Inflation or Deflation?

In the more eschatological corners of the financial blogosphere, a debate has raged for centuries: Inflation or deflation? I'm going with the former.

I recommend Michael Shedlock as a thoughtful and passionate proponent of the deflationary view. (See e.g. here and here, but he's been making the case for years and it's worth searching the archives.) Also, Karl Denninger recently offered a nice deflationary tract.

I'm more certain of monetary and price volatility than I am of inflation or deflation. But on balance, even as commodities crash and the dollar rallies, my best guess is inflation.

Do read today's excellent post by the always excellent Brad Setser, The changing balance of global financial power. Take a look at his graphs, showing the external official claims of "democracies" vs "autocracies". You'll notice that the autocracies are owed a great deal more money than the democracies are. Mostly, money is owed by the democracies to the autocracies in the form of debt denominated in the democracies' currencies.

[Note: For the purpose of this piece, it matters only that policy in the "democracies" be sensitive to public pressure. The internals of the "autocracies", and whether they are justly characterized as such, is not relevant to the argument, and not anything I want to get into here.]

Inflation helps debtors at the expense of creditors. In democracies where those who can vote are, on balance, debtors, one would expect collective indebtedness to favor inflation. Not all citizens are debtors, there would be domestic winners and losers. But on balance, voters gain by printing currency. If that's a good argument for free trade, why should it not be an argument for weak money?

There are, of course, institutional constraints, "independent" central banks and all. It is one thing for a nation's central bank to stand above the fray with respect to competing domestic interests, but quite another for the bank to put foreign interests or economic ideals above a collective national interest. That's especially true if the alternative to devaluation is deflation. Under a deflation, American workers (those who remain employed!) would have to work more to pay off their fixed dollar debts. Individuals can declare bankruptcy and default, but collectively we cannot default on official debt (pace Felix Salmon, whose heretical idea I adore).

One way or another, as reckless debtors or noble taxpayers, Americans would have to work harder under a deflation than they had signed on for when they took on the debt. Americans are having a hard time coming to grips with their nominal debt burden, public and private. I think it implausible that they would accept a large increase in the real interest rate they must pay. Officially it is the policy of the American central bank to maintain price stability and full employment regardless of the external value of the dollar. If the Fed faces a choice between deflation and high unemployment, or tolerating a significant inflation (with or without high unemployment), I'm pretty certain it would choose the latter as the less-bad option.

Japan's experience in the 1990s and the US' in the 1930s are often cited to suggest the inevitability of deflation, despite monetary policy heroics. But in both cases, the deflating country had a large, positive international asset position. To the degree money was owed by foreigners in domestic or pegged currency, the "national interest", looking past winners and losers, was to tolerate deflation.

All of this ignores the secondary consequences of a partial default through inflation and devaluation. A wise polity would weigh the immediate collective benefit of reduced debt load against costs including higher future interest rates (foreign creditors get spooked), more expensive tradables, and a nationalistic backlash by creditor states.

Of course, it would also have to consider the secondary effects of tolerating deflation, such as a spike in bankruptcies combined with a large tax spike to avoid a sovereign default. It seems to me that the adverse consequences of deflation would be sharp and domestic, while high prices and interest rates can be billed as "facts of nature" in a market economy, and other people's hostile nationalism often helps domestic politicians, who can provoke some hostile nationalism of their own.

It is not impossible that the Fed will square the circle, maintaining something close to price stability while the US gears up its tradables economy and foreign creditors silently ease our debt burden via real appreciation. Obviously, that's the best outcome (at least for the United States).

But if deflationary winds do blow, if the Fed is faced with the choice of tolerating a spiraling credit contraction, falling prices, and bankruptcies or overshooting with "quantitive easing" into inflation, well, as Ben Bernanke famously put it...

[T]he 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. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

 

Disclosure: My investment portfolio includes inflation hedges such as precious metals and short positions on long bonds. My portfolio return over the past several weeks has been large and negative, and if you take anything here as investment advice please expect a similar outcome.

Comments

[Dean Plassaras]

I too support the inflation argument as the most likely outcome.

[bigmoney]

inflation is an excellent tax because most people don't recognize it as a tax, and so its much more politically acceptable. Housing bubble = good. Everyone getting richer trading houses with each other. High oil prices = evil conspiracy by Big Oil.

[TinyTim]

No doubt in my mind the entire system is biased toward inflation. Since the USA is one massive debt instrument at this point, and "Inflation helps debtors at the expense of creditors", only something hugely unanticipated would cause deflation.

[JasonC]

Yes fiat money and the political system are wired to inflate. No, this doesn't mean doubling the price level actually helps, net. Nor that it is currently happening.

