Deflation in a Debt Based Economy

April 8, 2002


I support the idea that Fed Chairman Greenspan is walking a high wire act between the two known evils of inflation and deflation. The possibility of inflation exists but is of secondary concern at the moment given the higher probability that loan defaults will cause trillions of dollars to simply disappear. This would surely cause a lack of liquidity that in turn, could cause a deflationary collapse of the banking system. Such a catastrophe would be to the detriment of Mr. Greenspan's real employer, and place severe strains on his public image, if not his self-esteem.

Through his writings and his testimony we gather that Mr. Greenspan believes that the great depression of the 30's was caused by lack of liquidity in the banking system. The crisis of 1987 stock market crash had the effect of forcing the Fed to develop "better" means of micro managing the economy. The sudden plunge could have precipitated the very liquidity crisis the Fed chairman fears most. Another LTCM like crisis could topple the financial system into the abyss. In hindsight, we now know what the Fed knew in the moment. The LTCM failure almost created a collapse.

The Fed must now be using a very complex computer model in its attempt to act as a governor on what has become a dysfunctional economic engine. This is the motor that drives our great nation and most of the world is dependent on it. The new Fed model is not working as planned, and evidence suggests that it no longer has the horsepower to do its job. Despite what is told in the daily news cycle, nations around the globe are still in deep economic trouble.

I do not covet the job of Mr. Greenspan. I think it was an impossible task from its creation 70+ years ago. Soon, we'll all see its disastrous effects but will blame only Mr. Greenspan. Poor soul.

It would be educational to have access to the same model and supporting data afforded the Fed. I do not have direct knowledge of the Fed outlook for the economy. However, I believe all actions related to Fed funds are precipitated out of the new mathematical model. I believe this very model would show a probability that massive defaults are forthcoming. Like the models used by LTCM in its derivative operations, something has gone terribly amiss.

The new model used by the Fed may be defective, but I do not think that the Fed Governors act arbitrarily and capriciously. I believe them to be honorable men facing what has now become an impossible task.

The Fed has been aggressively adding funds since 1997. It is my premise that for the last 18 months the Fed has been injecting money at a mathematically calculated rate based solely on projections of the amount needed to prevent a liquidity crisis. Also, such a liquidity crisis would be caused by forthcoming defaults that are already being anticipated by the same model. This is to say that the amounts have been and continue to be adjusted to accommodate a coming crisis.

It might be that the model used by the Fed is so complicated the Governors don't understand it well enough to see the looming crisis. Perhaps they really believe the billions needed daily are just that amount required to stimulate the economy out of recession. BUT, someone knows a truth that no one dares speak. If it was originally designed as a stimulus model, it has now become a "berserker". It is destroying the very thing it was designed "save".

I suspect that the first hint of pending crisis was deemed mild in context of the then new Fed model. But, as time has passed, the need for additional cash injections has accelerated. The computer simulation (model) is now driving all Fed actions. It is already straining the Fed's capability to inject credit as fast as demanded. All hopes of the real manipulators - that the magnitude of the coming defaults will be small - have been dashed and born witness as false by the escalating cash infusions demanded.

If true, then one can only gape at the specter of what must lie ahead. The level of infusion of capital portends a day like every other day when 11 billion dollars just vanishes. And tomorrow again, and then again. One day there is no vanishing, everything just stops.

If the Fed model had been adequate, then any dislocation would have been in those sectors where capital was misallocated. It was not adequate. It is also a fact that no model is needed for this to occur. An unmanaged, normally functioning, free market would accomplish this.

However, history will record that our economy proved difficult to model with mathematics. Is that the understatement of this millennium? Attempts to micro manage have failed. Every cash infusion results in misallocation of more capital i.e., the new money doesn't go where the model thinks it will. In addition, since cash infusions are debt instruments, they require another infusion in a subsequent period just to service the new debt. The model calculates this in circular logic that yields an indeterminate spiral. The amount of cash needed, if properly allocated in a free market, is X, plus interest Y, equals the corrective stimulation needed today. Next iteration, the model calculates that we need X amount plus Z (the amount which was misallocated out of the last stimulus injection), plus Y interest on the cumulative total. There can be no "firing solution" which will eliminate another and then another infusion. Once critical mass is achieved, the system will implode as there will be insufficient additional resources that can be monetized as debt. The model is flawed. The Fed has spawned a berserk cash infusion machine.

What outcome will result from the Fed model? The model errs by underestimating the dollars necessary to offset the coming defaults because it adds to that very total. At some point the Fed will be unable to monetize sufficient assets. Then a global meltdown will occur that will vanquish all historical precedents set in the 1930's. Deflation is a forgone conclusion, but on such a massive and sudden scale that a new word is needed to separate this phenomena from the ordinary.

Others suggest that if surplus funds, beyond that needed to offset wealth destroyed, can or have already been injected, the results will be hyper-inflation not unlike that experienced in the Weimer Republic. This, they argue, will destroy the currency.

Perhaps we will have a bit of both, as the coming default crisis will probably generate an immediate over stimulus by the Fed. If so, then some new method will need to be invented to put additional currency in the system. There will simply be nothing left on which to base new debt.

In either event, our standard of living will be severely depressed. This will last until a time when chaos is reordered.

History will record these as times of great triumph and great failure. We live in interesting times where every day feels like a high wire balancing act. Is there any end to it? Yes, for the Fed, very soon.

Respectfully submitted for peer review - Your critique is solicited.

Carl Elkins, PhD
torus@ipdi.com

Gold is still being mined and refined at the rate of almost 2,600 tonnes per year.