The impact from a central bank's credit policy is perhaps the most misunderstood factor in the study of economics.  The majority believes easy credit from the Federal Reserve and expanding deficits by the federal government will quickly lead to price inflation.  Because of this belief, and because of the Federal Reserve's ballooning balance sheet, a large number of investors have recently embraced "inflationary hedges" and "inflationary investments" aimed at protecting their wealth against monetary depreciation.

The truth about Federal Reserve expansion policies; however, is significantly different from perceptions. A more correct assessment of expanding credit is this….  The United States has transformed its monetary system into one that's credit-based.  In such a system, the aggregate level of debt influences price trends.  Furthermore, in a credit-based economy, a creditor lends money to a debtor.  At that instant, the creditor holds a monetary asset that fluctuates in value.  The debtor normally uses the proceeds to purchase goods, services, or investments.  From the debtor's perspective, the immediate impact from this loan is twofold: (a) Spending power is enhanced in the short-term, and (b) as loan payments begin, disposable income is reduced over the long-term.

When new credit being issued exceeds old credit being paid off, it creates inflationary pressure during the months immediately following the lending.  Additionally, excessive lending creates steady, continual deflationary pressure once loan repayments begin.  Over the long-term, every short-term inflationary benefit is offset by an equal and opposite looming deflationary force.  That's why, throughout history, great credit inflations (bubbles) always end with prices crashing back down to a level roughly equal to the level at the start of the inflation.

In the United States, the deflationary potential created from new loans has been deferred for several decades by both Congress and the Federal Reserve providing consumers, homeowners, and business owners with incentives to borrow (rather than save) anytime a deflationary threat became real.  The repeated process of deferring deflation convinced the majority that government leaders can and will permanently prevent a serious deflation.  However, that perception is based on incomplete thinking.  The remainder of this letter will show why the long-delayed deflation is highly likely to strike in the coming months and years.

Led by Paul Tudor Jones, managers at the Clarium hedge fund have recently positioned their clients for deflation and depression rather than inflation and recovery.  In a September 1 article entitled, Goldman Sachs Wrong on Economic Recovery, Macro Hedge Funds Say, Cristina Alesci explains part of the deflationary case:

"Paul Tudor Jones, the billionaire hedge-fund manager who outperformed peers last year, is wagering that Goldman Sachs Group Inc. and Morgan Stanley got it wrong in declaring the start of an economic recovery….  'If we have a recovery at all, it isn't sustainable,' Kevin Harrington, managing director at Clarium, said in an interview at the firm's New York offices. 'This is more likely a ski-jump recession, with short-term stimulus creating a bump that will ultimately lead to a more precipitous decline later.'  Equity and credit markets have rallied on hopes that government intervention is pulling the US out of the deepest economic slump since the Great Depression….  Tudor … told clients in an Aug. 3 letter that the stock market's climb was a 'bear-market rally.'  Weak growth in household income was among the reasons to be dubious about the rebound's chances of survival, Tudor said.  A focus on misleading indicators is driving markets, macro managers say….  The housing data isn't as rosy as some see it, Harrington said.  As existing U.S. home sales rose 7.2 percent in July from the previous month, distressed deals including foreclosures accounted for 31 percent of transactions…. Clarium, which oversees about $2 billion, is positioned for an equity bear market through investments in the U.S. dollar, Harrington said.  Falling stock prices will strengthen the currency by forcing leveraged investors to sell equities to pay down the dollar-denominated debt they used to finance those trades, he said….  Macro managers' pessimism is fueled in part by the U.S. government's response to last year's financial crisis, which they say fails to address the root cause.  Banks still hold hard-to-sell assets on their balance sheets, the managers said….  The Financial Accounting Standards Board voted in April to relax fair-value accounting rules.  The change to mark-to-market accounting allowed companies to use 'significant' judgment in gauging prices of some investments on their books, including mortgage-backed securities that plunged with the housing market.  Banks are reporting better earnings because they haven't been forced to account for their losses yet, Clarium's Harrington said.  'We haven't fixed the problem,' he said.  'We've just slowed down the official recognition of it.'" [Alesci, 2009]

It seems that most investors have either forgotten or completely ignore the fact that banks hold hundreds of billions of dollars of toxic assets.  These are assets that are valued on quarterly earnings at levels well above market-price.  Even though bank executives were successful in pressuring regulators to changing accounting rules, they still hold the toxic assets.  The financial crisis persists.  The only factor that has changed is confidence.  Investors and executives are more confident now - even though actual financial conditions have continued to deteriorate.  It's simply a matter of time before the newfound confidence reverts back to panic and deflation.

