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Daniel R. Amerman, CFA, InflationIntoWealth.com
As the financial crisis continues to
deepen, many people are deeply concerned that collapsing credit availability will
lead to powerful monetary deflation, much like it did during the US Great
Depression of the 1930s. As compelling
as these arguments seem to be – are they backed up by the actual historical
evidence?
In this article we will:
1) Ask a crucial real world question
about deflation theories;
2) Revisit the US Great Depression
with a focus on 1933 rather than 1929;
3) Show that the central monetary
lesson of the US Depression is not the unstoppable power of deflation, but
rather, the historical proof of how a sufficiently
determined government can smash monetary deflation and replace it with
inflation – at will and almost instantly, even in the midst of a depression;
4) Examine two historical and
logical fallacies that lead to the mistaken (albeit widespread) belief that the
Depression proves the modern deflationary case, when it in fact proves the
opposite; and
5) Briefly discuss the third logical
fallacy that threatens many investors’ standards of living over the years to
come, particularly those who are retired or investing for retirement.
I received a letter from “GW”, an economically
astute and well read person who had attended one of my inflation solutions workshops. GW said that I had made the most compelling
case for inflation he had ever heard, but that he remained troubled. There were a lot of deflationists out there,
and there were some highly intelligent and credentialed people who were making
some powerful theoretical arguments for deflation. GW asked:
would I be willing to debate some of those arguments with him?
I replied that I would, but I would
only debate theory if he could first answer a simple, real world question:
Name
an example of a modern, major nation where the domestic purchasing
power (as measured by CPI) of its purely symbolic & independent currency
uncontrollably grew in value at a rapid rate over a sustained
period, despite the best efforts of the nation to stop this rapid
deflation?
GW thought he had two answers – the
usual two of the United States during the Great Depression, and modern Japan. Understanding why neither of those answers
were correct is the subject of this and the following article. This article, Part 1, will be devoted to
uncovering some lessons from the US Great Depression that will surprise many
readers, while Part 2 will separate truth from fiction regarding Japan’s
deflationary struggles, even as it separates asset deflation from price
deflation
Please carefully note the underlined words in the central question
above. They are essential. Consumer price deflation has a long and
sometimes infamous history, as we will discuss below. However, a specific argument being made by
many observers is that the United States (and other major modern economic
powers) run the risk of falling into a powerful deflationary trap as the
availability of credit collapses, the volume and velocity of money shrink, and
this combination will then lead to major and rapid monetary and price deflation
that the government will be powerless
to stop. On paper – some powerful theoretical
arguments appear to exist to support this assertion.
However, before millions of
investors shift their portfolios to protect themselves from unstoppable deflation,
or neglect to protect themselves from inflation because they do not know
whether the future holds inflation or deflation – isn’t it worthwhile to first
demand that proof be provided of at least one fully relevant real world case
study where this actually happened? Simply
stated:
Where’s
the beef?
What
is the specific example of a modern, major economic power proving powerless to
stop the rapid rise in the domestic purchasing power of its own independent currency,
as measured by the CPI?
And if such a deflationary example
cannot be produced and defended – but we do have a very long and repeated
history of inflation across nearly
all modern nations with modern currencies – is this not the single most
important data point that individuals should consider in weighing the relative
risks of monetary deflation versus inflation?
The Dow Jones Industrial Average
reached a peak of 381 on September 3, 1929.
By July 8, 1932, it had reached its floor of 41, a plunge of 89% in less
than 3 years. (This is a historical
tidbit that those who think they are “bottom fishing” at current stock market
levels should keep in mind.)
The United States Gross Domestic
Product was $103 billion in 1929. By
1933 it had fallen to $56 billion, a decline of 46%.
Accompanying the freefall in both
the economy and the markets, price levels were falling as well – meaning that
the value of a dollar was rising rapidly.
The Consumer Price Index was at a level of 17.3 in September of 1929,
and by March of 1933 had fallen to a level of 12.6. This means that what cost $1.00 in 1929, cost
73 cents (on average) by 1933. This 27%
deflation, this fall in the average cost of goods and services, represents a
37% increase in the purchasing power of a dollar.
For some people, the effect of this
deflation was to increase both their wealth and their standard of living. These are the people who had substantial
money savings, either in physical cash, or fixed denomination financial assets
that survived the economic turmoil, such as accounts in banks that did not go
bust, or the bonds of companies that did not default. For these individuals, all else being equal,
their standards of living rose because they had the same amount of dollars, and
each dollar bought more than it had previously.
