Money: Why Deflation Will Not Happen


How many people do you know who bought gold around $103? Sold out in December 1974 at the height of the boom? Bought stocks when the Dow bottomed and sold them when the Dow was over 1000?

Not many, I'd bet. The majority of people, especially when entering markets for the first time, tend to buy near the top and hold all the way down, waiting for the market to turn. The psychology of the market, grounded in good old human optimism, is the reason. When prices are going up, people expect and want them to keep rising. When prices are going down, people want them to go up, but believe they are going to keep going down.

The theory of contrary opinion is based on this simple observation: Sell when the public buys; buy when the public sells. That, in a nutshell, is the way to make money in markets.

Of course, you need to know a lot more than that. Timing is all important, and beyond the scope of this column. But whenever you are considering investment, always keep in mind what I call The Market's Law of Gravity: Everything that goes up, must come down; and everything that goes down, must come up.

Such a simple rule has a host of exceptions. If a company goes bankrupt, its shares are never going to come out of that down phase. Prices can move sideways rather than up or down. Keeping this rule in mind will guard against being caught in the feverish atmosphere surrounding the top of any bull market—and from missing out on the bargains at the bottom of the bear.

Such straight-line thinking about the future is an easy trap to fall into in any area of prediction. I think it accounts for the increasing numbers of people in hard-money circles who are predicting deflation, rather than runaway inflation, as the ultimate consequence of the current monetary crisis.

If we remember back to 1973-74, predictions of imminent runaway inflation were a dime a dozen. When inflation subsided, so did the fear of an inflationary collapse. Now many people are afraid of deflation and depression, a fear based on the current enormous level of pyramiding debt, with the prospect of a credit collapse.

Certainly, the level of debt is a cause I for concern. So is its poor quality, with so much lent to Third World countries. Their shaky economies would guarantee a default in times of stable money. Or the borrowings of communist nations, who sell less than they buy in the West, and have little or nothing left to pay back the interest, let alone the capital.

John Exter, former Citibank executive, is possibly the most well-known proponent of deflation as the most probable future for the United States. Many others are appearing in growing numbers.

The crux of their argument is that many of these shaky debtors must default sometime soon. Since much of this debt is held by the top US banks, such a widespread default will render these banks illiquid. They will be unable to pay out their depositors, resulting in a run on the banks; and the nation will be gripped in a banking panic like that of the 1930's.

There are many flaws in the arguments of the deflationists (those predicting deflation). Exter, for example, doesn't understand what deflation is: namely, a reduction in the money supply. His definition—falling prices—presupposes a falling or stable money supply. As the government isn't about to change its policy of printing money, a deflation could only happen as a result of a banking collapse.

In the absence of a government policy of deflation, the likelihood of that banking collapse is about zero. New York City provides us with a perfect example of the deflationist scenario. Banks like Citibank and Chase Manhattan have upwards of 50 percent of their assets in New York City and State paper. New York City declares a moratorium on interest payments. The market for New York City bonds drops to zero. Big New York banks suddenly find a substantial part of their assets worthless. If they've invested in W.T. Grant, Penn Central or Lockheed paper as well, they've got a few more problems.

But neither Citibank nor Chase closed its doors. No run eventuated. And it wasn't as though the Fed or Washington raced to the rescue. Far from it. Then-president Ford made it clear he wasn't about to bail out New York—though Congress eventually came through with some assistance. Why didn't a run develop? Why didn't depositors line up to get out their money when it was known the big banks could be in trouble?

One reason is that people are so thoroughly bamboozled by the government and the banks, they're not aware that fractional-reserve banking means all banks are technically bankrupt now. No bank can pay out all its depositors on demand, because they only keep 10-15 percent of the depositors' money on hand (or at the Fed). The rest they loaned to New York City, the Soviet Union, Zambia and Peru. Not to mention Pan Am, Lockheed, and a few sound risks as well. The myth of the FDIC helps, of course, as does the belief (correct in my opinion) that the government, in its Federal Reserve clothing, stands ready to print unlimited dollars to stem any widespread bank run.

More importantly, New York's moratorium on interest payments didn't affect the banks' day-to-day operations. All they lost was some income, and only temporarily. Banks make their money from interest. So long as this keeps coming in, it doesn't matter too much if the capital is never repaid. If one of their borrowers is in trouble, especially one as big as New York City, the banks will reschedule repayments by postponing the date when the capital has to be repaid.

Providing the borrower can make the interest payments, the day of reckoning will be postponed indefinitely. Only when the borrower goes bankrupt do the banks have to write the loan off their books. If it's a borrower as big as New York City, then the banks would be in real trouble.

The temporary loss of interest income, even on a large part of a bank's assets, does not create cash flow problems at the tellers' windows. Since the amount is so small relative to the bank's total liabilities to its depositors, it can always borrow a little more from the Fed to tide it through until the interest starts rolling back in.

If New York City's default didn't start a bank run, how could a default by Peru or the Soviet Union? Neither country—or any other borrower—owes as much to the big US banks as New York City or New York State.

I'd be the first to agree this continual rolling over of loans is very poor banking practice. But it is only one of the many effects of inflation on debt the deflationists ignore completely. For example, inflation reduces the real value of any debt. Thus, if New York City—or you—manage to postpone repayment of a debt, you'll be able to pay back a debt contracted in 1976 with 1978 or 1980 dollars.

Inflation also encourages debt for this very reason. The rising level of debt is simply another result of inflation, as everyone tries to buy assets today and pay for them with dollars tomorrow. Thus, we've seen the troubled companies of 1974-75 becoming profitable in 1977, partly because inflation has enabled them to trade out of trouble. The same thing applies to the Soviet Union or Third World nations.

But there is also a host of international bodies like the IMF standing by to bail out any Third World nation that has trouble paying back its loans. And the bankers themselves stand ready to "reschedule" repayments on loans which Third World nations are having trouble servicing.

To put the final hole in the deflationists' arguments, the events of the 1930's do not bear out their thesis of a credit collapse. The worst years of bank failures were 1931 and 1933—two and four years after the depression had begun. The bank failures resulted from a government policy of deflation.* They were not the cause, but the result of deflation.

In other words, there is no way a deflation can happen now unless the government causes it to happen. What are the chances of that?

* See Milton Friedman and Anna Schwartz, A Monetary History of the United States; or Murray Rothbard, America's Great Depression.