Inflation Deflation

Will We Have Inflation, Deflation, or Hyperinflation?
This article is presented in four parts. It deals with what I feel is the
primary question investors must now answer: is our future to be
inflation or deflation? The answer has vast implications to our
investment planning and decisions for the near term, and possibly for
our long term. It is a very complex question with a lot of moving parts
involving economics and politics.
Like it or not, it is economic theory that is driving macroeconomic
policies and political decisions that determine whether we will have
inflation or deflation. Since not all of my readers are sophisticated
traders I have tried to present the issues in a direct and hopefully
understandable way. To those sophisticated readers, please bear with
me.
The Problem
The economy is not acting according to plan. At least not the plan devised by the Fed or the
Obama Administration. According to the plan we should have liquidity flowing through the
economy and the credit crunch should be over. In fact we should have moderate inflation by
now. Government likes inflation because it gives the false impression that things are doing
better than they really are: people confuse rising prices and wages with economic gain. As well,
debtors, especially the government, can pay down debt with newly minted dollars. But the
signals from the economy are mixed: mild inflation yet we still have a credit crunch as credit has
continues to contract. Initial enthusiasm for a “recovery” is now giving way to concerns about
deflation.
So what is it to be: inflation or deflation?
The Dispute
There is a rather significant running argument going on in the Austrian economics theory
community about whether we are experiencing inflation or deflation. Further there are the gold
bugs who are predicting, as they have for many years, hyperinflation. The deflationists are led
by Mike Shedlock, known as “Mish” who argues that we are seeing deflation and that it will
continue for some time. The inflationists are a variety of folks, but the loudest voice and
harshest critic of Mish is Gary North. The most credible inflationists are Bob Murphy, a well
known Austrian school economist, and Frank Shostak, chief economist for MF Global, formerly
© Jeff Harding, The Daily Capitalist.

