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.

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The Dollar Crisis in its Final Chapter

A prescient outlook from Chapter 20 of Richard Duncan’s The Dollar Crisis:

Chapter 20: Bernankeism

Anticipating the Policy Response to Global Deflation

“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”
Fed Governor Ben Bernanke, 2002

The Fed would already be faced with its worst nightmare, deflation in the United States, had the price of oil not risen above US$50 a barrel following the U.S. invasion of Iraq. Globalization is exerting tremendous downward pressure on the U.S. cost structure that can only intensify in the years ahead as service sector jobs follow manufacturing jobs offshore. A correction in the U.S. current account deficit will cause the floor to drop out from under global prices and threaten the world with a 1930s-style deflationary depression. The following paragraphs will consider how policymakers in the United States are likely to respond to that event.

America’s free trade policy, which it has pursued for decades, is obviously flawed. Free trade between countries with enormous wage rate differentials, and within an international monetary system entirely lacking in any mechanism to prevent large-scale, persistent trade imbalances, is untenable. However, U.S. policymakers are afflicted by the collective hypnosis of conventional wisdom which has taught them that free trade is good and must always be good under any and all circumstances. It is anyone’s guess as to how much longer those in charge of economic policy in the U.S. will cling on to this strange idea.

Meanwhile, it is almost certain that they will respond to the approaching crisis by applying the two great economic policy tools of the last century: Keynesianism and monetarism. The abuse of those tools will prolong and exacerbate the death throes of the dollar standard.

The first recourse will be to employ more fiscal stimuli. With prices falling and in light of the extraordinary amount of paper that has been created in recent years, interest rates will be very low and there will be little difficulty in paying interest on a much larger amount of government debt. It would not be surprising to see the U.S. budget deficit surpass US$1 trillion by 2007 or 2008 if the U.S. current account has come down significantly by that time.

If, at that point, the U.S. current account deficit has been reduced, foreign central banks would not have a sufficient inflow of dollars to finance such a large deterioration in the U.S. budget deficit, even assuming that Fannie Mae and Freddie Mac have ceased issuing any new, competing, debt of their own.

The Fed, however, as Governor Bernanke explained, has already put considerable thought into how to deal with such a contingency and stands ready, in Bernanke’s opinion, to support “a broad-based tax cut” through “a program of open-market purchases to alleviate any tendency for interest rates to rise.”

How long could such “cooperation between the monetary and fiscal authorities” underpin the global economy? For quite a number of years, most probably. Economic cycles play themselves out over very long periods of time. Moreover, U.S. policymakers will use every last tool at their disposal to prevent, or at least delay, a global depression. An economic system underpinned by large-scale fiscal stimulus financed by central bank monetization of government debt could hardly be described as capitalism (perhaps the term “Bernankeism” would be appropriate) but, with any luck, it could stave off disaster for a considerable length of time.

Nevertheless, despite the best efforts of policymakers to keep the dollar standard alive and to stave off the depression that would most probably follow its collapse, ultimately, one of the following scenarios is likely to overwhelm even Bernankeism:

1. A protectionist backlash against free trade, resulting in a trade war similar to that which occurred during the Great Depression.

2. A U.S. asset price bubble (as interest rates fall toward zero) that drives property prices so high they can’t be financed even at very low interest rates. This is similar to what occurred in Japan at the end of the l980s.

3. A meltdown of the under-regulated US$200 trillion derivatives market. (Two hundred trillion U.S. dollars is roughly six times global GDP.)

4. A loss of nerve on the part of policymakers that deters them from undertaking ever more unorthodox economic policies, resulting in a “deer in the headlights” kind of policy freeze.

5. A decline in interest rates to 0%, or very near 0%, as in Japan at present.

Any one of the first four scenarios could undermine the dollar standard, but the final scenario, where interest rates fall very near 0%, would certainly deal it a fatal blow. From that point, the only option left to stimulate aggregate demand would be to drop paper money from helicopters. That too would fail, however, for who would accept paper dropped from helicopters in exchange for real goods and services? Hyperinflation would quickly set in. Economic transactions would then be conducted through barter rather than via the medium of a debased script. Eventually, a gold standard would re-emerge.

Exactly how these events will unfold is impossible to forecast; nevertheless, the eventual outcome is within sight. The dollar standard is inherently flawed and increasingly unstable. Its demise is imminent. The only question is, will it be death by fire — hyperinflation — or death by ice — deflation? Fortunes will be made and lost, depending on the answer to that question.

Right now it seems like the answer is death by ice – deflation…if by deflation the author is not referring to pure monetary deflation, but rather to a money & credit deflation (or wealth deflation as I would prefer to call it) as per Mish’s model. On the correctness of his predictions on trade and budget deficits, please consider Trade Deficit Continues to Decline and President Obama’s Budget.

