Things fall apart, the center cannot hold

Let no man deceive you with vain words.

By Greg Nyquist

During the nineties, financial gurus and other palpable frauds were fond of trying to predict what the Next Big Thing would be. Back in the eighties it was junk bonds and real estate; but the savings and loan debacle, accompanied by a dramatic fall in real estate values, ruined all that. In the mid-nineties it was tech stocks, the Internet, and NASDAQ. But that, too, went the way of dodo. Then it was the Stock Market in general or what was left of it after the dotcoms blew up; but that didn't last long. Nowadays it's real estate and mortgages; but who believes that will go on much longer? There are constant attempts to get consumers and investors hyped by this or that product or scheme. Yet there is rarely any real conviction about the business. A mere desperate gambit is about the size of it. Indeed, we have had so many Next Big Things in the last few years that no one has any faith any more. Even those who try to hype this financial scheme or that economic panacea can muster only an histrionic enthusiasm for the object of their fancy. There is no depth to their conviction; they believe because it is in their self-interest to believe, not because there is anything to it.

This lamentable lack of faith is entirely unwarranted. All the pessimism and investment doldrums notwithstanding, there is something on the horizon that will almost definitely become the Next Big Thing. What can this most auspicious of developments possibly be? Why, it is nothing less than our good friend Mr. Chapter 11, otherwise known in ordinary parlance as bankruptcy or going belly-up. Already, in the last few years, we have seen an impressive growth in this sector of the economy. Just in the last two years, more than 150 of the nations largest public corporations have filed for Chapter 11. Given the extraordinary high level of debt that exists in America, there is every reason to believe that this trend will continue well into the year 2003, if not beyond. 

For something to last for more than a few weeks or months, the sources that fuel it must be stocked. The source of bankruptcy is debt. As long as America continues to be blessed with ample reserves of debt, the bankruptcy boom can continue to flourish. In the last four years or so, credit growth (which is just debt growth looked at from the other side of the ledger) has ballooned by almost $10 trillion. Total credit now stands at over $30 trillion.  In that same period of time, business debt has increased to $7 trillion, household debt to $8.2 billion, and State and Local Government debt to a measly $1.5 trillion.

This enormous mountain of debt has already begun to pay huge dividends. The fiscal year 2002 was a great year for bankruptcies. The Administrative Office of the U.S. Courts reported more bankruptcy filings in the last fiscal year than at any other time in history. Although 2001 was a record year for monetary insolvency, bankruptcies have risen more than 15 percent over the course of 2002. 

There is every reason to believe that this trend will accelerate in 2003. Why? Largely for one reason, a reason described by the most frightening word in contemporary economics, the infamous D-word: deflation. Ever since the triumph of the Keynesian Revolution in economics, there has been little fear of deflating prices. Most economists have for many decades believed that a general and widespread fall in prices over the economy at large is nearly impossible. Thus we find Federal Reserve Governor Ben S. Bernanke opining that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. What are Dr. Bernankes two reasons? His first reason is the alleged resilience and structural stability of the economy itself. Now it is all very good to say nice things about the economy, but such a reason merely assumes the very point at issue. It is sort of like replying to a charge of dishonesty: Well, so-and-so cannot be dishonest because he never tells lies. Yes, but isn't that the very point at issue?  To say that deflation cannot happen because of the resiliency and structural stability of the economy itself is really no different from saying deflation cannot happen because it cannot happen. The pessimists who keep bringing up the specter of deflation do so precisely because they hold that the economy is not as resilient and structurally stable as banking authorities and the financial media would like us to believe. And to make their case, these pessimists need only note what has happened to the Stock Market in the last two years, along with the massive increase in debt and the money supply.

To be entirely fair, Dr. Bernanke does attempt to give several reasons for his touching faith in the resiliency and structural vitality of the American economy, but they are all lame and very little to the purpose. The economy, the professor tells us, has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow. Has it really? Try telling that to all those investors who lost close to everything in this current bear market. Those who have lost most of their retirement pensions may not find the economy's ability to withstand shocks of all kinds to be so very remarkable. Yet this is not the only reason to object to Dr. Bernankes argument. The economy may be as remarkable as you like; but that says nothing against the possibility of deflation. Suppose upon a visit to a friend's house, you notice your host's poodle walking around the house on its hind legs. Suppose further that you express skepticism regarding the animal's ability to remain on his hind legs indefinitely. What would you think if your friend countered by suggesting that the animal's remarkable ability to absorb all kinds of shocks and other threats to his balance means he'll never come off his hind legs? This contention is not a whit more convincing than Dr. Bernankes concerning the American economy. Sure, the fact that we have not had a major disturbance in the economy is in fact most remarkable. But it is remarkable for other reasons than what Dr. Bernanke has provided. Any economy as overloaded with bad debt as this one should have blown to pieces a long time ago, and the fact that it hasn't is the only thing remarkable about it.

