Does the Fed really want banks to lend?

With the Fed yet to announce a new round of quantitative easing, some economists are starting to offer their own opinion about what else the central bank can do to introduce more money into the American economy and spur growth. One of the proposals I have heard is for the Fed to eliminate its policy, instituted in October of 2008, of paying interest on reserves and excess reserves kept by banks at the Fed.

I believe that anyone advocating for this proposal either does not understand why the Fed is paying interest on reserves to begin with, or believes that there is somehow enough loan demand for profitable investments that the enormous mountain of reserves now sitting with the Fed won’t result in hyperinflation if it were actually drawn down.

Let’s start first with the reason why the Fed is paying interest on reserves, because this is something entirely new and was only instituted in 2008 as a result of the crisis in the credit markets. You will recall at the time that interbank lending had frozen up, as banks were afraid that they may not have enough cash on hand to meet their short-term obligations. There was not only uncertainty about the health of a given bank’s own balance sheet (the value of its own assets and quality of its own loans), but there was also massive uncertainty about the health of other banks’ balance sheets, which is why we heard so much at the time about “counterparty risk.” The demand for money was high relative to the supply (drop in bank lending = drop in supply of money and credit), and so interest rates began to spike, as was seen most prominently in the interbank lending market (the interest rate set by this market is known as LIBOR). This is the core component of what we think of as the money markets, and it was freezing up. A freeze in money markets means that everyone from Fortune 500 companies to small businesses can’t get the money they need to meet their short-term obligations, since so much of today’s business is conducted on credit. And since a failure to meet one’s financial obligations is the definition of insolvency, the chain of events taking place at the time would have resulted in the bankruptcy of an untold number of banks, corporations, and small businesses, and could very well have collapsed the American economy into a state far worse than what we saw after 1929.

So, in response to this freeze in credit markets, central banks around the world (the Federal Reserve playing leader of the pack) needed to find a way to prevent, first and foremost, a collapse of the banking system. During the great depression, approximately 1/3 of all banks went belly-up, and many economists, Ben Bernanke included, contributed this collapse of the banking sector as the prime cause of the depression. It was his intention, therefore, to make sure that the financial system would be propped up at all costs, even if it meant risking hyperinflation at some unforeseen date in the future. I say hyperinflation, because the only way for the Fed to keep the banking system from failing as a result of all the bad loans and onerous debt that it had created over the years was to expand the money supply. It did this using all those “loan-facilities” we have heard so much about, and which were exposed by the most recent Fed audit by the GAO. Since banks would not lend to each other, the Fed decided that it had to pick up the slack, and it did just that, pumping in trillions and trillions of dollars worth of credit into the financial markets in order to keep the system from falling apart.

Most of this money came in the form of loans meant to meet short-term liabilities, but clearly a great deal of the money the Fed has created has simply been used to monetize outstanding debt (Treasuries, GSE paper and certain financial derivatives like the credit default swaps issued by AIG). The monetization is evidenced by the extraordinary rise in the adjusted monetary base since 2008, which is widely regarded as “money.” (in a fiat money world, money is not easily definable, so there are various definitions for money including the widely cited M1). In turn, because banks were afraid to lend money out during the crisis, and because the Federal Reserve incentivized banks to keep an excess amount of money on reserve by paying interest on overnight balances at the Fed, much of this newly created money began to accumulate as excess reserves on the balance sheets of the nation’s largest banks as can be seen here. And of course, with interest from the Fed being the equivalent of risk-free money, excess reserves held at the Fed can only grow the money supply over time, creating inflationary pressures that will eventually have to be released (the mechanism by which such a release could theoretically occur is something that we can speak about another time, but I have my doubts about how effective it will be).

