Inflation & Deflation Revisited

I have in the past defined inflation as an increase in the true money supply. I defined deflation as a drop or only a very minor increase in the money supply. In those strict terms I have interpreted economic data correctly. I said we were in a major inflation through the 90s and from 2001 through 2006, then I switched to the deflationary camp and later, and toward the end of 2008 again supported the inflationary view. The chart below shows the money supply growth up until the end of 2008.

I include only actual money in cash or in checking accounts in my data. I still would not change a word of what I said regarding what is and what is not to be included in the true money supply, the supply of the medium of exchange inside a country.

But I admit that I used an insufficient definition for inflation and deflation. What I was really referring to was monetary inflation. We create definitions in order to understand and/or explain cause and effect of market events.

I agree with Mish in that:

I prefer a practical definition of deflation that matches and even predicts what the credit markets and stock markets are going to do, not some definition that is useless for anything but academic debate.

Inflation is broadly understood as an event where, due to monetary intervention, a large group of people consumes and/or produces differently from how they would have consumed or produced without the intervention. The dislocations of demand versus supply generally cause prices to rise differently from how they would have risen/fallen without the intervention. I explained these phenomena in the consumption business cycle and the production business cycle. Deflation is the reversal of this development back toward market equilibrium.

I said in The Dispute About the True Money Supply:

We are trying to ascertain the true money supply for a reason. We want to explain the current and the future development of asset and consumption prices in the country, measured in dollars. The more money is available for spending the higher will the prices be. But prices emerge in exchange transactions where money is surrendered in exchange for goods and services. They change over time as a result of continuous ongoing exchange transactions. As a tendency, they change with every additional exchange transaction. The medium used in these transactions and thus affecting prices, and nothing but it, is what we need to measure (…)

…maybe if we want to know how many media of exchange are available. But it won’t necessarily help us in explaining inflation and deflation. Why? It’s simple. Inflation is created based on how much money people think they have, not how much they actually have. People act based on perception. Their error will only become apparent at a later point in time. In addition to that, prices don’t necessarily have to emerge through exchange transactions only. When two investors agree on a certain price to trade claims to money from some business, then all other holders of the same may see that same price on their broker statement at the end of the day without having done anything.

Imagine a society with a relatively free market and a certain amount of fiat money in circulation. Now imagine the central bank or one of its fractional reserve banks offers to A a new credit of $100, pushing down interest rates and pushing up the prices for debt instruments. Now imagine the person A who receives the loaned money passes it on as a loan to someone else, B. If A is certain that he’ll be paid back with interest he will consider the claim to future money as good as money. B may do the same and so on and so forth.

All participants in this chain will think their claim to $100 is actually $100 of money owned. Each of them will, at worst, consider it a wash: I owe $100 and I am owed $100. In other cases they may value the asset owned higher than the money owed, especially when government intervention creates an ongoing demand for these claims by buying them up or by offering guarantees to banks who buy them up (see Fannie Mae and Freddie Mac) and push up their prices. Everyone will continue spending the rest of their other money as if their claim was as good as money. But what if the final debtor in the chain has squandered the money and defaults. Now others in the chain may default as well: The price of the claims drops to zero.

Suddenly reality kicks in and everybody realizes that they never owned as much money as they thought. “I have my money in mortgage backed securities.” or “I have my money in corporate bonds.” may be some of the things they used to say before their net worth evaporated. But they never had money in anything. They had given their money away in exchange for a future claim to it. There was never enough money in circulation to pay off every debt in the first place. This is when people begin appreciating true cash again, with no strings attached, earned money. Everybody will be scrambling for it on order to pay off their debts. Others see this happening before their eyes and will save more than they used to.

The US economy has been at the center of a worldwide network of such cascading credit relationships. Central banks loaned fiat money to fractional reserve banks, those would pass it on to financial institutions which would make it available as wholesale mortgages, individual mortgage banks would take those on and make loans to homebuyers. Insurance companies would insure one or the other loan in the chain and again consider the insurance policy as good as money, using it as collateral to obtain … more credit. On top of that, huge pension plans would invest money in such financial institutions and insurance companies. This is just one example of how the entire world economy has been permeated by credit that is now imploding.

