The Inflation / Deflation Forces Battles On

There is a great debate raging between students of monetary economics. On the one hand, there are the deflationists who point to the massive deleveraging in the housing, mortgage, credit and stock markets. The fall in prices in these asset markets, at least through March 2009, was devastating and destroyed trillions of dollars of wealth and credit.

On the other hand, there are the inflationists who focus on Fed policies and the money supply. Since the onset of the financial crisis, the Fed has taken the federal funds rate down to 0% and initiated countless programs including the purchase of $1.45 trillion in Fannie Mae (FNM) and Freddie Mac (FRE) debt and mortgage backed securities, guaranteeing hundreds of billions of dollars in new bank debt, purcashing hundreds of billions of commercial paper, etc… This has resulted in a massive increase in the money supply which logically will lead to inflation, argue the inflationists.

This has been a very thorny debate, with good arguments and respected voices on both sides. But little ground has been given and little progress made as participants of both camps seem unimpressed by the arguments of the other side.

This is unfortunate because in my estimation the two sides are talking past each other and both are right. That is, there are both inflationary and deflationary forces at work in the economy right now and which one is ultimately stronger can only be answered by future history. All we can do is inventory these forces and do our best to weigh them in making a forecast about the future.

Let’s start with what the deflationists obviously have right. The driver of the current economy and the policy response was the bust in the housing market and as a result the busts in the mortgage, credit and stock markets. These busts substracted tens of trillions of dollars of wealth and credit from the global financial system from August 2005 through March 2009 as prices of the various assets declined precipitously.

This is clearly deflationary. The housing, mortgage, credit and stock markets were in a deflationary spiral with prices dropping on the order of 50%.

On the other hand, the policy response from the Federal government is clearly inflationary. 0% fed funds rate, all the various Fed programs, cash for clunkers, the $8,000 first time home buyers credit and the stimulus package are being primarily financed by money creation. The federal government doesn’t have the money for all these programs which is why we are going to run a $2 trillion deficit this year. They fill the gap by borrowing and by money creation. Much of the borrowing will be repaid in the future by money creation. The massive scope of these inflationary programs makes inflationists jaw drop when they hear anyone forecasting deflation. How is that possible with the trillions of dollars the Fed is printing right now? Doesn’t that money have to filter out into the economy and cause inflation?

*****

At this point, it is crucial to understand a key point about the process of inflation made by the great scholar of the business cycle, the Austrian economist Ludwig von Mises. On pages 399-400 of his magnum opus, Human Action, von Mises wrote:

There is first of all the spurious idea of the supposed neutrality of money. An outgrowth of this doctrine was the notion of the “level” of prices that rises or falls proportionately with the increase or decrease in the quantity of money in circulation. It was not realized that changes in the quantity of money can never affect the prices of all goods and services at the same time and to the same extent.

……

It is not recognized that changes in these magnitudes do not emerge in the Volkswirtschaft as such, but in the individual actors’ conditions, and that it is the interplay of the reactions of these actors that results in alterations of the price structure.

What Mises is saying here is that the course of any inflation/deflation is always an individual and historical one and that you cannot predict inflation/deflation by looking at the overall price level or money supply. That’s because new money enters the economy not uniformly but at specific points and via specific actors.

There was actually massive inflation from 2002-2007 but it was focused in one particular area of the economy: the housing sector. The Fed’s low interest rates created a boom in the mortgage market and consequently huge inflation in house prices.

This point is key in understanding that both the deflationists and inflationists are right. As I wrote at the outset, there are both deflationary and inflationary forces at work in the economy right now.

Interestingly, all of the easy money policies of the Fed and stimulus from the Treasury have begun to have some real impact in the last 6 months. The best explanation of the boom in stock, credit and mortgage markets are the all the government policies which have put a floor under these asset markets. All these government programs, which are inflationary, have started to re-inflate asset markets resulting in a 60% rally in the stock market and corresponding moves in mortgage and credit markets, including a stabilization of housing prices.

These inflationary forces are starting to counteract the deflationary forces that have dominated asset markets since 2007. The forces of deflation and inflation are now fighting it out in asset markets.

*****

Notice that I wrote “in asset markets”. That’s because our economy has become quite speculative and asset based and the inflations and deflations we’ve experienced of late have been focused on asset markets. Government policies have caused artificial booms in stocks, real estate and other assets and the busts have occurred in these asset prices as well.

But what of “consumer prices”, which are of greater concern to most of us? What about the things we need to live like gas, food, phone bills, household goods, etc…? Is deflation of inflation in the cards for consumer prices?