www.dailycapitalist.com
June 24, 2010
the trading arm of Man Financial, the world’s largest hedge fund. They insist that we are seeing
inflation now and that more is coming.
I will side with the inflationists but I think Mish makes some valid points and that his timing
has been good. I would say that some inflationists have been excellent on theory, but less
accurate on timing. I call my position Modified Inflationism.
Predictions: All Signs Point to Yes
It’s easy to make predictions, but difficult to get it right. A recent Freakonomics column in
the NY Times by Stephen Dubner gave this humorous quote on economic prognostication:
The future will be different from the present to some degree and
some point, and I have anecdotes and hearsay to prove it.
My point is that it is not easy to make accurate predictions about the future, and when
intelligent people make them they are sticking their necks out, a brave thing to do, but fraught
with uncertainty which few of them are willing to acknowledge. We need to consider the
implications of randomness in our world where it is hard to know if the prognosticators were
right or just lucky. I am not saying that it is impossible to differentiate between luck and skill,
but that it is very difficult.
I have found that the best economists and prognosticators derive from the Austrian School
of economics, to which I subscribe. These free market gurus stem from a remarkable
intellectual tradition, and are the only ones, I believe, to have created a valid theoretical
background on human social behavior, which, if one thinks about it, is what economics is.
The problem with forecasting inflation is that we need to be able to predict what the Fed
will do under certain circumstances, and how the Fed’s bosses, the politicians, see the world.
With those caveats in mind, I am going to stick my neck out.
What is Inflation?
The first thing we need to understand is what inflation is. It is not rising prices, but rising
prices are an indication and one result of inflation. There are impacts other than rising prices.
Inflation is purely a monetary phenomenon. It is an increase in the
supply of money, assuming that demand for money remains the
same.
If everyone woke up one morning with twice as much money as the day before, then
people would be buying goods at an increased rate and, since the supply of goods aren’t
infinite, prices go up. The fact that we all have twice as much money doesn’t mean we are all
wealthier, it just means that we have more pieces of paper to spend. For those who wish to
understand why our paper money is not wealth, then please see my article, “Money: A semi
Fictional Fable.”
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The greatest problem people have with understanding inflation is confusing it with rising
prices. For example, the argument goes that if oil prices increase it causes inflation because oil’s
use is so pervasive in the economy that it causes all prices to rise. But that isn’t the case. If
money supply remains constant, and if I have to spend more money on gasoline, then it means
that I will have less money to spend on something else. Thus there is less demand for the goods
that I would have otherwise bought and their prices decline. This is a response to supply and
demand of goods: some prices go up, some go down. But it isn’t inflation.
Deflation is the opposite of inflation. All things being equal, if the supply of money declines,
then prices will also decline because there is less money chasing the same amount of goods.
Money Supply and the Credit Crunch
To cause inflation then, we need to increase the supply of money. To have deflation we
need to decrease the supply of money. There are many complexities to the theory and
disagreements within the Austrian community, but I’ll stick with my general definition for the
moment.
This article is not meant to be a treatise on money and banking, but a few concepts are
important to understand.
It is relatively easy to see what money supply is doing. While there are many components
to it, and it is a complex topic, there are measures of money that most people use.
Money base1 is the primary monetary measure of currency in banks and circulating in the
economy, and bank reserves held at the Fed. When the Fed starts pumping money into the
system, this shows up as money base.
1
See the Wikipedia article on the definitions of money aggregate measures.
http://en.wikipedia.org/wiki/Money_supply
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This chart (BASE) shows what the Fed has been doing since the October 2008 crash. As you
can see they doubled the money base, and then increased it again to 2.5X by Q1 2010.
The rate of year-over-year (YoY) change in money base is shown in this chart below. You
will note the volatility as shown by the verticality of the increases and decreases.
This shows how the Fed was countering the contraction in money supply and credit during
the initial stages of the crash. The idea was to provide enough liquidity for financial institutions
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so they wouldn’t go bankrupt. Economists refer to this as “quantitative easing,” (QE) or
monetary stimulus which is a concept of Monetary theory (Milton Friedman and Irving Fisher),
of which Ben Bernanke is a follower. Mr. Bernanke also seems to also be Keynesian in his
acceptance of fiscal stimulus.
The crash, the rapid decline of real estate asset values, and the questionable value of real
estate and consumer loans, led to the credit crunch. As we all know credit dried up, consumers
retrenched, business contracted, loan defaults took off, and only the biggest institutions had
access to credit at the Fed’s commercial paper window (Commercial Paper Funding Facility). At
one point the Fed was responsible for about 90% of the U.S. commercial paper market—almost
$350 billion. Major institutions were also backed up with TARP money.
Money base must find its way into the economy to affect the supply of money. The M1
money supply measure (currency in circulation plus demand deposits) immediately jumped.
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But the problem was that much of this cash didn’t find its way into the economy. Take a
look at what banks did with the new money: they held much of it as excess reserves
(EXCRESNS):
The significance of excess reserves is that it is a good indicator of liquidity in the system.
These reserves are considered “excess” when they exceed the regulatory requirement for the
reserves a bank must hold. As you can see, prior to the crash, excess reserves were nil,
reflecting banks’ willingness to lend.
The reason for high excess reserves was that banks were not lending, for very good
reasons.
First, their own balance sheets were in jeopardy. Their loan losses grew and in order to
meet regulatory requirements, they were uncertain how much capital they would need. Banks
didn’t understand the depth of the crash and the impact of the world’s biggest debt induced
boom would have on their loans. An uncertain future caused banks to pull in their loans in
order to preserve capital. It was obvious that as their loans soured, good borrowers were
harder to find. Bankers respond rationally to uncertainty: protect their depositors and their
loans. If you don’t think a lender will be able to pay you back, you won’t lend money.
Second, they were unsure what the response of the regulators would be regarding capital
requirements, especially what is called Tier 1 capital. It made good sense to hold on to the vast
amounts of credit the Fed was providing in order to hedge regulatory uncertainty.
As I have been saying, there were valid economic reasons for banks to hold large reserves;
there was nothing “excess” about them.
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The impact of high excess reserves shows up as a decline in the M1 multiplier which means
that bank lending collapsed. The M1 Multiplier is the multiplier effect of fractional reserve
banking from an increase in the M1 money supply. If banks only have to keep 10% of deposits
on hand and can lend out 90%, the money effect is multiplied many times. If Bank A has $100 of
new money, it can lend $90 to Customer A. Mr. A spends the money which ends up in Bank B,
thus increasing their deposits and enabling them to lend out 90% of it, or $81, and so on. The
multiplier (10:1) basically turns $100 new dollars into almost $1,000 as it goes through the
economy.
Post crash the M1 multiplier collapsed:
This shows the credit crunch as bank lending dropped off a cliff.
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The below chart of commercial banks loans (TOTLL) shows what happened to loans:
It is easier to see from the YoY percentage change:
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This is the classic credit crunch. No one can get a loan from banks. Large corporations were
able to go directly to the Fed, but most businesses and consumers could not get a bank loan.
Consumer credit, the mother’s milk for consumer spending (70% of GDP) dried up:
When consumers don’t spend, the economy goes into recession.
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Part 2
The Inflation Argument
The argument for inflation rests on the money supply charts. The inflationists show various
measures of money supply increasing, including the version used by Austrian theory
economists, called True Money Supply (TMS)2:
Note: The M1 chart shown earlier more clearly shows the trend in the M1 money supply increase.
2
The True Money Supply (TMS) was formulated by Murray Rothbard and represents the amount of money in
the economy that is available for immediate use in exchange. It has been referred to in the past as the Austrian
Money Supply, the Rothbard Money Supply and the True Money Supply. The benefits of TMS over conventional
measures calculated by the Federal Reserve are that it counts only immediately available money for exchange and
