This page has been archived and commenting is disabled.
The Problem With Rosie On Inflation
From The Daily Capitalist
Before I start I wish to say that I highly respect David Rosenberg at Gluskin Sheff, one of the few mainstream economists to call the crash, and whose observations about the markets are always worth reading.
This morning he came out with a long-term analysis of inflation which I don't think is right. I urge you to read his commentary, below, but in general he sees one to two years of continuing "deflationary" pressure that favors the bond market and he says "inflation" will be at zero. He then see the beginning of "inflation" as the result of war and the need of government to fund it. The result, he says, will be high inflation and perhaps hyperinflation.
While you would think as a fellow doom and gloomer I would hop on his bandwagon, but for the most part I think Rosenberg's analysis of the forces behind inflation and deflation are wrong. He uses historical analysis to prove his point, but he doesn't explain the underlying factors that cause inflation or deflation, which, as I have discussed before, have to do with increases and decreases of money supply by the Fed.
He assumes that Boomers will cut back on consumption and increase savings. I agree and I went into detail on that in my Megatrends and other articles. He says that will result in "deflation." But deflation is a monetary phenomenon, not a savings problem or lack of consumption problem. We will see deflation because money supply is declining, and it has been declining since late last year.
Rosenberg conflates increases and decreases in prices with inflation and deflation.
Let's use hypotheticals to analyze this.
Assume we have an economy with a fixed supply on money.
Hypo 1: Assume that from technological advances, the cost of consumer goods decline. That is, people spend less on goods than they previously did. Rosenberg assumes that is deflation. In fact it is a supply and demand factor resulting from economic competition. It doesn't result in a decline of consumer spending. Since consumers have more money to spend on goods because of technological efficiencies they will spend more and the economy expands.
Hypo 2: Assume that Boomers, formerly big spenders and a significant part of the consumer market, now decide to cut back spending and save more. Retailers will see sales decline. They will lay off workers, have sales to reduce inventory, and hope for the best. It would be safe to say that retail goods will decline in price until supply meets demand. That's not deflation; it is a supply-demand issue.
You have to ask: what happened to the money Boomers didn't spend? Was it just locked up in the bank? No.
By saving, Boomers are saying, "We don't wish to buy stuff right now and we will save our money for future consumption." They plow money into savings accounts. As a result, interest rates decline because of the influx of Boomer cash into banks. Since consumer goods aren't selling, that sector of the economy won't borrow. What happens is that the manufacturers of industrial production goods, or goods that take a long time to make (such as homes), see the opportunity and borrow at the cheaper rate. They spend the money on commodities, machinery, technology, and labor. As the money spreads through the economy, eventually, consumption picks up, manufacturers and retailers of consumer goods see that and order consumer goods. Money is diverted from industrial production to consumer production. This is how recoveries begin. Some prices increase because of demand, others don't. It's not inflation. In inflation all prices rise over time because new money, money created out of thin air, is pumped into the economy.
Hypo 3: Assume all of a sudden everyone has $200 in their pockets rather than $100, does that make us wealthier? No. The amount of goods hasn't changed but we have more pieces of paper chasing them. This is just an increase in money supply. No new wealth was created. One of the results of an increase in money supply (inflation) is that prices go up. If the government could make us wealthy this way, why not just print money? Who needs to be productive? Price increases are not the only result of inflation; many things occur that distort the economy and lead to booms and busts.
Rosenberg associates our current "deflation", or as he sees it, declining prices, with lack of demand. He never mentions money supply. He assumes that we had low "inflation" in the last several decades because globalization and technology reduced production costs and reduced prices. That is like saying that since computers are dirt cheap today because of competition, that is deflation. No, it is a factor of supply and demand.
He then says that "deflation" will end when the government sees the need to fund its wartime expenditures. He says, "Increased credit demands to fund the war effort combined with the drop in productivity that goes along with blowing everything up is an inflationary stew." He then says that, as families and the government rebuild their balance sheets, then you'll have inflation.
I am not sure what he means here. If the government borrows more, there is a crowding out effect which makes credit more expensive for businesses. That would make it more difficult for the economy to expand. But this has nothing to do with inflation. According to his theory this would all lead to less consumer demand because of the resulting decline in GDP and that would be "deflationary." This is a Keynesian view of the economy.
When you do have inflation is when the government prints money to pay for their expenditures because they feel they can't tax folks more without getting voted out. The influx of fiat money is inflation. It doesn't have to be war. It could be the massive entitlement and spending programs recently created by the Bush and Obama Administrations. They borrow to pay for it, but taxes will pay it back. They favor inflation because it makes debt cheaper.
The nice thing about Rosenberg is, that despite his errors, his timing on deflation/inflation might be pretty good. Money supply is now declining which is deflation. In my Inflation-Deflation article, I suggest that since money supply leads the economy by 6 to 9 months, we'll have deflation and deleveraging will continue. When the Fed is convinced that GDP is declining, then they will pull out the stops and hit the "print" button through Open Market Operations which eventually will lead to an increased money supply and inflation. This monetary inflation will take another 6 to 9 months to impact the economy. So he may be right for all the wrong reasons.
It's rather disappointing to see this kind of analysis from an economist I admire and follow.
Here is his article: Breakfast with Dave, July 28 , 2010. Tyler Durden excerpts Rosenberg's article here.
»
- advertisements -
Thank you for your comment.
You are looking at the wrong thing. While Base has increased, money supply has declined. Check out excess reserves (EXCRESNS) and you'll see where the cash is. It's not circulating in the economy. Money supply is now declining and has been doing so since about 12/09.
+ 10,000 ATG!
Dead on. Basic concept and it amazes me that everyone leaves out velocity. We tripled the monetary base in an attempt to make up for crashing velocity - given we are still obviously deflating even given some speculative activity in markets and government binge indications, it's not enough to compensate for the hit to velocity.
In 2006 around 70% of all lending/credit (velocity) was shadow bank system/securitization. Traditional bank lending when standards were lowest and balance sheets assumed solid was roughly 30%. Well the shadow bank system is wiped out and the remaining 30% is under massive stress. Combine that with lower demand for funds as well as destruction of previously created credit/debt deflation and you start to get an idea of how much velocity was suddenly taken out of the system. If money supply was constant we'd effectively need to reprice the entire system and we are still headed in that direction albeit much more slowly.
Very very hard to fix velocity.
In regard to this comment: "Since consumer goods aren't selling, that sector of the economy won't borrow. What happens is that the manufacturers of industrial production goods, or goods that take a long time to make (such as homes), see the opportunity and borrow at the cheaper rate. They spend the money on commodities, machinery, technology, and labor." - everything eventually comes down to the consumer/population even government is simply pulled forward demand through debt on future tax revenues. This is why velocity is so hard to fix when you are in a balance sheet recession that affects such a broad swath of the people.
Austrians call it Time Preferences. At some point, people will spend their savings and bank are willing to lend to make money. When this happens, the tripling of the money supply will will have its vengeance.
Maybe those dollars that starts the spending spree won't come from Americans, but the Chinese who are sitting on piles of Dollars. At some point they will demand real stuff for their paper dollars.
The crash of the dollar will happen...
I agree with your comments Slim. I compare what's coming to the Indonesian tidal wave. The undersea earthquake caused a shift/drop in the floor and the waters flowed out to sea. When the floor was shifted/raised the waters flowed inshore and wiped everyone out.
Rosie has it right. We are seeing dropping or low velocities as everyone sits tight in something of value and waits to see what will happen. Once the printing presses pick up for real, velocity will go through the roof as no one wants to hold cash.