A Plague of Deflation-fighting Bureaucrats

The biggest financial news item on Thursday was without a doubt the declaration of St. Louis Fed governor James Bullard – a voting member of the FOMC board – that the Fed must be ready with a 'deflation fighting strategy'. With this Bullard is the second regional Fed chief after Boston's Eric Rosengren to discuss the Fed's options with regards to the deflation issue. Note here that Bullard, similar to other Fed members, is not referring to a decline in the money supply – he wrongly defines deflation as a 'fall in the general price level'.


It should be mentioned that yet another 'deflation fighter' is about to be nominated to the Fed's board: Peter Diamond, who told Senator Richard Shelby in a written reply that he thinks 'deflation is currently a greater threat than inflation'.

Similar to other Fed board members, Bullard has studied Japan's two decade long economic predicament closely and has come to the conclusion that apparently nothing Japan did helped it to escape its what we might term 'deflationary era'. It is important to note here that Japan's money supply never once declined – it merely grew very slowly. Due to a rising demand for precautionary cash balances by the private sector and a long period of net private sector debt repayment, prices – which were extremely high as a result of the inflationary boom of the 1980's – came under mild, but persistent,  pressure. This is seen as a great calamity by everyone, due to the entirely mistaken notion that falling prices cause economic depressions.

If that were true, it should be a great mystery to all these economists why the  US economy grew so vigorously in the latter three decades of the 19th century – much more vigorously than it has ever done again since the establishment of the Fed – while prices consistently fell nearly every year. We presume they would also be at a loss to explain the profitability and success of the computer industry, which has faced falling prices for its products every year since it was born.

In a pure free market economy based on traditional legal principles with a stable market-chosen money supply, prices would always be in a gentle downtrend. This is so  because the accumulation of capital and the more and more 'roundabout' and thus more productive production processes it enables would lead to a large increase in the output of goods and services relative to the supply of money.  We are mentioning 'traditional legal principles' on purpose in this context: they exclude the practice of creating fiduciary media from thin air.


Deflation of  Money and Credit

The problem the Fed and with it all the other central banks of the industrialized nations of the Western world are now facing is that they have presided over the biggest inflationary boom in all of history in recent decades . When we say 'inflationary boom' we do not refer to the rise in prices that has accompanied this boom, although it was certainly considerable and notable. We are referring to the vast increase in the supply of money and credit it has entailed. The fiduciary media created by the fractionally reserved banking system –  a process aided and abetted by central banks mistakenly focused on the 'general price level' – are creating a system-wide balance sheet problem that appears intractable. On the one hand, there is the huge amount of money created by the system that consists mostly of its deposit liabilities, on the other hand there is the equally huge amount of credit that represents the system's assets and that looks since 2008 intensely vulnerable to both default and net repayment. In short, the long inflationary boom has reached its zenith around 2007, and has since then gone into reverse.

In a free market setting this deflationary process would certainly be considered painful, but it could be accommodated, since the problems of wage rigidity and other institutionalized market rigidities stemming from government intervention would be absent. As Wilhelm Röpke remarked in 'Crisis and Cycles',


[The deflation] is the unavoidable reaction to the inflation of the boom and must not be counteracted, otherwise a prolongation and aggravation of the crisis will ensue, as the experiences in the United States in 1930 have shown


As John Hussman has noted in his always excellent weekly market commentary (which lately has been especially noteworthy for its trenchant observations):


“The crisis occurred because credit froze up, and credit froze up largely because of the incessant self-serving warnings from the heads of major financial institutions that a second Great Depression would result if they were allowed to "fail" – which in fact means nothing but that the operating entity changes hands (as occurred with Washington Mutual), and the stock and bondholders of the company appropriately take a loss. The government has issued trillions of dollars in new debt in the attempt to sustain the previous misallocation of capital – trying to prevent bad loans from failing; to keep elevated home prices from adjusting to normal levels relative to income; to maintain unsustainable consumption habits; and to subsidize purchases of autos, homes and other big-ticket items that have weak intrinsic demand because people already have too much debt. Huge chunks of national savings that should have been available for productive economic activity have been diverted in an effort to maintain an inefficient status quo.”


In other words, government has propped up unsound investments and unsound credit in defiance of the rules of free market capitalism, and saddled us with a situation in which the market processes that are the necessary sine qua non for genuine economic recovery have been thwarted. In addition, since there are indeed massive rigidities in our economic system, a deflationary contraction of money and credit leads to numerous economic difficulties, chiefly among them a large rise in unemployment, which further depresses demand and leads to more defaults and secondary recessionary effects that tend to aggravate the already tenuous economic situation. In the 1930's , the mixture of keeping wages artificially high, introducing protectionist tariffs in order to artificially prop up prices and increasing both government's deficit spending and taxation combined to turn what could have been a short, if sharp, recession into a long-lasting depression. Due to the fact that the credit and money inflation of the 1920's was almost completely reversed due to defaults leading to bank failures that at the time actually destroyed deposit liabilities, the wage and price rigidities the government insisted upon led to an unprecedented increase in unemployment. The Federal Reserve attempted to  combat the deflationary trend by slashing administered interest rates and blowing up its balance sheet by over 400% between 1929 and 1933, but to no avail – it could not stop the contraction.

Modern mainstream economists have thus concluded that the deflation was the problem. Austrian economists by contrast hold that the primary problem was the inflationary boom – this was the period during which the major mistakes were made that could simply not be 'unmade' by government fiat later on. They also hold that the bust itself was not aggravated by a failure to inflate even more, but by a failure to give the market free rein to work out the problem unhindered.


