Most of the loudest critics of the Federal Reserve are aghast at Ben Bernanke’s recent interview, in which he stated that:
We’re not printing money.
The amount of currency in circulation is not changing.
The money supply is not changing in any significant way.
— Ben Bernanke, 60 Minutes Interview, December 2010
What on earth, people wonder, does he mean by that? How could he say such an obviously crazy thing?
I mean, he is spending NEW money buying up bonds and notes…everyone but Bernanke is calling this QE2 (Quantitative Easing)…and the whole point of this is to add money to the economy.
How can he say the money supply is not changing?
But he isn’t simply crazy…he means something specific, and sane (if misguided).
He means this:
Quantity Times Velocity
The real money supply is not simply the number of dollars in existence. As Nobel-laureate economist Friedrich Hayek pointed out, real money supply is really a multiplication of the amount of money, times how much the money is moving around.
(S)upply equals (Q)uantity times (V)elocity.
And right now, money velocity is as low as it’s been since the Great Depression…not surprising, since this is the first depression the US has suffered, since.
That means it’s moving very little. In fact, it’s mostly sitting around in banks, doing nothing. It is, as Bernanke implied, effectively out of circulation.
That money is as absent from the economy as if it did not exist. This is the Fed’s fault, because they started paying interest on reserves held idle right at the beginning of this depression, but that’s a separate article.
So even though we now have more Quantity than ever, it’s multiplied by an abnormally low Velocity, to the real supply is lacking.
Right now, Austrians like Hayek and socialists like Keynes would agree that our real money supply is actually at a traumatic low, because much of the quantity is sitting around, unavailable.
Let’s hear Hayek agree with Keynes, himself:
On the first issue — whether to use one’s money or whether to hoard it — there is no important difference between us. 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.
— Hayek in an open letter to Keynes, 1932, regarding how to respond to the Great Depression
Money, money, everywhere, but not a cent to spend.
Like the ocean in my favorite poet’s most famous poem, the money sitting around in banks is, ironically, unavailable for the real money supply.
Bernanke is trying to fix this, by temporarily buying up bonds and treasury notes, therefore bypassing the banks’ massive reserves, putting money directly in the economy.
For the moment, he is correct, that this isn’t boosting the real money supply, because so much of the money is lying salted in (virtual) bank vaults, useless.
Now his critics, those who know enough monetary theory to understand about velocity the way you now do, say this doesn’t matter, because eventually the velocity will recover, and then we’ll have normal velocity times much more quantity. And that would mean inflation…there’s no way around that.
Bernanke would point out, correctly, that this is not correct, either…
See, the Fed doesn’t consider the money it is printing real. It is ephemeral, temporary money, like a Virtual Particle in physics…popped into existence for a bit, then gone.
And this is true:
When the Fed lends money to a bank overnight, the bank is required to pay it back the next day, plus interest. The same for its more recent, unhealthy bout of lending for thirty or ninety days…after that time, the bank pays the money back, with interest.
And when that money is paid back, it literally “vanishes”, into the “thin air” out of which it was created.
For now, the banks keep re-borrowing money, keeping the extra Quantity in a cycle…but when the Fed decides things are getting better, it can start making that borrowing less desirable, so banks re-borrow less, causing the Quantity of money to decline.
When it engages in Quantitative Easing (Bernanke hates that term, and calls it Credit Easing…bureaucrats love euphemisms), the same thing happens;
The Fed buys notes, adding money to the economy…but later it can SELL those notes, and destroy the money paid for them. It will probably sell them at a higher price than it bought, allowing it to actually destroy MORE money than it created, if it chooses.
So it could, in theory, keep the real money supply at a constant, stable level, allowing prices to be natural.
So Bernanke is Right, Everything Is OK?
The first problem is that Bernanke, and his peers, don’t understand some economic basics:
We’ve been very, very clear that we will not allow inflation to rise above two percent or less…We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time.
Now THAT is the part that makes me gasp in horror…he thinks he can stop inflation in fifteen minutes? Doesn’t he know the fishtail effect?
Bernanke’s predecessor, Alan Greenspan, and the Nobel Laureate Chicago school economist Milton Friedman, both understood that when the Fed meddles with the economy, its effects take up to EIGHTEEN MONTHS to show up.
So the day that Bernanke decides “Oh, we’ve hit two percent inflation”, he will raise rates…and then inflation will KEEP GOING UP for at least the next eighteen months.
Eighteen months is a LONG time, in economic terms.
It’s long enough that the Fed will become frantic, as its efforts fail to show any results…they’ll keep raising rates, selling notes and bonds, destroying money, until the economy finally seems to be turning around…weakening.
Then they will have overshot the actual mark by around 18 months. For the next 18 months the economy will KEEP getting worse, KEEP getting slower, until it enters into a recession. Because of the amount of money the Fed bubbled in during this depression, and has to suck out, it will probably be the worst recession since the Stagflation of the late seventies and resulting recessions, which were the worst in history.