[*Note: I find it interesting and noteworthy that, for the first time to my knowledge at least, the nominal supply of base money in the economy is greater than M1, which actually includes demand deposits. This may very well be the result of the perverse incentives now operating in the marketplace that reward banks for not lending money out, thus preventing base money from turning, through the multiplier effect of fractional reserve lending, into demand deposits. Hence the term "Zombie Banks"]

So, taking into account the fact that we may be headed back into recession (by official standards at least), banks may still be unwilling to lend out the reserves they have on hand, and the Fed unwilling to promote such action, for fear that further write downs on overvalued assets and non-performing loans will force banks to draw down their reserves anyway. The larger-than-required reserves being held by the banking system, therefore, may be all too justified given the continued uncertainty about the health of global balance sheets. However, even if banks were willing to lend the money out, there is good reason that the Fed should be extremely skeptical about allowing for such a prospect, and the reason why is because it could cause run-away inflation or even hyperinflation.

I have talked before, both on this blog, as well as in interviews, about how the money multiplier is broken in the banking system. The money multiplier is just another name for the fractional reverse lending process by which base money is converted into demand deposits. It is the process by which a bank takes X amount of money, and pyramids on top of it fresh loans that show up as deposits in other banks within the system. Here, the bank is functioning with the expectation that, at no given moment in time will the demand for bank capital (basically, depositors withdrawing their money from the bank) outstrip the amount of money that the bank has on reserve. In this sense, any bank engaged in fractional reserve banking is inherently and theoretically bankrupt, but in practice it usually does not have to acknowledge this fact since the amount of money it keeps on reserve is enough to cover its expected short-term obligations. In the even that depositors’ demand for their money exceeds the amount of capital that a bank has on hand, the bank goes from being theoretically bankrupt, to functionally bankrupt. When this occurs, it is usually referred to as a “run on the bank,” but unlike banks in the 1930′s which instructed tellers to slowly count the cash leaving depositors hands from the front as money was being rushed in through the back, today’s banks have been able to rely on a much more powerful, and institutionally rested Federal Reserve System to keep them from sinking into the bankruptcy abyss.

Once you understand how money is pyramided in a fractional reserve system, then you can understand how even a modest increase in base money (or actual money lets say) can quickly expand by at least 10 times that amount through the multiplier effect. Therefore, not only would Bernanke and the Fed have to worry about the inflationary effects of adding an extra 2 trillion or so dollars into circulation by emptying out excess bank reserves (prior to the onset of the financial crisis, excess reserves were roughly $1.5 billion, whereas now they are right around $1.7 trillion!) they would also need to be concerned about the multiplier effect that this money would have on demand deposits in the economy. In essence, the alarming amount of money now sitting in reserve at the nation’s largest banks has the potential, if lent out, to create runaway or hyperinflation. If this were to occur, arresting the process would prove extraordinarily difficult for the Fed, as it would have to raise interest rates dramatically by selling assets from its portfolio in exchange for trillions of dollars in federal reserve notes that it created in the past 3 years. Such an action would collapse the US economy, and this is why I said earlier that I do not believe the Fed will be able to stop inflation if it gets started this time around in the way that the Volker Fed did during the 1980′s. In any case, the rate of interest on deposits would have to go much higher than the 20% reached by Paul Volcker during his inflation fighting, because the potential for the problem today is much greater, so it’s really a practical impossibility. Let’s not even pretend like the Fed could stop the inflation, because it can’t. Sorry.

So, if the Fed can’t afford to allow banks to lend the money that they have accumulated on reserve, then how exactly is “credit supposed to start flowing again?” It isn’t, and that’s the point. The banks, having recklessly inflated the largest credit bubble in history, have now decided that the option that best benefits them is to allow the economy to slowly roast under decades of zero or negative growth as the economy dips in and out of recession and deflation as far as the eye can see. As long as the banks can remain afloat, they will continue to generate risk-free revenue through Fed subsidies of various sorts (the interest paid on reserves is just one form that these subsidies take) as the economy is allowed to collapse all around them. So long as social unrest does not become unmanageable, the cumulative effect of such a policy over time is to grossly accumulate a disproportionate amount of the world’s wealth on the balance sheet of financial institutions with a lifeline to the central banks. Bank executives become the new global landlords, and we rapidly move from what was once a relatively free-market capitalist economy into a neofeudal state where banks and multi-national corporations own the bulk of the world’s assets and charge onerous rents, payment for which is made by issuance of more loans by the largest banks, for the most basic type of accommodations. It will be subsistence farming on a global, technocratic scale, and this is again, why you hear me say that I will alway choose a system reset over what we have today, because the only thing that the current system is leading us towards is global serfdom.

