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 and Freddie 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 US 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 US 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 US 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 US 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.
“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.