Depressions and Their Solution

This is a simple outline of what depressions are and how they are solved. The problem and its solution are simple and should be understood by every voter. It may take a little effort, but the answers are available to us all.

(1) The market, if left free of government intervention and other forms of fraud and misappropriation, is immune to serious economic downturns (Say’s Law). There will always be individual business failures, but the misfortune of one person in the free market is another person’s opportunity. The same amount of material wealth in the economy remains the same; there is just a change of ownership. Because of this balancing of fortunes and the fact that the total wealth of the economy remains the same, there should never be epidemics of business failures.

(2) Business failures reach epidemic proportions because there is a change in the money supply. A reduction in the money supply, referred to as deflation, means that there are insufficient funds to maintain the demand for goods and services at existing prices. This change in demand reduces trading and creates employment. This is the essence of a depression. There is the same amount of wealth in terms of real goods and services but there is not enough money to purchase them.

(3) All that needs to be done to prevent depressions is provide a money supply that cannot be reduced. If the money supply were stable, there will still be goods on the market that are overpriced, causing business failures, but the money of the economy would be directed to cheaper alternatives. These cheaper alternatives would provide new business opportunities to offset the losses, preventing business failures from reaching the epidemic proportions that are characteristic of depressions.

(4) Durable commodities, such as gold, do not disappear and therefore can serve as a money supply that would prevent depressions from happening. In turn, government issued money can be made stable and can also serve an economy that is depression-free. Even if a government caused inflation through deficit spending, it would not necessarily lead to a depression, since the government’s money would still not disappear and thereby lead to the reduction of money that would cause a depression. This inflation would cause a misallocation of the economy’s resources and reduce its overall productivity but it would not lead to the unemployment that is caused by a reduction in the money supply.

(5) However, the US government, along with the other governments of the industrial world, cannot provide us with a money supply that is invulnerable to depression-causing deflation. Why? Because governments have no control over the creation of most of the money in their own economies – banks do. To see how this is done, please read the previous post to this blog “Our Money is Not Real” below. Through fractional-reserve banking, banks are allowed to multiply the government issued money up to six times through issuing credit on money that they do not really possess. This money exists on paper only and can disappear with the application of more paperwork. When our banks contract their credit (reduce the loans outstanding), the money supply of the nation is reduced and a depression results.

(6) The fractional-reserve banking is solely responsible for our recessions and depressions and it is nothing more than a form of fraud that our governments allow bankers to perform upon the rest of the economy. It is supported legally through transparent legal fictions that actually contradict each other and make no sense. The primary fiction is that bank deposits are not really deposits, but rather, are loans. But if this is the case, then the depositor commits fraud every time he writes a check on money that he has already loaned to his banker. An accessory to the depositor’s fraud is the banker who honors the check even though he has already borrowed the money and loaned it to another customer.

(7) Depressions can be brought to an end if the lawyers and judges of our country consistently apply the laws of fraud to the bankers who duplicate and triplicate our money during boom times and then reduce that money to vapor when they contract that credit.

Indeflation

Indeflation is the phenomenon that turns a curative recession into a disastrous depression. It is what happens when a government attempts to stimulate its country’s economy with inflationary spending but, paradoxically, causes that economy to further deflate and sink deeper into a state of high unemployment and falling prices. It happened in the Great Depression; it has happened again in Japan’s ongoing depression; and it is happening now in America under the misguided leaderships of George W. Bush and Barack Obama.

The term “indeflation” is not being coined for the first time here; it lives on the internet, where a working definition can be found at http://mileslater.wordpress.com/2008/05/05/indeflation/. According to that site, “INDEFLATION is the production of traditionally inflationary observations and reactions causing deflationary results.” The seeming paradox of inflationary reactions actually causing deflation, along with all of the unemployment that comes with deflation, can be explained very simply. It might seem like a paradox, but it is actually the natural consequence of a government attempting to prevent an economic correction that cannot be denied.

To understand how indeflation happens we must begin by recognizing that a recession is a curative process whereby market prices go down to correct their overpriced state during a preceding bubble. If left to run it s course, a recession results in a lower volume of money but approximately the same amount of goods. Because of the lower volume of money, the same goods sell for a smaller price. The inflation caused by the preceding bubble is corrected by the recession’s deflation.