Italian Town Mints its Own Money in Order to Fight Austerity

The small town of Filettino, has decided that, instead of merging its small town government with other equally small towns in the area in order to comply with recent austerity measures, it will simply start to mint its own money.

Filettino, which is located around 100km (65 miles) east of Rome and has around 550 inhabitants, has decided that instead of merging its government with that of neighboring Trevi, it will set up a “principality” along the lines of the famous republic of San Marino (perhaps the smallest, independent city state in the world) located to the north.

The mayor of the town, Luca Sellari, has started minting the towns own currency, called the “Fiorito,” with a picture of himself on the back that is already being used by the townsfolk.

This is “the first real example of municipal federalism,” said Sellari, in a recent interview with the wire service Ansa. “At a time in which, in Italy, there is much talk of federal reform, we are looking to take concrete steps with an innovative project that, for this very reason, is gaining acclaim and success. Our goal is really to gain true autonomy of management and we have the financial resources to do it.”

Across Italy, small-town mayors are up in arms about over the national government’s decision to cut money for their relatively small public expenditures rather than deal with what are seen as much thornier political issues, like raising the country’s retirement age. The current measures to merge small towns and cut budgets are part of the 45.5 billion euro ($65.3 billion) austerity package passed on August 12th, which is meant to help balance Italy’s national budget by the year 2013.


Can the Federal Reserve and Global Central Banks Save the World?

It’s never possible to draw a line and say “this is when it all started,” but one can certainly look at the 1960′s in America – the guns and butter deficits that ultimately ended in the breakdown of gold convertibility in 1971 – as a point of departure for sound money and healthy economic growth for the global economy.

Since 1971, the US – the engine of growth for global exports – began running chronically sickening current account deficits. In other words, it began consuming more than it could produce. However, with the aid of the Federal Reserve and other central banks around the world, this alarming imbalance was able to remain in place for what is running now on 40 years.

The current fiat monetary system is designed to self-destruct. It is architected in such a way so as the only outcome is unmitigated disaster caused by disoriented capital flows responding to false market signals. This is why, since going off of the last iteration of the gold standard in 1971, we have had stagflation followed by one debt crisis after another. We had the Latin American debt crisis, the savings and loan, the 1987 stock market crash, the Mexican debacle, the Asian Financial crisis, LTCM, the NASDAQ, the housing refinancing credit bubble, and now, the bubble in sovereign debt, as nations around the world have stepped in for what should hopefully be the last bailout that this system is ever meant to carry out.

And throughout all this time, we were told that we were actually living through “The Great Moderation,” where central banks around the world had come fully in control of the business cycle, smoothing out recessions and making the boom all the more powerful. We had put the fate of humanity in the hands of technocrats, statisticians, economists, policymakers and politicians. Homage was paid to the market but the banking oligopoly called the shots. Now we have finally arrived at a point where, after years of “save me” cries being lobbied out to politicians and central bankers, our patrons have run out of bullets. The credit mechanism is irreparably broken.

Just as QE2 proved less effective than QE1 in papering over the crisis that broke last in 2008, I expect the next round of easing to be even less effective. More importantly, I expect its announcement – whether that announcement is tomorrow, next week, next month or next year – to result in markets actually tanking. Why? Because at this point, any reminder of quantitative easing is bound to recall images of impotence, helplessness and confusion. Markets know that all this money printing has done is add further smoke to a battlefield already littered with mines. Investors have no idea where to put their money anymore, because prices have been so grossly manipulated. This is why gold has broken out above 1,750 an ounce (despite my deepest hopes that we would have seen a buying opportunity correction at 1,300) and this is why any further plans at monetary easing and money printing by the Fed will result in nothing but despair.

