Deflation explained in two simple charts

The charts below come via Mish’s post today on why it doesn’t matter that Bernanke wants to eliminate bank reserve requirements. The quick answer: Greenspan already did that in 1994 when he allowed overnight sweeps on checking accounts to free them from reserve requirements just like savings accounts. In this era, banks lend first and look for reserves later.

Anyway, way back in 2007 I first became convinced that this would be a deflationary depression because of this simple equation: there was $52 trillion in outstanding debt in the US, and only (at the time) $850 billion in base money (all the “cash” that the Fed had created since it was founded in 1913). As defaults and write-downs started to reduce the amount of debt, the Fed was likely to create new money to bail out banks and monetize deficits. It was plain to see that the difference in scale betwean the two pools, debt and cash, would tip the scales in favor of deflation, along with a shift in attitude towards frugality and a new respect for the value of a dollar.

Well, here we are in 2010, and the Fed has indeed created a fresh $1.2 trillion, but the debt pile has stopped growing over the last year, even taking into account the massive issuance of treasury debt. This chart comes from Karl Denninger:


I suspect that if properly marked to market, the private debt figures (household, business credit and financial instruments) would be considerably lower. There is a lot of pretending going on at banks, since they do not want to take write-downs. How much of that household credit card and mortgage debt will really be paid off?How much of those financial instruments are junk (and even investment-rated) bonds that will be defaulted on in the next few years? How many business loans are in arrears or just barely being made?

On the other side of the equation, here is the base money supply since 1999:


If reserve ratios mattered, wouldn’t debt have at least doubled (or more if you believe in the multiplier effect)? The fact is, nobody who can handle a loan wants one, and nobody who wants one can handle it.

Credit conditions and risk appetite are what drive lending, not reserves. Banks simply don’t hold reserves anymore, which is why bubbles get so out of hand and why they are always a few bad loans away from bankrupcy. If bankers’ asses and depositors’ funds were on the line like in the 1800s, you better believe banks would hold reserves. Depositors would sniff out those that tried to scimp, and take their funds elsewhere, nipping any trouble in the bud. Busts were frequent and localized, and freed up capital for productive hands. That’s why that era produced the greatest improvement in living standards and real GDP growth of 3-4% while prices were steady to falling for decades.


Here’s another chart that shows our state of debt saturation from Nathan’s Economic Edge. GDP no longer grows with debt — this is the point of no-return where interest can no longer be serviced with production, so the whole thing starts to collapse.

A little anti-bankster populism is apparently a grassroots movement to inspire people to withdraw their savings from the powerful mega-banks and to deposit it in local institutions. The premise is that the big boys blew the bubble and that the little guys sat out the craziness.

It is true that the largest banks are some of the highest-leveraged, that they have benefitted the most from government and central bank actions, and that many of their executives are nefarious bastards, but it is by no means a given that community banks are safer. In fact, these are being put down by the FDIC at the rate of several a week (the announcements come out late on Fridays). Check out this list of Texas ratios here before deciding to trust any bank. It is just the nature of fractional reserve lending that virtually all modern banks operate from the get-go in a state of insolvency, since they lend out money that they do not have. This is the very source of the inflation/deflation (or “boom-bust” or “business”) cycle.

It is not right, but certain institutions like JP Morgan will be the very last to disappear, since the government and Federal Reserve were created by big banks, for big banks. In fact, I would consider JP Morgan to be the safest place to stash cash in the US aside from a Treasury-only money market fund or Treasury Direct. If JP Morgan goes under, that means the government won’t be far behind. Don’t hold your breath. Anyway, this video makes for good holiday viewing:


For more on fractional reserve lending, central banks and moral hazard see:

In praise of bank runs; the only regulator we need

A crash course on the banking cartel

Greenspan was framed! Blame bankers’ moral hazard, not their lackey.

