In the financial blogosphere and eve in the mainstream financial media, the great debate since the year end of 2007 has been will this crisis result in inflation, deflation or hyperinflation.
The complicated answer is all three, but for now and an indefinite time into the future deflation will be the net result.
Inflation: A net increase in the supply of money and credit into the economy
Deflation: A net decrease in the supply of money and credit in the economy
Hyperinflation: A large net increase in the supply of money and credit into the economy, followed by a large increase in the velocity of money, a large decrease in demand for money and finally a complete mistrust of money itself (in paper form-fiat currency)
With inflation and deflation properly defined, let's explore the historical role of central banks:
- Create a sense of confidence in the banking system
- Monopolize currency in the form of legal tender-notes
- Act as lender of last resort
The goal is to direct inflation without losing confidence in the currency and without letting any one bank's own inflationary agenda run unchecked. Central banks essentially strive to maintain monetary authority...monopoly over legal tender.
Why are central banks given these exceptional powers? They are granted by the government, because the government wishes to push their own agendas, but high taxation of the people would result; a largely unpopular act. Installing a central bank promotes the hidden agenda of the government to fund wars, socialize services and grow in general by means of inflation, the hidden tax.
Over the history of the Federal Reserve System and the global system, the mechanics behind the currency regime in place has changed several times to accommodate new inflationary policy. There have been classic gold standards-backed by an inherent ratio of gold; gold exchange standards-more like quasi gold backed currencies more flexible to inflationary policy; fixed exchange rate quasi gold standards-Bretton Woods; the dirty floats of the 1930's-exception US and competitive devaluations; and finally freely floating 100% fiat currencies of today.
What is exceptional to note about all of the currency regimes mentioned is that the classic gold standard regime was the only regime NOT to fail. The regime of today is nearly identical to that of the 1930's.
So How Has The Fed Lost Power?Refer back to the three roles of central banks. Without checking the power of commercial banks, the Fed loses power to a certain extent.
Since the 1980's commercial and investment banks have grow more innovative in their product offerings. This sophistication has largely been in the arena of financial derivatives derived from complex mathematical abominations. Most of the brokers dealing in them did not and still do not fully understand them. Adding even more fuel to this derivative fire, is the accounting, which grew more and more mysterious.
Ex-Chairman Greenspan promoted and cheered the use of derivatives and left their issuance unregulated, meaning they required no reserves or oversight. Furthermore, Greenspan introduced complex reserve arrangements to banks known as "sweeps" that effectively lowered the reserve requirements without officially lowering the reserve requirements.
In 1999, the Glass-Steagal Act was repealed and replaced with Sarbanes-Oxley. Now commercial banks could add to their portfolio of creating money out of thin air by leveraging up their own investment bank subsidiaries.
Throughout the 1990's and especially into the 2000's, Greenspan kept in place historically low interesting rates for far too long, fueling investment from credit, rather than from savings. Greenspan also bailed out Long-Term Capital Management, giving the greenlight to financial insitutions to speculate in very damaging and inflationary ways.
The SEC played a part in fueling inflation as well, removing net capital requirement rules from "certain" well known investment banks, allowing them leverage up their balance sheets to absurd levels.
Now the banks and the public, armed with new financial technology and fooled by low interest rates, continued to borrow and speculate, typically leading to malinvestment. Asset prices soared and more credit was taken on to speculate more on "forever" climbing asset prices. Of course, this path is unsustainable.
The result was that the consolidation of market share in the financial world into the hands of very few players. You know the commercial banks as JP Morgan, Bank of America, Wells Fargo, etc. The investment banks were/are Goldman Sachs, Bear Stearns, Lehman Brothers, Morgan Stanley & Merrill Lynch.
So Again, How Have Central banks Lost Power & Why Is That Deflationary? The Fed and other central banks lost power because they ignored one of their mandates; do not let any one commercial bank inflate too much. With so much concentration of credit into so few, central banks have done just that.
Central banks forgot the lesson of the wildcat banking days, when a single bank would inflate credit too much causing a boom and bust. So central banks were to "check" this inflation by creating and spreading reserves for the entire banking system and acting as lender of last resort. Of course recently, this has not been true, as few banks have concentrated power.
The concentration of this power (commercial bank credit-inflation) is so great that the Fed and other central banks are playing "inflation catch up". During this period, deflation is the net result as
Credit trumps Base Money. It was in that post I brought to attention this simple fact:
Bernanke’s expansion of M0 in the last four months of 2008 has merely reduced the debt to M0 ratio from 47:1 to 36:1 (the debt data is quarterly whole money stock data is monthly, so the fall in the ratio is more than shown here given the lag in reporting of debt).
To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels. That US$20 trillion truckload of greenbacks might enable Americans to repay, say, one quarter of outstanding debt with one half—thus reducing the debt to GDP ratio about 200% (roughly what it was during the DotCom bubble and, coincidentally, 1931)—and get back to some serious inflationary spending with the other (of course, in the context of a seriously depreciating currency). But with anything less than that, his attempts to reflate the American economy will sink in the ocean of debt created by America’s modern-day “Roving Cavaliers of Credit”.
The Central Bank ResponseBecause central banks allowed credit and hence inflation to run unchecked for so long in the hands of so few, credit now trumps base money by a large margin. Keep in mind, these figures have surely changed in the past several months. This happened in the great depression and we're all going through it now.
The response is that the Fed and other central banks will stop at no costs to regain the power of money. Therefore, slowly over time the margin between credit and base money will contract, until ultimately base money is at optimal levels to credit, whatever that may be in the eyes of central banks.
The ability to do this effectively can not result in immediate inflation, but inflation will ultimately be the result. Of course, it is becoming clear, the Fed will purchase an infinite amount of government debt in order to funnell money into the economy. It's only a matter of time and how much they commit within that time frame. The end result will be bad. In the meantime though, look for the era of deflation to continue, as malinvestments are cleared from the system.
Eventually, as the past indicates and economics dictates, a new currency scheme will be created. This could be a new world currency, or hopefully a classic goldstandard that restricts inflation and promotes international trade and specialization.
There's a whole lot more to this story, in both current terms and economic philosophy terms. I recommend to all to read Murray Rothbard's "
What Has Government Done To Our Money?"