In Europe, the situation is a bit different. The Eurozone debt crisis is such that markets could actually rally if leaders there announced some “Grand Bargain” that involved the issuance of a new Eurobond, a European Treasury and a “Marshal Plan” for Europe. That’s not going to happen for political reasons – at least not at the present moment – but its something that could actually instill confidence in the European economy, which still has plenty of industry and productive capacity. This is not to say that I agree with such a solution, because I don’t, but I think that it is novel enough that it could keep things together on the continent for a while longer.

So, given my opinion that any new round of easing by the Fed will be useless, and given my view that the Eurozone debt crisis will have to get much worse before the political will emerges for a “Grand Bargain” (that is still destined to fail, in the end, because it doesn’t address the underlying, structural imbalances of the global economy), my answer to the question posed in the title of this post should be already obviously. Central banks have fire their last bullets at this latest credit bubble collapse, and in my view, no longer have control over the real deflation overtaking the globe.

As Ludwig von Mises has so famously said, and as I have so often been quoting him as saying: “There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.”

We are headed towards the later.

Has a Bank Run Started in Greece? Maybe, but the ECB is unlikely to let them fail.

Depositors lining up at a bank in Greece to withdraw their Money

When I started this blog along with my radio show, my intention was to focus on issues of finance and economics. Political issues would be broached from time to time, but mainly in response to the need for providing further context for our financial debates.

Well, I have been consumed the past few days by the events in Greece, and thus seem to have completely abandoned coverage of other themes, news and current events. For those of you who would prefer that I focus more on the type of news and events that I have covered in the past, I would like to apologize in advance. I simply cannot avoid speaking out against the injustices being perpetrated against my home country (I have both American, as well as Greek citizenship). I love both of these two countries, and the problems they face have more in common than people may realize. Also, I feel that things in Greece are coming to a head, and therefore, I think that our audience would be well served by such coverage now that things have not yet completely exploded into full-blown revolution.

Ok, mia culpa’s aside, I would like to point to an increasingly concerning development that is evolving in Greece. No, I am not talking about the recent allegations against George Papandreou that I addressed in a previous post, but rather the mounting margin pressure being put on domestic banks as depositors are demanding withdrawal of their funds ahead of what they fear is an “Argentine-style” bank-run and subsequent account freeze by the government.

I wrote about what a scenario like this would look like only a week ago. There is certainly a risk that a default could lead the ECB to pull its lifeline from the domestic banking system, and that would mark the end for the “solvency” of Greek banks (they are already insolvent, which is why I used quotes, but a pullout of the backstop by the ECB would expose this to the world quite dramatically). However, I do not feel that this will occur any time soon. I think, instead, that the ECB will continue to prop up accounts in Greece, regardless of what happens with defaults, because I don’t believe that they want to risk starting a panic in Ireland and Portugal.

Besides the billions and billions of dollars that were removed from Greece in the early stages of the Crisis last year, recent numbers from “Proto Thema,” suggest that, between thursday and friday of last week, roughly 1.5bn euros was pulled out of deposit accounts. The banks ran out of larger denomination bills, as senior citizens and other vulnerable Greeks were trying to takeout as much cash as possible to store with them at home and in other places.

The precarious situation with the nation’s banks has created further pressure on the government to seek more bailout money, and the vulnerability of the nation to outside speculative attacks and capital flight makes negotiations on the terms of such funding even more vicious and predatory.

