Inflation vs. Deflation: Pick Your Poison

One of the most important debates now occurring in the public forum is whether the economy will be hobbled by crippling inflation, hobbled by crippling deflation, or somehow muddle through without much of either. Too much of the debate seems to regard inflation and deflation as things that somehow just occur in an economy, rather than as choices that we, as the participants in the economy, make.

While that view of in/deflation is correct in some circumstances, it is not correct for the circumstances we find ourselves in currently. Instead, we need to realize that whether we have inflation or deflation is a decision that we (well, some of us, anyway) actively make, and that one of these “-flations” is highly preferable to the other.

Why do inflation and deflation occur? Simply put, they are the result of the interplay between the quantity of money in the economy and the size of the economy. There are many different ways of measuring the quantity of money in the economy (M1, M2, MZM, etc.), but no matter how you measure it, the basic relationship between the quantity of money in the economy and the size of the economy determines the degree of in/deflation experienced in that economy.

A simple thought experiment is perhaps the best way to look at it. Imagine two pirates stranded on a deserted island. One used to be a fisherman, and the other used to be woodsman. When they washed up on the shore, they each had two gold coins from their earlier pirating exploits. Soon, the fisherman is catching fish and the woodsman is gathering nuts and berries. At the end of each day, each man gives the other two gold coins for half of what the other man caught/gathered that day, and they sit down to their supper.

Now imagine the two men find a treasure chest buried on the island, filled with 200 gold coins. They decide to split the loot 50/50. Now, at the end of each day, each gives the other 102 gold coins for the exact same amount of fish or nuts and berries. So what used to cost two gold coins now costs 102 gold coins. Voila! The two pirates have just experienced inflation.

Now, let’s imagine they never found the chest. Instead, imagine both pirates happen to each lose one of their gold coins. Now, instead of giving each other two gold coins at the end of each day, they give each other just one – but the quantity of fish, nuts, and berries they exchange does not change. So what used to cost two gold coins now costs one gold coin. Voila! The two pirates have just experienced deflation.

So, the “-flations” are just the result of the quantity of money in the economy (the gold coins) relative to the size of the economy (the amount of fish, nuts, and berries exchanged). Since most economies tend to grow, the natural tendency is for economies to experience de-flation – which is only prevented because central banks print a certain amount of money precisely to prevent that from occurring.

In our pirate example, we only looked at the price of goods but ignored the price of financial assets (aren’t too many of those on a deserted island!) But financial assets can also experience inflation. Once the price of a financial asset increases above the net present value (“NPV” – basically, adding up all future profits into a lump sum) of the profit one can expect to earn from that asset, it has entered a “bubble” phase. Eventually (though it can sometimes take a very, very long time), the price of the asset will revert to the NPV of the profit one can expect to earn from that asset. It simply must – like any ponzi scheme, there are a finite number of dupes to which to sell an inflated asset, and once that number has been exhausted, the price will come crashing down.

But, there are two ways for the price of a financial asset to revert to the NPV of the profit one can expect to earn from that asset: (1) the price of everything else can stay the same and the price of the asset can come down, or, (2) the price of everything else can go up and the price of the asset can stay the same. Obviously, option (1) is deflationary, and option (2) is inflationary.

Right now, many asset prices are still too high relative to the profit one can expect to earn from them. This is especially true of the toxic (ahem, I mean, “legacy”) assets that clog banks’ balance sheets. Investors have come to realize that the expected profits to be made from those assets are much lower than was previously thought, so investors are only willing to pay cents on the dollar for them.

Of course, if the banks were to sell to investors at these new, lower prices, it would bankrupt them (or rather, would make their bankrupt status too obvious to be papered over with government handouts and looser accounting standards). Instead, the banks hold on to their assets and pretend that they are worth more than the market is willing to pay.

Similarly, houses are still priced too high in most markets. Though prices have come down a long way since their ’06 peak, they still have a ways to drop to bring them back in line with their historical price range (see chart below, compiled by Steve Barry and posted to Barry Ritholz's The Big Picture).

As you can see from the above graph, even the recent declines in housing prices have not been enough to bring them back to the 100 – 110 range that prevailed before the housing boom took off. The question is, how do we get prices back to that level?

Similarly with the toxic assets on the banks’ balance sheets, how do we get their prices back in line with their NPV? By letting their prices fall, or by letting the price of everything else rise?