It’s like when you are on an icy road, and you try to turn…the car doesn’t respond, so you turn the wheel more, and more…by the time the car responds, you’ve turned too much. You straighten the wheel happily, but the car KEEPS turning past where you wanted. So you turn in the other direction…but it keeps turning the original direction. By the time it responds, you turned too much the other way…et cetera.
This is the source of the modern “business cycle” of recessions, that have happened since the US left the Gold Standard in the 1930s. The Fed, and the rest of government, are constantly meddling with the economy, and then discovering the damage they did when it shows up years later, then reacting to that with even more damaging behavior, back and forth in an endless cycle of unintended consequences.
Now this has, up to now, been better than the “business cycle” of depressions and panics the US suffered from 1873-1933, when the US was on a fiat gold standard. But now we’re suffering a depression, despite being off the gold standard, so that’s all out the window.
What we need, of course, is for the Federal Reserve’s monopoly dollar to be replaced by a free market in money, as Friedrich Hayek proposed.
But, failing that, we need the Fed to at least go back to mostly staying out of the economy, as Alan Greenspan tried to do, instead of constantly expanding its meddling, as Bernanke has done, helping lock us into this cycle of economic devastation.
But, unlike neocons at Fox and on the radio, and other advocates of Big Brothernment, true Conservatives have no problem at all with this, for two reasons:
First) It’s true. Bush governed like a Liberal, spending money, increasing regulations, and dragging us into a trillion dollars in wars, and then mismanaged them abysmally. Even if it is embarrassing to “our side”, we believe in supporting the truth, taking responsibility for mistakes (something Bush rarely did), and fixing problems.
Second) It’s not a condemnation of Conservatism, anyway, because Bush was so Liberal. Like neocons in general, he only talked Conservative, but when the chips were down he always turned to huge government solutions, more squandering of taxpayer money, et cetera.
It’s no surprise that we had economic and political trauma, when Bush violated Conservative principles in these ways:
- He had claimed the economy needed to be deregulated, yet he rolled out more huge regulatory schemes, even counting only his first two years in office, than Clinton did in eight…hundreds of billions of dollars in new regulations on insurance, shipping, health care, and many other industries.
- Even his “tax cuts” were mostly semi-annual welfare checks disguised as “refunds”, along with “tax credits” that are literally welfare, plus a maze of new exemptions that truly increased tax compliance cost just as much as any actual tax savings. Compare this to Reagan simplifying the tax code so much that people saved as much in compliance costs as they saved in taxes.
- His “solution” to the failure of socialized education was to break his School Choice promise and set up a massive Federal bureaucracy called No Child Left Behind.
- His response to 9-11 was to set up a police state in violation of the Constitution, to refuse Afghanistan’s offer to turn over bin Laden for war crimes trial in order to invade, and to attack Al Qaeda’s mortal enemy, Saddam Hussein.
- His promise to make Socialist Security more privatized and voluntary was abandoned because he was spending all of his political capital on a voluntary trillion-dollar set of wars.
- Speaking of socialism, until Obama’s health care plan passes (shudder), Bush’s prescription drug plan stands as the largest socialized medicine expansion in US history.
- Speaking of being more Liberal than Clinton, in EVERY SINGLE YEAR, of his eight years in office, Bush increased domestic spending more than Clinton did in his entire second term.
- His answer to Katrina was to throw $87,000,000,000 dollars at the region, that had already squandered more than the rest of the nation’s combined Army Corps of Engineers budget at NOT fixing its levees.
- His response to the economic decline was to not only increase spending above his super-Clinton levels, but to bail out companies and squander hundreds of billions on “stimulus” packages that actually depress the economy more.
Who’s seriously surprised that this kind of socialism caused an economic depression? Hoover’s big-government approach helped cause the Great Depression, and Bush’s similar approach did the same.
Real Conservatives don’t try to defend this. Instead, we say:
Yes, that’s right, Bush’s domestic policies cause economic catastrophe…so stop doing exactly the same stuff, Obama!
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.
Why does this economic downturn seem different than previous ones in our lifetime? Why does it seem familiar to anyone who is familiar with the economic history of 19th and early 20th centuries?
Because, up to the mid 1940s, the US tended to face economic depressions. Since then, we had not had one…until now.
What we are suffering, today, is an economic depression.
Sure, it had been trendy, in the last decade or more, to say “we just stopped using the D word after the Great Depression”. But, once again, anyone who knows economic history realizes there’s more to it than that.
There is no official definition of an economic depression, other than the idea that they’re worse than recessions.
There isn’t really an official definition of an economic recession, either, although the pat answer is “two quarters of GPD shrinkage”. Real economists hate that definition, because it ignores more factors than it considers, to the point of being almost useless.
But we can simply examine what were called “depressions”, from 1800 through 1938, and compare them to the recessions between 1947 and 2007, and the differences are obvious.