Dr. Bernanke puts forth the strength of our financial system as another of his reasons for regarding the threat of deflation as virtually nonexistent. This is so laughable that it hardly requires comment. Where has Dr. Bernanke been the last ten years? Can we describe a financial system that has helped make the United States the greatest debtor nation in the history of the world a strong one? The good professor apparently is not familiar with recent statistics on business and personal debt, because we later find him suggesting that firm and household balance sheets are for the most part in good shape. Reading this, one begins to wonder how such a man becomes a Federal Reserve Governor. Since when has ignorance of basic economic facts been a prerequisite for election to the Federal Reserve?

But all this is nothing compared to Dr. Bernankes second bulwark against deflation. I quote the passage in full to avoid any possible befuddlements:

The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.

And what are these policy instruments? Dr. Bernanke does not hesitate to enlighten us. "Under a fiat (that is, paper) money system, a government ... should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero."

Dr. Bernanke develops this basic premise as follows: The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. [http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm]

In other words, Dr. Bernanke is arguing that deflation is no threat to the economy because we can easily inflate our way out of it. "If we do fall into deflation ... we can take comfort that the logic of the printing press ... must assert itself, he goes on to assure us, and sufficient injections of money will ultimately always reverse a deflation."

True enough, inflating the money supply would ultimately reverse the deflation. But so would doing nothing. Ultimately, any bad thing will pass. But that is little comfort to those who are maimed or destroyed in the meantime. The real question is whether having a fiat money system can prevent or significantly mitigate the effects of a sudden and drastic deflation. Dr. Bernanke, along with most of his colleagues at the Fed and within academia, appear to think so. They have all succumbed to the influence of the economist Milton Friedman, who, in his Monetary History of the United States, argued that the Great Depression was caused by the Feds refusal to provide sufficient liquidity to prevent a calamitous contraction in the money supply. Not only Dr. Bernanke, but even Alan Greenspan himself, appear to have bought into Friedman's thesis without a trace of misgivings. They all believe that fiat money can more or less make an economy deflation-proof.

But it just isn't so. If the principle method by which the money supply is inflated involves the expansion of credit (which is the case here in America), then any inflationary policy must ipso facto be a policy of debt expansion, since any expansion of debt must involve, as the flip side of the equation, an equal expansion of debt.  At a certain point, inflation via credit expansion creates a debt so large that many debtors cant help but default.  When these debts are written off, the money supply contracts.

If the debts could be liquidated little by little, perhaps no harm would occur. But that is not how it always works. When an economy is in over its ears in debt, debtors become increasingly dependent on other debtors. Peter's ability to repay his debts to Paul depends on Sam's ability to pay his debt to Peter; so that if Sam can't pay Peter, all three are ruined. Now imagine an economy where hundreds of debtors depend on each other to remain solvent, so that if one goes down, the whole lot of them must go down.  This is roughly the situation we are facing in regards to some of our major financial and banking corporations. What if tomorrow we suddenly learned that JPMorgan had gone completely bust? What kind of shockwave would such a catastrophe send through the entire economy? If, as is not improbable, there exist other important companies that rely on JPMorgan's ability to pay for debts owed or services rendered, would they end up going belly-up as well? Where would the domino effect cease in its reckless rampage through the economy? How many companies would fall as a result of the fall of one company?

No one of course has any idea. The earthquake is not satisfied at once. The economy managed to survive Enron's debacle, but who is to say it could weather the fall of a JPMorgan or a Citicorp or a Goldman Sachs? 

The situation is made even more precarious by the widespread use of derivatives as a kind of makeshift insurance policy. Firms routinely make contracted bets with speculators in order to hedge possible losses in investments. If company A loses on its investment in tech stocks, speculator B agrees to make up part of the loss. In return, B gets to pocket a specified amount if company A profits from its tech stock investment. This financial gimmick is looked upon as an insurance policy that makes investment safe, by passing risk to those who are more willing to take them. Yet there is one problem in the logic of the scheme. What if investments in general go into the tank? Where are the holders of these derivatives, these speculations on disaster, going to find the ready cash to pay the compensation fees when an entire economy goes into the tank?

