The banks don’t have to lend to inflate

Contrary to popular belief, banks do not need to lend to expand the money supply and eventually create price inflation. Yes, the Australian banks are still lending at an impressive rate but since the bust this has been predominantly to the housing, individual and public sectors, with commercial lending actually declining year-on-year (although it is already on the way back up from July lows).

Just because the demand for loans by businesses fell off does not mean that the monetary pumping undertaken by the RBA will have no effect on price inflation. Banks never have to be passive and, indeed, they usually waste no time in spending their new cash reserves. All they have to do to expand the money supply is buy existing securities, whether from each other or other corporations, thereby increasing deposits. They do not have to depend upon business firms to request commercial loans, or to float new bond issues.

…But it doesn’t matter anyway

Saying that, in a speech today the RBA's head of domestic markets department, John Broadbent, revealed that “…listed corporates have raised a record amount of equity this year, totalling some $60 billion, with issues broadly based across all sectors.” So not only are banks buying existing securities but they are buying up new bonds at record levels. This will be inflationary.

Mr Broadbent continued to say that most of these equity raisings had been used to pay down debt, with some companies explicitly saying the funds raised were to repay bank loans. While this may sound deflationary, it is not.  When someone pays back debt, the money used to pay that debt with does not suddenly disappear but simply goes to the creditor, in the case the bank. The bank then spends on additional security purchases, shares, or issues more loans which increase deposits. In other words, most if not all of the ‘repaid debt’ flows straight back into the economy.

The seeds have been sown

“The first sign of a hyperinflation is a rally in the stock market,” Jens O. Parrson, Dying of Money: A History of the Great German and American Inflations.

The new money and all-time low interest rates from the RBA coupled with a record fiscal deficit and added public debt obligations has created a new wave of malinvestments (investment in areas not aligned with consumer preferences but that which appears profitable thanks to the artificially low cost of credit and rising prices) in Australia that will eventually need to be liquidated. As an example of the rising confidence, the latest Dun & Bradstreet business expectations survey of 1200 business owners and executives shows expectations for investing in capital are at the highest level in 10 quarters, registering an index level of eight points. It is only a matter of time before the distortions created by all of the new cash created by the banks – and enabled by the RBA – will be revealed. While it may take a few years thanks to factors such as China’s demand for Australian resources, foreign accumulation of the Australian dollar (as bad as it was, every other nation appears to be inflating more) and so on, those same factors will mean the eventual bust will be worse in Australia than elsewhere.

The Australian recovery is not sustainable and rapid price inflation is a very distinct possibility.

It has to. The extreme—unprecedented—moves that respective governments, policy makers and central bankers have taken in the past year are going to have an effect on the long-term health of the economy.

Let us take a brief look at what happened and what is still taking place in Australia.

In response to the crisis the RBA followed the lead of the central banks of the US and UK and increased base money considerably—from approximately $47 billion to over $72 billion, an increase of over $25 billion in just four months, something that has never been done before in Australia.

Although we don’t know exactly where the money went (the RBA does not comment on particular counterparties), based on the data it is safe to say that it went into the banking sector, either to encourage banks to keep lending to each other or simply as a direct subsidy by taking securities off the bank’s balance sheets and giving them cash in return.

The thing is, unlike the US and UK where the massive increase in base money is still sitting in reserves at their central banks (they receive a ‘safe’ level of interest and are keeping the reserves on hand for future asset write-downs), the Australian banks have already decided to use the new money. I’ll touch on where it has gone in a moment, but for now this means that at least some of the new money has already entered the wider economy and will have to have an inflationary effect at some point in the future. Historically it can take up to two years for an increase in the money base to end up in the CPI (a horrible, heavily manipulated figure)…but who knows this time. What it has done though, in the short term, is keep assets inflated, preventing prices in financial markets, housing, credit markets and so on from adjusting downwards.

So where has the money gone? A quick glance at the data for long-term securities reveals that a lot of the new money has probably entered that market with the amount invested, both public and private, increasing significantly since the money was injected. So the banks are monetising at least part of the government’s deficit with RBA-created money. This is important to note, because fiscal spending is not inflationary under one condition: when you as an individual buy a government bond. When you do this you are making a loan to the government; you are putting part of your cash holdings into the hands of the treasury. There is then no increase in the total quantity of currency or credits available and hence no inflation.

