Inflation, recession, and new currencies

by Alasdair Macleod, GoldMoney:

Central bankers are trying to steer markets away from higher interest rates, citing growing evidence of the harm they are doing to economic growth. Quantitative tightening is dead on arrival.

Predictably — because it is a repetitive cycle — bank credit is beginning to contract. But contracting bank credit is associated with periodic systemic crises. The credit contraction crisis promises to be even worse than the Lehman failure and any that came before it. And because central banks are sure to protect financial asset values from collapsing, their currencies are likely to suffer instead. Being entirely fiat unbacked by legal money, currencies are dependent entirely on the public faith in a financial system which lacks the backing of real money. 


We are all rapidly drifting onto the rocks which sank John Law in 1720. Central bankers, like John Law with his Mississippi bubble, are prioritising support for financial asset values over their currencies, which is what interest rate suppression is all about. Just as Law’s fiat livres rapidly became worthless, so will today’s fiat currencies.

Therefore, in the interests of one’s own self-protection, it is time to fully understand the difference between legal money, fiat currency and the importance of bank credit.

Central banks refuse public access to legal money, which is their gold reserves. Nor is access demanded by the investment establishment, which has thrived on monetary inflation. Instead, there is a developing debate about collapsing currencies being backed by commodities instead. This article puts these developments into context.

Macroeconomic policies are to blame for the crisis

It is a mark of how bad the condition of Western economies has become when interest rate rises of only a per cent or so is enough to expose their fragility. The blame can be laid entirely at the door of neo-Keynesian macroeconomic beliefs. And like a dog with a bone, their high priests refuse to let them go. They would now have you believe that inflation is transient after all. They say that interest rates have risen enough to tip the world into recession. 

In this way of thinking, it is either inflation or recession, not both. A recession is falling demand and falling demand leads to falling prices, according to macroeconomic notions. When both inflation and a recession are present, they cannot explain it and does not accord with their computer models. Therefore, government economists insist that consumer price rises will return to the 2% target, because rising interest rates will trigger a recession and demand will fall. It will just take a little longer than they originally thought.

They now say that the danger is no longer inflation. Instead, interest rate policy must take the growing evidence of recession into account, which means that bond yields will stop rising and after their recent correction equity markets should stabilise. For them, this is the road to salvation. 

What is really happening is that bank credit is now beginning to contract. Bank credit represents roughly 90% of currency and credit in circulation and its contraction is a serious matter. It is a change in bankers’ mass psychology, where greed for profits from lending, satisfied by balance sheet expansion is replaced by caution and fear of losses, leading to balance sheet contraction. This was the point behind Jamie Dimon’s speech at a banking conference in New York earlier this month, when he modified his description of the economic outlook from stormy to a hurricane. It is the clearest indication we can possibly have of where we are in the cycle of bank credit.

So, even though their analysis is flawed, macroeconomists are very worried. Nine-tenths of US currency and bank deposits face a meaningful contraction. At the beginning of a credit downturn, it is revolving credit which is first curtailed, hitting businesses which are cashflow deficient. This is a particular problem following covid lockdowns and for businesses affected by supply chain issues. Then, the easiest loans to call in those financing positions in financial assets —bonds and equities. And it is also a simple matter to call in and liquidate financial asset collateral when loans begin to sour. And goodness knows, modern economies are exceptionally exposed to accumulated malinvestments.

Central banks see these evolving conditions as their worst nightmare. They are what led to the collapse of thousands of American banks following the Wall Street crash of 1929-1932. In blaming the private sector for the 1930s slump which followed and was directly attributable to the collapse in bank credit, central bankers and Keynesian economists have vowed that it must never happen again.

But because this tin-can has been kicked down the road for far too long, we are not just staring at the end of a ten-year cycle of bank credit, but potentially at a multi-decade super-cyclical event, rivalling the 1930s, and given the greater elemental forces today potentially worse than that.

We can all understand that unless the Fed and other central banks lighten up on their restrictive monetary policies, a stock market crash is bound to ensue. And this is what we have seen, with the Fed funds rate only increasing by a paltry 1 ½% in the last year — an inadequate response to official US consumer prices rising 8.6% so far. Being forced into rethinking its priorities, preventing a stock market crash is now more important for the Fed than managing the economy’s financial condition. It is not that the Fed doesn’t care, it’s because their cherished neo-Keynesian philosophies are at stake.

Consequently, while we can see the dangers from contracting bank credit, we can also anticipate that the Fed and other major central banks will be pulling out all the currency and credit stops to support markets. Not least because rising bond yields to reflect a CPI rising at 8.6% and going even higher add significantly to the Federal Government’s budget deficit.

In effect, the macroeconomic establishment is making a predictable choice of prioritising the prevention of bank credit deflation over supporting their currencies. Realistically, it has no option but to fight recession with yet more inflation of central bank currency and through further expansion of commercial bank reserves on its own balance sheet. 

Besides central bank initiatives to keep bond yields suppressed, runaway government budget deficits due to falling tax income and extra spending to counteract the decline in economic activity will need to be financed. And given that the world is on a dollar standard, in the early stages the Fed will probably assume that the consequences for foreign exchange rates of a new round of currency debasement can be ignored. Currency debasement will be expected to accelerate not just for the dollar, but for all the other major currencies as well keeping their exchange rates in some sort of line. 

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