Consumer behavior will obviously change drastically as a result of this. This is exactly what has been going on for the past 2 years. It is a credit deflation. The sum of money inflation/deflation and credit inflation/deflation can thus be defined as total inflation/deflation. The amount of debt at this point is so huge that the pure money inflation/deflation component almost doesn’t matter: The true money supply is currently at around $2.14 trillion. According to Michael Hodges, in January 2009 total Debt in the US excluding unfunded social security and medicare commitments is estimated at roughly $60 trillion, and at around $174 trillion when those are included.

Some may now ask “But what about the Fed with all its money pumping and printing?”. But the Fed is not just printing money and unloading it over our cities. The only way the Fed and other banks can currently add money to the economy is by offering credit. But when it offers credit then naturally someone on the other end must accept it. When the demand for credit dries up the game is over. Robert Prechter offers a great illustration with his Jaguar example:

Jaguar Inflation

I am tired of hearing people insist that the Fed can expand credit all it wants. Sometimes an analogy clarifies a subject so let’s try one.

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing Jaguar automobiles and providing them to as many people as possible. To facilitate that goal, it begins operating Jaguar plants all over the country, subsidizing it with tax money. To everyone’s delight , it offers these luxury cars for sale at 50 percent off the old price. People flock to the showrooms and buy. Later, sales slow down, so the government cuts the price in half again. More people rush in and buy. Sales again slow, so it lowers the price to $900 each. People return to the stores and buy two or three, or half a dozen. Why not? Look how cheap they are! Buyers give Jaguars to their kids and park an extra one on the lawn. Finally, the country is awash in Jaguars. Alas, sales slow again, and the government panics. It must move more Jaguars, or, according to its theory – ironically now made fact – the economy will recede. People are working three days a week just to pay their taxes so the government can keep producing more Jaguars. If Jaguars stop moving the economy will stop. So the government begins giving Jaguars away. A few more cars move out of the showrooms, but then it ends. Nobody wants any more Jaguars. They don’t care if they’re free. They can’t find a use for them. Production of Jaguars ceases. It takes years to work through the overhanging supply of Jaguars. Tax collections collapse, the factories close, and unemployment soars. The economy is wrecked. People can’t afford to buy gasoline , so many of the Jaguars rust away to worthlessness. The number of Jaguars – at best – returns to the level it was before the program began.

The same thing can happen with credit.
It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing credit and providing it to as many people as possible. To facilitate that goal, it begins operating credit production plants all over the country, called Federal Reserve Banks. To everyone’s delight , the banks offer the credit for sale at below market rates. People flock to the banks and buy. Later, sales slow down, so the banks cut the price again. More people rush in and buy. Sales again slow, so it lowers the price to 1 percent. People return to the banks and buy even more credit. Why not? Look how cheap it is! Borrowers use credit to buy houses, boats and an extra Jaguar to park out  on the lawn. Finally, the country is awash in credit. Alas, sales slow again, and the banks panic. They must move more credit, or, according to its theory – ironically now made fact – the economy will recede. People are working three days a week just to pay the interest on their debt so the banks can keep offering more credit. If credit stops moving the economy will stop. So they start giving credit away at zero percent interest. A few more loans move through the tellers’ windows, but then it ends. Nobody wants any more credit. They don’t care if they’re free. They can’t find a use for it. Production of credit ceases. It takes years to work through the overhanging supply of credit. Interest payments collapse, banks close, and unemployment soars. The economy is wrecked. People can’t afford to pay interest on their debts , so many bonds deteriorate away to worthlessness. The value of credit – at best – returns to the level it was before the program began.