Now, when the banks buy government securities from their new reserves, as I suspect they have been, it is just as inflationary as effects of issuing more paper money. It is under this scenario that the government’s fiscal spending will create future inflation as the loans funding it are not sourced from real, productive savings: there are now more dollars chasing the same amount of goods.

Loans are still relatively stagnant, reinforcing the view that the banks are choosing to invest the new cash in relatively safe long-term securities instead of issuing new loans (although there’s hardly been a ‘crash’ in loans – loan growth is still close to 10% YoY and appears to be turning upwards).

So what does this all mean? For one thing, it appears the banks received a good ol’ fashioned bail out, although the RBA was much more covert in its efforts than the Fed. While this will probably prop up the financial sector in the short term, it can’t be good for the wider economy as prices, production and consumption have failed to coordinate…I have no doubt one of the reasons the market hit records recently is because a lot of the new money was being channelled into the stock market (it often is).

In the short-term the RBA is going to be under pressure to raise rates – I wonder if they can hold out until the election next year (Rudd and Swan will be putting a lot of pressure on them to hold off till then). I’m not sure if the RBA will fight the upwards pressure on interest rates by issuing more money (the only way they can keep it down) or if they will let rates rise…if they keep rates down until next year then inflation will be guaranteed in the medium-long term.

On the subject of inflation/deflation, the best indicator for future inflation has to be M3—coincidently, it is a figure that has been rising at near record levels over the past couple of years (34.8% from July 2007 – July 2009[1]).

Gold is also a good leading indicator for inflation; the AUD gold price (indexed) historically trends close to M3.

The above seems to indicate that inflation rather than deflation will be on the cards for Australia in the near future. Yes, there are plenty of bad debts that need to be written down but I don’t think we have to worry about deflation: the RBA will monetise most of the toxic assets and prevent the money supply and prices from falling too far. It is politically suicidal—for both Glen Stevens and the government—to allow deflation to occur on their watch.

This leads me to the fiscal issue. The reckless “stimulus” undertaken by the government has to have caused massive structural instabilities and further malinvestment in the economy. Rather than let the necessary restructuring occur, they have simply—at best—delayed it. At worst they have caused even more malinvestment and imbalances that will radiate throughout the economy for several years. It’s important to understand that the government can only create what it has first taken from someone else. All of the jobs the stimulus created are temporary in nature—they cannot be maintained unless the government keeps spending. They are not in areas demanded by the preferences of the consumers but by the fancies of Julia Gillard. Building roads to nowhere and new gymnasiums is wealth destruction plain and simple.

If the stimulus is wound down—a necessity to restore economic health—and the inflationary fears forecast above both take hold, stagflation is a distinct possibility. Especially considering that once rates start to rise again the glaring bubble that is the property market will come under stress and put further pressure on both the mortgage industry and jobs related to it (housing, construction and so on).

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved," -- Ludwig von Mises, Human Action

However, we do have more room to move than the US and UK (we actually export stuff and so have a larger pool of real savings to exhaust through government waste and bank subsidies), so it might be possible for the powers that be to keep this fiat regime going and avoid the necessary deflation (or hyperinflation and a collapse of the currency).

The beauty of monetary inflation is that it is never the same and does not necessarily affect the same industries. Loose-money policies at home and overseas could very easily create another asset bubble in our economy. Only time will tell.

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[1] M3 growth has only matched this rate twice in Australia over the past 40 years. Those years were 1973 and 1989 and were followed with two recessions.

An excellent question. though most would say ‘who cares’?  Let us examine the end result of each scenario:

INFLATION       The value of your money progressively decreases as central banks print enough money to prevent deflation (a contraction in the money and credit supply).  Anyone who has a debt will have no problems paying off the nominal value of the debt, as the nominal value of your wage increases over the nominal value of your debt.  Example: this year the price of bread is $1… next year the price of bread is $3.  I have covered this phenomena in some detail in previous posts, I encourage you to ask me questions if you still want some help understanding the concept of inflation.

DEFLATION      The value of your money progressively increases as central banks are unable to print enough money to prevent the contraction in the money and credit supply.  If you have a debt, it is almost impossible to pay off the debt as it’s real value increases (nominal value is unchanged) while the nominal value of your wage decreases.  Example: the price of bread decreases from $1 to 50 cents in one year.  The collapse of lending, increased number of loan defaults, all contribute to a contraction of the supply of money, which makes the individual value of money greater (think the polar opposite of inflation).

