Refuting the Deflation Scare

(How can there be Deflation, when Inflation is raging?!)

Silver Stock Report

by Jason Hommel, July 10, 2009

A reader asks:  "Are defaults deflationary?  When borrowers default on loans, does not the currency disappear in the same manner that it appeared?"

I answer:

That's the popular thought, they call that "deflation", but it's not what is happening.

When someone borrows money from a bank, that bank creates the money, lends money out, and that money gets spent, and thus, given to someone else.  That someone else, the third party, still has the money, or they spend it, giving it to 4th, 5th, and 6th parties, and that money is NEVER destroyed.

So when the bank can't get repaid, no money is destroyed, it's only the bank's balance sheet that is harmed.  Now, if that bank were allowed to go bankrupt, and if that bank could not pay out depositors, who thought they had money with the bank, which then would disappear, yes, then we would have deflation.  But it's a weird kind of deflation, because the amount "destroyed" would exactly match what they lent out in the first place, which was originally created, so it would be a "push".

But that is not happening either.  When banks get bailed out, no money is destroyed.  In fact, the money supply is essentially doubled.  So if the bank loans $300,000, and then the home loan goes bad, and then the bank loan is sold to the Fed for another $300,000, then the $300,000 is created twice!   The first time was when it was lent out the first time, and the second time is when the Fed bails out the bank to give the bank the $300,000 again.  And both times, the $300,000 is created out of thin air, which is highly inflationary.

Further question:  I think that the defaults are offsetting the new currency that is being created now.

My continued answer:

That's not really right.

Housing values, for example, are not "money", despite the fact that people were using their rising home values like an ATM during the boom.  If housing values go down, it does not "destroy currency".  What we have is a housing bubble that was created by too much paper money creation, which was too much inflation.  That inflation is still with us, all the money "spent" on housing is still out there.  It's just in the hands of the people who did the things to create the houses, and in the hands of people who sold houses, and in the hands of people who borrowed against the full value of their houses by refinancing. 

And if that money was spent on things made in China, then that money is now in the hands of China, who can spend it on anything that China wants, such as commodities like copper, zinc, iron, etc. to build their economy.  Or China might decide to buy gold, such as the entire world's annual production of gold.  Thus, those other things that dollar holders may buy, will likely go up, in response to the dollar inflation, or money creation that we saw that drove the housing boom.

The reason why we don't immediately see prices go up in response to the money creation is not that it's "balancing out", but rather, that the bulk of the money is sitting tight.  China is using it as "reserves" to back up the printing of their own currency, and US banks have deposited their money right back with the Fed, to boost their balance sheets and to prevent their own bankruptcy.  Money that is not spent on gold does not make gold go up, even though new money was, indeed, created.

But money that is spent on gold does make gold go up, potentially a lot.  For example, if you buy gold from me, I go to repurchase that gold, and hopefully a tiny bit more, because I have to both meet expenses, and hope to make a small profit to compensate for risking a delivery default by the next dealer or refinery.  So, I buy more gold, the mint buys more gold, the refinery buys more gold, and so on.

My own question:

So, why is there so much confusion about what deflation is?  And what is deflation?

Deflation is defined by a decrease in the amount of money.   It might result in higher values for the currency, and lower prices for other things, but lower prices for other things is NOT deflation.  The trouble is that in today's world, money is fraud, and nobody even knows what money is.

But to sustain the fraud of paper money, the spin masters must lie about what money is, and lie about what deflation is, specifically to confuse people, and to prevent them from abandoning the fraud of paper money for real money such as silver and gold.

In fact, I've been reading about the "dangers of deflation" in the popular press since the start of the bull market in gold in 1999, and during that entire time, we have had inflation raging higher than ever, except during a few years during the Carter Administration.  But they continue to lie even about the inflation rates, because they measure inflation by "price inflation" and measure by things that "don't count", as they exclude housing, food, fuel, gold and silver.  In such deceptive ways, many commodity prices can rise by 1000%, but there is "no inflation", which is simply ridiculous.

Getting back to defintions, if money is "paper money", like dollars, then deflation of paper dollars would be a reduction only of paper dollars.  That is not happening.

We have INFLATION of U.S. paper money dollars, and anyone who says otherwise is distorting the defintions, lying, or is self-deceived.

If money is "the amount of paper money that homes are worth", then deflation is happening, as home values are decreasing, but that is not a destruction of paper money!  Therefore, home values decreasing does not mean that other assets like gold will also decrease in value.  When home values decrease, they must, by definition, decrease against something else.  That something else is usually either the currency, like the paper money, or gold, which is a far superior form of money!

A deflation of paper money, or a reduction in the amount (not value) of paper money, is supposed to mean that paper money would increase in value.

But even that is not always what happens, and here's why.  Today, banks practice fractional reserve lending.  That means that a bank might have $100 million in deposits and issued in bonds (liabilities), but only $5 million in cash in the bank, and $5 million with the Fed, and $25 million in loans (for $35 million in assets).  Essentially, all banks are technically bankrupt like that, but they are not "actually" bankrupt as long as they can meet redemption of depositors or payments on the bonds they have issued.  It is said that banks loan out only a fraction of the cash on deposit.  But if money on deposit is withdrawn, then loans must be called in, or the bank must borrow from the Fed.  Or, another way to look at it, if a bank gets a new deposit, then if they wish to keep "reserve ratios" low enough, then banks can essentially loan out multiples of the cash on deposit.

Yes, today we have bank failures, about 50 so far in recent months.  However, very little money is being destroyed, since the banks are getting bailed out, merged, or deposits are being backed by FDIC insurance (which is, itself, now bankrupt, so they will be borrowing more from the FED, which is INFLATIONARY!)

