An Inflationary Depression

Oct 3, 2019·Alasdair Macleod

Financial markets are ignoring bearish developments in international trade, which coincide with the end of a long expansionary phase for credit. Both empirical evidence from the one occasion these conditions existed in the past and reasoned theory suggest the consequences of this collective folly will be enormous, undermining both financial asset values and fiat currencies.

The last time this coincidence occurred was 1929-32, leading into the great depression, when prices for commodities and output prices for consumer goods fell heavily. With unsound money and a central banking determination to maintain prices, depression conditions will be concealed by monetary expansion, but still exist, nonetheless.


The unfortunate souls who are beholden to macroeconomics will read this article’s headline as a contradiction, because they regard inflation as a stimulant and a depression as the consequence of deflation, the opposite of inflation.

An economic depression does not require deflation, if by that term is meant a contraction of the money in circulation. More correctly, it is the collective impoverishment of the people, which is most easily achieved by debasement of the currency: in other words, monetary inflation. Fundamental to the myth that an inflation of the money supply is the path to economic recovery are the forecasts by the economic establishment that the world, or its smaller national units, will suffer no more than a mild recession before economic growth resumes. It is not only complacent central bank and government economists that say this, but their followers in the private sector as well.

It is for this reason that the S&P 500 Index is still only a few per cent below its all-time high. If there was the slightest hint that Corporate America risks being destabilised by a depression, this would not be the case. All the alarmist chatter about this and that in the blogosphere has no relevance: the world of investment is as bullish as it has ever been. Everyone has bought into the promise of applied macroeconomics and cannot afford to believe in the contrary signals from classical economics, shorn of the macroeconomists’ insistence that what applies to individuals on a micro-level does not apply to them at the macro-level.

It will shortly prove to be a huge mistake: we must not mince our words. The purpose of this article is to explain why it is a blunder by examining the interaction between the peak of the credit cycle and the increase in trade tariffs introduced by President Trump. It will almost certainly turn out to be one of those times when, metaphorically, one plus one equals much more than two: the coincidence of these factors has the potential to be even more destructive than they are likely to be simply put together.

Credit cycles within credit cycles, and their increasing force

On its own, the credit cycle always leads to a periodic crisis of a greater or lesser degree, which may or may not result in a full-blown banking crisis. The earlier expansion of bank credit, even under a gold standard, leads to malinvestments, which we can define simplistically as investments driven by monetary opportunism instead of undertaken on a sound commercial basis. It has the effect of turning the random occurrences of Schumpeter’s creative destruction into a coordinated distortion, allowing malinvestments to thrive until they all crash together. Without fractional reserve banking or the ability of banks to loan money into existence, there would be no credit cycle, and the symptoms, a business or trade cycle, would not exist either. There is also a proportionality: the more the expansion of credit, the greater the eventual crash.

This fundamental truth is ignored by the state theories of money, which make things worse by expanding base money as an added stimulant to credit and suppressing interest rates to further encourage businesses to malinvest. This first happened in modern times following the brief post-war slump in 1920-21. The Fed, which was born before the First World War, became fully operational as a modern central bank under Benjamin Strong, who was its first executive officer, and remained at its head until his death in 1928. He presided over a monetary expansion that lasted until the year after his death, when the stock market began its crash.

The Wall Street crash of 1929-1932 was the credit crisis that unwound Strong’s credit expansion. It combined with President Hoover’s failed attempts to prevent unemployment and maintain prices to result in the 1930s depression, prolonged even further by President Roosevelt’s New Deal.

We shall return to that period in our discussion of trade tariffs at that time after continuing our current thread. Following the 1930s the Second World War had commandeered the economies of both Allied and Axis countries, and when it was over a new cycle of credit expansion then commenced. The experience of the nineteen thirties depression led to a post-war determination that high levels of unemployment were never to be permitted again, and the new religion of macroeconomics was deployed by governments to that end.