In short… INFLATION = good for people with debts.  DEFLATION = bad for people with debts.

Now “deflationists” will not contend with the assumption that INFLATION can occur, even hyperinflation like Zimbabwe, but they see it as highly unlikely as the level of money printing would be astronomically high.  Furthermore, any attempts to neutralize the effects of deflation with money print would hopelessly collapse as seen with the central bank of Japan in the Asian Financial Crisis.  Also, any money that is printed goes directly to creditors and doesn’t touch the local economy to raise the price of everything.  Post-Keynesian economists like Steven Keen, a man whom I deeply respect, also contend that there is evidence to suggests that the money print by the central bank precedes the increase in the money supply (M2 to be exact)…. which means that the central banks are printing money in response to bank insolvency.  Thus, the increase of $1-2 trillion in the Federal Reserve’s balance sheet was in response to the ‘bank runs’ which took place at the end of last year, rather than an effort to create new money to pump into the local economy.

Inflationists on the other hand say that the government is perfectly willing to go as far as to print our way to hyperinflation.  More importantly, that the government is currently pursuing a course that will inevitable lead to hyperinflation.  They contend that the government has a course of trading private debt with public debt, these are also known as bailouts and they continue to this day as the government is pursuing a relentless nationalization agenda.  This isn’t perceived to be so much of a problem as the price of the debt (i.e. the interest rate) is quite low, thanks to the majority of the debt financed by short terms T-bills (1-3 years bonds).  When these bonds are required to be paid off, the government rolls the debt over into new bonds… or simply put, it borrows money to pay off borrowed money.  This is somewhat manageable when the economy is in a boom phase, where there is predictable growth that can theoretically outpace the increase in debt.  The failure of neoclassical economics for both monetarists and Keynesians was that their models assumed the the economy would be in perpetual growth, which was found to be the case as gravity exists in the economics in the form of finite resources.  As the government increasingly swaps more private debt with public debt and simply rolls over the debt repayments, exponential functions take over and the debt servicing on the debt starts to become impossible.

Pretty soon, people who buy the debt (like China and Japan) start to realize that the US is not going to pay back that money with any real value and stop purchasing this debt (they already have btw).  This forces the US to start doing something called ‘quantitative easing’, which means that the central bank prints money and buys it’s own bonds.  As the money print continues, the government starts to pay creditors the freshly printed money.  These creditors want to dispose of this currency either through exchange into their own currency (as most of the creditors are foreigners) or they will spend it on raw materials or even US financial assets.  As more US money abounds, the value of this money begins to decrease, even outside the local US economy.  As the value of the dollar decreases, the US central bank will be in a trap: the only way to defend the value of the dollar is to raise interest rates, but this will increase the amount of debt the government as to go into to service the existing debt.  And, if the interest rates rise, all of a sudden the credit based economy grinds to a halt as no one can pay back their debts.  If the central bank chooses to ignore that the value of the money is decreasing and the prices of everything are increasing, entering into hyperinflation will occur more rapidly than anyone predicts as they will eventual ‘turn the corner’ on the exponential curve of the depreciation of the US dollar.

The Japanese example isn’t applicable, the inflationists say, as the nature and origin of Japan’s productive capacity and creditors are completely different to the US.  Also there is the tiny little fact that Japan is the largest creditor nation in the world, while the US is the largest debtor nation.  This is a striking point between the two schools… the PKs say that the scale of the debt black hole is too enormous for pure money printing to overcome.  The Austrians are saying that the money printing is being used to swap the private debt with the public debt, and if this process continues then the value of the currency will collapse.

So… which one is right?  The answer is, no one really knows.  Some people will say ‘I’m 100% sure this way or that way’, but in reality, we’re all just economic geeks watching the carnage unfold.  This is exciting to watch, but painful in reality to the people at the bottom of this gigantic pyramid scheme that we call money and banking.

Personally I’m not interested in the little esoteric arguments between the economic schools… and there are many.  I think there’s value in the analysis of the financial system from both schools and both possible scenarios make sense and are plausible.  We’ll just have to see what happens.  In any case, my advice is to horde faith in God and put your money in assets that will protect you from either scenario, which are precious metals (i.e. gold, silver, platinum).

