Out of Knowledge of Money comes Freedom

Inflation, Deflation and Financial Markets

Berlin, March, 14th 2014 Mark J. Valek
mjv@incrementum.li www.incrementum.li

Are we experiencing Inflation or Deflation?

What is Inflation?

What people today call inflation is not inflation, (i.e., the increase in the quantity of money and money substitutes) but the general rise in commodity prices and wage rates which is the inevitable consequence of inflation. Ludwig von Mises
Planning for Freedom

Inflation is the increase in the quantity of (uncovered) money and money substitutes

Monetary Inflation vs. Price Inflation

12

10

Trillion USD

6 Uncovered Money Substitute 4 Base Money

Sources: Fed St. Louis, Incrementum AG

Money Creation within a Fractional Reserve World*

Banks create money. That is what they are for The manufacturing process to make money consists of making an entry in a book. That is all. Each and every time a Bank makes a loan new Bank credit is created - brand new money.
Graham Towers
Governor of the Bank of Canada from 1934 to 1954

Todays monetary system is a debt based fiat money system within a fractional reserve banking system

The Currency Composition within a Fractional Reserve World*

Total Effective Liquidity (including Repo) USD 47,500 Bn M3 USD 16,555 Bn M2 USD 10,934 Bn
M0 USD 4,010 Bn

Total liquidity, including liquidity created trough financial markets (repo markets)

Fiduciary media lent into existence by commercial banks, through fractional reserve system.

M0 or base money is directly created by the FED

*Note: We encourage the interested reader to look up what F.A.Hayek wrote about the concept of the inverted pyramid: http://mises.org/books/pricesproduction.pdf

Sources: Nowandfutures.com, UBS Research, Federal Reserve St. Louis, Incrementum AG

The Monetary Atlas Shrugs So Much Easing, And Still No Price Inflation?
Total Effective Liquidity (including Repo) USD 47,500 Bn

Total Liquidity is 13x larger than Monetary Base

Monetary Deflation: Credit deleveraging e.g. due to regulatory changes and sluggish credit growth means currency supply is being reduced.

M3 USD 16,555 Bn M2 USD 10,934 Bn

M0 USD 4,010 Bn

Monetary Inflation: Central bank (directly) only controls a tiny part of the total effective liquidity! Monetary Inflation of the FED intends to offset deflationary forces.

Sources: Nowandfutures.com, UBS Research, Federal Reserve St. Louis, Incrementum AG

Preventing Price Deflation, Creating Asset Price Inflation?

In a highly leveraged world, price deflation is from a political viewpoint a horror scenario that has to be averted whatever it takes, due to the following reasons:

Deleveraging* leads to consumer price deflation and asset price deflation. Tax revenue declines significantly. Asset price inflation is taxed, asset price deflation cannot be. Falling prices result in real appreciation of nominal denominated debt. Increasing amounts of debt can therefore no longer be serviced. Debt liquidation and price deflation have fatal consequences for large parts of the banking system, in an over-indebted world. Central banks also have the mandate to guarantee financial market stability and to make sure It doesnt happen here
Translation: Make sure to keep currency and credit supply growing exponentially

There is no inflation? False! Successful prevention of price deflation via monetary inflation has led to massive asset price inflation!

*Note: Deleveraging may have taken place in some parts of the economy but in aggregate the total debt/credit has kept on growing 8 Please refer to: http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/

Monetary Regimes & Price Inflation Price Deflation Was Common Before The Fed Was Established
40

43% of all Years Price Deflation

30 20 CPI yoy 10 0 -10 -20 1775

12% of all years Price Deflation

1795

1815

1835

1855

1875

1895

1915

1935

1955

1975

1995

Gold/Silver Money (with Interruptions)

3000 2500 CPI Basket 2000 1500 1000 500 0 1775 1795 1815 1835 1855

Classic GS

Partly Debt Based

Debt Based Fiat

1875

1895

1915

1935

1955

1975

1995

Source: Measuringworth.com, Incrementum AG

The History Of UnderQEstimation Is This Time Really Different?

5.000 4.500 4.000 FED Balance Sheet in Bn. USD 3.500 3.000 2.500 2.000 1.500 1.000 500 0
01.2007 05.2007 09.2007 01.2008 05.2008 09.2008 01.2009 QE3: 12% Tapering, Jan 2014

QE 2: 100% Tapering QE 1: 100% Tapering

Failed Projection: Autumn 2013 Tapering Failed Projection: Post OT Exit Strategy

Current Projection: 100% QE3 Tapering in Dec 2014; no Exit Strategy formulated

Failed Projection: Post QE 1 Exit Strategy

Failed Projection: Post QE 2 Exit Strategy

QE 1
05.2009 09.2009 01.2010 05.2010 09.2010

QE 2
01.2011 05.2011 09.2011 01.2012

OT
05.2012 09.2012 01.2013 05.2013

QE 3
09.2013 01.2014 05.2014 09.2014 01.2015 05.2015 09.2015 01.2016

All Federal Reserve Banks - Actual Path Projection 2012

Projection 2010 Projection Mid 2013

Projection 2011 Projection 2014

Sources: Federal Reserve St. Louis, Incrementum AG

10

The Tug Of War*

Team Blue: Deflationary Forces

Team Red: Inflationary Forces

Balance Sheet Deleveraging: Undercapitalized banks still recovering from the crisis are reluctant to lend Sluggish Credit Growth: Over-indebted consumers are reluctant to borrow Regulation: Basel III High Demand to hold Money (low inflation exp.)** Productivity gains Defaults and Bail-ins (Europe: Greece, Cyprus) Demographics

