In my previous paper The Revisionist Theory and History of
Depressions I argued that persistently falling interest rates cause an
erosion of capital, unseen but nonetheless lethal. Producers are squeezed and
try to survive by cutting prices. Lower prices add to pressures lowering
interest rates, and a vicious spiral is set in motion. Thus money-creation by
the Fed has a little-noticed deflationary side-effect to it,
that may ultimately overwhelm the inflationary effect, in spite of
predictions by the Quantity Theory of Money.
Money
out of the thin air?
Detractors of our fiat money system (myself not included) are
fond of saying that “the Fed is creating money out of the thin
air.” If that were true, then the Quantity Theory of Money (QTM) might
be valid implying that the present runaway money-printing exercise would
indeed lead to hyperinflation before long. How could anyone suggest that the
denouement will be deflationary after all?
I maintain that the Federal Reserve banks are not creating money out
of the thin air. In fact, they must first post collateral with the Federal
Reserve Agent (who is not under the jurisdiction of the Fed but under that of
the government). Only after the collateral has been posted can they create a
commensurate amount of Federal Reserve notes and deposits. Typically, the
collateral is U.S. Treasury bills, notes, or bonds, purchased in the open
market on behalf of the Fed’s Open Market Committee.
Because open market purchases of Treasury paper have consequences, we must
examine them before passing a judgment on the validity of the QTM. Such an
examination is always side-stepped by the devotees of the QTM. What are those
consequences? They are the effect of open market operations on the rate of
interest. Since open market purchases of the Fed involve bidding up the price
of government obligations which varies inversely with the rate of interest,
we can say that they will make interest rates fall. (To be sure, on occasion,
the Fed may be a seller of Treasury paper but, on a net basis, it has been a
buyer every single year.)
This means that the regime of irredeemable currency, depending as it is on
the open market operations of the Fed for its existence, imparts a definite
bias to the interest rate structure establishing a falling trend,
whereas interest rates would be stable in the absence of that regime. This in
itself is a condemnation of irredeemable currencies as they introduce an
unwarranted bias into the economy favoring debtors and spenders while
punishing creditors and savers. In addition, it favors the financial sector
at the expense of the producing sector. Falling interest rates, as opposed to
low but stable ones, are detrimental to productive capital.
Thus we have two effects to reconcile as a consequence of money-creation by
the Fed: an inflationary and a deflationary one. We cannot say which of these
two forces will ultimately prevail without digging deeper.
Risk
free bond speculation
In the actual case there are other important forces at play, which are
induced by the Fed’s open market purchases. We have to take into
account bond speculation, a permanent fixture on the monetary firmament since
1971 when the U.S.
government defaulted on its gold obligations to foreign governments and central
banks. (There was no bond speculation before, for reasons having to do
with the lack of sufficient variation in the rate of interest, making such
speculation unprofitable.) Analysts and financial writers hardly ever
consider bond speculation as a factor in the money-creating process. For this
reason alone, their predictions are practically always worthless.
The fact goes virtually unrecognized that open market operations render
bond speculation risk free. All the speculators have to do is to second-guess
the Fed. They know that the Fed must be a net buyer. They know the identity
of the agents the Fed is using to execute its purchase orders, and stalk
them. Speculators study the same monetary statistics which the Fed itself is
using to determine the timing of its open market purchases. Can the Fed
outsmart speculators? Hardly. The Fed is run by bureaucrats and their trading
losses are ‘on the house’. By contrast, the speculators risk
their own fortune. They are certainly smart enough to detect false-carding on
the part of the Fed. Even if we assume that they have no inside information
(which is a rather naïve assumption), the speculators can easily
front-run the Fed’s open market purchases.
The presence of risk-free bullish bond speculation imparts a huge additional
bias to the economy, virtually guaranteeing a falling interest-rate
structure, as demonstrated by the past quarter of a century, during which
interest rates have been driven down from the high teens to close to zero. It
may distort the ultimate outcome of this latest tragic experimentation with
irredeemable currency. No longer can it be taken for granted that the
denouement of unlimited money-creation will be hyperinflation with the
Federal Reserve notes rapidly losing purchasing power. On the contrary, it
could be an unprecedented deflation with the Federal Reserve notes being
hoarded by the people, firms, and institutions as their purchasing power is
actually increasing (in fact, they are already being hoarded by foreigners in
the second and third world countries in unprecedented amounts). The dollar
will not be the first among irredeemable currencies to be annihilated in this
latest hecatomb of currencies. It will be last one.
Price
wars
The QTM is a linear model that may be valid as a first approximation,
but fails in most cases as the real world is highly non-linear. My own theory
predicts that it is not hyperinflation but a vicious deflation which is in
store for the dollar. Here is the argument.
