- Inflation vs. Deflation - R.Deutsch, 05.07.2001, 10:05
- Re: Inflation vs. Deflation - Fontvieille, 06.07.2001, 01:36
- Re: Noch zum Backgorund: - dottore, 06.07.2001, 12:15
- Re: Inflation vs. Deflation - Fontvieille, 06.07.2001, 01:36
Inflation vs. Deflation
Sehr interessante Theorie! Etwas mühsam zu lesen aber lohnt! Was Fekete sagt, hat Gewicht.
The Dos Passos Table
Guest Speaker
Topic du Jour
DEFLATION OR RUNAWAY INFLATION?
The Denouement of the Gold-in-Exile Saga
Antal E. Fekete*
Abstract
Runaway inflation is not a monetary phenomenon, the claims of monetarists notwithstanding. It is an
interest-rate phenomenon predicated on the linkage. (See: Kondratieff Revisited *) The price level and the
rate of interest resonate with the oscillating money-flows between the bond and the commodity
markets. This economic resonance, under the concerted pounding by speculators, ultimately reaches
the state of runaway vibration. Commodities are bought up, and all bids for bonds are withdrawn. The
rate of interest, together with the price level, reach astronomical heights. There is no scientific way to
predict whether the denouement of the present plight of the world will take the form of a depression or
that of a runaway inflation.
Sinking of the sinking fund
Bondholders of old, typically widows and orphans, were buying the bond because they wanted to earn
interest income and, at the same time, they wanted to preserve the value of their capital. They had
no reason to be concerned about the danger of their investment losing value due to a rise in the rate
of interest. There was no such danger. Issuers of bonds were required to make provision for a
sinking fund. The manager of the sinking fund would step in and buy the bond every time it was
offered below face value in the open market — as much and as long as it was necessary in order to
restore market value to face value. Those were the happy days of the gold standard when interest
rates were stable. In today’s environment it would be suicidal for issuers of bonds to offer this
protection to bondholders. Sinking funds would be exhausted in no time, due to gyrations in the rate
of interest, reflecting the uncertain value of the currency in which the bond is denominated.
The exile of the Constitutional Monarch, gold, also meant the sinking of the sinking fund. No longer
is a vehicle available to those who are in need of a steady income and have no expertise in trading
derivatives in order to protect the value of their capital. Savers have been disenfranchised and left
out in the cold. The bond market no longer serves the interest of widows and orphans. It serves
exclusively that of the bond speculator — a new parasitic species that did not exist under the regime
of the gold standard.
_________________________________________
* Professor Emeritus, Memorial University of Newfoundland, Canada; recipient of the 1996
International Currency Prize awarded by Bank Lips, Zürich, Switzerland, for his essay Whither Gold?
This paper is a follow-up to a talk Kondratieff Revisited given at the Babes-Bolyai University, School of
Business Administration, in Sf. Gheorghe, Romania on May 2, 2001. It is based on a Chapter of the
author’s projected 3-volume treatise entitled Credit. E-mail: fekete@math.mun.ca and/or:
aefekete@hotmail.com
In praise of speculation
It may come as a surprise that the role of speculation is the same as that of engineering. Both are
responses to the presence of uncertainty in human affairs. The engineer establishes safety
standards for his projects. He is not designing buildings that can withstand all earthquakes. His
buildings are designed to withstand earthquakes that have a high probability to occur.
Speculation addresses uncertainty about the price of produce due to the fickleness of nature,
especially the weather. The speculator buys low during the seven fat years, and tries to sell high
during the seven lean years. He may also sell short, that is, sell forward inventory he hasn’t got but
hopes to get at a cheaper price before the date of delivery arrives. In either case, the speculator is
performing a useful public service. During the fat years he is helping producers who, without the
benefit of speculation, would be forced to sell below cost. During the lean years he is helping
consumers who, without the benefit of speculation, would be forced to pay outrageously high prices
or do without. Of course, the speculator can go wrong and lose his bet; this happens when he buys
before the fall (or he sells before the rise) in prices has run its course. However, it is important to
note that the benefits to producers and consumers are not affected. Only the capital of the
speculator is at stake, not the welfare of the public. If he makes too many bad bets, then the
speculator will lose his entire capital. But this, too, is beneficial to the public: capital is passed from
less to more competent hands, to speculators who are better at judging the future course of market
conditions. Speculation is beneficial to society as long as speculators address only nature-given risks,
use their own capital in their enterprise, and do not try to unload their losses to the public.
