In 2008, banks stopped lending as much money, helping drag the economy down.
They started holding it in extra reserves, instead.
This caused deflationary pressure the Federal Reserve has been “protecting” us from ever since.
We’re so lucky we have the Fed.
But why did the banks start holding excess reserves instead of lending? Were they simply scared of the economic conditions?
No, they are being PAID to do it, by the Federal Reserve.
That’s right…the Federal Reserve that is “saving” us from the banks’ refusal to lend, is paying the banks to do it.
How the Banks Work
See, banks usually take the money you deposit, and invest it. They make business loans, home loans, buy securities, and so on.
The profit they make doing that pays for the banking services they “give” you “free”.
In a sense, they are acting like a mutual fund for you…investing your money and paying you “interest” in the way of free banking.
But they don’t invest all of your money. The Federal Reserve requires them to hold back a bit “in reserve”. This is to ensure that they have money in case people want to withdraw it.
The Fed makes banks hold 10% of your checking account (and everyone else’s) in their Reserve.
The other 90%, the bank invests, driving the economy through business loans, buying securities, et cetera.
Or it did.
The Fed Wags the Dog
But in 2008, the Federal Reserve started paying banks interest for anything they held in reserve.
Immediately, banks started holding EXTRA money in reserve. This is called “excess reserves”, and it had never happened in any large amount before.
Strangely, the Fed’s response to the banks doing what it is now paying them to do has been to complain that they’re doing it, and to expand its power even more, to “save” us from the lost money.
See, our capitalist economy depends on money being used to create wealth. With hundreds of billions being stuck in “reserves”, it’s not being invested to create wealth, and the economy is suffering.
In effect, the Fed is causing what Friedrich Hayek called “hording”, and identified as something that NO economic school considers healthy.
It is agreed that hording money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable.
— Friedrich Hayek’s 1932 Letter on the Great Depression
If banks respond to free market demand by increasing their reserves, that’s good.
If the government (including the Fed, acting as its agent) forces more reserves, that’s bad.
The reason the Fed has added, or says it is adding, over a trillion dollars in “Quantitative Easing” (including the recent QE2) is to fight the deflationary effects of banks “hording” in their reserves.
This “easing” is the printing of temporary money the Fed uses to buy securities. It hopes that money will get spent without going into excess reserves…but this is dangerous, because that extra money could cause inflation after the economy recovers.
The Fed hopes to sell those securities and destroy the money it gets back, but history says it will respond almost two years too late, leaving us suffering inflation.
So the Fed is risking dramatic inflation, in order to save us from the risk of deflation it is paying the banks to create in the first place.
Many thanks to Steve Horwitz for his feedback during the writing of this article.
They are pointing to two signs we are having bad deflation…first, the falling price of commodities like oil, and the disappearance of money in this economic failure causing demand to plunge. One of those is actually good, the other is very bad.
When prices go down naturally, because of an increase in efficiency or improvement in technology, it is good for everyone.
- Improved efficiency makes the manufacture of computers cheaper, while more advanced computers make the old versions cost less.
- Food used to take up most of humanity’s effort, therefore most of a family’s cost of living, but has declined to third or fourth place as technology and efficiency allowed us to grow more with less.
The decline in oil prices, returning to only double their normal level, will cause a good kind of global price decline, because most prices are effected by the cost of the energy required to create and deliver products and services.
But, again, those specific cost reductions are not deflation.
What Are Real Deflation and Inflation?
In real economic terms, inflation and deflation happen when the ratio of money to economic wealth changes. If the amount of money becomes greater, in comparison to the economy, then you get inflation. Because the most common result of this is for prices to increase, we confuse the terms and call general price increases “inflation”, but actually it’s the change in ratio that is inflation.
The eleven trillion-plus dollars of capital that have purportedly vanished in the past few months represent a huge decline in money supply, causing actual deflation. This failure was caused by the inability of central authority to manage money any better in the US than it could provide shoes and food in the Soviet Union.
Prices Can Increase Without Inflation, Too
Prices can actually increase for other reasons, and that’s not really inflation. For example, when oil increased 600% in price, it drove up the cost of production, without regard for the number of dollars in the economy. This general price increase was NOT inflation.
And when prices decrease for other reasons, it’s not deflation.
Inflation is Harmful
We all know that when the ratio of money to wealth increases, causing inflation, it is bad for the economy, and especially for the poor and middle classes. This is because it usually drives up prices, and the poorer you are, the more of your wealth and well-being is in cash.
Poorer people depend on cash they have in a bank, or other savings. They are paid by employers who give them only a set rate, plus raises for special reasons like increased skill.
Wealthier people tend to have more of their wealth in assets like, stocks and real estate, that will simply increase in price, sheltering them from some of the effect if inflation. They get cost of living increases in salary every year, on top of any other raises.