I also explained this, albeit a bit less vividly, in Sick and Tired of Debt. I recommend reading Prechter’s excellent paper The Guide to Understanding Deflation in full. Nowhere else have I seen the concepts behind deflation explained so precisely and with so much foresight.

A lot of economists and investors, such as Peter Schiff and Marc Faber are ignoring the ideas that I outlined above. They are expecting a Weimar style hyperinflation. I used to think the same way. But I wasn’t looking at the details. Weimar Germany’s hyperinflation happened because the German government simply printed money, actual currency, in order to pay off debts owed to the victors from World War 1. Zimbabwe did the same thing to honor IMF loans. This is nothing near to what is going on in the US. Money is created by issuing new debt, not by paying it off. When people have had enough, it ends.

Hyperinflation is simply not going to happen under the current conditions. So long as credit remains the only means for the Federal Reserve Bank to “inject” money, deflation will continue to run its course.

What will happen after the debt is written off? Who knows. We may or may not see a hyperinflation at some point in the far distant future, depending on how monetary policy changes over time. But to put all your eggs in that basket, and to do so right now would be a mistake.


Related Posts:

18 thoughts on “Inflation & Deflation Revisited”

  1. Nima, I’m applauding you :-)

    I consider this last blog post as the pinnacle of your journey. I thank you for investing all your time and energy along the way and making this available to the public (including me).

    I hope your blog will be preserved in one way or the other for future generations (maybe you can pick up a book deal), although the current system might have disappeared by then already. It looks like it is imploding and we are witnessing its final act or one of its final acts :-)

  2. Thanks Shauna. I appreciate your feedback and continued interest. I thought exactly the same thing about this post of mine. Reading Prechter’s paper clarified a lot of questions I was trying to answer to myself. I consider this another great leap toward understanding.

  3. Excellent post. I have a question. While we are still in a deflationary environment right now, there does exist a plausible scenario where the USA will have to print money to pay off its debt. If the rate of debt/gdp grows too quickly, then the government will be forced to borrow at a faster rate, raise taxes massively, or print money. Borrowing at a faster rate might work but as you so clearly outlined the fact is no one has any money. Raising taxes massively is probably a political non-starter, but it may work. If those two things don’t work then the only option left is to debase the dollar. Then you might see hyperinflation.

    So while I agree that anyone placing bets on hyperinflation right now is going to lose money – we still have a long way to go before we reach a bottom in my opinion – it isn’t an event that is *too* far in the future. Before 2020 is not an unbelievable scenario, because I believe that is when SS/Medicare are effectively bankrupt.

  4. Here is how I see it:

    – borrowing at a faster rate will do nothing but add to the debt service and the interest to be serviced. Once this amount reaches a certain portion of the budget there is no way any more borrowing will help

    – regarding printing money to pay off debts: currently there is no regime in place to do such a thing. The government would itself have to assume full control of issuing currency. Currently all money created HAS to be injected via credit

    – we also have to look at the motivations of the players involved. Printing money to pay off debt would immediately make bondholders all over the world panic because of the obvious prospect of inflation. They would dump their treasury bonds in masses and cause rates to spike up sharply. The Federal Reserve’s assets would evaporate. Falling bond prices on investors’ portfolios would counteract any inflationary pressure until all debts will have been monetized. Then the currency would be destroyed via hyperinflation. Neither the Fed, nor Treasury have any interest in having this happen, at least it is very unlikely.

  5. “regarding printing money to pay off debts: currently there is no regime in place to do such a thing.”

    Doesn’t the Fed buy toxic assets and T-bills with what is essentially printed money?

    Also, can you elaborate a little more on the last point you made about the motivations of players involved? I don’t understand these points:
    The Federal Reserve’s assets would evaporate.
    Falling bond prices on investors’ portfolios would counteract any inflationary pressure until all debts will have been monetized.