does not double count. MMMF shares are excluded from TMS precisely because they represent equity shares in a
portfolio of highly liquid, short-term investments which must be sold in exchange for money before such shares
can be redeemed. It includes: Currency Component of M1, Total Checkable Deposits, Savings Deposits, U.S.
Government Demand Deposits and Note Balances, Demand Deposits Due to Foreign Commercial Banks, and
Demand Deposits Due to Foreign Official Institutions. There are different takes on TMS. See
http://mises.org/content/nofed/chart.aspx?series=TMS.
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Again, the YoY percentage change is more revealing:
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The inflationists also point to the Consumer Price Index (CPI) which shows price increases:
The YoY rate of change of the CPI clearer:
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As the chart reveals, prices have been rising since mid-2009. Even the measure of Core CPI
(CPI less energy and food, CPILFENS) appears to be rising:
The inflationists would say that this effect of inflation, rising prices, is a classic measure
that proves new money is hitting the economy and that has caused, among other things, prices
to rise.
The Deflation Argument
The deflationists have a different take on the data. They point to theories by economist
Steve Keen which states that first banks make loans, and then the Fed increases money supply
to meet demand. According to Keen and Mish, money supply is created first by banks making
loans, then by the Fed supplying the money, because you can’t increase money supply without
getting it into the economy. If there is no lending the money supply remains unchanged. Thus it
is a rise in credit that leads to money supply growth.
Mish also argues that excess reserves don’t really exist; they are a fiction created by the
Fed, a mere computer entry. If you consider all the loans made by lenders, and the actual or
potential defaults of their loans, those losses would absorb all the “excess” reserves. Therefore,
those “reserves” are more or less spoken for and don’t represent money for making new loans.
Mish also believes that reserves aren’t the problem with banks; rather it is their shaky
capital base. Lending is constrained by their lack of capital and financial instability rather than
by reserves.
The deflationists say that because the size and breadth of the crash in the real estate
markets and related debt, the problem is too big for the Fed to handle. Until debt is
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deleveraged and banks and businesses repair their balance sheets, the Fed’s effort to increase
the money supply is like pushing on the proverbial string.
The result is that real estate asset prices are declining and that results in deflation. They say
it is similar to what the Japanese experienced in the late ‘80s and ‘90s, when they experienced
almost zero growth, no inflation, and declining asset values. Banks, they say, are not going to
lend until this deleveraging occurs and businesses become solvent and creditworthy.
The deflationists say that the current measures of prices are inaccurate because they don’t
reflect the declining values of real estate. If real estate was factored in, then prices would be
shown as declining. The only measure of real estate in the CPI computation is what is called the
real estate rental equivalent which measures the rental value of homes rather than their asset
value.
They suggest that prices are indeed falling anyway if you look at Core CPI (CPI less energy
and food) on a year-over-year percentage change basis:
Obviously there is some evidence of declining prices as shown by this chart.
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Which is it: Inflation or Deflation?
Let me suggest a way of looking at the problem.
We understand that inflation or deflation is a monetary phenomenon, not just an increase
or decrease in prices. And, in order to cause inflation new money must find its way into the
economy.
There are several ways the Fed can do that.
The Fed can make cheap money available by lowering the interest rate on money it lends
out, which increases money supply. Even with the Fed Funds rate at 0.18%, effectively zero, this
doesn’t seem to be working.
The Fed can make it easier for banks to lend. This seems to be a problem for the Fed right
now. As we have seen previously, lending is way down, excess reserves are high, and the money
multiplier has fallen dramatically. This hasn’t worked either.
Yet money supply has been increasing despite the failure of these policies.
There is another tool in the Fed’s arsenal called Open Market Operations (OMO) whereby it
buys and sells securities with its primary dealers. For example, buying Treasury paper from
dealers increases money supply and selling decreases money supply.
Starting in January 2009, the Fed began a program of buying mortgage backed securities
(MBS) issued by Fannie, Freddie, and Ginnie Mae. At its peak, they bought $1.25 trillion of these
assets, pumping up money supply by that amount. The purpose was to get liquidity into the
economy and try to revive credit and economic activity. Further it absorbed the risk of these
“toxic” assets, relieving the former holders of their bad investment decisions.
This form of money inflation does not have the impact of the money multiplier were those
funds in the hands of bankers who would lend out the new money, but it does represent a
substantial amount of new money injected into the system.
This money infusion is being used by the very willing sellers of these toxic assets, the big
investment banks or the investment banking operations of the big commercial banks, not so
much for making loans, but for their own investment purposes; this money has been driving the
financial markets.
Deflationists vs. Inflationists vs. Modified Inflationists
This is the point where the inflationists and deflationists part. The inflationists believe that
the Fed can and will increase the money supply any time they wish through open market
operations. The deflationists believe it doesn’t matter what the Fed will do because banks are
not in a position to resume lending, thus counteracting the Fed’s attempts at increasing the
money supply.
I have a different take on this, but it is a bit complicated to explain. To try to put it in a
nutshell:
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June 24, 2010
A. I don’t agree with the deflationists that we will be just like Japan: continued deflation
which would be the result of keeping alive bankrupt (zombie) banks and corporations.
B. I part a bit with inflationists because I don’t believe Open Market Operations will have
the inflationary impact they believe will occur. I believe that bank lending, the best tool
for inflating money supply, will remain constrained and be a drag on the economy.
C. I believe that as the economy goes into a double-dip decline, the Fed will create ways
to inflate using Open Market Operations that will be effective.
I refer to my position as Modified Inflationism.
Predictions and a Decision Tree
Here is the problem in trying to forecast what will happen in the future: tell me what the
Fed and the government will do. Remember the Freakonomics’ humorous take on forecasting:
The future will be different from the present to some degree and
some point, and I have anecdotes and hearsay to prove it.
Austrian types don’t believe that you can use econometric models to predict the future
because such models are usually wrong. You can’t distill millions and millions of economic
decisions down to a simple or even complex formula of human behavior because the data set is
too vast to be useful. We believe you have to understand why individuals do things in the
economy first before you can study data. These were some of the breakthroughs of the great
economists Mises and Hayek.
To figure out what the Fed might do involves a lot of probabilities. And that is my method
of analysis: what are the probabilities that the Fed will do one thing rather than another when
faced with different circumstances. It is much like constructing a decision tree to see where
they can go. If X happens, then the Fed’s choices are A, B, and C. What are the consequences of
each and what is more likely to happen.
Stick with me.
Part 3
What Factors Will Drive the Economy?
This is the point where we need to look at some long-term trends in the economy to see
how they will impact a recovery.
If our economy is based on consumer spending (70% of GDP) then GDP will see a decline in
the second half of 2010.
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In my article, Economic Megatrends That Will Drive Our Future, I point our seven
megatrends that will impact our economy for the long term:
1. The culture of consumption is broken and won’t return to former levels. This is the
key to everything.
2. Consumers will continue to increase savings to prepare for retirement.
3. Declining U.S. consumer demand will continue to negatively impact the world
economy.
4. Deflation (deleveraging) will continue for some time.
5. Home ownership rates will decline to more historical levels of, say, around 66%,
down from the high of 69% during the boom, which will keep a lid on home prices.
6. Government stimulus and recovery programs only delay recovery and deepen the
pain for workers.
7. Massive federal deficits will double the national debt, result in higher taxes, and will
act as a permanent drag on the economy.
I wrote this article in September, 2009, and it still stands. The significant things to note are
No. 1 and No.2. Consumers are over-indebted and are doing their best to pay down debt. This
article from the Wall Street Journal defines the issue:
After years of bingeing on debt, U.S. households are paring back.
Those not doing so by choice are often being forced, because lending
standards remain tight.
[T]he household sector's debt level, which includes both consumer