Deflation is Harmful, too
But the opposite kind of damage occurs if you have deflation, and is compounded by a new problem.
First, deflation artificially drives down prices. To a person with no real assets or investments, this sounds good, because “stuff costs less”.
But it comes at a horrible price.
For example, the decline in prices includes wages. Deflation is universal, with a shortage of money everywhere, so that your income will decline, along with the price you pay for things. What good is cheaper stuff, if you also have less money?
So people with fewer assets and no investments will more or less end up breaking even. But they still lose out in the end, because they become blocked from gaining assets, trapping them in relative poverty.
How Deflation Traps the Poor and Middle Class
Imagine you’re buying a house. Not on a sub-prime loan, but one where your income is perfectly fit for the home you’re getting.
It’s probably a thirty year loan. So you’re going to be stuck paying on the original price of your house, for thirty years, at the original size of house payment.
Now remember that your income (in dollars) is getting smaller every year. That’s deflation.
And the price of your house, too. Each year, its is worth fewer dollars, yet your original debt is the same. And so are your payments.
Within just a few years, you are making far less money, but are stuck with the same size house payment you always had.
While you still have to pay the same percentage of of your paycheck income for food, electricity, and so on, your house payment takes up a higher percentage of that money every year.
Soon, your income has shrunken to the point where you cannot make your house payment at all. Not even if you paid your whole check to the bank every week.
And worse, you can’t simply sell his house to get out of it. The price of your house has also declined every year. Selling it now that the payment is too high won’t even pay off your remaining house debt.
Of course people would quickly learn this, and that they simply cannot buy houses, unless they are so incredibly wealthy that they can save up enough to pay cash.
But even those wealthy people who can pay cash for a house now face the situation where buying a house is a horrible investment, because the house’s value will decline, in dollars.
It would actually be better to leave the money in a vault, and rent monthly, even for a billionaire, because the money’s value increases, while the house’s price declines. One thousand dollars will be worth more next year, if you simply stick it in your mattress, than one thousand dollars worth of house will be worth in that same year.
In fact, owning land becomes a losing proposition. With even the wealthy better-off renting, who’s going to actually be the landlord?
Deflation Attacks Economic Freedom
In fact, ALL property ownership becomes punished!
With deflation, anything you buy does not just depreciate with use and age, but declines in value every year with prices, compared to if you’d simply kept the money.
Today, you could buy that console game, or car, or collectible, and then sell it on eBay a few years from now and recoup part of the cost. But with deflation, the price you recoup is even farther from if you’d kept the cash in the first place.
Deflation Destroys Capitalism
In fact (and this is where the entire economy implodes from deflation), simply holding on to your money is rewarded versus ANY investment, in a deflationary economy. If you put your money in a big ol’ vault, removing it from the economy entirely, it grows in value every year. But if, instead, you buy stocks, or invest in commodities, then your money is gone, replaced with an asset that becomes worth less every year, in dollar terms.
The growth of every business, in fact, would be undone by the rate of deflation. Now from the company’s standpoint, that is fine, because its expenses decline every year by the same amount.
But from an investor’s standpoint, a company growing at 2% per year during 3% deflation would mean you lose 1% over just stuffing your money in a safe. And yet you also risk, when investing money.
Why bother investing even in a company you think might grow at 5%, when you could have a 100% safe 3% investment in a vault under your mattress? So, really, the company facing deflation is NOT fine, because it discovers that it’s far harder to get investors. In fact, the entrepreneur who would have started that company is 3% punished each year for the effort, making him that much less likely to even bother.
With investors discouraged because of deflation, it becomes harder to create wealth. Capitalism, in fact, becomes almost impossible:
- An entrepreneur can’t get investors for his new project.
- There’s less reason to buy stocks, so companies can’t raise capital.
- You can’t get a loan to start a business, because your company’s income would decline every year, yet the loan payment would stay as large as ever.
With deflation, the very engines of capitalism all die out.
Speculation Defines Capitalism
It is the uncertain investment on the wild new idea that makes capitalism superior to central planning. Anyone can decide to invest in a “sure thing”: if that were good enough, socialism would work, because a government bureaucrat could declare money for the obvious solution. It’s diverse people choosing to risk money on many different wild ideas that lets the best solutions rise to the top.
But that very kind of capital investment, in a deflationary economy, is punished, because you get such a good deal by not investing in anything at all, but holding your money in a vault.
All of this, by the way, is aside from the additional destruction caused by the lack of downward price elasticity on many commodities and time-based investments. That’s much more arcane, but a key source of economic depression, that I’ll get into some other time.
For now, it’s enough to realize that prices being FORCED downward by deflation includes your pay, and the value of any investments you make, so that private property ownership, borrowing, and investing, in fact all capitalism, is crippled under deflation.