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KrugmanWatch – About that deflation risk

Paul Krugman is a terribly confused economist. His shallow theories justify virtually every measure of government intervention and sound palatable to the common man who seeks intellectual justification for false policies.

We shall expose his falsehoods on a regular basis in this blog.

In About that deflation risk Krugman writes:

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There has been a distinct change in tone from the Obama team today, as they seem to have become suddenly aware that there’s a real risk that the stimulus plan will either fail to pass, or be emasculated to the point that it doesn’t come close to doing the job. Obama himself has warned of catastrophe if we fail to act, and — finally!– denounced the tax-cut philosophy.

It is of course not surprising that Krugman blindly supports the common notion that there was some kind of tax cut philosophy at work under the Bush administration and that the financial crisis is proof that it failed. It is probably unnecessary to point it out again, but whoever cares to look at the actual numbers will immediately realize that all these tirades against a supposed tax cut philosophy are complete nonsense. As I explained in Obama Makes an Unnecessary Gamble:

The tax cuts were completely insignificant, the spending kept on growing. In fact, the only period in the post war history of the US where taxes where higher than now was from 1997 through 2002. That aside, taxes are at an all time high right now. So please , everyone, stop spreading the nonsense that what has happened in the past 8 years is a proof that a policy of limited government, little government spending and low taxes has failed.

So to everyone reading Krugman, assuming he is even remotely right on tax cuts, please can that notion immediately. Krugman goes on to write:

Meanwhile, Larry Summers has finally made the point I’ve been pushing for a while — that we’re at major risk of falling into a deflationary trap.

It’s at best amusing, but certainly not surprising that Krugman is about 3 years late with this realization. In fact he still talks about the possibility of a deflation. He doesn’t realize its past existence. The US had begun slipping into a deflationary period in mid 2006 already, when the True Money Supply growth had begun dropping below 3%. This was precisely when the housing bubble begun to deflate and one by one the other bubbles, viz. stocks, commodities, foreign exchange, followed. My economic indicator, the true money supply, enabled me to predict these developments a long time ago. This asset price deflation keeps going on to this date. Now, almost 3 years later, after the money supply has actually begun to grow by more than 3% again, Krugman begins to realize that there might be a deflation looming.

But worse yet, he doesn’t even know what the essence of a deflation is. A deflation is a correction of the previous misallocations created by inflation: The over-employment of resources in risky longer-term projects and an underemployment of resources in the consumer goods and basic materials industries, coupled with an over-consumption of consumer goods and a lack of capital from savings. The Business Cycle would certainly be an appropriate read for Mr. Krugman.

The worst thing the government can do is to try and fight the deflation. It will accomplish nothing but to slow the correction and create a long and painful period of adjustment, very much like the lost decade in Japan.

I thought it might be useful to present a bit of evidence behind that concern. The figure above plots an estimate of the output gap — the difference between actual and potential GDP, as a percentage of potential — and the change in the inflation rate. Both series are taken from the IMF WEO database, for convenience, and use data from 1980-2007.

It’s not a perfect fit — this is economics, not physics, and anyway stuff besides the output gap bounces inflation around from year to year. But still, there’s a clear correlation, driven largely but not entirely by the deep slump and disinflation of the early 1980s, and an implied slope of about 0.5 — that is, every percentage point by which real GDP fall short of potential tends to reduce the inflation rate by about half a point over the course of the year.

What exactly is this supposed to be evidence for? Krugman plots a change in inflation rate against a so called output gap which is supposed to be the gap between actual and potential GDP. How does he determine potential GDP? Either way, all this is based on inflation and GDP data provided by the government, data that is highly unsatisfactory and insufficient. It may be too much to ask of Krugman to expect him to have looked into alternative measures that actually provide useful information, such as True GDP. Either way, we all know we are seeing effects of a long term deflation as I explained above, Krugman doesn’t need to provide more proof for it. But he is dead wrong in viewing it as an evil.

And right now the CBO is saying that in the absence of a policy action the average output gap will average 6.8 percent over the next two years. Do the math: if anything like the historical relationship between output and inflation holds, we’re looking at major deflation.

OK, maybe that relationship won’t hold — getting to actual deflation may take a deeper slump than merely reducing the inflation rate. And maybe a regression driven in part by 80s data isn’t a good guide to current events. But deflation is a huge risk — and getting out of a deflationary trap is very, very hard.

We truly are flirting with disaster.

Yes, we are in a deflation and have been for many years. We don’t need Mr. Krugman to dwell on the obvious for us. Nor do we need to listen to his utter nonsense regarding its dangers. All we need to do is look at good data. Everyone shall decide for himself if he trusts indicators that correctly predicted future developments years ago, or if he trusts a Keynesian clown who saw absolutely nothing of this coming in time, who can do nothing but sway with shallow common notions, and apply a substantially flawed kindergarten theory whenever he needs to.

