Catalysts for a major correction

[Foreign Tuffett]

Central banks don't run out of money. They magically create more when they need it. The Federal Reserve never had $4 trillion in equity to purchase all of those bonds with. They're levered like 80x to their equity base and they just created the money to purchase those bonds electronically. Crazy that you can just use fake, electronic money to acquire real assets representing claims on the value of labor measuring in the trillions, right?

 

Your comment hints at some of the criticisms of fiat currency that have been around for many decades (centuries?). Ultimately the success of a given fiat currency is dependent on people's confidence in it. This psychological underpinning makes some people very nervous.

[wachtwoord]

Central banks don't run out of money. They magically create more when they need it. The Federal Reserve never had $4 trillion in equity to purchase all of those bonds with. They're levered like 80x to their equity base and they just created the money to purchase those bonds electronically. Crazy that you can just use fake, electronic money to acquire real assets representing claims on the value of labor measuring in the trillions, right?

 

Your comment hints at some of the criticisms of fiat currency that have been around for many decades (centuries?). Ultimately the success of a given fiat currency is dependent on people's confidence in it. This psychological underpinning makes some people very nervous.

 

Centuries? Nixon removed the gold standard in 1971 so 45 years. Or do you mean when they started reducing the gold peg to USD in 1930s?

 

Ultimately fiat currency cannot be successful because it is a government mandated ponzi schema which gets forced on a population by enforcing the payment of taxes in fiat currency.

[petec]

 

Centuries? Nixon removed the gold standard in 1971 so 45 years. 

 

 

Yep.  Amazes me how few people know this (and how few mention it when explaining the inflation of the 1970s).

[TwoCitiesCapital]

Central banks don't run out of money. They magically create more when they need it. The Federal Reserve never had $4 trillion in equity to purchase all of those bonds with. They're levered like 80x to their equity base and they just created the money to purchase those bonds electronically. Crazy that you can just use fake, electronic money to acquire real assets representing claims on the value of labor measuring in the trillions, right?

 

Your comment hints at some of the criticisms of fiat currency that have been around for many decades (centuries?). Ultimately the success of a given fiat currency is dependent on people's confidence in it. This psychological underpinning makes some people very nervous.

 

I don't disagree. And I imagine that it's becomes easier to lose confidence when you can hit the "print" button and magically have $4 trillion worth of stored labor value acquiring real assets that would typically require real work and real productivity to acquire...but maybe that's just me.

 

Anyhow, my criticisms of fiat currencies aside, that was the point of the post. The point was that they can't run out of money because they just print however much they desire to "achieve" their goals. The last 8 years have proved that.

[PatientCheetah]

Yes they can print money at will. But getting these money into the economy is the tricky part - unless they give everyone free money directly, there are hard limits with bond buying.

[wachtwoord]

Yes they can print money at will. But getting these money into the economy is the tricky part - unless they give everyone free money directly, there are hard limits with bond buying.

 

They'll just buy equity like in Japan. Look at Japan and see the future.

[TwoCitiesCapital]

Yes they can print money at will. But getting these money into the economy is the tricky part - unless they give everyone free money directly, there are hard limits with bond buying.

 

Sure, and we haven't hit them yet at $4 trillion so they could keep going if they wanted. And when they hit those limits, the could open it up to corporate bonds and equities immediately adding tens of trillions in potential buying capacity. I don't know where the limit is at for the public to lose faith - maybe never if because they seem wholly uneducated on these items, but it's odd to me the Federal Reserve can engage in the same activity that counterfeiters engage in and it's encouraged.

 

Money has value because it acts as a medium of stored labor value. If you can just assign that stored labor value to any piece of paper, whether it is created by the Fed or a petty street thief, it detracts from the overall confidence one should have in the continuing value of their money. It's as simple as that. I don't know what limit the average person has - mine was hit long before we did $4 trillion in funny money.

 

TBC - I'm not a prepper, I don't own bars of gold, I'm not suggesting we hoard gas/food/guns/ammo. I just have no confidence that the U.S. dollar (or any other massively manipulated currency like the euro or the JPY) will be worth much of anything by the time I retire. I prefer sensible policies that pass a simple smell test - the Federal Reserve counterfeiting $4 trillion dollars in a bid to stimulate the economy doesn't do that UNLESS it actually does ruin the faith in our currency and erodes the value of the debt overhang we have...but then, that's no better than simple a default in my eyes.

