There are many people still bandying around the idea that we will suffer a prolonged period of deflation and their primary argument in support of this thesis is the fact that despite the ECB, the Federal Reserve, the Bank of England, the Bank of Japan and other Central Banks printing trillions upon trillions of currency out of thin air, the cumulative amount of this printing still does not equal the enormous wealth destruction that has occurred over the past several of years. In this article, I’ll explain why this argument as the justification for prolonged deflation holds no water.
The figures regarding the level of wealth destruction over the past several years vary from $30 to $50 trillion. From October 31, 2007 to November 21, 2008, the MSCI World Index has fallen 51% which equates to losses of $21 trillion (source: the Financial Times). However when you factor in losses in bond markets, currency markets, and collateralized financial instruments, and extend the time frame from one year to four years (2003 to 2007), according to an Asian Development Bank study (Global Financial Turmoil and Emerging Market Economies: Major Contagion and a Shocking Loss of Wealth), cumulative losses may very well exceed $50 trillion. In comparison, Bloomberg released a report at the end of March in which they estimated total US bailout money at $12.8 trillion.
The basic deflationary argument is built around the premise that if you add up all the bailout money from the major economies of the world, this sum is still far less than the $30 to $50 trillion of wealth destroyed over the past several years, not to mention the trillions more that will be destroyed in coming years. Thus, a prolonged bout of deflation must be a certainty. However, the very premise upon which this argument is based is heavily flawed. The destruction of the paper value of these grossly distorted financial instruments has little bearing on global monetary supply growth and subsequent inflation, so comparing the destruction of paper wealth to the growth in monetary base is like comparing apples to oranges.
To illustrate my point with an analogy, consider that I lived on a small hypothetical island nation that had 88 inhabitants. I was the wealthiest citizen of this small island nation and decided to purchase a fleet of 100 Maybach 62 S. Though I didn’t realize it at the time, I overpaid for each car at a price of $800,000 because I dealt with an unscrupulous car dealer that took advantage of my naivete. Four months after I purchased my fleet, I realized my egregious mistake and that the market value of each car was only $450,000. Upon this realization, I marked down the book value of my fleet of Maybachs from $80 million to $45 million and that this markdown of $35 million in value equaled the entire wealth destruction of my island nation. During the same period of my losses, the Central Bank of my small island nation decided to the monetary base by $45 million, $35 million of which ended up in the monetary supply. In this hypothetical scenario, would the value of my fiat money decline due to inflationary processes? Of course, because the monetary supply of my small island nation just increased despite an equivalent destruction of wealth. Though this is a hypothetical example, this analogy is absolutely applicable to real world situations.
If $50 trillion of grossly distorted paper values of stocks and other financial instruments have been destroyed over the past several years, this destruction can still have a muted effect on the growth rates of monetary supply that dictate inflation rates. What if a tranche of $50 billion of MBS (mortgage backed securities) had instead ballooned, at the height of our financial bubbles, to a paper value of $150 billion and would now be valued in the open market at $10 billion. Does that mean $100 billion of wealth was destroyed instead of just $40 billion? In book valuations, yes, but in reality, no. Though MBS and ABCP (asset backed commercial paper) comprise some money market funds and money market funds are considered part of the monetary supply, certainly the bulk of the $50 trillion of wealth destruction has not been from financial instruments that constitute money supply.
The definition of M3 money supply is the cumulative amount of physical currency, demand accounts, savings deposits, money market accounts, time deposits, CDs, foreign US dollar accounts and short-term repurchase agreements. Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, illustrated that Bank of America booked a $2.2 billion gain this past earnings quarter by increasing the value of Merrill Lynch’s assets it acquired to prices that were even higher than Merrill’s own book values at the time of acquisition. And what if $1 billion of these gains disappear in the future when Bank of America actually sells these assets in the open market because the $2.2 billion valuation of these assets are delusional? Does this mean $1 billion of “asset wealth” was destroyed? Of course not, because the valuations are meaningless to begin with. And that is why the destruction of $50 trillion will not have a significant deflationary effect, because the bulk of this destruction has not occured with financial instruments that contribute to monetary supply but rather were paper losses derived from grossly distorted values of financial instruments. In reality, though the paper losses of financial instruments that plummeted as a result of this crisis will feel “real” to their owners, in reality, these paper losses merely mean that many financial assets have now dropped back down to their fair valuations or perhaps are even undervalued now. In response to the trillions upon trillions of dollars being manufactured out of thin air, Dana Johnson, the chief economist for Comerica Bank in Dallas, stated, “The comparison to GDP serves the useful purpose of underscoring how extraordinary the efforts have been to stabilize the credit markets.” The belief that the best solution to solving a problem is repeating the mistakes that created the problem is exactly what is wrong about the central thesis of prolonged deflation.
I can only speculate about where and how deflationary theories garnered so much attention in the media, but I imagine that they in large were disseminated in the media by Central Banks and big banks. Why? Imagine if the world were to discover that in addition to causing this global financial crisis, that Central Banks were now engaging in policies that were going to further destroy the purchasing power of all paper currencies. Mutiny may very well arise upon this realization. If deflationists still have trouble grasping my argument, then I will appeal to them with logic. From a logical standpoint, what possible reason would the US Federal Reserve have to stop printing M3 statistics more than 3 years ago in March of 2006 if these numbers would support their deflationary arguments? Why is the British Parliament now following in the footsteps of the US Federal Reserve with the introduction of a new banking bill that will abolish a 165-year old law that requires the Bank of England to publish a weekly account of its balance sheet? If a prolonged deflationary period will truly be the consequence of these massive increases in monetary bases, why are the world’s Central Banks not transparent and forthright about releasing money supply statistics?
Of course, the valid argument against massive future inflation is the fact that this bailout money must eventually end up not just in the monetary base but in the monetary supply. Though the US dollar money supply growth rate has shrunk from a peak of about 17% in the beginning of 2008 to about 8% presently (source: Shadowstats.com), the money supply growth rate is still positive and quite significant at 8%, meaning that there has been no deflation this year nor last. Granted, the slowdown in money supply growth rate has occurred due to the fact that US banks are not lending right now, but if you understand that a bank makes money by creating money out of thin air (i.e. being able to create up to 100 times in loan amounts the value of the money they receive in deposits), then you will realize that for banks to survive they must create significant growth in monetary supply in the imminent future if they do not wish to collapse. Significant inflation can be avoided in the interim as long as
(1) The Federal Reserve and the US Treasury continues to throw bad money after bad money by continuing to give trillions of more dollars of bailout money to banks; and
(2) Banks continue to refuse to lend and use their bailout money, aka our tax money, to continue propping up the US Treasury market.
However, one thing is for certain. Banks cannot survive by producing fantasy land earnings based upon delusional internal asset valuation models. When this significant inflationary period arises, and it will, those that have realized that hard asset investments, including gold and silver investments, are the means to create wealth from this crisis, will be richly rewarded. We’re likely to see some downward pressure in the gold and silver futures markets in the very near term and specifically next Monday, but as we move into May and June, this current consolidation we are experiencing in gold and silver markets will likely give rise to the next significant leg higher.