How Quantitative Easing Fuels Deflation and Fails to Stimulate

James West

Quantitative Easing is celebrated as the secret weapon of economic salvation in the arsenal of central banks that their unfortunate and less-enlightened predecessors did not possess. Thus the long duration of the Great Recession of 1929. Or at least, that’s the revised history.

In reality, the massive deflationary event now known as the Financial Crisis of 2008 was the result of a buildup in liquidity caused by low interest rates and incrementally easier lending terms. The global liquidity pool itself was further inflated by creative accounting techniques like multi-leveraging, where Tier 1 capital and other solid assets were pledged multiple times from various lenders.

The application of that liquidity to the housing market fuelled an asset price bubble, and when panic resulted from a collective realization that a Wyle E. Coyote moment was about to ensue, the domino effect began, taking down Bear Stearns, Lehman Brother, and almost, if it weren’t for a quick nationalization of AIG by the Fed masquerading as an $85 billion loan, one of the world’s largest insurers of financial instruments. The contagion would have continued to engulf banks and insurers alike as default triggered default, and liquidity froze out everyone out of fear of counterparty balance sheet fraud.

With the public in shock over the sudden reversal of fortunes – especially after a half-decade’s worth of muscular year-on-year growth that had accelerated the economy out of the dot com debacle -the newly elected Barack Obama flexed his freshly pumped presidential muscle, and unleashed successive rounds of Stimulus – or Quantitative Easing as it was subsequently re-branded – totalling $4.5 trillion in new liquidity before the effects of fractional banking expand that by 4 – 12 times.

Regardless of the decorous and technical language that now varnishes and anoints Quantitative Easing, it remains nothing more or less than the creation of money out of thin air. This will require bearing in mind as we contemplate the future of a thus artificially stimulated global financial system.

However, in the meantime, Interbank lending has normalized, the stock market is in bull mode, employment data has been massaged into an apparent increase, and the recovery was/is complete/underway.

Except for….one tiny little widely glossed over detail that at this point constitutes an Inconvenient Truth.

The fundamental cause of the crisis – excessive liquidity and rampant lending – is still present. In fact, it is present in an exponentially greater iteration of its former self. What stock market performance and electro-plated employment numbers fail to convey is the absence of fundamental demand for real goods.

The excess liquidity now supercharges synthetic asset classes derived from real commodities, and in a fascinating case of utter delusion, the derivative asset classes have become the largest consumers of the fabricated capital and credit.

This is fundamentally why price inflation has remained largely absent – the world’s largest capital pools have grown so big that dealing in the markets of real goods is just too puny a pond to be attractive to these whales.

Thus, the bulk of the fabricated liquidity multiplies and moves in a layer of the financial food chain largely separate from the real world.

GDP: The False Positive

Quantitative Easing created marginal GDP acceleration, and this is proof of a return to growth based on fundamental economic demand, claim the economists.

But that argument is looking progressively um…lets use the word ‘disingenuous’ to avoid any appearance of impropriety. A less discrete characterization would probably fall along the lines of ‘like complete bullshit’.

Stepping backward and upward to the 50,000 foot view, the economic mantra of ‘growth at all costs’ has become increasingly difficult to obtain, as developed countries have three and four of everything, and undeveloped ones, though they would like to imitate their northern counterparts and have three and four of everything and a bottle of chablis in the fridge and meat for dinner instead of beans and rice, simply have too many people trying to squeeze that lifestyle out of too few resources.

At the top end of the economic food chain, nobody but nobody is paying anywhere near a proportionally appropriate income tax relative to their lifestyles. Of course, if you were to suggest that over polite and well-heeled conversation at Le Bernardin, you would find yourself ostracized by high society and branded a communist.

The North American and European standard of living has been developed over centuries on the resources of what we politely term ‘developing countries’, and so that term becomes a contradiction in terms, as the plum assets have already been plucked and shipped north.

And so, here in 2015, we are stuck clinging to the illusion that the economic thrum of the 2000’s is just around the corner.

Unfortunately, such is not the case. What we have around the corner, and what is already, in reality, well underway, is the global deflationary response to the collective realization that the planet is maxed out in terms of what it can provide for its number one consumer species – humanity. In fact, if you consider the scope, scale and duration of the deflationary event of 2008 that preceded ‘the worst financial crisis since the Great Depression’, when the benchmark of global liquidity – the U.S. Federal Reserve’s balance sheet – was a mere $800 million, just imagine what that scope scale and duration will look like magnified by 5.5.

Just like the precursor to a massive tidal wave is an abnormally low tide presaging the advent of an outsized wave, the outflow of capital from oil, metals, commodities (and soon real estate) is underway now. It is in fact, the first stage of the next major deflationary event and recession. Which this time, if I were to be a claimant on the mantle of Oracle, I predict will result in the Greatest Depression ever.

Economy is Ultimately Subject to Physical Laws

If we accept the economy as an essentially biological ecosystem that is subject to the largely self-moderating nature of healthy ecosystems, this makes sense.

I would argue that Quantitative Easing – or more accurately, an excess of liquidity – is the cause of deflation. I will further argue here that spreading deflation is the precursor to not just inflation, but hyper-inflation. Furthermore, this whole deflationary phase that has defined the global economy since 2008 is the outcome of excessive liquidity in the system in the first place.

