Al-Addin’s Lamp

by Sean Corrigan
by Sean Corrigan

Even in the face of mounting evidence that the Fed and its peers have uncorked the bottle which has largely contained the genie of higher prices for goods and services (as opposed to those for assets and property) for so long, there are respectable market commentators, among them the estimable Richard Russell, who still seem concerned about the prospects for deflation.

Recently – and very much in the same vein – I was asked whether I agreed with the thoughts expressed by Robert Prechter when he wrote:

My correspondent went on to inquire what I though of Prechter’s further argument, as he paraphrased it, that:

Given the current state of affairs, it may be of some interest to others to read the reply I gave the gentleman concerned.

Sir (I began), where I think Mr. Prechter’s work is at its most perceptive is in its emphasis that economics is not a natural science, but a social one, and that Man, being conscious – if not always fully rational – in his actions, can take steps to alter the course of history, rather than blindly having to obey some analogy to the laws of thermodynamics, as is implicitly maintained by the mainstream.

On the direct subject of deflation, I would argue that we have to be very careful how we apply any lessons we may be tempted to draw from history, given that our globalized monetary system is, for the first time ever, based only on those electronic entries which pass for money at banks, and which are underwritten in extremis by no more than the blips of data which their central banks, in turn, create to give them an exchange value of some sort.

It is true that a central bank could begin a policy of severe restrictionism, raising short-term rates and limiting, even reducing, reserves in such a draconian fashion that credit becomes both more scarce and much more expensive. Thus implemented, the bank could indeed occasion a round of defaults and deferments, asset sales and margin calls, banking failures and a seizure of the credit system, much as Prechter describes.

However, we must ask ourselves how likely it is that any presently instituted central bank, or political party – incumbent or otherwise – would actively promote such a policy, or, having stumbled into it, would persist with it.

I trust you would agree with me that this would be an almost unconscionable prospect.

Indeed, the recent history of bail-outs, emergency rate cuts, the instant provision of vast swathes of ‘liquidity’, and other such interventions undertaken by the central banks in the face of anything from the Mexican crisis of late-1994, through the Asian Crisis of 1997/8, the Long-Term Capital Management fiasco, the Dot.com bust, Y2k, 9/11, and so on and so forth, argues strongly that whenever the US financial system (in particular) is threatened, the floodgates are opened without further ado, even if ‘rules’ have to be infringed and the dictates of best practice eschewed in the process.

Adding weight to this argument, you may recall that the Fed itself – as well as the Bank of Japan, among others – have, in fact, been at some pains, in recent months, to boast of their readiness to embark upon a programme of such ‘unorthodox’ measures, should the need arise.

But, if we rule out the purposeful enactment of restriction, the question then becomes one of whether a genuine deflation (i.e. an undesired contraction of money and credit, not supply-led falling prices) can, under today’s circumstances, set in spontaneously across the broad economy.

This, too, while perhaps not to be fully ruled out, also seems difficult to envisage at present.

Firstly, in the case of the main offender to sound economic management, the United States, its dollar is the global unit of exchange and the basis for over 80% of the world’s foreign exchange reserves and while the US has trillions of dollars of its liabilities in the hands of foreigners, they are also wholly denominated in those very same dollars, meaning America’s debts can always be paid off – at least notionally – if only more dollars are printed to that end.

Meanwhile, within the US, there is little constraint either upon an official expansion of credit aimed at offsetting the actions of private entities, if the latter were acting to contract credit.

Nor is there any gold standard to irremediably drain banks of reserves – and even if the populace did rush for today’s notes and coins, these are mere tokens which could be minted and printed forthwith in near limitless quantities – as was seen in precautionary fashion at the turn of the Millennium.

Should the banks need to raise this cash to pay out their depositors, be assured they have plenty of securities on hand to discount or to sell direct to the Fed and, again absent some external restraint like gold, the Fed only has to write a cheque upon itself to pay for these.

If traditionally eligible assets were to run out in such a panic, the Fed has made its intentions clear that it would then monetize just about any identifiable claim necessary, from anything within the whole gamut of financial assets, right down to physical property itself.

Furthermore, if even this were to be of little avail in encouraging private agents to borrow and spend in some desperately uncertain tomorrow, we can also be sure that the State would instantly step in to fill up the gap. We only have to look at the record of governments everywhere in these past few years to see just how eager they always are to apply a little Keynesian snake oil to the system and to advance their prestige, their power, and their influence as they do.

Once more, we must note that the US government is uniquely placed to undertake such emergency action without regard for any outside considerations. If no genuine investor will buy its bonds, then – underpinned by the Fed – the banks can always be made to fill up any gap and, in the last resort, the Fed itself can directly issue currency against government IOUs.