[tede02]

What's sad to me is the missed opportunity.  If even half of the QE money were spent on fiscal stimulus (roads, bridges, mass transit, improved broadband,

electric grid, etc.) the world would be structurally better positioned to drive economic growth.  Instead, we have little more than all of these financial assets sitting on the balance sheets of the central banks.  I guess we also have inflated asset prices but that doesn't seem to be doing much to spur growth or increased lending activity. 

[RichardGibbons]

What's the alternative to fiat money?  Physical commodities don't seem to work, because the growth of the supplies of the physical commodity might not match the growth of the actual economy.  (Like, if gold supplies grow by 1.6% a year, and the economy grows by 3% a year, it seems like you have a problem--constant deflation.  Or, if you're getting too much of the physical commodity relative to the economy, you get inflation.)

 

So is there a better alternative I'm missing, or is something wrong with my reasoning here?

[PatientCheetah]

blame politics, much easier for corruption to occur when you are giving out government contracts to build physical things. We don't have an impartial technocratic bureau to allocate government funds, in fact, the budgeting process is highly politicized and devolves into simply buying votes, not necessarily for the greatest public gains.

[petec]

What's sad to me is the missed opportunity.  If even half of the QE money were spent on fiscal stimulus (roads, bridges, mass transit, improved broadband,

electric grid, etc.) the world would be structurally better positioned to drive economic growth.  Instead, we have little more than all of these financial assets sitting on the balance sheets of the central banks.  I guess we also have inflated asset prices but that doesn't seem to be doing much to spur growth or increased lending activity.

 

I totally agree that QE should be spent in the real economy, not the financial asset economy.

 

Problem is, I don't trust government to allocate the capital particularly smartly, so I'm less sure it would be great for growth.  But it would be better than what's been done.

[petec]

What's the alternative to fiat money?  Physical commodities don't seem to work, because the growth of the supplies of the physical commodity might not match the growth of the actual economy.  (Like, if gold supplies grow by 1.6% a year, and the economy grows by 3% a year, it seems like you have a problem--constant deflation.  Or, if you're getting too much of the physical commodity relative to the economy, you get inflation.)

 

So is there a better alternative I'm missing, or is something wrong with my reasoning here?

 

Why is deflation in the situation you describe a problem?  This is the situation that ruled in the US from 1776 to 1913 (and arguably 1936 or even 1971).  Those were, overall, pretty good years.  There is absolutely nothing wrong with structural deflation of the type you describe.

 

What *is* a problem is financial inflation (credit boom) followed by financial deflation (credit bust) when prices are not allowed to fall.  If you allow money to be destroyed through deleveraging, you must allow prices to fall.  Eventually they will stop falling because the process of deleveraging and destroying money will slow.  Preventing prices from falling during a rapid deleveraging (as Hoover did in 1930-32) is disastrous.  I found reading Jim Grant's book on the 1921 depression and Murray Rothbard on the great depression, one after the other, very instructive on this topic.  There is a solid case to be made that if Calvin Coolidge has been President in 1930, the great depression would have lasted a couple of years only.  (There's also a solid case to be made that if the Fed hadn't existed, the credit boom that preceded it would never have happened either.)

 

Bottom line for me is that you either need to allow occasional rapid painful recessions under a gold standard, complete with deflation including wage deflation, or you need to go for a fiat currency on the understanding that you can probably prevent wage deflation and the really painful parts of the cycle but you'll destroy the value of the currency over time and you'll probably dull the wealth creation process a bit through capital misallocation.  Both work.  The former is more attractive to hardline market theorists, but the latter is easier politically, so it is where most societies end up over time and it is where we are now. 

 

I'm not arguing for one or the other, but it's crucial to understand what system prevails and it's clear which one does!

[RichardGibbons]

Interesting argument--very different than what I've seen from mainstream economists, who mostly seem to vilify deflation as destroying the economy by reducing demand. On the other hand, building demand through constantly growing debt doesn't seem particularly sustainable either, but they seem enthusiastic about doing that recently.

 

Thanks petec. 