However, this increase in the value
of a dollar was achieved at great cost for most of the nation (and the world). The reason for the increase in value was that
dollars had become scarcer for businesses and most individuals. The destruction of the banks and much of the
financial markets had dried up access to money on attractive terms. Widespread unemployment meant fewer dollars
available to buy goods and services, which drove down the prices, which is what
dropped the Consumer Price Index.
Most importantly, the deflation was
not independent of the plunge in the markets and economy, and not just a
result, but most economists agree that this monetary deflation was actually a
reason why the Great Depression got as bad as it did. Because there was not enough money, the
source of funding for growing businesses was gone. Because there was not enough money, and the
money outstanding had grown too dear, consumers were not spending. Because there wasn’t enough spending,
businesses had to lay people off. Which
further reduced consumer spending. The
nation was caught in a vicious deflationary cycle, which it seemingly could not
break out of.
Yet, the United States did break out
of the deflationary cycle, as illustrated in the graph above. After rapidly plunging for about 30 months,
with the CPI seemingly in free fall and not able to find a floor – there was an
abrupt turnaround. Not only was a floor
found, but an immediate cycle of inflation replaced the seemingly unstoppable
deflation. The nation turned essentially
“on a dime”, from unstoppable deflation to inflation instead. A cycle of inflation that has continued until
this day.
What happened?
President Franklin D. Roosevelt was
inaugurated on March 4, 1933. He came
into office with a mandate and agenda to stop the Depression, and that meant
breaking the back of the deflationary spiral.
His actions were swift, beginning with a mandatory four day bank holiday
imposed the day after his inauguration. Five days after Roosevelt took office, on
March 9th, the Emergency Banking Relief Act was passed by
Congress. This was the first in a series
of executive orders and bills that would take place over the following weeks
and year, and would cumulatively take the United States government off the gold
standard – and would also effectively confiscate all investment gold from US citizens
at a 41% mandatory discount.
From 1900 to 1933, the US government
had been on a gold standard, and had issued gold certificates. In a matter of days in March of 1933, there
would be a radical change, a veritable 180 degree turn, that would not only
repeal the gold standard, but effectively make the use of gold as money illegal
in the United States.
There is a common simplification
that people make when they look at money over time. They think that a dollar is a dollar, even if
the purchasing power has changed a bit. This
is a quite understandable mistake, particularly if your profession does not involve
the study of money.
When we look back over history –
nothing could be further from the truth. This assumption instead reflects an elementary
logical error, that may be quite dangerous for your personal future standard of
living, if it leads to your drawing the wrong conclusions. The term “dollar” is only a name (the same
holds true for the “pound”, “franc”, “peso”, “mark”, and all other
currencies). What matters is not the
name, but the set of rules – or collateral – that back the value of the currency,
during a particular historical period. When
we look back over long-term history, then sometimes it is gold, sometimes it is
silver, sometimes it is both, and sometimes it is something else altogether. (As a creature of politics, money has always
been of a complex and quite variable nature, given enough time.)
So when we say history “proves”
something about a currency, we need to be very, very careful that we are
talking apples and apples, rather than apples and oranges. For instance, when we look at precious metals
backed currencies, the deflation of 1929 to 1933 when the US was on the gold
standard was nothing new. It was just
the latest development in the ongoing cycle of inflation and deflation that
characterizes this type of currency. Indeed,
there were four major deflations during the century before Roosevelt ended the
domestic gold standard, and the deflations of 1839-1843 and 1869-1896 were each
much larger than the deflation of 1929-1933, with the dollar deflating roughly
40% in each of those earlier major deflations. This
deflationary history does not, however, reflect the value of the “dollar” (as
we currently know it) bouncing up and down, but rather the value of the
tangible assets securing the dollar bouncing up and down around a long term
average.
Going off the gold standard was
nothing new either. Many nations have
gone through periods, particularly during wars, when more money is needed than
there is gold or silver to back it up.
So, they issued symbolic (fiat) currencies that were backed only by the
authority of the government, or debased the metals content of the coins. These fiat currencies almost always turned
out badly. Instead of cycling up and
down in value over time, they tended to go straight down and never come back
up. While global monetary history is
complex and long, it is highly, highly unusual for a symbolic currency to
experience major and sustained deflation at the levels that are the norm with precious
metals backed currencies.