The logic behind using derivatives as insurance against failed investments is clearly a dubious one. In the first place, the rational use of insurance can only be extended to matters that involve a calculable risk, such as life expectancy or the odds of a particular individual getting into an auto accident. The statistical rates of such events are fairly uniform over time, making it possible to determine with a fair measure of accuracy the risk of insuring an individual's car or his life. Entrepreneurial investment, on the other hand, involves few, if any, calculable risks. No one really knows ahead of time which investments will pan out and which wont. To calculate the risk for such activities is like trying to hit a moving target in the dark.

Imagine if everyone could get cheap unemployment insurance from private companies. What would happen if there was suddenly a depression with mass unemployment? Would the insurance companies be able to meet their obligations? Of course not. Yet this is not the only bad consequence of such a scheme. If everyone believed they had viable unemployment insurance, they would tend to behave with far less prudence. No one would ever save for a rainy day, because they would all believe that even if the worst happened and they wound up losing their jobs, they could always fall back on their unemployment insurance. The existence of such insurance would encourage reckless and irrational decision-making, thereby increasing the odds of the very type of economic catastrophe against which the insurance would prove useless. 

Very much the same effect is produced by the investment insurance provided by derivatives, only it is much worse. Investing is inherently risky and hazardous even when conducted with the greatest prudence and circumspection. Derivatives have served merely to give investors the illusory sense that the dangers of speculation are much less than they really are. What little sense of caution existed before has now been tossed aside, as investors enter one dubious scheme after another, hardly thinking twice about what they are doing. This has significantly worsened the problems created by credit and debt excess.

If one major financial corporation were to go bust, we would not merely have to worry about its creditors, who might also go bust, but also the holders of derivative securities, who would suddenly find themselves owing millions of dollars and not having any means by which to meet their obligations. The domino effect initiated by a handful of defaulters could be little short of apocalyptic in its scope and extent. 

These massive debt defaults are what would bring about the deflation. Just as credit expansion creates money out of thin air, so the consequent debt contraction causes money to vanish back into nothingness.  During the Great Depression, massive liquidation of bank loans caused the money supply to contract by a third, despite efforts to pour liquidity into the system. This happened despite attempts by the banking authorities to inflate the money supply. The economist Benjamin Anderson, in his monumental Economics and the Public Welfare, explains how it all happened. Late in December, 1929, one found the conviction among [the few responsible men in the Federal Reserve System] that monetary ease would have to wait for a substantial liquidation of the volume of bank credit outstanding. We were strong enough at that time to have gone through an orderly liquidation. But early in 1930 Federal Reserve policy quickly veered in the other direction, and the purchase of Government securities was resumed. [In other words, the Fed followed an easy money policy, pouring liquidity into the banks.] The Federal Reserve System was gambling, using dangerous devices to stave off an unpleasant liquidation, and hoping for a return of the prosperity which was just around the corner. [Sound familiar? The Federal Reserve has followed a very similar policy in the last two years.] They succeeded in making money cheap. They succeeded in bringing about a further expansion of bank credit against securities. [263]

This policy, however, failed to prevent what Anderson calls The Great Liquidation of Bank Credit.   Between June 30, 1931, and December 31, 1931, the deposits of the member banks of the Federal Reserve System dropped $5,522,000,000, while the loans and investments dropped $3,347,000,000.  The process of liquidation went further in the months that followed. [268] This led to massive bank runs and bank failures. About 10,000 banks closed their doors between 1929 and 1934. The Feds easy money supply failed to prevent the catastrophic deflation that ravaged the economy in the early thirties.

There is a very elemental reason why this is so. Economists like Milton Friedman place far too much weight on the quantity of money and credit. But quantity of money and credit are less important than quality of money and credit, wrote Anderson. [272] And if the quality of money and credit is poor, increasing it won't make it a jot better. It will, if anything, only make things worse.

The quality of credit nowadays is very poor. It is poor because there is too much of it and one major defaulter could set off a chain of defaults. If this happens, we will have deflation regardless of how much liquidity is pumped into the banking system. Given the circumstances we are in, this thing must happen in the next few months or years. There is no way of evading it. Perhaps it can be postponed. But that is all. It will happen. The womb of time will deliver it, despite all our attempts to abort the calamity. See Chart, Quality of Credit

As further evidence that this is so, consider the fact that even the banking authorities themselves are beginning to worry about it. Thus we find Alan Greenspan, in his last public speech, noting [http://www.federalreserve.gov/boarddocs/speeches/2002/20021219/default.htm] that recent experience ... has stimulated policy makers worldwide to refocus on deflation and its consequences, decades after dismissing it as a possibility so remote that it no longer warranted serious attention.