Capitalism needs failure, say winning fund managers

Kevin Duffy and Bill Laggner are acquaintances of mine who run the Bearing Fund, which returned high double digits for its investors in 2008. Their moral and economic philosophy is grounded in the Austrian understanding of the credit cycle and the parasitic role that government plays in today’s economy. I highly recommend an interview with them in this week’s Barrons (subscription only). Here are some excerpts:

Duffy: Any healthy system needs a way to correct error and remove waste. Nature has extinction, the economy has loss, bankruptcy, liquidation. Interfering in this process lengthens feedback loops. Error and waste are allowed to accumulate, and you ultimately get a massive collapse.

Capitalism is primarily attacked by two groups: utopians who wish to impose a more “compassionate” system, and political capitalists who want to enjoy the fruits of success without bearing the pain of failure. They use the coercion of the state to gain privileges, at the expense of everyone else.

As a country we’ve become less tolerant of economic failure. The result has been a series of interventions, such as meddling in the credit markets, promoting homeownership and creating a variety of safety nets for investors. Each crisis leads to an even greater crisis. The solution is always greater doses of intervention. So the system becomes increasingly unstable. The interventionists never see the bust coming, then blame it on “capitalism.” …

Laggner: AIG made sure its creditors received 100 cents on the dollar. Essentially you have the socialization of risk, but the survivors are still highly leveraged. There is still a multi-trillion dollar shadow banking system that FASB [the Financial Accounting Standards Board] wants to address next year. The central planners have already spent $3.15 trillion on various bailouts, credit backstops, guarantees, etc., and given approximately $17.5 trillion of government commitments, etc., while allowing many of these institutions to remain in place, with the same people running them…

Barron’s: What kind of financial reform would you like to see?

Laggner: We don’t believe in a central bank. The idea that banks can speculate with essentially free money from the [Federal Reserve], which ultimately is the taxpayer, and that when they lose money the Fed bails them out and then passes that invoice to the taxpayer — that whole model is broken and needs to go away.

Duffy: To get to the heart of the problem, we need to address fractional-reserve banking, which is causing the instability. We have essentially socialized deposit insurance and prevented the bank run, which used to impose discipline on this unstable system. At least it had some check on those who were acting most recklessly. Until we address the root of the problem, we are going to have a series of crises, greater responses and intervention, and more bubbles — and the system will keep perpetuating itself.


The whole system is broken and needs to go away. We can only hope that this depression fosters that end, though the actors that control the guns (i.e. government) will use all of their wiles to hold onto their racket.

Yes, the 1700s and 1800s had their booms and busts, but the 200 years leading up to the first world war saw the greatest improvement in living standards that the world has ever seen. The industrial revolution and development of modern communications, medicine and transportation happened on the gold standard, with non-existent or non-interventionist central banks and governments that allowed busts to clear away mal-investments and bad debts so that the market could guide capital and labor into productive hands.

Nobody back then believed that consumption and “stimulous” could generate anything but debt and waste. Since the ruinous economic policies of the 20th century took hold, we have been squandering our wealth and merely coasting on technological improvements, which government only impedes in a thousand ways.

In praise of bank runs, the only regulator we need

Graphite here. Mike has asked me to join up as a guest blogger, and since I’ve always loved the spirited mix of finance, politics, and righteous anger of The Sovereign Speculator, I’m happy to come aboard.

If you needed another sign that this deflationary crash is just getting started, take a look at this blog post over at The Baseline Scenario. It’s stunning that in August 2009, with the FDIC in a state of de facto bankruptcy, anyone can write “the FDIC works” with a straight face. Just because it’s not the kind of horrible fascist “solution” that the current pack of knaves in Washington would pursue, doesn’t mean it’s some kind of brilliant idea.

The FDIC’s explicit purpose is to bail out imprudent depositors at the expense of prudent ones. If it wasn’t for the FDIC, all those people strutting into Corus’s Chicago branches to put their money in CDs yielding 0.25% more than the competition might have been just a little bit more concerned that it was going to fund condo development projects in Florida. Instead, they got a free lunch — why look at where your money’s going when Uncle Sucker (sorry, Sam) gets to eat the losses?