Benjamin Strong’s price targeting through open market operations that led to the Wall Street Crash and the subsequent depression were given a new respectability. Central banks doubled down on Strong’s policies, encouraged by the writings of luminaries such as Irving Fisher and Lord Keynes. According to the US’s National Bureau of Economic Research, the 1950s saw a series of minor business cycles and then a longer one, which ran from 1961 to a peak in 1969. It was the early-1970s expansion, coupled with the abandonment of the gold standard in 1971, that then fuelled price inflation throughout the 1970s. Monetary inflation led to rising oil and energy prices, giving power to the OPEC cartel. And as monetary inflation undermined the purchasing power of state currencies generally, record interest rates in 1980-81 became inevitable.

The current credit cycle can be regarded as being nurtured by the reforms of the financial system in the 1980s, when banks integrated their investment and retail operations, expanding bank credit into market-making, proprietary trading and derivatives. This led to three inflationary peaks in securities markets: the dot-com boom, the residential property and stock market boom of 2005-2007, and the current boom.

The current boom can therefore be regarded as the culmination of a series of monetary inflations targeted at financial asset prices. It has also been noticeable that the productive side of major economies have only kept afloat due to the expansion of consumer credit, and the draw-down of savings. And when American politicians bemoan the transfer of production to China and South-East Asia, they fail to recognise their own role in the destruction of domestic manufacturing through credit inflation.

It should be apparent to all who understand that the root of economic cycles, however described, is a cycle of credit, and that the current credit cycle comes on top of the previous two, their malinvestments having been prevented from unwinding. Taken together with the previous two, it is a far, far greater credit elevation than that of 1922-1929, which led to the greatest depression of modern times – so far.

The additional factor that made the 1929-32 Wall Street crash was trade protectionism, when Congress signed the Smoot-Hawley Tariff Act into law on 30 October that year. And October was the month when the stock market collapse commenced.

The role of tariffs in the credit cycle – an historical perspective

For America, the 1920s were book-ended by two tariff acts, the first being a combination of the 1921 Tariff Act and the Fordney-McCumber Tariff of 1922, which followed the 1921-22 slump. The primary purpose of these tariffs was to protect agriculture, which had expanded substantially during the First World War, due to higher war-time prices, demand from war-torn Europe and the withdrawal of Russia from world markets. But by the time of the 1921 slump, the value of US farm output had collapsed from a war-time high of $17.7bn to only $10.5bn, a fall of 40%.[i]

Following the First World War, imports from Europe began to threaten American farmers, who had had the protection of a wartime economy, and manufacturers in non-agricultural sectors feared that they would suffer the same fate as well. This led to the Fordney-McCumber tariffs being extended from protecting agricultural output, to a wider tariff act protecting America from the economic and monetary turmoil of the post-war years.

It is worth noting that following the war, the US economy was almost entirely self-sufficient having been on a war-time footing. The disruption to domestic production from import tariffs was not significant. Furthermore, the expansion of bank credit was at the earliest stage of the credit cycle, so there was a low tendency for credit expansion to feed into a trade deficit. Consequently, the economic derangement from an increase in tariffs was considerably less than it would prove to be later on in the credit cycle.

The trade situation elsewhere was not nearly so benign. Between the First World War and 1924 most European nations saw their currencies, no longer backed by gold, collapse, in a few cases, entirely. America, which had loaned $10bn in war credits to Europe became the world’s creditor, and its European debtors found their exports to America, necessary for them to service and repay their loans, shut out by tariffs.[ii] But when the European economies eventually recovered from war-time devastation, governments responded by imposing tariffs on American goods as well as those of their neighbours.

On a balance of payments basis, the US ran a trade surplus by a large margin every year following the end of the Great War despite mounting trade protectionism in Europe. At the same time, the supply of farm products expanded rapidly as marginal land in the US was increasingly cultivated, and Australia, Canada, the UK, France Germany and Italy increased farm production and tariffs to protect their farmers. Mechanisation rapidly improved outputs, while populations, whose lifestyles were improving, were spending less on food as a proportion of their total spending. Agricultural product prices continued to weaken.