For the immediate moment, the forces of deflation seem to be carrying the day. That’s because the massive destruction of wealth has resulted in a reverse wealth effect. Having less wealth and feeling less wealthy, the average American is cutting back on consumer spending. In addition, the contraction of the economy is causing un-and-under employment, sapping the purchasing power of many Americans. That decrease in demand lowers prices and that appears to be what we are seeing in consumer prices: mild declines i.e. mild deflation.

But I believe the forces of inflation in consumer prices are gathering themselves for a mighty storm. The fiscal stimulus programs currently in effect are inflationary. The $8,000 1st time home buyer tax credit will put $15 billion in the hands of first time home buyers through Nov. 30 and the program will likely be extended through May of next year putting another $15 billion in their hands as well. The cash for clunkers program put a couple billion in the hands of auto dealers and manufacturers. The $787 billion stimulus package will put real money in the hands of construction, environmental, health and whatever other programs Congress decides to allocate the money to. The tax breaks will increase the amount of money in the hands of businesses and consumers. All that money will work its way through the economy and because it is not being offset by a corresponding decrease in goverment expenditures, but rather created via money printing, it will be inflationary. It is a process and it takes time for this money to enter and work its way through the economy, but it is happening.

*****

Interestingly and importantly, much of the inflationary potential for consumer prices is being mitigated for now by the willingness of foreign central banks to continue to finance our economy. A great deal of the goods Americans consume are produced overseas. Americans actually consume far more foreign goods, especially those produced in Asia, than they consume of our goods. That results in what is called a current account deficit. The difference in monetary value between what we pay them for their stuff and what they pay us for our stuff is made up by their purchasing a great amount of our financial assets, historically primarily government debt. Their manufacturers convert dollars earned from selling products to us into local currencies and the central banks ends up holding all these dollars which they recycle into government debt.

It’s only their willingness to continue holding dollars and buying our debt that keeps the dollar and treasuries strong in markets. Once they tire of this arrangment, it will be a large pressure on the dollar and U.S. treasuries. And they are tiring of the arrangement. They know what all these easy money Fed policies and stimulus packages mean. It means we will print money to pay them back, destroying the purchasing power of their massive dollar and U.S. debt holdings. That’s why they’re starting to grumble about our policies.

For now, their willingness to pay the price for our profligacy is holding consumer price inflation in check. Once they tire of this arrangement, and all signs are that this is happening and will play out over a number of years, however, the consumer price inflation inherent in our current government policies will be felt. That’s because Asian central banks refusal to continue accumulating dollars and treasuries will mean a drop in the price of both. A drop in the price of the dollar relative to the yuan, yen and other Asian currencies will increase the prices of all the goods we import from them and depend on. A drop in the price of treasuries will cause a rise in interest rates.

The rise in interest rates will cripple our over-debted economy but will actually be deflationary. Debt service costs will squeeze consumers and businesses and leave less money to spend on other things. The higher cost of debt will constrain borrowing that was formerly used to buy stuff.

But the drop in the dollar and corresponding rise in the price of imports will be inflationary. It will increase the cost for average Americans of all the everyday things they buy and use that are now made overseas, especially in Asia. This is all very abstract but it is very real and it will result in consumer price inflation.

For now, much of the inherent inflationary potential of our governments current spending spree is being buffetted by the bizarre economic system that has grown up between the U.S. and Asia in the last 30 years. As that system unwinds, the ultimate inflationary results of our policies will be felt at the level of consumer prices.

*****

In conclusion, the deflationists and inflationists are both right. Deflationary and inflationary forces are both at work in our economy. For now, most of the action has been concentrated in asset markets. The bizarre economic system that has sprung up between the U.S. and Asia has kept consumer price inflation in check, for now. As it unwinds, however, the massive inflation inherent in our current government spending spree will be felt at the level of consumer prices.

The realities of real world inflation/deflation are intricate and empirical. Therefore, the debate is not solvable at the theoretical level at which it usually takes place. As Mises showed, inflation/deflation is at plays in various sectors of the economy and works its way through the system in idiosyncratic and specific ways. When we break it down, we can see that both inflationary and deflationary forces are at work and make educated forecasts about the weight and timing to attribute to each of them.