Greeks need to think hard about what is best for themselves without losing sight of what is right for the nation. We cannot allow ourselves to be bullied or manipulated into a model of neo-feudalism just because our bank accounts, pensions and imports are being held hostage by a bunch of financial terrorists, globalist sycophants, and treasonous serpents. If you are concerned about your savings, I have always said that a safe play would be to take whatever savings you have and convert them to precious metals, storing them in a safety deposit box or in some other safe location. Inevitably, you will need to have a certain amount of cash at the bank, and this cash is more than likely to be lost at some point in the future through either a devaluation or complete bank bankruptcy.

IMF now on board with Capital Controls

The IMF released a statement today, adjusting its position on capital controls by proposing a framework, under which capital inflows could be managed.

I have been saying for years that capital controls will become more and more common, not just in countries like Brazil and emerging Asia, but in the United States as well. The most obvious concern has been for emerging markets. All the money printing and credit expansion in the west has lead a lot of speculative capital to wreak havoc on capital markets in these emerging economies, as was seen most obviously in the 1997 Asian financial crisis.

However, not much is said about the increased difficulty that Americans face in moving capital abroad. The United States, under the guise of fighting terrorism, has made it harder for its own citizens to keep their money out of reach of their own government. Laws to this effect are often hidden in larger, unrelated pieces of legislation, like the healthcare bill or the HIRE act.

And the US government has good reason to worry about a flight of capital. The precarious position of the dollar and the increasing disrespect for individual liberties and the rule of law have made many citizens increasingly wary of their government. The price of gold is a reflection of this, as it can still be easily moved without a risk of seizure, but don’t expect this to last forever.

Inflation or Deflation?

Those of you who listened to last tuesday’s live broadcast of Covering the Spread, or for those who heard the Sound Money podcast online, you will know that one of our guests was the always informative and highly thoughtful Mike “Mish” Shedlock.

Originally, I only wanted to have one interview for the show and spend the rest of the time covering important news and headlines. However, after finishing a taped segment with Gerald Celente earlier in the week, it dawned on me that almost everyone in the media, the blogosphere and within “intellectual circles” were either exclusively on the inflation bandwagon, or otherwise, saw stable prices and positive economic growth going forward.

The inflationist alarm bells that rang so violently in the months following the Fed’s unprecedented intervention into the markets were quickly silenced once it became clear that, despite an astronomical increase in base money supply, an all-out collapse in prices could not be avoided. Commodities and equities crashed and the economy fell off a cliff, contracting almost 12% (GDP) in the span of just 6 months. The dollar strengthened, the Dow dropped a further 40% (and was chopped in half if measured from its 2007 high), and precious metals were liquidated as investors scrambled to meet margin requirements. All this despite a historically unprecidented increase in the adjusted monetary base.

I should mention here that I too believed, wrongly, that the Fed’s intervention into the economy was going to crash the dollar and send us into a hyper-inflationary tailspin. Granted, I did not expect this change to happen right away, but certainly before the end of 2013. In fact, I believed that a forced devaluation of the dollar was going to occur at some point over the next 5 years, and that a new global currency, either the SDR or a carbon credit unit issued by some bank in Copenhagen, was going to be floated as a replacement (I still believe that a global currency will be attempted, but am less confident that efforts to implement it will succeed).

Fortunately, my economic outlook did not impair my investment decisions since, my single biggest hedge against the debasement of the currency and my hyper-bearish outlook for the credit system and property rights made me a big buyer of gold between the months of October and December of 2008 (see my Dec 2008 article on the future of gold). The rush for liquidity eventually led investors to dump anything and everything they could in order to raise the money they needed in order to stay afloat and meet their margin and capital requirements, making plenty of gold and silver readily available to investors willing to buy and hold at these very low prices.

Not long before we reached the stock market bottom of March 2009 however, my views on the effectiveness of monetary policy as a tool for preventing liquidations, crashes and market declines began to change. I saw that, despite the massive money printing and government bailouts, the potential losses that banks could suffer far outweighed anything the Fed had provided through its open-market and discount operations (TARP included). It was also clear to me that banks had no intention of lending all the free money provided to them by the Fed that was showing up as excess reserves. Instead, this money was going to pay for record bonuses and into proprietary trading operations. Very little, in other words, was being redistributed into the larger economy where it could cause real price inflation, and for good reason: the banks were not being honest about the just how impaired their balance sheets were. They needed this extra money to safeguard against more loan defaults.

