The global monetary/liquidity crisis is back in full swing. If you haven’t noticed, central bankers the world over are imploring their monetary counterparts to ‘do everything possible’ in order to ‘stave off a potential crisis’. After rapidly reversing policy in 2019, it seems that global central banks have moved into full panic mode over the past several weeks. The enemy: deflation, and the risk of recession in financial asset prices.
Central Bank Shenanigans
In September, departing European Central Bank President, Mario Draghi, unveiled new plans to restart a giant bond-buying program -read: money printing – to the tune of €20 billion per month. Not to be outdone, America’s Federal Reserve announced a new ‘debt monetization program’ and ‘liquidity-providing repo facilities’ – read again: money printing – to the tune of $60 billion a month, and $120 billion per day, respectively.
Before the 2008 Financial Crisis, the Fed’s balance sheet totaled roughly $870 Billion, or about 7% of US GDP. After three rounds of Quantitative Easing during and after the crisis, the Fed’s balance sheet now stands at c.$4 trillion – a nearly five-fold increase in a span of eleven years – and 19% of US GDP. The ECB’s balance sheet has swollen to a staggering 40% of Eurozone annual economic output, double the share of the US Fed’s.
To put these new liquidity initiatives into perspective, one must remember that the US’s QE3 was only $85 Billion a month of freshly printed dollars…
Okay, But Why?
These actions aim to do two things: firstly, the central bank monetizes the government’s debt, which allows government to make debt repayments to creditors by taking on new debt. This money is created out of thin air whereby the government’s treasury department borrows money from the central bank themselves. This is done by way of issuing government bonds and other debt instruments to the central bank.
Secondly, by injecting new money into the monetary system, the banks hope to drive up stubbornly low inflation in the economies and hopefully, financial asset prices – particularly the stock market. Et voila, recession averted! So, what’s not to like? Paper money creation and inflation allows the government to spend more, it keeps interest rates low, and makes stock prices go higher.
Paper Isn’t Wealth
The logic that a healthy inflation rate and low interest rates spur economic growth relies on the notion that with more paper money in circulation, and the expectation by consumers that the purchasing power of this paper should drop, they are driven to spend more. And of course, more spending must mean greater economic activity and resultant economic growth.
In a prior article, however, we explained that economic growth occurs when we 1) save 2) invest those savings, and 3) produce real goods and services from the invested savings. The real goods and services are then available to be consumed and enjoyed by everyone, raising the general standard of living for all in society.
The foundations of economic growth, then, are savings! Not spending, or an increase in economic activity.
When the currency supply is inflated and expanded, society’s savings are eroded and all existing currency units already in circulation are devalued.
One can then no longer rely on the purchasing power of one’s savings being maintained, and as such, people elect to rather consume their savings in the present. It follows that the savings foundation of economic growth is compromised resulting in ever-decreasing rates of growth, as there is less and less savings to power the production mechanism in the economy.
Shenanigans then, serve only to prop up and maintain illusory price growth in financial assets, especially stocks.
Deflation the Enemy
Most mainstream economists define deflation as a general decline in prices of goods and services.
The fear of deflation serves as the justification of every inflationary action taken by the central banks around the world. It is why the Federal Reserve targets a price inflation rate of 2 percent, and not 0 percent. And it is, simply, a great myth, for there is nothing inherently dangerous or damaging about deflation.
Opponents make the case that if people expect prices to fall, they become less willing to spend or borrow, dropping consumer spending into perpetuity and hence, a slump in economic activity. However, consumption cannot be foregone forever, and as we notice in the electronics industry daily, the value derived from the use of a smartphone over the foreseeable future, is worth more than the savings from delaying the spend.
Gold & Deflation: Paying Less for More
We decided to calculate the cost of both everyday consumer items, as well South Africa’s premier stock index (JSE ALSI), since the global financial crisis – in gold and in paper Rands.
The data clearly illustrates that once the Financial Crisis erupted, if you decided to convert your paper currency savings to gold, you would have safely mitigated the inflationary effects of central banks’ shenanigans, and in fact, you would have enjoyed the natural benefits of deflation in gold terms.
Whereas the average Rand increase in prices for the above basket of goods amounts to 140%, the average decline in goods priced in ounces, and concomitant increase in purchasing power, equaled 50%. Consumers wouldn’t need to bring forward spending and this stability in value would create a sound savings base in the economy – the true pre-requisite for growth.
Numbers, as the saying goes, never lie… deflation is golden.