Wednesday, December 09, 2009

Betting on inflation

Despite protestations to the contrary, the recession continues. Among those who realize the fragility of our financial system, there is no doubt that the elites have failed to produce the sustained recovery which they insist is already upon us. Playing with numbers can only do so much; in the end, the people know a recession when they are living through it. GDP means nothing to the man who has lost his job, or the housewife trying to feed her family on a salary which is losing its purchasing power. It is a matter of when--not if--the people compel their leaders to dispense with the lying.

But there is another question which is arguably more important. Will the United States experience inflation of deflation in the coming months. Most of the Austrians are in the former camp, but there are other hard money types--Robert Prechter, for instance--who find the isolationist argument unconvincing. Of course, the neo-Keynesians fear deflation above all else, and Bernanke will do his best to inflate his way out of the latest mess. The question is whether or not he will be able to do so, or if he is pushing on a string.

I want to get to an argument in favor of an inflationary scenario in a bit, but it's probably worthwhile to explain why the question is being asked in the first place. It's strange that people who agree on many aspects of economics would disagree about which scenario may be soon upon us. But with a bit of explanation, it should become apparent why disagreement exists. For more information about the topics I briefly cover below, I highly recommend Chris Martenson's Crash Course.

Due to our fractional reserve banking system, every dollar deposited in a bank need not remain in that bank; much of it can be loaned out, even if it is a demand deposit. This is the "money multiplier", which ensures that the money in circulation is far greater than that which can be returned to creditors should they attempt to withdraw their money from the bank. There is much talk about solvency, but in reality all fractional reserve banks are insolvent. This isn't problematic so long as the economy is booming, but all banks are prone to runs during bust times. The FDIC exists to insure bank deposits, so as to prevent runs, but as the FDIC is itself bankrupt, the trouble remains.

Now, when the government bails out a bank, it does so in the hopes that the bank will begin to lend out the money, thereby generating another boom. In reality, the bank knows that it is already over-extended; that many of its mortgages, for instance, are drastically over-valued and will not be paid; and that the threat of a bank run is more real than ever. Thus, rather than lend out the additional money, they keep it as a reserve, to shore up the problems which are inevitable in fractional reserve banking. This is what the deflationists call pushing on a string; no matter how much money the Fed gives to the banks, the money will not cause inflation if it sits idly rather than being lent out.

Gary North is well aware of these arguments, but he points out that the Fed can still force banks to lend, thereby causing inflation:

The FED could get every banker in the country to pull back all excess reserves ($1 trillion these days) tomorrow and lend the money. It does not have to issue an edict. It does not have to take over the banks. All it has to do is charge 10% per annum on all excess reserves. Probably 1% would do the trick...

Just raise the price of not lending until banks are fully lent out.

This argument makes a good deal of sense. The question now becomes whether or not Bernanke is liable to take such a step. In the short run--that is, until it becomes untenable to maintain the fiction that the recession is behind us--he is unlikely to do so. But given Bernanke's belief that deflation is what turned an ordinary recession into the Great Depression, it is unlikely that he will be content to allow banks to refrain from lending. I might be missing something here, but North's argument seems to lend considerable strength to the inflationary case.


Anonymous said...


troutsky said...

The question is lend for what? What is there to invest in? Employers can simply squeeze profits out of a cowed workforce.Investing in new machinery just puts more "consumers" out of work and producing anything can be done cheaper overseas. We just lost our biggest employer ( cardboard and paper mill) and company shares skyrocketed. It's game over, not inflation/ deflation.

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