nixon
reneged on the international gold obligations of the U.S. thereby globalizing
the monetary crisis in 1971
J'accuse -- cringing academia failed to point out the consequences
of trying to oust gold from the monetary system: price spiral of marketable
commodities world-wide; roller-coaster ride of long-term interest rates,
up to 16 percent per annum and down to 4 percent per annum or lower and back
up again; and, last but not least, the fact that interest rates may take
prices along for the ride
J'accuse -- foreign governments accepted Nixon's breach of faith
without demur, apparently because in exchange for their compliance they were
given the freedom to inflate their own money supply with abandon on the coattails
of dollar inflation
J'accuse -- the banks have embraced the regime of irredeemable currency
with gusto and greatly profited from it, instead of protesting that under
such a regime it was impossible to discharge the bank's sacred duty to act
as the guardian of the savings of the people, and to protect the value of
the estate of widows and orphans
J'accuse -- the accounting profession for their compliance in accepting
grieviously compromised accounting standards that allows the conversion of
liabilities into assets in the balance sheets of the government and the Federal
Reserve.
J'accuse -- Ben Bernanke is lying to the people in stating that he
has the authority to print and air dop FR notes in order to fight deflation;
the notes must be collateralized
J'accuse -- the financial press is lying to the people in parroting
the propaganda line that gold has been demonetized; gold is still used as
collateral for FR notes
* * *
In the words of Chief Justice Reynolds, in delivering the dissenting minority
opinion on the 1935 Supreme Court decision that upheld president Roosevelt's
confiscation of the people's gold:
"Loss of reputation for honorable dealing will bring us unending humiliation.
The impending legal and moral chaos is appalling."
No less appalling, we may add, is the impending financial and economic chaos.
Reference:
Alf Field, Gear Today, Gone Tomorrow, www.gold-eagle.com,
September 6, 2006
Gold Standard University Live
Session Three of Gold Standard University Live will take place in Dallas,
Texas, from February 11-17, 2008 (please note the change of place and date.)
It will have three parts: (1) a course on Adam Smith's Real Bill Doctrine
and its Relevance Today, consisting of 13 lectures, from February 11-14;
(2) an open-ended debate on True and Fraudulent Hedging of Gold Mines,
with industry participation representing both sides of the issue; (3) a panel
discussion entitled Gold Profits in Troubled Times where paraphernalia
such as the basis, the gold and silver lease rate, the NAV of gold and silver
ETF's and the variation of these will be discussed with invited experts. Program
(2) and (3) are scheduled for the week-end February 15-17. The registration
fee covers participation in the debates during the week-end, but it is possible
to register for the week-end program only. Participation is limited; first
come first served. Participants pay their own hotel and meal bills; a closing
banquet is included in the registration fee.
For the benefit of European friends of Gold Standard University, Session Three
will be repeated in March, 2008, at Martineum Academy in Szombathely, Hungary,
where the first two sessions were held, provided that a sufficient number of
people register. More details will follow later.
For further information please inquire at GSUL@t-online.hu.
Comment