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Can the Fed Prevent Deflation? Does it want to?

by Michael Nystrom
January 24, 2007
Arlington, MA

It has been a few weeks since I've written on the subject of deflation, and in the meantime Mish has had a couple of good articles (here and here) on deflation that have answered just about every question anyone could ask on the subject. But after mulling all this over, I've got another more fundamental question that I'm looking for an answer to: Does the Fed really want to prevent deflation?

As Mish points out, there is near complete confidence that the Fed can and will be able to stop deflation simply by "printing money." Under this inflationist view, the Fed is obliged to stop deflation simply because it is in the best interest of the system -- American consumers, businesses, and the government. As the thinking goes, all of these entities are in so much debt that they can simply never pay it all back. Therefore, not only the easy way out - but the only possible way out - is through continued inflation of the currency - the printing press solution. Bernanke shouted this intention loud and clear in his "It" speech that I discussed last time. As part of the new and improved, Clear-speak program at the Fed, Bernie didn't mash or mince words the way his predecessor Greenie did, and judging from what everyone seems to think, the message has gotten through. Mission accomplished, Ben! The threat of deflation has been dispelled and we've seen red hot inflation since 2003.

But deflationists argue that this inflation cannot continue forever, and the trend will ultimately reverse. At which point, try as it might, the Fed will be helpless to prevent or reverse deflation for a variety of reasons. What the two camps share in common is the underlying assumption that the Fed is terrified of deflation. But why should it be? Why does everyone think the Fed wants to prevent deflation in the first place? The common wisdom is that deflation would simply be too detrimental. But for whom?

Ah, there is the rub.

A Brief History of the Fed
Nearly everyone thinks that the Federal Reserve and the Federal Government are one and the same, but this is not the case. The Fed is a private, for-profit banking cartel and the government is, well, the government. The reason for the confusion is clear because it is, in fact, quite deliberate. The formation of the Fed in 1913 was and continues to be one of the greatest Statue of Liberty plays in American history. "The Federal Reserve is no more Federal than Federal Express" says Michael Ruppert in America From Freedom to Fascism. But separate as they may be, these two powerful institutions are joined in an unholy matrimony - a powerful marriage of convenience in which each party benefits tremendously.

Elected officials (i.e. the government) love to spend money and hate to raise taxes. If anything, they want to spend more money and levy fewer taxes. This is surely the path to reelection. Bankers love to make money with as little risk as possible. Voilà! An opportunity is seen, and a partnership is struck. The government hands over monetary responsibilities to the Fed, the Fed loans money back to the government at interest and each party is happy. The Fed reaps profits, the Government spends money thereby providing the people with pork and programs, and taxes are not raised a dime. It is a win, win, win situation, right? Right!

Except for the little matter of the Federal debt which grows and grows and grows. Oh, and also the small matter of inflation that eats away at the savings, buying power and quality of life of the American people. The buying power of the dollar has dwindled so far since the formation of the Fed in 1913 as to leave it practically worthless. So the question of whether we will have hyperinflation is the wrong question - we've already had hyperinflation! It takes a full dollar today to buy what a nickel would have bought in 1913, according to the Fed's own CPI calculator!

The Fed is not Stupid
This level of inflation cannot continue indefinitely without dire consequences, and the Fed knows it. Anything us regular folks know about inflation, deflation, fiat money and the gold standard (not because we learned it in school, or heard it on the news but because we read it on the internet!) - the Fed certainly already knows, too. Like us, they too understand that every fiat currency throughout history has ended the same way - in a hyperinflationary blowout, and despite what Ben has said about the magic printing press, they want to avoid such an outcome with the Dollar. Such an end is not good for anyone, least of all them. The bank gets its power from the ability to issue dollars - it would do them no good to kill their golden goose.

So what can they do?

In football, it's called the Statue of Liberty play. For those of you who don't know football, this is a trick play designed to fool the opposition. In it, the quarterback - the one who normally throws the ball - instead hands it off to a running back. The running back, who normally runs with the ball, instead motions to throw it. But just as he is getting ready to throw, another player sneaks around from behind, grabs the ball, and takes off running down the field! (The running back is left standing in a pose like the Statue of Liberty - thus the name of the play.)