The key point here is that there is no middle ground. Either asset prices (i.e., houses, bonds, stocks, etc.) must fall, or the price of everything else (i.e., commodities, wages, etc.) must rise. And the power to choose is ours.

Well, not really ours, but it is the Federal Reserve’s – the Fed can either print enough money to bring the price of goods and services back in line with financial asset prices (the sin of commission), or the Fed can keep its fingers off the printing press and let financial asset prices fall enough to be back in line with the prices of goods and services (the sin of omission).

Again, there is no middle ground here – one of these two things MUST occur. We have no “good” options at this point. We must sin; the question is, which is the “least bad” way to do it?

Without question, inflation is the preferable outcome to deflation. We have seen the effect deflation has had on Japan for almost twenty years now, and it is not pretty. Our own experience with deflation during the Great Depression should be enough to disabuse us of the notion that deflation is the better way to go.

By allowing inflation to grow to around 7% annually, we would double the price level in just 10 years. Because this would be “demand-pull” inflation, wages would keep up with rising prices, making the effects of the inflation palatable to most Americans (with the exception of holders of fixed-income assets).

Servicing debt would become much less of a burden to the average citizen. Holders of financial assets (except equities) would see the real value of those assets fall, but, that would have occurred anyway – if the value hadn’t been slowly eroded by inflation, it would have been swiftly and mercilessly decimated through default and then measly recovery. Better to lose 50% over the course of ten years than 60% in a single day!

We face an unpalatable choice: actively create inflation, or passively create deflation. Again, there are “good” options at this point – either inflation or deflation must occur. The choice now lies with the members of the Federal Open Market Committee and its Chairman, Ben Bernanke. Let’s hope they make the right one.

Disclosure: Long TBT, GLD, GDX, EWA, DBA, PWE

Comments

[Mad Hedge F...:]

Poison, indeed. The incredible melt up in Treasuries yesterday tells you that traders are dumping the global reflation trade like a hot potato. The ten year yield spiked up to a high of 3.28%, down from 4% only a month ago. Yesterday’s auction of ten year Treasury notes saw an amazing bid to cover ratio of 3.28, the highest in 15 years. When traders don’t want to play, they flee to government paper. The music has stopped playing, so it’s time to sit down. It looks like the deflationistas are going to have the upper hand over the inflationistas for the next couple of months. See my interview with Janet Yellen at (www.madhedgefundtrader...). This certainly puts my TBT trade on hold (see “Sell in May and Go Away” at www.madhedgefundtrader... and “The Viagra is Wearing Off” at www.madhedgefundtrader...). It’s best to read the writing on the wall, especially when it is in ten foot high, in fluorescent block letters, like this.

Jul 23 10:53 AM

[Carneades:]

Who would gain the upper in the event that the island's ability to supply new berries was obviously insufficient to meet the two former pirate's consumption habits? Would the woodsman believe that, given the trend towards a lower supply of berries, he would be justified in charging the fisherman more for each unit of berry? Or would the fisherman interpret the dwindling berry population as a decline in the woodman's usefulness and/or bargaining position?

Or would the woodsman try to hide this reality?

Jul 23 11:09 AM

[WhoisJohnGalt:]

If the scenario were in our golden of transparency (yes, sarcastic), the woodsman would definitely try to hide it.

To further complicate the example, is it really fair for the two to charge each other at an equal rate? Granted the exchange involves only the fisherman and woodsman, but the level of skill required for their respective tasks should also be gauged in the value of their provided goods/services. Their consumption preferences would also have to be incorporated in the pricing, etc.

It's a fine example, but as with all these macro issues, multiple inputs must be considered for the outcome.

Jul 23 11:16 AM

[Mill Rat:]

Hmm... if only the real world could operate according to this theory.

I don't recall my own salary increase last year (or the year before) being large enough to compensate me for paying dramatically higher prices for gasoline and groceries.

Consequently, like many other Americans, I compensated for this inflation by reducing my spending on less important things. Unfortunately, a substantial number of Americans also responded to this inflation by defaulting on their debts.

Your theory about wages keeping up with inflation would be more true if every human were a commision-paid employee, an entrepreneur, or an independent contractor. Unfortunately, a very large portion of the workforce is not employed in any of those categories.

In response to what I have just described, one might offer the theory that, over time, existing companies and entrepreneurs will respond to commodity inflation by expanding capacity and, consequently, beginning to compete with each other for more labor - thus, driving up wages and salaries.

