Al Coryell
Host/Moderator 

Question:

“Most people who believe that we will slip into a depression seem to think it will be caused by inflation brought on by the collapsing of the dollar. Why is it you say the problem isn’t inflation but rather deflation and that the dollar will get stronger, not weaker?”

The Dollar

The Fed has pumped trillions of dollars into the economy which has had almost no real effect of any kind other than to feed the coffers of the banking elite. Deflation has negated any impact of the Fed’s monetary inflation. But the dollar is still the reserve currency of the world and will be seen as the safest haven possible when the global markets begin to collapse yet again. So I would expect the dollar to rise relative to most currencies. Eventually the dollar will be supplanted as the reserve currency, we can see that in the actions of the emerging markets as they attempt to mitigate their exposure to the dollar. But that won’t happen over night and the dollar should remain strong for quite a while.

The collapse of the stock market and the rise of the dollar will confound a lot of people who don’t understand how deflation works. In this video of Robert Prechter, whose book Conquer the Crash was influential in my understanding of deflation, he talks about the contrarian indications for a reversal in the dollar’s decline. It is a great explanation.  

As Prechter explained, an inverse linkage between the dollar and the stock market exists and will remain for a while at least, perhaps until the stock market begins to find a bottom some years from now. However, once the stock market bottoms, I am unsure what the dollar will do. If the Federal Reserve is still around (which is hard to say – I am convinced it will eventually be totally discredited and dismantled) it is conceivable they will continue to inflate the money supply which could lead to hyper-inflation and the scenario that the gold mania is anticipating. But that’s not a given in my mind. Currently, they have inflated the money supply with astronomical amounts of dollars with little to no noticeable affect on prices. As you read further you will see why. Their paltry $3-4 trillion dollars of balance sheet expansion pales in comparison to the amount of debt that must be liquidated to end the coming depression. As one publication I recently read described it, “It’s like trying to fill Lake Michigan with a garden hose”.

Many people seem to want to link gold to the dollar in an inverse relationship. But gold is less linked to the dollar than it is the stock market. As a commodity, gold will collapse in sympathy with the stock market as will all other commodities. A stronger dollar is the result of shrinking market value so in that respect gold and the dollar share a common linkage. But gold will only play a major role if and when the dollar begins to hyper-inflate. For the foreseeable future that won’t happen and those who understand what is happening these days are chanting the mantra, “Cash is King”.
 

Inflation – The cause of the problems we face today

I am convinced that the problems we face today are deflationary and will eventually result in the deepest depression in 300 years. But the deflationary environment we are experiencing today was caused by many years of inflation which created the conditions and set the stage for the crisis that awaits us. It is important to understand inflation because without an understanding of inflation and how it has affected our economy for decades, it is not possible to truly understand deflation. We need an overall understanding, a frame of reference, as to how the economy works, how and why it expands and contracts as business gets conducted. I think we are all aware that business cycles occur, that is, sometimes prices are cheap, sometimes they are expensive. But why? Most of us have no idea.

Inflation can occur in many ways but the most common and the easiest way to create it is the expansion of credit. When the Federal Reserve provides credit to lending institutions it is the same as printing money. There is effectively no difference. It is not necessary to actually print dollar bills to inflate the money supply. Today it is done quickly and easily, electronically, with a click of a button.

The primary effect of printing money or expanding credit in an economic system is that it raises the prices of the goods in the system. That is why counterfeiting is illegal. The more money in the system the more stuff costs. If that’s not clear, think of it this way. If you have a monetary system consisting of a table with three equally valuable items on it and there are three dollar bills on the table, then each item on the table would cost one dollar. If a counterfeiter came along and added three more dollars to the table, there are now six dollars in circulation in the system, but still only three items, thus each item would now cost two dollars. The aggregate price of goods in an economic system is equal to the total amount of money and credit in the system. More money equals higher prices, less money equals lower prices.

To understand why counterfeiting is such a problem, think of it this way. You are working to earn one of those dollars so you can buy an item from the table. You have to work a whole year to earn your dollar. But as you are earning your dollar, a counterfeiter is adding money to the table (money supply), thus artificially raising the cost of all the items on the table. At the end of the year, you have earned your dollar but now it is not enough money to buy an item because of the countefeit money in circulation. Frustrated, you continue to work until you finally earn enough to buy the item at the inflated price.

That scenario has actually been happening to you over the years on a scale that is mind-boggeling when contemplated. It was not perpetrated by some clandestine organization of insideous criminals (well maybe it was), that is what the Federal Reserve has done every year for decades. The dollar has lost 96% of its purchasing power since the creation of the Federal Reserve system. The Fed’s claim to the right to do this is their mandate from the Federal Reserve Act of 1913 to “maintain price stability and promote full employment”.

The Federal Reserve has constantly expanded credit and added money to the system (legalized counterfeiting) and has been doing so since its formation in 1913. Why? The simplest and most basic of all motivations… greed. As a for profit corporation, the Fed loans money to the US government. When the government pays it back, it pays it back with interest. How much interest? Usually 3-5%, the same amount as the relative annual inflation of the money in the economy (which we will see later when we talk about the Consumer Price Index or CPI). But where did the government get the interest with which to pay the Fed back? Oddly enough, from the Fed itself. For decades, the Fed artificially prints enough counterfeit money to allow the US government to pay it back. This strange relationship is considered perfectly normal, acceptable and legal under The Federal Reserve Act of 1913. Were you or I to print money to pay each other back we would go to jail.

Most of us don’t realize how badly we have been hurt by the legal counterfeiting that makes our dollars worth less and less every year. Nor have we understood that deficit spending and the “easy credit” with which we bought houses and cars and big screen TVs and took vacations was the cause of the inflation. For every time we pulled out our credit card to buy a TV on time, or signed the papers on a new house, the Federal Reserve was clicking the button that transferred the money (out of thin air – to quote Ron Paul) from their make believe bank account to the real bank account of the bank that loaned us the money. In the flash of an electron, the prices of all of our collective stuff went up ever so slightly with each credit transaction and legalized counterfeiting was the culprit.

There is a mathematical limit to how long it is possible to keep this kind of activity up. It is no different than a ponzi scheme. There is no specific number you can put on how long the scheme can be employed, but I have heard many generalizations that all sum it up pretty much the same way. Nouriel Roubini has said “Once you run current-account deficits, you depend on the kindness of strangers.” Perhaps the most poignant comment belongs to the Bush administration’s fired Treasury Secretary, Paul O’Neill, who refused to go along with the Bush tax cuts in 2002 because he realized how inflationary they would be.  “I think we only need to look at the fate of other countries who have lived beyond their means for a long time. You inevitably get into trouble. When you get extended to the point that you can’t service your debt… you’re finished.” When O’Neill was appointed as the Treasury secretary in 2001, the US deficit was roughly $5.6 trillion dollars.

According to the US Gross National Debt Clock, as I write this, the debt today is over $12.1 trillion dollars and growing. We have long since passed the point where we will be able to pay back our creditors. The strangers, on whose kindness we will inevitably be forced to depend, are the likes of Russia and China and the gulf states and Japan. Our government’s propensity to spend money we didn’t have perpetuated an inflationary spiral that has made the United States of America the largest debtor nation in the history of the world.

In the next installment we will take a look at the differences between Austrian School and Keynesian economics. We will analyze the events that led to the crisis that confronts us and compare how Keynesian economists (the Federal Reserve) are dealing with the problems versus the approach that would be taken if the Austrians were in charge.

Continue to Part 2 >>