End Game Analysis

Someone just alerted me to an interesting article by Steve Saville entitled The End Game. Following are some snips:

We occasionally read that deflation is inevitable because the total amount of debt in the system is so huge. The point will eventually be reached, according to those who are forecasting a deflationary outcome, when the amount of debt carried by the average person and the interest burden associated with the debt is so large relative to his/her income that he/she will be unwilling or unable to take-on additional debt; and at that time the total amount of money and credit in the system will begin to contract. That is, deflation* will occur.

No one can predict the future with certainty, but we would be extremely surprised if the uninterrupted inflation of the past 70 years were followed by a period of genuine deflation (a prolonged decline in the total supply of money and credit). One of the reasons this would surprise us is that there IS so much debt in the system. The high debt levels actually make deflation LESS likely, not more likely, because the current monetary system -- the world's greatest-ever Ponzi scheme -- could not survive a bout of genuine deflation. That is, deflation will never be a viable policy option regardless of how bad things get. Instead, the central banks of the world will likely risk destroying their currencies and obliterating the values of their bonds before they will permit deflation to occur.

For starters I have to give Steve Saville 100% credit for understanding what deflation is: "a prolonged decline in the total supply of money and credit". It is impossible to have any sort of reasonable debate unless one can agree on terms.

In Inflation: What the heck is it? I presented strong evidence that the proper definitions of inflation and deflation are as follows:

• Inflation is best described as a net expansion of money supply and credit.
• Deflation is logically the opposite, a net contraction of money supply and credit.

Thus it seems we have reasonable grounds for starting a discussion.

Steve Saville Continues:

The question then becomes: central banks may well WANT to avoid deflation at all cost, but will they be ABLE to avoid it? Will they be able to implement policies that cause the currency to lose its purchasing power in an environment where almost all potential borrowers are 'tapped out'?

We don't really understand why this is even a question because it's such a basic economic truth that someone with the ability to increase the supply of some 'thing' by an unlimited amount also has the ability to push the price of the thing down by as much as they desire. This is true regardless of whether the thing in question is a dollar or an apple or communications bandwidth. Central banks have the ability to create currency in unlimited amounts so they have the power to reduce the purchasing power of currency under any and all circumstances should they choose to do so.

But assuming the central banks don't just print currency and then drop it out of helicopters, how would new currency be brought into circulation at a time when most individuals and corporations were cutting back on their borrowing/spending?

One option would be for the government -- an entity that will always be able to borrow more currency into existence regardless of its current level of indebtedness -- to shoulder the entire burden of keeping the supply of money in an upward trend and the purchasing power of money in a downward trend. But even if the government decided not to go down this path the central bank would have other options. It could, for instance, start monetising the mortgage debt held by private banks.

There is a chance that monetising debt (buying debt with newly printed currency) would not be effective because it would simply shift debt from the balance sheets of commercial banks to the balance sheet of the central bank. The debt would continue to exist and the borrowers -- the people who mortgaged their houses -- would be in the same financial situation; it's just that they would owe money to the central bank instead of owing it to private banks.

There is, however, a surer way to get more money into circulation and reduce the purchasing power of the money. Taking the example of the US, instead of monetising debt the Fed could monetise assets. That is, rather than buying mortgages from commercial banks the Fed could buy houses. Furthermore, to achieve the desired purpose -- a reduction in the dollar's purchasing power -- the number of houses that would actually have to be bought might not be that great. The reason is that if the Fed came out and said something along the lines of "for the next 90 days we will use newly printed dollars to purchase anyone's house at a price equal to today's market value or the amount owing on the mortgage, whichever is the higher" there's a good chance that there would immediately be a substantial devaluation of the dollar relative to houses (and every other tangible asset).

The time when the Fed needs to resort to such drastic measures in order to keep the inflation going is probably many years away. The point is, the Fed does have the power to keep the inflation going and the fact that debt levels have become so high means it has no alternative other than to keep the inflation going. Our view, therefore, is that the inflation will continue until the dollar and all other fiat currencies become so devalued and discredited that they cease to function as mediums of exchange, or, at least, until inflation fears become great enough that the current monetary system is abandoned in favour of something else.

As we've said many times in the past, keeping the inflation going is not the real challenge for the Fed; rather, the real challenge for the Fed is to keep inflation EXPECTATIONS in check. In our opinion, the next time inflation expectations spiral out of control will be the last time because doing what Paul Volcker did at the end of the 1970s (pushing interest rates to astronomical heights) is no longer a viable policy option. This is why the Fed's biggest fear is an uncontrolled rise in inflation expectations.