The idea that the FDIC “self funds” out of the banking system is nothing but a polite fiction. It has nearly always had to rely on taxpayer bailouts when resolving banking crises. Meanwhile, the banks that stayed prudent, made reasonable loans, and kept their reserve deposits in more liquid holdings are being slammed with huge assessments and fees, which are preventing them from recapitalizing themselves or offering better rates to their customers — in effect, spreading the stress and weakness of America’s worst banks to its best ones.

Yeah, this is a great solution to the problem of bank runs. Let’s see what happens when we really do get a full banking panic and the FDIC needs to go draw on its $500 billion line of credit with the Treasury. If you think that story ends with American depositors happily riding off into the sunset with their cash, I’d love to have some of whatever you’re smoking.

People talk about bank runs as though they’re some kind of unmitigated evil, just because some people lose money. As a matter of fact, they impose discipline and order on both banks and depositors, and ensure that the banking system as a whole remains diverse and resilient to major shocks. The moral hazard created by the FDIC was one of the most important drivers of the concentration of deposits at a few mega-banks, which (all carping about the “unregulated shadow banking system” notwithstanding) were the primary source of the awful lending binge which precipitated the credit crisis.

Look for a bottom after people finally start to dismiss, ignore, and ridicule the FDIC and its absurd apologists.

Hugh Hendry walks around China

Hendry is the founder of Eclectica Asset Management.

“Who is going to pay the debt that that building is resting on? …A building with no tennants. Half a billion dollars of someone else’s liabilities.”

“…very expensive, empty building where the developer went bust.”

“I haven’t seen any sign of a manufacturing base anywhere close to here.”

Two contemporary libertarian greats talk about the crisis.

Mises Foundation founder Lew Rockwell interviewed blogger Mike “Mish” Shedlock on his podcast series:

Link here.

Topics include bailouts, ‘stimulus’ plans, the benefits of deflation, and Mish’s campaigns to end bailouts and abolish the Fed.

Mish is really pushing hard politically. I’m 100% behind him, but I worry a bit about how the gangsters might respond to him now that he is getting so popular.

Also check out Lew Rockwell’s podcast archives and look for Jim Rogers’ interview yesterday.

PS — Sorry again for the lack of posts. I’ve been a bit unsettled of late, having been in the middle of a transoceanic move.

Lending won’t stop if banks go under.

The Journal has a story about a venture-funded alternative lender called On Deck Capital that extends credit to small businesses, many of whom don’t qualify for bank loans at the moment. Interest is high, at 18+ percent, but that sounds about right considering the risks of lending to small companies in this environment.

This business model reminds me of person-to-person loan companies such as Prosper Marketplace, Inc., where savers are matched with lenders through an auction process.

No fractional reserve lending.

The beauty of these lenders is that they can’t create money out of thin air like the banking cartel. Every penny they lend out was earned and saved by someone, either the investors in the venture fund that backed On Deck or the very individuals who find borrowers on These companies do not create fake credit like banks, but simply fulfill the proper role of intermediaries.

No moral hazard.

The president of Chemical Bank, George Gilbert Williams, credited “the fear of God” for the bank’s continued ability to satisfy withdrawals with gold coin through the panic of 1857*. Without the FDIC or Fed to bail anyone out, lenders have to be very careful about each loan. In such a free-market system, lenders’ fear of losing their own money prevents bubbles from being blown. Without the explicit or implicit promise of bailouts, there is no need for them.

Market rates.

If all the fractional reserve banks in the world were to fail tomorrow, and the Fed and FDIC were abolished, all kinds of new lenders would crop up, offering everything from high-yield consumer credit to asset-backed trade loans to mortgages. The interest rates would be set by market forces, which is to say that they would be high at the moment to reflect risks. Only very strong borrowers could secure loans, and the weak would have to de-lever or fold.

Savings encouraged.

Without the fear of inflation, but with strong deflation, savings would be encouraged. More and more of those savings would be lent out as the bust ran its course and risks were better balanced against rewards, in no small part because asset prices would be much lower.

Unfortunately, nobody seems to understand such simple logic these days, and Bernanke’s models say that inflating away savings to prop up the insolvent is the way to prosperity. We’ll see who is right.


