Happy new year one and all,

So far Aussienomics has had over 200 000 web-hits since it's inception!  That is truly amazing stuff, thanks for supporting the website and please feel free to comment on any of our articles, we love the interaction.

I was paying a visit to Steve Keen's website, as I often do from time to time, when I came across his repost article from Mish Shedlock.  Mish, a well known Austrian school commentator, was making the case that the economy was going to experience a very severe debt deflationary depression (the dreaded triple D).  This of course fits in perfectly with Steve Keen's long term views for America and Australia.  It is an excellent article, and he's written other similar articles of a high quality that he links to.  The main points of the article were:

"1) Lending comes first and what little reserves there are (if any) come later.
2) There really are no excess reserves.
3) Not only are there no excess reserves, there are essentially no reserves to speak of at all. Indeed, bank reserves are completely “fictional”.
4) Banks are capital constrained not reserve constrained.
5) Banks aren’t lending because there are few credit worthy borrowers worth the risk."

His overall assessment of the deflation/inflation debate can be summarized by his concluding remarks from an article entitled 'Fiat World Mathematical Model':

"What happens next depends somewhat on the political will of the central banks and politicians. However, it depends more on the psychology of the borrowers. If consumers and businesses refuse to spend and instead pay back debts (or default on them along with rising unemployment), the picture simply is not inflationary, at least to any significant decree.

The credit bubble that just popped exceeded that preceding the great depression, not just in the US but worldwide. Thus, it is unrealistic to expect the deflationary bust to be anything other than the biggest bust in history. Those looking for hyperinflation or even strong inflation in light of the above, are simply looking at the wrong model.

At some point the market value of credit will start expanding again, but that is likely further down the road, and weaker in scope than most think."

Now, it appears that the mainstream Austrian school economic thought is that we're heading down a purely inflationary path due to unprecedented levels of fiat money creation by governments around the world, including Australia.  Mish is among a few who take a contrarian view to this prevailing thought.  Like Steve Keen, who's a post-keynesian, I like Mish's analysis a lot, but I reach different conclusions as to the outcomes.

One of the most useful contributions Mish has made is clarifying the terms: inflation and deflation.  Both are the expansion or contraction, respectively, of the supply of money and credit.  Many times we tend to leave that last one out.  The way Mish reaches the conclusion of a massive debt deflationary depression is that he focuses on the contraction of credit due to the massive current and future wave of credit defaults.

Consider this example, a bank has 50 IOUs representing 50 different mortgages worth $100K each.  The total amount of money lent out by the bank is $5 000 000.  50 people receive the loaned money, the bank holds on to the IOU pieces of paper and over time the bank receives monthly principal/interest repayments.  Suddenly, 49 out of the 50 individuals cease to make principal/interest repayments due to either unemployment or higher interest rates.  These individuals walk away from their mortgages and the bank is left holding these mortgages with no one servicing these IOUs.  Insult turns to injury when the mortgage/IOUs drop in value considerably due to falling house prices.  The bank then has to mark-to-market a loss of $4 900 000 worth of 49 IOUs on their balance sheet.  It could be even worse if the bank leveraged money against these used these IOUs.

Now I can only assume that both Mish and Steve look at this example as a textbook case of deflation.  The money supply, made up of money (cash) and credit (IOU paper) has contracted in this case (remember that banks essentially treat credit money (i.e. IOUs) like cash money on their balance sheet).  The bank is left in ruins and takes a massive hit on it's balance sheet and share price.  It is facing insolvency.  What happens next, one of two things:

1)  The bank goes bankrupt

2)  The Feds bail them out

Ok, so option number 1 is out, unless you're a competitor with Goldman Sachs, in which case they'll let you go under (sorry Lehman Brothers).  Option number two involves using sovereign debt/tax payer money and/or freshly printed money by the central bank to purchase the banks worthless IOUs, now labeled 'toxic assets'.  The bank are recapitalized at 100 cents on the dollar and balance sheet goes from red to black; the share price begins to rise.  Question: is that deflationary?  We'll make it even harder, let's say the Feds only bail them out at 20 cents on the dollar, is that still deflationary?