[TwoCitiesCapital]

Interesting argument--very different than what I've seen from mainstream economists, who mostly seem to vilify deflation as destroying the economy by reducing demand. On the other hand, building demand through constantly growing debt doesn't seem particularly sustainable either, but they seem enthusiastic about doing that recently.

 

Thanks petec.

 

Deflation would slow the level of current consumption, but the level it settled at would be entirely sustainable and still support this economy and it would be a healthier growth with far less debt (i.e. less prone to shocks and far more sustainable).

 

I love when people say deflation prevents people from purchasing. It does to an extent, but it doesn't prevent purchases indefinitely. If you know that you can wait 3 months and it will be significantly cheaper, you may wait 3 months to purchase. But that doesn't necessarily mean you'll wait 9, 12, or 15 months (or indefinitely!).

 

We all know that TVs will get cheaper if we wait. We all still own TVs.

We all know that used cars will get cheaper if we wait. The used car business is still a functioning business model.

We all know that if you wait until the end of the season to buy clothes, you get the best deal....but plenty of people buy clothes in season.

 

People will buy something when they want it bad enough. Most people will wait a little bit if they can get a better price, but nobody puts off the purchase indefinitely. Some people won't even wait 2 weeks. People still would buy TVs, clothes, cars, and houses when they wanted them. This would be no different in an economy that consistent, modest deflation.

 

Think of how ridiculous you would sound if you told someone you bought a car you didn't need because you just new it would be more expensive next year as prices inflated and you may need it next year (i.e. inflation is supposed to spur consumption). That's how stupid you sound when you say people would put off purchases indefinitely to wait for a lower price for things they do need/want now (i.e. deflation delays consumption). 

 

The U.S. has operated through many periods of persistent deflation and did just fine through them. It was literally ONLY the Great Depression that it was an issue before the fears today. The Great Depression was brought on by financial speculation through the use of too much margin debt which further confirms the one rule of deflation: it's only bad if you owe a lot of money.

 

[Spekulatius]

It seems like there is just vast pessimism surrouding stock prices yet buying pressure is coming from somewhere.

 

Global QE is at all time highs (Europe and Japan) and money is leaking to the US, is my guess.  Plus China stimulating like crazy and I suspect money is flowing out.

 

With QE, the money is never going, where it is supposed to go. Rather than stimulating the economy, tends to inflate assets often where it is not beneficial.

 

My guess is that a commercial RE crash could cause trouble. Cap rates are at all time lows, but a lot of business renting (banks, shopping malls) are being disrupted. Higher interest rates together with structural problems (malls becoming obsolete etc) could cause a crash that would also affect the financial system, since so many loans  from smaller and mid sized banks are secured by commercial RE.

[wachtwoord]

What's the alternative to fiat money?  Physical commodities don't seem to work, because the growth of the supplies of the physical commodity might not match the growth of the actual economy.  (Like, if gold supplies grow by 1.6% a year, and the economy grows by 3% a year, it seems like you have a problem--constant deflation.  Or, if you're getting too much of the physical commodity relative to the economy, you get inflation.)

 

So is there a better alternative I'm missing, or is something wrong with my reasoning here?

 

You're honestly telling me you never heard of Bitcoin?

 

And why do you believe money supply should expand? You read it in text book or something?  ::)

All the currebt fiscal policies are not just wrong but stupid. It's Keynesian and it's no science but religion/dogma that has been going rampant for way too long.

[petec]

Interesting argument--very different than what I've seen from mainstream economists, who mostly seem to vilify deflation as destroying the economy by reducing demand. On the other hand, building demand through constantly growing debt doesn't seem particularly sustainable either, but they seem enthusiastic about doing that recently.

 

Thanks petec.

 

Jim Rogers in Investment Biker makes the opposite argument.  He says that if governments persistently devalue to keep the economy competitive, companies don't innovate.  By contrast, governments that sustain a hard currency force their companies to innovate to compete, and by doing so create real wealth (as distinct from money).  Europe would appear to be an excellent example: every single one of the Eurozone currencies devalued against Germany in every single one of the five decades before the unified currency.  By contrast the mark was one of the hardest currencies in the world.  Which Eurozone country has the strongest companies, the most innovation, and is the wealthiest?