*Page 112, Money of the Mind, by James Grant.

Real credit vs. fake credit.

The essence of why bailouts will only deepen our problems is that real credit cannot be created out of thin air. This counterfeit operation is what caused the bubble to begin with, and by trying to put out a fire with gasoline, Bernanke, Congress and Obama are going to burn down the whole city.

Frank Shostak, the Chief Economist at M.F. Global, knows a thing or two about economics, which is not something you can say about many of today’s economists. The Mises Institute website publishes this essay of his on credit, which illustrates the critical identity between savings and investment, and the proper role of banks in an honest system.

Central-bank policy makers have said that the key for economic growth is a smooth flow of credit. For them (in particular, for Bernanke) it is credit that provides the foundation for economic growth and raises individuals’ living standards. From this perspective, it makes a lot of sense for the central bank to make sure that credit flows again.

Following the teachings of Friedman and Keynes, it is an almost-unanimous view among experts that if lenders are unwilling to lend, then it is the duty of the government and the central bank to keep the flow of lending going. …

It is true that credit is the key for economic growth. However, one must make a distinction between good credit and bad credit. It is good credit that makes real economic growth possible and thus improves people’s lives and well-being. False credit, however, is an agent of economic destruction and leads to economic impoverishment.

Good Credit versus Bad Credit

There are two kinds of credit: that which would be offered in a market economy with sound money and banking (good credit); and that which is made possible only through a system of central banking, artificially low interest rates, and fractional reserves (bad credit).

Banks cannot expand good credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (lenders) to borrowers. To understand why, we must first understand how good credit comes to be and the function it serves.

Consider the case of a baker who bakes ten loaves of bread. Out of his stock of real wealth (ten loaves of bread), the baker consumes two loaves and saves eight. He lends his eight remaining loaves to the shoemaker in return for a pair of shoes in one week’s time. Note that credit here is the transfer of “real stuff,” i.e., eight saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes.

Also, observe that the amount of real savings determines the amount of available credit. If the baker had saved only four loaves of bread, the amount of credit would have only been four loaves instead of eight.

Note that the saved loaves of bread provide support to the shoemaker, i.e., they sustain him while he is busy making shoes. This means that credit, by sustaining the shoemaker, gives rise to the production of shoes and therefore to the formation of more real wealth. This is a path to real economic growth.

Money and Credit

The introduction of money does not alter the essence of what credit is. Instead of lending his eight loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for eight dollars and then lend those dollars to the shoemaker. With eight dollars, the shoemaker can secure either eight loaves of bread (or other goods) to support him while he is engaged in the making of shoes. The baker is supplying the shoemaker with the facility to access the pool of real savings, which among other things includes eight loaves of bread that the baker has produced. Note that without real savings, the lending of money is an exercise in futility. …

The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker. …

Despite the apparent complexity that the banking system introduces, the act of credit remains the transfer of saved real stuff from lender to borrower. Without the increase in the pool of real savings, banks cannot create more credit. At the heart of the expansion of good credit by the banking system is an expansion of real savings.

Now, when the baker lends his eight dollars, we must remember that he has exchanged for these dollars eight saved loaves of bread. In other words, he has exchanged something for eight dollars. So when a bank lends those eight dollars to the shoemaker, the bank lends fully “backed-up” dollars so to speak.

False Credit Is an Agent of Economic Destruction

Trouble emerges however if, instead of lending fully backed-up money, a bank engages in fractional-reserve banking, the issuing of empty money, backed up by nothing.

When unbacked money is created, it masquerades as genuine money that is supposedly supported by real stuff. In reality, however, nothing has been saved. So when such money is issued, it cannot help the shoemaker, since the pieces of empty paper cannot support him in producing shoes — what he needs instead is bread. But, since the printed money masquerades as proper money, it can be used to “steal” bread from some other activities and thereby weaken those activities.