Mish rebuttal.

Steve is correct about the "theoretical ability" of the FED to increase money supply at will. His statement" "Central banks have the ability to create currency in unlimited amounts so they have the power to reduce the purchasing power of currency under any and all circumstances should they choose to do so" is completely accurate. Has any deflationist ever disagreed?

Unfortunately there are huge practical reasons why they will not and why it would not work even if they tried. For starters, let's consider the statement "One option would be for the government -- an entity that will always be able to borrow more currency into existence regardless of its current level of indebtedness -- to shoulder the entire burden of keeping the supply of money in an upward trend and the purchasing power of money in a downward trend."

The FED can print but it can neither force people to borrow nor banks to lend. If banks do lend, there is no guarantee that the money does not pour into gold or silver. Just how effective would that be at solving anything?

Assume instead that the FED just gave money away. Well this would take an act of Congress for starters and even with that, inflationists ignore the Austrian construct of "Time Preference". Simply put, there is no guarantee the people would not take the money and just pay off debts. Given a negative savings rate, I think that would be likely. Does anyone think the government is going to give money away just so people could pay off debts? I don't. Regardless, how long could the government keep this up, even if it was tried, and what would interest rates soar to if they did? What would soaring interest rates do to housing? Booming Bankruptcies? You bet. Are bankruptcies deflationary? You bet.

Another argument that I have heard (but not proposed by Steve) was that the government could put a tax on savings accounts to force people to spend. Would that work? No, it would likely force more money into stocks or bonds, and/or it might cause people to just pay off more debts leaving banks with less money to lend. In short, it is likely that this idea too would be counter productive. In fact, the uproar at proposing it would be so strong, the idea would never fly in the first place.

Of more interest is the fact that Steve is worried about inflation expectations.
Speaking of which, exactly what would happen if the FED started monetizing houses as he proposed? To begin with, it is not in the FED's charter to buy houses, but assuming a Congressional bill allowed it, what would it accomplish?

If after a prolonged decline in housing prices (where people owe more money on them houses than they are worth) would not people (and lots of them) simply turn them over to the government? If so what would the government do with them? Whether they did so or not what would it do to inflation expectations?

Given that such a drastic measure has never been tried, what might the unforeseen consequences of monetizing houses be? Hmmm.... How about long term interest rates temporarily rocketing up to 10% causing even more people to be thrown out of work and even more people to walk away from their houses? The only valid conclusion is that monetizing houses is an interesting theory but it simply would not work even if Congress would approve it, which of course is doubtful in the first place.

At the crux of the matter are these simple facts:

• The FED can print money but it can not dictate where the money goes.
• The consequences of the FED attempting to control the long and the short end would likely be disastrous. It is actually impossible in practice.
  
• Deflationary forces such as global wage arbitrage and outsourcing can not be defeated by FED policy.
• Consumer debt in conjunction with a housing bust is simply the nut that inflationists can not crack. There just is no plausible scenario under which the government would bail out consumers at the expense of banks and creditors. The Bankruptcy Reform Act should be proof enough of that statement.

Five Constraints

In theory the inflationists are correct.
In practice the FED is constrained by five factors:

1. Ability of consumers/corporations to take on more debt
2. Willingness of consumers/corporations to take on more debt
3. Willingness of banks/credit companies to extend more credit
4. Ability of banks/credit companies to extend more credit
5. Unwillingness of the federal reserve to print themselves out of power

Let's dismiss corporate spending as to being any kind of savior for this economy right off the bat. We discarded that idea previously in Thoughts on the Handover Fallacy.

Given that consumer spending is 70% of the economy, consumers are the key to proper End Game Analysis. In a scenario where consumers are underwater on their house, out of work in a housing bust, and bankruptcies and late payments are soaring, would banks be willing to extend credit? At what interest rate? Might not consumer interest rates rise even in the face of lower fed funds rates? After all, the FED can not dictate consumer lending rates. The consequences if the FED attempted to do so would likely be severe as discussed earlier. What about the willingness of consumers to take on more debt even if the FED could force rates lower? Unfortunately for the FED, time preferences can change. A negative savings rate practically dictates that time preferences will change. Thus, the willingness of a baby boomer generation to take on more debt headed into retirement could very well be limited, even if further credit was extended.

Careful analysis shows that in practice, the FED can only control #4 above, if anything at all. Also note that hyperinflation ends the game. The FED will be very reluctant to print themselves out of power.

The case of inflationists is far greater in theory than it will prove to be in practice.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/