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Paul Krugman is wrong. (Wow that was exhilarating to say. Let’s see if I can prove an exception to Delong’s Two Rules of Krugman.)

The major, world threatening “flation” problems are not likely to destroy us with Stagflation or Hyperflation and are only tangentially related to simple Deflation as measured by the GDP deflator. They are much worse.

Krugman spends a lot of blogging time trying to debunk hyperinflation, an event which even its supporters claim is years in the future. Krugman has been caught by what salesmen call the “Fool’s Choice” where a question is framed so that the real issue is excluded and discussion is in choices favorable to his opponents.

Looking at what got us in this mess identifies the real danger: The current crisis was caused by dropping values for leveraged physical assets, primarily real estate and commodities. Existing assets are not directly part of the government’s inflation/deflation calculation so the effects of major existing asset “flation” (AKA: Ex-asse-flation*) are not well reflected in the GDP deflator. Significant negative Ex-asse-flation causes a crisis in the financial system which basically stops world commerce. Economists partially recognize the problem as “debt deflation” since it was defined by Fisher in 1938 but it is not something that politicians or the general public have the tools or training to understand.

Krugman argues as if all deflation is the same – it’s not. For example deflation in stock prices does not necessarily lead to economic crisis or recession. As the saying goes, "The stock market has predicted nine of the last five recessions."

When the drop in leveraged physical assets got to the point that it caused a financial crisis that harmed the productive sectors, the world’s governments started a massive stimulus program to try to reignite inflation and halt the drop in asset values. Let’s call this Stimu-flation***.

Because we’re currently in a period of economic feudalism** the actions designed to cause stimu-flation were not effective at reigniting lending, which Minsky theorized was the key to growth and asset appreciate/inflation. Instead, basically the same thing happened as in 2002-8: very low interest rates and loose regulation resulted in highly leveraged speculative bets being made on physical assets. Because real estate has flatlined and is radioactive as far as securitization goes, speculation has attacked commodities where there is a basic demand that can be played with.

The inflow of funds from this speculation has resulted in the price of commodities appreciating far above underlying demand. Let’s call this Specu-flation****. Conspiracy theorists please note that corn has not had a speculative rise, possibly because of the political fallout when people could not afford to eat in 2008.

It’s pretty easy to prove Specu-flation has occurred. In 2009, US oil increased in price over 100% from $37.44/bbl to $75.45/bbl while world oil consumption dropped 2%, production exceeded demand and inventories remained at historic highs.

The problem with Specu-flation is that, as the guys at the Daily Reckoning say, “high prices are the cure to high prices.” High prices mean increased production and lower demand in the near term. When there is no buyer for the last barrel of oil and there is no place to store it then the game is over for leveraged speculators.

Krugman has missed the importance of how much of current inflation is caused by speculation and even stated that the rise in the price of oil may be due to constraints in production. Production constrains don’t seem likely as oil inventories rose for most of 2009 in tandem with the price rise.

In any case, removing either production constraints or speculative demand will result in an oversupply of commodities and a drop in the price unless there is a rapid increase in economic demand. The drop in commodity prices could result in another financial crisis if it causes another collapse in leveraged financial companies.

Definitions:

* Ex-Asse-Flation is changes in value to existing assets. When demand-driven the result is the development of economically viable substitutes and can be positive to economic growth. When asset inflation is caused by speculation, the result is bubbles which eventually deflate, often with negative effects.

** Economic Feudalism is where a central government does not have the power or the will (in the case of “free market” adherents) to control powerful companies, which proceed to act in their best interests even at significant cost to the country. In this situation countries like China with strong central governments will grow at the expense of “free market” countries.

*** Stimu-flation is inflation deliberately caused to help increase economic growth and employment.

**** Specu-flation is asset price changes caused by speculative activity. While specu-flation usually occurs when demand is rising, It is most easily recognized when prices rise in the face of falling demand and rising inventories, such as for oil in 2009.

Disclosure: No positions for this post

Source: Hyper, Stag or De-Flation?