May 22, 2011
The Coming Deflationary ContractionBy Peter Raymond
Determining when the next great liquidation will occur is impossible to predict with any degree of certainty; nevertheless it is fair to say the sooner the better. Economic liquidation is a restorative process that corrects the harm done by inflationary policies. If accepting of this premise, then liquidations or deflationary depressions cannot be considered the disease in need of cure which unfortunately has been the position of economic interventionists since the early 1920's.
Instead, they are a necessary and unavoidable adjustment after years of excessive credit expansions have destabilized the economy. Efforts to further delay these self-corrections by instituting a series of escalating inflationary policies only needlessly extends and deepens economic woes and increases the size and scope of the inevitable adjustment. With the increasingly aggressive actions of the world's central banks and governments over the last decade to inflate the monetary supply, it seems a safe bet the next liquidation phase, when it does finally take place, will be a very large and abrupt correction.
Already, the ominous signs of economic stress caused by historic intervention measures are becoming evident. Despite the extraordinary monetary and fiscal policies to ward off deflationary pressures and economic contraction, prices are once again signaling that certain sectors of the economy would quickly liquidate if the stabilization programs in place were lifted. Home and auto prices for example have been pushing through a series of price support schemes and headed to lower levels in spite of a rapidly depreciating dollar. Also, the recent increase in volatility in both the commodity and currency markets is suggestive of price distortions generated by the Federal Reserve's ongoing quantitative easing programs.
The combined initiatives of policymakers and central bankers to suspend economic forces to create the impression of a recovery and price stability can go on for only so long before the building wave of deflation can no longer be contained. Not even the most ambitious plans to flood the economy with easy money can prevent the eventual contraction of the economy and a general fall in prices. It has been tried before and it does not work. There is of course a cost for such heavy-handed intervention. The longer and more aggressively a market correction is delayed by predictably ad hoc measures of panicking policymakers, the greater the size and duration of the liquidation.
Perhaps most concerning is the continued arrogance of the present day interventionists. They are never in want of self-confidence or devotion to their policies. Unfortunately, their conventional wisdom continues to justify radical inflationary measures as a means to indefinitely hold off a liquidation cycle and miraculously jumpstart another period of economic expansion. Nearly four years after the first indications of looming economic trouble appeared in the second half of 2007, these tinkering central planners now seem willing to sacrifice the dollar in order to defeat the deflationary pressures their previous inflationary policies fostered in the first place. Needless to say, it will be utterly demoralizing to witness the expected ramp up of desperate actions by these frustrated interventionists utterly dumbfounded by their repeated failures to stimulate economic growth. Of course, they will never acknowledge their actions prolonged and aggravated economic decline.
So what happens when the liquidation process of a depression begins in spite of the slew of much touted countermeasures that are soon followed by heated accusations of interventionists looking to assign fault to hapless scapegoats? It entails a dramatic fall in prices and production of nearly every non-essential good and service until price and production reach levels supported by market conditions. Wages, durables, equities, and real estate will plunge at an alarming rate. Labor unions and major industrialists will unsuccessfully try to shield themselves from deflation and job losses by demanding the government implement price and production controls. But government can do nothing long term to bolster artificially high price levels and will only further decimate the economy by trying. In fact, stabilization efforts during a liquidation period often cause prices to sink far below where they would otherwise have been under a passive policy. Sadly, unemployment does spike, especially in high order industries until wages adjust much lower. This is truly an unpleasant affair, but completely necessary and usually short lived.
Although it is counterintuitive and obviously controversial, it is imperative to allow the monetary supply to contract and interest rates to rise while simultaneously reducing public spending. Without such action or, in many instances, inaction, the economy will only be further disrupted and recovery delayed. Even something as innocuous and seemingly compassionate as extending unemployment income has the unintended consequence of delaying reemployment and economic recovery. It is interesting to note that prior to the New Deal, private charitable organizations strongly opposed government funding of humanitarian efforts including unemployment income. They correctly argued charity was best left in the private sector.
Such austerity and money tightening measures employ exactly the opposite philosophy cooked up by Secretary of Commerce Herbert Hoover, and later expanded upon while president, to "counter attack" depressions and supposedly avert economic ruin. Amazingly, Hoover's basic premise that government action is the "better option" has not lost any of its appeal to this day.
By the way, do not believe the revisionists' false portrayal of Hoover as ever favoring a laissez faire approach with the economy before or during the depression. Hoover was an enthusiastic central planner who frequently boasted of his intervention successes in 1931 when it was thought government stopped the depression with its numerous command and control programs. And records prove the Federal Reserve was pouring cash into the reserves of national banks trying in vain to expand credit. The shrinking of bank reserves was the result of a justifiable loss of faith in the banking industry leading to abnormally high demand for physical possession of legal tender.
To his credit, Hoover ignored the rather stunning proposals put forth by leading industrialists and labor leaders to institute full blown national planning, much of which was supposed to emulate the then en vogue Soviet model. Many of their ideas would emerge later under the disastrous New Deal policies of the FDR administration. Had he complied with their requests, Hoover would have joined the ranks of other prominent Marxist leaders of that period and not just another failed interventionist who spent the remainder of his life vigorously defending his actions to the very end.