If executed properly, this is a masterful play of deception. The defense is in a state of complete disarray, having no idea what is going on. Is the other team passing? No - running! No, passing! No! Running! What the hell is going on?! By this time the play is over and the offensive team has scored a huge gain, capitalizing on the opposition's confusion. Wikipedia's definition of it adds: "The phrase has also come to represent any bit of desperate trickery or misdirection outside of sports…" Though it adds that the play is rarely used in professional leagues, but more often in pee-wee or high school football because "...a professional player is less likely to be tricked..."

Unfortunately, it has become all too easy to trick the average American when it comes to the subject of money. Just watching the first few minutes of Fiat Empire gives you a taste of how woefully unsophisticated Americans are when it comes to the subject our money. Because of this woeful unsophistication, the Fed can talk relentlessly about the war against inflation, yet all the while be the primary culprit behind inflation. Ron Paul, who serves on the Congressional Banking Committee, has said many times that some members who sit on the committee with him still believe the dollar is backed by gold! It is not. But this demonstrates just how effective the Statue of Liberty play that the Fed has been running since its creation truly is. The Fed was born of deception in 1913 and yet most people still to this day solemnly take what it says at face value.

In a PBS interview in 2000, the late Milton Friedman was very clear about where the blame lies for the first great depression:
We had repeated recessions over hundreds of years, but what converted [this one] into a major depression was bad monetary policy.

The Federal Reserve system had been established to prevent what actually happened. It was set up to avoid a situation in which you would have to close down banks, in which you would have a banking crisis. And yet, under the Federal Reserve system, you had the worst banking crisis in the history of the United States. There's no other example I can think of, of a government measure which produced so clearly the opposite of the results that were intended.

And what happened is that [the Federal Reserve] followed policies which led to a decline in the quantity of money by a third. For every $100 in paper money, in deposits, in cash, in currency, in existence in 1929, by the time you got to 1933 there was only about $65, $66 left. And that extraordinary collapse in the banking system, with about a third of the banks failing from beginning to end, with millions of people having their savings essentially washed out, that decline was utterly unnecessary. At all times, the Federal Reserve had the power and the knowledge to have stopped that. And there were people at the time who were all the time urging them to do that.

So it was, in my opinion, clearly a mistake of policy that led to the Great Depression. (all emphasis mine)
Mistake? Really? For whom? 75% of the banks that failed were not part of the Federal Reserve System. Those banking failures went a long way towards eliminated the Fed's competition. The American people were devastated, but the Fed and the Government came out of the Great Depression stronger than ever. Gold was outlawed, confiscated from the American people and once it was safely in the hands of the government, the official price was raised. The greatest power couple in world history consolidated their gains.

Today's common wisdom is that the Fed didn't know what it was doing back in the 30's and ineptly caused deflation and the Depression. But now - thank God -- we know so much more and that will never happen again! Lest you have any doubt, Bernanke spelled it out for us loud and clear in his tribute to Milton Friedman on his 90th birthday. "Regarding the Great Depression," Bernanke said, addressing Friedman. "You're right, we (the Federal Reserve) did it. We're very sorry. But thanks to you, we won't do it again."

Great job, Ben! A command performance, complete with an admission of guilt, a show of contrition and a loud proclamation that it won't happen again. You may as well have used a megaphone. And followed up, no less with a rousing encore in the form of the now infamous printing press speech just two weeks later.

But after all we know about the Fed, you're telling me that we're supposed to take this dog and pony show at face value? Ha! As the old saying goes, fool me once, shame on you...

Thought Exercise: Now Pretend You're the Bank
Take a look at this quote, which can be found all over the internet:
If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered.
This quote is attributed to Thomas Jefferson, though it is most certainly apocryphal. However I use it because it is instructive in many ways. First, don't believe anything just because you read it, even if you've read it many times. You can find this quote on a hundred web pages attributed to Jefferson. Second, even though Jefferson didn't say it, there is still wisdom in whoever did: "First by inflation, and then by deflation..."

