The Dollar deflation myth unraveled; a big picture view

For years I’ve been listening to deflationists, a narrative that is especially popular under dollar bulls. The deflation narrative makes little to no sense to me. In this blog I’ll explain why deflationist Dollar bulls could be wrong.

Deflationists do think that there will be a 1929 – 1933 type of deflationary crisis again some day. The main argument why there’s a low chance this happens again is the nature of the banking cartel and its fiat money.  Central banks and commercial banks have the ability to create money into existence via loans (fractional reserve banking). Before 1934, the Dollar was on a gold standard and the banks therefore couldn’t print money. That was in fact a deflationary period as the credit that banks created did in fact shrink as the money supply was disrupted when debts weren’t paid back. 

The Gold chart below shows the gold price since 1800 and shows the situation when the Dollar was on a gold standard, versus what happened after 1934, when the Dollar was no longer backed by Gold. If there was lasting deflation Gold’s long term trend in Dollar terms would be at least sideways or downwards, not upwards as it is does since the abolishment of the Gold standard. 

Gold price in Dollar terms since 1800

After the gold standard was abolished in 1934, there wasn’t any real or lasting deflation of the sort that the ‘hard core’ deflation believers are talking about. The goal of abolishment of the gold standard was that banks, in collaboration with governments, shaped the ability to create an elastic money supply to subsidize and institutionalize fractional reserve banking. The deflation view was relevant until 1933. To expect serious, lasting deflation today, ignores the changes in banking and money creation since 1934. During economic crises, like the recent one labeled as ‘Corona crisis’, banks can inflate the money supply despite loans aren’t being paid back. In other words: the Fed has the ability to monetize all the unsound bank debt. 

This FRED chart shows a constant growth of money supply since 1960. 

M1M2 and M3 are measurements of the United States money supply, known as the money aggregates. M1 includes money in circulation plus checkable deposits in banks. M2 includes M1 plus savings deposits (less than $100,000) and money market mutual funds. M3 includes M2 plus large time deposits in banks.

This FRED chart shows it is crucial to understand that the money supply does not contract when credit is in default. If that was the case, it should have shown a decreasing trend in money supply, or at least serious interruptions during crises. It shows the exact opposite, an ongoing increase of money supply. Thus when debt aren’t being paid back, the money that was created is still out there. If all the debt created was paid back, the total amount of debt wouldn’t grow at a rate shown in the FRED chart below,  as total public debt.

FRED chart public debt

The idea of a credit crunch where everyone is scrambling for Dollars to pay back their debts, one of the favorite topics of Dollar bulls, is mistaken in my opinion. It assumes that people always do pay back their debts rather than file for bankruptcy and default on them, and in case of the big guys never get a bail out. 

Especially bail outs are important to take into account. As deflationists Dollar bulls have mainly technical, credit driven arguments for a credit crunch, they forget that bail outs, and thus money supply are driven by political power, not by any free market and sound money principles. The Fed works together with the Treasury to loan out more to big corporate. When they can’t pay back debt, they get bailed out, meaning additional money is borrowed to them ‘under the table’ and tax payers finally get the bill for the bailed out debt in terms of less purchasing power of their saving and salaries. 

This is how it works in big lines. If you want to learn more about how money creation and bail outs do work, I suggest you pick up The Creature from Jekyll Island. A second look at the Federal Reserve’ by Edward Griffin. 

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