Inevitably, increasing protectionism in farming led to expensive government subsidies, particularly in Europe, creating budget deficits which tended to lead to greater trade imbalances. However, apart from the problems faced by the global farming industry, there was significant economic progress, in America following the 1921 slump and in Europe from about 1925 onwards. These recoveries were augmented by the expansion of credit, not only in America, but fuelled by government budget deficits in Europe, most notably in France and Germany.

Big businesses began to see that tariffs were an impediment to their trade. But tariffs had become the automatic response by politicians to all changes in trading conditions, not just in America. The election of President Hoover in 1928, who was highly protectionist, impelled protectionism even further. It was this political atmosphere that resulted in the Smoot-Hawley Tariff Act, which raised the average of all US import tariffs from 38% to 60%.

Smoot-Hawley was passed by Congress on 30 October 1929, the month the Wall Street Crash began. Wall Street recovered its poise from the October crisis, until Hoover signed it into law, the following June, whereupon the stock market continued its collapse without much remittance until mid-1932. Subsequent analysis by market historians cite a number of reasons for the crash, putting tariffs well down the list while not mentioning a credit cycle at all.

The combination of credit expansion and Smoot-Hawley were lethal

The differences between the consequences of Ford-McCumber and Smoot-Hawley can be summed up as follows:

  • Ford-McCumber and the 1921 Emergency tariffs preserved the post-war American economy and represented little change to American domestic business. Smoot-Hawley was a substantial addition to protectionist policies and ended up hitting American business hard.
  • While the burden of the Ford-McCumber tariffs was not significant for Americans, it was felt more by America’s European trading partners. It exacerbated their recessions and their currency difficulties in the early twenties. Furthermore, in a mood of protectionism the Europeans also raised tariffs against each other as their economies progressed, stifling their own cross-border trade.
  • Fordney-McCumber raised tariffs to an average of 38% on imported goods, whereas Smoot-Hawley increased them to 60%. Foreign governments responded by threatening retaliation and prohibition of American goods even before Smoot-Hawley was signed into law.
  • The different consequences of Ford-McCumber and Smoot-Hawley on the US stock market reflected the expansion of credit that had fuelled stock prices in the intervening period.

The levels to which tariffs had risen in consequence of the introduction of Smoot-Hawley were far higher than the American tariffs introduced against China by President Trump. Furthermore, today it is only one nation which has been targeted, as opposed to every trading partner in 1930. It is therefore tempting to dismiss comparisons between today’s events and those of ninety years ago, but this would be a mistake.

So far, President Trump has announced tariffs of up to 30% on Chinese imported goods with more tariffs to come on 15 December. If this happens, all Chinese imports will be subjected to tariffs. China has hit back, and by the end of the year intends to include a further 3,000 American products in its tariff regime. The increase in America’s tariffs is similar in scale to the increase in tariff rates introduced by Smoot-Hawley. It was clear that the world had become accustomed to the Fordney-McCumber tariffs, so the additional Smoot-Hawley tariffs were the true global shock. And equally, the world has today become accustomed to the World Trade Organisation’s rules and rates, which average five or six per cent, in which case the shock with respect to US-Chinese trade must be of similar magnitude.

Today’s global trade conditions are considerably more developed than they were ninety years ago, with nations not only more dependent on the importation of foodstuffs, raw materials, energy and commodities, but also with supply chains stretching across multiple jurisdictions. American businesses own many of the factories that produce their goods in China and elsewhere, so are themselves victims of Trump’s tariffs. And American farmers, for whom China represents a growing and lucrative market, find themselves shut out by China’s retaliation. Manufacturing businesses, dependent on processed steel and other materials from China for their manufacturing find their costs are inflated by tariffs, making them less competitive in their markets both at home and abroad.

