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The Keynesians and Monetarists have
fooled people with a clever sleight of hand. They have convinced people
to look at prices (especially consumer prices) to understand what’s
happening in the monetary system.
Anyone who has ever been at a magic act
performance is familiar with how sleight of hand often works. With
a huge flourish of the cape, often accompanied by a loud sound, the right
hand attracts all eyes in the audience. The left hand of the
illusionist then quickly and subtly takes a rabbit out of a hat, or a dove
out of someone’s pocket.
Watching a performer is just harmless
entertainment, and everyone knows that it’s just a series of clever
tricks. In contrast, the monetary illusions created by central
banks, and the evil acts they conceal, can cause serious pain and suffering. This
is a topic that needs more exposure.
The commonly accepted definition of
inflation is “an increase in consumer prices”, and deflation is
“a decrease in consumer prices.” A corollary is a myth
that stubbornly persists: “today, a fine suit costs the same in gold
terms as it did in 1911, about one ounce.” Why should that
be? Surely it takes less land today to raise enough sheep to
produce the wool for a suit, due to improvements in agricultural efficiency. I
assume that sheep farmers have been breeding sheep to maximize wool
production too. And doesn’t it take less labor to shear a
sheep, not to mention card the wool, clean it, bleach it, spin it into yarn,
weave the yarn into fabric, and cut and stitch the fabric into a suit?
Consumer prices are affected by a
myriad of factors. Increasing efficiency in production is a force
for lower prices. Changing consumer demand is another force. In
1911, any man who had any money wore a suit. Today, fewer and
fewer professions require one to be dressed in a suit, and so the suit has
transitioned from being a mainstream product to more of a specialty market. This
would tend to be a force for higher prices.
I don’t know if a decent suit
cost $20 (i.e. one ounce of gold) in 1911. Today, one can
certainly get a decent suit for far less than $1600 (i.e. one ounce), and one
could pay 3 or 4 ounces too for a high-end suit.
My point is that consumer prices are a
red herring. Increased production efficiency tends to push prices
down, and monetary debasement tends to push prices up. If those
forces balance in any given year, the monetary authorities claim that there
is no inflation.
This is a lie.
Inflation is not rising consumer
prices. One can’t understand much about the monetary system
from inside this box. I offer a different definition.
Inflation is an expansion of
counterfeit credit.
Most Austrian School economists realize
that inflation is a monetary phenomenon. But simply plotting the
money supply is not sufficient. In a gold standard, does gold
mining create inflation? How about private lending? Bank
lending? What about Real Bills of Exchange
As I will show, these processes do not
create inflation under a gold standard. Thus I contend the focus should be on
counterfeit credit. By definition and by nature, gold production
is never counterfeit. Gold is gold, it is divisible and every
piece is equivalent to any other piece of the same weight.
Gold mining is arbitrage: when the cost
of mining an ounce of gold is less than one ounce of gold, miners will act to
profit from this opportunity. This is how the market signals that
it needs more money. Gold, of course, has non-declining marginal
utility, which is what makes it money in the first place, so incremental
changes in its supply cause no harm to anyone.
Similarly, if Joe works hard, saves his
money, and gives a loan of 100 ounces to John, this is an expansion of
credit. But it is not counterfeit or illegitimate or inflation by
any useable definition of the term.
By extension, it does not matter
whether there are market makers or other intermediaries in between the saver
and the borrower. This is because such middlemen have no power to
expand credit beyond what the source—the saver—willingly
provides. And thus bank lending is not inflation.
Below, I will discuss various kinds of
credit in light of my definition of inflation.
In all legitimate credit, at least two
factors distinguish it from counterfeit credit. First, someone has
produced more than he has consumed. Second, this producer
knowingly and willingly extends credit. He understands exactly
when, and on what terms, with what risks he will be paid in full. He
realizes that in the meantime he does not have the use of his money.
Let’s look at the case of
fractional reserve banking. I have written on this topic before (Fractional Reserve Banking). To summarize:
if a bank takes in a deposit and lends for a longer duration than the
deposit, that is duration mismatch. This is fraud and the source
of banking system instability and crashes. If a bank lends
deposits only for the same or shorter duration, then the bank is perfectly
stable and perfectly honest with its depositors. Such banks can
expand credit by lending, (though they cannot expand money, i.e. gold), but
it is real credit. It is not counterfeit.
Legitimate lending begins with someone
who has worked to save money. That person goes to a bank, and
based on the bank’s offer of different interest rates for different
durations, chooses how long he is willing to lock up his money. He
lends to the bank under a contract of that duration. The bank then
lends it out for that same duration (or less).
The saver knows he must do without his
money for the duration. And the borrower has the use of the money. The
borrower typically spends it on a capital purchase of some sort. The
seller of that good receives the money free and clear. The seller
is not aware of, nor concerned with, the duration of the original
saver’s deposit. He may deposit the money on demand, or on a
time deposit of whatever duration.
There is no counterfeiting here; this
process is perfectly honest and fair to all parties. This is not
inflation!
Now let’s look at Real Bills of
Exchange, a controversial topic among members of the Austrian School. In
brief, here is how Real Bills worked under the gold standard of the 19th century. A
business buys merchandise from its supplier and agrees to pay on Net 90
terms. If this merchandise is in urgent consumer demand, then the
signed invoice, or Bill of Exchange, can circulate as a kind of money. It
is accepted by most people, at a discount from the face value based on the
time to maturity and the prevailing discount rate.
