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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Net Drain on US Foreign Reserves

Asia Times’ Julian Delasantellis article US Fed’s move is the bigger problem would be a brilliant piece if he didn’t continuously make the assumption that what caused the US financial crisis was an outgrowth of a lack of government rules and decrees (Please see Credit Expansion Policy and The Business Cycle). That gaffe taken aside, he makes a lot of good observations. In particular:

The first article I ever wrote for Asia Times Online, (US living on borrowed time – and money” March 28, 2006), introduced readers to the US Treasury’s monthly Treasury International Capital (TIC) report, a compendium of how much investment
or short-term capital the US receives from foreign sources every month. Back then, the US was quite the popular parking spot for foreign capital, frequently drawing in over $100 billion a month.

That worm has certainly turned; the US in January, the last month data is available, was actually net drained of foreign capital, to the tune of $150 billion. On his blog at the Council of Foreign Relations, economist Brad Setser interpreted the data this way.

Today’s TIC January data was a disaster. $150 billion in (net) capital outflows (negative $148.9 billion to be precise) cannot sustain even a $40 billion trade deficit.

Obviously, the concern is that those with still the capital to lend to the US, primarily China, seeing the huge increase in US government demand for borrowed funds with its now huge and ever-burgeoning budget deficits being used to finance the economic crisis recovery programs, will fear that the US dollars they use to buy US debt will depreciate in value, devastating the value of their investments.

Previously, China has tried to give messages that slowly pulling out of its dollar positions was exactly what it wanted to do, but America’s cherished habit of ignoring anything that foreigners say to it had it lending a stone-deaf ear to the warnings.

One can only hope that China will act in accordance with its rhetoric. A Chinese withdrawal from additional purchases of US Treasury securites will make the American people wake up to reality and understand the consequences of their government’s policy of inflation. When exactly this will happen is hard to determine. The current deflation may continue to go on for a very long time, in spite of all the Fed’s desperate attempts to reflate.

More on China-US relations in the US Current Account Deficit and in US on the Hook for Chinese Investments.

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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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Money Supply Growth – November 2008

Click on image to enlarge.

The true money supply has grown by 12% over the past year to now about $2.07 trillion. The enormous increase of the monetary base is now spilling over to private bank accounts. The effects can already be seen in a resurgence of gold and silver. Due to the unprecedented increase of the monetary base I don’t see an end to this trend anytime soon. Welcome back, inflation!

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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 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 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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