“But there is no inflation!” – This is a statement I hear quite often, sometimes from people who are, in principle, sympathetic to my arguments, sometimes from people who are less so. In either case, those who state “but there is no inflation” consider it to be a statement of fact and one that they assume must pose a challenge for me. Should the man who argues that we are heading for the collapse of paper money, for some kind of hyperinflationary endgame, not be concerned that all this money printing by central banks around the world has not led to much higher inflation yet? Do present inflation statistics not provide comfort to those who believe in the practicability and even superiority of central-bank-managed fiat money, and do these statistics not allow them to discard my analysis as paranoid?
The short answer is, no.
The long answer I will provide below.
First of all, there is, of course, inflation, and quite a bit of it. In all major industrial countries official inflation is positive, and in some countries inflation has for years been persistently above the official inflation target (UK, Euro Zone). As I keep saying, the debasement of paper money continues. This is meaningful. Also, this inflation is harmful, even if it is not hyperinflation yet. That this inflation is nothing to worry about, or that it is even beneficial is a complete misconception.
Furthermore, I do expect inflation to get worse, if only marginally at first. Even more importantly, I do think that the risk of an inflationary endgame to our fiat money system has been increasing in recent years and is still increasing today, thanks to present policies and the future policies that seem presently most likely. I will explain this in more detail in a minute. Present inflation rates pose no problem for my analysis and my forecast. To see why, I need to first repeat my key premise.
Inflation in the context of the crisis
Please remember that my key statement in Paper Money Collapse is this: A monetary system like ours, which is a system of entirely elastic, unconstrained fiat money under central bank control, designed to constantly expand the supply of this fiat money so that its purchasing power keeps diminishing (controlled inflation), and that will be used periodically to ‘stimulate’ growth, is not, as the mainstream would have it, a guarantor of economic stability but, to the contrary, suboptimal compared to hard money, inherently unstable and indeed unsustainable. Such a system is fundamentally incompatible with functioning capitalism and a danger to economic stability and prosperity. If taken to its logical conclusion – which is what central banks seem determined to do at present – such a system must end in chaos.
Ongoing monetary expansion must cause the economy to accumulate imbalances over time and these imbalances will be an ever more powerful hindrance to proper growth. As I show in detail in Paper Money Collapse, money injections ALWAYS create dislocations, misallocations of capital, that will have to be liquidated in the future. Such imbalances are now abundant and certainly include excessive levels of debt, overstretched banks and inflated asset prices, i.e. distorted relative prices. As long as the mainstream maintains that ‘easy money’ is a necessary antidote to recession and as long as central banks continue to fight the present crisis with low interest rates and ongoing monetary expansion, these imbalances – that are the root cause of the current malaise and that logically have their origin in previous interludes of ‘necessary monetary stimulus’ – will not be allowed to dissolve or get liquidated but will instead be maintained, and new imbalances will get added to the old ones. The economic system moves further and further away from balance. The crisis is not ended but sustained.
Policy makers claim that without their intervention the crisis would be worse, which only means the liquidation of certain imbalances would now have occurred. Their policies have taken us further away from a proper solution of the crisis and have given us a fleeting but false impression of stability, for which we pay with yet more imbalances.
At this point, one of the reasons for the still ‘moderate’ headline inflation today in spite of the massive monetary stimulus from central banks already becomes apparent: As the imbalances – such as excessive levels of debt, overstretched banks and inflated asset prices – get bigger, the (market) forces that work towards their liquidation become stronger. These forces are deflationary in nature. Sustaining the imbalances – in order to keep the illusion of stability alive – requires ever more aggressive money printing on the part of the central banks, which is what we are seeing around the world today. New ‘base money’ – the type of money that central banks issue and that functions as the monetary system’s raw material – does at the moment not lead to higher headline inflation as quickly as it did in the past. Balance sheets are stretched, overall debt levels are high, and asset markets are distorted – all of this a result of previous monetary expansion. Consequently, banks are reluctant to lend, and the private sector is reluctant to borrow. Ongoing monetary accommodation is blunting its own effectiveness. There are other reasons for the presently still contained headline inflation figure, to which I will come soon.
But remember, in our system of entirely unconstrained fiat money, ever more money can be injected ever faster – and in fact ever more money will have to be injected ever faster for the central banks to keep achieving their near-term policy goals, which are to obstruct any liquidation of capital misallocations and excess debt, and to keep debasing money’s purchasing power. The tipping point – and the trigger for much higher inflation – will be reached when the public loses confidence in this charade. When the public reduces its money balances out of fear of future inflation, money’s velocity will shoot up and inflation will accelerate. Persistent moderate inflation or even slightly accelerating inflation could play a role in taking us to this tipping point. In this respect, current inflation developments are not unimportant. But we have to analyse them in the context of the theory here presented.
