Global Central Bank Focus


The excessive use of debt fueled by money printing was the pathway to the global debt crisis. Money printing is the highway out.

Critics of the Federal Reserve, you have your wish. The Federal Reserve doesn’t exist. Those of you wishing to end the Fed have been given a gift: to see what the world would be like without the Fed. It is a world that ever since the financial crisis erupted in 2008 has been wretched and miserable.

Unemployment lines are wrapped around every street corner, the financial markets are in ruins, and the fiat currency system the Fed helped build is now a wreck, because the Fed’s printing press wasn’t there to save it. In its place: bartering, bank runs and bankruptcies – bedlam.

It is akin to Pottersville, the dark town in the movie “It’s a Wonderful Life” that the charming town of Bedford Falls becomes when the lead character, George Bailey, is given the chance to see what the world would be like had he not been born. George learns that, despite his failings and his disappointment with his current circumstance, the world is a far better place because of him – George really had a wonderful life. It is no different for the Federal Reserve – the world is a far better place because of it.

To be sure, there are many misgivings to be had about the Fed’s use of the printing press and it is fair to ask whether the Fed’s new policy of keeping it running around the clock is sound policy. After all, didn’t the indebtedness that resulted from excessive money printing get the developed world into the mess that it’s in? How can money printing be the way out of it?

To understand how, let’s go back to 2008 to see what the world would have been like without the Fed, by applying to the present day the sequence of events found in the theory of debt deflation and depression developed by Irving Fisher in 1933.

September 2008
It is 2008 and it is a warm September in New York City, where calm winds are whisking the smatterings of leaves that have fallen to the concrete ground as a result of the summer’s heat. The serenity masks the tumult that has erupted on Wall Street from a steady stream of unpleasant headlines flashing across newswires on computers atop rows of desks in the crowded trading rooms on Wall Street.

Financial markets are in turmoil and the stock market is plunging.

Meanwhile, dejected employees at scores of financial firms are spilling onto the streets carrying bankers’ boxes brimming with their belongings.

Overleveraged investment banks are now bleeding red ink, battered by losses from bets they made during the housing boom. Woe to them, because their debts are greater than their lots and they’ve no choice but to liquidate their assets – no one will lend to them.

The age of deleveraging has now begun.

Selling begets selling, with investors rushing to meet margin calls and to pay off their debts. The liquidation of debts wouldn’t be such a bad thing if it weren’t happening all at once, but it is. Debt liquidation in a fractional reserve system – a system by which banks go beyond their warehouse function and collectively lend out more dollars than are held in deposit (thereby creating new money) – causes the money supply to contract.

With the money supply now contracting, deflation sets in, even on prices for items that are in limited supply, which by itself is very telling, because rare items normally hold their value. Even SWAG (silver, wine, art and gold) prices lose their swagger from the carnage on Wall Street.

The scramble for money puts creditors in charge, driving real interest rates higher – money is scarce.

With asset prices falling, household net worth plummets and with it, household purchases. This crushes small and big businesses alike, their goods now sitting idle in their empty stores. Bankruptcy looms for many.

Amid bankruptcies, falling profits, and tight credit, businesses have no choice but to slash output and employment, igniting a vicious cycle of self-reinforcing decreases in production, income and spending.

Relentless asset sales further contract the money supply, strengthening the vicious cycle. There is no circuit breaker because there is no central bank – the cycle can’t be broken without a big balance sheet.

With confidence crushed, money hoarding begins. Frenzied mobs fill the streets and rush to their banks to withdraw their money. They empty nearly every bank vault before the last depositor has walked up to the teller’s window because banks can’t magically meet the demands of depositors all at once – in a fractional reserve system there are more loans outstanding than there are deposits. Needing liquidity, banks liquidate still more of their assets. Bunches of banks fail.

There is no money to stop depositors from fleeing.

There is no money to keep businesses from failing.

There is no money to stop asset prices from falling.

There is a torrent of fear.

Like a total eclipse of the sun, here in Pottersville the world is suddenly dark and the outlook is grim.

Paine and the perniciousness of paper money
Financial panics such as those described in Pottersville are nothing new, but what separates this panic from those of yesteryear is the enormity and complexity of today’s financial system, which developed in no small part from the growth of the world’s fiat (paper) currency system. It started decades ago when the world abandoned the gold standard, which eliminated the need for nations to be disciplined about their finances simply to avoid the loss of their gold reserves. This opened the door to fiscal profligacy. Banks joined in on the act when they exercised their unique ability to create money, turbocharging the growth of money and credit. Banks obviously went too far with the fractional reserve model and now they are paying a price.