What actually happens is the Fed tolerates inflation in boom times, and in the smashes it holds the line and no downward movement in prices, where economically a strong deflation would occur. That functions over whole cycles as a ratchet, and allows the price level to rise at 3-4% rates on average over whole cycles.

The particular phase of that cycle we are in now, however, is the economically driven, independent, strong deflation. If the Fed did nothing right now the money supply would contract by a third in real terms, spreading deflation and multiplying debt pain.

The Fed isn't going to let that happen. It will prevent the deflation that would normally follow the bubble of the "oughts". But preventing that deflation from happening is not the same as some strong inflation. It will not, in particular, support $1000 gold or $150 oil. The Fed isn't going to double wages by pushing excesss, unwanted dollar balances on people until they throw them away on triffles like monopoly money.

Instead the Fed has held M1 completely flat since early 2005, and that was enough to tighten rates and break the real estate bubble. The decline in rates afterward reflected the economic-force swing to deflationary tendencies - banks are trying to shrink their balance sheets not extend them, etc. It has not required any increase in M1.

The Fed is done lowering rates for this cycle. Its next move will be upward, but is a year away, maybe more. No great leap upward in the price level is going to accompany or prompt this. And no great smash in the general price level or in wages will, either.

But the bubbles everyone has been blowing in the commodity markets, in anticipation of rapid violent unwanted money creation, simply do not reflect reality. They are an ideological line, not a reaction to the actual actions of the Fed this cycle, nor to the broader economic context of those actions.

You aren't going to get either one, in other words. We will get moderate inflation over the next cycle, and the same crowd will moan that the Fed was late to tighten, yet again. But in fact it is acting correctly to prevent a deflation that would otherwise be occurring this instant.

[Levin70]

The only comment I would add to what JasonC said above is that while he believes that the FED will wait a year if not more to begin raising rates, I am less inclined to this view and believe the FED will feel obliged to being raisng rates sooner, beginning as early as the last meeting this year, as the markets will interpret the length of low rates in the last period as the root of all that is currently evil and lead the FED higher

[dougnhi]

There's no doubt that the Fed would use inflation if it could. However, the assumption that it can without consequence is flawed. The Fed can't just print dollars without financing those dollars with Bond sales. Someone must buy the debt. When the bond buyers cry uncle because the payback is less than what is expected, they'll demand much higher interest for the risk. Bernanke may think he's in the driver's seat, but in fact, the real drivers are the bond holders. When they sense that Bernanke's printing press has started to deteriorate beyond what they are willing to absorb in losses, the game will be up and deflation will occur. We are a nation of debtors and the creditors must be paid. To think otherwise is to go down the road to Zimbabwe. Remember, first inflation, then deflation. It's uncontrollable in a credit crunch, and if you believe Bernanke and Paulson have it together, you're kidding yourselves. This situation is a powder keg. Will it blow? Nobody knows, but if you want to be safe, think long and hard about what the natural outcome of a credit crunch is......deflation.

[John Pseudonym]

Deflation for everything that was artificially inflated by lending trillions of $$$ to people that would never repay.

Inflation in everything else; food, energy, etc.

[wes mantooth]

I agree with dougnhi in that deflation will be the end result. Ben's printing press works wonders when people can't spend money fast enough hoping to make even more money on the parabolic asset class of the moment. The problem is that the root of our economy is primarily based on consumer perception. You can sense that peoples' attitude towards credit is changing right now. They witness the pain of their overleveraged neighbors and they become even more risk averse. Potential homebuyers now have the "wait until prices drop even more" attitude instead of "buy it quick before it's snatched up by someone else!". This mind-set is at the root of a deflationary environment. When everyone is looking for the best deal possible the demand for credit is severely weakened and no amount of printing presses and helicopters can defeat it once it takes hold.

[investor88]

Steve is to be commended for bringing forth this detailed article of inflation vs deflation. It is a core issue for economic well being and survival. I also appreciate the insightful response of reader's comments. On balance I think readers are correct that there is a limit to printing currency and inflation; the bond/debt buyers will ultimately not take further losses then eventually you get deflation after a period of inflation. Right now we are going through the inflation phase and can only guess whether the next phase is even higher inflation or and then the beginning of a deflationary phase. If the next phase is a deflationary phase how severe the deflationary phase, will it be Japan's 1990s type or the US 1930s type? Now the world is in financial turmoil caused by its biggest and most advanced economy USA at the core, the turmoil radiating outwards around the globe. Whether developed economy or emerging ones, the net result of the turmoil has been negative, witness the usd10trillion+ equity value wiped out and economies one by one descending into slowgrowth/recession. Truly we must observe, analyse and think about what the economic future holds for us in the next few years.

