Pushing on a String

Recently by Gary North: The Federal Reserve System’s Party Line

Back in 1973, gold standard advocate John Exter made a phrase famous in hard-money circles: “Pushing on a string.” Exter argued that prices of all assets except gold (he ignored silver) would someday collapse because of the pyramiding of debt. Banks would eventually cease to lend, out of fear of default. That would cause the default.

The FED would inflate the monetary base, he said, but this would not reverse the price decline. The commercial banks would not lend. The FED would therefore push on a string. Its attempt to inflate would fail.

Exter had been a central banker (Sri Lanka) and a senior officer at Citibank. He was the first deflation predictor in the hard-money movement. He was soon joined by C. Vern Myers.

His argument remains the central pillar of the deflationist camp — a tiny band of intrepid non-economists who have seen their founder’s prediction refuted by the facts in every year since 1973. But economic events since mid-2008 seem to indicate that Exter may have been right, they insist. They continue to predict price deflation. The FED is at long last pushing on a string.

I still predict price inflation, just as I did in 1963, 1973, 1983, 1993, and 2003.


The debate between those who predict price deflation and those who predict price inflation is gridlocked today. The rate of price increases — both the CPI and the Median CPI — in May 2009 was 0.1% per annum. That is as close to zero as statistical indicators get. The CPI has been showing slight price deflation this year. The Median CPI has been showing slight price inflation. Statistical sampling errors and theoretical conceptual errors can affect the outcome of either indicator. What we have seen is essentially a flatlined price level.

As I have previously written, to decide which is coming — a 2% fall in prices or a 2% increase — flip a coin. Nobody in either the deflationist camp or the inflationist camp is playing Cassandra based on 2% moves. Nobody cares about 2% moves — not Congress, not the FED, not the general public, and not investors.

What matters is the sustained direction of prices, year after year, at rates above 2% per annum. If prices fall, long-term debt contracts favor creditors. These contracts become oppressive. Consider 30-year bonds. Corporations and the U.S. Treasury will be paying appreciating money for old debt. Corporations can recall the debt by borrowing money and paying off old bondholders. This is why corporate bonds are asymmetric. Bondholders get killed during price inflation, with the accompanying rise in long-term rates. They get killed in price deflation because of pre-payment. With U.S. Treasury bonds, pre-payment has never taken place previously. But it could.

If prices increase above 2% per annum, then previous contracts favor borrowers, who pay off in depreciating money. There are more borrowers who vote than creditors who vote. This is why democratic politics always favors long-term price inflation.

Inflationists point to the increase of the balance sheet of the Federal Reserve System, which has shot up faster than at any time in the post-World War II era. See for yourself.

They conclude: serious price inflation lies ahead.

Deflationists point to the M1 money multiplier, which is headed sharply down. See for yourself.

This is the result of decisions by commercial bankers to lend money to the public (no) vs. pile up excess reserves at the FED (yes). Banks are not lending. Deflationists conclude: serious price deflation lies ahead.

Inflationists respond to the falling M1 money multiplier along these lines. “Bankers must pay depositors a rate of return. The banks are being paid by the FED for excess reserves, but only at the federal funds rate: barely above 0%. If banks do not start lending, they will be bled dry by payments to depositors. The bankers at some point must lend, if only to buy Treasury bonds that pay more than what banks pay depositors.”

Deflationists reply along these lines. “Bankers are afraid of losing money. They will not lend until the economy turns up, but it cannot turn up unless borrowers apply for loans and banks respond by lending. Meanwhile, real estate prices continue to fall, foreclosures continue to increase, and banks continue to lose capital, thus lowering their balance sheets. They will not lend. The M1 money multiplier will stay low, offsetting increases in the FED’s balance sheet, which serves as the banking system’s legal reserves.”

Who is right? We don’t know yet. Neither does Bernanke.

Is the FED impotent? Is it trapped in a corner, frantically pushing on a string? Is price deflation an irreversible force? I don’t think so. Here’s why.


Every school of economic thought except the Austrian School trusts either the government or the central bank to “kiss it and make it all well” when the economy stumbles. The greenbackers and populists trust the government. Everyone else trusts the central bank.