credit and mortgage loans, remained at about 20% of total assets in
the first quarter.
In the mid-1990s that ratio was around 15%, compared with a peak in
the first quarter of 2009 of about 22.5%.
Just getting debt down to 18% would require households to shed an

additional $1.4 trillion of debt.
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The way to pay down debt is to decrease spending and increase savings, especially when
unemployment is at 9.7% and when real wages (inflation adjusted) have been essentially flat:
J. M. Keynes referred to the phenomenon of increased savings and reduced spending as

“hoarding” by consumers and believed it harmed the economy, which is why, he said, the
government needs to spend in their stead. In fact, what consumers are doing is very rational
economic behavior in light of uncertainty. Savings will actually lead the economy out of the
recession by creating new capital to fund an economic expansion.
The main point here is that the consumption cycle for the majority of big spenders, the
Baby Boomers, has changed, in my opinion, permanently. Boomers now realize that they need
to save for retirement because Social Security won’t be enough, they don’t have enough
financial assets, their home values will not regain their former highs, and they won’t inherit
enough from their parents to help them in their old age.
This has significant impacts on the recovery and the inflation/deflation issue. That is
because the politicians making policy decisions believe that Keynes is right. I’ll discuss this later.
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Is Credit Unfreezing?
Recently lending has increased and excess reserves have decreased. Some have suggested
that this is the beginning of the end of the credit freeze but I disagree.
This chart (TOTLL, YoY) reveals an increase in lending by commercial banks in Q1 2010:
This corresponds to a like decrease in excess reserves (EXCRESNS) during the same period:
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This lending is evidenced by an increase in consumer loans in Q1 2010 (CONSUMER):
What happened was that consumers went on a mild spending spree. I believe that almost
all of the increase in consumer spending had to do with government fiscal stimulus: Cash for
Clunkers, Cash for Appliances, and the home buyer credit which has spurred sales in home
improvement goods.
New car sales have been doing better as a result of dealer incentives. The data show that
nonrevolving loans (NREVNCB), the measure for (mainly) auto loans (up 7.1% in April), went up
dramatically in Q1 2010:
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Retail sales increased during that period, but now it is declining, much to the concern of
the Fed.
The latest Fed Flow of Funds report showed renewed declines in total credit as well as
consumer credit. For Q1 overall household debt decreased for the seventh consecutive month
(-2.4%). Consumer credit contracted 1.5%. Nonfinancial business debt was flat after four
months of declines.
The Report said revolving credit, or credit-card use, fell a 19th straight time in April, down
12.0%. Further, personal savings are increasing again after the drawdown.
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It appears that the temporary increase in consumer spending was not related entirely to
money supply increases. Nonrevolving loans for autos increased, but a significant portion of
general spending was fueled by personal savings of consumers. The following chart reveals that
the rate of consumer savings (PSAVERT) declined in response to government incentives which
favored certain industries (mid-2009 to Q1 2010). Personal savings appears to be rising again,
but we will need to watch the data to confirm such a trend:
The Fed’s Problem