It is this quite understandable but
wrong belief that a “dollar” is a “dollar” that creates the ironic situation of
many millions of people believing that the deflation of the US Great Depression
proves the case for deflationary dangers in the current crisis. Not at all – what we have instead is the
elemental logical fallacy of mixing up apples and oranges. Yes, the US experienced powerful monetary and
price deflation during the early years of the Great Depression, but that was
with a dollar that was backed by gold. A
currency in other words, that has almost nothing to do with today’s dollar,
other than the name. A currency type
whose long term history is radically different than fiat currencies – such as
the dollar today.
Let’s revisit the sequence of events
and what actually happened. The United
States was stuck in a powerful deflationary spiral with a gold-backed currency,
that seemed unstoppable. A currency that
had little to do with what we call the dollar today, other than sharing the
name.
So, the government changed the rules, and replaced the old
dollar with a new dollar, whose value was not based on gold. A dollar much like we have today (albeit not
quite the same as there was still a gold backing on an international basis). And what happened?
In the depths of depression, at the
height of a deflationary spiral, the government successfully broke the back of
deflation within one week. In the midst
of deflationary pressures far greater than we are seeing today, the government
not only stopped the deflation, but replaced it with inflation. Indeed, by May of 1933, only two months after
the currency rules changed, the monthly rate of inflation hit an annualized
rate of 10%, and even hit a 40%+ plus (annualized) monthly rate by June of
1933.
If you’re concerned about a new US
depression leading to unstoppable price or monetary deflation because of what
happened in the 1930s, let me suggest that you study and remember the graph
above. When you get worried about
monetary deflation – take another look at March of 1933. Remember as well the one near universal
lesson from the long and convoluted history of money: every
time the rules governing a currency lead to a problem that causes too much pain
for a government to bear – the government just changes the rules. The bigger the problem – the bigger the rules
change (and the bigger the wealth redistribution, as discussed in the full
version of this article).
So, when we look not at near irrelevant
gold certificates, but the dollar we have today, what the Great Depression of the 20th century in the United
States historically proves is not the unstoppable power of deflation, but the
opposite: that a sufficiently determined government can smash deflation at will,
virtually instantly, even in the midst of depression, and replace it with
inflation.
In the process of breaking the back
of deflation - the nature of the dollar itself fundamentally changed. Throughout the 19th century and
the first 30 years of the 20th century, the value of the dollar went
both up and down, as the (usually) gold-backed currency experienced regular
cycles of both inflation and deflation. This
cycle was replaced entirely by a new pattern – which could be characterized as
down, down, down, as illustrated in the graph below.
(The
graph above may look like it starts at 95 cents, but it doesn’t, it starts at
$1.00. The fall in the value of the
dollar in 1933 once the gold standard was abandoned was so fast it can’t be
seen with a 75 year scale and monthly increments.)
A 76 year old man or woman born in
the 19th or 18th centuries would have seen the value of
their currency go both up and down over their lifetimes, and there is a pretty
good chance that at age 76, the dollar (or pound) would be worth the same or
more than it was when they were born.
When the US Government fundamentally changed the nature of money in 1933,
it created an entirely different pattern – all down, and no up, so that for a
76 year old person today, a dollar will only buy what 6 cents did at the time
they born.
So as we try to decide whether the
danger ahead is inflation or deflation today, what is the monetary lesson for
us from the US Great Depression?
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The common belief is to say the Great Depression proves the awesome power of deflation, that the government can
have a great deal of difficulty in fighting it, and may not be able to fight it
at all. This is an extraordinary
misunderstanding, and constitutes the second of our logical and historical
fallacies.
What the Great Depression showed was
that if you have a tangible asset backed currency, such as gold or silver, and
you enter a depression, then history has shown time and again that you're likely
to have a period of substantial deflation. However what March of 1933 shows us, is that
even in the midst of a terrific burst of asset deflation, even in the midst of
a terrible depression, if you take away the tangible assets that back your
currency and you introduce a purely symbolic currency, than the force of
inflation that is associated with a purely symbolic currency (as well as the
changes in monetary policy that are thereby enabled) can be so powerful that it
overcomes the depressionary economic pressures and forces inflation.
Indeed what March of 1933 shows is
that the value of money can turn on a dime when we are using a symbolic
currency. We have absolute proof that
even in the middle of a depression, the government has the power to stop a
deflationary spiral at will. We further
know this deflation fighting strategy was not a one time anomaly, but was so
successful that it broke the ongoing inflation / deflation historical cycle,
and led to a 94% destruction of the value of the dollar over the next 76 years.