In rough terms, the real estate bubble in U.S. grew to the size it did because interest rates were low and banks were lending to ever less qualified borrowers in pursuit of expanded income at any cost. Since then, the deflationary wound-licking that has gone on has been offset by the Fed’s wishful thinking that replacing the since absent liquidity with synthetic liquidity of its own will somehow purchase fundamental demand. All it has purchased is bigger capital pools for the elite, and record equity market highs. The only stimulating effect on the broader economy is when the elites need their pools cleaned and their grass cut; not the sort of demand that is going to rekindle the American Dream

Consider the nature of the financial system in its now nearly totally globalized system of transmission and trade. Money can go anywhere electronically, at the press of a keystroke, and in fact, 98%+ of fabricated liquidity (my term for Quantitative Easing) exists and moves through the system in electronic form, converting into different currencies automatically.

There are two aspects to each of inflation and deflation that differ yet accompany one another, usually with some latency in time.

At its most elemental, monetary inflation occurs when central banks create money in excess of what is required for use by the trade in the economy. Price inflation occurs when an excess of capital chases goods for inventory purposes, just as a way to deploy some of the excess capital accrued through monetary inflation. The reverse, in both cases, roughly defines deflation.

When the excess of fabricated capital and credit reaches the point where no more capital can be deployed to acquire inventories because inventory is at capacity, the capital ceases to be accessed, and capital velocity – the rate at which money flows through the financial system – grinds to a standstill.

At that point, money can only park itself in fixed income and derivative strategies where risk is minimized in line with capital preservation objectives. It becomes ‘stagflation’. No economic growth. No price inflation. No investment in the real economy.

After a period of stagflation, monetary deflation – the precursor to economic stagflation – begins to foster price deflation. The prices of goods begin to go down, as competition for diminished dollars causes manufacturers to blow out inventories just to stay afloat. When that general tend solidifies, the available purchasers of goods begin to defer spending, accurately speculating that future prices are going to go down further, thus reinforcing monetary deflation, a reduction in capital velocity, and ultimately, recession followed by depression.

We are currently at the point where monetary deflation has begun to induce price deflation. And several fundamental changes have now occurred on the macro-economic landscape that are converging to reassert the physical laws of the universe by which we are all governed.

The End of the Business Cycle

Students of modern history take solace in the belief that the cyclicality of business is a cornerstone of economic reality. Unfortunately for them, such is the case only when certain aspects of the mechanics of global finance are consistent. For example, the supply of money has, until the last five years, always borne some semblance to what was required by the daily movement of goods and services throughout the economy. So that is the first fundamental shift that has undermined the cyclicality of business.

Secondly, the willingness and ability to regulate the world’s largest financial pools has deteriorated to the point where it is more accurate to state that regulators are governed by the interests of the world’s largest capital pools. That is the second major fundamental shift from the 20th century that will result in the end of all traditional business cycles.

The result of these two major tectonic shifts is that traditional investment is ending, and for the most part, only trading remains. The idea that a capital resource is willing to deploy capital for equity or interest in a given enterprise, and wait 3 – 5 years for that value to be amplified and returned to the investor through the output of the enterprise, grows increasingly scarce. Who wants to put a billion dollars at risk for 2 -3 years to build a mine when you can deploy such a sum algorithmically for a day or a week or a month and realize an admittedly more conservative return, but with a fraction of the risk. The capital can be deployed again and again in the world of synthetic derivatives, ETFs and as short term tranches of high yield corporate debt, making such trading far more attractive than traditional investing.

This capital and credit black hole did not previously exist on such a scale, and so previous buildups of excess liquidity in the system resulted in price inflation, as the only place for that money to go was into real commodities and their (then) real derivatives. (Real derivatives versus synthetic derivatives are differentiated by real ones actually resulting in a quanitity of the underlying asset being delivered, whereas in the modern age of synthetic derivatives, futures contracts are never reconciled to actual inventory, and credit default swaps are synthesized to bet on the outcome of bets on other synthetic products).

This may sound like simplistic thinking, but it is important to bear in mind that all things economic and financial are still governed ultimately by the physical limitations of real supply and real demand. Thus economics, at the end of the day, is always simple – technical mathematical quant mumbo-jumbo notwithstanding.

Thus, our infrastructure crumbles, pensions go unfunded, manufacturing is extirpated, and the economy striates into hugely imbalanced classes.The decline of civilization is underway, though if you’re a member of the uppermost percent, you will find such an idea ridiculous because you are so insulated from reality that you won’t be able to see what’s going on outside of your Faberegé egg existence.

When the system breaks, as is inevitable, it is those with vast accumulated wealth who will become the targets of the tremendously more impoverished and desperate. Financially, you cannot ‘protect’ yourself from the inevitable.

James West

James West

Editor and Publisher

James West founded Midas Letter in 2008 and has since been covering the best of Canadian and US small cap companies. He covers global economics, monetary policy, geopolitical evolution, political corruption, commodities, cannabis and cryptocurrencies. As an active market participant, James is not a journalist and is invariably discussing markets...
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