The Fed has a dilemma.
On the one hand, if they believe we are in a strong recovery, then they are worried about
inflation.
There was a lot of talk about recovery and the problem of what will happen when banks
start lending again: banks will use their huge excess reserves which would cause money supply
to explode, thus fueling “inflation” which they define as rising prices. This is what has been
popularly referred to as the “draining the pond” or the “exit strategy” problem: how can the
Fed sop up excess reserves before they hit the economy and cause rising prices? It is a very
serious issue.
The Fed closely monitors CPI and, as shown before, prices are growing at the rate of 2%
YoY. (I’ll discuss signs of a decreasing CPI rate below.) If they decide to decrease the money
supply by raising the Fed Funds rate from nearly zero percent, they believe they run the risk of
jeopardizing the nascent recovery.
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For many months now most of the discussion by the Fed and most economists concerned
exit strategy. Now the discussion has changed almost 180°: the buzz is now all about the
possibility of deflation and economic decline. (See discussion below.)
For these reasons, I don’t think they are that concerned with inflation for the near term.
The Implications of a Double-Dip Decline
Temporary Effects of Stimulus
I think the economy is headed for a decline commencing at some point in the second half
of 2010. I believe the Fed is concerned about this as well. Evidence of this is starting to show up
in the numbers. The reasons for this are complex, but:
1. Most of the economic gains have been the result of fiscal stimulus which is running out
of steam.
2. There has not been sufficient deleveraging in the economy by which banks have
repaired their balance sheets.
3. The remaining huge real estate debt hanging over banks, especially commercial real
estate, has not been dealt with because of various government policies that postpone
the inevitable write-downs (mark-to-make believe, extend and pretend, housing
credits, and delay and pray) and will restrict lending.
4. Monetary stimulus has failed to create viable economic growth.
5. These facts inhibit the creation of credit and will act like an anchor on the economy.
6. The long-term megatrends mentioned before will reduce economic activity and cause
major shifts in the economy.
There is no question that consumer spending has been stimulated by government
programs. Those programs are now coming to an end. Recent data as shown above reveals a
decline in retail sales surprised most economists.
The Wealth Effect
Another factor is that the stock markets have had a positive impact on families’ perceived
wealth which has helped consumer spending. But, it appears that most of such spending has
been from the wealthier segment of the economy. A recent Gallup poll showed that consumers
earning more than $90,000 accounted for the bulk of that spending increase. A market stock
decline will reduce this wealth effect.
Manufacturing Recovery
I believe our manufacturing recovery has been a result of cyclical factors unrelated to
stimulus programs. As nervous retailers and wholesalers cleared out inventories in the early
stages of the recession, at some point they had to restock. While unemployment is high, the
fact is that at least 80% of the work force have jobs and, even though they may feel insecure,
they still spend on what is necessary. That boosted manufacturing. But manufacturing without
renewed consumer demand and a revival of credit will not lead us out of the recession.
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Also, manufacturing has been benefited by the cheap dollar which has boosted exports.
Other countries, especially developing countries, have been buyers of US products. But I think
this is changing because of:
1. The dollar’s rise caused by Europe’s deep economic problems will reduce our cheap
dollar advantage; and
2. China’s economy is based on exports and declining US and EU economies will impact its
growth. Further they are facing a serious housing bubble that will burst the hard way.
China needs an American economic recovery to save them, not vice versa.
It is clear that the American economy headed for a double dip decline, which I believe will
occur in the second half of 2010.
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Deflation Fears
I have noticed in the mainstream media that with increasingly weak numbers coming out
recently there is a lot of talk about deflation. This is important because it is a reflection of
mainstream economic thinking, which includes the Fed. Ben Bernanke reads the same
headlines as you and I do.
Here are some recent headlines and a summary of some of them and the issues they raise:
CPI Declines
The consumer price index dropped 0.2% last month, the Labor
Department said. The "core" rate of inflation--underlying consumer
prices, which strip out volatile energy and food items and are closely
watched by the Fed--rose 0.1% in May. …
This concerns shows up in Core CPI YoY (CPI less energy and food):
Deflation Fears Stir in Developed Economies

