What's the Better Solution - Inflation or Deflation?

There was something about the article I wrote last week for Bourbon & Bayonets that touched a nerve with a lot of people. There wasn’t a lot of middle-ground; readers loved it, hated it, or were annoyed with me for complaining without proposing a solution. I’m glad I was able to stir the pot and get something controversial enough on paper to bring out the passion on both sides of the arguments. This article isn’t written to further my points and persuade those who disagreed with me. Instead I want to propose what I see to be the best potential solution to a very difficult problem. I agree with the readers who took issue with my empty complaints. Today’s article is written for those who see the problems, but wonder what choices or alternatives we have to current policy.

Given all of that, there’s no easy solution to our current mess. I wish there was a simple solution, but there isn’t. We have cornered ourselves through decades of loose monetary and fiscal policy with those practices being taken to a recent extreme. Essentially we have left ourselves with two potential roads that probably lead to the same location. The two roads are inflation or deflation. I’ll elaborate…

As mentioned, we have gone through decades of loose monetary and fiscal policies. What I mean is that during economic downturns, monetary and fiscal tools have been used to artificially stimulate growth. In recent times, they have been used rather extensively. The Clinton administration should be known for nothing other than the inventions of sub-prime lending, 40x leverage, and credit derivatives (I’m sure a certain intern will be remembered as well). This created a massive artificial pile of liquidity that the domestic economy grew to service. The growth, not the means of the growth, is what people remember from Clinton.

What should be remembered is an economy whose growth is based upon changes in money supply and outstanding credit. This growth cannot be maintained. Bush inherited this mess, but his policies only made the situation more desperate. In attempting to keep the economy running at its artificial level he cut taxes, increased government spending, and grew the money supply. All are loose policies and economic stimulants in their own right, but when combined they create a very powerful force. Like the Clinton era, this artificial stimulus worked for a while, but the new economy was running artificially higher levels of liquidity than its predecessor.

Inflate or Die

All in all, what I’m trying to say is that an economy whose growth is based on liquidity expansions cannot last. It’s the notion of Adam Smith’s invisible hand. Our economy is not running at its equilibrium point and the further we get from that equilibrium, and the longer we stay there just means the invisible hand starts to push harder and harder. Natural forces are trying to push our current economy back to equilibrium. The excessive growth was the result of an expansion of liquidity (inflation), and in order to get back to equilibrium, liquidity must do the exact opposite and contract (deflation). So the question of do we inflate or deflate becomes a question of if we can’t inflate we deflate. The question of policy is do policy makers try and inflate or let it deflate? Let’s look at what happens in each scenario.

The x-factor of each “flation” has to do with outstanding debt. The U.S. government and its citizens are staring at a lot of debt. If inflation is increasing at a faster pace than interest rates represent (negative real interest rates), than the real value of debt decreases. This is in the best interest of the borrower, which is the credit card/mortgage strapped consumer and the debt laden U.S. government. Unfortunately this makes our debt look unattractive to buyers.

The problem is that both parties greatly need credit lines to be open in order to keep the artificial level of liquidity up. If we choose to inflate, buyers of U.S. debt will either stop buying or demand higher interest rates. This would simply be unacceptable at a time when the U.S. and its citizens need to finance exponentially more debt than it ever has. The path of inflation leads to monetizing debt as foreign demand for Treasuries and asset backed paper denominated in dollars dries up. If we are forced to monetize our debt, the U.S. dollar will collapse and inflation will turn to hyperinflation. This is as certain as the sun rising tomorrow.

The deflation path isn’t much prettier. Just as inflation decreases the real value of debt, deflation increases it. If we deflate, the value of all the outstanding debt faced by consumers and the U.S. government will begin to increase, and increase substantially. You have to look at how far above market equilibrium we are. A rough nominal judge of that is housing prices. Housing prices increased for multiple years at double digit rates when historically, housing prices increase a point or two above inflation. That created a massive pile of excess liquidity which resulted in all sorts of new demand for goods and services.

Now consider the expansion of the industrial and commercial sectors that grew to service this new pile of liquidity. All of it must contract, and it is my belief that if allowed to deflate, we would see deflation that would dwarf the deflation seen in the Great Depression. It’s rather frightening to compare the liquidity growths prior to the 1930s and prior to our current economic crisis. This extreme deflation would result in a massive growth in the real value of outstanding debt denominated in dollars. As a result, there would be enormous amounts of personal, corporate, and municipal bankruptcies. There would also be a high probability the U.S. would default on its debt.