It is important to understand that speculation does not, nor can it ever, address risks created
artificially by man. In particular, speculation cannot address successfully the risks created by
government and the banks. When risks are artificially created in order to enable venturesome
people to place bets in the hope of a large payoff, we talk about gambling. To confuse it with
speculation is a very common mistake. Unfortunately, the confusion is not always due to ignorance.
Often it is due to obfuscation. Take the example of government and academic economists making a
case for the derivative business using the language of speculation. They speak admiringly of the
sophistication involved in trading financial futures, and options on financial futures. However, the
derivative business: futures and options trading of foreign exchange, bonds and bills, interest rate
swaps, and a host of other derivatives of financial instruments that are invented almost every day,
this entire business, squarely belongs to the category of gambling. It does not belong to the category
of speculation. The reason is simple: the risk, whether it is a foreign-exchange or an interest-rate
risk, has been artificially created when the gold standard was abolished.
Economists blithely assume that, just as in the case of wheat, so also in the case of bonds, price
fluctuations can be smoothed out by allowing speculators to buy low and sell high. However, this
reasoning is fallacious, as we shall see. Economists should know better and make the distinction
between speculation and gambling clear. If they don’t, not only do they make a serious theoretical
mistake, but they also call the integrity of their own profession into question. They should not be
accomplices to a scheme which exposes society as a whole to very great economic dangers.
Responsibility of the economists
Why is it unethical for an economist or a financial journalist to compromise standards of precision
in their language of communication? By wiping out the distinction between speculation and
gambling, they are lying to the public who rely on them for correct information and interpretation.
They pretend, for example, that bond futures trading is just as essential to the welfare of society as
wheat futures trading is. The proof that this is false is in the fact that there were no bond futures
under the gold standard, while wheat speculation goes back to the Genesis (see the story of Joseph
deciphering the Pharaoh’s dream). The introduction of derivatives does not show that our society
has become more sophisticated. What it shows is that our society is so far from being sophisticated
that it does not even notice when it is being victimized by the crudest of swindles. The destabilization
of foreign exchange and interest rates through the abolition of the gold standard was not done in the
interest of society. On the contrary, it was done in order to benefit a small minority of people by
enabling them to milk the vast majority dry of its substance.
The speculator is pitting his wit against the blind forces of nature. His profits, if any, are
well-deserved. In the case of foreign exchange or bond trading the ‘speculator’ is pitting his wits
against the wits of bureaucrats working for the government. Those bureaucrats are not risking their
own funds. The bets they make are covered by the taxpayers. We may admit that, on occasion, these
bureaucrats make winning bets. But it would be a great mistake to believe that the payoff from
those bets would benefit the taxpayers in any way, or that the profits and losses incurred by the
government even out in the long run. The evidence available shows that, in the long run, there are
consistent and very substantial losses which the taxpayer is forced to make good. Incidentally, the
fact that profits and losses don’t even out is not surprising: the bureaucrats making the bets on
behalf of the government work for fixed salaries. Even if they were paid a bonus, it would never
match the compensation of the foreign exchange or bond ‘speculator’. The whole scheme is a fraud,
with zero public benefit. The public is plundered as it is made to underwrite the risks of a (for them)
completely unproductive gambling activity on private account. Take the words of arch-speculator
George Soros for it, who could, single-handed, force the devaluation of the British pound.
If it wasn’t for the scientific obscurantism of the economist profession, an impartial inquiry would
have found that our present monetary arrangements involving irredeemable currency are
untenable. These arrangements are based upon privileges granted without countervailing
responsibilities. In more details, unwarranted privileges have been extended to the treasury and the
Federal Reserve banks (which they ought not to have under the U.S. Constitution), namely, the
privilege to issue liabilities such as bonds, bills, and bank notes without countervailing
responsibilities, such as the obligation to redeem (as opposed to ‘rolling over’) those liabilities at
maturity. This also involves an outrageous double juridical standard. If a private party issued
liabilities under the same pretenses, then it would be charged with fraud and be dealt with according
to the Criminal Code. The monetary provisions of the Constitution of the United States (which,
incidentally, have never been repealed showing that, indeed, a coup d’etat has taken place
overthrowing Constitutional order) are very clear on the point that the government has not been
granted power to organize its bills of credit into currency, or to pay its debt in any other manner
than paying specie. It is to the eternal shame of their profession that the economists were not in the
vanguard demanding such an impartial inquiry, on the contrary, they were most prominent among
those who wanted to stifle the budding debate aiming at the clarification of the issues involved.
