Can the Fed Prevent Deflation? Does it want to?(ZT)

Can the Fed Prevent Deflation? Does it want to?

by Michael Nystrom
January 24, 2007
Arlington, MA

It has been a few weeks since I've written on the subject of deflation,and in the meantime Mish has had a couple of good articles (here and here)on deflation that have answered just about every question anyone couldask on the subject. But after mulling all this over, I've got anothermore fundamental question that I'm looking for an answer to: Does theFed really want to prevent deflation?

As Mish points out, there is near complete confidence that the Fed canand will be able to stop deflation simply by "printing money." Underthis inflationist view, the Fed is obliged to stop deflation simplybecause it is in the best interest of the system -- American consumers,businesses, and the government. As the thinking goes, all of theseentities are in so much debt that they can simply never pay it allback. Therefore, not only the easy way out - but the only possible wayout - is through continued inflation of the currency - the printingpress solution. Bernanke shouted this intention loud and clear in his "It" speech that I discussed last time.As part of the new and improved, Clear-speak program at the Fed, Berniedidn't mash or mince words the way his predecessor Greenie did, andjudging from what everyone seems to think, the message has gottenthrough. Mission accomplished, Ben! The threat of deflation has beendispelled and we've seen red hot inflation since 2003.

But deflationists argue that this inflation cannot continueforever, and the trend will ultimately reverse. At which point, try asit might, the Fed will be helpless to prevent or reverse deflation fora variety of reasons. What the two camps share in common is theunderlying assumption that the Fed is terrified of deflation. But whyshould it be? Why does everyone think the Fed wants to preventdeflation in the first place? The common wisdom is that deflation wouldsimply be too detrimental. But for whom?

Ah, there is the rub.

A Brief History of the Fed
Nearly everyone thinks that the Federal Reserve and the FederalGovernment are one and the same, but this is not the case. The Fed is aprivate, for-profit banking cartel and the government is, well, thegovernment. The reason for the confusion is clear because it is, infact, quite deliberate. The formation of the Fed in 1913 was andcontinues to be one of the greatest Statue of Liberty plays in American history. "The Federal Reserve is no more Federal than Federal Express" says Michael Ruppert in America From Freedom to Fascism.But separate as they may be, these two powerful institutions are joinedin an unholy matrimony - a powerful marriage of convenience in whicheach party benefits tremendously.

Elected officials (i.e. the government) love to spend money and hate toraise taxes. If anything, they want to spend more money and levy fewertaxes. This is surely the path to reelection. Bankers love to makemoney with as little risk as possible. Voilà! An opportunity is seen,and a partnership is struck. The government hands over monetaryresponsibilities to the Fed, the Fed loans money back to the governmentat interest and each party is happy. The Fed reaps profits, theGovernment spends money thereby providing the people with pork andprograms, and taxes are not raised a dime. It is a win, win, winsituation, right? Right!

Except for the little matter of the Federal debt which grows and growsand grows. Oh, and also the small matter of inflation that eats away atthe savings, buying power and quality of life of the American people.The buying power of the dollar has dwindled so far since the formationof the Fed in 1913 as to leave it practically worthless. So thequestion of whether we will have hyperinflation is the wrong question -we've already had hyperinflation! It takes a full dollar today to buy what a nickel would have bought in 1913, according to the Fed's own CPI calculator!

The Fed is not Stupid
This level of inflation cannot continue indefinitely without direconsequences, and the Fed knows it. Anything us regular folks knowabout inflation, deflation, fiat money and the gold standard (notbecause we learned it in school, or heard it on the news but because weread it on the internet!) - the Fed certainly already knows, too. Likeus, they too understand that every fiat currency throughout history hasended the same way - in a hyperinflationary blowout, and despite whatBen has said about the magic printing press, they want to avoid such anoutcome with the Dollar. Such an end is not good for anyone, least ofall them. The bank gets its power from the ability to issue dollars -it would do them no good to kill their golden goose.