To get a taste of what expects you when reading The Conscience of a Liberal, this well qualified amazon review certainly tells a lot:

Paul Krugman continues to spin dubious conclusions from fuzzy thinking. First of all, Krugman should be discredited simply because he buys into the idea that the government has shrunk in the last few years. Anyone who thinks that George W. Bush has been an exemplar of limited government has obviously been living underneath a rock for the last eight years. The War on Terror has been a mammoth by itself, but Bush’s appointment of inflation-happy Fed chief Ben Bernanke, the Medicare Prescription plan, “No Child Left Behind”, etc. and compassionate “conservatism” in general have been every bit as welfare statist as a liberal like Krugman. Also Krugman falls for a whole lot of historical nonsense like many. For instance, he talks about the huge gap between rich and poor during the Industrial Revolution, completely ignoring the role that high tariffs, the National Banking Act, and government subsidies for numerous industries such as railroads had in the whole way. Not to mention new laws that were passed during the Industrial Revolution which exempted many industries from punishment for violating other people’s property with pollution. He claims that the New Deal is what created the Middle Class in the 50’s. Apparently someone forgot to tell him that after FDR died and WWII ended, most New Deal programs were abolished (Social Security might still be with us, but it’s headed for a collapse) and federal spending was cut by over a trillion dollars. Plus, the prospects of peace really helped out the Stock Market. Much of this and more was covered in the far more scholarly “Depression, War, and Cold War” by Robert Higgs, someone who’s far more of an economist than Paul Krugman with his discredited Keynesian ideology is.

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Federal Reserve Balances Decline

Since the Federal Reserve released its balance sheet from December 18th 2008 reserve balances have steadily begun to decline. On that day they amounted to a total of $2.25 trillion. Since then they have dropped by roughly 15% to $1.99 trillion on January 29th.

At the same time retail sweeps have been falling since October 08. I have been talking about a resurgence of inflation since the money supply growth seemed to have exceeded the 3% mark lastingly. However, it looks like I called that way too early. It will be important to watch how the true money supply will develop over the next few months. Recent trends and data indicate that it might be headed back down and that all recent reflation attempts by the Fed could fail completely.

Deflation, it is true, is not easy to beat, if at all possible. It might work if the correction is a mild one. When faced with a global financial tsunami, it should be rather impossible.

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Inflation & Deflation

Inflation and deflation are market phenomena whose occurrence only becomes important under a fiat money system. Under a voluntary money system in which individuals are given the immediate choice to choose what they in fact prefer as the best money, goods that are limited in supply will naturally prevail and inflation will be modest and negligible. It is a historical fact that over time the precious metals gold and silver outstripped all other goods as media of exchange for their limited supply, durability, uniformity, divisibility, and aesthetic appeal. In the Untied States it was of course the compulsory intervention by a cash strapped government that outlawed the non-acceptance of the paper dollar, a fiat money, and on top of that outlawed any private ownership of gold.

Inflation

Inflation is defined as an increase in the money supply, the nominal amount of money units held by all individuals within a certain territory.

Inflation occurs in a fiat money system when the central bank or fractional reserve banks produce additional money to be used in a certain territory and use it to buy goods or to perform credit transactions with other individuals on the market.

Since the marginal value preference assigned by individuals to each additional unit of money will be lower the more money they hold, the price of goods expressed in terms of money will be more likely to rise over time, if the money growth exceeds the growth of other goods.

The fundamental issue with inflation is not that prices go up. If the newly created money was distributed evenly across society, all incomes would rise in lockstep with prices. The entire operation would be a zero sum game. The fundamental issue is that inflation in a fiat money system occurs through creation of new money that certain individuals receive earlier than others. Wealth is thus shifted from those who receive the money later (after prices have already gone up) to those who receive it earlier (before prices have gone up). Typically this means a shift of wealth from workers to the government and to owners of fractional reserve banks and the central bank. It lowers the general standard of living insofar as it becomes less desirable to perform work that fulfills voluntary value preferences and more desirable to perform work based on bureaucratic government decisions that involve theft and compulsory action.

Deflation

Deflation is defined as a drop in the money supply. It occurs when the central bank or fractional reserve banks reduce the money supply by reversing their inflation by selling goods other than money, thus withdrawing money out of circulation, or when individuals make more re-payments as part of credit transactions (which they entered into with the central banks or fractional reserve bank) than additional money is produced.

As the money supply declines, the price of other goods in terms of money is more likely to drop over time.

Deflation is in essence a correction of the previous misallocations created by inflation.

Addendum: What I was referring to above is monetary inflation. Please see more details in Inflation & Deflation Revisited.

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