  6. – “regarding printing money to pay off debts: currently there is no regime in place to do such a thing.” – “Doesn’t the Fed buy toxic assets and T-bills with what is essentially printed money? ”

    The Fed does buy assets and T-Bills but that is the opposite of paying off debt. It is the government incurring ADDITIONAL debt for new bonds issued and/or bonds/t-bills simply moving from one portfolio to another. But the debt stays, the interest payments stay, the burden gets bigger and bigger. The money is owed to the federal reserve bank. In Weimar Germany, the government simply cranked up the printing press to rid themselves of outstanding debts, to essentially “buy the debts back”, not to sell more.

    As far as the quality of the assets purchased. I’m not so sure if they are really buying toxic assets. Actually the requirements are pretty strict as to what assets the fed accepts on its balance sheet. Yes, the balance sheet has grown by $1 trillion, but the total debt load in the US is at least a crushing $60 trillion. That would be a lot of assets for the fed to buy up before it could have any impact. On top of that, a lot of the fed’s facilities come with the requirement for the seller of the asset to BUY IT BACK after a relatively short period of time, sometimes just a few days.

    All this has a reason: The Fed has no interest in destroying itself.

    – Regarding “The Federal Reserve’s assets would evaporate.
    Falling bond prices on investors’ portfolios would counteract any inflationary pressure until all debts will have been monetized.”

    If someone were to decide that the government can start printing money and simply wipe out its debts with it, this would clearly signal to everyone that hyperinflation is around the corner. This would make bondholders investors around the globe panic and sell their bonds because they fear the money they receive as interest will be worthless sooner or later. All the treasury bonds and bills on the Fed’s balance sheet would become worthless. But those are its main power base.

  7. Neither Schiff nor Faber are saying that if things stay the way they are, that we will have hyperinflation. What they are saying is that they predict that the governments will do certains things that will lead to hyperinflation.

  8. @Daniel

    And that’s what they are wrong about, and will be proven wrong about. How many more months do you want to give Schiff for his hyperinflation theory to become true? I tell you right here and right now: Forget about it. It won’t happen!

  9. OK, come back in 10 years and see if Faber was right or wrong. I tell you a hyperinflation IS NOT GOING TO HAPPEN in the US.
    I recommend in the following order:
    – Treasury Notes
    – Gold
    – Silver

  10. The easiest way to understand the difference between money and credit is that, money doesn’t POOF! out of existence when a bank fails. Plus, no bank, not even the Federal Reserve, can print money, that is the exclusive privilege of Government.

    Another way to understand the difference is; unlike credit, the actual cash money supply does not come into existence as debt. The treasuries that back the issue of money is a part of the accounting process for the note issue, they do not represent a debt obligation. The Treasury explains it as such:

    “Congress has specified that a Federal Reserve Bank must hold collateral equal in value to the Federal Reserve notes that the Bank receives. This collateral is chiefly gold certificates and United States securities. This provides backing for the note issue. The idea was that if the Congress dissolved the Federal Reserve System, the United States would take over the notes (Fed liabilities). This would meet the requirements of Section 411/412 (Federal Reserve Act), but the government would also take over the assets, which would be of equal value. Federal Reserve notes represent a first lien on all the assets of the Federal Reserve Banks, and on the collateral specifically held against them.”

    As you can see, if the Gov. were to take control of the actual money, they would also get the Treasuries and Gold Certificates that back the money as well, ergo the actual money supply is not based in debt.

    See: http://carl-random-thoughts.blogspot.com/

    What the Gov. does not get, if it were to take over the money supply, is all the bank generated credit that comprises 100% of all deposit accounts and the trillions in credit that drives Wall Street. For the Gov. to claim all of that credit as being a part of the money supply, they would have to nationalize all the banks and the economy.

    So now that we’ve got some idea of the true difference between money and credit, try this: Take the $1.33-Trillion in actual fiat legal tender money supply and divide it by the of credit being used as a medium of exchange and see if you can devise a dollar value for all that credit. In other words; how many units of credit would a dollar buy?

Leave a Reply

Your email address will not be published. Required fields are marked *

 

Subscribe without commenting