While prices of primary products such as crude oil
and foodstuffs may initially rise, there is no purchasing power in the hands
of the consumers, nor can they borrow as they used to do in order to pay the
higher prices much as though they would like to do, to support it. The newly
created money is going into bailing out banks, much of it being diverted to
continue paying bloated bonuses to bankers. Very little, if any of it has
“trickled down” to the ordinary consumer who is squeezed relentlessly
on his debts contracted when interest rates were higher.
It turns out that the price rises are
unsustainable as the consumer is unable to pay them. They will have to be
rescinded. Retail merchants will start a damaging price war underbidding one
another. Wholesale merchants are also squeezed. They have to retrench.
Pressure from vanishing demand is further passed on to the producers who have
to retrench as well. All of them experience ebbing cash flows. They lay off
more people. This aggravates the crisis further as cash in the hand of the
consumers diminishes even more through increased unemployment. The vicious
spiral is on.
But what is happening to the unprecedented tide of
new money flooding the economy? Well, it is used to pay off debt by people
desperately scrambling to get out of debt. Businessmen are lethargic; every
cut in the rate of interest hits them by eroding the value of their previous
investments. In my other writings I have explained how falling interest rates
make the liquidation value of debt rise, which becomes a negative item in the
profit-and-loss statement eating into capital of businesses. Capital ought to
be replenished but isn’t.
Worse still, there is no way businessmen can
be induced to make new investments as long as further reductions in the rate
of interest are in the cards. They are aware that their investments would go
up in smoke as the rate of interest fell further in the wake of
“quantitative easing”.
Self-fulfilling speculation on falling interest rates
The only enterprise prospering in this deflationary environment is
bond speculation. Speculators corner every dollar made available by the Fed,
and use it to expand their activities further in bidding up bond prices. They
have been told in advance that the Fed is going to move its operations from
the short to the long end of the yield curve. It will buy $300 billion worth
of longer dated Treasury issues during the next six months. It is likely that
it will have to buy much more after that. Speculation on falling interest
rates becomes self-fulfilling, thanks to the insane idea of open market
operations making, as it does, bullish bond speculation risk-free and bearish
bond speculation suicidal. Deflation is made self-sustaining.
Investors are urged by the Treasury and the Fed to
invest in the toxic assets of the failing banking system. They are offered
incentives if they do, making it appear that speculating in toxic assets has
been made risk free as well. So the choice before the investors is either
investing in toxic assets for which there is no market, or invest in Treasury
paper which bond speculators and foreigners are scrambling to get. Naturally,
they will choose the latter. They don’t want to be taken for a ride by
the Treasury and the Fed. The idea to offer incentives to investors to make
them buy toxic assets is preposterous.
Marginal productivity of debt
Another way to understand the problem is through the marginal
productivity of debt. This is the ratio of additional GDP to
additional debt, or the amount of new GDP contributed by the creation of
$1 in new debt. It is this ratio that determines the quality of total debt.
Indeed, the higher the ratio, the more successful entrepreneurs are in
increasing productivity, which is the only valid justification for going into
debt in the first place. The concept is due to the Hungarian-born Chicago
economist Melchior Palyi (1892-1970), although its
name has been introduced after he died.
Palyi started watching this ratio in the United State s
in 1945. Initially it was 3 or higher, meaning that every dollar of new debt
contracted contributed $3 to GDP. However, subsequently the ratio went into a
decline and twenty years later it was around 1. Palyi
ran a weekly column in The Commercial and Financial Chronicle entitled
A Point of View. On January 2, 1969, he publicly warned
president-elect Nixon in his column that the country is adding $2 in debt for
every $1 increase in GDP (in other words, the marginal productivity of debt
is ½).
“Does Mr. Nixon
realize the kind of ‘heritage’ he is taking over? That he is
supposed to keep up a rate of economic growth or even improve on the same, a
rate that stands or falls with an utterly reckless mortgaging of the future?... Presently, the volume of outstanding debt is rising
faster than the gross national product… True, most of the new debt
— other than that of the federal government — has a
‘counterpart’ in real assets: homes, automobiles, plants and
equipment, etc. But their value in dollars is unpredictable, while the debts
are due in a fixed number of dollars…
“Trading on the
Equity was the earmark of the 1920’s. The ‘House of Credit
Cards’ broke down as the first cold wind — a serious decline in
commodity prices — hit the structure of artificially inflated values of
real estate and equities. The more debt had been piled up, the higher went
the stock market. And so it goes today, only more so. A new generation of operators
has arisen, one that has not witnessed as yet a wholesale debt-liquidation.
The experience of the fathers is lost on the sons. The dream of Eternal
Prosperity is replaced by the mirage of Perpetual Inflation. More is at stake
than mere economics. A ‘new frontier’ has captured the
imagination: ‘Young man, go in debt!’ Debt has become a
status-symbol — in addition to being a prime source of riches.