Greenspan, in this speech, was quick to assure his audience that the United States is nowhere close to sliding into a pernicious deflation; however, the subtext of his remarks seemed to suggest these words were only inserted to prevent a panic.  After all, if Greenspan came out tomorrow and announced that a catastrophic deflation was all but inevitable, his very words would become a self-fulfilling prophesy.  Because of his position, he can never tell America what is really going on. At best, he can merely hint at it. His latest hint appeared at the very beginning of his speech. Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800, he remarked before the Economic Club of New York. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent over-issuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.

This is a strange way to begin a speech about deflation and economic bubbles. Greenspan further argues, just as oddly, that the attempt in the last twenty years to reverse excesses of fiat currency and chronic inflation have brought about the very bubbles that have plagued us during his reign as chairman of the Fed. 

The conditions of extended low inflation and low risk were combined with breakthrough technologies to produce the bubble of recent years.... [I]t seems ironic that a monetary policy that is successful in inducing stability may inadvertently be sowing the seeds of instability associated with asset bubbles. I trust that the use by the central bank of deliberately inflationary policy as protection against bubbles can be readily dismissed. While the current episode has not yet concluded, it appears that, responding vigorously in a relatively flexible economy to the aftermath of bubbles, as traumatic as that may be, is less inhibiting to long-term growth than chronic high-inflation monetary policy. Moderate inflation might possibly inhibit bubbles, though at some cost of reduced economic efficiency. However, I doubt that such policies could be sustained or well-controlled by central banks. Among our realistically limited alternatives, dealing aggressively with the aftermath of a bubble appears the most likely to avert long-term damage to the economy.

This is largely an apology for Greenspan's own policies over the last decade or so. But it is not an entirely accurate picture of what has occurred. It is simply not true that the Fed has pursued a policy of induced stability and low inflation. Granted, there has not been much price inflation of consumer and producer goods in the last twenty years. But there has been plenty of inflation in asset and real estate prices; and it is this inflation that has brought us to the present crisis.

Given Greenspan's background in free market and monetary fundamentalism, one wonders if he really, in his heart of hearts and mind of minds, believes what he says. Or does his remark about gold, in which he compared the stability of the gold standard with the instability of fiat money, come closer to what he really believes? Of course, it goes without saying that no Chairman of the Fed can ever come out in favor of the gold standard. But why then do we find occasional hints in Mr. Greenspan's speeches that the gold standard was, in many respects, superior to a paper one?

In any case, Greenspan's decision to talk about deflations and bursting bubbles shows that the issue is clearly on his mind. And why would it be on his mind unless he believes it to be a real possibility (his remarks to the contrary notwithstanding)?  There is no way to get around it. The deflation is coming. All the best economic minds know it. True, the best economic minds constitute a select minority, but that is the way it always has been. There are only a few people who at any moment in history have any notion of what is really going on. The rest merely follow whatever illusory bilge happens to pass for correct thinking at that moment in the human comedy. 

The correct thinking nowadays is all on the side of the Dr. Bernankes and other shallow pedants who believe that deflation is more or less impossible under a fiat money system. We'll simply inflate our way out of it, they insist. Easier said than done. It is not as if the deflation will be so courteous as to announce its arrival. It will come when least expected and precisely at the moment when the banking authorities are least equipped to deal with it. When the debt liquidation dominoes begin to fall, there will be no stopping it with a sudden influx of inflationary credit. Again, to repeat what was said earlier: it is the quality of money and credit, not the quantity, that is critical. "In 1930 and the first half of 1931, there was no shortage of bank reserves. There was, however, a very serious shortage in creditworthy customers. There had been progressive questioning of individual credits," reports Benjamin Anderson, "and there had been a progressive realization of the unsatisfactory quality of a good deal of the credit, but there had been no limitation on the quantity of credit to anybody who was good. We had had, incidentally, a complete demonstration of inability of abundant and superabundant money and credit to offset deterioration in the quality of credit, and to reverse a decisive down trend in business." [264, italics added]

When the first wave of deflation hits the economy, the Federal Reserve and the U.S. Treasury will do everything in their power to inflate their way out of it. Under the influence of Friedman's monetarism, Greenspan, Bernanke, and other banking and money authorities will flood the economy with liquidity, since, as Bernanke puts it, "sufficient injections of money will ... always reverse a deflation." 

