The Keynesians and Monetarists have
fooled people with a clever sleight of hand. They have convinced
people to look at prices (especially consumer prices) to understand what’s
happening in the monetary system.
Anyone who has ever been at a magic
act performance is familiar with how sleight of hand often works. With
a huge flourish of the cape, often accompanied by a loud sound, the right hand
attracts all eyes in the audience. The left hand of the illusionist
then quickly and subtly takes a rabbit out of a hat, or a dove out of someone’s
pocket.
Watching a performer is just harmless
entertainment, and everyone knows that it’s just a series of clever tricks. In
contrast, the monetary illusions created by central banks, and the evil acts
they conceal, can cause serious pain and suffering. This is a topic
that needs more exposure.
The commonly accepted definition of inflation is “an increase in consumer prices”, and deflation is “a decrease in consumer prices.” A corollary is a myth that stubbornly persists: “today, a fine suit costs the same in gold terms as it did in 1911, about one ounce.” Why should that be? Surely it takes less land today to raise enough sheep to produce the wool for a suit, due to improvements in agricultural efficiency. I assume that sheep farmers have been breeding sheep to maximize wool production too. And doesn’t it take less labor to shear a sheep, not to mention card the wool, clean it, bleach it, spin it into yarn, weave the yarn into fabric, and cut and stitch the fabric into a suit?
Consumer prices are affected by a
myriad of factors. Increasing efficiency in production is a force
for lower prices. Changing consumer demand is another force. In
1911, any man who had any money wore a suit. Today, fewer and fewer
professions require one to be dressed in a suit, and so the suit has transitioned
from being a mainstream product to more of a specialty market. This
would tend to be a force for higher prices.
I don’t know if a decent suit cost $20
(i.e. one ounce of gold) in 1911. Today, one can certainly get a
decent suit for far less than $1600 (i.e. one ounce), and one could pay 3 or 4
ounces too for a high-end suit.
My point is that consumer prices are a
red herring. Increased production efficiency tends to push prices
down, and monetary debasement tends to push prices up. If those
forces balance in any given year, the monetary authorities claim that there is
no inflation.
This is a lie.
Inflation is not rising consumer
prices. One can’t understand much about the monetary system from
inside this box. I offer a different definition.
Inflation is an expansion of
counterfeit credit.
Most Austrian School economists
realize that inflation is a monetary phenomenon. But simply plotting
the money supply is not sufficient. In a gold standard, does gold
mining create inflation? How about private lending? Bank
lending? What about Real Bills of Exchange
As I will show, these processes do not
create inflation under a gold standard. Thus I contend the focus should be on
counterfeit credit. By definition and by nature, gold production is
never counterfeit. Gold is gold, it is divisible and every piece is
equivalent to any other piece of the same weight.
Gold mining is arbitrage: when the
cost of mining an ounce of gold is less than one ounce of gold, miners will act
to profit from this opportunity. This is how the market signals that
it needs more money. Gold, of course, has non-declining marginal
utility, which is what makes it money in the first place, so incremental
changes in its supply cause no harm to anyone.
Similarly, if Joe works hard, saves
his money, and gives a loan of 100 ounces to John, this is an expansion of
credit. But it is not counterfeit or illegitimate or inflation by
any useable definition of the term.
By extension, it does not matter whether there are market makers or
other intermediaries in between the saver and the borrower. This is
because such middlemen have no power to expand credit beyond what the
source—the saver—willingly provides. And thus bank lending is not
inflation.
Below, I will discuss various kinds of
credit in light of my definition of inflation.
In all legitimate credit, at least two
factors distinguish it from counterfeit credit. First, someone has
produced more than he has consumed. Second, this producer knowingly
and willingly extends credit. He understands exactly when, and on
what terms, with what risks he will be paid in full. He realizes
that in the meantime he does not have the use of his money.
Let’s look at the case of fractional
reserve banking. I have written on this topic before (Fractional Reserve Banking). To
summarize: if a bank takes in a deposit and lends for a longer duration than
the deposit, that is duration mismatch. This is fraud and the source
of banking system instability and crashes. If a bank lends deposits
only for the same or shorter duration, then the bank is perfectly stable and
perfectly honest with its depositors. Such banks can expand credit
by lending, (though they cannot expand money, i.e. gold), but it is real
credit. It is not counterfeit.
Legitimate lending begins with someone
who has worked to save money. That person goes to a bank, and based
on the bank’s offer of different interest rates for different durations,
chooses how long he is willing to lock up his money. He lends to the
bank under a contract of that duration. The bank then lends it out
for that same duration (or less).
The saver knows he must do without his
money for the duration. And the borrower has the use of the money. The
borrower typically spends it on a capital purchase of some sort. The
seller of that good receives the money free and clear. The seller is
not aware of, nor concerned with, the duration of the original saver’s deposit. He
may deposit the money on demand, or on a time deposit of whatever duration.
There is no counterfeiting here; this
process is perfectly honest and fair to all parties. This is not
inflation!
Now let’s look at Real Bills of
Exchange, a controversial topic among members of the Austrian School. In
brief, here is how Real Bills worked under the gold standard of the 19th century. A
business buys merchandise from its supplier and agrees to pay on Net 90 terms. If
this merchandise is in urgent consumer demand, then the signed invoice, or Bill
of Exchange, can circulate as a kind of money. It is accepted by
most people, at a discount from the face value based on the time to maturity
and the prevailing discount rate.