The whole world is committed to monetary inflation as the supreme cure-all for bad economic times. Whenever the economy slows, the printing presses speed up.

Those forecasters who are predicting price deflation argue that monetary inflation will not be powerful enough to overcome price deflation. Nobody is predicting an actual decrease in the money supply, short of some sort of banking gridlock and a complete breakdown of monetary transactions, which no conventional analyst even considers, since it is just too pessimistic to consider seriously, like nuclear war.

If a central bank can legally monetize debt — create new money by buying ownership of debt — then why not the monetization of equity? Do you think a central bank won’t have eager sellers of depressed shares? When sellers of anything need money, they don’t care who will buy their assets with money. Only when they suspect that the prevailing monetary unit will not function as money in the near-term future will they refuse an offer to buy. This takes place in the final stages of what Ludwig von Mises called the crack-up boom: the mass inflation-generated collapse of the division of labor.

Why anyone worries about price deflation is a mystery to me. With the power of money creation through the purchase of assets, there is no theoretical limit to how high prices can rise. Because people associate rising prices of whatever they sell or own as a sign of prosperity, there is always support for fiat money.

The deflationist says, “the banks can create credit, but people may decide not to borrow.” This is true. But why wouldn’t they borrow? Because of their fear of falling prices — debt repayment. Well, there is nothing like a little mass inflation to chase away the fear of falling prices! If people are afraid of falling prices, and therefore refuse to borrow money even at 0% interest, then the central bank can do the buying directly. Eliminate the middlemen! If businessmen won’t borrow money to produce future goods, the central bank can go out and contract to buy commercial goods directly, or else get the government to do this with newly created money. This is the Keynesian solution.

Could the FED buy up all of the shares listed on the New York Stock Exchange? Legally, yes. What about buying up all of the mortgages held by Fannie Mae and Freddy Mac? Of course. But wouldn’t this be a financial revolution? Not conceptually, only pragmatically. The idea is inherent in central banking, which stretches back to 1694: the Bank of England. If a bank can legally create money to buy an asset, there is no theoretical limit to the kind of asset involved.

I wish people were willing to think through these implications, but this is not an easy thing to do, especially in the area of central banking, where deliberate deception is fundamental to the entire operation. (Thibaut de Saint Phalle, The Federal Reserve System: An Intentional Mystery [Praeger, 1985].)

My point is simple: at a 0% interest rate, people will usually borrow money to buy things. But people who are in a financial jam will sell assets for money. If central bankers can’t get producers to borrow money at 0%, they can probably persuade consumers to borrow at 0%. But even if they can’t persuade consumers to buy, they can lend money to the government, which will send the money to special-interest groups. Those groups will take the money. They will spend it.

At some low price — such as “free” — people will take the money. That’s why price inflation is in our future. Price deflation isn’t, short of a banking gridlock, which is quite possible, but an unpredictable event.

Here is the fact of facts regarding central banking: the central bank can buy any asset with its fiat money. The stock market can fall, and I believe it will. But it can be saved from total collapse by FED purchases. The FED can buy up America’s capital on the cheap with fiat money. The bond market can also fall, and will if the FED starts buying equities on a mass scale.

There is nothing like free money to persuade people to buy and others to sell. The worse the economy gets, the more willing hard-pressed capital owners will be to sell. That points to two events: (1) a stock market sell-off and (2) the FED’s eventual purchase of capital assets in order to prevent that most feared event among central bankers, a banking gridlock, where bank A cannot settle with bank B because bank C has not paid bank A.

General deflation? Don’t bet on it. Fiat money moves the merchandise.

[Long-time subscribers to my newsletter, Gary North’s Reality Check, may have a sense of déjà vu. That is because the previous section appeared in the October 7, 2002 issue. This time, I dropped a brief paragraph about Japanese central bank policies. I also skipped a section on real estate, in which I was bullish — not a radical position in 2002. I reversed that position in late 2005, and warned my readers. But every word was extracted from that issue. I reprinted it here because it sounds as though I composed it today. Events have caught up with my predictions.]


