Question Of The Week

Many have written to ask how I could possibly think a deflationary environment would unfold over the next few years when "evidence of inflation is so obvious"!

From a psychological perspective, part of the answer is in the question. The mere fact inflation is "obvious," that it is widely accepted and freely discussed in financial news outlets, is part of the reason we should no longer focus on it as a long-term probability. As a coorelated example, let's consider the recent bull market in Gold. After it became common knowledge that "Gold is in a bull market" and we saw daily commercials on investment opportunities in precious metals, plus we heard market gurus calling for a doubling or tripling of its value, it was obvious Gold's bull market was coming to an end. At the present time, the coverage of inflation is starting to possess the same, psychological characteristics.

But, the primary reason I believe a deflationary environment is underway is based on the little understood, structural and fundamental realities of today's banking system. The U.S. financial system today is far different from what it was 100 years ago. With the creation of the Federal Reserve in 1913, plus the elimination of a Gold backed currency, and the U.S.'s removal of Silver from coins in 1965, we moved from an "equity-type" financial system (where everyone could win) to a "net-sum-zero-type" financial system (where at least half must lose). Let me explain.

Around 100 years ago, if you borrowed money from a bank, they could not lend you more than they had on deposit. The bank's job was to make sure the investments they allowed were good for the public and likely to return a profit so they could ensure the safe return of depositor's money along with interest to both parties. As a result, the amount of money in circulation grew ONLY as the productivity and total value of all assets in the country increased. This created a very stable financial system with a slowly growing capital base that benefitted everyone.

When the U.S. removed all gold and silver backing from its currency, and moved to a "fractional reserve banking" system, money was no longer lent from one person to the next, it was created merely by the act of borrowing. In the same way futures contracts are "created out of nothing" when a buyer and seller come together and agree to take contrary positions, loans under a fractional reserve banking system "create money out of nothing" when the bank decides to lend money to someone who wants to borrow. In the same way that closing a futures position automatically reduces open interest and "elminates the contract," paying off (or writing off) a loan automatically reduces the amount of money in circulation.

If you follow this through to its logical conclusion, the money-lending boom of the last 10-20 years (the result of the public's insatiable appetite for housing) "created" excess dollars that went into the system and devalued each remaining dollar in circulation. That in turn created the inflation (i.e., each dollar is worth less) we have experienced over the same period. As the housing and stock market booms have come to an end, and as bank's have tightened their lending standards (i.e., they are lending less money), the supply of dollars in the system will begin to contract (this has already started). As loans are written off or paid off, dollars in circulation "disappear into nothing" (exactly where they came from), making every dollar left in circulation worth more. The paying off or writing down of loans, mortgages, the liquidation of leveraged positions are all the same as liquidating futures contracts - the contract's satisfaction or cancellation reduces that which it created - in this case, money.

The NET result of a net reduction in lending, and an increase in the number of loans and debts being paid down or written off, is DEFLATION.