Unfortunately, it didn't work that way last year.


Footnote:
The business media has not given sufficient coverage to the impact that inflation had on the economy last year. Instead, they hyped the "credit crunch". I don't dispute that the credit crunch was, indeed, a critical issue. However, it was only part of the whole story.

Jul 23 11:49 AM

[Leftfield:]

I agree with An MBA Stil....: Inflation will have an unequal impact against pay for ordinary people. Inflation was not considered a problem with $150/barrel oil but if pay went up, suddenly CNBC and Wall St. would be all abuzz. Never happened.
They will understate massive hikes in ordinary person's expenses and use inflation as a tool, like stupid trade and all phony statistics, to move average Americans towards third world status.

Jul 23 01:02 PM

[Living4Divi...:]

I believe there will be higher than average inflation

I think your example discounts the possiblitiy that if a treasure chest of coins is found, the pirates would hoard the coins and not introduce them into trade. thus money velocity neither increases nor decreases and there is no price inflation.

What your island needs is a group of financial wizards to come in and create some asset backed securities based on price of fish, berries and wood. Then an exchange could be set up trading the various asset backed securities (ABS). Respectively, there would be FishBS, BerryBS, WoodBS. Furthermore, derivatives could be created to place side bets against the rise or fall or the risk of default on the ABSes.

Market commentators would spring up to comment how the price of berries looked high as speculators were trading the market. One of the pirates could stop working and spend his time trading the market.

Jul 23 02:15 PM

[whidbey:]

Nice analysis, good teaching, but likely incomplete. The history of governments is that they never make choices such as you suggest, no they usually get pushed into acting. The result is no clear cut policy or announcement, just insidious slippage in the currency - we know about that one, and the constant default on the undertakings of government - fewer services, less defense, and little international interaction. It is called debt default. There is no need to say no to creditors yet, when citizens can be defaulted upon - 0 interest rates is a default in payment for savings reflecting the time value of money, forced savings in many cases( the SS the government forced on the citizenry) which will soon not pay any measurable amount of the costs of retirement (too bad, you trusted us!)

No, it will not be a clear cut choice, it will be some combination of inflated costs (taxes too), and default, fewer services (or goods) for whatever you pay. The lesson is that we will be told it is our fault, wall street's fault, China's fault but never Congress's fault or bad leadership such as Geo Bush offered on Medicare Part D (everything now is Not Enough! and you pay nothing. We learned many bad habits and its our due to unlearn them the hard way.

In the end we elected Congress and let them hoodwink us, so we really screwed ourselves. It that perversion, or does any one care?

Jul 23 03:39 PM

[Roman_Fiddler:]

I'm fairly sure inflation will be the chosen poison. But I don't think it will be quite so painless as you imply.

P.S. I think the fisher pirate would 'accidentally' feed the woodsman pirate some puffer fish and keep all the gold to himself.

Jul 23 07:04 PM

[Tortoise:]

Doesn't the inflation choice spur resets higher in variable loan rates and destroy what's left of the housing industry?

Jul 23 07:52 PM

[Barbarous R...:]

Although inflation is obviously the route chosen by our esteemed central bankers, I would argue that that is the worst possible choice.

Inflation arbitrarily transfers wealth to those who receive the new money first. It also sends misleading signals to entrepreneurs, leading to the poor investment decisions of the last boom (i.e. housing bubble).

Better to leave the money supply alone and let asset prices fall to where they represent value to buyers. Allow industries to downsize with the least efficient and most indebted companies going out of business. Allow resources to be re-allocated to where they will be best used. Allow savings to be rebuilt. Allow people to pay lower prices for things in their time of need. A painful route, but important nonetheless.

The inflationary route unfairly benefits some at the expense of others and guarantees that another crisis lurks just around the corner.

Jul 23 09:56 PM

[Dirk McCoy:]

Truth is, some things can go up in price while others go down. The story of the 2000s was globalization that provided a huge source of cheap labor to the world market. This lowered the price of many goods and services, creating a boom in economic activity globally and creating many jobs in transitioning resources into these areas, as well as benefitting from these lower cost goods (retail boom).

Meanwhile low interest rates and beneficial tax policy caused the spike in home values (just calculate the npv of a house pre- vs. post that change and you'll see why) and combined with shrinking manufacturing sector to lead to a booming housing sector.