Deflation makes it harder for consumers, businesses and
governments to pay off debts. Principal repayments on debt are fixed
but deflation is marked by falling incomes, so as deflation sets in the
burden of paying off old debts gets greater. …
That's an acute worry today. In addition to government debt, U.S.
households are still trying to work off large debt burdens built up in
the last two decades. A Federal Reserve report Thursday [Flow of
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Funds report] showed households cut their borrowings in the first
quarter to $13.5 trillion, down from a peak of $13.9 trillion in 2008.
Bernanke Warns on Deficits
Deflation isn’t a concern at moment
Bernanke Calls for Deficit Plan
Advancing a theme he has emphasized in the last few months, Mr.
Bernanke said that if Congress pursued more fiscal stimulus to sustain
the recovery, it should be accompanied by a concrete plan to bring
the deficit back into line in the long run. Without a fiscal "exit
strategy," he said, the U.S. could, "in the worst case," see financial
instability like in Greece.
The Congressional Budget Office projects the U.S. deficit will hit $1.4
trillion this year, or 9.4% of gross domestic product. Even as the
economy recovers, it projects deficits in excess of $400 billion a year
later this decade.
Bernanke Urges Deficit Cuts
At a moment when many economists warn that the American
economic recovery is likely to be imperiled by prolonged high
unemployment and slow growth, President Obama is discovering that
the tools available to him last year — a big economic stimulus and
action by the Federal Reserve — are both now politically untenable.
Fed Weighs Growth Risks
But fiscal woes in Europe, stock-market declines at home and
stubbornly high U.S. unemployment have alerted some officials to
risks that the economy could lose momentum and that inflation,
already running below the Fed's informal target of 1.5% to 2%, could
fall further, raising a risk of price deflation.
Martin Wolf on the Danger of Deflation
There is no world economy big enough to offset renewed contraction
in Europe and the US. Concerted fiscal tightening could, in current
circumstances, fail: larger cyclical deficits, as economies weaken,
could offset attempts at structural fiscal tightening. …
Policymakers must recognise that deflation is a risk, too, and that
tighter fiscal policy requires effective monetary policy offsets, which
may be hard to deliver today, above all in the eurozone.
Premature fiscal tightening is, warns experience, as big a danger as
delayed tightening would be. There are no certainties here.
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S&P Warns of Rising Corporate Defaults
Small banks are big problem in government bailout program
Business Hold Record Amounts of Cash
The Federal Reserve reported Thursday that non-financial companies
had socked away $1.84 trillion in cash and other liquid assets as of the
end of March, up 26% from a year earlier and the largest increase on
records going back to 1952. Cash made up about 7% of all company
assets including factories and financial investments, the highest level
since 1963.
You get the drift: the economy is not going as the Fed and most economists have predicted
so naturally they talk about deflation. They are worried about the possibility of experiencing
deflation similar to what occurred in the Great Depression.
Why Most Economists Have it Wrong
Most economists believe that more fiscal stimulus is needed now and that Bernanke’s cries
for fiscal sanity must not be heeded or we will sink into a depression. This is a normal Keynesian
reaction to the world. In fact the arch knee-jerk Keynesian of our time, Paul Krugman’s last
three editorials have spoken to this issue. Across the pond Martin Wolf of the Financial Times
has been beating the same drum.
I wish they would explain why all the fiscal and monetary stimulus the government has
done since October, 2008 hasn’t worked yet. Krugman would just say government hasn’t spent
enough. But then he always says that. Perhaps he should read some of Rogoff and Reinhart’s
research on what government debt does to a country’s ability to recover. The fact is fiscal
stimulus never works and never has. But it will leave us saddled with huge debt.
It would be a mistake to credit government spending on fiscal stimulus projects for any
lasting economic gains. Since the government can ultimately only obtain money from
taxpayers, it is only a shift of capital from individuals (i.e., the folks that make the economy
function) to the government to fund projects it deems politically beneficial.
Government fiscal stimulus projects do not create any lasting economic benefit. While it is
true that new roads and safe bridges benefit the economy, that is not the purpose of fiscal
stimulus. The purpose of fiscal stimulus is to create “jobs” and stimulate consumer spending.
Such stimulus is wasteful and never creates a viable economic enterprise which would continue
after the money dries up.
One must ask what the private economy would do with the $62 billion already spent
through the American Recovery and Reinvestment Act ($202 billion contracts, grants and loans
awarded to date). I urge anyone who believes the spending through ARRA would stimulate the
economy to check out the various contracts and grants that are being awarded. The main web
site is Recovery.gov. You will see that most are repairs to federal facilities or grants for federal
programs. I recommend you hold your nose while doing this. They are outrageous wastes of
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June 24, 2010
your tax money and they will damage the ability of the economy to recover and will place a
great burden on future generations to pay them.
If government spending were the key to economic wealth then we should all be rich.
Part 4
What is Money Supply Doing Now?
Money supply will tell you if we are headed for inflation or deflation. If we look at the rates
of change of M1 or Austrian TMS, they are declining. In fact, M1 and TMS appears to have
peaked in 2009 and have been declining on a year-over-year basis ever since. On an absolute
basis, as shown previously, M1 growth is flattening. These two charts below show the year-
over-year percentage change in money supply.
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June 24, 2010
What Will the Fed’s Options be in a Double-Dip Economic Decline?
This is the main point. If, as I have been saying, the economy declines in the second half of
2010, what will the Fed do?
Let me paint a scenario. In any scenario with declining economic growth, unemployment
will rise. If unemployment at the narrowest measure is now 9.7% and at the broadest measures
(U-6) is 16.9%, rising unemployment will become politically unacceptable to the Obama
Administration.
I believe the politicians will first take Paul Krugman’s advice and extend existing stimulus
programs and create new ones to spur spending. All the talk about fiscal sanity and deficit
warnings will be forgotten as politicians on both sides of the aisle panic. Look for further
