Happy new year one and all,

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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

In today's Unleashed, Bruce Haigh wrote an article entitled "What can Rudd do to restore a healthy economy?", outlining his thoughts on what the Rudd government should do to make sure our economy gets back on track. Initially I thought he was on to some good points, stating that Australian's haven't learnt much from the past...before unleashing against capitalism and promoting full-blown socialism.

Mr. Rudd has a responsibility in times of a shrinking economy to provide a minimum wage, housing, health care, transport and education for adults and children least able to financially cope in the forthcoming straightened circumstances. This is survival spending, it is not designed to create jobs; it is to keep people alive and healthy and to provide the means for their children to participate in and help engineer a revitalised economy when the global economic sickness has passed. This is basic humanitarian assistance; it will not in the short to medium term, of itself, rebuild the economy.

The only thing Mr. Rudd has a responsibility to do is to make sure this doesn't happen again. He needs to do exactly the opposite of what Bruce recommends above and avoid any and all involvement in the economy, financial system, education, health care and so on. We haven't been living with capitalism; on the contrary, we've had statists masquerading as 'capitalists' to suit their own personal endeavors. Rudd himself was a self-proclaimed believer in the market until this crisis happened, but he sure jumped ship quickly (he was always a socialist). There is no middle-ground (see The Myth of the Failure of Capitalism by Ludwig von Mises, 1932.

It can't happen overnight -- the state is so involved in everything we do it's going to be a slow process but these are the types of policies we need. From Friedrich Hayek in a 1975 Meet the Press:

"No, but it goes back to the same cause. The unemployment of which you speak, which is the initial cause, is due to labor being temporarily directed into places or activities or industries where they cannot be maintained without further inflation. Therefore you can only cure that by achieving a new redistribution of labor between employments. Adaptation to a condition in which aggregate demand need not progressively increase to maintain that employment."

"We mustn't assume that all problems are solvable in the short period. There are problems that we cannot solve or which trying to solve them quickly may do more harm than good."

Hayek was saying (he was talking about the U.S. economy) to do the opposite of what Bruce is recommending. The government created this distortion in the allocation of labour and the market needs to redistribute it to more productive areas. Any short-sighted attempt to "save jobs" will do more harm than good. Back to Bruce,

"Mr. Rudd will need to take some drastic and decisive action, taking into account the lessons learnt from the last Great Depression. He will need to cancel some overseas defence orders and rethink defence requirements and strategies, utilising local capacity, particularly in ship building. He will need to take over the local car manufacturing industry, which can also be used for defence production. These decisions will protect and provide new jobs as well as build a local defence production capacity in what will be uncertain times."

I agree with the removal of our (due to our alliance with the US Empire) overseas troop contingent but I'm not sure how to read the rest -- is Bruce really suggesting we mobilize our economy 1930s style to prepare for some (looking at his words, inevitable?) upcoming war? This won't protect jobs. This won't create wealth. Times are only uncertain because people such as Bruce are advocating full-on socialism as a response to the continued failures of the state!

The government needs to regulate the banking industry and get back into the business of banking. It needs to take over Telstra, railway infrastructure and rolling stock and providing an air service in remote Australia. The tyranny of distance demands it. User pays has failed, particularly in rural Australia.

No, the government has had its turn at running banking, telecommunications and public transport into the ground. It needs to remove ANY and ALL involvement in these industries as soon as possible. It needs to remove the red tape completely. It needs to stop creating monopolies through regulation and laws. It needs to let people decide what they want!

The federal government needs to take over the management of water and abolish water licences, as a short and long term stimulator of the economy, particularly the rural economy.

The water debacle is a creation of the government. How will more involvement solve anything? This is a touchy one though, because the state is so involved already (massive property rights issues) you can't just privatise the whole thing in an instant.

The private schools must fend for themselves, that's what private used to mean and the funding of public education significantly increased, particularly in the area of skill creation. Pulling out of depression will require it.

Here's an idea: cut all funding for schools and return the tax dollars used in it back to the parents. As with all of the above, spending needs to be cut dramatically and the market needs to be allowed to provide these services. Private schools can fend for themselves perfectly well -- that is, of course, unless they're competing with these "super schools" with endless pockets and no profit motive!

Import replacement needs to be encouraged and funded, directly, and from loans through the government bank.

Absolutely not. People should be free to choose where they buy their goods from. If there's a market for it, and people really care as much as you think about saving local jobs, then there will be an opportunity for profit (by charging premiums for "made in Australia" products) that entrepreneurs will capitalise on. Why should the government make this decision for us, at our expense? We need to remove all tariffs, subsidies and "import replacement" schemes as soon as possible.

This depression is a direct result of Globalisation. Australia should seek future protection from the buffeting of overseas financial institutions by exercising more control, discipline, stimulus and protection of its own economy.

You're right -- the U.S. Federal Reserve is the key culprit in this crisis, fuelling banks across the world with cheap credit and encouraging consumer debt. But we should not, under any circumstances, revert to a protectionist state-run economy. This cannot work and will serve only to lower our standard of living considerably. We can insulate ourselves against this sort of thing by abolishing the RBA, significantly shrinking the size and involvement of the state, and allow free banking (in other words, let banks create their own currency, backed by commodities of the markets choosing).

Despite what he says, Bruce obviously hasn't learnt anything from the past failures of the policies he advocates.