Having given the historical context, let’s now to put these factors together to examine today’s dynamic. The Fed’s balance sheet in 2007 was in the neighborhood of 800 billion dollars, of which perhaps 500 billion was held in foreign banks, and not contributing to the reserves in America’s banks. That left an effective 300 billion dollars of monetary base available in US banks, against which all leveraged money was created. M1 at that time was in the neighborhood of 1.5 trillion, about 5-fold above the effective monetary base, which is more than one would conclude if just using the figure of 800 billion as the monetary base without correcting for the amount held abroad. When the current deleveraging cycle started, the Fed, not willing to let big financial institutions go bankrupt, bought mortgage securities directly, swapped them for T-bills at face value, and bought new T-bills, engaged in “quantitative easing”, whereby they bought longer-dated Federal debt, all combining to swell the balance sheet to today’s 2.4 trillion. I don’t have access to what component is overseas, but for now will assume it is still about 500 billion. So the effective monetary base has gone from 300 billion to 1.9 trillion, more or less. Yet M1 is stagnant, and even shows occasional signs of shrinkage. This has many stymied, and our friend Ambrose Evans Pritchard again calling for deflation. Do note however, that this time he shows some interest – hence the title “The Death of Paper Money” – in the possibility of hyperinflation, and the article recalls the dynamic at work during Weimar Germany’s episode of hyperinflation. Even the estimable Bill Bonner is now predicting that “The de-leveraging period will be longer and harder than people expect…leading to spells of deflation…”. So how do we explain what is happening?
The first item to explore is the increase in monetary base. It has indeed increased from an effective 300 billion to 1.9 trillion, an increase of 1.6 trillion. But of that 1.6 trillion, about 1.1 trillion has never left the Fed. See this graph from the St. Louis Fed. What it shows is the reserves held by banks that are retained at the Fed, to secure the capital structure of the bank, and never loaned into the economy. The Fed does not own the money, the banks do. They could withdraw it at any time but they have chosen not to. The Fed pays interest on the money, about 0.25%, that it did not historically pay, which is apparently enough incentive to keep the money out of the economy. Also notice that the graph, going back to 1950, was at close to zero for the whole period up until the current financial crisis, when it rocketed over 1.1 trillion. This is so highly unusual that it may be right to read into it. Bernanke’s first responsibility is to keep the big banks solvent, and his second is to keep the depreciation of the dollar slow enough not to cause economic disruptions. He did this in the first instance by swapping the Fed’s T-bills for worthless mortgage securities at face value. He is now in a quandary. He can’t return those mortgage securities, because the banks won’t take them. Even if he could force the issue, that would again undermine the banks’ capital. So the money belongs to the banks, and he can’t get it back. So what is keeping the banks from taking that money and lending it into the economy? We can’t know if he has any other threats up his sleeve, and I’m open to there being something along those lines because of the absolute avoidance of any withdrawals of that money. But for the most part, it is fear that keeps the banks from lending. They fear deflation. They see that M1 is less than the monetary base, a highly-negative money-multiplier. Like Penguins on an ice-floe, nobody wants to be the first to jump off, lest there be a shark waiting.
Of the additional 500 billion in new monetary base (the difference between the 1.1 trillion excess reserves and 1.6 trillion in new monetary base) that does not correspond to excess reserves, about 300 billion was used to buy longer-dated government debt (Quantitative Easing, it was called), putting it in the hands of government to spend directly, and about 200 billion more is not clearly accounted-for. It is fair to assume that the amount of the QE made its way into the economy, but it’s not clear at least to me, about the 200 billion left over. If the pre-crisis effective monetary base was about 300 billion, then it has likely doubled now, but M1 is still flat, and bankers fear deflation. It appears that the goal at the Fed all along was to maintain M1, which they don’t directly control, by making up for the loss of M1 by loan defaults with new money in the monetary base, which they do control. I think they would never let true deflation happen, and I think they are holding back most of the money they have created, in case it is needed. Even the official reports of occasional minor deflation should be taken with a grain of salt, since the measures of inflation have changed radically over the years, effectively understating true inflation numbers. Shadowstats.com carries the numbers measured by previous methodologies, and they constantly show positive inflation in the 5-10% range, something that agrees with everyday people’s experiences. But assets are deflating, and that is what worries banks, for the danger that creditors will default on mortgages en masse. Everything possible will be done by the Fed to prevent this, even if it means taking things too far, and even if it means the real estate market stays highly illiquid because prices are not allowed to equilibrate to where they are affordable.