Zero interest rate policy Communications Policy (forward guidance) Operation Twist Quantitative Easing Currency Wars Eligibility Criteria for Collateral (ECB)

* Please also refer to another outstanding speech of James Rickards here: http://www.youtube.com/watch?v=9fXHV6MnP0E ** Low velocity according to the Monetarist Paradigm

11

Where Did All The Money Go?

Financial Assets And Luxury Goods Profit From Monetary Inflation

Cumulative Price Changes 12/2008 12/2013

0% Consumer Price Index - U all items*

50%

100%

150%

200%

250%

300%

350%

400%

450%

500%

M2 US Money Supply*

BofA US Corporate Bond Index

S&P 500 Index

LVMH Louis Vuitton Shareprice

Sotheby's Shareprice

*Latest data available, Nov, 2013

Sources: Federal Reserve St. Louis, Incrementum AG

12

The Cantillon Effect

Inflation and credit expansion, the preferred methods of present day government openhandedness, do not add anything to the amount of resources available. They make some people more prosperous, but only to the extent that they make others poorer.
Ludwig von Mises
Bureaucracy

Monetary inflation is a wealth transfer and the root cause for growing inequalitly

13

Conclusion

Inflationism, however, is not an isolated phenomenon. It is only one piece in the total framework of politico-economic and sociophilosophical ideas of our time. Just as the sound money policy of gold standard advocates went hand in hand with liberalism, free trade, capitalism and peace, so is inflationism part and parcel of imperialism, militarism, protectionism, statism and socialism.
Ludwig von Mises
On the Manipulation of Money and Credit

A free society requires sound money.

14

15

IV.

APPENDIX

16

Our Philosophy At Incrementum: The Austrian School Of Economics

The Austrian School of Economics originated in Vienna in the late 19th century and provides an alternative assessment of economic affairs. Contrary to mainstream economics, this analysis produces a truly holistic view of financial markets, because it integrates the current state of the monetary regime. Followers of the Austrian School have been extremely successful at anticipating major economic events like the Great Depression, the stagflationary environment of the 1970s, the Dotcom Bubble and the Housing Bubble. The insights of this school of thought offer exceptional understanding and superior interpretation of the interdependencies between money supply and price inflation. This knowledge is valuable especially nowadays, as central bank policies massively distort and influence financial markets. Grasping the consequences of the interplay between monetary inflation and deflation will be crucial for prudent investors. Scholars of the Austrian School are convinced, that today's radical monetary and fiscal policy interventions will not lead to a self-sustained recovery of the economy, but to further turmoil in financial markets.

For further information about the Austrian School please visit our webpage: http://www.incrementum.li/austrian-school-of-economics/an-introduction-to-the-austrian-school-of-economics

17

Disclaimer

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS THE INFORMATION CONTAINED IN THIS DOCUMENT HAS NOT BEEN INDEPENDENTLY VERIFIED AND NO REPRESENTATION OR WARRANTY EXPRESSED OR IMPLIED IS MADE AS TO, AND NO RELIANCE SHOULD BE PLACED ON, THE FAIRNESS, ACCURACY,COMPLETENESS OR CORRECTNESS OF THIS INFORMATION OR OPINIONS CONTAINED HEREIN. CERTAIN STATEMENTS CONTAINED IN THIS DOCUMENT MAY BE STATEMENTS OF FUTURE EXPECTATIONS AND OTHER FORWARD-LOOKING STATEMENTS THAT ARE BASED ON MANAGEMENTS CURRENT VIEWS AND ASSUMPTIONS AND INVOLVE KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS, PERFORMANCE OR EVENTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED IN SUCH STATEMENTS. NONE OF INCREMENTUM AG OR ANY OF ITS AFFILIATES, ADVISORS OR REPRESENTATIVES SHALL HAVE ANY LIABILITY WHATSOEVER (IN NEGLIGENCE OR OTHERWISE) FOR ANY LOSS HOWSOEVER ARISING FROM ANY USE OF THIS DOCUMENT OR ITS CONTENT OR OTHERWISE ARISING IN CONNECTION WITH THIS DOCUMENT. THIS DOCUMENT DOES NOT CONSTITUTE AN OFFER OR INVITATION TO PURCHASE OR SUBSCRIBE FOR ANY SHARES AND NEITHER IT NOR ANY PART OF IT SHALLFORM THE BASIS OF OR BE RELIED UPON IN CONNECTION WITH ANY CONTRACT OR COMMITMENT WHATSOEVER.