extensions of the home buyer tax credit program, and other programs that politicians believe
will help businesses in their districts. Cash for [Your Industry Here] will be the byword. It will
increase federal debt much further.
On top of all this, the politicians will hammer Bernanke to create jobs. But how can he do
that? He will try to inflate.
The Fed has limited options in such a case. They can’t reduce the Fed Funds rate any
further and they can’t force banks to lend. It is likely that banks will further restrict credit as the
economy declines.
I think their only viable option is to use Open Market Operations (OMO) to inject new
money into the economy. The question is: what will they buy?
30
June 24, 2010
From January, 2009 to April, 2010, the Fed acquired $1.25 trillion dollars of mortgage
backed securities (MBS) through OMO purchases. The only problem is that it didn’t do much for
the economy. Most of the OMO money pumping has been going into the hands of the big
financial institutions which has been driving the financial markets. It is no coincidence that
Goldman Sachs had 63 perfect trading days in Q1. It is no coincidence that New York
restaurants are recovering nicely.
There is a theory called the Cantillon Effect which says an increase in money supply doesn’t
affect all prices equally: money flows initially into some assets and the inflationary effect is
borne by later by consumers who get no benefit from the new money, only the burden of
higher prices. Such an effect may have occurred when the Fed bought MBS from dealers which
resulted in cleaner balance sheets and high profits for the big banks and left consumers with
slightly higher prices. But I recognize that this idea is conjecture on my part. But, as I pointed
out above, OMO money pumping doesn’t have the same multiplier effect as lending by banks.
There are two other choices the Fed may consider in its Open Market Operations. Neither
alternative is good:
Alternative No. 1. Buy bad CRE loans (non-MBS) directly from regional and local banks.
If it buys CRE debt from smaller banks, it would compound the problem it already has
with MBS purchases. That is, it is unlikely they could sell these assets for what they paid.
The positive effect, if there is one, is that banks would more quickly repair their balance
sheets and regain financial health. This would then allow them to raise needed Tier 1
capital and commence lending to viable businesses (this is a big “if”). But it may appeal
to the Fed. They recognize, as good Keynesians, that they need to get the smaller banks
lending again to spur the economy and create inflation.
This of course ignores the “moral hazard” caused by bailing out troubled banks. But I
don’t think there is a lot of political sentiment to allow massive bank failures. And the
political pressure on the Fed to “do something” will be intense.
The question still remains, that if these banks are artificially restored to health, would
that lead to economic expansion? In my opinion it will lead to a “bomb-bust” cycle
(economic stagnation and inflation).
Alternative No. 2. Buy Treasury paper which would have the effect of monetizing Federal
debt (the government prints currency to pay for its own debts).
The monetization of federal debt on a large scale basis would most certainly increase
the money supply. The downside is that it would cause greater economic distortions
than if they bought bank CRE debt because the effect would be to fund wasteful
government projects.
Further they still have the problem of getting banks to lend and if they just buy Treasury
paper from these small banks, they will sock the cash away at the Fed as excess
reserves.
31
June 24, 2010
Will Inflation Be the Effect of the Fed’s Action?
In either alternative or a combination of the two, we would have inflation because money
supply would increase. How much inflation depends on how much cash is injected into the
system. Such inflation would eventually cause another artificial business cycle that would
further damage the economy by destroying more capital as the new money is misdirected into
businesses that would not be otherwise viable but for the effects of inflation. This is called
“malinvestment.” We are presently seeing the results of malinvestment in real estate assets.
This new cycle will be less of a boom and more of a bomb. This is what happened in the
1970s when the CPI went sky high yet economic activity stagnated. Stagflation was the term
devised to describe it.
The problem is this: how many times can you destroy capital before you have jeopardized
the ability of investors and entrepreneurs to create new profitable businesses?
Real wealth as I discussed before, is not a piece of paper. It is goods produced that are not
consumed. (See my article, “Money: A semi Fictional Fable.”) Money is just a way of holding
wealth until you wish to consume something. If I am a factory owner producing silicon chips for
Apple, and I save some of my profits rather than spend all of it, those savings are real capital.
The problem is that it is difficult in our complex economy to measure “real capital.”
Some Austrians believe a decline economic activity is indicative of a decline of real capital. I
would agree that is probably the case, but, I would agree the last two cycles have been
destructive of real capital. I do know that more pieces of green paper will not solve the
problem. More pieces of paper will only result in rising prices.
This is where I believe the deflationist argument fails. The deflationists believe we will have
years of deflation because of the credit freeze. While I understand the similarities with the
Japanese experience (massive fiscal stimulus, zero interest rate policy, low inflation, and
stagnation) I believe the situation will be different here.
The difference is that we are cleaning up our mess whereas the Japanese, perhaps because
of cultural reasons, let bankrupt companies and banks stay alive. This tied up capital in
unprofitable businesses (malinvestment), and new capital was not able to be directed to
entrepreneurs and profitable companies.
While we may be going at it slowly, America has a rich tradition of failure, foreclosure, and
bankruptcies which acts as a cleansing mechanism to rid the economy of malinvestment. This is
what Joseph Schumpeter referred to as “creative destruction,” or the process by which
capitalism corrects its mistakes. This process is occurring here, but the problem is that the
process is being slowed down by government policies that prevent bankruptcies (mark-to-make
believe, extend and pretend, delay and pray, and TARP, TALF, and housing subsidies).
Further, as pointed out by economist Bob Murphy, we haven’t seen deflation yet, or at
least it has not been reflected in the CPI. In fact, he says, we haven’t had deflation since the
Great Depression.
32
June 24, 2010
At some point the increase in money supply will be effective, especially if the Fed buys CRE
debt. I don’t agree that deflation is a decline in real estate asset values. I believe they conflate