 

Inflation does not create wealth.

 

Mainstream economists hate deflation for three reasons:

1. They think it delays purchases.  TCC has rebutted this very well - I would just add that if the money in your pocket keeps getting more valuable, aren't you more likely to spend it because you find you can afford things you always wanted?  I know I would be.

2. They blame it for the Great Depression.

3. If they accepted hard currencies and market primacy they'd all be out of jobs in which they teach how clever macroeconomic management can prevent the terrible consequences of hard currencies and market primacy ;)

 

Concentrating on #2:

 

First, deflation can be caused by innovation in a hard currency environment or it can be created by a deleveraging event.  The first is not dangerous; the second can be.

 

Second, deflation was a symptom of the great depression, but not the cause.  Many people thought it was the cause then, and many still do, but if you understand that money is simply a way of measuring activity then you'll understand that price changes can't really be very causal in driving activity.  (Relative price changes do drive activity because they signal economic need and guide the allocation of capital, but general price changes don't.)

 

In the 1920s there was a huge credit expansion, meaning money got created through fractional reserve banking etc.  This drove prices up (more money chasing roughly the same amount of assets and produce).  Starting in 1929, this process went into reverse and prices started falling.  This process doesn't have to be harmful to most real activity.  What it does do is show who's been using debt to invest in bad projects, as so often happens in a credit boom.  And to the extent that those bad projects stop, there's a temporary impact on real activity.

 

Now, if you allow prices to fall in this situation you're ok: less money, broadly the same activity level, lower prices.  But you have to allow prices to fall.  If you organise labour to keep wages up, and organise pools to buy commodities to keep their prices up, you will cause chaos.  As prices of goods fall companies must be able to cut labour costs or go out of business.  As market prices of commodities fall, you need to get to the point where they are so cheap people want to buy them, but stockpiling prevents this by a) holding up the price and curbing demand, and b) causing a huge overhang which does cause people to delay purchases.

 

Hoover did everything he could to stop prices falling, because he believed that falling prices was the cause of the problem.  He organised labour and commodity pools.  Yet in fact, deleveraging and money destruction was the cause of the problem, and falling prices was a natural consequence of that - and a very healthy one, if left to operate properly.  A similarly rapid deflation fixed itself in 18 months in 1921, because nothing was done to interfere with markets clearing. 

 

It's important to understand that a deleveraging/deflation episode must come to a stop.  This is because while deleveraging can destroy all credit-created money, it can't destroy base money, so the amount of money in the system will never fall to zero.  If prices keep falling, they will eventually look so cheap that buyers will be motivated to buy, and prices will stop falling.  Credit deflations end themselves naturally if markets are allowed to clear.

 

The other alternative solution to excessive leverage is inflation to make the debt go away.  This involves price controls (like the minimum wage and inflation targeting, which I think is a really dangerous idea) and rapid creation of new fiat money to offset money destruction via deleverage.  This is politically popular - people don't like wage cuts or having to pay their debts by working hard - but as Rogers argues, it probably impairs innovation and wealth creation, and it also means ever-higher levels of debt.

 

In the next 20 or 30 years, we will find out whether fiat money and stunning debt levels are worse than hard money and less debt.

 

Sorry for the long and very off topic post!

 

 

[wachtwoord]

And a child could see #1 is foolish. Just because your money will buy you more today than tomorrow doesn't mean you'll postpone purchases indefinitely. This is true for purchases of any kind (including frivolous spending) but particularly obvious for the primary survival needs such as food and shelter.

[Rainforesthiker]

What's the alternative to fiat money?  Physical commodities don't seem to work, because the growth of the supplies of the physical commodity might not match the growth of the actual economy.  (Like, if gold supplies grow by 1.6% a year, and the economy grows by 3% a year, it seems like you have a problem--constant deflation.  Or, if you're getting too much of the physical commodity relative to the economy, you get inflation.)

 

So is there a better alternative I'm missing, or is something wrong with my reasoning here?

 

Why is deflation in the situation you describe a problem?  This is the situation that ruled in the US from 1776 to 1913 (and arguably 1936 or even 1971).  Those were, overall, pretty good years.  There is absolutely nothing wrong with structural deflation of the type you describe.