But this is not entirely true. Oh, sure, if you pour enough liquidity into a deflating economy, it will eventually come around. The trouble is, it won't happen instantaneously. Even in a normally functioning economy, there is a delay between the injection of money into the economy and the consequent price inflation. Under conditions of deflation, this delay will be even longer than normal. Keep in mind what happens in a deflation. Prices fall. Nor do they fall all at once, but little by little, in a series of peevish jumps and starts. This leads to three important consequences. In the first place, money becomes more valuable in relation to goods and services. The demand for money begins to rise as people prefer to hold money over using it to buy goods. In the second place, for the very reason that prices are continuously falling, individuals become adverse to buying anything until they believe prices have hit bottom. Why buy a car today when a month from now it will be $1,000 less? And last of all, we have the natural effect on consumer and business spending brought about by depressed economic conditions. For not only does the economy experience high unemployment, but even those who still hold on to their jobs are afraid that at any moment they may find themselves among the ranks of the unemployed. In this kind of environment, most people become adverse to buying nonessential goods and services. 

What does all this mean? Merely this: that the economic conditions create powerful incentives against spending money. So even if the authorities do succeed in flooding the economy with liquidity, this alone will not cure the deflation. The psychological aversion against spending will still exist as an aversion, moreover, which cannot be cured merely by inflating the money supply. 

This aversion has one other important consequence. The banking authorities, having no firsthand experience of deflation and regarding inflation as the ultimate panacea, will likely become very frustrated when month after month goes by and nothing happens. The danger is that, instead of waiting for the aversion against spending to diminish on its own, they will try to conquer it by literally drowning the economy in liquidity, so that when consumer confidence finally does begin to mend, spending will shoot up like a rocket, with prices jumping from the absurd lows of the deflation to absurd highs of the consequent over-inflation. 

This is no way to cure an economy already overburdened with excess debt and malinvestment. The economist Ludwig von Mises was fond of using an analogy to explain to his students the folly of trying to cure a catastrophic deflation through inflation. He compared it to running over someone with a car, and then coming to a stop, putting the car in reverse, and running them over from the other direction. Using inflation to get over a deflation amounts to pretty much the same thing. It is an attempt to use one evil to cure another. A deflation may be catastrophic, but it at least has the virtue of an emetic in the sense that it forces the economy to get rid of all that is rotten in it. But if you use a hyper-inflation to get your way out of it, you wind up destroying much of the good that comes out of the deflation without greatly reducing the calamity of the thing. If we must go through a deflation, let us at least extract whatever good can be got out of it. Why suffer for no reason at all? Let the deflation do its work to sweep away all bad business practices and malinvestment that have accumulated during the credit inflation of the last decade.

Deflation will also (as mentioned earlier) have the salubrious effect of bringing about a great many bankruptcies, thus assuring (what I contended at the commencement of this essay) that bankruptcy would most assuredly be the Next Big Thing. There is no economic condition better suited for the nourishment and proliferation of bankruptcy than a good hearty deflation. Consider what happens when the value of money increases. The value of debts also increase. In other words, deflation causes real debt (i.e., debt in terms of real, rather than nominal dollars) to rise. That $500,000 loan that Mr. Jones took out on that three bedroom house he bought in Southern California is, in real terms, now a $600,000 loan. Yet it gets even worse (or better, depending on your perspective). The value of Mr. Jones's house is, in real terms, even less. Deflation increases the amount of Mr. Jones's loan and his mortgage payment while at the same time it takes away a good chunk of his collateral value (if there was any to begin with). Could anyone think of a better way of promoting bankruptcy than this? If you were trying to spread bankruptcy on purpose, you could not come up with a better scheme.

Hence the confidence with which we can predict that bankruptcy will, in all truth, be the Next Big Thing on the economic front. If it were possible to invest in it or buy stocks or bonds in it, it would verily be the thing to do. But alas, it is not something you can get a whole lot of money out of  although certainly there will be people who will try. In a deflation, very few people make any money. But a great many people lose money. "My father hath chastised you with whips, but I will chastise you with scorpions," the Bible tells us. A deflation does even better than that: it chastises with both whips and scorpions. 

Don't say you weren't warned.

Greg Nyquist's next book will be titled Machiavellian Economics and Other Essays. He is an assistant editor at www.JRNyquist.com. In past years he was a regular contributor to WorldNet magazine, Dispatches magazine and The Final Phase Newsletter.

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