Bear in mind that the US has no foreign constraints about which to worry directly. If private agents abroad seek to lessen their exposure to the effects of this dilution, by selling their own holdings of dollars, the US authorities would welcome the resulting change in foreign exchange parities as a ‘stimulus’ to their export industry.

Because the dollar is the world’s main reserve currency and its primary medium of exchange – with even countries such as Japan and China, with their huge bilateral trade volumes, transacting much of their commerce via the USD – it will be a long while before we reach such a pass that the US cannot issue paper to secure its needs on international markets.

Moreover, since the other central banks are prey to the very same Mercantilist fallacies (i.e. they confuse mere money with genuine wealth), they stand all too ready to swamp their private citizens’ distrust of the dollar with profuse emissions of their own currency – as has happened on an unparalleled scale in the past nine months or so.

Accordingly, the US usually relies on the fact that the overuse of its own printing press can induce others – by dint of the fact of the dollar’s pivotal role in the world monetary order – to prostitute their own virtue and to run their own presses just as rapidly, in turn.

Thus, the US may, to a cynic, appear to have a set of fundamentals more characteristic of the Latin, rather than the Northern, half of America, but the status of the dollar still insulates it from the habitual fate of those using the peso, the real, or the bolivar, in any of their many incarnations.

All of this means that the idea of a fire sale of assets driving up the absolute value of the dollar (rather than just the implied discount rate, or yield, on the assets being liquidated) is hard to accept. More forcefully, the notion that the dollar will take a dramatic and prolonged turn higher seems a strange one, to my eyes.

Perhaps, as in 1997–8, if the crisis first breaks out abroad – such as in China, for example – a temporary flight back to the Greenback might unfold.

Perhaps, even if the trouble were to start at home, US traders and investors, struggling to offset their losses, might sell their foreign holdings first, willy-nilly: that, too, we have seen before – in fact, there is some evidence that this dynamic is at play, even as I write.

But, we must not lose sight of the fact that – in ultimo – the US is perhaps the greatest external debtor in history and so, to put it simply, the rest of us have more of theirs to sell than they have of ours!

It is hard to imagine then, that any such generalized retreat to home base would not leave the US Dollar worse off than before, even without taking into account the ramifications of the monetary and fiscal steps outlined above, all of which would shortly act greatly to increase the supply of such dollars to be had.

If, by this, I have begun to convince you of the further unlikelihood of a sustained deflation developing, this does leave one further possibility – namely that a sudden rupture occurs, much like the LTCM panic of October 1998 (though possibly incomparably larger given how rapid has been the advance in financial speculation, much of it hidden from outside eyes in arcane over-the-counter derivative instruments and so-called ‘structured obligations’ in the intervening, inflationary years).

Here, we could indeed suffer a temporary seizure as all manner of toxic waste – much of it hidden away from investors’ scrutiny in arcane off-balance sheet instruments and in obscure ‘special purpose entities’, much of its inherent risks little understood by those who have contracted to run them – is suddenly revealed as the danger to both liquidity and solvency that it has proved to be so many times in the recent past.

The banking settlements system might freeze and asset prices would undoubtedly plunge, but, again, there is no limit to the countervailing monetary actions which could be undertaken in such circumstances (you should be aware that these have not only been rehearsed at official financial ‘war games’, but indeed, some of them, in the aftermath of the Twin Towers attack, put into practice).

Thus, I would contend that while it is possible that the complexities of the intertwining of today’s overlarge financial architecture could contain all sorts of triggers and trip wires, or that unforeseen disasters and unintended consequences would abound, it is hard to see how the authorities around the world – acting in concert, but led by the Fed – would fail to find a vessel into which to pour all the new money needed to keep the system afloat thereafter.

Certainly, some prices would thereby decline; some firms would go under; some banks would close their doors: but we can assuredly predict that the new money created as a countermeasure would end up boosting prices elsewhere and probably, on the aggregate, by more.

To see an instance of this, just look at the equities to housing switch, or at the marked private to public sector drift of the past three to four years, as the partial repair of the damage wrought upon corporate balance sheets in the late-90s has been effected at the cost of the ruin of their governmental and household equivalents.

Of course, amid any such upheavals, we would undeniably be materially poorer – capital would turn out to have been misallocated, the wrong skills acquired; business plans and personal ambition, both, would be thrown into disarray – but – monetarily – it is incomparably more likely that we will find our decreased prosperity takes the form of too much, rather than too little, money chasing what goods and services are out there for sale.

Wheelbarrows and war finance are the main dangers to capital which lie ahead, not specie shortage and soup kitchens – not at first, at any rate.

May 13, 2004

Sean Corrigan [send him mail] writes from London.

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