This is what the diversion of real wealth by means of money “out of thin air” is all about. If the extra eight loaves of bread aren’t produced and saved, it is not possible to have more shoes without hurting some other activities — activities that are much higher on the priority lists of consumers as far as life and well-being are concerned. This in turn also means that unbacked credit cannot be an agent of economic growth.

Rather than facilitating the transfer of savings across the economy to wealth-generating activities, when banks issue unbacked credit they are in fact setting in motion a weakening of the process of wealth formation. It has to be realized that banks cannot relentlessly pursue unbacked lending without the existence of the central bank, which, by means of monetary pumping, makes sure that the expansion of unbacked credit doesn’t cause banks to bankrupt each other.

We can thus conclude that, as long as the increase in lending is fully backed up by real savings, it must be regarded as good news, since it promotes the formation of real wealth. False credit, which is generated “out of thin air,” is bad news: credit which is unbacked by real savings is an agent of economic destruction.

Fed and Treasury Actions Only Make Things Worse

Neither the Fed nor the Treasury is a wealth generator: they cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot increase lending unless the pool of real savings is expanding. On the contrary, the more money the Fed and other central banks are pushing, the more they are diluting the pool of real savings. …

If the pool of real savings is still growing, then doing nothing (and allowing the interest rate to reflect reality) will allow the recession to be short lived and economic recovery to emerge as fast as possible. (At a higher interest rate, various bubble activities will go belly up. As a result, more real savings will become available to wealth generators. This in turn will work towards the lowering of interest rates.)

We suggest that decades of reckless monetary policies by the Fed have severely depleted the pool of real savings. More of these same loose policies cannot make the current situation better. On the contrary, such policies only further delay the economic recovery.

By impoverishing wealth generators, the current policies of the government and the Fed run the risk of converting a short recession into a prolonged and severe slump.

If Princeton and the rest weren’t run by fools and knaves, this is the kind of thing they would be teaching, not Bernanke’s brand of institutionalized theft.

I recommend reading Shostak’s whole essay. Click around the Mises site while you’re there. It is a wonderful resource for real economics, the kind that can make you money. The Rothhbard and Mises files would be good places to start.

What bankers’ plot? Greenberg, Fuld, Cayne, Blankfein among biggest losers.

Those crowing about sinister machinations by the banking cartel to topple world finance, buy up the scraps on the cheap, and set up a dictatorship while they’re at it are overestimating today’s financial honchos. Morgan and Rockefeller were the real deal, but these guys are just amateurs. Do these look like the spoils of a successful machination?

  • Dick Fuld’s Lehman shareholdings went from $1.2 billion to under $500k (Bloomberg). He was paid a total of $168.5 million from 2005 to 2007 for destroying the company, but after NYC and federal taxes, his real take-home pay was under 100M. Cool-Aid drinker that he was, how much of that has since been spent or lost in bad investments?
  • Jimmy Cayne’s stake in Bear Stearns, once a cool $1 billion, sold for $61 million in March.
  • Lloyd Blankfein’s 1.64 million Goldman shares have gone from $410 million to $164 million (and falling) within the last 12 months, but at least he has been taking home $50 million bonuses lately.
  • Last but certainly not least, the venerable Hank Greenberg has gone from mega-wealthy to just plain rich. Yahoo! Finance reports that he holds roughly 12.8 million in AIG stock, which would have gone for over $900 million last year, but today would fetch under $30 million. Bloomberg has a higher figure, counting controlled entities that collectively seem to have lost nearly $24 billion since AIG peaked at over $70 per share. My last quote was $2.25, putting the present total at well under $1 billion.

The US financial system is indeed corrupt and anything but a free market. Bankers do have politicians and regulators (such as Fed chairmen) in their pockets, but the boom-bust cycle is not intentional. It is the inevitable but unintended result of very narrow, short-term interests run wild. Bankers have bought from the government a license to inflate (most inflation is due to credit), and the fraud of fractional reserve lending with socialized risk always ends badly.

Most people used to understand that only gold and silver were money, and that paper promises (aka ‘notes’) could only create phoney wealth and depressions. Maybe parts of this latest lesson will take, but I’m not holding my breath.