So what can they do?

In football, it's called the Statue of Liberty play. For those of youwho don't know football, this is a trick play designed to fool theopposition. In it, the quarterback - the one who normally throws theball - instead hands it off to a running back. The running back, whonormally runs with the ball, instead motions to throw it. But just ashe is getting ready to throw, another player sneaks around from behind,grabs the ball, and takes off running down the field! (The running backis left standing in a pose like the Statue of Liberty - thus the nameof the play.)

If executed properly, this is a masterful play of deception. Thedefense is in a state of complete disarray, having no idea what isgoing on. Is the other team passing? No - running! No, passing! No!Running! What the hell is going on?! By this time the play is over andthe offensive team has scored a huge gain, capitalizing on theopposition's confusion. Wikipedia's definition of it adds: "The phrasehas also come to represent any bit of desperate trickery ormisdirection outside of sports…" Though it adds that the play is rarelyused in professional leagues, but more often in pee-wee or high schoolfootball because "...a professional player is less likely to betricked..."

Unfortunately, it has become all too easy to trick the averageAmerican when it comes to the subject of money. Just watching the firstfew minutes of Fiat Empiregives you a taste of how woefully unsophisticated Americans are when itcomes to the subject our money. Because of this woefulunsophistication, the Fed can talk relentlessly about the war againstinflation, yet all the while be the primary culprit behind inflation. Ron Paul, who serves on the Congressional Banking Committee, has said many times that some members who sit on the committee with him still believe the dollar is backed by gold!It is not. But this demonstrates just how effective the Statue ofLiberty play that the Fed has been running since its creation truly is.The Fed was born of deception in 1913 and yet most people still to thisday solemnly take what it says at face value.

In a PBS interview in 2000, the late Milton Friedman was very clear about where the blame lies for the first great depression:

We had repeated recessions over hundreds of years, but what converted[this one] into a major depression was bad monetary policy.

The Federal Reserve system had been established to prevent whatactually happened. It was set up to avoid a situation in which youwould have to close down banks, in which you would have a bankingcrisis. And yet, under the Federal Reserve system, you had the worstbanking crisis in the history of the United States. There's no otherexample I can think of, of a government measure which produced soclearly the opposite of the results that were intended.

And what happened is that [the Federal Reserve] followed policies whichled to a decline in the quantity of money by a third. For every $100 inpaper money, in deposits, in cash, in currency, in existence in 1929,by the time you got to 1933 there was only about $65, $66 left. Andthat extraordinary collapse in the banking system, with about a thirdof the banks failing from beginning to end, with millions of peoplehaving their savings essentially washed out, that decline was utterlyunnecessary. At all times, the Federal Reserve had the power and the knowledge to have stopped that. And there were people at the time who were all the time urging them to do that.

So it was, in my opinion, clearly a mistake of policy that led to the Great Depression. (all emphasis mine)

Mistake? Really? For whom? 75% of the banks that failed were not part of the Federal Reserve System.Those banking failures went a long way towards eliminated the Fed'scompetition. The American people were devastated, but the Fed and theGovernment came out of the Great Depression stronger than ever. Goldwas outlawed, confiscated from the American people and once it wassafely in the hands of the government, the official price was raised.The greatest power couple in world history consolidated their gains.

Today's common wisdom is that the Fed didn't know what it was doingback in the 30's and ineptly caused deflation and the Depression. Butnow - thank God -- we know so much more and that will never happenagain! Lest you have any doubt, Bernanke spelled it out for us loud andclear in his tribute to Milton Friedman on his 90th birthday."Regarding the Great Depression," Bernanke said, addressing Friedman."You're right, we (the Federal Reserve) did it. We're very sorry. Butthanks to you, we won't do it again."

Great job, Ben! A command performance, complete with anadmission of guilt, a show of contrition and a loud proclamation thatit won't happen again. You may as well have used a megaphone. Andfollowed up, no less with a rousing encore in the form of the nowinfamous printing press speech just two weeks later.