Each depression / panic from 1819 through 1938 shared certain traits:
A shortage of money itself, leading to
- Usually at least 2 years, as many as 23 years
- Sudden runs on banks, causing bank failures
- Commodity price collapse, where something generic like cotton, steel, oil, or real estate plunged in value, causing a domino effect that devastated the economy
- A more general decline in prices across the economy
- A collapse in capital, for example stock market collapse, once that became an important factor
- A credit freeze, making loans and other forms of obtaining temporary money more difficult
- Massive business closings
- Astonishing amounts of job loss and unemployment
Now what about the subsequent “recessions”, from 1948 through 2003?
Every one of them happened like this:
A dramatic raising of interest rates by the Federal Reserve, followed by
- Usually only a few months, rarely more than a year
- An increase in private interest rates
- An increase in unemployment
- Moderate to extreme price increases
- A plunge in the stock market and moderate tightening of capital
- Some amount of business failure
You can see examples of both recessions and depressions at the History of Economic Downturns.
What’s the Difference?
Now the most obvious difference is timespan.
During the days of economic depressions, the downturns lasted much longer. Always years, sometimes decades. Economic recessions generally only last months, rarely more than a year…the longest recession has not lasted as long as the shortest depression.
The second is that the trigger is slightly different.
Depressions were caused by a direct shortage of currency (money) in the economy. This, in fact, led to the other obvious differences, like runs on banks, mostly caused by a shortage of money making people worry about bank stability.
Recessions, on the other hand, have been preceded, in every single case, by the Federal Reserve raising rates, trying to make it harder to get new money. That’s very similar, but it leaves the financial sector able to compensate, however painfully, so that bank runs and commodity price failures never become “necessary”.
And that’s probably the next most important difference:
During the depressions, bank runs were almost universal, commodity price collapse was normal, the loss of huge numbers of jobs and businesses was a constant.
In the era of recessions, none of those things occurred at all. Unemployment, though miserable, was generally only a few percentage points higher, and while some businesses failed, nothing like the tens of thousands of the depression days, even though the economy was smaller back then.
Now, which are we seeing today?
Are We Depressed?
- Runs on banks, and bank failures
- Real estate price collapse, along with some other commodities, including many metals like gold, copper, and nickel
- The massive price inflation expected to result from high energy prices failed to materialize, representing an inability of people to pay more, even though production cost had to rise
- A collapse in capital, for example stock market free-fall
- A failure in credit, making loans and other forms of obtaining temporary money more difficult
- Massive business closings
- A rising snowball of job loss and unemployment
Well, this does indeed sound almost exactly like a depression, not a recession.
And, in fact, it was preceded by a money shortage, just like other depressions. In our case, the shortage was caused by high oil prices, two wars, and hundreds of billions in new foreign “aid” shipping trillions of dollars overseas, much faster than the Federal Reserve was creating new money. This meant that, while the surplus of foreign-based dollars caused its value to plunge compared to foreign money, here in the US there was less money available than usual.
Without as much money, we could not maintain the prices of some commodities, we became distrusting of banks, credit became scarce…ultimately, a new economic depression was natural.
Why didn’t we have depressions from 1948 through 2007?
Up to the 1940s, the US had usually depended upon gold, and sometimes silver, to back its money. It claimed you could cash in a paper dollar, any time you wanted, for gold. This meant that money was, in a sense, just a glorified form of barter for a commodity.
In those days of a gold standard, if the economy grew faster than the supply of gold, this created a shortage of money, which could only grow as fast as people could dig up gold. When the economy grew faster, the relative shortage of money would eventually force banks to close, commodity prices to plunge, prices to decline, credit to freeze, and generally the economy to grind to a halt, to wait for gold to catch up.
That ended in 1946, when the US entered into the Breton Woods agreement. This was a sort of price fixing scheme, where instead of making a dollar equal to a certain amount of gold for exchange, each government just attempted to force the price of gold to remain a certain amount, compared to its money.
This happened to coincide, exactly, to the end of economic depressions. Without money being linked to the barter of a commodity that had its own separate value and supply, it did not end up in such short demand that the whole economy would fail. The recessions that did occur were from money shortages caused by the Federal Reserve, but these could be overcome, so banks never had runs, commodity prices never collapsed, et cetera.
This became even more true in the 1970s, when even the Breton Woods agreement was ended, and the price of gold became a legitimate free market price, not a fixed one.
Why are we having a depression, today?
As I noted earlier, this is the first time since the 1930s when there was a shortage of money so grave that we stopped trusting banks, could not pay for important commodities, and so on.
This is because we sent so much money overseas, out of our own reach.
The normal money we have sent abroad for decades, because we buy goods, was actually barely enough to keep up with foreign demand for dollars…but in 2001, that began to change:
The price of oil went through the roof. At its peak, we were paying 700% of oil’s natural price. This amounted to as much as one trillion dollars leaving the US to import oil, without getting anything in return (beyond what we normally got for 1/7th the amount).
Meanwhile, we engaged in two wars, that cost hundreds of billions of dollars, much of which went to foreign countries.
And, in order to support those wars, paid hundreds of billions in new “foreign aid”, money shipped abroad with no imported wealth to offset it, at all.
This left us without enough money to simply run our own economy.
The result? Bank closings, real estate and other price failures, massive unemployment, bankrupcies, business failures…
Another economic depression.