People have peppered me with questions about why the dollar has strengthened recently, why oil has plummeted, and other inquiries related currencies and prices. My responses of deflation or demand destruction have led to more questions about what both are, since neither term is oft mentioned in the “buy and consume until death” sponsored and owned media. I will attempt to go into depth about how we got to this point with the dollar and commodities, what’s currently happening, and what to expect going forward.
I’ll start off with deflation since it best explains both actions in the dollar and commodities. Because it has so rarely occurred in the lifetimes of those currently going through this economic crisis, very few in the media or in society in general, know what deflation is. In fact, to see evidence of the last period of deflation, one needs to look back to the decade before World War Two, when the explosion of the stock markets and banking industry of the late 1920's and early 1930's triggered a deflationary depression. The stock market crash and consequent bank failures resulted in not only a severe decline in the availability of money (there was no FDIC until 1933, bank failures in the past meant your money was gone), but in the availability of credit as well, as a loss in faith of the banking system, and a failure of hundreds of banks, greatly reduced the availability of credit availability for one to borrow.
The eerie similarities between the credit bubble of the late 90's into 2007, and the credit bubble of the late 1920's are astonishing, with the differences and economy wide impact of the latest bubble being far more ominous and wide reaching in their scope. In both cases, massive borrowing (in the case of investment banks, leveraging) took place in order purchase non-productive assets (stocks in the 20's, stocks and then houses from the tech boom through 2007), creating price ramps in each, to the point where affordability (for housing) or value (for stocks) reached unsustainable levels, creating crashes in prices in the aforementioned assets.
To recap the deflation of the 1930's, banks lent out money to people speculating in the rise of stock prices, with the hope of making a profit without risking any of their own money. This process, known as buying on the margin, is VERY risky practice, as stocks do NOT always go up in value. In fact, stocks can go straight to ZERO, leaving the margin buyer on the hook for the loan from the bank in its entirety. As stock prices climbed and climbed during the late 20s, more and more people engaged in margin buying, as the stock market was widely speculated to continue going up. This continued until A. People with hard cash decided to take profits, or stay away from the market entirely and B. Banks started to cut back on their lending to margin buyers out of fear of declining stock prices. This is called an inflection point, the point on a curve at which the direction of change switches, either to positive or negative. In the case of stocks in October of 1929, the inflection point was a negative turn for stocks, as people began to sell out of stocks, and sell fast.
As the selling accelerated many margin buyers were left with a negative balance between what they could sell their stock positions for versus what they owed the bank on the money they had initially borrowed to buy in. When the lender went to collect their money, there was a significant lack of backing assets to sell in an effort to recoup losses, as they had banked (pun intended) on stocks rising in value. The net effect of this action resulted in the debtor going bankrupt, the lender losing depositors money, which greatly reduced the appetite and ability of the bank who initially lent the money to lend going forward.
This was deflationary in two ways.
- The primary impact resulted from the position of the margin buyer, as they were now in debt to the bank without having gained a productive asset. Money which could have been put towards production, or spent on consumption of goods, was now instead flowing back to the bank to replace the balance of the debt, or was simply lost forever in bankruptcy.
- In the case of the bank, there was a reduced amount of money available to be lent out to the public, a de facto decrease in the money supply. Additionally, losses of a certain loan type often spurred more stringent lending standards going forward of not only that loan type, but other loans as well, in order to preserve the banks solvency.
These are deflationary as there is less money available for consumption, and therefore production. Decreased demand (or a decrease in dollars available) puts downward pressures on prices of both finished goods
For the depositor, this meant a portion of their “savings” no longer “existed” in the bank, which under normal circumstances happens fairly often. However, since it is rare for anyone to demand all of their money from a bank at any one time the impact of this loss is minimal. However, if the bank suffers a large number of losses, as it occurred for many banks during the stock market crash, depositor withdrawals begin to significantly hinder normal banking operations. The red flag indications of a distressed bank included severe withdrawal limits, reduced lending, increased interest rates on savings accounts, amongst other abnormal actions.
During the stock market declines of 1929, a much more financially informed public (significantly lest trusting of banks as well), recognized these warning signs, and began to withdraw their deposits for fear of not getting them back (No FDIC protection until 1933). A double edged sword, of losses on loans and massive depositor withdrawals, began to hack away at the solvency of banks across the nation, leading to the collapse of hundreds of banks as they lacked the cash to pay depositors or to function as a bank by loaning money.
The effect of collapsing banks is amplified by the fractional reserve system, as removal of dollars from the system has a larger actual effect than the bottom line notional amount lost. Assuming a 10% reserve requirement, a loss of $1,000,000 from the system also costs almost 9 million additional dollars worth of potential capital! This works as follows: Bank A receives a new deposit of one million dollars, bank A can lend out nine hundred thousand of this to Bank B, who can then lend eight hundred and ten thousand of this to Bank C, and so on. To fully exploit the initial million dollars into ten million in totality can take years, if not longer, as the money is continually loaned out from one institution to another. However, when money is removed from the system, the effect is instantaneous, and the carry on effects are not limited to restrictions on new lending and the creation of capital which leads us to our current situation.
Much of the money lent out and borrowed is used to purchase assets, and in the case of the recent boom, they were used to buy houses. This use of debt, in regards to the effect of capital destruction above, has painful consequences when the boom is no long sustainable (see 2006). As defaults began to mount, banks and investors were faced with the same painful scenario as they had been in 1929 with regards to stocks.
The conundrum is this:
- Assets against which their money had been borrowed were only worth what the market would bear.
- In order to maintain prices, the banks need deposits to push their reserves above mandated reserve ratios in order to lend, and they needed prospective borrowers to take on the debt.
- Should the banks ability to lend or a supply of willing borrowers cease to exist; prices collapse.
The latter two points are extremely pertinent when analyzing the failure of the Federal Reserve's attempts to jump start lending and fight deflation. Banks are not willing to lend for a host of reasons (lack of creditworthy borrowers, need to hoard various alphabet soup funds to remain solvent), and compounding this further is a lack of willing borrowers! The average citizen is seeing falling asset prices, devalued retirement plans, uncertainties in the job market, and other confidence shaking conditions and has moved away from debt based spending and consumption.
The failure of the money "printed" (most of the money sent to the banks has been gained from massive treasury issuance) to reach the real economy (though much of it has found its way into the equity markets) has guaranteed with near certainty the continued price declines in asset prices here within the United States, more tightening of credit, which begets more asset price declines. A deflationary death cycle.
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