 

What *is* a problem is financial inflation (credit boom) followed by financial deflation (credit bust) when prices are not allowed to fall.  If you allow money to be destroyed through deleveraging, you must allow prices to fall.  Eventually they will stop falling because the process of deleveraging and destroying money will slow.  Preventing prices from falling during a rapid deleveraging (as Hoover did in 1930-32) is disastrous.  I found reading Jim Grant's book on the 1921 depression and Murray Rothbard on the great depression, one after the other, very instructive on this topic.  There is a solid case to be made that if Calvin Coolidge has been President in 1930, the great depression would have lasted a couple of years only.  (There's also a solid case to be made that if the Fed hadn't existed, the credit boom that preceded it would never have happened either.)

 

Bottom line for me is that you either need to allow occasional rapid painful recessions under a gold standard, complete with deflation including wage deflation, or you need to go for a fiat currency on the understanding that you can probably prevent wage deflation and the really painful parts of the cycle but you'll destroy the value of the currency over time and you'll probably dull the wealth creation process a bit through capital misallocation.  Both work.  The former is more attractive to hardline market theorists, but the latter is easier politically, so it is where most societies end up over time and it is where we are now. 

 

I'm not arguing for one or the other, but it's crucial to understand what system prevails and it's clear which one does!

 

+1

[RichardGibbons]

You're honestly telling me you never heard of Bitcoin?

 

You're honestly telling me that you are criticizing someone about  Bitcoin without realizing that, in terms of growth, its properties are similar to gold with respect to supply?  Worse, actually, since there is a finite supply. Or are you just ignorant about how Bitcoin actually works?

 

And why do you believe money supply should expand? You read it in text book or something?  ::)

All the currebt fiscal policies are not just wrong but stupid. It's Keynesian and it's no science but religion/dogma that has been going rampant for way too long.

 

Umm, I was asking a question because I was curious about the pro-deflation reasoning and how people account for the fall in demand.  Petec's response was very useful in explaining it to me, much more so than "Wrong! Stupid! blah blah religious dogma! blah blah not science! blah Keynesian!" 

 

His response has persuaded me that there's something to be said for not discarding the idea just because it leads to deflation.  Yours has persuaded me that many people are religious zealots when it comes to this topic, and, even if the idea might be right, they harm the credibility of the idea by being unable to communicate anything beyond their fervour.

 

Thanks for trying.

 

(And thanks for succeeding, petec--you've enlightened me and I'm coming around to that point of view.)

[wachtwoord]

You're honestly telling me you never heard of Bitcoin?

 

You're honestly telling me that you are criticizing someone about  Bitcoin without realizing that, in terms of growth, its properties are similar to gold with respect to supply?  Worse, actually, since there is a finite supply. Or are you just ignorant about how Bitcoin actually works?

 

And why do you believe money supply should expand? You read it in text book or something?  ::)

All the currebt fiscal policies are not just wrong but stupid. It's Keynesian and it's no science but religion/dogma that has been going rampant for way too long.

 

Umm, I was asking a question because I was curious about the pro-deflation reasoning and how people account for the fall in demand.  Petec's response was very useful in explaining it to me, much more so than "Wrong! Stupid! blah blah religious dogma! blah blah not science! blah Keynesian!" 

 

His response has persuaded me that there's something to be said for not discarding the idea just because it leads to deflation.  Yours has persuaded me that many people are religious zealots when it comes to this topic, and, even if the idea might be right, they harm the credibility of the idea by being unable to communicate anything beyond their fervour.

 

Thanks for trying.

 

(And thanks for succeeding, petec--you've enlightened me and I'm coming around to that point of view.)

 

Petec still has some more patience. I lost most of mine with people that start with the unfunded premise that deflation is bad and inflation is not only good is necessary. You attack me for not using proper argumentation for my statements yet did the same. If you don't feel like you need to, I don't need to either.

 

Anyway: to react to your post: yes, Bitcoin is improved gold and it solves all the issues of fiat currency you mentioned. If there were no Bitcoin I'd be advocating gold or a gold backed currency as gold has the huge problem that it's not digital and therefore payments (transfers of ownership) with it are local or slow. Bitcoin is the first valuable asset that is digital itself and therefore can be transferred nearly instantly. Thus far we have only been trading tokens representing assets, not the assets them-self (with all the associated weaknesses).