Sources:

“The Big Inflationist Scare”, Michael Shedlock, Mish’s Global Economic Analysis, June 22, 2009

“Mish Should Ditch His Deflation Fears”, Robert Murphy, The Mises Institute, July 13, 2009

Human Action: A Treatise On Economics (originally 1949), Ludwig von Mises

NOTE: I want to thank my good friend, with an M.A. in Economics from Cal State University at Hayward, and a student of economics since I met him in college, Mark Sawkar, for an invaluable conversation the other day which clarified my thinking on this subject.

Comments

[Joe Shareho...:]

Deflation is too powerful to be defeated by inflation. Why? Because companies which are struggling will have to lower prices. Too much slack in the economy right now.

Sep 27 10:23 AM

[Joe Shareho...:]

Inflationary measures taken right now will only delay deflation.

Sep 27 10:23 AM

[bluesmoke:]

Very good article. You've have laid out both sides in terms that are easy to understand. I believe you are correct in your assumptions as well. Thanks.

Sep 27 10:40 AM

[user8240:]

As the author indicates there are both inflationary and deflationary forces at work but takes no position on the ultimate resolution or outcome. So while somewhat informative, what do we make of this article? While many economists concerned with the consequences of fiscal and monetary policies that amount to "borrowing our way out of debt", see deflation for up to two more years then massive if not hyper-inflation, the more likely prospect is another asset bubble in a jobless recovery. The policy choices that fit government objectives are gradual depreciation of our currency while keeping long term interest rates down to avoid more unemployment. The argument that interest rates will rise as the Chinese e al stop buying our bonds is not realistic....oh, they may decrease purchases but the Federal Reserve has both an infinite balance sheet and the Congressional mandate to work toward full employment and stable prices (despite the inherent contradiction).
So, with a declining dollar putting pressure on prices to rise and interest rates held steady why would inflation not explode? Because, prices are the result of the demand supply equation not just the cost to import/produce goods. In a jobless recovery, household income won't increase and housing prices will decline in real terms...the money won't be there to pay higher prices. Demand for foreign goods will fall to offset the exchange rate changes. Until we get a government that wakes up to loss of our manufacturing base to China (83% of our non oil trade deficit is with China) and stops talking up free trade instead of fair trade, inflation or deflation will be the least of our problems.

Sep 27 11:11 AM

[chap08:]

The main mistake that you, and others, make is to look at this as a question of economics. It's partly that, but politics is more important.

Between the govt and the Fed, they have the power to beat any level of deflation. For example, let's say they print $1 million for every person in the country and mail it out - that would beat deflation in a hurry. So the question is, what powers will they use, how much and when? To answer this, you only need to look at the record. You also need to understand that seet price inflation will not be enough. Bernanke will not rest until positive CPI is firmly established. Their intentions are clear, inflation is coming.

Sep 27 01:27 PM

[58robbo:]

i think you underestimate the resolve of the fed and the administration to bring about inflation. companies which lower prices too far will eventually shut. their assets will invariably go to some bank who, together with an open check from government, will mothball these assets. they will withdraw supply indefinitely and on a gargantuan scale until the stimulus, loose monetary policy and huge deficits start working.
i personally don't consider what is being done ideal, but there is no question that this is what IS BEING DONE!
On Sep 27 10:23 AM Joe Shareholder wrote:

> Deflation is too powerful to be defeated by inflation. Why? Because
> companies which are struggling will have to lower prices. Too much
> slack in the economy right now.

Sep 27 02:25 PM

[mna:]

You know the funny thing is, if you raise all tax rates in all tax brackets by 2%, the entire country would be up in arms. Yet if you raise the inflation rate by 2%, no one notices, even though they are financially and functionally equivalent for everyone using dollars.

so let's recap. We have 2 ways of paying off our obligations. Increase the tax and have the citizens up in arms, or inflation so that no one notices. Hmmm.... That's a tough one.

Sep 27 02:41 PM

[untrusting ...:]

User8240,
You state that "Until we get a government that wakes up to loss of our manufacturing base to China (83% of our non oil trade deficit is with China) and stops talking up free trade instead of fair trade, inflation or deflation will be the least of our problems."

