Contra Keynes, instead of genuine capital accumulation, central-bank credit
expansion generates the boom-bust cycle. Newly-created money is used to buy
securities from banks, expanding their supply of credit and lowering
interest rates. Entrepreneurs and consumers borrow the money and spend it on
capital projects and consumer durable goods, respectively. Prices rise for
capital goods and consumer durables which makes their production more
profitable and brings about a shift of productive factors into them and out
of other goods. If energetic enough, as the Bank of Japan's efforts were in
the late 1980s, central-bank credit expansion leads to a bubble in asset
The boom ends when the central bank's credit expansion can no longer
maintain artificially low interest rates. Typically this happens when the
monetary inflation results in significant, widespread price inflation. Once
people realize that money's purchasing power will be lower in the future,
they adjust interest rates upward. Sometimes, as in Japan in 1989, the
central bank cuts off the monetary inflation. In any case, these higher
interest rates collapse capital values, including stock and asset prices.
With their prices smashed, the production of capital goods and consumer
durables suffers losses and must be cut back.
The true financial corrective to the artificial and unsustainable inflation
of asset prices induced by central-bank credit expansion during the boom is
deflation of asset prices. No longer distorted, prices now reveal
misallocated factors and malinvestments and make profitable the transfer of
the former and the liquidation and reinvestment of the latter into valuable
activities. In short, asset-price deflation is the market economy's way of
restoring its function of effectively satisfying consumer preferences.
But what really frightens Keynesians is not, strictly speaking, asset-price
deflation but its complement: credit contraction. When the central bank
inflates paper money during the boom, banks expand credit and checkable
deposits. Assets valued at inflated, boom-level prices serve as collateral
against these loans. When asset prices collapse and borrowers default,
banks' net worth becomes negative. They retrench in the face of bad loans by
scaling back their lending. Customers, realizing the banks' distress, cash
out their checkable deposits, further reducing bank reserves and adding to
the financial pressure on banks.
This is what has happened in Japan and is what we are now facing. The ONLY
appropriate palliative is a deflation of overly inflated asset prices.
Can it happen slowly enough to restore a sensible level and avoid a panic.
I think not. For several reasons. An asset inflation by ITSELF is one
thing. An asset inflation wholly fueled by a mountian of debt is another. An
asset inflation fueled by a mountain of debt based on fiat money is yet
'Fiat' is Italian for 'faith'. Our 'money is not backed by anything at all.
Not by anything but the mere 'confidence' of those holding it. In
otherwords, it is a scam, a 'con' game. When the asset deflation begins
people will undoubtedly understand that their 'money' is worthless.
It is so much paper, and not even good for 'toilet' use, at that.
It was always the fault of the credit expansion; the incresing amounts of
debt accumulation; the fault of a specious Keynesian monetary policy.
Every time we needed an appropriate and healthy contraction the Fed did just
the opposite. They continued to inflate the money supply. It temporarily put
off a contraction, a cooling off period, in the name of continued growth.
Its like a game I used to play as a kid called 'Blockhead'. You have a
great number of random sized and shaped blocks that you build up and the
winner is the last one to stack a block before the tower falls down. The
'Blockhead' is the one who puts on the last block causing it to tumble.
Now, if every once in a while, as the the 'growth' of pile became unstable,
the player removed some of the blocks and restacked them in a more suitable
and more stable foundation before proceeding, the 'growth' could have
proceeded nicely. If the Fed had allowed the economy to contract, allowing
those who borrowed unwisely or invested unwisely to feel the pain of their
foolishness, it could have built a more stable foundation. That would have
revealed malinvestment and curtailed some of its potentially painfull
results. It would have allowed retrenchment and reallocation of resources
into more appropriate channels. It would have allowed banks to take the
painful steps of calling in bad loans and writing them off at levels, that
while painful, were still manageable. But, it did not.
What it did do, was provide a never ending source of blocks to build as high
and as fast as possible, only making more inevitable the fall and
exacerbating the severity.
It provided a never ending stream of easy credit creating more opportunities
for malinvestment up until the point that over-capacity is reached. Saddled
with bad debt, banks will curtail credit just at the point when a
never-ending stream of increasing amounts of credit is vital. And it will be
over.... in an avalanche of bad debt. The mountain of unrepayable debt will
come crashing down.
Just like in the Tulip Mania of 1634-1637, at some point people will realize
it is over. The 'capacity' will have been reached. There will be no bids.
Plenty of bids one day and the next....gone. The 'blockhead' will have laid
the last block.
Clinton: "I did not have sex with that woman, Miss Lewinsky"
bks: "It was not overt lying. It was overgeneralization for rhetorical