The answer is no.  This is where both Mish and Steve Keen might be missing something.  Both Mish and Steve point out that even if a magical printing press were to print $5 trillion dollars out of thin air and you buried the money into the ground, no actual inflation would occur as the money hasn't touched or circulated within the real economy.  So now there's a distinction between active and passive money and credit.  This is important to remember this for next point:

Back to the example, the initial $5 000 000 lent-out by the bank is active money, it is in the hands of 50 people who have given it to 50 other people in exchange for a house, this cash is circulating within the real economy.  The $5 000 000 IOUs the bank sits on is "passive credit", it doesn't really circulate in the real economy like cash (yes it can be bought and sold as a credit instrument, but by in large it sits there and does nothing).  It is only a demand for money to be paid back over time.  For all intents and purposes, the IOUs are buried in the backyard.  When the IOUs are devalued due to falling house prices, the bank loses $4 900 000 of passive credit.

Mish and Steve may call this a black hole of $4 900 000, but in reality it will not suck this amount of money from the real economy directly from people's wallets.  Ultimately it will be written-off.  By definition this was a deflationary outcome, but in the real economy, no money has been withdrawn from circulation.  Yes the promise of future money is gone, but in the present, circulating money isn't sucked into a piece of paper demanding to be filled by $4 900 000.

Now enter the Feds, who make up for some of the posted loses by lending the bank some cash.  This money can then be used for future loans, or if the bank isn't prepared to lend, it will turn to the foreign exchange (Forex) market for speculation in order to collect some interest.  This action is inflationary as the supply of money has expanded.  This is also active money that will circulate in the real economy either through commercial loans or Forex.  Don't underestimate the use of money by banks in Forex, which turns over $2 trillion per day!  They can easily place the money into a carry trade between the Australian-US dollar.

Apply this example to the entire banking industry and the same conclusions still stand: while technically there will be a deflation in the money supply, this will be on the passive credit side of things.  Since the financial institutions are the major players sitting on this mountain of IOUs, they will be the losers who face insolvency (as they already have).  However, due to the governments actions, and the future inflationary actions by the central banks (which are almost a foregone conclusion), the expansion in the active money supply to bailout banks will have a net inflationary outcome.  This will be immediately evident in asset price inflation and a weakening dollar, which will in turn raise the cost of oil, commodities and food prices.

In the case of the US, the very real threat of massive inflation from sovereign debt interest servicing, and you've got a strong case for an inflationary depression over the next 5-10 years.  The insolvency and underperformance of the banks will contract the level of credit expansion we've been used to these few decades.  This will significantly threaten both medium and long-term productive loans/investments and more importantly short-term consumer debt-driven spending, which is the foundation of both the US and Australian economy.  This will be a deflationary force behind the recession, in the sense that it may lead to lower asset prices.  However, as the governments around the world are adopting the time-honored Keynesian solution of stimulating aggregate demand, both government deficits and actions by the central banks will be a major and overriding inflationary force in the economy.  The idea that money is being withdrawn from economy by these debt 'black holes' is fallacious, even money that is being paid back to the banks is being used for speculation by the banks in Forex.  Deflationists are also underestimating the willingness of governments to take over the demand for credit to new and uncharted levels.

In truth, the economy is in need of a contraction of credit/money and restructuring towards production, savings and trade.  History has demonstrated that credit liquidation, inaction by the government and the central banks (i.e. no bailouts) is the fastest way to restore a healthy economy (e.g. the 'forgotten' depression of 1920-21 in the US).  This process will be very painful, very hard, but will be prolonged only by government intervention aimed at slowing or preventing this action from occurring.  If they continue with Keynesian-style intervention and money printing, welcome the start of a very long depression.

God bless,

Washington

Hey everyone,

So Justin is going to be away for a little while and I've been staring at the home page of aussienomics for the past few days blankly, waiting for some sort of inspiration to descend or arise upon me... sadly nought.  I do have several small thoughts that I guess I can post as regularly as I can until I come up with something long and profound to post.  In any case, feedback and interaction makes the experience better for all of us.