Thomas Paine warned of the dangers of paper currency systems in a paper he wrote in 1786 called “Dissertations on Government, The Affairs of the Bank, and Paper Money.” He wrote:

“When an assembly undertakes to issue paper as money, the whole system of safety and certainty is overturned, and property set afloat. Paper notes given and taken between individuals as a promise of payment are one thing, but paper issued by an assembly as money is another thing.”

The paper currency system could have worked better and many problems avoided if central bankers had worked in concert with regulators and their respective fiscal authorities to ensure that lenders and borrowers – both in the public and private sectors – acted responsibly.

They didn’t.

Hence the crisis.

Ron Paul’s world
In “End the Fed,” Ron Paul contends that the fiat currency and fractional reserve system upon which the U.S. financial system is based is a super Ponzi scheme made possible by the Federal Reserve’s printing press and it creating elasticity of money. He claims that under this system, the U.S. needn’t choose between guns and butter because the Fed can fund both. He calls deficit spending a scheme for the confiscation of wealth and says the Fed is responsible for bad investments and for the misdirection of capital. Tyranny, he says, always goes hand-in-hand with government wrecking of the monetary system, and that by destroying money and fueling growth of the state, the Fed is the biggest generator of underground criminal activity ever. A cheery set of beliefs he has!

As brazen as Ron Paul’s claims seem, his views on the failings of a paper based, fractional reserve system are rational, especially given the Fed’s ability to print money willy-nilly. As Paul says,

“Prosperity can never be achieved by cheap credit; if that were so, no one would ever have to work for a living.”

In other words, Paul is saying that money printing and cheap credit has its limits, and too much of it can be a bad thing, a lesson known today more than ever.

Irving Fisher’s world
So, if money printing is so bad, what then are we to make of the Federal Reserve’s current policy stance, which is to print, print, print? How can the Fed justify revving up the printing press these past few years and its latest decision to keep on printing until the employment situation improves? The answer is that in the absence of the Fed’s money printing, the liquidation of debts would otherwise lead to a very wretched sequence of events that would reduce the standards of living for all Americans and indeed throughout the world.

In an article entitled “The Debt-Deflation Theory of Great Depressions” published in the journal Econometrica in October 1933, Fisher identifies nine woeful elements in the sequencing of the debt liquidation process along with their wretched consequences:

  1. Debt liquidation leads to distressed selling, which leads to
  2. Contraction of the money supply, thereby resulting in
  3. A fall in the level of prices, and
  4. A still greater fall in the net worths of businesses, precipitating bankruptcies and
  5. A fall in profits that leads to
  6. A reduction in output, employment and trade, all of which lead to
  7. Pessimism and loss of confidence, and then
  8. Money hoarding
  9. All of the above then result in an increase in real interest rates

Fisher identified this process when he developed his famous debt-deflation theory on the causes of great depressions. The process is the same one that unfolded during the Great Depression. It is a process that can be stymied by the firepower of a central bank but wasn’t during the Great Depression. Fed Chairman Ben Bernanke, an expert on the Great Depression, understands the ravages of debt deflation and his every action has been to prevent it from occurring. It is one of the reasons why, on September 13th, 2012 the Fed included an explicit inflation target in its policy statement for the first time.

Bagehot’s world: the way out of Pottersville
Chiding Ben Bernanke for his revving up the printing press and its potential consequences, Fed critics say the Fed’s printing press is responsible for the excessive growth of credit in recent decades. They believe that Fisher’s debt deflation process would never ignite in the first place if not for the Fed facilitating the growth of credit that typically precedes it. The Fed’s detractors might be right but it would be perilous to disrupt the Fed’s activities now, because the Fed is the only entity capable of smoothing the deleveraging process while it is in motion.

To be sure, much greater care must be taken in the future to ensure that our fiat based, fractional reserve system does not run amok. This is why regulators are demanding that banks raise capital, reduce their proprietary trading activities, and shift their business models closer to a utility-style model. For today, however, the Fed must in this era of deleveraging heed the essence of Walter Bagehot’s dictum and lend freely in a time of crisis. This is especially important now because the Fed is the only game in town – awaiting anxiously, and building a bridge to, a time when Washington will devise solutions to the many economic challenges facing the United States. Until then, the Fed will continue with great vigor in the time ahead to follow in principle the same aggressive policy path that the Bank of England did in response to the Panic of 1825, as described by Bagehot in his 1873 classic, “Lombard Street”:

“We lent it,” said Mr. Harman, on behalf of the Bank of England, “by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.”

The excessive use of debt fueled by money printing was the pathway to the global debt crisis. Money printing is the highway out.

The Author

Tony Crescenzi

Portfolio Manager, Market Strategist

View Profile

Latest Insights


Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission. © 2012, PIMCO.