Some believe that future inflation is a foregone conclusion because government control over the banking system has been greatly enhanced as a result of the financial crisis.  Smaller institutions have been failing in ever increasing numbers, while the rescued banks meeting the "Too Big to Fail" criteria now increasingly dominate all areas of the country.  These large banks now operate under increased political control.  In an August 28, 2009 Washington Post article, entitled Banks 'Too Big to Fail' Have Grown Even Bigger, David Cho describes various issues related to the new banking environment:

"When the credit crisis struck last year, federal regulators pumped tens of billions of dollars into the nation's leading financial institutions because the banks were so big that officials feared their failure would ruin the entire financial system.  The crisis may be turning out very well for many of the behemoths that dominate U.S. finance. A series of federally arranged mergers safely landed troubled banks on the decks of more stable firms. And it allowed the survivors to emerge from the turmoil with strengthened market positions, giving them even greater control over consumer lending and more potential to profit.  J.P. Morgan Chase, an amalgam of some of Wall Street's most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued-and-owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show….  But no consequence of the crisis alarms top regulators more than having banks that were already too big to fail grow even larger and more interconnected….  Regulators' concerns are twofold: that consumers will wind up with fewer choices for services and that big banks will assume they always have the government's backing if things go wrong. That presumed guarantee means large companies could return to the risky behavior that led to the crisis if they figure federal officials will clean up their mess….  The worry for consumers is that the bailouts skewed the financial industry in favor of the big and powerful.  Fresh data from the FDIC show that big banks have the ability to borrow more cheaply than their peers because creditors assume these large companies are not at risk of failing.  That imbalance could eventually squeeze out smaller competitors.  Already, consumers are seeing fewer choices and higher prices for financial services…  [During the crisis] officials waived long-standing regulations to make [merger] deals work. J.P. Morgan Chase, Bank of America and Wells Fargo were each allowed to hold more than 10 percent of the nation's deposits despite a rule barring such a practice.  In several metropolitan regions, these banks were permitted to take market share beyond what the Department of Justice's antitrust guidelines typically allow….  Last October, when the Fed was arranging the merger between Wells Fargo and Wachovia, it identified six other metropolitan regions in which the combined company would either exceed the Justice Department's antitrust guidelines or hold more than a third of an area's deposits.  But the central bank thought local competition in each of those places was sufficient to allow the merger to go through, documents show.   Camden Fine, president of the Independent Community Bankers of America, said those comments reveal the government's preferential treatment of big banks....  'To favor one class of financial institutions over another class skews the market.  You don't have a free market; you have a government-favored market,' he said. 'We will never have free markets again if you have the government picking winners and losers.'" [Cho, 2009]

Does this new system of "government favored banks" really mean that inflation is a foregone conclusion?  As a direct consequence, it does mean that the majority of financial assets and liabilities are now on the balance sheets of a handful of banks.  The greatest risk lies on the asset side of the ledger.  That's where losses are being hidden and disguised in droves.  To be sure, look at what's happening to property values in the private sector.  That ultimately represents the collateral behind bank assets.  The liability side of the ledger also poses risk if depositors suddenly decide to flee banks in a big way.  This threat is greatest among foreign depositors.  These are both looming deflationary threats that are mostly being ignored for now.

Government officials always overlook the fact that a deflationary recession cleanses unstable debt from the financial system.  Nonetheless, since the Great Depression, officials have remained paranoid of deflation.  In particular, recent Federal Reserve chairmen, Alan Greenspan and Ben Bernanke, have publicly stated their knowledge of the Great Depression and their ability to avert a similar disaster.  In a statement prior to becoming the Fed chairman, Bernanke said that if conditions became too desperate, the Fed could simply drop dollars from helicopters to re-inflate the economy - thus earning the nickname Helicopter Ben.  Following the tendencies of his predecessors, Bernanke's interventions again prevented the natural debt-cleansing process of free markets.

As a result, bad debt keeps building within our financial system.  Excessive risk-taking is repeatedly encouraged.  And allocation of credit becomes increasingly distorted and misplaced.  In the final stages of a monetary-system built on ever-expanding credit, the debt problem becomes so huge that government efforts to stabilize the system repeatedly fail.  That's the stage the US economy now finds itself.  At this point, even the combined efforts of the Federal Reserve and the US Treasury will fail to fix the debt-problem.