Recently I watched the movie 1984, based off the novel written by George Orwell.  I don't recommend people watch the film, unless you want to see the fantastic acting performance by Richard Burton.  The book is sensational, I'm about 10% of my way through the book myself.  What hit home to me today is that governments around the world are heading for that dystopian destination.  I once thought that it was virtually impossible for that level of tyranny to occur within my life time... I now believe differently.  Sadly, the level of apathy and disengagement of the population has me worried about the future.  My beef is not with the politicians, as they are just men and women with the same power complex that average individuals possess.  My discontent is with you, the person reading this article and the persons who are not reading this article.  My disappointment is with all of us, past and present, who have allowed, either actively or passively, this monstrosity to occur.

What am I talking about, it's simple: legalized tyranny.  In this country you cannot defend yourself with a weapon without fear of imprisonment, they restrict the ability to defend yourself by making it virtually impractical to have a gun in your home and use it for self defense.  The crazy thing about it is, people actually think this is a great idea.  My response is this, if a murderer breaks into your home, which scenario would you prefer:  1) Call the cops and wait 10-20 minutes before they arrive OR  2) Have the means and ability to personally defend yourself without fear of imprisonment for manslaughter?  How about economic tyranny... an income tax, a GST, a corporate tax, property tax, capital gains tax and now, the upcoming carbon tax.  I've said it before, one day the government will find a way to tax you for every breath of CO2 you exhale.

Last in this tirade, but not least, the inflation tax... the debasement of the value of the money you keep in the bank.  I've discussed this previously, but did you know that the money you keep in the bank depreciates in value despite the interest you earn in the bank?  The central bank of Australia (i.e. the RBA) continues to print and print money, perpetuating a fraudulent banking that loans money into existence.  Now as I wrote this sentence I know that people's brains have 'glazed over', they don't know what I'm referring to.  The term 'fractional reserve banking' is a foreign term, much like 'magna carta' or 'habeus corpus'... concepts and principles too difficult to invest time for learning.  And what is the price for this ignorance, this intellectual slavery to our overlords... it is not the suffering that we are enduring now, no that would be too obvious.  The penalty for our unconsciousness is the fact that people LOVE to be enslaved and will defend tooth and nail to 'return to Egypt, for it was better for us there...'.

This is an angry post, and I am angry at all of us... we must wake up before it is too late and we all end up distracted by 'Dancing with the Stars', 'Master Chef' or 'Gossip Girl' and surrender our brain, wallet and soul into the hands of a Beast.

Dr Washo

PS    Love mercy, truth, freedom, knowledge, wisdom, understanding and love itself rather than entertainment, lust and greed.

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’

From the Times:

The Bank of England will begin radical moves to “print money” in as little as two weeks as it embarks on an aggressive new phase of its efforts to stem the economic slump.

In a surprise acceleration of its fight against the recession, it emerged that the Bank has already written to Alistair Darling to seek his permission to begin so-called “quantitative easing”.

The step means that the Bank will begin creating new money to boost the amount of cash and credit flowing through the economy in an attempt to jump-start growth as soon as March 5, when its Monetary Policy Committee next meets to set interest rates.

Don't be fooled by terms such as "quantitative easing", it's just an attempt to make theft sound positive. Whenever the government (or central bank -- these are one and the same) decides to print money, guess who gets to spend it first? The government and the banks. With more money now floating around, each dollar (or pound in this case) is now worth less -- "quantitative easing" acts as a stealth tax on the value of cash holdings. It just creates the illusion of prosperity and is often popular because at first glance it doesn't appear as though the government has taken resources from anywhere. In reality, they have taken resources from everyone and anyone who holds the currency. The only people who benefit are, as mentioned earlier, the first recipients -- banks and government.

Unfortunately printing money to "...boost the commercial banks' reserves held with the Bank, so improving their ability to make new loans to consumers and businesses and, it is hoped, breathe fresh life into the economy" delays the necessary adjustment in the structure of prices towards consumer's true wishes. That is the only way real demand will be restored and this stunt is nothing more than a transfer of wealth.