deflation and deleveraging. I agree with the deflationists that deleveraging and the decline in
real estate values will suppress economic activity because of the reasons I have previously
discussed, but it isn’t deflation.
I think we are seeing current declines in money supply growth as a response to the Fed’s
cessation of MBS purchases. It is possible that we may go into negative territory which would
be deflation, but, with evidence of a double-dip economic decline, the Fed will do everything it
can to re-inflate.
When the cleansing process is completed, then growth will restart. In the meantime, we will
suffer stagnation and inflation.
Will We Have Hyperinflation?
Is hyperinflation possible in America? The proper question to ask is if it is probable. To that
question I would say no. Hyperinflation would result in the destruction of our monetary system
and Ben Bernanke and just about everyone at the Fed and the Administration’s economic
advisors understand this quite well. I believe they understand the mechanism of printing money
as the cause of hyperinflation.
I am also aware of the implications of runaway Federal debt and the political choices the
government has to pay it: higher taxes and/or inflation. The third method to pay it would be a
thriving economy caused by a reduction of government’s heavy hand, but free market
capitalism is out of favor right now.
To prevent runaway inflation the Fed would raise interest rates, increase reserve
requirement and sell assets to stabilize money supply. The hit to the economy would be worth
the risk. This is essentially what Volcker did back in 1979-1980. If it really got rough, price and
wage controls would be instituted on a temporary basis to cool things down. I am fully aware of
the implications of such controls as is Mr. Bernanke. But it would politically acceptable on a
temporary basis. That famous Republican, Richard Nixon, did this in 1971. We all understand
that such controls only further distort the economy because only market prices enable us to
make economic decisions, which is why such controls would be short lived.
33
June 24, 2010
Summary
1. Inflation or deflation is a monetary phenomenon. An increase in money supply causes
inflation. A decrease in money supply produces deflation. (Ceteris paribus.)
2. Price increases are a result of inflation, not inflation itself.
3. The Fed has been trying to inflate the money supply to end the credit crunch.
4. The Fed’s inflation efforts have been mixed. Most banks are still not lending and credit
and money supply have been declining.
5. Banks are not lending because their balance sheets are loaded with bad CRE debt which
has caused them to be concerned about their financial viability.
6. The government has enabled banks to postpone the inevitable write-downs of bad debt
which has drawn out the credit crunch and has impeded economic recovery.
7. Monetary stimulus has been achieved by the Fed’s Open Market Operations which has
injected almost $1.25 trillion of new money into the economy.
8. The impact of such stimulus has served to benefit the large money center financial
institutions, and does not appear to have aided liquidity or to have stimulated
economic growth other than the financial markets.
9. Government fiscal stimulus has had little positive economic impacts on the economy,
and, as the effect of government spending winds down, we are left with wasteful
spending of no lasting economic benefit and high public debt.
10. Recent increases in consumer spending and consumer lending are temporary blips
caused by government stimulus programs and are having no lasting effect.
11. Money supply has increased since the October, 2008 crash, but there are signs that it is
beginning to decline again.
12. While the CPI has been increasing, increases are modest and are a result of the Fed’s
less inflationary OMO purchases of MBS.
13. The current trend of the CPI seems to be declining.
14. It appears that economic activity is slowing down as stimulus runs out and money
supply declines, and that we are headed for a double-dip recession or decline.
15. Until banks’ balance sheets are cleaned up by resolving the overhang of bad CRE debt,
they will continue to restrict credit and thus constrain the growth of money supply.
16. The deflationists’ analogy to Japan’s experience from 1989 to 2003 is only partially
applicable. The American tradition is to allow banks and businesses to fail.
17. This cleansing process is ongoing but is slow because the government has given banks
incentives to delay the process.
18. The deflationists have yet to show that deflation has occurred as they say. While asset
values are declining, mainly real estate assets, money supply has not crossed the
deflation Rubicon yet.
19. The deflationists seem to conflate the concepts of deflation and deleveraging, which
aren’t the same things.
20. A double-dip recession will put political pressure on the government to take any steps
they can to thwart the decline.
34
June 24, 2010
21. An inevitable increase in unemployment will be politically unacceptable to the
Administration and Congress.
22. The government will renew attempts at fiscal stimulus on a grander scale.
23. The Administration and Congress will put pressure on the Fed to counteract the
decline. All politicians and most Keynesians and even Monetarists believe that price
inflation is preferable to price deflation.
24. Inflation destroys real capital which will limit future economic growth.
25. The Fed has limited options to create inflation but they will attempt to do so by
injecting money into the system through OMO.
26. One option is to buy Treasury paper, thus monetizing federal debt, which will ultimately
create price and monetary inflation.
27. Another option is to buy CRE debt from smaller banks to clean up their balance sheets
and allow them to resume lending activities and expand money supply which will result
in inflation.
28. The problem will these alternatives is that they will serve to reduce economic growth
while at the same time create inflation, which is called stagflation.
29. If inflation gets out of hand, it is probable that the government will impose temporary
price and wage controls while they counteract inflation through increased interest
rates.
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June 24, 2010

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Will We Have Inflation, Deflation, or Hyperinflation?

© Jeff Harding, The Daily Capitalist.

It is easier to see from the YoY percentage change:

When consumers don’t spend, the economy goes into recession.

The YoY rate of change of the CPI clearer:

Obviously there is some evidence of declining prices as shown by this chart.

[T]he household sector's debt level, which includes both consumer

Just getting debt down to 18% would require households to shed an

J. M. Keynes referred to the phenomenon of increased savings and reduced spending as

The Fed’s Problem

Deflation Fears Stir in Developed Economies

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