The Death of Money (34 page)

The bitcoin and barter examples both illustrate that the dollar grows less essential
every day. This is also seen in the rise of regional trade currency blocs, such as
Northeast Asia and the China–South America connection. Three-way trade among China,
Japan, and Korea, and the bilateral trade between China and its respective trading
partners in South America, are among the largest and fastest-growing trading relationships
in the world. None of the currencies involved—yuan, yen, won, real, or peso—are close
to becoming reserve currencies. But all serve perfectly well as trade currencies for
transactions that would previously have been
invoiced in dollars. Trade currencies are used as a temporary way to keep score in
the balance of trade, while reserve currencies come with deep pools of investable
assets used to store wealth. Even if these local currencies are used for trade and
not as reserves, each transaction represents a diminution in the role of the dollar.

To paraphrase Hemingway, confidence in the dollar is lost slowly at first, then quickly.
Virtual currencies, new trade currencies, and the absence of currency (in the case
of barter) are all symptoms of the slow, gradual loss of confidence in the dollar.
They are the symptoms but not the cause. The causes of declining confidence in the
dollar are the dual specter of inflation
and
deflation, the perception on the part of many that the dollar is no longer a store
of value but a lottery ticket, potentially worth far more, or far less, than face
value for reasons beyond the holder’s control. Panic gold buying, and the emergency
issuance of SDRs to restore liquidity when it comes, will signal the stage of a rapid
loss of confidence.

Volcker was right in his assertion that confidence is indispensable to the stability
of any fiat currency system. Unfortunately, the academics who are now responsible
for monetary policy focus exclusively on equilibrium models and take confidence too
much for granted.

■
Failure of Imagination

Following the 9/11 attacks in New York and Washington, D.C., the U.S. intelligence
community was reproached for its failure to detect and prevent the hijacking plots.
These criticisms reached a crescendo when it was revealed that the CIA and the FBI
had specific intelligence linking terrorists and flying lessons but failed to share
the information or connect the dots.

New York Times
columnist Tom Friedman offered the best description of what went wrong: “
Sept. 11 was not a failure of intelligence or coordination. It was a failure of imagination.”
Friedman’s point was that even if all the facts had been known and shared by the various
intelligence agencies, they still would have missed the plot because it was too unusual
and too evil to fit analysts’ preconceived notions of terrorist capabilities.

A similar challenge confronts U.S. economic policy makers today. Data on economic
performance, unemployment, and the buildup of derivatives inside megabanks are readily
available. Conventional economic models abound, and the analysts applying those models
are among the best and brightest in their field. There is no lack of information and
no shortage of intelligence; the missing piece is imagination. Fed and Wall Street
analysts, tied to the use of models based on past business cycles, seem incapable
of imagining the dangers actually confronting the U.S. economy. The 9/11 attacks demonstrated
that the failure to imagine the worst often results in a failure to prevent it.

The worst economic danger confronting the United States is deceptively simple. It
looks like this:

(-1) – (-3) = 2

In this equation, the first term represents nominal growth, the second term represents
inflation or deflation, and the right side of the equation equals real growth. A more
familiar presentation of this equation is:

5 – 2 = 3

In this familiar form, the equation says that we begin with 5 percent nominal growth,
then subtract 2 percent inflation, in order to reach 3 percent real growth. Nominal
growth is the gross value of goods and services produced in the economy, and inflation
is a change in the price level that does not represent real growth. To arrive at real
growth, one subtracts inflation from the nominal value. This same inflation adjustment
can be applied to asset values, interest rates, and many other data points. One must
subtract inflation from the stated or nominal value in order to get the real value.

When inflation turns to deflation, the price adjustment becomes a negative value rather
than a positive one, because prices decline in a deflationary environment. The expression
(-1) – (-3) = 2 describes nominal growth of negative 1 percent, minus a price change
of negative 3 percent, producing positive 2 percent real growth. In effect, the impact
of declining prices more than offsets declining nominal growth and therefore
produces real growth. This condition has almost never been seen in the United States
since the late nineteenth century. But it is neither rare elsewhere nor impossible
in the United States; in fact, it has been Japan’s condition for parts of the past
twenty-five years.

The first thing to notice about this equation is that there is
real growth
of 2 percent, which is weak by historic standards but roughly equal to U.S. growth
since 2009. As an alternative scenario, using the formula above, assume annual deflation
of 4 percent, as actually occurred from 1931 to 1933. Now the expression is (-1) –
(-4) = 3. In this case,
real
growth would be 3 percent, much closer to trend and arguably not at depressionary
levels. However, a condition of
high deflation, zero interest rates, and continuing high unemployment closely resembles
a depression
. This is an example of the through-the-looking-glass quality of economic analysis
in a world of deflation.

Despite possible real growth, the U.S. Treasury and the Federal Reserve fear deflation
more than any other economic outcome. Deflation means a persistent decline in price
levels for goods and services. Lower prices allow for a higher living standard even
when wages are constant, because consumer goods cost less. This would seem to be a
desirable outcome, based on advances in technology and productivity that result in
certain products dropping in price over time, such as computers and mobile phones.
Why is the Federal Reserve so fearful of deflation that it resorts to extraordinary
policy measures designed to cause inflation? There are four reasons for this fear.

The first is deflation’s impact on government debt repayment. Debt’s real value may
fluctuate based on inflation or deflation, but the nominal value of a debt is fixed
by contract. If one borrows $1 million, then one must repay $1 million plus interest,
regardless of whether the real value of $1 million is greater or less due to deflation
or inflation. U.S. debt is at a point where no feasible combination of real growth
and taxes will finance repayment of the amount owed. But if the Fed can cause inflation—slowly
at first to create money illusion, and then more rapidly—the debt will be manageable
because it will be repaid in less valuable nominal dollars. In deflation, the opposite
occurs, and the real value of the debt increases, making repayment more difficult.