The Federal Reserve is not yet buying equity. It is instead lending to the Federal government, which is buying equity. The government is buying equity on a scale never before seen in American history. It is buying equity in the financial industry: banks. It is buying equity in the automotive industry: Chrysler and General Motors. The precedent has been set. Voters overwhelmingly oppose this policy, but Congress ignores the voters. So does the Obama Administration (autos). So did the Bush Administration (banks).

This is not happening only in the United States. In a long, detailed, and funny article that appeared in late May in the “London Review of Books,” John Lanchester surveyed the transfer to the government of both risk and ownership of the largest banks in Great Britain. The article was titled, “It’s Finished.” What was he referring to? Confidence in Thatcher’s capitalism. But there is nothing to take the place of this confidence, he says.

Of course there is: the economic ideology that has reigned supreme since the 1930’s. I refer to Keynesianism. The mixed economy never went away. Neither did academic Keynesians.

Economic growth has yet to reappear anywhere in the West. The rate of contraction is higher in Japan and Europe than in the United States. Trade is falling rapidly. Unemployment in the United States is shooting upward, with no end in sight. No one is predicting a reversal of this trend in 2009. Optimists think it may stabilize by mid-2010. I am not one of the optimists.

In this scenario, the Federal government is expanding its percentage of the economy. With at least a $1.8 trillion deficit this year, and perhaps an equally large deficit next year, the government is absorbing the net new capital of the nation. The private sector cannot compete with the Treasury. The rollover of existing Federal debt, coupled with the deficit, totals over $4 trillion a year. Where will capital come from to finance the recovery? It won’t.

The Federal government is now the spender of last resort. It is buying equity in firms regarded as too big to fail.

So far, commercial banks are not buying Treasury debt. They prefer to keep excess reserves at the FED. This is unprecedented in American banking history. Here are bankers, lending money to the FED at 0.15% or thereabouts, who could lend to the U.S. Treasury to buy bonds at 2.5% (5-year T-bonds) or 4.5% (30-year T-bonds). They refuse. They are so fearful of the U.S. government’s promise to pay that they have decided to stick with 0.15%. They trust the FED far more than they trust the Treasury.

Keynesianism teaches that the government is the borrower of first resort in order to be the spender of last resort. Keynesians cheer the Federal deficit. They want the government to replace private borrowers as the borrower of last resort. They do this because Keynes and his disciples have believed that spending, not saving, is the heart of economic progress. They believe that consumer demand is the heart and soul of economic growth, not per capita productivity. They do not worry much about private investment in private enterprise, which they do not trust during recessions. They have faith in aggregate spending, and they fully understand that when it comes to spending, the national government is the undisputed champion. When it comes to writing blank checks, nothing matches the Congress of the United States.


The magnitude of the Federal deficit this year is beyond comprehension. If the economy produces the estimated $14 trillion in goods and services this year, the government’s $1.8 trillion deficit constitutes almost 13% of the economy. But this is way too optimistic. Government spending at all levels constitutes at least 40% of the American economy. Deduct most of this from the total output — maybe 35%. (Lew Rockwell would say to deduct the whole 40%.)

This cuts national productivity to $9.1 trillion. The deficit then constitutes about 20% of the private sector’s total output. That’s just the deficit. That does not count this year’s share of the rollover of the existing Federal debt: at least another $2.5 trillion. The average maturity of the national debt is now 48 months.

The debt is now $11.5 trillion. But I am taking the pre-Obama debt of $10 trillion. Whatever is tacked on this year must be rolled over next year.

Where will this borrowed money come from? These are the main sources:

1. Private American investors and their agents2. Foreign private investors3. Foreign central banks (Japan and China)4. The Federal Reserve System

That’s it: a short list. If these four do not fork over the money, the U.S. government will be forced to default on some portion of its debt. At some price — higher interest rates — they will fork it over. Rising Treasury debt rates will suck in more money from the first three. But before rates rise too far, the fourth will intervene to buy more of this additional debt. Why? Because of the effect on the capital markets of rising Treasury debt rates: a deeper recession. Think “higher mortgage rates and housing prices.” Think “stock market.” Think “corporate bond market.” Think “projects postponed.”