Jacking up interest rates took the wind out of those sails, mark-to-market pro-cyclicality pressured lower, and global demand bust sunk commodities.

But labor will continue to stay depressed because there are billions more to come (including Vietnam with their $11.23/month minimum wage). As long as we allow our economy to benefit from that instead of respond with protectionism (hmm, not doing too good on that at the moment), the global economic boom can resume as more consumers are created around the world. The primary question will be- what will America's role be in that growth? Lead financier, contect creator, and travel mecca? Or more insular also-ran?

Jul 24 02:58 AM

[Adrena:]

Agree that inflation is the worst choice, but will be the choosen one. And agree that it might run over 7%. The ones to benefit will again with the ones with the money: unfair. Wages might keep up with rising prices for some, making it more "palatable", but what about retired people (growing in numbers), with fixed-income assets. This will be horrible.

Jul 24 08:34 AM

[capt Brian:]

Good article I guess, digesting it may make my tummy hurt, but I suppose you are saying I get to choose what is going to happen. Drat friend, I am too busy running a lil sightseeing boat, can't you tell me wht is gonna happen, or at least, mate, what you 'think' is gonna happen? I listened to a lot of Seeking A contributors, including myself, and was convinced this market was rotten from the core, yet the market steams ahead, missing all the reefs everyone was talking about. I have been 'short' the market for 3 years now, (My being short the market is simply, NOT IN IT) so I am missing the Bull Market, of just the Bull? Can you rephrase this article, boil it down, then republish so a smelly ole sea cap'n can understand what to do?
Thanx
The Lost Navigator
Cap'n Brian

Jul 24 08:47 AM

[Gem Hudson:]

What is wrong with this picture?

China is dumping dollar not by selling on the foreign exchange. They are buying up asset but nobody are demanding the dollar and the exchange rate will fall off the dollar index.

The currency not only crash. China will no longer buy any of our debt and the Unite States can not finance any of their deficit spending.

But they got to spend bigger now and faster immediatly. We will win. That is all of Polosi for themselves.

The answer is: Since print money is still nothing but paper money. They are still printing up plenty of paper money or fractional reserve out from an congressional I.O.U. bonds. The gold dose not fluctuate. It is print money becoming capital money only if earned. That is to sell and to produce what you have sold.

Jul 24 08:54 AM

[Gnothead:]

Good article that I just sent to my kids.

Jul 24 09:24 AM

[CLH:]

Mostly your analogy makes no sense. You have not said that the govt. nor the people can not alter the outcome but this is the effect. This crises is a self generating correction. Only deflation will take place. Its not possible to have inflation.

Deflation is caused by elimination of debt. No matter how much money the govt. prints inflation wont return for many years. The deflation will continue because money will not be used (borrowed). Trillions of dollars sitting in bank vaults will not cause inflation.

What you see in Japan is what we will go through. Deflation and no chance of inflation. People in Amerca have the mistaken belief that govt can solve all problems.

Jul 24 09:32 AM

[Seng:]

Inflation is theft of purchasing power and nothing less. It disproportionally hurts the poor and fixed wage earners who get stuck with the 'new money' last. To think that is the recipe to solve our economic troubles is asking for political upheaval.

Jul 24 09:42 AM

[GMC:]

In the 1960's my father bought a larg-ish three bedroom house in California for $30,000, his salary was roughly $32,000. I can't buy THAT SAME three bedroom house today for anywhere near my salary and I am in a job that is very similar to the job he held then, except that he was a civil servant, (i.e., paid at a lower rate than the private sector), and I'm in the private sector. It would take at least twice my annual salary today to buy the same house. And, with taxes much higher thn they were then it would actually take much more than double my wages to pay for the house - and it's 40 years older to boot! I don't think the representation of house prices in the chart is accurate of their "real" values.

Jul 24 09:53 AM

[Barbarous R...:]

Central banks can always create inflation if they are determined to do so. If banks won't "cooperate" by lending out their reserves -- bypass the banks. There is no practical limit to how much "money" can be printed and what assets can be monetized. Similarly, there is no practical limit to government spending programs that can be dreamt up by motivated bureaucrats which can then be funded with printed money.

It's simply a question of how aggressive (reckless) the central bank wants to be. And how willing it is to suffer the unintended consequences.

