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Deflation
isn't limited to paper money (dollar, pound, etc...). In fact,
deflation has nothing to do with paper money: it is about the destruction of
credit money. Below is an extract from the Wikipedia's explanation of the history of money which
explains what credit money is.
Credit
money
Credit money often exists in conjunction with other money such as fiat
money or commodity money, and from the user's point of view is
indistinguishable from it. Most of the western world's money is credit
money derived from national fiat money currencies.
In a modern economy, a bank will lend to borrowers in excess of the reserve
it carries at any time, this is known as fractional reserve banking. In doing
so, it increases the total money supply above that of the total amount of the
fiat money in existence (also known as M0). While a bank will not have access
to sufficient cash (fiat money) to meet all the obligations it has to
depositors if they wish to withdraw the balance of their cheque accounts
(credit money), the majority of transactions will occur using the credit
money (cheques and electronic transfers).
Strictly speaking a debt is not money, primarily because debt can not act as
a unit of account. All debts are denominated in units of something external
to the debt. However, credit money certainly acts as a substitute for money
when it is used in other functions of money (medium of exchange and store of
value).
Deflation can
happen in any asset class whose supply has been boosted by "credit
money" (debt/IOUs). This might be confusing, but by reading the two
examples below, you should get an idea how deflation can (and will) happen in
the gold market.
From the Wikipedia's explanation of the history of money:
Warehouse
receipts
Warehouse receipts became a very successful form of representative money in
ancient Egypt during the reign of the Ptolemies around 330 BC. Farmers
deposited their surplus food grains for safe-keeping in royal or private
warehouses and received in exchange written receipts for specific quantities
of grain. The receipts were backed and redeemable for a usable commodity.
Being much easier to carry, store and exchange than bags of grain, they were
accepted in trade as a secure and more convenient form of payment, acting as
a symbolic substitute for the quantities of food grain they represented. The
warehouse receipt itself had no inherent value. It was only a symbol for
something of value.
The invention of representative money had profound effect on the evolution of
both money and society. It directly led to the creation of a new social
organization, banking. The network of royal and private banks that were
created during the reign of the Ptolemies constituted a national grain or
giro-banking system. Grains were deposited in 'banks' for safekeeping.
Warehouse receipts were accepted as a form of symbolic money because they
were fully 'backed' by the grains in the warehouse.
More important but less obvious, the introduction of banking by the
pharaohs made possible the creation of money. Until then new money could
be grown as a crop, raised as an animal or discovered as metal in the earth. Now
it could be created by writing a warehouse receipt. At first these
receipts were issued only when additional grain was deposited and cancelled
whenever the grain was withdrawn from the warehouse. But it required only a
small step in imagination for the bankers to realize that they could also
create new grain receipts on other occasions. If someone applied to the bank
for financial assistance, the bank did not need to provide it in the form of
grain. It could simply create and give to the borrower a new warehouse
receipt that was indistinguishable from those issued when grain was
deposited. Although the new receipts were not backed by additional
deposits of grain, they were still backed by the total value of grain on
deposit at the warehouse and, therefore, readily accepted in the market as a
medium of exchange, so long as the public had trust and confidence in the
overall financial strength of the grain bank.
Creating
indistinguishable warehouse receipts = creating "credit money"
The graphic below
illustrates how ancient Egypt’s banking system used IOUs to inflate
supply:
Here is an another example of
how "credit money" can expand the supply of a commodity like gold.
Hundreds
of years ago people would pay the local goldsmith to store their gold for
them in his vault. He would then give them a receipt for the amount of gold
that was stored. The receipt was not money, it was a money substitute. It was
later common for people to use the receipts as payment for goods and services
since they could be exchanged for the gold held in the vault at any time.
The goldsmith found out that only a small amount of the gold was ever claimed
since people just kept exchanging the receipts. The goldsmith started
writing receipts for more gold than he had, using some of the receipts to buy
things and loaning the rest at interest, while taking title to real property
as collateral. The gold for these extra receipts did not exist. By adding
to the amount of receipts in circulation, the goldsmith stole from the people
with the real receipts and decreased the value of the real gold receipts by
creating inflation. The more of something there is, the less it is worth and
more it takes to trade it for something else.