This is a kind of credit that is not
debt. The Real Bill and its market act as a clearing mechanism. The
end consumer will buy the final goods with his gold coin. In the
meantime, every business in the entire supply chain does not necessarily have
the cash gold to pay at time of delivery.
This problem of having gold to pay at
time of delivery would become worse as business and technology improved to
allow additional specialization and thus extend the supply chain with
additional value-added businesses. And it would become worse as
certain goods went into high demand seasonally (e.g. at Christmas).
The Real Bill does not come about via
saving and lending. It is commercial credit that is extended based
on expectations of the consumer’s purchases. It is credit that
arises from consumption, and it is self-liquidating. It is another
kind of legitimate credit.
For more discussion of Real Bills, see
the series of pieces by Professor Antal Fekete (seehttp://www.silverbearcafe.com/private/fekete.html,
starting with Lecture 4).
Now let’s look at counterfeit credit. By
the criteria I offered above, it is counterfeit because there is no one who has
produced more than he has consumed, or he does not knowingly or willing forego
the use of his savings to extend credit.
First, is the example where no one has
produced a surplus. A good example of this is when the Federal
Reserve creates currency to buy a Treasury bond. On their books,
they create a liability for the currency issued and an asset for the
corresponding bond purchase. Fed monetization of bonds is
counterfeit credit, by its very nature. Every time the Fed expands
its balance sheet, it is inflation.
It is no exaggeration to say that the
very purpose of the Fed is to create inflation. When real capital
becomes more scarce, and thus its owners become more reluctant to lend it
(especially at low interest rates), the Fed’s official role is to be the
“lender of last resort”. Their goal is to continue to expand credit
against the ever-increasing market forces that demand credit contraction.
And of course, all counterfeit credit
would go to default, unless the creditor has strong collateral or another lever
to force the debtor to repay. Thus the Fed must act to continue to
extend and pretend. Counterfeit credit must never end up where it’s
“pay or else”. It must be “rolled”. Debtors must be able
to borrow anew to repay the old debts—forever. The job of the Fed is
to make this possible (for as long as possible).
Next, let’s look at duration mismatch
in the financial system. It begins in the same way as the previous
example of non-counterfeit credit—with a saver who has produced more than he
has consumed. So far, so good. He deposits money in a
bank, and this is where the counterfeiting occurs. Perhaps he
deposits money on demand and the bank lends it out. Or perhaps he
deposits money in a 1-year time account and the bank lends it for 5 years. Both
cases are the same. The saver is not knowingly foregoing the use of
his money, nor lending it out on such terms and length.
This, in a nutshell, is the common
complaint that is erroneously levied against all fractionally reserved banks. The
saver thinks he has his money, but yet there is another party who actually has
it. The saver holds a paper credit instrument, which is redeemable
on demand. The bank relies on the fact that on most days, they will
not face too many withdrawal demands. However, it is a mathematical
certainty that eventually the bank will default in the face a large crowd all
trying to withdraw their money at once. And other banks will be in a
similar position. And the collapsing banking system causes a plunge
into a depression.
There are also instances where the
saver is not willingly extending credit. The worker who foregoes 16%
of his wage to Social Security definitely knows that he is not getting the use
of his money. He is extending credit, by force—i.e. unwillingly. The
government promises him that in exchange, they will pay him a monthly stipend
after he reaches the age of retirement, plus most of his medical expenses. Anyone
who does the math will see that this is a bad deal. The amount the
government promises to pay is less than one would expect for lending money for
so long, especially considering that the money is forfeit when you die.
But it’s worse than it first seems,
because the amount of the monthly stipend, the age of retirement, and the
amount they pay towards medical expenses are unknown and unknowable in advance,
when the person is working. They are subject to a political process. Politics
can shift suddenly with each new election.
Social Security is counterfeit credit.
With legitimate credit, there is a
risk of not being repaid. However, one has a rational expectation of
being repaid, and typically one is repaid. On the contrary, counterfeit
credit is mathematically certain not to be repaid in the ordinary course. This
is because the borrower is without the intent or means of ever repaying the
loan. Then it is a matter of time before it defaults, or in some
circumstances forces the borrower to repay under duress.
Above, I offered two factors
distinguishing legitimate credit:
The creditor has produced more than he has consumed
He knowingly and willingly extends credit
Now, let’s complete this definition
with the third factor:
3. The
borrower has the means and the intent to repay
Every instance of counterfeit credit
also fails on the third factor. If the borrower had both the means
and the intent to repay, he could obtain legitimate credit in the market.
A corollary to this is that the
dealers in counterfeit credit, by nature and design, must work constantly to
extend it, postpone it, “roll” it, and generally maintain the confidence game. Counterfeit
credit cannot be liquidated the way legitimate credit can be: by paying it back
normally. Sooner, or later, it inevitably becomes a crisis that
either hurts the creditor by default or the debtor by threatening or seizing
his collateral.
I repeat my definition of inflation
and add my definition of deflation:
Inflation is an expansion of counterfeit credit.
Deflation is a forcible contraction of counterfeit credit.
Inflation is only possible by the
initiation of the use of physical force or fraud by the government, the central
bank, and the privileged banks they enfranchise. Deflation is only
possible from, and is indeed the inevitable outcome of, inflation. Whenever
credit is extended with no means or ability to repay, that credit is certain to
eventually become a crisis that threatens to harm the creditor. That
the creditor may have collateral or other means to force the debtor to take the
pain and hold the creditor harmless does not change the nature of deflation.
Here’s to hoping that in 2012, the
discussion of a more sound monetary and banking system begins in earnest.
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