Jul 24 10:44 AM

[stojan nena...:]

Congress must create new money as gift which come from formula:
dM = k M ; k = (supply - demand)/demand ; If new money (dM) is emitted according to the cited formula, inflation cannot exist. New money is non-credit money as gift from taxes whch are annulled for the amount of non-credt money. The consumers pay less and producers get more than today, in the order of credit money. There is not inflation, there is nort deflation, there is not economic crisis. This is new order of non-credit money. Money is not debt than gift.

Jul 24 10:57 AM

[Old Rick:]

Having sold a San Diego house (and escaped the fool's golden state) in 2003 as the boom was gathering steam, I have kept a watch on those prices since. My calculation at the time was that we sold at about 70% over what the "norm" value of the house "should" have been based on original purchase price, original value, and time. The same house then proceeded to add another 60% in the next 2 years before the market collapsed of its own weight. The prices in that area are since down to a mere 50% over "norm" value in 2009. It appears to me, having lived through about 3 California housing boomlets/bustlets that California (coastal at least) may have as much as another 30-40% decline ahead before a bottom is reached. During the bustlets (late 70s, late 80s, mid 90s) housing prices went BELOW norm value. Thus while extrapolation of the Steve Barry chart to the 100-110 level implies a further decline of ~22%, an overcorrection to those levels seen in the 3 bustlet periods discussed would mean that California house prices could see a further 35-40% decline further exacerbating that economy. My vote based on that scenario would be for an extended period of deflation followed by a delayed inflationary reaction to helicopter Ben's current exploits. Reversion to the mean always works.

Jul 24 11:09 AM

[David Braun...:]

I can't see inflation without getting the newly printed money to the people. In your island example, the reason you had inflation was that both pirates got the money. I wouldn't have changed a thing if there was tons of money on the island, but no one found it. The Fed expands the money supply by buying treasury securities in the open market with newly printed money. Big deal! I could also expand the money supply by pledging my treasruy to the bank for a loan. Inflation can only occur when the newly created money either by printing or expansion of debt gets into the consumers wallets. This can be done by creating new jobs, increasing pay of existing jobs, and giving government subsidies. But most likely the new money will find its way into the hands of corrupt politicans, obscene top management salaries and bonuses, and of course into the few lucky soles who work at Goldman Sachs. Money that only goes to a few privileged individuals instead of the masses equals deflation may friends.

Jul 24 11:19 AM

[armadillo:]

I see it as the number of gold coins staying the same but the number of berries and fish going down.

Jul 24 11:34 AM

[FitBusiness...:]

What about the possibility of Deflation THEN monetary hyper-inflation?

One must point out that there is a difference between MONETARY inflation/deflation and SUPPLY/DEMAND inflation/deflation as the inventory supply does contribute.

However, what we seem to be experiencing now is price deflation (inventory liquidation) and monetary hyper-inflation (fed's balance sheet).

It has been continued practiced of the fed to flood economies with easy credit, then remove that credit supply after businesses become addicted to bring the buying power away from the average consumer and into the pocket of JP.

Therefore, economies do not suffer deflation because of growth, they suffer deflation at the direct and orchestrated hand of the fed.

Easy to overlook, but not if you study the history.

OUR BUYING POWER IS BEING ROBBED IN THE HEAT OF THE DAY.

Bubbles are caused by design.

This is the issue caused by loose legislature written by the idiots on Capitol Hill (really lobbied and written by banksters) that allows debt to be claimed as an asset.

Fact is, if...for some reason that debt is not collected, all of your past profit claims are ABSOLUTELY WORTHLESS.

Shadow accounting at it's best.

In the case of housing, smart investors (including myself who is the least of these investors) saw the whole damn thing coming.

It's not WHAT you buy, but WHEN you buy it...and WHEN you sell it.

"Again, there is no middle ground here – one of these two things MUST occur. We have no “good” options at this point. We must sin; the question is, which is the “least bad” way to do it?"

The ultimate sin... DO NEITHER AND HIDE GOVT. DEBT IN THE PEGGING OF A NEW CURRENCY.

Jul 24 11:54 AM

[Maxe Paul:]

Matey, hows this for a theory?

If two pirates were on an island with 204 gold coins, bigger pirates, once hearing the rumour of riches, such as those from the merchant frigate "Goldman Sachs" would soon make sail, on a mission to render inflation/deflation obsolete on the island!

Jul 24 01:07 PM

[American in...:]

Sloppy analysis. The velocity of money is important as well and the author appears to be completely unaware. Rapid money supply growth during Japan's Lost Decade did not result in inflation. Ever!


