Why the Bankers Are Trapped

Few seem to grasp that we have arrived at a turning point; a nation and a world confronted with extraordinary structural change.

To think of the future in terms of recovering the past will not be helpful. We must pick ourselves up, hit the reset button, and move forward in a manner that is congruent with a rapidly changing reality.

I am not a banker or economist. I cannot speak with authority regarding the fragile conditions to which we are exposed. But neither am I trapped in past assumptions or blinkered by custom. My intent here is to monitor a transition I think we should all try to understand.

There are many aspects to the changes we are experiencing, some with immediate implications, others longer-term.

However, I think it useful to begin with a particular question with critical immediacy: “Why is the Federal Reserve unable to return the economy to some semblance of order?” Or, to put it another way: “Why has nothing actually been fixed since 2008?”

Here we find a powerful illustration of what is meant by structural change.

The short answer to these questions is that they want to believe they are dealing with a cyclical crisis rather than a structural crisis.

Again, why? Because the truth represents an unbearable existential threat.

Structural change has shifted the economy into a long-term deflationary trend, which presents financial institutions and governments with an impossible situation.

I refer you here to James Rickards’ recent best-seller, “The Death of Money: The Coming Collapse of the International Monetary System”. A monetary economist and former banker, Rickards is an adviser to the Pentagon and CIA.

Using simple math, Rickards’ explains how “in effect, the impact of declining prices [deflation] more than offsets declining nominal growth [GDP] and therefore produces real growth.”

Most of us would think this is a good thing.

He writes: “Despite possible real growth, the U.S. Treasury and the Federal Reserve fear deflation more than any other economic outcome. Deflation means a persistent decline in price levels for goods and services. Lower prices allow for a higher living standard even when wages are constant, because consumer goods cost less. This would seem to be a desirable outcome, based on advances in technology and productivity that result in certain products dropping in price over time….”

Why is the Federal Reserve so fearful of deflation that it resorts to extreme measures to oppose it? Rickards gives us four reasons.

First, deflation has a severe impact on government debt. “U.S. debt is at a point where no feasible combination of real growth and taxes will finance repayment…. But if the Fed can cause inflation…, the debt will be manageable because it will be repaid in less valuable nominal dollars. In deflation, the opposite occurs, and the real value of the debt increases….”

Second, deflation impacts the debt-to-GDP ratio, causing foreign creditors to lose confidence and demand higher interest rates. This is an urgent problem because the debt is continually increasing. Budget deficits require new financing, and interest payments are being financed with new debt.

Third, deflation is a major problem for banks. As Rickards’ puts it, “deflation increases money’s real value and therefore increases the real value of lenders’ claims on debtors…. But as deflation progresses, the real weight of the debt becomes too great, and debtor defaults surge.”

The fourth problem with deflation is about taxes. When a worker receives a raise, the additional income is subject to taxes. But, if the cost of living drops by the same amount, the worker in effect receives the same raise and the government cannot tax it.

“In summary,” writes Rickards, “the Federal Reserve prefers inflation because it erases government debt, reduces the debt-to-GDP ratio, props up banks, and can be taxed.”

“Deflation may help consumers and workers,” he says, “but it hurts the Treasury and the banks…. The consequence of these deflationary dynamics is that the government must have inflation, and the Fed must cause it. The dynamics amount to a historic collision between the natural forces of deflation and the government’s need for inflation.”

Such are the difficulties and dilemmas of structural change.


Next week: Insolvency and the Devaluation of the Dollar.

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