[RichardGibbons]

Petec still has some more patience. I lost most of mine with people that start with the unfunded premise that deflation is bad and inflation is not only good is necessary. You attack me for not using proper argumentation for my statements yet did the same. If you don't feel like you need to, I don't need to either.

 

So to summarize the conversation:

 

Richard: Doesn't a gold standard lead to deflation which is a bad thing?  Or am I missing something?

 

Petec: Yeah, it could lead to deflation, but deflation isn't necessarily a bad thing.

 

Richard: I see.  That's outside the mainstream view, but the mainstream view seems to have major problems so there might be something to what you say.

 

wachtwoord: Bitcoin exists, therefore good!  Evil Keynesians!  Religious dogma!  Stupid fiscal policies!  And education is bad!  Avoid text books!

 

Richard: Uh, what?  You know that I'm actually thinking petec might be correct, right?  Your zealous foamings are not actually providing any insight.

 

wachtwoord: I have no patience for people who ask questions when they don't understand!  You're attacking me and you haven't made an argument either.

 

Richard: I'm trying to understand what petec's saying. Not make an argument.

 

Your "Bitcoins are better than gold" statement is actually coherent and relevant.  Thanks for that.

 

 

 

[petec]

Wachtwoord: the gold standard lasted LONG after gold ceased to be carried around in people's pockets, as I'm sure you know.  The gold was stored in vaults and little bits of paper that said "go to my banker and he will give you gold" were traded instead.

 

Why can that not be done digitally?

 

This is a genuine question, not a dig!  I'm fairly ignorant of Bitcoin so I hadn't considered the Bitcoin vs. gold argument very well.

 

Richard: don't be too persuaded by my arguments.  The gold standard has one fatal flaw: it works by enforcing discipline, and humans don't like discipline.  Politicians don't like it because it enforces fiscal discipline on them.  Populations don't like it because every now and again, when it enforces discipline on them, it hurts (briefly).  And populations like policies that the gold standard just can't co-exist with, like the minimum wage.  The gold standard doesn't work because no society has ever had the discipline to stick to it. 

[TwoCitiesCapital]

Wachtwoord: the gold standard lasted LONG after gold ceased to be carried around in people's pockets, as I'm sure you know.  The gold was stored in vaults and little bits of paper that said "go to my banker and he will give you gold" were traded instead.

 

Why can that not be done digitally?

 

This is a genuine question, not a dig!  I'm fairly ignorant of Bitcoin so I hadn't considered the Bitcoin vs. gold argument very well.

 

Richard: don't be too persuaded by my arguments.  The gold standard has one fatal flaw: it works by enforcing discipline, and humans don't like discipline.  Politicians don't like it because it enforces fiscal discipline on them.  Populations don't like it because every now and again, when it enforces discipline on them, it hurts (briefly).  And populations like policies that the gold standard just can't co-exist with, like the minimum wage.  The gold standard doesn't work because no society has ever had the discipline to stick to it.

 

+1

 

Politicians win by promising their constituents more stuff (regardless if it can be delivered or not). Gold results in a failure to deliver. Fiat currency and perpetual debt allow for them to deliver on some things. Politicians are happy. People are happy. And yet everyone is worse off for it.

 

 

[Jurgis]

Politicians are happy. People are happy. And yet everyone is worse off for it.

 

Any proof for this?

 

Let's see: People are happy and yet somehow everyone is worse off for it?

 

And BTW before you go on your gold bug bandwagon, maybe you should explain why the last 50 years of fiat money was one of the best times of the history of our civilization. For businesses and entrepreneurism too. Or will you claim that it made everyone worse off and it would have been so much better on gold standard?

 

Edit: it's also rather funny seeing people railing for gold standard at the time when there is no inflation, no inflation on horizon and there might be deflation because of a number of reasons. So you want to go back to gold standard why?

 

BTW both gold standard and bitcoin are bad because they encourage spending resources on unproductive endeavors: gold mining and fruitless computations. There's already way more gold in the world than there's need for it. If you're so smart, at least tie your bitcoin computations to finding cure for cancer. I'd vote for "cancer-cure-coin" maybe.  ::)