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Wednesday, October 31, 2007 10:22 AM

Which Comes First: The Cart or the Horse?

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Before we get to the cart and the horse, let's answer a reader question that just came in: "What prevents the Fed from sending every household $100k?"

Just Five Things

1) Lack of authority
2) People would use it to pay off debt
3) Banks do not want to be paid back with money that is worthless
4) The Fed will act to bailout banks, not consumers
5) Hyperinflation ends the game. The Fed is simply not in the business of destroying itself.

Rest assured the Fed is going to do almost everything under the sun to encourage more borrowing. That includes slashing the discount rate, the Fed Fund's Rate, loosening rules on collateral, etc. Some of those we have already seen. This is likely the first inning.

But the one thing the Fed is not going to do is send everyone $100,000 or $10,000 or even $5,000. If for some reason I am mistaken and the Fed starts sending out checks or depositing money into people checking accounts to a significant degree, then I am willing to eat my deflation hat. Just so we are clear on this, another piddly $300 from Congress is not enough.

The Cart and the Horse

There was an interesting editorial article on Gold Eagle last week by Peter Schiff.

Prices Are The Cart, Money Supply Is The Horse

The sad truth is that despite the best efforts of monetary economists everywhere, fundamental misconceptions about inflation remain entrenched in government, business, and the media.

In an exchange earlier this week on CNBC, a guest explained that rising oil prices can not cause inflation because prices for other goods must fall as spending is diverted to pay for more expensive oil. That explanation prompted host Becky Quick to ask: "If rising oil prices do not cause inflation, then what does?" Since that question was left unanswered on the air, I thought I would take the time to answer it here.

Inflation has only one cause and that is the Federal Reserve itself. In the United States, the supply of money and credit is regulated by the Fed. Since inflation is by definition an increase in the supply of money and credit, only the Fed can create it.

If the money supply were held constant, increases in some prices would be offset by decreases in others. The result would be no overall inflation. In fact, without government created expansions of the money supply, the natural tendency of prices would be to decline as technology allowed for more efficient production of goods and services. So while most regard the Fed as the primary inflation fighter, in reality it is the sole inflation creator.
That is a near perfect explanation by Peter Schiff. Certainly, his definition of inflation is perfect: "Inflation is by definition an increase in the supply of money and credit."

My take, complete with an image of the cart and the horse, can be found in Inflation: What the heck is it?

Peter Schiff did make an error, however. That error is in the phrase "only the Fed can create it". When it comes to credit, the statement is simply wrong. Money (credit actually) and there is a difference, is borrowed into existence every day. This is a systemic problem and the Fed is clearly not in control of it.

Money As Debt

There is an educational 5 part You-Tube series on money and debt. It covers in nice cartoon animation what has happened to money over time, fractional reserve lending, how money is created today, why interest rates are so low, why we get unsolicited credit offers, and why debt is exploding.

The video concludes that it is taking exponential increases in debt (money) to stave off a collapse of the entire banking system, and that this cannot go on forever.

Click here (not on the image above) to see this 5 part series on debt.

I agree with the video that there are practical limits on how high debt can get. So does economist Paul Kasriel at the Northern Trust. (See An Interview with Paul Kasriel)

Interesting Quotes from the Video:

  • "Debt... That's what our money system is. If there were no debts in our money system, there wouldn't be any money." Marriner S. Eccles. Chairman and Governor of the Federal Reserve Board.
  • This is a staggering thought. Someone has to borrow every dollar we have in circulation, cash or credit. We are absolutely, without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is." Robert H. Hemphill, Credit Manager, Federal Reserve Bank, Atlanta Georgia.
  • "One thing to realize about our fractional reserve banking system is that, like a child's game of musical chairs, as long as the music is playing there are no losers." Andrew Gause, Monetary Historian
  • "Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist." Kenneth Boulding, economist
  • I have never yet had anyone who could through the use of logic and reason, justify the Federal Government borrowing the use of its own money... I believe the time will come when people will demand that this be changed. I believe the time will come in this country when they actually blame you and me and everyone connected with Congress for sitting idly by and permitting such an idiotic system to continue." Wreight Patman, Congressman 1928-1976, Chairman, Committee on Banking and Currency 1963-1975
  • The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented. Sir Josiah Stamp, Director, Bank of England 1928-1941
Unfortunately, the video's conclusion is a bunch of socialist nonsense: Eliminate interest, let governments and only governments create money, and supposedly government will then use that money wisely to build roads and bridges that will add value to society.

Unfortunately, the government cannot decide what has value or not. Only the free market can do that. Otherwise you have bridges built to nowhere based on political clout, needless wars and other malinvestments of capital.

If government printing led to prosperity we would be talking about Zimbabwe, the Weimar Republic, and the Soviet style command economy of the 1940's through 1980's in glowing terms. The proposed solution is ridiculous.

The video also incorrectly blames the gold standard for problems created by fractional reserve lending. However, the video does a reasonable job of pointing out many of the problems with the current system of debt creation in a very entertaining and (for the most part) educational way. On that basis, I recommend watching all five parts.

Ability to Take on Debt is not Infinite

At the top of this article I outlined 5 reason why the Fed was not going to give money away. If one believes that rationale, then one must logically accept there is a practical limit to debt, at least at the consumer level.

Proof of concept is easy enough to find. Massively rising delinquencies, foreclosures, and bankruptcies should be proof enough. Additional proof can be found in a Drop in Revenue Growth at State and Federal Level.

At the state level, it's easy to see what is going to happen. Unlike the Federal Government, states are required to have balanced budgets. That means one of three things.
  • Cutting Spending
  • Raising Taxes
  • Floating Bonds to Postpone the Problem
Raising taxes headed into a consumer led recession will not work. Cutting spending is absolutely needed but will throw people out of work at the worst time, and postponing the problem is not solving the problem. Postponement only makes things worse.

This is yet another version of Economic Zugzwang where there are no winning answers (at least as far as politicians are concerned).

The proper solution is to let free market forces work. If that means banks fail, then banks should fail. If that means the stock market collapses, the stock market should collapse.

Letting (encouraging) the dollar fall to zero is not a solution for the simple reason it does not create any jobs where they are needed, which is right here right now.

Given the amount of credit in the system vs. actual cash, and given global wage arbitrage and slower consumer spending, it would take a mammoth effort from Congress and the Fed to forestall the inevitable once again.

A Sure Thing?

Right now the surest bet in the world is that when the dollar drops the US stock markets rise. How long that remains is anyone's guess.

There is going to come a time when borrowing dollars to invest in equities is going to blow up. Of course the carry trade may blow up first (sinking everything in its wake). Perhaps a massive derivatives unwind sinks everything first. Then again, perhaps the trigger is something from way left field that no one is watching.

The fuse is now lit. The structural imbalances worldwide have never been greater and the fuel at the end of the fuse is enormous. In addition, amount at risk increases every day.

The interesting thing is that no one knows how long the fuse is. For some inexplicable reason everyone acts as if they can get out before the stick ignites. It's simply not possible.

Mike Shedlock / Mish

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