In a modern economy, the relationship between the purchasing power of the fiat currency and economic strength generally resembles a teeter-totter: When one goes up, the other goes down.
For example, in times of economic boom, we have more employment, more products, more consumption, more demand and more currency in circulation. Result? Price inflation. As the economy rises in strength, prices rise while the correlative purchasing power of the dollar tends to fall. Teeter-totter.
On the other hand, in most depressions, we produce less, we consume less, demand for products falls and prices for products also fall. Result? Price deflation wherein the prices of products like homes, cars and computers fall while the purchasing power of the currency rises since each dollar buys more than it did before the depression. Deflation. As the economy slows down, the purchasing power of the currency goes up. Again, teeter-totter.
Gov-co believes that it can regulate the economy by controlling the supply of money in circulation. If the economy is booming and prices are rising too fast, gov-co can restrict the money supply and thereby slow demand for products. (You can’t buy a new house if you can’t get the money to do so.)
On the other hand, if the economy declines into a recession or depression, gov-co believes that it can “stimulate” economic activity by injecting masses of dollars into the economy and thereby causing monetary inflation. This is exactly what the Bush and Obama administrations have attempted to do over the past 12 to 18 months.
In theory, as the money supply increases (and dollars necessarily become less valuable), people become more willing to spend, demand for products increases, businesses employ more workers, and more people have more money to buy more products. Result? By increasing the money supply, the economy regains its strength and the depression is avoided.
The problem is that we live in a credit-based financial system wherein gov-co’s control of the “money supply” is achieved indirectly by means of changes in the “monetary base”. The “monetary base” is a measure of the Federal Reserve’s currency and reserves. In very broad strokes, the “monetary base” is the amount of currency that the gov-co makes available to banks and financial institutions for the purpose of lending to the consumers.
Unlike the “monetary base,” the “money supply” includes personal bank deposits and other forms of money and is therefore a much broader measure of money. Given that we live in a credit-based monetary system, the “money supply” largely reflects the amount of currency that’s actually lent by the banks and borrowed by the consumers.
Under normal circumstance, gov-co can increase the “money supply” (which is available to the people) by increasing the “monetary base” (which is primarily available to banks and financial institutions). Historically, when the Federal Reserve increased the “monetary base,” soon after, there’d be a correlative increase in the “money supply”.
But there’s a potential problem. If gov-co increases the “monetary base” so as to provide billions to bankers, but the bankers refuse to lend those billions to consumers, there is little or no correlative increase in the “money supply” and no significant effect on a lagging economy.
Likewise, even if the bankers agree to lend additional billions of dollars, but consumers refuse to borrow, a significant increase in the Fed’s monetary base will cause little or no increase in the public’s money supply. I.e., you can lead a consumer to the bank, but you can’t make him borrow. If the consumers can’t or won’t borrow, increasing the monetary base (funds available to banks to lend) won’t increase the money supply (funds available to the people to spend) and the economy may continue to slide towards depression.
Today, a refusal to lend (by bankers) and to borrow (by consumers) is compromising the gov-co’s attempt to “stimulate” the economy.
I’m reading a chart from Laffer Associates that illustrates the annual percentage increase in the “monetary base” between 1961 and 2009. According to the chart, during the 47 years from 1961 to 2007, the monetary base increased by an average of about 6% per year. This average increase is illustrated on the chart by a fairly flat, horizontal line from 1961 through most of 2008.
However, the chart shows that the US monetary base exploded in late 2008 through 2009 in a way never before seen. Over the past 12 to 18 months, the Federal Reserve bought up billions of dollars in “toxic” securities from the banks, pumped billions of dollars into the banking sector and increased the “monetary base” in order to increase the “money supply” and thereby prevent the “Greater Depression”. As a result, the chart’s horizontal line from 1961 to 2007 turns absolutely vertical in late 2008 and 2009 as the monetary base increased by 108% in one year. This 108% increase is unprecedented and about eighteen times the average annual rate of increase for the previous 47 years. Clearly, gov-co is working mightily to stave off the “Greater Depression” by inflating the monetary base.
Nevertheless, despite gov-co’s massive efforts, we see two seeming contradictions:
1) As indicated by the US Dollar Index, we see significant monetary inflation (increase in the monetary base and depreciation in the purchasing power of the paper dollar). Since A.D. 2001, the US$ Index has fallen from 125 to 75—a 40% fall in purchasing power as compared to other, foreign currencies. But,
2) We simultaneously see evidence of persistent, domestic price deflation as indicated by falling prices for homes, cars, land, factories, commercial real estate, etc..
Thus, so far, the Fed’s massive increase in the monetary base has not resulted in a corresponding increase in the money supply to offset the current forces of price deflation and economic depression. In fact, despite the increase in the “monetary base,” some report that the “money supply” as measured by M-3 has actually declined.
Why? How can this be? How can gov-co seemingly pump billions of dollars into the economy (which should cause enormous inflation) while most prices continue to languish and even fall (price deflation)?
