Sowing Lysenko's Seeds in a Monetary Twilightzone

The U.S. economy has become opaque. Galactic sums of money disappear into centrally planned interventions. Every week new stratagems are employed, directives issued. No one knows who devised them. By legerdemain, the risks of impenetrable credit schemes are shifted onto the unsuspecting. Expansive swaths of the economy are subsumed into a quasi-governmental underworld. 

Glimpses into the financial funhouse are frightening and disorienting. The wealth of pensions, municipalities, and charities has been pilfered. The Treasury has been emptied to recapitalize banks so the capital can be loaned back to its former owners, the taxpayer, with interest. Monetary and credit excesses are cured with even greater excess. It is three card monte inside a shell game inside a Ponzi scheme inside a Rube Goldberg device in a hall of smoke and mirrors at the center of a maze one can only navigate by shuffling blindly through darkness.

We have entered the monetary twilightzone. The future of the world's largest economy now rests in the hands of a few secretive men. Their guiding philosophy is derived from a thought experiment conducted by a Ph.D. student who concluded that monetary intervention by enlightened academics can create a new world in which economies will never again suffer economic depressions. 

The natural world is seldom so agreeable as to reform itself in the image of utopias imagined by academicians. Rather it reasserts itself. Ruthlessly. In the first half of the twentieth century, communist states adopted agricultural policies based on the ideas promoted by Trofim Lysenko. Lysenko proposed that seeds exposed to cold would pass the genetic characteristic of cold tolerance to the next generation of plants in a Lamarkian mode of evolution. The denouement of said agricultural policies was mass starvation and death on a horrifying scale. 

When ideas that conflict with nature are pursued with determination, the amount of energy required to maintain them soon consumes the entire system. More and more energy is required to sustain them and more and more of the resources of the system need to be diverted to perpetuate them. The system becomes infinitely elaborate, circular, confused, grotesquely distorted.  Many have hypothesized as to the outcome of the current monetary experiment. But it is unlikely that anyone truly knows how this will end as we have breached the outer limits of the mapped economic universe. It is probably not premature, however, to rule out one possibility, and that is that our newfangled financial innovations will lead us back through a hole in time to 2005 and folks will resume borrowing against their homes to purchase luxury vehicles. Not in our lifetimes.

Hyperdeflation and The Bernanke Anti-Economy

This is a brief exploration of the concepts of inflation, deflation, and disinflation and of how the current monetary policy of the Federal Reserve Bank may or may not be inducing the manifestation of one of these phenomena.

If we define inflation as a growth in the total supply of money and credit relative to goods and services, we see that inflation has two components: money and credit.  The critical part of this formula is that, in a fractional reserve banking system, the amount of credit in the system, generally, is in vast excess to the money that has been created. Therefore, a contraction in credit can rapidly overwhelm the ability of the Federal Reserve to combat deflation through money creation.

Many fear that the current binge of money creation will end in hyperinflation. Others contend that the amount of money being created is too small, relative to the massive contraction in credit, to deflect the deflation bomb triggered by the subprime fuse. We can refer to this as the 'pushing on a string theory'. Still others propose that a relatively short deflationary trough will be followed by a hyperinflationary catastrophe on par with Zimbabwe or the Weimar Republic: disinflation. Here we will discuss a fourth possibility. Let's call it hyperdeflation.

Let us suppose that, at the height of a credit bubble, the relationship between money and credit changes. Let's think of it as 'reversing polarity'. During the cycle of credit expansion, money creation leads to more lending through credit. The aggregate of money/credit may grow logarithmically as credit is created in great excess to the actual dollars in circulation. Once the credit expansion cycle exhausts itself by extending credit to all worthy and unworthy borrowers who are willing to assume the risk of credit, the growth of the credit side of the equation in our inflation formula stops. In reality, the credit variable in our formula begins to contract as borrowers who assumed too much debt must sell assets to reduce their debt burden. The cycle of deflation begins.

The current operating theory--and it is only a theory--of the Federal Reserve is that deflation can always be rectified through money creation, which in turn reignites the lending/credit cycle. Those familiar with the writings of Bernanke know that it is his assertion that deflation is unneccesary and that the 'tools' available to the Federal Reserve are sufficient to banish for all time the spectre of deflationary depression. A utopian fantasy, perhaps. Well, likely.

Now let's revisit the supposition that the relationship between money and credit changes when the cycle of credit expansion goes into reverse. That is, counterintuitively, an increase in the money supply actually causes a decrease in the supply of credit. In a cycle of credit contraction and deflation, the pool of worthy borrowers has largely been exhausted. Banks, whose earnings depend on credit, must be very judicious about lending. It takes hard work and very astute accountants and analysts to make money by lending in such difficult times. But what if banks could swell their balance sheets without bothering with the risks of lending? What if they could recapitalize through risk free money supplied by the Federal Reserve? Here we reach the crux of the biscuit, a hypothesis that may be worth considering for those risking capital by betting on macroeconomic trends. It states that the current Federal Reserve policy is not inflationary and not 'just pushing on a string' but is, in fact, hyperdeflationary because it is destroying the system of credit when it would otherwise be rejuvenating itself by creating a stronger foundation from a smaller capital base. This theory states that the current Federal Reserve monetary policy, contrary to its intent, is accelerating and exacerbating the current deflationary trend and will ultimately result, if pursued to its logical conclusion, in hyperdeflation through complete destruction of the checks and balances that govern the system of credit.