[Alan von Altendorf]

I'm double long gold, like the author, and I echo his warning not to follow us, unless you can tolerate pain. Gold is the ultimate geopolitical hedge. I look at Detroit, Memphis, Stockton etc and see high probability of social upheaval especially if McPain wins the election, which I think is narrowly probable. The foreign situation is no better.

[bearfund]

My positions look like yours, as do my returns. I have absolutely no doubt that we will end up winners. Well argued.

[Elaine Supkis]

This article is a typical example of looking at only one thing at a time and therefore, being unable to see the bigger picture.

Deflation is really wealth destruction. When any entity in the world manages to flood the world with too much currencies backed by too little asset values, yes, we get global inflation. We just passed through a nasty taste of this.

The US cannot allow this sort of inflation for the simple reason, it involves OIL. And since oil is the fundamental basis for modern civilization and the US, unlike our trade rivals, has adamantly refused to upgrade alternative energy systems, transportation systems or domestic fuel use, we are stuck out on a very dangerous limb here.

Example: in Japan and Europe, NO ONE builds anything with hot water heaters such as we see in nearly every US home. I have a Japanese water heater that uses less than 1/5th the energy of the typical US water systems.

Since we import tremendous amounts of energy, if we inflate our currency faster than wealth destruction of our finances, we end up with energy hyperinflation. This, in turn, kills our domestic economy. The US nearly ground to a halt this last session of hyperinflation in energy and other commodities.

As gasoline inflated in price, all activities literally stopped. I can watch traffic from my mountain. I was astonished in July to see virtually no cars. An hour could pass and only one car would go buy on a major north/south route to vacation sites! It was like a ghost town out here!

We are NOT seeing inflation in worker's wages. We are seeing DEPRESSION in worker's wages. So if the government cynically prints money while depressing wages, we get a DEPRESSION, not raging inflation. All commerce will cease. Just as we saw last month. The government and central bank is now hysterical about preventing energy inflation. The Saudis gamely helped us in this in order to protect their trillion dollars invested in the US systems.

But if the price of oil collapses, they will bite our heads off. They will turn off the taps and we resume energy inflation coupled with deflation of all assets and equities in the US. We have no control over this dynamic except to tax oil imports heavily and tax energy use in the US. Then we still get 'inflation' but it will cure our abuse of oil resources.

We will be motivated finally to fix our houses so they are energy efficient. Drive much more efficient cars. And stop living as if we are a first world nation and more like a second class power which is what we really are.

[CLH]

Housing down 25-50% and housing is 25% of the cost of living. Oil down and all commodities down --gold crashing and dollar up big. And you believe inflation?

Good god you all have lost your minds.

[lblaine]

We are in a deflationary spiral. The clearing out of the over-leveraged assets (houses, certain businesses, SIVs, etc.) requires a downward re-pricing of everything. Many more people will be bankrupt, as unemployment increases and home prices continue to fall. Businesses will not be able to make their bond payments and will re-negotiate with lenders or go under. Banks and hedge funds holdings highly leveraged CDOs will fail. If the government stops interfering, this washout could occur in a reasonable time frame.

Gold will hold its purchasing power, but not necessarily its price.

Oil and its derivatives will always be costly, because of dwindling supplies and manipulation of OPEC. Other supply-constrained resources, such as agricultural products and potable water, will continue to be costly.

[SF Mechanist]

I agree with much of the article in terms of formulating the problem, but I disagree with the conclusion that this all ends with the Fed printing in a big way. Not that I'm positive it won't and not that I'm watching M1 closely, but I find it unlikely.

I do agree that high inflation would benefit the democratic majority through the destruction of debt. However the constituency of the Fed-- the elite of the banking industry-- is harmed by this very thing. For every dollar borrowed, there is someone expecting to be paid back that same dollar. While those who owe debt are benefited by inflation, their creditors are harmed by inflation and benefited by deflation.

[djohncbh]

The path of least resistance is will be deflation. The statement in the article "Inflation helps debtors at the expense of creditors", exposes the theme. There are many more debtors than creditors and the markets always move in a way to frustrate the greatest number of people.

[adan]

is it possible that both are used to advantage, as per thomas jefferson, circa late 1700's (ie, it must've not been a big secret back then either; or maybe it's more a secret now :-)

"Thomas Jefferson was concise in his early warning to the American nation, "If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered."

found on: sonic.net/sentinel/nai... (no personal connection of any kind to this particular site, just where i found the quote)