The second problem with deflation is its impact on the debt-to-GDP
ratio. This ratio is the debt amount divided by the GDP amount, both expressed in
nominal terms. Debt is continually increasing in nominal terms because of continuing
budget deficits that require new financing, and interest payments that are financed
with new debt. However, as shown in the previous example, real growth can be positive
even if nominal GDP is shrinking, provided deflation exceeds nominal growth. In the
debt-to-GDP ratio, when the debt numerator expands and the GDP denominator shrinks,
the ratio increases. Even without calculating entitlements, the U.S. debt-to-GDP ratio
is already at its highest level since the Second World War; including entitlements
makes the situation far worse. Over time, the impact of deflation could drive the
U.S. debt-to-GDP ratio above the level of Greece, closer to that of Japan. Indeed,
this deflationary dynamic is one reason the Japanese debt-to-GDP ratio currently exceeds
220 percent, by far the highest of any developed economy. One impact of such sky-high
debt-to-GDP ratios on foreign creditors is ultimately a loss of confidence, higher
interest rates, worse deficits because of the higher interest rates, and finally an
outright default on the debt.

The third deflation concern has to do with the health of the banking system and systemic
risk. Deflation increases money’s real value and therefore increases the real value
of lenders’ claims on debtors. This would seem to favor lenders over debtors, and
initially it does. But as deflation progresses, the real weight of the debt becomes
too great, and debtor defaults surge. This puts the losses back on the bank lenders
and causes bank insolvencies. Thus the government prefers inflation, since it props
up the banking system by keeping banks and debtors solvent.

The fourth and final problem with deflation is its impact on tax collection. This
problem is illustrated by comparing a worker making $100,000 per year in two different
scenarios. In the first scenario, prices are constant and the worker receives a $5,000
raise. In the second scenario, prices drop 5 percent and the worker receives no raise.
On a pre-tax basis, the worker has the same 5 percent increase in her standard of
living in both scenarios. In the first scenario, the improvement comes from a higher
wage, and in the second it comes from lower prices, but the economic result is the
same. Yet on an after-tax basis, these scenarios produce entirely different outcomes.
The government taxes the raise, say, at a 40 percent rate, but the government
cannot
tax
the declining prices.
In the first scenario, the worker keeps only 60 percent of the raise after taxes.
But in the second scenario, she keeps 100 percent of the benefit of lower prices.
If one assumes inflation in the first example, the worker may be even worse off because
the part of the raise remaining after taxes is diminished by inflation, and the government
is better off because it collects more taxes, and the real value of government debt
declines. Since inflation favors the government and deflation favors the worker, governments
always favor inflation.

In summary, the Federal Reserve prefers inflation because it erases government debt,
reduces the debt-to-GDP ratio, props up the banks, and can be taxed. Deflation may
help consumers and workers, but it hurts the Treasury and the banks and is firmly
opposed by the Fed. This explains Alan Greenspan’s extraordinary low-interest-rate
policies in 2002 and Ben Bernanke’s zero-rate policy beginning in 2008. From the Fed’s
perspective, aiding the economy and reducing unemployment are incidental by-products
of the drive to inflate. The consequence of these deflationary dynamics is that the
government must have inflation,
and the Fed must cause it
.

The dynamics amount to a historic collision between the natural forces of deflation
and government’s need for inflation. So long as price index data show that deflation
is a threat, the Fed will continue with its zero-rate policy, money printing, and
efforts to cheapen the dollar in foreign exchange markets in order to import inflation
through higher import prices. When the data show a trend toward inflation, the Fed
will allow the trend to continue in the hope that nominal growth will become self-sustaining.
This will cause inflation to take on a life of its own through behavioral feedback
loops not included in Fed models.

Japan is a large canary in a coal mine in this regard. The Asian nation has undergone
persistent core deflation since 1999 but also saw positive real growth from 2003 to
2007 and negative nominal growth in 2001 and 2002. Japan has not experienced the precise
combination of negative nominal growth, deflation, and positive real growth on a persistent
basis, but it has flirted with all those elements throughout the past fifteen years.
To break out of this coil, Japan’s new prime minister, Shinzo Abe, elected in December
2012, declared his policy of the “three arrows”: money printing to cause inflation,
deficit spending, and structural reforms. A
corollary to this policy was to weaken the exchange value of the yen to import inflation,
mostly through higher prices for energy imports.

The initial response to “Abenomics” was highly favorable. In the five months following
Abe’s election, the yen, measured against dollars, dropped 17 percent, from 85 to
1 to 102 to 1, while the Japanese Nikkei stock index rose 50 percent. The combination
of a cheaper yen, the wealth effect from rising stock prices, and the promise of more
money printing and deficit spending seemed like a page from a central banker’s playbook
on how to break out of a deflationary spiral.

Despite the burst of market enthusiasm for Abenomics, a cautionary note was raised
in a speech on May 31, 2013, in Seoul, South Korea, by one of the most senior figures
in Japanese finance, Eisuke Sakakibara, a former deputy finance minister, nicknamed
“Mr. Yen.” Sakakibara emphasized the importance of real growth even in the absence
of nominal growth and pointed out that the Japanese people are wealthy and have prospered
personally despite decades of low nominal growth. He made the often-overlooked point
that because of Japan’s declining population, real GDP
per capita
will grow faster than real
aggregate
GDP. Far from a disaster story, a Japan that has deflation, depopulation, and declining
nominal GDP can nevertheless produce robust real per capita GDP growth for its citizens.
Combined with the accumulated wealth of the Japanese people, this condition can result
in well-to-do society even in the face of nominal growth that would cause most central
bankers to flood the economy with money.