For those who have read Paper Money Collapse carefully and fully understood it, none of this is new, and I do apologize for the repetition. But let me stress again, my forecast in recent years has not been that by 2012 or 2013 we will already have much higher inflation or even hyperinflation. Of course, I would not and could not have excluded the possibility that we had much higher inflation or even hyperinflation by now. Nobody can. If and when confidence wanes, the inflation dynamic changes quickly. The system is on thin ice, and central banks are betting every day that this ice will not break. But it was not and still is not my central forecast, at least for the immediate future. My forecast has been and continues to be this, which flows directly from the analysis above: The present super-easy monetary policy does not solve the crisis. This policy does not lead to self-sustaining growth of the kind that would allow central banks to withdraw ‘stimulus’ and normalize interest rates and other policy parameters – something that has been promised in recent years but never happened, nowhere in the world. There is no end to ‘quantitative easing’. It will have to continue forever. QE-policies will even have to be expanded and intensified. There is no ‘exit strategy’. The central banks are digging themselves – and all of us – an ever deeper hole.
These forecasts have been accurate so far and they continue to be my forecast for the future. And here is another forecast: The present measures will over time be seconded with others that in my book I label ‘nationalization of money and credit’, that is, institutional investors will be coerced via legislation and regulation to remain invested in certain asset classes, the war on cash and the war on off-shore will continue and intensify, ultimately we will see capital controls.
Back to inflation
I also expect inflation to remain elevated and even increase over time. Despite the massive imbalances which increasingly clutter the normal transmission mechanisms of easy money, enough of the new money will find its way into the wider monetary aggregates and the wider economy, and this will make sure that our paper money continues to lose purchasing power as is indeed one of the main goals of the central banks. Remember, central banks now de facto fund the public sector through money printing. The central banks are the lenders of last resort and the public sector is the borrower of last resort (the private sector is reluctant, for good reasons, as I explained above). In the US, almost 80 percent of new government debt goes straight to the central bank. The ECB is ready to buy government debt directly, rather than fund European governments indirectly as the ECB has done for years and on a large scale by funding all European banks generously against the collateral of government debt. The Bank of England is, of course, the Queen of QE.
Investors will not accept negative real interest rates forever – not even with the ‘encouragement’ of repression through the state and its agencies – and they will demand higher yields at some point. Again, when the public ‘gets it’, when the public realizes that this charade will have to go on forever and on an ever larger scale, that there is no ‘natural’ end point to this policy of continuous debasement, and that this policy involves ever more fiat money creation and indeed substantial debt accumulation, the public will ditch bonds and paper money. At that point inflation will go up, and it won’t go up just a bit.
Today’s inflation is already harmful
Last week, it was reported that official consumer price inflation in the UK had receded and was now closer, although still above, the Bank of England’s target. One newspaper commented that this was good news for British families, and I fully agree. In particular at difficult times for the economy, when many people are unemployed and have to rely on their savings or on reduced income, it is helpful when stuff gets more expensive at least at a somewhat slower pace, which is what is presently happening in the UK. But would it not even be more helpful if stuff actually got cheaper? What if prices would not rise by about 2.6 percent on average but would fall by 2.6 percent? What if every pound in your pocket got you that much further? Would that not even be better news for the British family?
But ironically, that would be that dreadful deflation that mainstream economists never tire of warning us about. We are constantly told that, although incomes hardly rise and many people have to spend some of their savings to make ends meet, we should still be thanking the central bankers for making sure that our money’s purchasing power keeps dwindling.
It used to be the case that the inflationary boom was followed by the deflationary bust. The tendency for prices to fall in a recession was an important factor in stabilizing things again and doing so quite naturally. Lower prices supported those on lower income, and at some stage lower prices lured those with money on the sidelines back into the economy and back to spending and investing it.
Today, policymakers also try to entice people to spend their money balances by artificially depressing interest rates to zero and by debasing money’s purchasing power. Inflationist policies are, in their view, a tool to encourage spending and investing. Money is supposed to become an unwanted asset. They ignore that what is required to keep lowering money’s purchasing power, namely super-low interest rates and injections of new money, simultaneously props up asset prices artificially and obstructs the deleveraging of the economy. This is a persistent disincentive to invest. Those who have money to spend are reluctant to do as long as asset prices are inflated through easy money and cheap credit. They know, of course, that these are not true market prices. Nobody wants to invest in a manipulated market.
It would undoubtedly be much better to stop printing new money, stop manipulating interest rates and stop debasing money, that is, to end inflationary policies. The market would then go through a much needed cleansing, a liquidation of imbalances. The clear advantage would be that interest rates would reflect the availability of true savings again, and prices would reflect true demand for assets. Prices would be lower but would once again be real market prices. Those with money to spend would feel more comfortable investing their funds. This would truly kick-start the economy.
