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The Fed Is Out Of Ammunition

user profile picture Chris Martenson Nov 24, 2008
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This title is not mine, but that of an article that appeared in The Wall Street Journal today (Nov 24), which closely mirrors my own assessment of where we are and what is likely coming next. In short, deflation is so unacceptable to a debt-based money system that it will be avoided at all costs. And I do mean all costs.

This was written by an equity strategist in Hong Kong; be sure to catch his startling conclusion at the end. Startling because of where it was printed – in the main circular of the high church of fiat money, a.k.a. the WSJ.

The whole thing is worth a read, and a ponder, but let’s review some of the more relevant bits.

The Fed Is Out of Ammunition

A discredited dollar is a likely outcome of the current crisis.

With an estimated $4 trillion in housing wealth and $9 trillion in stock-market wealth destroyed so far in the United States, there is little doubt that we are witnessing a classic debt-deflation bust at work, characterized by falling prices, frozen credit markets and plummeting asset values.

Those who want to understand the mechanism might ponder Irving Fisher’s comment in 1933: When it comes to booms gone bust, "over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money."

My comment: Here he’s laying the groundwork – our current crisis is ultimately one of “too much borrowing.” Given this, one can easily be stumped by the current plan of having the US government borrow even more to give to already failed institutions. How does borrowing more solve a crisis rooted in “too much borrowing?”

It’s a great question, and one that you will be hard pressed to find discussed in the usual mainstream media outlets.

Why is the government so desperate to borrow our way out of this deflationary problem? Let’s continue.

The growing risk of falling prices raises a challenge for one of the conventional wisdoms of the modern economics profession, and indeed modern central banking: the belief that it is impossible to have deflation in a fiat paper-money system. Yet U.S. core CPI fell by 0.1% month-on-month in October, the first such decline since December 1982.

The origins of the modern conventional wisdom lies in the simplistic monetarist interpretation of the Great Depression popularized by Milton Friedman and taught to generations of economics students ever since. This argued that the Great Depression could have been avoided if the Federal Reserve had been more proactive about printing money. Yet the Japanese experience of the 1990s — persistent deflationary malaise unresponsive to near zero-percent interest rates — shows that it is not so easy to inflate one’s way out of a debt bust.

My comment: The great fear of a deflationary spiral for central economic planners (like the former Soviet Union or the US central bank) is the loss of policy traction. That is, once the main levers break, the Federal Reserve rapidly loses both the ability to effect outcomes and credibility. Of the two, credibility is the most important feature in a faith-based economy. This is a large reason why such an outcome will be fought with every tool in chest. And also every dollar. Read on.

It is also true that under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks’ total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

My Comment: This massive increase in total Fed assets and bank reserves will someday, possibly sooner than most expect, come flooding back out into the “real economy,” creating another boom. That’s the way these systems work. Presently, all that matters to the central planners is that the economy (meaning credit growth) returns to higher levels than before. That is what it requires, and that’s what they will seek. Unfortunately, this will only mean that we’ll have failed to learn our lessons from the past crisis and will have sown the seeds for an even larger, more disruptive crisis in the future. I will note that such crises are becoming both more frequent and larger with every passing rescue.  [Next part: emphasis mine]

There are no easy policy answers to the current credit convulsion and intensifying financial panic — not as long as politicians and central bankers are determined not to let financial institutions fail, and so prevent the market from correcting the excesses. This is why this writer has a certain sympathy for Treasury Secretary Henry Paulson, even if nobody else seems to. The securitized nature of this credit cycle, combined with the nightmare levels of leverage embedded in the products dreamt up by the quantitative geeks, means this is a horribly difficult issue to solve.

Virtually everybody blames Mr. Paulson for the decision to let Lehman Brothers go. But this decision should be applauded for precipitating the deflationary unwind that was going to come sooner or later anyway.

My Comment: Exactly so – as long as this crisis is prevented from fully resolving itself, which it would do all on its own, we can be sure that it will take longer and have a less restorative outcome than if allowed to progress more or less naturally. But the author is correct – this is a horribly difficult issue to “solve,” probably because it is more of a predicament than a problem (hat tip to Switters). Problems can have solutions, predicaments only have responses.

What happens next? With a fed-funds rate at 0.5% or lower in coming months, it is fast becoming time for investors to read again Mr. Bernanke’s speeches in 2002 and 2003 on the subject of combating falling inflation. In these speeches, the Fed chairman outlined how policy could evolve once short-term interest rates get to near zero. A key focus in such an environment will be to bring down long-term interest rates, which help determine the rates of mortgages and other debt instruments. This would likely involve in practice the Fed buying longer-term Treasury bonds.

It would seem fair to conclude that a Bernanke-led Fed will follow through on such policies in coming months if, as is likely, the U.S. economy continues to suffer and if inflationary pressures continue to collapse. Such actions will not solve the problem but will merely compound it, by adding debt to debt.

My comment: And here’s the predicament in a nutshell: The only way to ‘solve’ a debt crisis in a debt-based money system is by adding more debt. Clearly, that cannot really work. I have long taken Bernanke at his word and assumed that he will use the power of the printing press to defeat deflation. I believe that is precisely why he was hired, and I believe it explains the more than one and a quarter trillion dollars (!) of money that he’s created out of thin air to buy distressed bank debts.

In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism — and with it the fiat paper-money system in general — as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the "barbarous relic" scorned by most modern central bankers, may well play a part.

My Comment:  And finally, the interesting conclusion. Any mention of the gold standard, let alone postulating its return, is a remarkable thing to see in the WSJ.  In any crisis, the solutions are usually fashioned from whatever happens to be lying around at the moment. The gold standard is well understood, and would undoubtedly have prevented the various monetary and trade imbalances from having grown to their current dangerously large proportions. Because it is a possible solution that ‘happens to be lying around,’ it stands a chance of being seriously considered.  So this conclusion is interesting, in part because of where it was printed (the WSJ), and in part because such thinking is creeping into more and more articles, indicating that it’s once again being considered by more and more people.

However, the possible return of some form of the gold standard is more speculative than his other assessment that the present crisis will end up discrediting the dollar itself, leading foreign investors to flee the dollar. This is something that I fully expect to happen at some point in the future and is something that everyone should consider.

How likely is it, and what will be the impact to you if it does?