Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model

May 5th, 2009

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One of the strongest leanings among investors is the view that deflation (instead of inflation) will be the problem of the future. The best argument for deflation we have seen so far is Professor Steve Keen’s “The Roving Cavaliers of Credit” article. We highly recommend that you take a read at that article if you have the time. If not, we have a summary as well as our additional commentary of that article below. Keen’s view is that in today’s GFC context, inflation, while it is possible under a pure paper money system, is impossible under the credit system of today.

To understand why, you have to understand the conventional textbook model of how money is created through the banking system through the fractional reserve money multiplier model. Our article, “The difference between money and credit” is the best illustration of how it works. In this conventional textbook model, banks can only lend out of their existing deposits. The inference of this model is that quantity of money will always be more than the quantity of credit in the system.

Unfortunately, the conventional textbook model is wrong. In the real world financial system, the quantity of credit is greater than the quantity of money. In today’s modern financial system, banks do the lending first before coming up with the ‘deposits.’ This sound very counter-intuitive, but let us explain how it works. Suppose you borrow $100 from the banks. All the bank has to do to ‘lend’ you money is to create an accounting entry of the $100 loan on their books. Suppose you transfer $50 out of the loan to your friend’s bank account:

  1. If your friend’s account reside in the same bank as yours, then it’s just a matter of the bank adjust the accounting entries between your loan account and your friend’s cash account. Simultaneously, you have to pay interest for the $50. A neat way of making money isn’t it?
  2. If your friend’s account reside in a different bank and let’s suppose the bank is short of say, $50 at the end of the day after all the bank transfers are netted out in the system. All the bank has to do is to borrow $50 from either another bank, the central bank, investors or depositors (or perhaps even run down its existing cash reserve). In the end, you will owe an IOU to the bank and the bank will owe an IOU to another entity. The interest rate that you pay for your IOU will be greater than the interest rate that the bank pays for its IOU. The difference is the bank’s profit.

So, you can see that ‘money’ in the financial system is just a long chain of IOUs. The quantity of ‘cash’ (or technically, monetary base) to back up the IOU is unimportant as long as trust reigns among participants of the financial system. A growing quantity of IOU relative to ‘cash’ implies greater leverage in the financial system, which further implies greater level of trust. But then, as we explained in “What is the role of real assets in preserving your wealth?” trust breaks down during the Global Financial Crisis (GFC):

Interestingly, the word ?credit? comes from the Latin word ?cr?dere,? which has the meaning of trust (?to believe?). Therefore, the credit crisis implies a crisis in trust in the global financial system. Without trust in the financial system, the value of financial assets becomes suspect.

With the breakdown of trust, institutional participants in the financial system began a mad scramble to reduce their vulnerability caused by their trust of others. This is what we call de-leveraging. De-leveraging implies that you reduce your obligations to others so that you don’t have to trust on others who have obligations to you to remain solvent. Also, you reduce your trust on others to protect yourself. As the quantity of IOUs in the system far exceeds the quantity of ‘cash’ in the system, many participants will be caught short in the scramble for cash to settle their IOUs. That’s why central bankers (e.g. The Federal Reserve, Bank of England, Bank of Japan) are busy printing money (technically called “quantitative easing”) to flood the system with ‘cash’ so that market participants can use them to settle their IOUs.

Now, Steve Keen reckons that this printing of money will not cause inflation. Because the quantity of IOUs far exceeds the quantity of newly printed ‘cash,’ which means market participants will still hoard the ‘cash’ to protect themselves. Unless the central banks print enough money to match the scale of IOUs destruction, then inflation will not happen. This has the same effect as what we described in “Demand for money, inflation/deflation & its implication”

Let?s say the quantity of money increases in the system. But if people want to increase their holdings of cash due to fear and uncertainty of the future, they will withdraw these cash from circulation in the economy. Consequently, prices fall.

The destruction of IOUs causes the quantity of credit to contract in the economy, which in turn causes asset price collapses and if not arrested, ultimately result in the fall in prices in the real economy. This is deflation. The second half of 2008 witnessed the destructive effects of deflation as the prices of assets and commodities collapsed, and the real economy deteriorated at an unprecedentedly rapid rate.


Last month, we took the liberty to forward Steve Keen’s “The Roving Cavaliers of Credit” to Marc Faber and asked for his opinion on Steve Keen’s deflation view. His reply was very short: “In my opinion, he is wrong.” Please note that this does not automatically imply that Steve Keen’s model is wrong. We think Steve’s model is highly valuable in understanding what is going on in the real world. It just mean that Marc Faber disagrees that the result will be deflation.

We did not get any further explanation from Marc Faber from his short reply. But in his latest Gloom, Boom, Doom market commentary, he finally explained his view further. We will present Marc Faber’s view in the next article. Keep in tune!

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