As I already pointed out, we've already had the inflation. Most everyone is in debt up to his eyeballs, and the dollar has been inflated to within 5% of its life. There's not much more room to go before it is completely dead. These are hard times for many individuals, corporations, and the government itself. Ben even told the government so recently -- that this is the "calm before the financial storm." (more on that next time)

But pretend for a moment that YOU are the bank, and all these entities owe YOU the money. When you look at the problem from this point of view, something quite amazing happens. Why, there is no problem at all! Those poor consumers, businesses and the Federal government have all gone and gotten themselves into debt, haven't they? Well now they are just going to have to pay it all back. End of story. What is the problem now?

As the Bank, you're power comes from 1) your monopoly on the issuance of legal tender, 2) your ability to create it out of thin air and 3) your willingness to loan it out and charge interest on it. In fact, deflation wouldn't be such a bad thing at all, since it increases the value the currency you have a monopoly on creating. During deflation it is best to have a mountain of cash and a positive cash flow to ride it out. The only problem is if folks start defaulting on you. But that has already been taken care of with the Bankruptcy Reform Act of 2005. That law was written by the credit card companies, i.e. the banks, i.e Federal Reserve members, to keep working people on a treadmill of perpetual debt.

This reminds me of the stories of economic colonialism John Perkins told in his book, Confessions of an Economic Hit Man. First the World Bank would go to some natural-resource-rich third world country and offer it a fat loan to "develop" its resources. The loan would be bigger than necessary, and certainly more than the country could ever afford to pay back - but the bank would say, "with your new refinery/mine/port/whatever, you'll have enough revenue to pay it back." When the country eventually did default, the IMF would sweep in with "fiscal austerity measures" for the people and the government. All the revenue from the new development would be siphoned to the banks in order to pay off the huge loan. Tsk tsk.

Sound familiar? Anyone who bought a house in the last five years knows that mortgage bankers rarely advocated financial prudence when buying a house, but instead pushed the idea to "buy as much house as you can (or can't) afford!" And now with prices coming down, many of those buyers are stuck right where those third world countries got stuck. Looks like a fiscal austerity plan is coming down the pike for many consumers so they can stay on the financial treadmill while the productive fruits their life - their labor - are siphoned off by the bank. Because the banks still know that as much money as they make trading and manipulating paper and financial "products," there is still only one true source of wealth, and that is human labor.

No, the Fed is not stupid. Not stupid at all. There will always be booms and busts, and the best way to position oneself is to take advantage of both sides of the trade. Or as one responder to my last article put it so eloquently:
I am fascinated by the common perception that the Federal Reserve is a proven non-stop inflation machine. Inherently, the Federal Reserve uses inflation and deflation to whipsaw the average bystander out of their savings. I don't see how one economic machination is more favored over the other when the goal is to ensure that the public's savings ends up in the accounts of the shareholders of the Federal Reserve System.
I couldn't have said it better myself. Don't count deflation out just yet.

Your Comments
Now it is your turn. I've done enough talking. Let's hear what you have to say. Post your comments here.

And if you're interested in hearing Part III of this deflation story, subscribe to my low volume announcement list. The way I see it, we may be gearing up for a war in heaven. In a marriage of convience between two powerful partners, eventually the interests will begin to diverge. Bernanke started with the henpecking last week, saying that the government would have to make some "hard choices..." Sign up to hear more.

If you learned something from this article, please pass it along to someone else who may also benefit from the learning. A vibrant democracy depends on an educated populace.

// End

* * ATTENTION TRADERS / MARKET WATCHERS * * Starting next Wednesday, I will be offering an exclusive FREE WEEK with Elliott Wave International. Readers will have access to the Elliott Wave Financial Forecast, Theorist and Short Term Update for one week, including the amazing December "Silent Crash" video edition of the Elliott Wave Theorist. To be notified sign up here, or just check back to the site homepage next Wednesday for details on how to participate.

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Other articles of interest:
The Specter of Deflation, Part I
Gold Corp, Wikinomics and Changing the World
A New American Dark Age
Ron Paul for President!

* * *

Turn off the TV and think!





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