Exactly what is it that you think the US government or for that matter even US business can realistically do about it? For example:
1) US per capita income is about $45-50K, whereas China per capita income is about $5K. Do you suggest we reduce US average wages to about the $500/month that they are in China in order to compete?
2) US healthcare costs are running in excess of 16% of GDP. Don't know what they are in China, but they likely are at best 1-2% of Chinese GDP. What do you suggest so that the US can compete with China? Are you suggesting the US government maybe pass something like wage and price controls and roll back all US healthcare costs to 1/8 of what they presently are?
3) The US military budget is greater than the military budgets of all the other countries in the world put together, much less just China. There is massive waste, unproductivity, lack of clear purpose/benefit, etc just in the hugh US military expenditures alone. What is it that you suggest? There is virtually no political chance that the US will significantly reduce military expenditures anytime soon.
4) Executive compensation - Just saw an article on banking compensation. China has 3 of the 10 largest banks in the world now. The highest CEO banker compensation in China was about $250K/year vs. the US large bank CEO's who make tens or even hundreds of millions/year in compensation. How is the US ever going to compete with that via fair trade? The same could probably be said about most public company executive compensation in the US today.
5) Environmental costs - the US has extensive environmental compliance/protection costs. China and many 3rd world countries have much lessor costs in these areas as they are willing to pollute now to increase per capita standard of living now, whereas the US is not. How do you factor that into fair trade with China?

In short, there are a whole host of issues facing the US as a nation and they will incredibly difficult to resolve, if in fact many are able to be resolved at all.

If one wants to think of it from a bigger picture viewpoint ... the US is about 5% of the world's population, but the US uses something like 25-30% of the world's resources. Do you think that will continue indefinitely? That is unlikely. Thus over time, one has to assume that over time the standard of living in the US will decline relative to the rest of the world, and the standard of living of the rest of the world will increase relative to the US. To some extent that is happening right now, but one would expect it to accelerate in the future.

Certainly there are things that the US government could do to attempt to "re-industrialize" the US. However, given the nepotism and self-serving relationship between the politicans, the lobbyists, and the wealthy elite/oligarchs.... all of who benefit enormously from the present arrangements, we think it is unlikely that much will change anytime soon.

As an example, the coporate/business tax structure could be very easily changed to heavily incentivize American business that is in fact mostly American business. Again for example, set corporate tax rates at 1% for US business that are 95% American employees and 95% American content of goods and services. Make corporate tax rates for any corporation less than this say 50%. That would very quickly get US corporations rushing to become "American corporations". But that will never happen, because it would not benefit the politicans, lobbyists, or oligarchs.

The overall point is, America certainly could be much better run for the benefit of the average American and the country as a whole (whether it is incentive taxation, or healthcare, or military, or the stock markets, or anything else for that matter), but it is highly unlikely to ever be done. The reason being that the US is essentially run and has been for a long time for the benefit of the wealthy elite and the political process is part of that.


On Sep 27 11:11 AM user8240 wrote:

> As the author indicates there are both inflationary and deflationary
> forces at work but takes no position on the ultimate resolution or
> outcome. So while somewhat informative, what do we make of this article?
> While many economists concerned with the consequences of fiscal and
> monetary policies that amount to "borrowing our way out of debt",
> see deflation for up to two more years then massive if not hyper-inflation,
> the more likely prospect is another asset bubble in a jobless recovery.
> The policy choices that fit government objectives are gradual depreciation
> of our currency while keeping long term interest rates down to avoid
> more unemployment. The argument that interest rates will rise as
> the Chinese e al stop buying our bonds is not realistic....oh, they
> may decrease purchases but the Federal Reserve has both an infinite
> balance sheet and the Congressional mandate to work toward full employment
> and stable prices (despite the inherent contradiction).
> So, with a declining dollar putting pressure on prices to rise and
> interest rates held steady why would inflation not explode? Because,
> prices are the result of the demand supply equation not just the
> cost to import/produce goods. In a jobless recovery, household income
> won't increase and housing prices will decline in real terms...the
> money won't be there to pay higher prices. Demand for foreign goods
> will fall to offset the exchange rate changes. Until we get a government
> that wakes up to loss of our manufacturing base to China (83% of
> our non oil trade deficit is with China) and stops talking up free
> trade instead of fair trade, inflation or deflation will be the least
> of our problems.

Sep 27 06:49 PM

[Dissenter:]

In my opinion, the Fed would like to see a sustained and stable level of inflation, as much as the economy can handle, to pay down all government, corporate, and personal debt.

Also understanding the underlying economics of whats going on only takes you so far. We don't know what governments are willing to do to each other in the abnormal course of economic warfare and how that will affect us.

Thanks Greg on such an informative article. And commenter User8240 had some great points too about China's end to buying our bonds being unrealistic to think it will cause U.S. interest rates to rise and why inflation will not explode.

Sep 27 08:06 PM

[Asbytec:]

I am of the camp the Fed cannot inflate enough. It can and has increased Fed power money, but that is merely a fraction (was less than 8%) of total global liquidity. That's the money the Fed can directly affect.