Now, if banks were to really fail, and if deposits were to really be wiped out, that would be deflationary.  But if that happens, then people would be more likely to stop trusting banks, and if they were to put even a tiny fraction of the $1-2 trillion in paper money now sitting in the banks (or up to $14 trillion on electronic bank deposit) into silver and gold, we would have massive increase in prices of silver and gold!  For example, silver could rise in value 10 times or more, if only about $100 billion were spent on real silver in a year.

So, to prevent that kind of "bank default" driven deflation from happening, the FED chooses inflation, which, these days, is about a doubling of the monetary base in the last year, which, these days, is enough to maintain confidence that the banks won't go under, and thus keep people away from investing in "no default" silver and gold, which will probably continue the "silent stealth bull market" and go up on average of 30-50% per year until something drastic happens, such as a delivery failure default in gold or silver at COMEX to a large fund or Soverign nation, at which time, silver and gold could begin to scream upwards even faster.

The real deflation is taking place in silver.  Silver is actually being destroyed.  The atoms are not being vaporized, but rather, silver is being "consumed" by industry, and the atoms of silver are being dispersed into products which are eventually thrown away back into landfills in the ground, and end up in lower concentrations (such as ounces per tonne) than at which they are mined from the ground in the first place.

This deflation in silver has taken place since the end of WWII, when humanity began the age of home electronic devices which consume silver in just about all switchs and contact points.  Yet, silver prices still have not moved significantly upwards, despite this silver deflation, or destruction of real silver.  Why not?

Because during this time period, the world continued to abaondon the use of silver as money, or currency.  It was not until 1965 that the US stopped using silver in US coinage in mass amounts.  That abaondonment of silver as a currency created additional supply of silver. 

Then, paper money manipulations through the introduction of "leveraged futures markets" in the 1970's and 1980's successfully diverted investment demand away from real silver, and into those paper products.  The scams continued in recent years with the introduction of paper silver certificates, silver storage programs, and ETFs which continue to divert demand away from real silver.

Now, just because the destruction of silver did not immediately make silver more valuable, does not mean that silver will never rise in value.  It will.  It may just take longer than most people in the "microwave generation" of instant gratification have patience for.  It seems that most people cannot wait longer than a year for predictions to be fulfilled.  Yet the main trends in silver such as demonitization are over 100 years old, and thus, in that context, predicting "when" can be considered good if you pick the right decade.

So, to get back to the original question, "Are defaults deflationary?"

If money is silver and gold, then yes.  When U.S. banks in the 1930s stopped giving gold for gold certificates, that was a default.  Afterwards, gold prices rose from $20 to $35/oz.

When the U.S. government stopped making silver coinage in 1964, and stopped giving silver for silver certificates, that was a default.  As a result, silver rose in price from $1.40 per oz. to $50/oz. by 1980.

When the U.S. government "closed the gold window" and stopped giving gold in exchange for U.S. dollars in 1971, that was a default.  As a result, gold prices rose from $35/oz. to $850/oz. by 1980.

The next major silver or gold delivery defaults will likely trigger another major price rise in the price of silver and gold.  Why?  Because the default will "destroy" the "perceived gold value" of the paper promises to deliver gold, and it will greatly reduce the perceived supply, and hence, increase the real value, and perceived importance, and significant difference of real gold and real silver that has already been delivered.

People will soon discover the difference between a promise of payment, and actual payment.  People today still do not yet know the difference, because they do not know that payment consists only of delivery of real money of silver or gold.

Receiving cash is not payment.  You merely are given a promise by the Fed, a promise that they will deliver nothing to you, except tax you, and you become a lender to the Fed.  Essentially, holding dollars means you are lending to the Fed at zero interest, in return for the privledge of being taxed!

It boggles the mind, I just discovered something new again.  Many people who attempt to refute Biblical Economics say that "lending at zero interest could never work".  Oh, but it is working.  That's what the dollar is!  A zero interest loan to the FED.  And it's working so well, nobody has been calling it by it's real name! 

In fact, since there is always constant inflation, holding dollars is like giving the Fed a negative interest rate loan.  IE, the "zero bound problem" (which is the theoretical problem of how to lower interest rates if they are already near zero, because you "can't" create a negative interest rate) is no problem at all, it's been solved, it's also right in front of our faces, but again, nobody is recognizing it because nobody calls things by their real name, and all of economics is a twisted joke of deception these days.


Amazing.  Something must be in the air.

Just as I was finishing writing this, two other articles debunking deflation just hit my inbox. 

Gold is bad in a deflationary environment - another gold myth

Ten Questions That Deflationists Prudently Ignore
(For Gary North Subscribers only)

A reader writes:

Thank you for your July 1st article.

Housing's Still Overvalued & Silver's Still Cheap

And thank you for sharing your recent insight:

"My main point is that anyone can exchange their paper money, for silver or gold, on much better terms today, at much less premiums today, than during the vast majority of the time that silver "officially" backed the currency!

The fallacy of thought was that silver could be bought for "zero premium" when it was money, while today, you have to pay an "unfair 5-10%". The truth is that when silver was money, government distortions and monopoly pricing created 400% premiums, also called "seniorage".

This is an excellent insight and it is as new to me, as it is to you. Thank you for spelling this out so clearly. --  regarding the silver market, your insights are priceless.

I replied:

Thank you.  I'll try to re-emphasize the point.  Silver is not only cheap, but it has a much much lower premium, or a much lower cost to acquire over the silver value, than when it was money!