As you can see, each situation is a mess. Obviously, current policy is to inflate at all costs, but I don’t think this is the best choice. It happens to be the most politically viable choice, but that’s a discussion for another day. You don’t necessarily have to agree with the motives, but you don’t need to look very hard to see which path the U.S. and rest of the G-7 economies have chosen. Their quantitative easing has not been subtle.

Deflation with the Edge

So why do I pick the deflation route as a less dismal choice than inflation? I would say that I have 1 ½ reasons. Both inflation and deflation probably result with the dollar no longer being the reserve currency of the world. Inflation will force the U.S. to monetize the debt as demand dries up. Attempting to monetize even a portion of the U.S.’s massive debt load will absolutely and completely destroy the dollar. Deflation will ALMOST surely result in a U.S. default on its debt. Considering the massive amount of outstanding debt, if the U.S. defaults on its debt the dollar will be worth the paper it’s printed on. I just have to say here that this will by far be the most painful part of this economic crisis. Don’t think you’ve seen chaos in financial markets yet. When U.S. dollars begin to flood global forex markets it will be like screaming fire in a crowded movie theater. A global panic among the largest holders of U.S. dollars will ensue, and for starters, resulting in a 20-30% overnight devaluation of the greenback.

So why deflation? Because with deflation, there’s a miniscule chance this doesn’t occur. More realistically, the deflation path is simply quicker. Think of it like taking a band aid off. Inflation is taking the band aid off slow, while deflation is just ripping it off. Financially, deflation will give something closer to a v-shaped recovery as opposed to an extended u-shaped recovery. My proposition is to IMMEDIATELY stop the monetary and fiscal irresponsibility. Stop growing the money supply and defend the dollar. Raise interest rates, re-value the dollar against gold, and implement a new gold standard. Pass legislation that only allows for balanced budgets. If there’s a deficit planned, cut spending. If there’s a surplus, cut taxes. It’s simple, yet probably perceived as barbaric and inflexible. I do not want to understate the pains this will cause in the short run, but the alternative is to postpone the inevitable.

The sooner we hit bottom the sooner we can begin the recovery process. This is when we can start an economy based on real growth; an economy whose economic activity is not based on growth and contractions in the liquidity base. We will have the potential to make an economic machine that doesn’t grow because of debt creation. This would be an economy with sustainable growth and less volatility. I used a key word there: potential.

Will we learn from our lessons? I doubt it. There may be a couple decades of prosperity, but I imagine we will eventually go through another one of these Keynesian cycles. It’s man’s flaws, and for whatever reason, it seems to be the most flawed, such as Maxine Waters, that sets policies. I’m not here to make the world a better place. I care about my family and my friends. I use what I’ve learned to make money and inform those who care to listen.

Disclosure: no positions

Comments

[User 143167:]

Deflation = Depression. and you still root for that?

Feb 18 08:32 AM

[patio:]

" If we are forced to monetize our debt, the U.S. dollar will collapse and inflation will turn to hyperinflation. This is as certain as the sun rising tomorrow."

When you state the dollar will collapse, you don't state relative to what?
The Euro, the Loonie, Yen, what?

Feb 18 08:38 AM

[MichaelJ007:]

Congratulations, you just lost the election for public office.

Feb 18 08:48 AM

[Dirk McCoy:]

Do you really think the US (government?) can default on its debt when the Fed can just monetize it, and the government can raise taxes?

The solution to this is clear: American living standards must stagnate will foreign living standards increase at a greater rate. This does not have to be accomplished in a way that creates millions of loan skippers, however. Inflation is a flat tax, but substitute technology and capacity can mitigate its effects on consumers- think solar for oil, stop paying farmers not to farm for food, and commercial real estate condo conversions for housing.

Feb 18 09:06 AM

[CLH:]

I tend to agree with you. The dollar must be maintained although it will cause a lot of pain. Yes depression is necessay to clean out the garbage.

Feb 18 09:06 AM

[Alex Filonov:]

Well, moderate deflation is exactly what we have right now. And exactly what Japan had in 1990s. Looking at Japan now I'm somewhat not optimistic about this route.