On matters of trade, Trump is at least as protectionist as Hoover was in 1930. He will be disappointed to find that despite his efforts to address supposed Chinese unfairness, the US trade deficit with China persists, having risen in the first half of 2019 to $244bn compared with $212bn for the first half of 2018. And with America now contemplating diverting capital flows from China, if anything the trade war is likely to intensify.

It comes at a time when the quantity of money and credit in circulation has increased by 91% since the Lehman crisis, representing a compound growth rate of just over 6%. With the savings rate being broadly unchanged over the period after factoring in the increase in consumer debt, monetary expansion can only fuel price inflation and a trade deficit. To the extent consumers buy cheaper foreign goods, the trade deficit simply defers price inflation. Therefore, by raising prices to the consumer without a compensating increase in wages and with his credit cards maxed out, trade tariffs end up depressing domestic demand generally.

This is the mechanism by which tariffs on imports ends up undermining domestic output, increasingly apparent from business surveys. We can also see this effect on China’s general level of business activity, which has slowed markedly. In turn, trade between other nations and China has been undermined, with Germany particularly hard hit. And only two days ago, Sweden, whose open economy is seen as a bellwether for the direction global trade is going, reported factory activity plummeting. Indeed, manufacturing everywhere appears to be turning turtle.

There is no doubt that the contraction in global trade is now beginning to bite in domestic economies. And because the source is the disruption of international trade, the reasons for domestic trade being affected are not immediately obvious, which probably explains why financial markets seem blissfully unaware of it all.

The difference between 1929-32 and today

Before 1933, the dollar was on a gold exchange standard at $20.67 to the ounce which meant that prices were measured in gold through the dollar. Consequently, when markets were toppled by the combination of Smoot-Hawley and the turning of the credit cycle, the effect was obvious, because gold’s purchasing power increased.

The situation today is different. Instead of a US president introducing price support and make-work programmes, today central banks will simply inflate in an attempt to achieve price stability. Back-calculated CPI statistics by the US Government tell us that consumer prices fell by twenty-four per cent between 1929 and 1933. If that is to be prevented in the coming years, assuming in real terms a similar situation develops, the purchasing power of the dollar will have to fall by at least 30%, if the two per cent inflation target is to be honoured.

If only it was so simple. Not only should we not take back calculations of consumer prices too seriously, but the relationship between changes in the quantity of money and prices are tenuous, depending on the public’s preferences for holding it relative to goods. It is likely that central bankers’ price stabilisation schemes will end up destabilising fiat currencies instead of stabilising prices, as the public awakens to the consequences of ever more aggressive monetary policies.

The combination of a collapse of trade due to protectionist measures, and bank credit tending to contract from elevated levels as bankers become aware of increased lending risks always leads to systemic problems for the banks. While bank capital in America has been bolstered in the wake of the Lehman Crisis (it has increased by 41.6%) total equity to total assets for banks stands at 11.5 times, the highest it has ever been.[iii] While in good times, such a ratio ensures high profitability, in bad times it means losses quickly wipe out the banks’ capital.

Sentiment in banking circles will turn on a dime, when bankers stop believing their mollifying in-house economists and pay attention to what their banking antennae tell them. They will rapidly discover that the crisis in international trade is undermining the creditworthiness of domestic non-financial businesses. They will also do everything they can to reduce counterparty risk with foreign banks deemed to be at risk of bankruptcy in their own markets.

As night follows day, another banking crisis will rapidly escalate, this time likely to be on a greater scale than ten years ago. And the evidence from failures in the dollar repo market in recent weeks points to the banking system beginning to unravel now.

Between the wars, the world suffered a deflationary depression. This time, we appear to be travelling towards an inflationary depression.

[i] Much of the information concerning the run-up to the Smoot-Hawley tariff Act is drawn from Professor Thomas Rustici’s Lessons from the Great Depression (Capitalism Works Publishing, 2005)

[ii] At $20.67 to the ounce, this was the equivalent today of 15,048 tonnes of gold, or $726bn.

[iii] See

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