So will they succeed? The market does not give you what you want, but what you deserve. With Bernanke waffling about all that extra money waiting at the Fed, and the continuing correction in the economy, it is likely that assets will continue to deflate for some time, as Bill Bonner predicts. But the situation is highly unstable: Too much deflation and defaults will pick up, right when commercial real estate is going through a difficult time. The reaction to this could be as simple as discontinuing the paying of interest to banks for their excess reserves, or it could be further quantitative easing. The point is that pressure will mount on the Fed to ramp up their inflating of the monetary base. At some point, they will overcome the reticence of the market, and that is when the money multiplier will turn positive. Pritchard noted that in the Weimar hyperinflation, money printing for the first several years had no effect on prices, since the money sat unused as people were fearful. When it finally hit, the inflation caught them by surprise because it had not come earlier. Likewise today, the justification for further inflation is that “price inflation expectations are low, so it is safe to inflate the money”.
When the first incipient inflation hits, itwill also likely be a surprise to the Fed, who will note that unemployment is too high for inflation to really take hold (ignoring or excusing the lesson of the 1970s). They will not react before events spiral out of control. They will not be able to take away the 1.1 trillion in excess reserves, because they don’t have quality assets to sell in order to repatriate them. They could sell them at a severe loss to limit the damage, but that would require an admission of a terribly embarrassing fact – that they took junk as collateral – and they are unlikely to do this. The Fed is hampered in many other ways, that Alan Greenspan likely foresaw, as outlined in part II. It now holds debt of longer maturity and lower quality, and lacks the credibility that they could effectively and quickly shrink it. The 1.1 trillion in excess reserves will be loaned into the economy, as will all the other money that has sat on the sidelines. It is possible to get to mass inflation with these factors alone. If the US dollar then collapses, it could cause a secondary effect, that of the whole world synchronously dumping all the dollars they have accumulated over 60 years. The world’s accumulation of these dollars blunted the price effects of past inflation, again with the people responsible no doubt assuring themselves that they had “gotten away” with that past inflation. But if it all reversed, it would only add gasoline to the fire of price inflation. If all the current 2.4 trillion in monetary base makes it into the economy at a multiplier of 5, it would balloon M1 to 9-fold greater than it was pre-crisis. Even at much lower rates of money entering the economy, it is easy to see price inflation hitting the neighborhood of 100%. At that point, what happens is a political decision. The time it takes to collect taxes allows the depreciation of the dollars used to pay those taxes, and costs of programs and wars the government chooses to wage will escalate substantially. The deficits in the federal budget would explode to 70-80% of the budget. If the US government decides that its spending is too important to sideline, and borrows the deficits, the Fed would be forced to buy most of the debt, which will lose its natural market in such a crisis. This will be the last tipping point into hyperinflation. But it is avoidable. It would require retrenchment, severe budget cutting, and a deep depression, but the crisis would be over in a matter of 2 years or so, if past history is a guide.
In conclusion, deflation is a myth. It is not upon us, other than the correction of seriously overvalued assets which were not in any case considered inflationary when they were appreciating. Even with assets, the Fed will not let the deflation run its natural course, and will continue to inflate money in order to prevent this. At some point, M1 will turn positive, very likely quickly, and the Fed will be first surprised, then powerless, to stop it. Mass inflation will ensue, which will require a deep depression to correct, though that will be preferable to the alternative.