The reason for this seeming contradiction appears to be a disconnect between the “monetary base” and “money supply”. This disconnect is psychological rather than technical. The Fed increased the “monetary base” to make more money available for banks to lend to consumers. The banks took the money but rather than lending it, chose to keep it to shore up the banks’ financial condition against possible economic recession/depression. Simultaneously, even when banks make loans available, consumers have increasingly refused to borrow because they don’t want to be debtors in the midst of a possible recession/depression.
The national psychology has changed. Faced with economic uncertainty, Americans have shifted suddenly and dramatically from being a nation of borrowers to a nation of savers. The bankers’ and consumers’ fear of economic depression has perpetuated a decrease in the domestic money supply (price deflation) at the same time the Fed is causing a massive increase in the “monetary base” (monetary inflation).
This apparent disconnect between the monetary base and money supply is dangerous. Why? Because if gov-co can’t pump up the economy by causing significant monetary inflation, there may be no other economic remedy to stop the Greater Depression.
In other words, if banks don’t soon start lending and people don’t soon start borrowing, we’re headed for big trouble.
How big?
Gerald Celente of Trends Research recently warned that people should be bracing for a worldwide “Greater Depression” that will not only cause a dramatic economic decline but will also mark the “decline of empire America.” (Celente at least implies that a national breakup of the sort last seen in the collapse of the former Soviet Union is at least possible for the U.S..)
Celente argues that the recent surge in the Dow back to the 10,000 level (still 30% below the previous 14,000 high), is no cause for celebration:
“There’s no recovery. This is merely a cover-up. The market crashed in March of 2009 and around the world they papered over the damage from the collapse with phantom money printed out of thin air backed by nothing.”
Mr. Celente’s “phantom money printed out of thin air backed by nothing” is merely a colorful description for the massive increase in this country’s “monetary base” caused by the Federal Reserve that was also mimicked by some of the world’s other central banks.
As a result, Mr. Celente warns that 2012 may be characterized by “Food riots, tax protests, farmer rebellions, student revolts, squatter diggins, homeless uprisings, tent cities, ghost malls, general strikes, bossnappings, kidnappings, industrial saboteurs, gang warfare, mob rule, and terror.”
Insofar as Mr. Celente doesn’t predict catastrophe until A.D. 2012, I hope he’s right. Like most people, I’d prefer to postpone the day of reckoning as long as possible. But I’m skeptical that we have two or three more years until economic Armageddon. I suspect that our circumstances are so fragile that unforeseen foreign events such as a Middle East war, hurricane or decision by OPEC to stop taking dollars could topple our economy at almost any moment.
I believe that we’re already in a period of significant price deflation (economic depression) strangely coincident with significant monetary inflation. I suspect our current condition defies the normal “teeter-totter” relationship between the economy and the currency. Instead of one going up while the other goes down, they’re both going down at the same time.
When both ends of the economic “teeter-totter” (the economy and the purchasing power of the currency) go down at the same time, the “teeter-totter” must break in half. If that happens, the result may resemble Mr. Celente’s dire predictions.
Domestic price deflation coincident with monetary inflation may be the worst of all possible economic worlds. For example, thanks to domestic price deflation, the prices of American homes, cars, land, factories, etc. will fall and contribute to unemployment. But thanks to monetary inflation, the prices of all foreign-made products—including crude oil—may increase dramatically.
What do you suppose will happen to American industries if they were simultaneously squeezed between the forces of domestic price deflation (depression and unemployment) and the forces of monetary inflation (higher prices for foreign oil and energy)? They’d fold like a house of cards. We might not see 20% or 25% unemployment as we did in the Great Depression. We might see unemployment rates of 40% or even more. We might see situations similar to the former Soviet Union where millions of people received no income for a year or more. We could see a complete breakdown of social order, increases in crime, gangs and violence as Americans struggled and fought each other to merely survive.
The result of a broken “teeter-totter” could be either 1) an economy is so broken as to cause national disintegration of the sort last seen in the former Soviet Union; 2) complete collapse of the paper dollar and replacement by some other monetary system (probably gold); or 3) both of the above.
Would this be bad? Not compared to global, thermo-nuclear war. Not compared to End Times.
But compared to just about everything else, it would be very, very bad.
Has the “teeter-totter” relationship between the banks’ “monetary base” and the people’s “money supply” been broken? It’s too early to say for sure. But it’s not too early to wonder.
Buckle up.
Until next time, I remain at arm’s length and within The United States of America,
Alfred Adask
1 Comment
November 2, 2009 at 11:55 AM
Al, 2011 is where I see the vortex opening. Perhaps earlier, who knows. Look up and listen to Lyndsey William’s recent interviews on Alex Jones. He echo’s Celente and gives a 2 year deadline. I hope to hell he is wrong, but his last 2 predictions were spot on on the main points and pretty close on a variety of others.
The banks are sucking all the money in to shore up there battered balence sheets and reducing credit lines to boot, hence deflation. God help us if that money comes out of hibernation. The Fed cannot reduce that amount of money without destroying everything. Perhap that is there goal? Good run down!