This is a kind of credit that is not
debt. The Real Bill and its market act as a clearing mechanism. The
end consumer will buy the final goods with his gold coin. In the
meantime, every business in the entire supply chain does not necessarily have
the cash gold to pay at time of delivery.
This problem of having gold to pay at
time of delivery would become worse as business and technology improved to
allow additional specialization and thus extend the supply chain with
additional value-added businesses. And it would become worse as
certain goods went into high demand seasonally (e.g. at Christmas).
The Real Bill does not come about via
saving and lending. It is commercial credit that is extended based
on expectations of the consumer’s purchases. It is credit
that arises from consumption, and it is self-liquidating. It is
another kind of legitimate credit.
For more discussion of Real Bills, see
the series of pieces by Professor Antal Fekete (see http://www.silverbearcafe.com/private/fekete.html, starting with Lecture 4).
Now let’s look at counterfeit
credit. By the criteria I offered above, it is counterfeit because
there is no one who has produced more than he has consumed, or he does not
knowingly or willing forego the use of his savings to extend credit.
First, is the example where no one has
produced a surplus. A good example of this is when the Federal
Reserve creates currency to buy a Treasury bond. On their books,
they create a liability for the currency issued and an asset for the
corresponding bond purchase. Fed monetization of bonds is
counterfeit credit, by its very nature. Every time the Fed expands
its balance sheet, it is inflation.
It is no exaggeration to say that the
very purpose of the Fed is to create inflation. When real capital
becomes more scarce, and thus its owners become more reluctant to lend it
(especially at low interest rates), the Fed’s official role is to be
the “lender of last resort”. Their goal is to continue
to expand credit against the ever-increasing market forces that demand credit
contraction.
And of course, all counterfeit credit
would go to default, unless the creditor has strong collateral or another
lever to force the debtor to repay. Thus the Fed must act to
continue to extend and pretend. Counterfeit credit must never end
up where it’s “pay or else”. It must be “rolled”. Debtors
must be able to borrow anew to repay the old debts—forever. The
job of the Fed is to make this possible (for as long as possible).
Next, let’s look at duration
mismatch in the financial system. It begins in the same way as the
previous example of non-counterfeit credit—with a saver who has
produced more than he has consumed. So far, so good. He
deposits money in a bank, and this is where the counterfeiting occurs. Perhaps
he deposits money on demand and the bank lends it out. Or perhaps
he deposits money in a 1-year time account and the bank lends it for 5 years. Both
cases are the same. The saver is not knowingly foregoing the use
of his money, nor lending it out on such terms and length.
This, in a nutshell, is the common
complaint that is erroneously levied against all fractionally reserved banks. The
saver thinks he has his money, but yet there is another party who actually
has it. The saver holds a paper credit instrument, which is redeemable
on demand. The bank relies on the fact that on most days, they
will not face too many withdrawal demands. However, it is a
mathematical certainty that eventually the bank will default in the face a
large crowd all trying to withdraw their money at once. And other
banks will be in a similar position. And the collapsing banking
system causes a plunge into a depression.
There are also instances where the
saver is not willingly extending credit. The worker who foregoes
16% of his wage to Social Security definitely knows that he is not getting
the use of his money. He is extending credit, by force—i.e.
unwillingly. The government promises him that in exchange, they will pay him
a monthly stipend after he reaches the age of retirement, plus most of his
medical expenses. Anyone who does the math will see that this is a
bad deal. The amount the government promises to pay is less than
one would expect for lending money for so long, especially considering that
the money is forfeit when you die.
But it’s worse than it first
seems, because the amount of the monthly stipend, the age of retirement, and
the amount they pay towards medical expenses are unknown and unknowable in
advance, when the person is working. They are subject to a
political process. Politics can shift suddenly with each new
election.
Social Security is counterfeit credit.
With legitimate credit, there is a risk
of not being repaid. However, one has a rational expectation of
being repaid, and typically one is repaid. On the contrary,
counterfeit credit is mathematically certain not to be repaid in the ordinary
course. This is because the borrower is without the intent or
means of ever repaying the loan. Then it is a matter of time
before it defaults, or in some circumstances forces the borrower to repay
under duress.
Above, I offered two factors
distinguishing legitimate credit:
1. The creditor has produced
more than he has consumed
2. He knowingly and willingly
extends credit
Now, let’s complete this
definition with the third factor:
3. The borrower has the means
and the intent to repay
Every instance of counterfeit credit
also fails on the third factor. If the borrower had both the means
and the intent to repay, he could obtain legitimate credit in the market.
A corollary to this is that the dealers
in counterfeit credit, by nature and design, must work constantly to extend
it, postpone it, “roll” it, and generally maintain the confidence
game. Counterfeit credit cannot be liquidated the way legitimate
credit can be: by paying it back normally. Sooner, or later, it
inevitably becomes a crisis that either hurts the creditor by default or the
debtor by threatening or seizing his collateral.
I repeat my definition of inflation and
add my definition of deflation:
Inflation is an expansion of
counterfeit credit.
Deflation is a forcible
contraction of counterfeit credit.
Inflation is only possible by the
initiation of the use of physical force or fraud by the government, the
central bank, and the privileged banks they enfranchise. Deflation
is only possible from, and is indeed the inevitable outcome of, inflation. Whenever
credit is extended with no means or ability to repay, that credit is certain
to eventually become a crisis that threatens to harm the creditor. That
the creditor may have collateral or other means to force the debtor to take
the pain and hold the creditor harmless does not change the nature of
deflation.
Here’s to hoping that in 2012,
the discussion of a more sound monetary and banking system begins in earnest.
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