The Fiat Money End Game

Wednesday, May 5, 2010
By Paul Martin

By: Michael S Rozeff
Market Oracle
May 05, 2010

Jim Sinclair has a slogan “QE to infinity.” That’s “Quantitative Easing to infinity.” That’s inflation to infinity. That’s the case for gold and silver in a nutshell. I think he’s right. I’d like to explain why I think he’s right, but in a roundabout way that gives me a chance to express some of my thoughts on the financial crisis we are observing.

The last time we had a really serious depression, the public didn’t start massively flying into quality for quite some time. Currency held by the public was stable all the way to October 1930. At that point, there was an increase in Midwestern bank failures. And the Bank of United States failed. The New York banking department tried mightily to save it and merge it, but the Clearing House banks doomed the deal. They didn’t trust the bank’s real estate holdings. These events triggered bank runs, which meant currency withdrawals. That created deflation in money supply, with its depressing economic effects. This is because currency is part of the money base and enters the money multiplier and multiple deposit expansion. Starting in October of 1930, the curve of currency held by the public suddenly started to rise. That accelerated the drop in money supply that was already occurring. In the pre-Fed days, the banks would have suspended payments en masse and stopped the resulting chain of bank failures. Since the Fed was around, they were more complacent. The Fed, however, didn’t stop the chain reaction. The banking system fell apart, which means bank closures became endemic into 1933.

Compare September 2008. The authorities could not save Lehman or maybe did not. The Fed says they tried (see here), which makes the Lehman event very much like the Bank of United States event. This triggered a stock market panic and a flight to currency and safety much like October of 1930 and in other panics. We had an old-fashioned panic. People even shifted out of money market funds. Even with insured deposits, people still flew to safety all across the board. Picking and choosing who will fail and who won’t fail is a mish-mash policy. The captains of the fiat money-big debt-big government-fractional-reserve system, who want to keep their jobs and see the system survive, either have to save it in the usual ways, inflation and taxpayer-funded bailouts, or else end the system altogether, which, of course, ain’t goin’ to happen if they can help it. The logic of the system has only one direction: rescues, more inflation, more bailouts, and the invention of new kinds of credits and currencies. The call for worldwide currency baskets is a step toward the ultimate bubble-making machine, a world fiat currency.

This time around, unlike October of 1930, the Fed counteracted the panic with massive inflation, so now we have a new scenario that differs from 1931-1933. Bernanke studied his Friedman & Schwartz. He knew how to stop a chain of failures. But, funny thing, the broader money aggregates are still moribund and bank failures are still occurring. Stopping the bank runs doesn’t solve the insolvency problems of banks with illiquid assets whose values are so much lower than their liabilities (by 30-50% it appears.) Inflation is not a cure all.

The Emergency Banking Act of 1933 included a host of inflation measures. They included purchase of preferred stock of banks by the Reconstruction Finance Agency. This reminds one of the TARP program in 2008. Inflation is built into the fractional-reserve system as a rescue device, and so is the taxpayer-funded bailout. Everything to save a flawed system rather than fix it properly, for it cannot be fixed without getting rid of the accompanying big government.

If the EU lets Greece fail, it’s like letting Lehman fail in 2008 or the Bank of United States fail in 1930. It sends out a signal. The dithering of the EU may already have sent out such a signal. They may already have altered expectations and behavior. The rescue package may lack believability for the moment. It may not have sunk in quite yet.

The rescue team, which consists of the stronger countries and the IMF, are damned if they do and damned if they don’t. Instead of banks being insolvent with runs occurring on them as in the 1930s and 2008, we have whole countries being bankrupt, but their paper is held by banks in France and elsewhere, so there is a contagion thing to worry about. If the EU lets default happen, there is a run against all the bonds of all the weaker countries. Their yields rise, and they have to default too, and then that weakens a host of banks and others who hold the paper, and then they demand to be bailed out. If instead they rescue Greece and others, then the rescuing governments have to issue more debt, or else the IMF does too, or else the ECB gets into the act too, and this weakens the stronger countries and drives down the euro. So, either way, there are problems. It appears that the rescue option has been invoked, although tardily and reluctantly. This means that the governments are rescuing the bondholding banks and whoever else holds the Greek paper. That’s the bailout here. This is preferable to the rescuers as compared with an outright default which then starts a contagion via the bond yields rising sharply which induces country bankruptcies and defaults.

The deflation at work here has already happened. It’s that the values of loans held by banks have declined a great deal, and are below the values of their liabilities. The fractional-reserve banking system doesn’t work today and it didn’t work in the 1930s and at other times when depositors demanded cash or gold and the banks couldn’t liquidate assets or gain access to cash flows to pay them. Even with the Fed turning bank loans into cash, the FDIC has to keep closing banks every week because they are way below any regulatory standards of operation.

Central bank inflation is necessary in this kind of a fiat money-fractional-reserve banking system to prevent the whole system from collapsing due to flight to safety. More money is like a blood transfusion to a patient who is losing blood. But this doesn’t resolve the insolvency in the system. The regulators have what is called “forbearance.” They ignore the insolvency and do not enforce mark to market. They then close the worst banks and hope that the rest make enough money to rebuild their liquidity. Gradually, as the banks use reserves that cost them 0% to invest in U.S. Treasuries at 3.5%, they make some money. The Treasury market stays firm for this reason. The Fed keeps rates low for this reason. The banks build up potential liquidity by holding treasuries. In a few years, they sell these and start making more loans, and price inflation starts appearing. Meanwhile, the economy limps along. This is the muddle-through scenario.

The boom-bust cycle had to end with a deflationary bust. The central bankers eventually prick bubbles to stop inflation, because if inflation takes hold and interest rates rise, the government finances are doomed. And so, the latest boom-bust cycle did come to an end. Greenspan, toward the end of his reign, and Bernanke caused this bust by restricting money growth. Most people don’t know this. One has only to look at money growth to see this. Look at the very low rates of growth of money between 2005 and 2008. There was a deceleration.

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