It is a great irony that this lesson
is so widely misunderstood.
Unfortunately, this misunderstanding is highly dangerous for investors,
as it leads them to worry about what is likely not a problem, instead of
concentrating on the grave dangers illustrated by this same historical
example. Dangers that involve the
simultaneous combination of asset deflation (the destruction of
the purchasing power of your assets) and monetary or price inflation (the
destruction of the purchasing power of your money). As I have written about in other articles and
books, these are a potent wealth destroying combination with a long and very
real history of destroying wealth in general – and retiree wealth in particular
– in societies that are in economic distress.
While misunderstanding what happened
in the Great Depression is common, it is not at all universal, particularly
among economists. Indeed, what really happened
during that period between 1929 and 1933 has been a career-long source of fascination
for one important economist in particular:
Ben Bernanke, Chairman of the Federal Reserve. Bernanke believes that a major mistake was
made – and it wasn’t abandoning the gold standard. No, Bernanke’s quite public belief is that the
economic contraction that was the Depression was much deeper and longer than it
needed to be, and the reason was that monetary stimulus was too small and too
late in coming. In other words, his
belief is that if the rules governing the nature of the US dollar had only been
changed earlier, so that there was inflation instead of deflation by 1930 or
1931, the economic devastation inflicted on the nation by the deflationary
spiral would have been much less. (Some
economists look to the example of Japan abandoning the gold standard in 1931, two
years earlier than the US, and the shallower and shorter economic contraction
that was experienced there.)
Bernanke got his nickname of
“Helicopter Ben” from a flippant comment he made, in which he dismissed deflationary
fears with a joke about dropping money from a helicopter if needed. This is a very important joke, with drastic
implications for your personal net worth.
Instead of fearing deflation, Bernanke finds fears about deflation to be
humorous because he understands the principles described in this article very,
very well indeed, and has for many years.
There are no immutable and awesome powers of deflation that render governments
helpless. Because once it is freed of its
connections to precious metals or other currencies – money is really just a
symbol with an inherent value of zero.
What gives a national currency value are the rules that are set up by
the government. And if the rules become
inconvenient, well, what’s the point in being in power, if you can’t change the
rules when you need to?
Changing the rules is not a theory about what Bernanke might do. It is a description of what he has already been doing on a massive scale. The self-imposed shackles that used to restrain past Fed chairmen are already history. The Fed is creating money at a rate never seen before, trillions of dollars a month, effectively out of thin air. The Fed typically doesn’t do this, because, of course, such actions rapidly destroy the value of the currency. But if the person in charge of the money supply understands that destroying the value of the currency is how you prevent deflationary spirals from getting started – and believes massive and fast government intervention is the best way to stop an incipient depression before it gets any worse – then much of what the Fed has been doing becomes more understandable.
Our first fallacy was the widespread
belief that the Deflation of 1929 to 1933 proves that major deflation is a
major risk for a nation in depression – when what it actually proves is that
deflationary spirals are a major risk for gold-backed currencies, even while
providing concrete historical evidence that symbolic currencies which are
backed by nothing but government policies (like the dollar today) can be forced
into inflation even in the very middle of a severe depression.
Our second fallacy was believing
that price deflation can grow so powerful that it can render a country’s
monetary policy almost helpless to fight it – when what March of 1933 shows is
that a sufficiently determined government can break the back of monetary deflation
at will and almost instantly, simply through changing the rules that govern the
value of that currency. (The far more
dangerous problem of asset deflation is a quite different matter, as we will
explore in Part 2.)
There is a third fallacy which is perhaps
the most important, and that is the belief that inflation or deflation changes
wealth for the nation as a whole and there's nothing that you personally can do
much about it. This belief that we are
all in the some boat together is perhaps the most dangerous mistake of all for
individuals seeking to protect their wealth. Inflation and deflation do have an
impact on the real wealth of society, they do affect the creation of real goods
and services, and impact the real GDP, but they also do something else that is
every bit as powerful, that is even more immediate and that is deeply personal.
What inflation and deflation do is that they redistribute the rights to wealth
within our society.
When we look back to the Great
Depression in the years 1929 to 1933 then, for retirees at that time who did
not have their savings in the market or in banks that went bust, those were
actually good years for them financially, particularly relative to the rest of
the population. Monetary deflation redistributes wealth from society at large
to many retirees.