On Jul 23 03:39 PM whidbey wrote:

> Nice analysis, good teaching, but likely incomplete. The history
> of governments is that they never make choices such as you suggest,
> no they usually get pushed into acting. The result is no clear cut
> policy or announcement, just insidious slippage in the currency -
> we know about that one, and the constant default on the undertakings
> of government - fewer services, less defense, and little international
> interaction. It is called debt default. There is no need to say
> no to creditors yet, when citizens can be defaulted upon - 0 interest
> rates is a default in payment for savings reflecting the time value
> of money, forced savings in many cases( the SS the government forced
> on the citizenry) which will soon not pay any measurable amount of
> the costs of retirement (too bad, you trusted us!)
>
> No, it will not be a clear cut choice, it will be some combination
> of inflated costs (taxes too), and default, fewer services (or goods)
> for whatever you pay. The lesson is that we will be told it is our
> fault, wall street's fault, China's fault but never Congress's fault
> or bad leadership such as Geo Bush offered on Medicare Part D (everything
> now is Not Enough! and you pay nothing. We learned many bad habits
> and its our due to unlearn them the hard way.
>
> In the end we elected Congress and let them hoodwink us, so we really
> screwed ourselves. It that perversion, or does any one care?

Jul 24 01:51 PM

[dogster:]

Suppose the woodsman was indebted to the fisherman. Then, all the berries would go to paying interest on the fish debt, so he wouldn't be able to buy any fish. The woodsman would have to eat all his berries, and the fisherman would have to eat all his fish. The fisherman would get sick of eating nothing but fish, so he would forgive the old fish debt and the woodsman could sell him some berries.

Jul 24 02:12 PM

[Dirk McCoy:]

Say one day another boat crashed on the island with a cook, a builder, a doctor, an entertainer, and a bureacrat.

Wouldn't you need more coins?

Also- would the bureacrat charge the same as the doctor?

Jul 24 02:26 PM

[ussmls7:]

Inflation is already here in the prices of food & every day living expences. But it will only get worse,as China & all of the other Nations spend their dollars for assets they are stocking up on,like Gold,Steel,Copper. The dollar is dead, but does not know it yet!

Jul 24 02:29 PM

[andychoka:]

The authors disclosure of holdings says one thing--he believes in the inflation outcome. I agree and own three of his picks TBT (which I believe is a sure thing bet, GLD and PWE, I will take a look at his other investments. Can anyone believe that rates will go down from here ?

Jul 24 02:42 PM

[devassocx:]

For sure inflation is here, it just isn't being measured because
that wouldn't be convenient to the huge economic and political manipulations that are going on.


On Jul 24 02:29 PM ussmls7 wrote:

> Inflation is already here in the prices of food & every day living
> expences. But it will only get worse,as China & all of the other
> Nations spend their dollars for assets they are stocking up on,like
> Gold,Steel,Copper. The dollar is dead, but does not know it yet!

Jul 24 02:53 PM

[Boxed Merlot:]

At the risk of sounding too simple minded, (again), let me introduce for your enjoyment Peter Schiff’s dad’s explanation / illustration that has plagued me throughout my adult years as an American. freedom-school.com/mon...

Jul 24 03:34 PM

[Gregman2:]

Still, your explanation seems to link dis-inflation with de-flation. And, doesn't really examine debt de-flation (which is when excessive debt levels and debt service cause asset prices to deflate and cause a general drying up of available capital).

Jul 24 04:14 PM

[Barbarous R...:]

People are getting too hung up on whether or not prices of certain things have risen on an ABSOLUTE basis. That constitutes their definition of "inflation".

The moment the money supply is increased by even a single dollar, each individual dollar has less purchasing power than it did before. Less purchasing power means higher aggregate prices in dollar terms than would otherwise be the case.

What if prices remained flat following an expansion of the money supply? This simply means that prices otherwise would have fallen in the absence of the monetary expansion. Inflation has still worked its evil, by raising prices RELATIVE to what they would otherwise be.

The early recipients of the new money would have arbitrarily benefited from the inflation at the expense of everyone else. And who is typically the earliest recipient of the new money in our society? Shocker -- our beloved banking system.

Jul 24 05:19 PM

[QED:]

Whether there are 4 or 204 gold coins, why would they even use them? They could just barter directly with each other or "share". No money or gold coins needed. The coins would not really have any value in the absence of other needed supplies/goods.

