In our previous article, Are we heading for a deflationary type of recession?, we explained the argument of those who believe that the current credit crisis in the US will lead to deflation of money and credit. The manifestation of such a deflation will be falling asset and consumer prices. Examples of such deflation are the Great Depression of the 1930s and the Japanese recession of the 1990s.
Today, we will explore the possibility of the inflationary scenario. Examples of such a scenario are the hyperinflation of Weimar Germany of the 1920s and Zimbabwe today. We assume that you have read our previous article, Are we heading for a deflationary type of recession? for today’s article.
Given that under today’s fiat money regime, central banks have the sole authority to create money out of thin air. Such authority entails vast power. To illustrate this point further, imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn’t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others. Likewise, the paper money that we have today is exactly such money. Look at any piece of paper money today and you will find the words of a government decree (e.g. “This Australian note is legal tender throughout Australia and its Territories”) and perhaps a signature or two.
Therefore, some kinds of ‘rules’ are necessary to fetter and curb such vast power. Without these ‘rules,’ it is impossible to maintain the integrity of money. If money loses its integrity, the financial system and economy will break down and we will be reduced to primitive bartering. The ancient Chinese knew about the necessity of ‘rules’ when they experimented with fiat paper money about a thousand years ago (see Ancient Chinese fiat paper money). During the Song Dynasty (960-1279), they had self-expiring fiat money in an attempt to prevent inflation.
Now, look at the current scheme of arrangement as described in our earlier article, Are we heading for a deflationary type of recession?:
- The creation of fiduciary money (credit) lies in the power of the banking system through the granting of credit. Today, with the proliferation of non-bank financial institutions and financial ‘innovations,’ the central bank is not able to control the supply of fiduciary money.
- The central bank sets the target price of money (interest rate), which influences the quantity of standard money (base money). As we said before in How does a central bank ‘set’ interest rates?, setting the target price of money involves open market operations. Injecting or draining base money from the financial system involves buying and selling government bonds and entering into repurchase agreement (repos). For those who are interested, this document from the Reserve Bank of Australia explains how money market operations work.
Such scheme of arrangements is just a tiny fraction of ‘rules’ that ‘govern’ the vast power associated with the authority to create money. Now, imagine that those above-mentioned ‘rules’ are being relaxed such that the government can order the central bank to bail out everyone and every business that is financially insolvent by giving them freshly printed money. Overnight, this will solve the problem of bad debts and we will not have any credit crisis to worry about. Everyone will be happy right?
Take the example of Japan in the 1990s. As this article from the Ludwig von Mises institute said,
If banks held 100% reserves, this would not sound the death knell. But for a fractional-reserve system, it’s institutional death. Only the central bank can prevent total collapse. It must act as a lender-of-last resort. Yet, when the credit expansion of the boom has been particularly extreme, making good on all bad loans with monetary inflation is something the central bank dare not do for fear of hyperinflation.
The current  level of bad debt in Japanese banks is estimated to be between 50 and 80 trillion yen, which translates to a 30 to 50% increase in the narrow money stock. The Bank of Japan simply cannot bail out the system with this level of monetary inflation.
The main point is, once those ‘rules’ are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins. A very fine example is Zimbabwe. With an autocratic despot in power, such loss of confidence is manifested in the form of hyperinflation.
Now, the question for us as investors is this: are we moving towards such a scenario?
One thing we have to be clear. Assuming that the ‘rules’ are strictly adhered to, there will only be one outcome for the current credit crisis: deflation. But alas, we live in a democracy where the mob rules. As we said before in A painful cleansing or pain avoidance at all cost?,
Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles’ heel of democracy. The mob will scream at the Fed to bail them out by ‘printing’ money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.
There is no way any politician can sell the message that America needs a severe recession (or even a depression) to cleanse the economy from the gross excesses, imbalances, blunders and mal-investments. Thus, it is very likely that they will have to fight deflation till the very bitter end, till the last drop of blood from their last soldier. Since the current structure of ‘rules’ will be too restrictive in such a war against deflation, there will be popular momentum towards the bending and rolling back of these ‘rules.’ If they press on relentlessly till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilization. Since the rest of the world’s currencies are as fiat as the US dollar and are based on the US dollar standard (see How does the US export inflation?), you can be sure the result will be ugly for the global financial system.
Therefore, watch what the US government is doing with the monetary ‘rules’ in its attempt to fight deflation. And hold gold as you watch them. Remember what we said before in Have we escaped from the dangers of inflation?,
One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.