God bless,

Dr Washo

PS   And if you’re a US citizen, support bills like H.R. 1207 ‘The Federal Reserve Transparency Act’ aka ‘Audit the Fed’

The prevailing opinion on the streets is that capitalism has failed and the government is a necessary evil required to "fix it". This opinion is so well ingrained it's almost impossible to sway with logic and reasoning; indeed, people seem to be passionate in their hatred towards the "greedy banks" and support of "job creation". This all follows the media storm around the banks raising interest rates despite the RBA keeping rates on hold, with a follow-up RBA study indicating that, contrary to what the Commonwealth bank was claiming, funding costs have not increased.

The issue of the whole central banking system aside[1], why is everyone so worried about the banks charging an interest rate (which is the price of borrowing capital) higher than it costs them to acquire? That's like saying because it only costs a bookstore owner $5 to produce a book, they shouldn't be allowed to sell it for above $6, as that's a "fair price" and anything above that would be "exploitative" (as determined by some all-knowledgeable bureaucrat). Let's not lose sight of the fact that every exchange is voluntary and no one was or is coerced into borrowing money (government "incentives" to take on debt aside!). The real issue, of course, is the government intervention that prevents competitors from entering the banking business. As long as the government doesn't restrict competition, no one is able to either exploit labour or remain in a "monopolistic" or "cartel" position for long.

In other news, I also noticed that today's Financial Review (Australian Edition) contained an article showing that of the OECD nations, Australia has the most progressive tax system - we outstrip even the quasi-socialist European countries as far as wealth redistribution and welfare 'nanny' state goes[2].

Finally, I've updated the Recommended Reading section with some great books and essays which anyone is free to read or download. One in particular is "The Myth of the Failure of Capitalism" by Ludwig von Mises, a short essay addressing the fallacious views that the market and not the government is to blame for this crisis. Here's an excerpt:

The crisis under which the world is presently suffering is the crisis of interventionism and of state and municipal socialism, in short the crisis of anticapitalist policies. Capitalist society is guided by the play of the market mechanism. On that issue there is no difference of opinion. The market prices bring supply and demand into congruence and determine the direction and extent of production. It is from the market that the capitalist economy receives its sense. If the function of the market as regulator of production is always thwarted by economic policies in so far as the latter try to determine prices, wages, and interest rates instead of letting the market determine them, then a crisis will surely develop.

Click here if you would like to read the full essay.

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[1] I personally think we need a return to sound money and free banking to avoid political manipulation of the money supply -- which, by the way, has been increasing by almost 20% YoY for the past decade. I'll provide a nice chart showing this growth within the next week.

[2] As with the above, I plan to write about this sometime in the next two weeks.

When in doubt, blame the banks! From the Australian:

Under new ATM access rules due to start on March 3, banks will no longer pay each other a fee every time a customer uses another institution's machine. But nothing will prevent banks from charging their customers a "foreign ATM fee".

Just like with so many things in this country, one government regulation will lead to another. Already we have 'consumer groups' (lobbyists/interest groups) worrying that the banks are going to increase charges to consumers as well as maintain old ones -- NAB, Westpac, ANZ and St George have already announced they will continue to charge foreign ATM fees and the others will follow shortly after.

Consumer advocate Choice yesterday stepped up pressure on the big banks to scrap foreign ATM fees, saying: "The benefits of direct charging reforms will be quickly undermined if customers are charged a separate second fee from their own bank."

Honestly, what do they expect? This is a perfect example of what happens when governments get involved, I can see it now:

Joe: "Hey Sam, those banks are ripping people off, lets come up with a way to stop them!"

Sam: "I agree completely. Let's get our whole team on this and have the new regulation out by friday!"

...one year later (on a friday!) the new regulation comes into effect...

Joe: "Sam, the banks don't seem to be suffering at all. In fact, it looks like they've found a loophole and are actually ripping customers off even more now!"

Sam: "Call the team Joe, it's going to be a long week!"

Now the above is a pretty poor example but it gets the point across -- history has shown over and over again that once you add one regulation they will continue to pile up until they've become some inticrate web of rules that only some 'expert' can untangle. But hey, that creates jobs right? What a joke. Why doesn't the government just deregulate the finance and banking sector, give up control of the dollar (yes, allow banks to create their own currency backed by whatever they want -- not guns like in our current system) and let the market decide if they're being ripped off or not.