Feb 18 11:23 AM

[3 degrees o...:]

I agree that deflation is the lesser of evils. I am afraid though, that our politicians will not have the backbone required to take us down that path. So as a debtor nation, we will go the route of inflation. Goodbye Yellow Brick Road!

Feb 18 11:31 AM

[Stephen Kanitz:]

" If we deflate, the value of all the outstanding debt faced by consumers and the U.S. government will begin to increase, and increase substantially."

So you propose increasing everybody's debt without even asking them if they agree ? What school of economics are we talking about here?

Any lawyers around to explain this guy the "rebus sic standibus" clause ?

Feb 18 01:24 PM

[adan:]

really interesting article, thanks!

i've read several posts that remind us that progress via technology and productivity should produce lower prices for higher quality goods

inflation is a falsely increased worth benefiting mostly those at the beginning of the inflation cycle, and punishes saving

deflation awards those who save

also, from the little i understand of keynesian stuff (and i'm more a ron paul fan, ie, gold backed currencies), people (govt) are supposed to SAVE the surpluses in the boom times

neglecting that part of the man's theory is like

still living in mankind's previous ages of feast and famine, eating in gorges of binges in times of plenty (and unable to store food for future use because of lack of preservative technology), then starving when little food's around during a famine, drought, etc

someone's convinced society:

we really haven't reached an age of abundance yet; technology hasn't freed us from being unable to store plentiful supplies (including money); or realizing inflating then deflating, in vicious cycles, mostly hurts those unaware of it's unnecessity

Feb 19 09:03 AM

[keithfeather:]

deflation rewards those that keep capital out of the production cycle. Not good. inflation rewards those that keep their capital in production cycle.

It is not possible for the US to repay in equivalent value the debts it owes, so as long as the US knows how to create inflation, and at the same time delude the capital holders that deflation is a possibility, the inflation tax on unproductive capital will continue.

Feb 19 11:12 AM

[henarl:]

Depends on whether we're talking about what is best for the country and it's politicians, or what is best for the individual. As an individual, I tend to think more about the latter. Inflation is good for the profligate spender who now finds himself heavily in debt as he is more likely to receive govt. assistance to keep him spending and his debts can be more easily paid with inflated dollars Deflation is better for the saver who can now buy more with his saved money. Since I am in the latter catagory, I choose deflation.

Feb 19 03:03 PM

[keithfeather:]

The one who controls the game, however, (gov) is a major debtor, and we must play by his rules.

Feb 20 09:13 AM

[granger:]

Great article, one of the nest I have read. I do not agree with everything, but very well though out and eye opening. It made me challenge and rethink some of my perceptions.

Thank you;

Feb 21 11:24 AM

[Steve in Gr...:]

What you call deflation is merely the downward adjustment of asset values (including real estate and equities) to where they should be as the bubble created by Greenspan bursts.

The current crisis is the result of inflation of the money supply by Greenspan, aggravated by the leftists’ coercion of banks into making mortgage loans to deadbeats for purposes of social engineering.

To “solve” the current crisis, Bernanke is sowing the seeds of a new one by inflating the money supply to an even more grotesque degree.

The solution to the problem is to take the power to inflate the money supply away from the rocket-scientists who run the Fed. Money supply needs to grow as the economy grows and shrink as it shrinks, so there is neither inflation nor deflation.

Feb 28 11:17 AM

[Dr Jilani:]

I am Muslim and I really admire this article. I don't want to debate with the writer or with some of those who comment on him, but i just want to share with you some verses from Qur'an which describe the source of our crises, its consequences and solution. These verses are from chapter 2 called albaqarah (the cow) " the number of each verse it is stated in the beginning:
275. Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, "Trade is [just] like interest." But Allāh has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allāh. But whoever returns to [dealing in interest or usury] – those are the companions of the Fire; they will abide eternally therein.

276. Allāh destroys interest and gives increase for charities. And Allāh does not like every sinning disbeliever.
278. O you who have believed, fear Allāh and give up what remains [due to you] of interest, if you should be believers.
279. And if you do not, then be informed of a war [against you] from Allāh and His Messenger. But if you repent, you may have your principal – [thus] you do no wrong, nor are you wronged.

280. And if someone is in hardship, then [let there be] postponement until [a time of] ease. But if you give [from your right as] charity, then it is better for you, if you only knew.

Aug 21 11:36 AM