I am a huge Peter Schiff fan, but one area where I think he is wrong is on his discussion of deflation. Deflation, depending on who you talk to, is either reduction of the money supply, or the reduction of prices. Peter Schiff and I agree that the money supply is the more accurate way to talk about inflation and deflation, so that is what I want to focus on.
Right now, Peter Schiff is critical of the Federal Reserve because they won’t tighten the money supply. He says that the Fed fears a false bogeyman of deflation. Schiff’s main argument is that a decrease in the money supply will cause a decrease in prices for the consumer. Therefore, while Wall Street mavens may hate the deflationary effects of tightening because their asset values will go down, the average person on the street will get a benefit of lower prices.
The problem, however, is that the idea of deflation causing decreasing prices is only true when sound money is involved, and, even if it were to be true, it would still be the death of both Wall Street and Main street. Before I go on, please understand that I don’t think that the Fed’s current money-printing policy is the answer. In fact, for reasons that will become clear, I prefer the deflation to the inflation. The only real answer, though, is to change the money system to one based on assets rather than debt.
So, first of all, why does the Fed fear deflation?
Our economy is based on debt. This means that nearly every dollar issued is based on a debt of money. The Federal Reserve’s balance sheet shows (assuming it is correct) that it has $11 billion in gold reserves and $3 trillion in debt assets. It has other assets as well, but they are dwarfed by these. I also think that this does not include the amount of revolving debt through its discount window program. For those that don’t know how this works, money is created when the Federal Reserve buys an asset. If the Federal Reserve buys gold, they print the money to purchase the gold. Therefore, they now have an asset (the gold) and a debt (the dollar, which, if you look, is a “Federal Reserve Note”). However, usually, rather than buying assets, the Fed buys debt, usually Treasury bonds. In other words, the “asset” that the Fed has is not a physical object like gold, but a promise to repay the dollars and more. If I give you a loan for $100 for 1%, that means you have to pay me back $101. This is normally not a problem, unless the only way that money enters the economy is through debt!
Let’s look at a small economy – Margaret, Bill, and Fred. There is no money in the economy, so they are bartering, which is very inefficient. Therefore, Sam enters the picture, taking the role of the Federal Reserve. “I’ll give you money,” he says, “but you have to pay it back!” Now, remember, this is currently an economy without money. And Sam’s a nice guy, so he will only charge 1% interest. So, he loans Margaret, Bill, and Fred $100 each at 1% due at the end of the year.
How much money is in the economy? The economy now has $300 in it. How much debt is in the economy? $303. There is now more debt than there is money to pay it back. So, at the end of the year, let’s say that Bill has been especially industrious, and he now has $200. Margaret and Fred both worked hard, but not quite as much as Bill, so they have $50 each. Now it is time to pay Sam back. Bill does fine, and has $99 left to spare. Margaret and Fred, however, are both $51 short. However, since it is the start of the new year, Sam will loan everyone $100 again, and even offers to loan Margaret and Fred an extra $50 to cover most of their losses. So now, Bill has $199, and Margaret and Fred both have $99 each. Now the economy has $397 in it, but $404 are owed.
As you can see, if the person issuing the money charges interest, there is literally no way to clear the debt obligations. In fact, the debt obligations will just keep growing until they take over the whole economy. That is basically where we are right now.
What happens in a few years, when they each have $50, but owe the bank $75? There will be less money in the economy, so will they lower their prices? Probably not. They will probably raise their prices, in order to cover the debts that they owe. But fewer people will be able to manage their debt obligations, and there will be very few winners – pretty much just the bank.
Now, the cure for this that the Federal Reserve and the federal government are proposing is that they just increase the amount of money in the economy every year. So the banker loans out money in increasing supply every year. The problem is that this compounds the problem for the future, and does not solve it for today. It brings inflation today, but at the cost of dramatic deflation tomorrow.
The Federal Reserve is right to be worried about deflation. In addition to the Federal Reserve’s $3 trillion in debts that they have purchased, total US debt (public and private) about $50 trillion. I also don’t know if that number includes obligations such as pension payments. Smart US households are getting out of debt. The problem is that there is much less total money than there is total debt. In other words, if we all decided to be good financial stewards and pay back our debts, there would come a point, long before the $50 trillion was paid back, that there would literally be no money left in the system. When we start teetering on that point, then everyone starts grabbing for cash just to make payments. The price of basic goods will skyrocket because everyone must hock their wares at higher prices to pay down the crushing debts. However, no one can afford to buy anything.
So what’s the Fed’s solution? Loan more money to fix the problem! When there is money back in the system, people can go about their lives more freely. But that just sets us up for another failure in the future. The alternate method is the one that Schiff recommends – for the Fed to tighten (i.e. increase interest rates). This will drain even more money from the system, because no one will be able to afford to revolve their debt at the new rate. This would be a disaster to anyone with debts, and those on main street are likely to have debts. Imagine if your credit card rate went from 20% to 40%? Or if home loans went to 25%? Or even this – let’s say that prices go down as Schiff assumes. Your wages will also go down. However, since your debt obligations are in dollars, your debt will not go down. So your debt will consume an even greater percentage of your take-home pay. Now, I actually agree with Schiff that tightening is the better alternative. But it is not because I think it will fix things, but rather because I think it will help us see the problems as they really are, rather than papering over them over and over again.
Now, as individuals, there are partial solutions. The first is to get out of debt. Those who have no debt will be the winners when deflation happens. This includes your home mortgage. I am paying a little extra each month to try to get out of debt earlier. The second is to switch all your loans to non-recourse loans. This means that if you default on your loan, the only thing they can go after is your collateral. You might not be aware, but normally, if your collateral does not pay your loan obligation, they can still go after the rest of your assets. So, if the housing market goes down and you default on your loan, if they can’t sell your house for what you owe on it, then you still owe the rest of the money! In a non-recourse loan, the collateral is all they can go after. I haven’t tried switching any of my loans to non-recourse loans, but it sounds like a good idea, though I don’t know that anyone is doing it for individuals.
The next thing is to store up physical cash. If the great deflation does come, you will need cash, and cash in the bank may not cut it (in Cyprus, they limited withdrawals). The third thing is to store up physical precious metals. Gold is the only physical asset that the federal reserve holds. Because of the debt-to-asset ratio of the federal reserve, I imagine that in a highly deflationary environment, gold will go up about 30x (basically, if a bank holds a 10% reserve, that means that it must have 10% of assets for every dollar it loans out. If you use this basis to *value* the fed’s holdings of gold, then it would take a 30x rise in the price of gold [the Fed’s only real non-debt-based asset] to give them the reserve holdings normally required). In other words, if you have gold, you may be able to pay off your debts. For individual transactions, I would hold silver. Hopefully in the future, silver will also be usable as a reserve asset, but for now it should be viewed as a tradable asset if money breaks down (or, in my next post, sooner). If any central bank decides to hold silver as a reserve asset (and China has thrown that idea around), then this will also be beneficial, as you could sell it to that reserve bank for their own currency, and then convert that to gold or US currency, and then pay down your debt with it.
So, as you can see, presuming that societal structure holds, in a deflationary event, you are screwed now, and in an inflationary event, you are screwed later. The only real solution is to not hold debt but only hold real assets.