If lending picks up again, we'll see liquidity sky rocket. But until then, we just cannot expect to run an economy of the 90's on the liquidity levels of today.

This also speaks to dollar strength, in my view. Less dollars are trying to close a reduced amount of global deals. It's a tricky balance.

Sep 28 09:02 AM

[Asbytec:]

I am of the camp the Fed cannot inflate enough. It can and has increased Fed power money, but that is merely a fraction (was less than 8%) of total global liquidity. That's the money the Fed can directly affect.

If lending picks up again, we'll see liquidity sky rocket. Equities and (newly regulated) derivatives will help and the velocity of money should pick up steam. But until then, we just cannot expect to run an economy of the 90's on the liquidity levels of today.

This also speaks to dollar strength, in my view. Less dollars are trying to close a reduced amount of global deals. It's a tricky balance.

Sep 28 09:04 AM

[user8240:]

Untrusting says, in response to my comment that inflation or deflation is not as important as our trade deficit with China: "one has to assume that over time the standard of living in the US will decline relative to the rest of the world" and asks "Exactly what is it that you think the US government or for that matter even US business can realistically do about it?" but feels "America certainly could be much better run for the benefit of the average American and the country as a whole... but it is highly unlikely to ever be done. The reason being that the US is essentially run and has been for a long time for the benefit of the wealthy elite and the political process is part of that."
Well, I haven't given up and am not willing to go like sheep toward a third world future for the United States.
Untrusting asked me if I favored his five politically incorrect means to solve the trade crisis. The first is noteworthy: "Do you suggest we reduce US average wages to about the $500/month that they are in China in order to compete?". Hello, this is already happening...its the problem not the solution.
Since Untrustworthy asked me what solutions I would favor to deal with the China trade deficit, I advocate:...eliminate the income tax and replace it with the Fair Tax (yeah, I know special interests love tax loopholes) since the overall trade consequences of this measure would be huge....resurrect Senator Schumer's legislation to impose tariffs to offset Chinese currency manipulation, or even better impose Import Certificate requirements on China (which are permitted under WTO rules).
BTW, why not solve our health care issues by putting all ciitzens at birth onto Medicare paid for by a tax on foreign oil. But I digress from the point that deflation vs. inflation is a nice topic to debate but we have more pressing immediate issues (including the national debt) to deal with that are causal to this debate.

Sep 28 10:26 AM

[Jimbo:]

Deflation+Inflation = Stagflation. Taxes and "fees" are rising and will continue to do so. Electricity, milk, bread, and other food items are increasing. The stock market and employment are stagnating.

Sep 28 01:05 PM

[Tony Daltorio:]

Great article, Greg! I believe we will see inflation for two reasons - a large drop in the value of the US dollar and Fed actions.

As Chap08 pointed out, if things get worse, the Fed can, and most likely will due to political pressure, just print up a bunch of money to give to people to pay off their debts. The end of the deflation problem.

Sep 28 03:11 PM

[Spartacuss:]

Deflation has the upper hand for the present as all the bad debt has to be written off. The holders are going to get screwed.

I am certain of this as there is not way to pay off the debt except with fabricated money and fabricated twisted policies by the nincompoops in Washington. Once the monitization gains real momentum we'll start to see the inflation and a whole lot more.

The US has a towering problem, the combined debt both public and private and the unfunded obligations of the government socialist policies. To gain perspective here, we are talking some 90 trillion dollars worth, and then there are the derivatives posited to be over 600 trillion. So, thus far the new monies injected are just a drop in the bucket. No, there is no fiscal responsability as evidenced by adding new social programs invigorating more debt and insolvency.

This author only touches on the peripheral issue, the real issue is going to be about survival when the currency becomes worthless.

Sep 28 08:14 PM

[Gold Bug:]

Deflationist Mish Mike Shedlock Global Economic Analysis at Google Tech Talk
Source :
peterschiffchannel.blo...

Oct 10 06:22 PM

[Elliott:]

Urban myth: the Fed is printing money like crazy. Not true. Go to FRED, the Fed's database, and look at a chart for M2. The total dollars in circulation in 2009 has leveled off after climbing in previous years. Government debt is increasing but total dollars in circulation is not... with high unemployment, there are fewer actual dollars chasing goods. That's why the inflation numbers are so low. With pay cuts, lack of jobs, huge housing price cuts, credit card contraction, etc., deflation is dominant right now. You can't have sustained inflation with a 10% unemployment rate... not enough buyers of goods to push up prices.

Oct 22 03:11 PM