The beneficiaries of inflationism
But those who defend present inflationist policies maintain we cannot allow the market to trade ‘proper’ prices and certainly not to cleanse anything. Falling prices now would lead to a dreadful debt deflation, a deflationary spiral that would cause substantial collateral damage. I do believe that fears of a deflationary spiral are overblown. As the purchasing power of money increases in a deflation, the opportunity costs of holding wealth in the form of money increase and incentives rise to spend money again. The notion that nobody who expects prices to fall in the future would spend money today is nonsense. It ignores entirely the concept of time preference, and we can see that this is not the case every day in the market for computers or smart phones. These products get cheaper and better every year, yet demand for them is strong and people spend considerable amounts of money on them today.
Allowing the market to correct and to liquidate imbalances and excess debt would not mean the end of borrowing and lending. However, it would certainly hurt those who overreached during the previous boom. Those who borrowed excessively and leveraged their balance sheets too much during the last period of easy money are the ones that would struggle in a deflationary correction, and they are now to be saved by means of a policy of ever easier money. Among them are, importantly, the banks and the states, both are, of course, systematic beneficiaries of the privilege to issue unconstrained fiat money, and both were certainly beneficiaries of the cheap credit boom that led us into this crisis. They are now the chief beneficiaries of the present policy of ongoing inflationism. Those who were most reckless in the boom are to be bailed out with easy money, while those who were prudent, who were not lured by cheap credit into dangerous balance sheet extension and who saved are now the victims of this policy, as present policies prohibit them from buying assets at depressed prices (i.e. true market prices) and in fact secretly confiscate their savings via ongoing money debasement.
Those who defend this policy will argue that collapsing banks and a bankrupt state are also not in the interest of the average British family. That may be so, but it only shows how far all of society has now been contaminated by the consequences of persistently easy money. On some level we have all been made addicts to the crack cocaine of endless cheap cash. But what is the alternative to liquidation? Is it really feasible to declare many prices to be free of the risk of decline and large sections of the economy to be free of the risk of default – regardless of the extent to which these entities issued claims against themselves during the good times? How much money do we have to print to make this anti-capitalist fantasy come true?
The fact that this policy has a targeted group of beneficiaries is also one of the reasons why inflation is not higher yet. Central banks create base money, that is, deposit money that sits on account at the central bank. This money functions as bank reserves. Since 2008, central banks around the world have flooded their banking systems with such bank reserves but this has not led to a similar expansion in broader monetary aggregates (although it has certainly encouraged further expansion of wider aggregates and is thus responsible for ongoing, harmful inflation, just not on the scale that the massive expansion of base money would normally suggest). As I said, a lot of this is due to the vast imbalances: banks are too scared to lend (and rather hold excess reserves) and the private sector too scared to borrow – and for good reason as pretty much all prices around us are distorted. However, the central banks have not really targeted the wider aggregates, yet. The US Federal Reserves even pays the banks interest on their risk-fee deposits at the Fed. It thus encourages them to keep excess reserves and not increase lending.
Remember, QE1 was designed to save the banks. The Fed gave the banks more than $1 trillion in new reserves and did so by taking one of the most toxic asset classes off their balance sheets in exchange for the new cash: mortgages. QE2 was designed to manipulate asset prices as Bernanke admitted here. Again, the main objective was not to have banks go out and create vast amounts of new deposit money via fractional-reserve banking and thus give a stronger boost to M2 (and to inflation) but to prop up the prices of ‘risk assets’.
But the economy has not entered a self-sustained recovery thanks to these measures – Surprise! Surprise! Of course, it has not. I explained this in detail above. These policies are simply geared towards avoiding the much-needed liquidation of imbalances. But QE3 is already an indication that patience with the pseudo-recovery among policymakers is running out. QE3 is, more than its predecessors, targeted at ‘lowering unemployment’ or ‘boosting aggregate demand’.
The newspapers are now full of ever more harebrained schemes of how to push more newly printed fiat money down the throat of the economy. Here are some more predictions from me:
Pretty soon, the Fed will stop paying interest on bank reserves. Interest rates will be taken to zero everywhere. We will, at some point, see negative interest rates everywhere. Cash holdings will ultimately get taxed. ‘Hoarders’ of cash will face the death penalty. (As to the last point, I am only half joking.)
I conclude: Still contained inflation readings at present are no reason to relax. It is no surprise that at the current stage of the crisis CPI inflation is not higher. More importantly, there is no reason to assume that present policy is without consequences. Present policy is making it ever more difficult to stop printing fiat money in the future, or to even stop accelerating the creation of fiat money in the future. That is why, if we keep pursuing current policies, we are heading towards paper money collapse. Present inflation readings do not change that.
If you are still wondering when inflation will go up, the answer is: when more people realize where policymakers are taking us.
This will end badly.
This article was previously published at DetlevSchlichter.com.