Apart from that a nice analysis IF they were to use the unpractical means of "money".

Jul 24 06:47 PM

[msoori:]

The article hides out the middle man completely, making the argument a completely flawed one. In the real life, majority do not participate in this "discovery of a treasure chest." Though we see and hear the printing presses roll, none of that makes it beyond the pockets of the rich bankers that are too fat to fail! I personally haven't seen any of these shiny new Benjamins and nor will majority of Americans. So the 2 people argument is completely flawed, yet the majority of the populous ends up having to cough up more and more for the same goods with a dwindling supply of money (as we loose jobs) while the new money clings onto the deep pockets, finding comfort in the flabby crevices where the sun never shines.

Jul 24 08:20 PM

[sod:]

I enjoyed reading this article and thought the analogy of the two pirates was apt and droll.

However, it is obvious from his securities declaration, Erasmus is betting on inflation. I think the consensus is deflation for at least the next several years. It will be interesting to if he is correct. I will continue to follow contributions to SA.

Jul 25 12:48 AM

[noob:]

Mystery of Banking - Murray Rothbard

Inflation is great if you have a debt. If you have a payment of $1000 a month on a house, with inflation this will move from 3X your groceries to 1X your groceries over decades. This makes inflation attractive to those who are into deficit spending or living beyond their means.
If you save $1000 a month then deflation is what you want because that money will buy more groceries in a decade than it can today. When we were under the gold standard this was the case and people who saved their income over the years had that nest egg for retirement. Today it melts away under inflation until you are living in a box by the side of the road.
If you hold someone elses debt, like a mortgage or some other loan, then inflation is bad because your return on your investment by interest earned is diluted by the inflation you are realizing at the same time. I would love to lock into a massive loan for 6.5% and watch inflation run up to 10% over the next 10 years. That would almost make me money.
The Federal Government loves deficit spending. That allows them to purchase whatever programs are necessary to get re-elections without fear of having to pay for it. And they manage it through the inflation or the dollar. Effectively, inflation is a black-tax because no one sees it on their ledgers but it insidiously erodes your earnings, assets, and income. And it makes their debt relatively smaller with each passing year.
The holders of American Debt (China, Japan) hate inflation because that makes their purchased debt of dollars worth less every year -- hence the concern about the American Dollar as a global form of currency exchange. With inflation, we win and they lose.
The Federal Reserve inflationary practices will always be supported by the Government until the government is void of it's debt and deficit spending. And that will eliminate any voluntary move towards a hard currency standard which would remove any future of inflation by fiat currency measures.

Jul 25 09:22 AM

[noob:]

In reality, one of the two pirates would find the chest and purchase all the goods from the other for 2 coins and at the same time raise his prices to 25 coins. The recipient of the new money (source of inflation) would grow immensely rich at the expense of the rest of the population.
If he were smart he would initiate a program of welfare wherein he would give the other man 20 coins for goods and tax him ten. And collect the rest on sales leaving him forever a despot.
Until the other man revolts against "The Man" slitting his throat in the middle of the night and taking all the gold for himself. And living off nuts and berries for the rest of his life....


On Jul 24 08:20 PM msoori wrote:

> The article hides out the middle man completely, making the argument
> a completely flawed one. In the real life, majority do not participate
> in this "discovery of a treasure chest." Though we see and hear
> the printing presses roll, none of that makes it beyond the pockets
> of the rich bankers that are too fat to fail! I personally haven't
> seen any of these shiny new Benjamins and nor will majority of Americans.
> So the 2 people argument is completely flawed, yet the majority of
> the populous ends up having to cough up more and more for the same
> goods with a dwindling supply of money (as we loose jobs) while the
> new money clings onto the deep pockets, finding comfort in the flabby
> crevices where the sun never shines.

Jul 25 09:25 AM

[erniem:]

As always, the truth lies between the extremes. I suspect Deflation over the next 2-5 years, as the Fed fairly carefully watches and regulates inflation. Once the toxic waste is eliminated, the Federal Govt has taken most of the hit, Goldman Sachs is up to $900 a share, and banks are again fairly healthy, the hens will come home to roost. And interest rates will rise, rise, and rise, as the underlying Federal debt has not been eliminated, but has grown continually, and NO ONE will want to finance it further.

Jul 25 12:27 PM