That's because too many individual and businesses hold too many bad debts that have no hope of ever being repaid.  A financial system built on ever-expanding debt is always doomed to fail - it's simply a matter of time before the expansion reaches its breaking point.

By preventing a series of minor deflations spread out over a period of several decades, the Federal Reserve has created an environment that will force one massive deflation (striking within a relatively short period of time).  By allowing bad-debt to continually build within the banking system, the Fed has created a situation that guarantees our government will completely loses control.  That almost happened last autumn, and it's guaranteed to happen sometime in the future.  It's only a question of when.

In an article entitled A Recovery Foundation Built on Sand, Michael Pento, the chief economist for Delta Global Advisors, describes how current government interference only prolongs financial agony, while never solving the underlying cause - which is excessive debt:

"Instead of allowing a cathartic and reconciling recession to run its course, the Federal Reserve (Fed) decided last year to again bail out the economy by greatly expanding the money supply.  In this latest case of artificial intervention, the expansion in the monetary base was a record-breaking trillion dollars, but that intervention has abated in the last few months.  What should become clear fairly soon is that the apparent recovery in the markets and the economy has been built primarily on the devaluation of the U.S. dollar, not from a healing of the economy's fundamentals.  That clarity will become evident once the dollar begins to make a brief rebound.  For the last few months, the Fed has temporarily halted its assault on the greenback in the mistaken belief that the economic crisis has ended.  Therefore, the most likely result will be a major correction in the market and a resumption of economic deterioration.  Unfortunately, that should eventually cause the Fed to resume its misguided efforts to bolster growth by wrecking the currency.  The Fed's conundrum is this: whether he is aware of it or not, Fed Chairman Ben Bernanke needs to defend the dollar and raise interest rates to provide for a viable and long-lasting recovery. But the short-term effect would be a devastating recession which is, of course, politically untenable…. That's because we just haven't acknowledged the reality of our addiction to debt and inflation as the basis for economic activity.  What I find most amazing about all this is how most in Washington and Wall Street fail to recognize what caused the crisis in the first place.  The problem never was that there wasn't enough borrowing, consuming and cheap money around.  The problem was that the level of debt in the country had become unsustainable.  In fact, as a country we are still actually increasing our level of debt.  Therefore, all our perceived healing was predicated on the devaluing of the dollar, not from the paying down of our obligations or a repudiation of our past behavior.  We just can't escape the day of reckoning.  The country will most likely go through a devastating bought of inflation to avoid a strengthening dollar and further erosion in asset prices.  However, a protracted period of deleveraging is still needed as a nation.  What we need is to return to a real economy based on a sound currency and reduced debt.  That will certainly be painful in the short term, but the only way to provide a long lasting and healthy economy." [Pento, 2009]

I agree with Pento on every point, except for one - a devastating bought of inflation is unlikely.  In the United States, two camps of thought dominate the marketplace.  The bullish camp believes that government interventions can be fine-tuned to hold inflation in-check, while allowing the economy to expand.  The bearish camp believes that government interventions will eventually unleash uncontrollable inflation that will send the price of gold, oil, and other commodities soaring to sky-high levels - while sending the economy into a prolonged tailspin due to reduced purchasing power.

But more than likely, both camps are wrong.  And the hyperinflation expected by the bearish comp is even more unlikely than the bullish viewpoint.  Why?  Throughout the world's financial history, there has never been a case of hyperinflation in a country using a monetary-system based on credit.  Hyperinflations only occur in countries that use currency for money.  That's an important distinction that cannot be overlooked.

A credit-based monetary system prevents severe inflation in two ways.  (1) During times of rising inflation, investors avoid bonds in favor of hard assets.  As a result, bond prices deflate, causing great losses for existing debt holders.  (2) During times of financial stress, bonds backed by questionable assets deflate in value.

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Alesci, C., [2009]. Goldman Sachs Wrong on Economic Recovery, Macro Hedge Funds Say.  Bloomberg, September 1, 2009.  http://www.bloomberg.com/apps/news?pid=20601009&sid=auGWGWlnohNo

Cho, D. [2009].  Banks 'Too Big to Fail' Have Grown Even Bigger.  Washington Post, August 28, 2009.  http://www.washingtonpost.com/wp-dyn/content/article/2009/08/27/AR2009082704193.html

Pento, M. [2009].  A Recovery Foundation Built on Sand.  Chief economist, Delta Global Advisors, August 17, 2009.  http://prudentbear.com/index.php/guestcommentaryview?art_id=10261