Still, after bottoming out in March 2009, equity and commodity stocks have sharply risen in value, and in the past year or so we have also seen an undeniable rise in the price of consumer items. Anyone who goes grocery shopping, fills his/her gas tank or pays to take the train to work can attest to this. In fact, this dramatic increase in the price of assets and consumer prices, coupled with the massive ongoing debt monetization by the Federal Reserve, has slowly weeded out many of the prior deflationists from the mainstream debate, bringing inflationist mantra back to the forefront.

Now, with the end of QE2 and the prospects for even more stimulus, the “inflation vs. deflation” debate has taken on an even greater imperative. Is someone like Marc Faber, correct when he says that any deflationary market event will be met with even more money printing that will lead to hyperinflation? Or, are people like Mish, Stoneleigh and Robert Prechter correct in pointing to the massive amounts of outstanding debt in the global financial system, and the potential for further credit contractions that will, once again, overwhelm any efforts by the Fed to monetize the defaulting loans and thus buffer bank deposits in time to prevent a new round of insolvencies? After all, 2008 proved just how impotent the Federal Reserve is when trying to influence credit contraction across the broader economy, and even hyperinflationist John Williams of Shadow Government Statistics points out that M3 (the broader measure of the money supply that the Federal Reserve no longer reports) has continued to contract year-over-year.

Although I agree, in part, with people like John Williams and Peter Schiff, that the dollar will eventually become worthless, I do not believe that this will happen as soon as these gentlemen expect. As impaired as the dollar is, there is no global currency alternative that businesses around the world feel confident holding instead. The Japanese yen has a plethora of problems, and the very viability of the Euro is now in doubt. The swiss frank has historically been a safe place to hide, but not a place to conduct daily business. In other words, although investors may be willing to diversify their dollar holdings further, dumping the dollar would require that they “dump it for something,” and that something does not exist. Would you feel safer holding Japanese yen or euros in place of your dollars?

The only way that I can see a currency crisis developing in the dollar at this point is if investors and businesses begin to convert a larger share of their dollar holdings into multiple currencies. This would require a real breakdown in global trade and US hegemony. If there were less of a need for a global reserve currency, then certainly the artificial edifice upon which the dollar is supported, would collapse. In such a scenario, we could indeed see a dollar crisis. Imports would collapse and prices would soar for anything not produced within the United States. Again however, this is a scenario that I would expect to see after renewed deflation and further loan and asset liquidation.

What is more likely, in my view, is that some unforeseen deflationary event will spook markets, precipitating a renewed rush for liquidity and a freezing of global credit. Such an event can manifest itself in many forms, but because of the fragility of the banking system, the result will almost certainly be further liquidations and a crash in prices. I simply cannot see the inflation of the past year continuing for much longer without sparking a crisis. How much more stagflation can people take? This is not the 1970s; Americans do not have savings to tap into. As home prices and wages continue to either stagnate or decline, the rise in consumer prices will generate unbearable pressure on American households at a time when their finances have never been in worse shape. Such conditions are deflationary, not inflationary, and no matter how much the Fed prints, it will not be able to resurrect the real economy, which will eventually drag the financial markets down with it.

Libyan Rebels Create a New Central Bank

The current Libyan Central Bank located in Tripoli


Many of us may remember the romantic images of Fidel Castro and Che Guevara riding into Havana during the new year of 1959 on that American-made Sherman tank. What less people know is that Che, was soon appointed by Fidel, as head of the nation’s newly created central bank.