Responsibility of the politicians
Why would the government tolerate the plunder of the majority for the benefit of a minority?
Granted that not all politicians have the intellectual powers to muster the technicalities of central
banking, money creation, and the derivative business, we may be sure that at least some have. It is
surprising that in the ranks of those few who have there have been no defections. We can only
guess that the potential defectors who were ready to denounce the scheme of plunder and pilferage
have been blackmailed. They must have been told that they would be blamed for the ‘systemic
failure’ of the monetary system that would surely follow hard upon the heels of any unauthorized
disclosure.
The fact is that the trading of derivatives absorbs a huge amount of currency. This currency is
already in existence. It cannot be wished away. We are talking about a high multiple of the amount
needed in the real economy (that is, money needed to produce and distribute goods and services
without which society cannot function). What will happen if all this currency, from one day to the
next, becomes surplus? If irredeemable currency is outlawed, the derivative markets will fade away
along with the drying up of volatility. The casino is closed, and the chips are worthless. Trillions of
dollars would become superfluous and have to go begging. The dollar would lose its value. Worse
still, along with it, all wealth denominated in dollars would also lose its value. People belonging to
the middle classes in America (and, for the stronger reason, also in the rest of the world) would lose
their life-savings, just as they did in the Weimar Republic of Germany in 1923. By now it is
recognized that runaway inflation, more than any other factor, was responsible for the birth of
Hitler’s Third Reich. The potential defectors from government, who would have been willing to
expose the regime of irredeemable currency for what it is, shirked their responsibility and remained
silent. They did not want the stigma of having helped spawn latter-day-Hitlers all over the world.
Resonance in economics
But even if it is maintained through the ‘conspiracy of silence’, the regime cannot endure. The issue
is not just scientific obfuscation, or the fact of an ongoing plunder of the majority by a minority.
More serious still is the fact that society is being exposed to very great dangers which one only in a
million can recognize. Great economic forces are at work that are potentially very destructive and,
when let loose, will cause very great economic pain. (In what follows I shall drop the quotation
marks ‘ ’ when referring to bond speculators).
Speculators don’t buy the bond because they want to earn the interest income. They buy it because
they want to ride the rising trend in bond prices (i.e., they want to profit from the expected fall in
interest rates). Speculators don’t sell the bonds because they are ready to employ capital, thus
raised, in the real economy. They sell it because they want to garner the difference between the
higher rate of interest on the longer-, and the lower rate on the shorter term debt. In other words,
they want to ride the yield-curve. The long and short legs with which speculators enter or exit the
bond market are not alternating randomly. Bond speculators march in lockstep.
Since Roman times, manuals for military commanders have included the interdictum that an
infantry unit crossing a bridge must not march in lockstep. The reason for this rule is that the
periodic thrusts of pounding boots could resonate with one of the harmonic frequencies of the
bridge. This resonance would then cause runaway vibration, culminating in the destruction of the
bridge.
Runaway vibration
The phenomenon of vibration is studied in physics. The most common varieties are even vibration
(oscillation) and damped vibration, according as the amplitude remains constant or it is decreasing
exponentially. But there is also a third variety, not as well known, called runaway vibration, where
the amplitude is increasing exponentially. The collapse of the Tacoma suspension bridge in the State
of Washington in 1940 was an example. Gusting winds caused the bridge to vibrate at one of its
harmonic frequencies. The increasing amplitude of the runaway vibration ultimately caused the
suspension cables to snap, and the whole structure was plunged into the river. The event has been
preserved on film — it must be seen to be believed. In general, the small parcels of energy
represented by each thrust would get dissipated harmlessly through damping. In the case of
resonance, however, not only are they not dissipated, they are allowed to be built up to a formidable
force capable of causing huge destruction.