The
graphic below illustrates how goldsmiths used IOUs to inflate the gold
supply:
Deflation
When the public stops trusting banks, people start redeeming their warehouse
receipts (or requesting delivery of gold futures, etc). This is a run on the
bank. As banks have been selling IOUs for assets they don't own (warehouse
receipt is an IOU) and since no one can print gold or grain, widespread
defaults and bank failures follow.
Why there hasn’t been hyperinflation so far
The US banking system has increased the dollar money supply nearly 20 times
in the last thirty years.
Despite this, the price of commodities like oil and gold has not increased 20
times:
The reason why there has been tame inflation so far is that banks have been
creating commoditiy (and stock) IOUs at the same rate they created dollar
IOUs. Below is a graphic that illustrate this massive credit bubble which has
grown in commodity derivatives.
As long as investors are willing to accept paper promises (like gold futures)
instead of the real thing, inflation will not go out of control. However,
when an event inevidably shakes faith in the US banking system, the world
will see hyperinflation unlike any seen before.
Instant Hyperinflation
ALL episodes of hyperinflations have been caused by rampant money printing.
However, there has never before been a country which has leverage every
single assets class to the extent that Wall Street has done. The
hyperinflation that is about to hit the US will be caused (at least
initially) by deflation of non-dollar assets (stocks, gold, grains,
etc…). The dollar’s collapse will therefore be more rapid than
any previous period of hyperinflation.
Manipulation of Gold
Believing commercial banks hold the price of gold down because it is only
thing that make sense. Consider the following:
1) Commercial banks have the ability to sell gold IOUs in unlimited
quantities, with no margin requirements or supervision. (This is fact)
2) Banks have been irresponsible in every aspect of their business that we
know about (subprime CDOs squared, for example) and have no risk control.
They are operating without reserve requirements thanks to an accounting
gimmick (deposit reclassification). They also built up trillions in OTC
derivatives and created overleveraged off-balance sheet financial vehicles
(ie: SIVs, VIEs, etc...),
Logically, these banks are virtually guaranteed to have abused their ability
sell paper gold and have boxed themselves into a massive short position as a
result. To support this claim, there is a mountain of evidence of gold
manipulation.
Warped perception of risk in the market place
Right now, the entire commodity derivative market is built on the idea of no
default risk. This is to say, investor are now taking default risks very
seriously in the credit markets (after experiencing horrible loses due to
financial crisis), but these concerns over counterparty solvency are
completely absent in commodity derivatives.
We now have a twisted situation where insolvent financial institutions can't
even sell bonds (promises to deliver dollars at a later date) without an FDIC
guarantee, but those same financial institutions have no problem selling
investors OTC commodity derivatives (promises to deliver commodities at a
later date). While there is no transparency to the OTC commodity derivative
market, simple logic dictates that financial institutions are taking
advantage of the complete absence of risks premiums and cheaply selling
enormous amounts of commodity denominated debt to meet funding needs. As long
as counterparty fears remain absent from commodity derivative markets, the
number of financial institutions turning to those markets for funding will
continue to grow, causing the commodity credit bubble to grow ever larger.
Widespread deflation fears have undoubtedly made the commodity credit bubble
worse. After all, if the price of commodities is expected to fall, why sell
debt denominated in dollars? Selling commodity derivatives instead would make
far more sense.
Unfortunately, as the credit crisis has demonstrated so far, reality
eventually catches up with those selling debt they have no hope or means of
repaying. Default will begin occurring on commodity derivatives, most
probably COMEX gold futures. Unlike the credit bubble, the fed will be
powerless to stop deflation of the commodity credit bubble, as it can't print
commodities.
Concern with default risks is also absent in the stock market, bond market,
and currency derivative market. This complete absence of risks premiums on
non-dollar denominated debt and currency derivatives is not sustainable.
The end is near
The dollar has begun to break down.
And the yield of the thirty year treasury has broken up.
This is evidence that confidence in the US, Wall Street, and the dollar is
near an end.
Eric
de Carbonnel
Market Skeptics
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