It shouldn’t surprise anyone that one of the first things any provisional government will do is set up a central bank and start issuing fiat currency. Don’t get me wrong, I’m not bashing the Cuban revolution; I’m actually a big fan of the ideals professed by those young revolutionaries, and I have the utmost respect for their passion, leadership and mythical courage. Instead, I’m just pointing out how important a central bank is to any aspiring power structure. It is more important than even a standing army. You can fight an insurgency and win if you have a functioning currency with which to fund your campaigns. You cannot win a war, even with the most powerful army, if you are broke (I accept the irony of this statement since the US is broke but it’s able to print and borrow, which is essentially what the Libyan rebels are doing).

In the press statement released by the new Transitional National Council, the decision was made at a March 19th meeting to establish the “Libyan Oil Company as a supervisory authority on oil production and policies in the country, based temporarily in Benghazi,” and to designate “the Central Bank of Benghazi as a monetary authority competent in monetary policies in Libya and the appointment of a governor to the Central Bank of Libya, with a temporary headquarters in Benghazi.”

Does anyone really think that the only help these ragtag rebels are getting from the US and Europe is the assurance of a “no-fly” zone? I am willing to bet the house that, as we speak, there are american “advisors” on the ground in Benghazi managing this entire affair.

More Nonsense from FT contributor Francis Bator

Anytime someone cites Paul Krugman in support of his thesis, I find myself scrambling for an aspirin. Please note the following excerpt from an article posted to the FT by Francis Bator, a former deputy national security advisor to LBJ and special consultant to the US Treasury:

If anyone tells you that cutbacks in this year’s and next year’s federal spending will encourage enough additional private spending to make up the difference — never mind narrow the inherited trillion dollar output and jobs gap — look him hard in the eye and ask him if he’d really bet his children’s tuition money on that proposition. It’s nonsense. Reduced sales to government and lower transfer payments from government, therefore less spendable private income, and more jobless workers and idle factories, will be more likely to cause both households and businesses to reduce their spending.

Granted, explosive growth in federal debt relative to gross domestic product can’t go on indefinitely. But Herbert Stein’s “so it will stop” does not tell you when and how fast it’s sensible to stop it. It depends on what you owe, to whom you owe it, and how rich you are. Except in extremis, it also depends on the state of the economy. Assuming responsible Republican leaders put a stop to Russian roulette lunacy over the debt limit, the US is light-years from extremis. Unlike say Greece, we can “print” what we owe, and owe almost half of it to each other. (“Printing” money is not tantamount to inflation. Whether it will cause price and wage inflation depends on the macroeconomic situation.)

As to the Chinese, frightened by what rapid yuan appreciation would do to their export-addicted economy, they have been, as Paul Krugman put it, pumping out yuan, buying up dollars. How likely is it that they’ll risk harming their own economy by reversing course abruptly? A gradual reversal calibrated to facilitate an orderly, collaboratively managed dollar depreciation is of course precisely what’s needed.

I want to start out by noting that, before 2007, when our inflation exporting economy began to experience the hiccups, there were actually “respected” economists out there saying that, theoretically, the debt could rise forever. In fact, I had gotten into a friendly argument with a well-known keynesian NYU economics professor of mine (not Nouriel Roubini), about just this issue. In the end, all he could do was quote the very same Herbert Stein Law repeated by Mr. Bator: “If something cannot go on forever, it will stop.” Is this a common talking point amongst deficit doves?

Furthermore, Mr. Bator continues to repeat inflationist mantra, by saying that we can print what we owe, unlike countries trapped in the European monetary straight jacket, and that printing money is not tantamount to inflation. Well, Mr. Bator is correct, but his statement is deceptive to say the least. Issuing bills of credit, which is what federal reserve notes are, is not tantamount to inflation, nor does it necessarily mean that the broader money supply will expand as a result. If credit in the broader economy is contracting faster than new loans can be generated, then money printing by the fed can still co-exist alongside deflation. Still, the action of printing money is by definition inflationary. If I am blowing into an air mattress, trying to inflate it, just because there may be a hole on the other side emitting an amount of air equivalent to what I am expending does not make my actions less inflationary. If I were not blowing into the mattress, and the hole were still there, net-net there would be less air in that mattress.