Resonance in economics, no less than in bridge design, is a problem to reckon with. I have discussed
linkage in my talk Kondratieff Revisited. The price level and the rate of interest move together up or
down, as they resonate with huge oscillating speculative money flows to and fro between the bond
and commodity markets. Bond speculators try to maximize their profits. For them the problem is
correct timing: they want to be the first to switch positions when the expected turn of the flow of
money materializes. This is just the point where the runaway vibrator starts spinning out of control.
As soon as speculators find that point, the oscillating speculative money-flows will become too big
and too destructive for anybody to control, and they will drown the economy.
It is clear that elementary principles of resonance were completely ignored by the designers of the
world’s present monetary system. Following Keynes, they blindly assumed that speculative buying
and selling bonds and foreign exchange takes place at random (as does the thrust of pounding boots
on the bridge if the infantry unit obeys the rules) and, on average, speculative buying and selling
balance out one another. It is true that speculators do act randomly in markets where risks are
nature-given. But this is no longer true when risks are man-made. As pointed out above, in that
case speculators march in lockstep. They are either net long or net short, according to the prevailing
market trend which they all want to ride and amplify. As a consequence, speculators periodically
cause great damage. In the worst-case scenario, they could destroy foreign exchange values. Every
episode of a currency devaluation (of which we had hundreds in the 20th century) is a proof of that.
They could also wipe out bond values. Every episode of a runaway inflation (of which we had dozens
in the 20th century) is a proof of that. But the danger has never been so great as it is today, when
the entire world has embraced irredeemable currency uncritically. The linkage may turn the
inflation/deflation cycle of Kondratieff into a runaway vibrator. The ever wider fluctuations in the
rate of interest and price level threaten the entire world economy with destruction. This is the
threat of runaway inflation on a global scale, something that the world has never before experienced.
Yet the calamity is entirely preventable — given the proper monetary system that takes the
phenomenon of economic resonance and runaway vibration fully into account. The gold standard was
such a monetary system before the banks and the government started sabotaging it. It stabilized the
economy by stabilizing foreign exchange and interest rates. This eliminated fluctuations in the bond
market without which speculators could not operate. A runaway vibrator in prices and interest rates
was forestalled. A gold standard, if re-introduced, would do it again.
The mechanism of runaway inflation
Virtually all historic runaway inflations have taken place in the wake of wars, in an economic
setting that involved physical shortages of consumer goods or the physical destruction of production
facilities. This confused the issue, and made it possible to explain the phenomenon in terms of linear
models such as the quantity theory of money. It has also provided grounds for optimism that, with
prudent monetary policy and strict controls over the rate of increase in the stock of money, runaway
inflations in the future can, at least in peacetime, be avoided.
Unfortunately, the optimism is not well-founded. The explanation of the phenomenon of runaway
inflation in terms of linear models is fallacious. Nor can the proposition that runaway inflations may
not occur in peacetime be established inductively. The historic runaway inflations were all confined
to individual countries engaged in experiments with irredeemable currency, while most other
countries remained on a metallic monetary standard. For this reason explanations of past episodes
of runaway inflations in terms of the quantity theory of money are irrelevant.
The fact is that linear models are useless in studying runaway inflations. The phenomenon itself is
non-linear in nature, as it is the culmination of a runaway vibration. Keynes was a keen observer of
the 1922-23 episode of runaway inflation in Germany. He was so convinced that the process was
cyclical rather than linear that he reportedly risked large sums of money in order to convert his
insight into cash. He was betting that every time the Reichsmark was oversold, there would be a
bounce-back. For a time, indeed, he was making money on the long side. But disaster struck as he
placed one bet too many. When Keynes bought Reichsmarks the last time, the bounce-back came to
an end so swiftly that he had no time to exit. He was trapped in a losing position. The collapse that
followed was so complete that Keynes reportedly lost all the capital he had committed to the
venture.
A deeper theoretical understanding of the phenomenon of runaway inflation shows that destruction
on that scale is not possible except in the case of runaway vibration. The quantity theory of money
(and, more generally, monetarist precepts) are entirely inadequate and can’t deal with the problem.