But after all we know about the Fed, you're telling me that we'resupposed to take this dog and pony show at face value? Ha! As the oldsaying goes, fool me once, shame on you...

Thought Exercise: Now Pretend You're the Bank
Take a look at this quote, which can be found all over the internet:

If the American people ever allow private banks to control the issuanceof their currency, first by inflation and then by deflation, the banksand corporations that will grow up around them will deprive the peopleof all their property until their children will wake up homeless on thecontinent their fathers conquered.

This quote is attributed to Thomas Jefferson, though it is mostcertainly apocryphal. However I use it because it is instructive inmany ways. First, don't believe anything just because you read it, evenif you've read it many times. You can find this quote on a hundred webpages attributed to Jefferson. Second, even though Jefferson didn't sayit, there is still wisdom in whoever did: "First by inflation, and thenby deflation..."

As I already pointed out, we've already had the inflation.Most everyone is in debt up to his eyeballs, and the dollar has beeninflated to within 5% of its life. There's not much more room to gobefore it is completely dead. These are hard times for many individuals, corporations, and the government itself. Ben even told the government so recently -- that this is the "calm before the financial storm." (more on that next time)

But pretend for a moment that YOU are the bank, and all these entitiesowe YOU the money. When you look at the problem from this point ofview, something quite amazing happens. Why, there is no problem at all!Those poor consumers, businesses and the Federal government have allgone and gotten themselves into debt, haven't they? Well now they arejust going to have to pay it all back. End of story. What is theproblem now?

As the Bank, you're power comes from 1) your monopoly on the issuanceof legal tender, 2) your ability to create it out of thin air and 3)your willingness to loan it out and charge interest on it. In fact,deflation wouldn't be such a bad thing at all, since it increases thevalue the currency you have a monopoly on creating. During deflation itis best to have a mountain of cash and a positive cash flow to ride itout. The only problem is if folks start defaulting on you. But that has already been taken care of with the Bankruptcy Reform Act of 2005.That law was written by the credit card companies, i.e. the banks, i.eFederal Reserve members, to keep working people on a treadmill ofperpetual debt.

This reminds me of the stories of economic colonialism John Perkins told in his book, Confessions of an Economic Hit Man.First the World Bank would go to some natural-resource-rich third worldcountry and offer it a fat loan to "develop" its resources. The loanwould be bigger than necessary, and certainly more than the countrycould ever afford to pay back - but the bank would say, "with your newrefinery/mine/port/whatever, you'll have enough revenue to pay itback." When the country eventually did default, the IMF would sweep inwith "fiscal austerity measures" for the people and the government. Allthe revenue from the new development would be siphoned to the banks inorder to pay off the huge loan. Tsk tsk.

Sound familiar? Anyone who bought a house in the last five years knowsthat mortgage bankers rarely advocated financial prudence when buying ahouse, but instead pushed the idea to "buy as much house as you can (orcan't) afford!" And now with prices coming down, many of those buyersare stuck right where those third world countries got stuck. Looks likea fiscal austerity plan is coming down the pike for many consumers sothey can stay on the financial treadmill while the productive fruitstheir life - their labor - are siphoned off by the bank. Because thebanks still know that as much money as they make trading andmanipulating paper and financial "products," there is still only onetrue source of wealth, and that is human labor.

No, the Fed is not stupid. Not stupid at all. There will always bebooms and busts, and the best way to position oneself is to takeadvantage of both sides of the trade. Or as one responder to my last article put it so eloquently:

I am fascinated by the common perception that the FederalReserve is a proven non-stop inflation machine. Inherently, the FederalReserve uses inflation and deflation to whipsaw the average bystanderout of their savings. I don't see how one economic machination is morefavored over the other when the goal is to ensure that the public'ssavings ends up in the accounts of the shareholders of the FederalReserve System.

I couldn't have said it better myself. Don't count deflation out just yet.