Maybe I am missing something, but does Francis think that the Chinese would be printing all this extra money to buy dollars if we weren’t driving down the exchange rate by printing more dollars of our own? What we are seeing develop between the Bank of China and the Fed is a currency war. Mr. Bantor should know from his days in the LBJ white house. Did the US and the USSR really need thousands of nuclear missiles, each one thousands of times more powerful than the A-bombs dropped on Japan during WWII in order to achieve their objectives? No, but this is what happens when you get into an arms race: every increase by one side is met with a subsequent increase by the other. The same is true in currency wars, only in this case the production costs are zero and the risks are far more difficult to calculate.

Even if printing more money could lead to this utopian ideal of gradual and orderly devaluation from which industrially competitive exchange rates could be achieved, as Mr. Bator is suggesting, the result would hardly be a boom in exports. Devaluing one’s currency as a means of expanding the production of exports suggests that one has an industry from which to produce cheap goods in the first place. Last time I checked, America gutted most of this infrastructure over the past 20 years, so a currency devaluation isn’t going to solve our problems in the short or medium run. In fact, a cheaper currency alone is not enough, even in the long-run. There are a plethora of factors that go into a corporation’s decision to set-up shop in any given country. Take a look at Germany. They have been using one of the strongest currencies in the world and their export market is one of the strongest on earth. If currency devaluation were the key to prosperity then everyone in Munich should be driving a Buick.

And finally, from a moral perspective, currency devaluation is completely unethical. The devaluation does not happen without a direct wealth transfer between savers and speculators. Purchasing power is stollen from the savings and pension accounts of some of the people least able to afford it, and moved to the spending accounts of the Fed’s most favored banks and financial intermediaries. Mr. Bator, nor anyone else who advocates money printing, ever seems willing to address this glaring immorality.

Inflation vs Deflation

We are on the cusp of a renewed intensification of the economic downturn that will probably feel a lot worse than 2008. The only real question that remains unanswered is whether that downturn will come riding the wave of inflation or whether it will arrive in the form of a deflationary glacier, carving canyons out of every asset class the world over. If the spring of 2011 not only feels like 2008, but looks like it too, then we can expect a sharp crash in equities, housing prices (which may already be upon us), and pretty much every asset class out there except precious metals.

Still, if I had to bet, and unfortunately I do since, leaving my savings in CDs at my local bank isn’t really an option, I would bet on stagflation. That is, I would bet on a sharp drop in the nominal price of equities, houses, and pretty much everything except precious metals and to a lesser degree, commodities.

Of course, just as I write these words, I am equally aware of just how pernicious a credit freeze can be. The events unfolding in Japan, the renewed military adventurism in the Arab world, and the massive monetary uncertainty in Europe all make me feel very uneasy. It is as though an increasing number of grenades are without their pins, and instead of being alarmed, our political and corporate overlords are starting to juggle the live ones. Markets have completely shrugged off what is probably, already the worst nuclear disaster in the history of humanity, the fast-track commitment to an entirely new war in North Africa, all-time record highs in gold and silver, and a major spike in the world’s most important resource, oil. I cannot recall a time when the world looked more chaotic and the future more uncertain, and yet here we are at S&P 1,300; the markets have doubled in the past two years! If the stars were ever aligned for an ominous market event, now would be the time…

So, if things play out the way most of the wise men expect, stagflation would be the way to go. But, if there is one thing that I have learned after all these years it is that things NEVER play out the way the wise men expect. It is always the fat tail that wags the market dog. People have been busy picking up pennies in front of bulldozers since September of 08′, and they will continue to go on sucking up those pennies until the next swan hits. If they last another year, then you can be sure that inflation will be the buzz word of the day. But, if something significantly unexpected occurs – a political assassination, an EU secession, etc. – then all bets are off, and deflation picks back up where it left off in 2008.