The Federal government will absorb any net increase in private thrift this year, next year, and the year after. All of it. There isn’t a high enough rate of saving in the country to fund the Treasury’s debt. The Federal debt is a black hole.

The question is this: Will the loss of new savings at the margin force down the other capital markets: stocks, bonds, and real estate? I think it will. I suspect that the deflationists think so, too.


There is no answer from economic theory. Their willingness to lend will depend on these factors:

1. Their balance sheets 2. Their fear of private borrowers’ defaulting3. Their fear of T-bonds (rising rates, falling prices)4. Their fear of running out of income to pay depositors5. The rate of interest on excess reserves (FedFunds rate)6. Their fear of nationalization

At this point, I offer my central response to the deflationists.

The Federal Reserve System can force the hands of commercial bankers at any time by charging interest on excess reserves for “safekeeping.” The fact that the FED has not done this indicates that it accepts the present situation: a collapsing M1 money multiplier. It accepts the string.

Let me put it even more sharply: “The string is central to Federal Reserve policy today. It is not the FED’s nemesis. It is the FED’s ally.”

The present economy is the result of Federal Reserve policy. Bernanke tried to pop Greenspan’s bubbles, but without creating a major recession. That policy failed, as I predicted it would from late 2006 until late 2008.

The FED decided to lower the federal funds rate. This is what it has always done in the past. I predicted it would.

It also decided to swap Treasury debt for the banks’ toxic assets. I did not predict this. This is Bernanke’s uniquely innovative policy. But this policy has not led to a revival of bank lending. The FED is pushing on a string.

This does not mean that the FED’s expansion of the monetary base is impotent. On the contrary, it means that the FED can buy Treasury debt, hold down Treasury interest rates, and enable the Federal government to buy equity in American businesses. The government can lend, as it lent TARP funds, at 5% per annum. The government can remain the spender of last resort. It can become the investor of last resort. This has already begun.

The FED knows it is pushing on a string. It loves that string. Why? Because that limp string — no commercial bank lending — delays the advent of price inflation. This has enabled the FED to achieve the following by doubling the monetary base (the FED’s balance sheet):

1. Bail out the big banks (asset swaps)2. Keep the banking system from imploding3. Bail out the Federal government4. Bail out Fannie Mae and Freddie Mac5. Keep real estate from collapsing6. Slow price inflation to close to zero7. Keep T-bill rates under 0.5%

At what cost? Unemployed workers. That is a small price to pay if you are a high-salary central banker with a fully funded pension.

The FED’s policies have not failed. They have succeeded beyond Bernanke’s wildest expectations. Greenspan’s bubbles are all popped. Price inflation is gone. There is no price deflation, either. For the first time since 1955, the FED has attained its mandate from Congress: price stability.

Greenspan’s FED never attained the power over the economy that Bernanke’s FED now possesses. The FED has been given almost complete regulatory control over the financial system. Congress buckled. Bernanke has been given a free ride. The Federal government now owns General Motors. Keynesianism is having its greatest revival in 30 years.

So far, the FED has won. Yet deflationists argue that the economy is in a deflationary spiral that the FED cannot prevent. They do not know what they are talking about. They never have.


The Federal Reserve can re-ignite monetary inflation at any time by charging banks a fee to keep excess reserves with the FED.

Anyone who predicts an inevitable price deflation does not understand that the present scenario is the product of legitimately terrified bankers and the Federal Reserve’s Board of Governors. At any time, the FED can get all of the banks’ money lent. But the FED knows that this will double the money supply within weeks. This will create mass price inflation.

This is the central fact in the inflation vs. deflation debate. Until the deflationists answer it with a unified voice, they will remain, as their predecessors remained, people with neither a theoretical nor a practical case for their position.

So, the FED waits. Meanwhile, the Federal government’s share of the economy rises relentlessly because of the deficits. This is not going to change in the next few years.

We are seeing Keynesianism’s last stand. When it fails, the FED will force the banks to lend. Then we will see mass inflation.

Mass deflation? Forget about it.

June 20, 2009

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2009 Gary North