Some unexpected developments can occur as a result of liquidation, barring any massive government intervention. First, there is normally a strengthening of the currency as the monetary base contracts. So in our case, the dollar's current downward trajectory would conceivably reverse course, causing the price of dollar-based commodities to fall as a result. Surprisingly, gold and silver prices fall as well in response to rising interest rates on savings and the strengthening currency. There recent selling of gold holdings by George Soros and other large hedge funds may presage a reversal of gold prices and dollar valuation. Second, falling wages do not automatically translate into a loss of purchasing power. This is because the drop in prices for most goods and services will normally outpace wages declines. Those lucky enough to remain employed throughout a depression will enjoy an increase in purchasing power even when adjusting for wage reductions. This phenomenon is just the opposite of what occurs in an inflationary environment where wage earners experience an erosion of purchasing power over time. Allowed to run its course, liquidation is very rapid and the majority of unemployed return to work in less than a year, albeit at much lower wages and mercifully without much change to the average standard of living.
It is the affluent investors that bear both the immediate and long term brunt of the losses since the price of equities, hard assets, and real estate collapse and remain suppressed for quite some time. This outcome seems rather fitting since the wealthy are the primary beneficiaries and supporters of inflationary policies.
The all-important point is that the disruptive oscillations of the economy are the unfortunate consequence of interventionism and inflationary monetary policies generating boom and bust cycles. The policymakers and central bankers deserve the total blame for these swings of the entire economy and not speculators, consumers, or producers. These cycles are certainly not attributable to some ludicrous theory citing mysterious shifts in overall consumption causing over or under consumption. Until such time government is prevented from manipulating the economy and the monetary supply, inflationary expansions followed by deflationary contractions, along with the misery they produce, will be a permanent and inescapable part of our future.
Admittedly, nearly a century of indoctrination has created the expectation and confidence governments can and must take action in every economic crisis. It would be politically untenable for all but the staunchest non-interventionists to maintain a passive stance during a depression. By far the majority of policymakers succumb to the demands of hard pressed constituents, even if it is known such actions would ultimately hurt the people they are meant to assist.
This brings me to the recent remarks made by the economist Joseph Stiglitz where he declared austerity measures are essentially a failed "experiment that has been tried before" which destroys jobs and undermines economic recovery. Naturally, the first question that comes to mind is: Where and when have austerity measures been proven to be ineffective in dealing with economic contractions? During the last depression, government actions incorporating most of Stiglitz's preferred spending policies yielded an unmitigated humanitarian disaster that dragged on for nearly a decade. Surely, it would seem unreasonable for Stiglitz to consider the New Deal "experiment" as even remotely effective in ending or even shortening the depression, let alone creating or saving jobs. Then again, nothing about the public intellectuals from the left shocks me anymore.
The conspicuous flaw with the interventionist logic is the fundamental belief wealth is created by consumption; the more that is consumed, the greater the wealth creation. Therefore, economic interventionism is centered on maintaining wage and price levels in order to maintain a targeted rate of consumption. In reality, it is production that creates wealth. And the wealth created by production is what results in greater consumption. Interventionists have the cart before the horse.
It is this nonsensical reversal in the order of wealth creation that leads to the erroneous conclusion that net prosperity is increased by more evenly redistributing wealth and expanding public spending. Since both are thought to increase overall consumption, interventionists reason the national prosperity will grow as a result of their economic and social engineering schemes. Interventionists are so beholden to the idea of wealth being created by consumption that they have derived out of thin air a formula to calculate how much government "investments" will grow the GNP. Somehow a dollar confiscated from the private sector through taxation magically produces more than a dollar in economic activity when spent by government.
In practice, such government spending sprees have a highly corrosive effect on the economy and employment by removing much-needed funds normally set aside for productive purposes, and instead using them for consumption. Since government, by and large, is a massive consumer of goods and services that uses the funds taken from the private sector, it contributes relatively little to production or investment no matter the level of spending.
The idea that government spending acts as an additional factor in the economy, and thus a productive investment, most likely comes from its odd inclusion in the GNP numbers. This undoubtedly obscures the negative impact public spending has on economic growth and prosperity. That fact that GNP was first introduced in 1934 in the midst of the New Deal era should arouse the suspicion of critical thinkers, however.
Because government spending is largely representative of consumption and not production, the coerced private sector contributions funding public spending is in fact a burden on the private sector that actually reduces overall production and wealth creation. This is why during any economic downturn it is best to reduce and not increase government spending in order to lessen the drain on private sector capital. Otherwise, there is less private capital available to invest in production and aid in the recovery process. Advocates of consumption-oriented economic policies are unwilling to accept that no manner or amount of government spending, whether or not it is referred to as an investment, can duplicate let alone outperform the positive return of voluntary private sector investment in production.
The overriding issue that will complicate our economic recovery is the massive national debt. A drop in tax revenues and any increase in the value of the dollar that normally accompanies a liquidation cycle will push the nation closer to insolvency as the economy works its way through monetary excesses. Also, the interest on the national debt will become an inescapable and growing drag on the private sector as interest rates rise from historic lows. These are the unfortunate consequences of a fiscally reckless government continuously accruing debt for over a generation. There is little doubt the Federal Reserve will continue their crusade to depreciate the dollar in order to facilitate deficit spending and lower the cost burden of the national debt. However, these inflationary efforts will likely fail to hold off a deflationary contraction for much longer.
Contrary to the predictions for the complete ruination of the dollar, I anticipate quite the opposite. In the near term, inflationary pressures will certainly continue to build and may surge for a short time, just before a sudden reversal occurs marking the beginning of a liquidation cycle and rapid deflation. Strange as it may sound, I believe the onset of a deflationary depression offers the best hope of salvaging the dollar and ending the reign of the inflationists. Growing public awareness and displeasure over the harm done by inflationary policies and runaway government spending may leave no option available to policymakers other than returning to the gold standard thereby forcing fiscal and monetary restraint.