However, governments tell us that they can prevent the corrective process of a recession and keep us in the bubble of poor investments that we have made for ourselves, and this is how the healthy process of a recession gets turned into the unhealthy state of a depression. The government, regardless of its leadership under either party, attempts to prevent a recession by “stimulating” the economy with deficit spending. Hoover did it, FDR did it, Bush did it, and Obama is now doing it – governments, unfortunately, do it. This stimulating deficit spending is intended to inflate the economy and undo the corrective work of the recession’s deflation, however, the needed correction cannot be denied and these attempts at inflating the economy will have the effect of actually further deflating the economy, causing more unemployment and increasing the misery of the adjustment process.

The government’s attempt to create inflation actually causes deflation because that government is only one of many producers of money. Banks, by issuing credit, actually produce money, just as they destroy money be withdrawing credit (to understand the simple mechanism of credit expansion and contraction, see the previous post on this blog). The one large inflater, the government, has the effect of activating thousands of small deflaters, the banks attempting to remain solvent. The cumulative effect of the many deflaters far exceeds that of the government – the deflationary credit contraction of banks exceeds Obama’s inflationary spending.

As a model of this indeflation phenomenon, let us take a hypothetical miniature economy where the government has issued and distributed $1,000. According to monetary theory, when the initial $1,000 gets deposited in a bank, the bank “multiplies” that money by loaning it to borrowers at the same time it makes it available to the depositors – deposited money gets duplicated and then duplicated again. Economists even have a formula that determines how much that initial money supply gets multiplied by the bankers. It is simply expressed as “1/R” where R represents the amount of reserve the bankers must keep of their deposit money. Since R is a fraction, usually around 1/6, the result of dividing it into one simply results in an inversion of the fraction: a 1/6 fractional-reserve requirement means that the banks can expand the money 6 times and a 1/8 fractional-reserve would mean that the banks can expand the initial money supply 8 times.

So, to elaborate on our simple model economy, let us say that the fractional-reserve is 1/5, meaning that the banks must keep 1/5 or 20% of its deposits on hand as a reserve, allowing themselves to loan out the other 80% of the deposited money. This means that the original $1,000 issued by the government will be expanded 5 times by the banks to produce a total money supply in the economy of $5,000.

Now, the government, in an attempt to stimulate the economy, decides to issue an additional $100, bringing its total issue into the economy to $1,100. The government plans to have its additional $100 expanded by the banks by a factor of 5, increasing the money supply by $500, for a total money supply of $5,500 – this is inflation.

However, the banks are wise to their government’s inflationary intentions and, just like the rest of us, begin to put their money into inflationary hedges, things that will not become less valuable if the government succeeds in making the dollar less valuable. Why have their money tied up in loans that are basically cash that cannot be touched for the term of the loan? By the time that the loan is repaid, the money is diluted by the government’s stimulation. The banks, as a way of not losing their shirts in the impending inflation, put their money into gold or otherwise act as we would all do to avoid being victims of inflation. The result of the banks’ adaptations to the government’s inflationary intentions is to reduce the volume of their credit. Although the law may only require them to reserve 1/5 of the money deposited in their safes, their financial strategies cause them to keep what Murray Rothbard referred to as “excess reserves.”

Returning to our model, let us say that the average bank in our little economy, in reaction to its government inflationary behavior, decides to keep 1/4 of its deposits in reserve, even though it is required to keep only 1/5. This would mean that the “multiplier” that determines the total money supply from the government issuances would be 4 rather than 5 (where R = 1/4, 1/R = 4). Since the government has issued a total of $1,100 into the economy, the total money supply after the banks have performed their credit expansion, would be only 4 times the original $1,100 or $4,400. In other words, an economy that had a money supply of $5,000 now has a money supply of $4,400 – it has been deflated by $600, resulting in further unemployment and a level of misery that would not have been necessary if the recession could have been allowed to run its natural course.

Recessions are the result of banks being able to expand and contract the money supply through fractional-reserve banking and the government cannot do anything to prevent this from happening. As long as we have fractional-reserve banking, there will be cycles of booms and busts and unfortunately, government intervention will only prolong and deepen the misery of the busts.