Automobile sales hit new records because millions of Americans buy (on down
payment) new cars before they have finished paying for the old ones…
True, to some extent rising living standards reflect extraordinary
technological progress. But the ultimate base is, largely, the ability not
to pay — to rely on the ability to borrow ever more.”
As we know, in 1969 president Nixon did not listen to sound advice. As
president Obama forty years later, he appointed dyed-in-the-wool Keynesian
and Friedmanite advisers. The concept of marginal
productivity of debt is curiously missing from the vocabulary of mainstream economists.
They are watching the wrong ratio, that of the GDP to total debt, and take
comfort in the thought that by that indicator ‘there is lots more
room’ to pile on more debt. As a consequence, the marginal productivity
of debt went into further decline. This was a danger sign showing that
additional debt had no economic justification. The volume of debt was rising
faster than national income, and capital supporting production was eroding
fast. If, as in the worst-case scenario, the ratio fell into negative
territory, the message would be that the economy was on a collision course
with the iceberg of total debt and crash was imminent. Not only does more
debt add nothing to the GDP, in fact, it necessarily causes economic
contraction, including greater unemployment. Immediate action is
absolutely necessary to avoid collision that would make the
‘unsinkable’ economy sink.
The watershed year of 2006
As long debt was constrained by the centripetal force of gold in the
system, tenuous though this constraint may have been, deterioration in the
quality of debt was relatively slow. Quality caved in, and quantity took a
flight to the stratosphere, when the centripetal force was cut and gold, the
only ultimate extinguisher of debt there is, was exiled from
the monetary system. Still, it took about 35 years before the capital of
society was eroded and consumed through a steadily deteriorating marginal
productivity of debt.
The year 2006 was the watershed. Late in that year the marginal productivity
of debt dropped below zero for the first time ever, switching on the red
alert sign to warn of an imminent economic catastrophe. Indeed, in February,
2007, the risk of debt default as measured by the skyrocketing cost of CDS
(credit default swaps) exploded and, as the saying goes, the rest is history.
Negative marginal productivity
Why is a negative marginal productivity of debt a sign of an imminent
economic catastrophe? Because it indicates that any further increase in
indebtedness would inevitably cause further economic contraction. Capital is
gone; production is no longer supported by the prerequisite quantity and
quality of tools and equipment. The economy is literally devouring itself
through debt. The earlier message, that unbridled breeding of debt through
the serial cutting of the rate of interest to zero was destroying
society’s capital, has been ignored. The budding financial crisis was
explained away through ad hoc reasoning, such as blaming it on loose
credit standards, subprime mortgages, and the like. Nothing was done to stop
the real cause of the disaster, the fast-breeder of debt. On the contrary,
debt-breeding was further accelerated through bailouts and stimulus packages.
In view of the fact that the marginal productivity of debt is
now negative, we can see that the damage-control measures of the Obama
administration which are financed through creating unprecedented amounts of
new debt, are counter-productive. Nay, they are the
direct cause of further economic contraction of an already prostrate economy,
including unemployment.
The head of the European Union and Czech prime minister Mirek Topolanek has publicly
said that the plan to spend nearly $2 trillion to push the U.S.
economy out of recession is “road to hell”. There is no reason to
castigate Mr. Topolanek for his characterization of
the Obama plan. True, it would have been more polite and diplomatic if he had
couched his comments in words to the effect that “the Obama plan was made
in blissful ignorance of the marginal productivity of debt which was now
negative and falling further. In consequence more spending on stimulus
packages would only stimulate deflation and economic contraction.”
President Obama, like president Nixon before him, missed an historic
opportunity in not ordering a complete change of guards at the Treasury and
at the Fed. Now the same gentlemen who have landed the country and the world
in this unprecedented débâcle are in
charge of the rescue effort. The QTM, the corner stone of Milton
Friedman’s monetarism, is the wrong prognosticating tool. The marginal
productivity of debt is superior as it focuses on deflation rather than
inflation.
The financial and economic collapse of the past two
years must be seen as part of the progressive disintegration of Western
civilization that started with the sabotaging of the gold standard by
governments exactly one hundred years ago when in France and in Germany
paper money was made legal tender. The measure was introduced in preparation
to the coming war, so that the government could stop paying the military and
the civil service in gold coins, starting in 1909.
Fed Chairman Ben Bernanke, who should have
been fired by the new president on the day after Inauguration for his part in
causing the cataclysm, a couple of years ago foolishly boasted that the
government has given him a tool, the printing press, with which he can fight
off deflations and depressions, now and forever. The reference to the GTM is
obvious.
Now Bernanke has the honor to administer the coup
de grâce to our civilization.
Reference
The
Revisionist Theory and History of Depressions, see:
www.professorfekete.com
Antal E. Fekete
www.professorfekete.com
Read
all of Professor Antal E. Fekete’s other essays
Professor, Intermountain Institute of Science and Applied Mathematics
Missoula, MT 59806, U.S.A.
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