Runaway inflation is not a monetary phenomenon. It is an interest-rate phenomenon, more
precisely, an economic resonance phenomenon involving the rate of interest. Recall that the linkage
is responsible for tying the price level and the rate of interest together. The bond speculator rushes
in like an elephant into the china-shop and starts causing great damage. The bond speculators’
concerted action causes the oscillation in the money-flows between the commodity and bond markets
to get out of control. The vibration is no longer damped (as it would be under a gold standard).
Instead, it follows the pattern of a runaway vibrator characterized by an amplitude increasing
exponentially. The energy-level of such a runaway vibrator also increases exponentially. At one
point during the inflationary spiral it will exceed the centripetal forces that keep the economy
together. The financial system snaps. The price level and the rate of interest reach astronomical
heights, destroying currency and bond values.
Why is a gold standard an effective brake on economic resonance, capable of preventing runaway
vibration? Because under a gold standard bond values cannot go to zero. Hence the rate of interest
cannot go to infinity. Compare that with the regime of irredeemable currency. A government bond
is merely a promise to replace one piece of paper with another at maturity. What is there is to stop
the value of the bond from going to zero, once the runaway vibrator starts spinning? The pious
wishes of central bankers? Or the altruism of bond speculators?
The debt incubus
Milton Friedman insists that the 1930 Great Depression in America was caused by the ‘collapse of
the stock of money’. He says that it could have been prevented by a more adept monetary policy:
the Federal Reserve banks should have put more money into circulation through open market
purchases of government bonds. Our position is diametrically opposed to that of the monetarists.
The long-wave inflation/deflation cycle is not a monetary phenomenon. It is an interest-rate
phenomenon. The Great Depression was an instance of debt-explosion, caused by the vanishing of
the rate of interest.
Several authors have pointed out that, as a matter of record, the Federal Reserve banks did in fact
create money through open market operations in the 1930's. However, the money so created was not
used in a way consistent with monetarist precepts. It was not used in commodity speculation that
would have met with the approval of the monetarists. Instead, it was used in bond speculation.
Businessmen were lethargic and did not see any profit potential in building up inventory. They
refused to take the loans offered by the banks. By contrast, bond speculators were frenetic. They
were full of exuberance (which in retrospect was not so irrational after all). They saw enormous
profit opportunities in what amounted to risk-free, government-subsidized bull market in bonds.
Speculators correctly diagnosed the meaning of Roosevelt’s monetary tinkering: the policeman on
duty to keep the rate of interest away from zero has been fired. Now the sky is the limit for bond
prices!
You can take the proverbial horse to water, but you cannot make him drink. Likewise, the Federal
Reserve banks can put all the money in the world into circulation, but still have no control over the
direction in which the new money will flow. In the 1930's newly created money flowed to the bond
market. This deepened the crisis in pushing bond prices ever higher and the rate of interest —
together with the price level — ever lower.
What Friedman calls a ‘collapsing stock of money’ was, in fact, the irresistible whirlpool of the bond
market sucking up money from the remotest corners of the economy. The bond market acted like a
giant vacuum cleaner running amok. The more money the Federal Reserve banks created, the more
destructive the sucking-effect became in draining money away from the real economy. Interest
rates kept declining throughout the 1930's. The consequences were devastating.
Every time the rate of interest falls, the present value of the outstanding debt rises (because a larger
capital sum can now be amortized by the same stream of money payments, as shown by the increase
in bond values). Even though the outstanding debt in the 1930's may look to us paltry by today’s
standards, when the interest rate goes to zero, its present value will still go to infinity. And as it did,
debt and inventory liquidation swept through the country. The pressure on business to liquidate debt
and inventory became unbearable. Those firms that could not reduce debt and inventory fast enough
were mercilessly forced into bankruptcy. The same was true of households and mortgages on homes.
The deflationary spiral, acting like a giant twister, uprooted fortunes, farms, firms, and families.
The dangers facing the world economy in the opening decade of the new century and millennium are
even greater than those of the 1930's. Indebtedness in the world is at a much higher level and it is
also much more widespread. The rate of interest started its descent from a much higher level,
making the bull market in bonds that much more ferocious. Government leaders and captains of the
economy see no great danger in the decline of the rate of interest. They congratulate themselves on
their success in ‘having licked inflation’. But the prolonged decline in th
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