Trying to Preserve the Status Quo remains a Mistake

We mentioned already that James Bullard has studied Japan's slow-motion depression, and that he has come to certain conclusions from this exercise.

As Bloomberg reports in this context:


“The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Bullard said, warning in a research paper released today about the possibility of deflation. “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

[…] “The conventional wisdom is that Japan has suffered through a ‘lost decade’ partially attributable to the fact that the economy has been stuck in the deflationary, low nominal interest rate steady state,” he said. “To the extent that is true, the U.S. and Europe can hardly afford to join Japan in the quagmire.”  The St. Louis Fed president, who said he visited Japan a month and a half ago, said policy makers there had been unsuccessful with efforts including “aggressive fiscal expansion.”  “They have tried many, many things to change their situation and they haven’t worked very well,” he said.


Somehow it seems to have escaped Bullard that Japan attempted a policy of 'quantitative easing' as well (the euphemism for creating money from thin air and using it to buy up government debt securities), which utterly failed to revive Japan's moribund economy. Bullard did not mention why he thinks the same method would work better in the US, but he appears to believe that it will.

The problem as we see it is that it would simply cement the existing unsound credit and investments into place, and lead to even more misallocation of resources , a process that may well briefly masquerade as 'economic recovery' in the government's statistics, but is in reality a process of further wealth destruction. Bullard and the rest of the 'deflation-fighting brigade' at the Fed are trying to find a painless way out of the dilemma, but such a painless way does not exist.

Consider what actually happens when the Fed buys up treasury (or other) securities and injects money into the banking system. Once an additional quantity of money has been injected in this manner, there is more money – but is there more wealth? Obviously not. So what is actually the point? Those who are first receivers of the new money (the Fed doesn't just credit every citizen's account with an additional sum of money after all) will be in an advantageous position since they can use it to appropriate resources for themselves before the additional money quantity has devalued the monetary unit's purchasing power. Everybody else pays for this process by losing purchasing power. However, the amount of capital goods and real resources available to the economy will not be increased at all. All that  happens is that the process of capital allocation is distorted further. In the end, the problem that occasions the Fed's 'emergency measures' will just recur again, only bigger. There is ultimately no way the current gigantic edifice of unsound debt can be preserved. The income necessary to service it does simply not exist, and it is not possible to conjure it up from thin air.

The lesson from the vast monetary inflation initiated by the Greenspan Fed to fight a previous 'deflation scare' in 2001 has apparently not been learned. If the Fed 'succeeds' in reigniting the inflationary boom, it will only be faced with an even greater dilemma some time down the road. However, as we have previously noted, there comes a time when all attempts to 'pump up' economic activity by means of the printing press are doomed to failure even by the standards of the planners: namely when the pool of real funding is so exhausted, when so much capital has been consumed in the boom preceding the bust, that it is not possible anymore to divert resources into new bubble activities. After all, the boom's consumption and malinvestment excesses were not  really financed by mere money – they had to be financed by the consumption of real capital.


The Great Experiment courtesy of the 'Dream Team'

We understand the dilemma policymakers find themselves in. It seems that no matter what they do, there will be painful consequences. At the heart of the dilemma we find a stubborn unwillingness to debate the real problem: namely that the system of fractionally reserved banking and nigh unlimited money and credit creation has failed once again, not only in spite of having a central planning agency that serves as 'lender of last resort' at its center, but in large part because of it. Naturally the banking cartel does not wish to lose its deposit creation privilege, and neither does the government want to lose its ability to spend money it doesn't have. However, as a nominally free society it is high time we asked ourselves if this is really the path we should continue to follow. Even though modern macro-economic theorizing is seemingly caught in the Keynes-inspired dead end of a mechanistic and completely unrealistic view of the economy, should not the empirical evidence of the repeated failure of this type of system and the failure of the policies designed to keep it afloat at least inspire a little bit of soul searching?

Instead the planners in their hubris insist that once again, they have a 'better plan' than their predecessors – that the problems that have laid low all previous attempts to counteract the bust following a long credit-expansion based boom will be successfully skirted by them due to their superior knowledge. This hubris has never been more succinctly captured as when Gregory Mankiw, a prominent Harvard economics professor and former adviser to president Bush remarked in a New York Times article in late 2007 entitled 'How to avoid Recession: Let the Fed Work' (okay, you can stop laughing now…it gets even better):


The truth is that the current Fed governors, together with their crack staff of Ph.D. economists and market analysts, are as close to an economic dream team as we are ever likely to see. They will make their share of mistakes, but it is too easy to find flaws when judging with the benefit of hindsight. The best Congress can do now is to let the Bernanke bunch do its job.”


Well, so much for that idea. If that's what an 'economic dream team' looks like, then we should definitely make sure that such dream teams have no authority to subject us to their economic experiments. The problem is that they're still not out of crazy schemes they want to try out on us, and nobody seems willing to stop them. As to what it means for investors, buying more gold on pullbacks seems a reasonable way to acquire insurance against the 'dream team's' coming machinations.



St. Louis Fed's James Bullard: 'Begone, Deflation-Satan!'

(Photo credit: Official Federal Reserve portait)





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One Response to “James Bullard Makes a Plan”

  • Bearster:

    How many labor hours and how many acres were required in 1910 to produce a ton of wheat? How many today. If the “price” of wheat in terms of labor hours or land capital has sunk as much as I suspect it has, then the price in terms of any stable measure of value must have sunk. If monetary debasement is held at a level to keep the nominal price of wheat constant, that is still not good.

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