by: Hyperinflation
October 26, 2009
The most convincing argument by those in the deflation camp regards the lack of loan origination by the largest money center banks despite the current $925 Billion of reserves ( which is capable of making $8.32 Trillion in new loans courtesy of our unethical monetary system aka fractional reserve banking). Though I'm very much in the inflationist camp, I do agree with the aforementioned argument that inflation to an extreme degree (hyperinflation) is impossible, at least in the foreseeable future without banks lending out a significant portion of their excess reserves. But what many choose not to acknowledge there are two sides to the inflationary coin.
1) the most damage inflicted on any fiat money currency has historically (at least in the modern era i.e. Argentina) via reckless credit expansion not backed by voluntary savings. The reasoning is twofold: real credit in a market economy would only be a small fraction of that outstanding today. This is because of the moral hazard fractional reserve banking has created. FRB punishes those banks who don't originate loans at a torrid pace, making them unable to compete with other member banks. Loans backed by voluntary savings keep a check on the lending practices of every bank, in addition to having no inflationary consequences should the loan default and the bank lacks the capital to cover these losses (The bank would simply go under). In a free market, reckless lending would be nearly impossible as individuals would actually do there due diligence regarding the health of their banking institution. In the current centrally planned economy, depositors have no incentive to do so as it is backed by the government. Though loan losses by their very nature are inflationary if both not backed by voluntary savings and repatriated for these losses by the central bank, there are consequences to credit expansion as well as inflationary pressures being created in several other places. The potential inflation that can result from enormous credit expansion in the economy will come home to roost as it is obvious these banks still aren't well capitalized and are sitting on large amounts of reserves in anticipation of coming loan losses. Other consequence of credit expansion unbaked by voluntary savings is as such
The money multiplier = 1/reserve requirement. In our case 1/.1= 10
So What? Well the moral hazard of having such a low reserve requirement + artificially low interest rates (talked about later) = Economic Boom! Well isn't that great? Nothing could be further from the truth because central banking on a fiat money system "paper backed by nothing" makes for a perfect storm that will bring a currency to its knees or collapse "hyper-inflation" should the current abundance of reserves be used to originated new loans. But in a recession the demand for money is high thus a high interest rate should prevail (which is the natural market mechanism signaling individuals to save, as savings generates real capital formation and the corresponding jobs when the capital is invested).
What is an interest rate really? This is what you are willing to give up in the future for something now. In a free market people have ever-changing time preferences. When people have a high demand for money (whatever the reason, it could be because they got fired, and need money to support their family until they can find another or a technological revolution has taken place i.e. Railroads, automobiles, the internet and thus wish to invest borrowed money to earn a large sum in the future) the interest rate will also go up because a constant supply and increasing demand to a rate that tells Joe Blow peoples time preference. This allows entrepreneurs to most accurately forecast the proper allocation for their funds. On the flipside, if a rate is artificially manipulated, as is our case, even great entrepreneurs misallocate large amounts of capital because he/she incorrectly interpreted people time preference. (This is the main cause of artificial booms).
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The other face of inflation, though not as damaging in terms of distorting capital allocation, is more than capable to generating a wave inflation that could wipe out tremendous amounts of purchasing power. The last seven years have shown a 50% increase of the amount of currency in circulation which excludes many other inflationary policies we have engaged upon. The $12-$14 trillion has no chance of ever being paid back in full and guess where this money came from? Electronic money printing (Ben Bernanke has admitted as much saying it is as easy as adding 000's to member bank balances deposited at the FED).I heard echoes of Argentina in 1990 after hearing this absurdity. 1.3-1.4 trillion of the most toxic mortgage backed securities (As they were the most sub-prime of the group due to Fannie and Freddie being the largest purchasers of MBS). Assuming they can even get 50 cents on the dollar, they will have already injected a large amount capital into the markets/economy) that again comes from electronic money printing. Now the two most devastating inflationary policies not related to credit expansion is the budget deficit and the mounting NPV of our unfunded liabilities.
Barrack Obama criticized Bush for reckless fiscal policy as a result of 500 Billion dollar budget deficit, yet he tripled that amount less than one year later! It is more likely than not this number will continue to rise for the foreseeable future as tax revenue continues to falls, we fund the war in Afghanistan, social security, Medicare and Medicaid require over 1 trillion of funding starting next year and doubling by 2018 to 2 trillion. Not to mention even more healthcare legislation that we can't possibly afford. The long end of the yield curve began to rise this year, nearly doubling from its lows, which in turn means the interest needed to service our debt doubled as well. The FED can only suppress medium to long term rates for so long, which leaves them with two choices, let the long end of the yield curve spike ( which will also send our annual interest payments over 1 trillion dollars per annum if not more) or monetize the debt with long maturities. Either way, these have vast inflationary implications.
So assuming the deflationist are right regarding the lack of lending which will keep inflation in check, it is inevitable there will be record rates of inflation sometime in the coming decade solely due the continuous bailouts, treasury funding for our mass unfunded liabilities, maintenance of our military empire, increasing deficit spending, likely monetization of debt by the FED in addition to the dramatic increase in the currency in circulation. One could argue that the velocity of money is non-existent, but the consumer spending figures from September presented a completely different picture. It reached a record as a percentage of GDP at 71%, which both shows individuals aren't hoarding cash as they were late last year in addition to the fact our savings rate will erase the gains it saw earlier this year. Savvy investors and government alike realize this fact, which is why Gold (GLD) and the gold miners (GDX) ETF continue to reach new all time highs.
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