However, sustained and major
monetary deflation with a symbolic currency is quite rare, and hasn’t happened
in modern times. This brings us back to
that central question regarding the case for deflation: “where’s
the beef?” Where is that example of “a modern, major nation where the domestic
purchasing power (as measured by CPI) of its purely symbolic & independent
currency uncontrollably grew in value at a rapid rate over a sustained period,
despite the best efforts of the nation to stop this rapid deflation?”
If actual history is what matters to
you rather than theoretical discussions, unfortunately, we have a long history
of what happens with nations in severe economic distress, when they have a
symbolic, independent currency (not explicitly tied to another currency). That history isn’t one of those fiat
currencies soaring in purchasing power, despite the best efforts of the economically
wounded nation to keep that from happening.
No, the very well established pattern is that the currency collapses in
value (price inflation), even as the purchasing power of assets is
collapsing (asset deflation), much like what is happening with Iceland
today.
That collapse in the value of the
currency necessarily forces a major redistribution of wealth, and the segment
of the population that is most devastated by this seems to always be the
same. It’s the retirees, and the people
close to retirement. When we look to
Germany, when we look to Argentina, when we look to Russia – it is the
pensioners who are impoverished more than any other group.
Unfortunately, history is repeating
itself again. When we look at the
headlines about the destruction of retiree investment values, pension assets
and so forth, we're really just seeing the beginning. Because the crisis
"solution" that is being chosen, which is creating dollars without
the ability to pay for those dollars, essentially represents the annihilation
of most of the retirement dreams of the baby boom generation, even if that is
not yet recognized. There is not an even
cost that is being born by society as a whole, rather some segments are bearing
much more of the burden than others. If
your peer group (particularly Boomers and older) is headed for disproportionate
financial devastation, then happenstance is unlikely to offer a personal way
out. Instead, you must instead take
quite deliberate actions to change your personal financial position so that wealth
is redistributed to you, rather than away from you.
To get out of step with your
generation, and have wealth redistributed to you even as your peer group is
being devastated by this extraordinary destruction of wealth, you need to start
with an essential and irreplaceable step:
education. You need to gain the
knowledge you will need to turn adversity into opportunity. This will mean looking inflation straight in
the eye and saying: “Inflation, you are
likely to play a big role in my personal future, and instead of ignoring you or
thoughtlessly flailing away at you – I will study you and your ways. I will learn the deeply unfair ways in which
you redistribute wealth, and the counterintuitive lessons about how some
investors will be destroyed by inflation and repeatedly pay taxes for the
privilege, even while other investors are claiming real wealth on a tax-free
basis. I will learn to position myself
so that you redistribute wealth to me, and the worse the financial devastation
you wreak – the more my personal real net worth grows. I will examine the official blindness to
inflation within government tax policy that creates the Inflation Tax, and
instead of raging or despairing, I will understand that a blind opponent is a
weak opponent, and I will take advantage of your blindness and use tax policy
to multiply my real wealth.”
(This article is Part 1 of a series
of public and private articles on puncturing deflation myths. Part 2 will separate truth from myth with
Japan’s deflation, and uncover some dangerous logical fallacies in the common
treatment of this deflation. In addition
to Japan, the relevance of modern era deflation in China, Hong Kong and
Argentina will also be briefly examined. The full versions of these articles,
with expanded discussion of the investment implications for investors in
general and retirement investors in particular, are available to Turning
Inflation Into Wealth mini-course subscribers.
Subscription is free.)
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will
redistribute real wealth to you, and the higher the rate of inflation – the
more your after-inflation net worth grows?
Do you know how to achieve these gains on a long-term and tax-advantaged
basis? Do you know how to potentially
triple your after-tax and after-inflation returns through Reversing The
Inflation Tax? So that instead
of paying real taxes on illusionary income, you are paying illusionary taxes on
real increases in net worth? These are
among the many topics covered in the free “Turning Inflation Into
Wealth” Mini-Course. Starting simple,
this course delivers a series of 10-15 minute readings, with each
reading building on the knowledge and information contained in previous
readings. More information on the course
is available at InflationIntoWealth.com .
Contact Information:
Daniel R. Amerman, CFA
Website: http://InflationIntoWealth.com/
E-mail: mail@the-great-retirement-experiment.com
This essay and the websites, including the mini-course, DVDs and books, contain the ideas and opinions of the author. They are conceptual explorations of general economic principles, and how people may – or may not – interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this website does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, DVDs, books and other materials, either directly or indirectly, are expressly disclaimed by the author.
Copyright 2009 by Daniel R. Amerman, CFA