Deflation Is The End Of Capitalism? A Look At Monetary Stimulus And A Real Solution

With a real solution offered at the end of this article, I have been trying to get a handle on what deflation will look like with negative interest rates. Certainly, we are familiar with disinflation, a slowing of inflation. Yet disinflation is not deflation. Deflation is a different animal we have not experienced. Deflation could include a serious reduction of production, a serious slowing of credit, but must include a serious contraction of the money supply and a serious reduction in prices for consumer goods across the board.

Imagine a housing crash with all other prices falling at the very same time. That is deflation. Since commodities have crashed, it makes no sense for houses, made out of commodities, to remain priced as if they cannot be replaced by cheaper production of new houses. Housing in white hot areas could crash, unless there is simply no room for replacement. New modes of high speed transportation may eventually cause a decay in prices in those areas. That will be painful but is not imminent.

Deflation is the diminishing of demand, so much so that businesses have difficulty making money. My parents experienced deflation in the Great Depression. My adopted father had his wages cut, but could have become unemployed but for the importance of oil in his community. His payments stayed the same. The car was parked because they could not afford gasoline, which was dirt cheap, but they simply had no money to buy it. Good thing they lived in a small oil town. They walked.

Deflation is the absence of money, the massive contraction of the money supply. For my parents money was in great demand. A little went a long way, but few had much money. Deflation coupled with negative rates, as a means to increase the money supply will be a crushing tax on the average consumer.

Deflation reduces business revenues. In the Great Depression, as pointed out by Zero Hedge, farmers could not make a profit. You have to have food, so subsidies were issued for the farmers.

A spiral or cycle of deflation brings unemployment, lack of profits, and requests by business for subsidies. So, we are apparently headed toward a global deflation, which certainly has a lot to do with a contraction of the money supply and price declines everywhere.

When the Federal Reserve was created in 1913, it immediately created deflation. If the Fed created deflation in 1913, is the Fed creating deflation along with all the central banks around the world now? One reason the Fed would want to do this is to force wages down in the developed nations as was what happened in 2008. Or the second reason is that the Fed wants deflation in order to ban cash and save the banks at the expense of the real world! That is creepy if true. I can't think of any other reasons why the central banks would do this.

Trusting the Fed in inflationary times is difficult enough. Trusting the Fed in deflationary times will be almost impossible.

And the government cannot be trusted, as it is in an austerity mode, when clearly Keynes said it should not be, that it should buy stuff and hire people in a deflationary scenario. So, why would Keynes be dead and the New Keynesians be all that is left? I believe it is because the NK's are really afraid of big federal stimulus, although they speak out against government austerity. They mainly want to ban cash and go negative with interest rates. The NK's, Paul Krugman being the most famous, are resigned to our Japan-like malaise.

And the central bank solution to deflation is negative interest rates as well. In Europe, negative rates are paid on bank reserves. Unfortunately, that is being passed along to some retail accounts. Scott Sumner says negative IOR is not bad in and of itself, but negative interest rates on bonds are bad. But Bill Woolsey, another market monetarist, has said negative IOR will get passed on to retail accounts. For me, that is a tax, a deflationary tax, making people feel poorer. 

But, for the market monetarist, that tax creates a hot potato effect, forcing people to spend or to buy other assets, like bonds. Yet, maybe not. It could be, as Stephen Williamson has said, be a cold potato effect. If that is the case, then even market monetarism doesn't work without the banning of cash!

It is becoming clear that deflation will destroy the ability of the central bank to stimulate the economy without banning cash! Without the banning of cash, we face a deflationary spiral of epic proportions unless we find other ways to increase the money supply! But we simply cannot ban cash on moral grounds!

Scott Sumner says:

I tell people to ignore banking when studying monetary policy—focus on the supply and demand for the medium of account (base money).  Negative IOR causes a fall in the demand for base money, and thus is expansionary.  Period.  End of story.

I don't know if anyone else really understands what Scott says on this issue, because he doesn't want cash banned, at least so far. But he is an economist, so his desire for a hot potato effect could overcome his stance against banning cash. Commenters on his blog, The Money Illusion, have agreed on this point!

But, he has been right on many things, including the fact that the Fed allowed GDP to drop in 2008, increasing the Great Recession.

Truth is though, it appears the Fed wants some deflation, and wanted it in the Great Depression and in 1913 and so on. Politicians need to get a handle on this. It isn't funny anymore now that we are approaching the negative. How much deflation is "safe"?

So, we also see from Morgan Stanley that this push into the negative is simply a bad idea. Morgan Stanley economists simply have stated that going negative is a "dangerous idea". They share Williamson's cold potato view:

“The credit impulse has turned negative, new loan origination has slowed, and systemic stress in the financial system has risen,”

The market monetarists, and the New Keynesians for that matter, want people to spend cash quickly, but apparently, that hot potato effect is not going to happen without the banning of cash, and then maybe not even then. Think about it. Americans could just save more, or pile into bonds, more than now, and that will not necessarily boost the economy. Again, the banking system is saved, but the real economy continues to decline.

And certainly other solutions that worked in the past, like a massive world war would not help, as fewer people means a smaller worldwide GDP assuming some of us survive. But eugenicists have come out and said there are simply too many people. How chilling. At least the growth of world population has slowed. Back off eugenicists!

Building cities where no one lives, like China does, will not permanently help, although it helped China grow, until it slowed.

The solution to deflation on the macroeconomic level is for creditors to lend to those who create production. Production must be encouraged, as most of the value of stocks is in production of goods. The service economy cannot thrive without production. In my view, simply pushing prices for assets up is the lazy man's way of overcoming deflation (fake supply side asset bubbles don't overcome deflation), and it is a poor substitute for creating more production.

Factory production simply must be ramped up with real supply side economics. The government must provide subsidies and apprenticeships for production and should even supply workers if private business is too lazy or financially constrained to train anyone. And we have to create products that are difficult to produce offshore. This approach could make the Keynesians happy as well. The government and private enterprise established the Hoover dam, so elite factories should be doable.

This process will help with the money supply:

If the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits. The banking system, however, can create a multiple expansion of deposits. As each bank lends and creates a deposit, it loses reserves to other banks, which use them to increase their loans and thus create new deposits, until all excess reserves are used up.

So, we have plenty of reserves. The government should work with the banks to target positive production of real goods. It is a no brainer.

As for individuals, they simply need to learn how to survive during the ravages of deflation. Getting out of debt is key, as cash becomes king. That can have dire consequences for consumer demand. Debt becomes more expensive in deflationary times. But don't underestimate the power of deflation. As prices decline, wages, which are sticky, force layoffs, except with my dad in the Great Depression. He was fortunate.  But for many, deflation was and will be devastating as many are laid off.















Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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