by Alasdair Macleod, GoldMoney:
There is a growing realisation that the world faces a combination of persistent inflation of prices and a recession at the same time. The factors driving both are visibly intensifying. Those of us versed in the cycle of bank credit are aware that it is the contraction of bank balance sheets which is driving the recession, while it is continuing currency debasement driving inflation.
Neo-Keynesians in the establishment think the current position is contradictory, that current rates of price inflation will decline back to their 2% target in a recession, and interest rates can then be reduced to stimulate economic activity.
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The key to understanding why prices can continue to rise in a recession requires a fuller understanding of the role of credit in an economy and what it represents. Its role is far greater than commonly thought, with considerably more than several quadrillions of dollar equivalents outstanding. All economic activity and wealth are credit. This article sketches out the various types of credit, and how credit equates to our collective wealth.
It also requires us to differentiate between a currency which is anchored to gold specie and one without a specie anchor. The former imposes a discipline on the state of non-intervention, while the latter encourages intervention. It is that intervention which leads to fiat currencies and all credit based upon it finally collapsing.
The importance of credit
That the monetary authorities do not understand credit might seem unbelievable. But evidenced by their actions, it is the only explanation for their mistakes. Clearly, as well as credit they don’t understand the importance of money, having banished gold from its role of anchoring the purchasing power of credit. The vested interest of replacing gold with currency, to obtain for governments the benefit of unfettered debasement, is ignored or forgotten by today’s state-educated economists and commentators. Disregarding what drove the dollar off the Bretton Woods standard in the first place, the establishment in the broadest sense can no longer distinguish between credit and legal money.
Currency and credit debasement started with a vengeance in the 1930s, when the dollar was devalued by repegging it to gold at $35 per ounce from $20.67 — only that Americans were banned from owning it at any price. Currency and credit expanded from then on.
US M3 money supply had peaked at $55.2bn in 1929, fell to $41.52 in 1933 (eerily similar to money supply prospects today), before rising to $692bn when Bretton Woods was suspended in 1971. That’s a multiple of 12.6 times while the dollar was anchored to gold at $35 per ounce. Since then, credit expansion has been far more dramatic at nearly 32 times, and we have seen the gold price increase from $35 to $1725 currently. It is better described as dollar currency and credit losing purchasing power relative to legal money by 98%.
Today, we are acutely aware that prices for energy, food, and consumer goods generally are rising while the economic outlook is deteriorating. Economists call the former inflation and the latter a recession. While it is natural to believe that these conditions are driven entirely by exogenous factors, such as supply chain disruptions and rising interest rates globally, this analysis is too simplistic. It is the massive, government-led expansion of credit which has debased the currency that is the underlying problem.
This is tacitly admitted by economists and statisticians who believed that excessive monetary expansion was a one-off action to deal with the covid crisis and associated problems. But now, the hesitancy in markets is attributable to the growing realisation that further expansion of currency and credit is required to face new challenges. Governments are debasing their currencies in a new round to allow individuals and businesses to accommodate soaring energy prices, which were the consequence of earlier debasement. Collectively, some market participants are now signalling, “Fool me once, shame on you. Fool me twice, shame on me”.
I remarked above that the contraction of M3 between 1929 and 1933 is eerily similar to what we face today. It needs explaining. In the years before the Wall Street crash (which started in September 1929) the Fed had begun to intervene in markets. In 1923, the Federal Open Market Committee was established with Benjamin Strong the Fed’s Governor as chairman (the title change from Governor to Chairman was made in the banking Act of 1935). From then on, the Fed began to conduct monetary policy.[i]
Accordingly, the Fed made substantial open market purchases in 1924 and 1927, which suppressed bond yields and therefore market interest rates, to ward off recessions. The latter particularly fuelled mounting stock market speculation as bank credit expanded due to increased credit demand supplied at suppressed interest rates. In 1928, the Fed’s FOMC took fright and reversed its expansionary policies by buying up government securities and raising its discount rates. The following year the market peaked, and the unwinding of the speculative bubble drove the Dow Jones Industrial Index down 89% by mid-1932.
While there are differences today, the similarity to current global monetary and market conditions are striking. The principal dissimilarity is that Strong believed in the gold standard, and guided FOMC policy in that context. But for the first time, the Fed intervened in the economy storing up trouble for the end of the decade. Today, FOMC interventions are far more pervasive, with similar distortions for financial markets but without the sheet-anchor of money —legally that is gold — securing confidence in the currency. We have yet to fully realise the consequences today, with the Dow Jones Industrial Index having lost only 21% so far.
The contraction of bank credit between 1929—1933 is the most important feature of that time. The withdrawal of credit for speculation in the stockmarket was undoubtedly what fuelled the Wall Street crash because withdrawal of credit forced speculators to sell their stocks. If they were not unsecured or secured against physical property, bank loans were secured on stocks. Falling values accelerated the decline as banks liquidated the collateral they held in financial assets, a point famously made by contemporary economist Irving Fisher. The start of these conditions is apparent today in the contraction of bank credit for stock speculation, shown in Figure 1.
The psychology of markets informs us that credit contraction of margin loans is driven not by happy profit takers, but by the effect of falling collateral values and banks foreclosing on positions. It is a process that has much further to go.
This brief analysis of the role of bank credit illustrates its financial and economic importance. Not only did its contraction in 1929—1932 undermine financial asset values, but it also plunged the agricultural economy into depression. It is estimated that about 9,000 banks failed, wiping out $140bn in deposits[ii]. On the asset side of bank balances sheets fire sales of farms and assets of small businesses failed to cover bank loans, but their owners were impoverished and left without a living. The lesson for today is that despite all the regulations designed to make banks safe, severe credit contraction still leads to widespread bank failures.
The experience of the 1930s spawned two very different conclusions. Austrian economists, being the most sophisticated extension of classical theorists, pointed out that the depression was the result of bank credit expansion in the 1920s unwinding, while a new breed of statist economist supported Herbert Hoover and Franklin Roosevelt’s view that the failure was essentially of free markets and the solution was in the hands of government. Both presidents were keen interventionists.
Intervention by the state became the foundation of Keynesianism, while the Austrians were widely ignored. However, many neo-Austrians argue that the business cycle can be eliminated if the cycle of bank credit is removed entirely. As to whether this course is practical requires an understanding of credit in its wider form. Bank credit is a small subset of overall credit, albeit an important one.
