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Will We Have Inflation, Deflation, or Hyperinflation? Part 2
From The Daily Capitalist
This is Part 2 of a four part article that 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.
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)[1]:
Note: The M1 chart shown in Part 1 more clearly shows the trend in the M1 money supply increase.
Again, the YoY percentage change is more revealing:
The inflationists also point to the Consumer Price Index (CPI) which shows price increases:
The YoY rate of change of the CPI clearer:
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 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.
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:
- 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.
- 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.
- I believe that as the economy goes into a double-dip recession, the Fed will create ways to inflate 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.
Tomorrow, Part 3. The double dip economy, the Fed's choices, and their fear of deflation.
After Part 4, I will publish the entire article as one downloadable PDF.
[1] 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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What is at the very top of the Feds list of priorities? Funding the national debt? Keeping the banks alive? I think it's the later. Whatever the answer is may be the best clue to where we are headed.
that was more or less what I was going to say before I saw your comment...although there are limits, sometimes people revolting can change their behavior, but it usually has to been extreme. I understand people are the most angry when their expectations are dashed, not when they have it quantatively real bad, but when its real bad qualitatively to what they expected, to much dashing and they have problems on their hands.
Also, there may be a limit to what these arrogant folks can control, maybe a century or three of their schemes working has embolden them to the point of going too far.
but in the short term, what ever works for them, so be it
Very good article that presents the cases of others and shows the will to place an intepretation.
My take is closer to this.
Economics is like art or history, and as with all art and history, there are artists and observers and the writer describes and inteprets events. No single art form dominates any other and no depiction of history is complete. (Rome may have sponsored an empire, but it removed countless kingdoms and, viewed from the perspective of those enslaved, was an abject failure).
Economics does not create or cause outcomes, but has some use as a description of how the same events have occurred in the past. The interpretation of art will attract connoisseurs who do it more often and are referred to by sycophants who have no original view, hence attracting followers. It is this aspect I will follow closely in these articles, to see if the analysis is original, or leads to a better description of past events.
Herein lies the rub, an artist assigns a bias towards the art form that reflects their personality and interpretation of life. Some AC/DC songs are mellow but most are not. Warhol fascinates observers and holds their attention. Both AC/DC and Warhol change the behaviour of the observers of their art, by making them stop a current behaviour for a while, but the behavioral change is temporary, but the knowledge of the art form remains for reference.
In that sense, artists are politicians (good and bad) and observers are central banks and economists, who try and impose their intepretation of the landscape or music by holding themselves out as connoisseurs of the art form of politicians.
Economics can be made "scientific" and predictive by saying that "painting by numbers" or "guitar hero" is possible and is as good as the original. Japan has fallen into this trap and (excuse the bigotry) cannot produce an original. (Perhaps because Japans creativity turned out the wrong way in the Second World War and was removed by the victors, turning Japanese people into followers).
To achieve an economic intepretation that is useful (causal) with this backdrop, requires a leap of faith that the evolution of economics (art and the intepretation of history) into its current state, contains solutions for us today. You will gather that I think this improbable and I will simply see what past masterpiece Econophile constructs with "painting by numbers". I think the quality of the work will be every bit as good, if not better than the Fed!
I am intrigued by "swarm", "chaos" and "behavioural finance" theories as, unfortunately, I think the human species is now more an uncontrollable "swarm" than in charge of its own future, meaning that "chaos" is the likely outcome and "behavioural finance" most closely describes the likely chaotic outcomes of surging mob law.
Governments (good or bad artists/historians) and central banks (connoisseurs/recorders appointed by artists/historians to agree) now only regulate a mob they have created. Shrugs. The spirit of individualism, creativity and simple joie de vivre is heavily shackled.
Okay guys, sorry if this sounds at all condescending or fatalistic, but I am a little down at the moment!
Check out the definition of "epistemology" and then read this: http://nobelprize.org/nobel_prizes/economics/laureates/1974/hayek-lecture.html
Thank you for posting these articles. The inflation/deflation debate is indeed the major theme of our time, and it is quite extraordinary that there is no universal certainty on the matter, despite the fact that there are many people who are certain that they are right on both sides of the debate.
As a general rule debtors welcome inflation, because it inflates away their debt. Sovereign governments are no exception to this rule, and since they represent the largest debtors in history, they are no doubt keen to induce some inflation. So far, as you note, their efforts have been unsuccessful, because the liquidity they have provided has not found its way into the wider economy.
The question that I should like answering is this. Why do governments not pay some or all of their payroll with printed rather than borrowed money? If they borrow the money, they are faced with adding to their accumulated debt burden, they must pay interest and fees, and since they are not in a position to repay this borrowing other than by incurring futher borrowing, or by printing, they might as well have printed in the first place.
If the printing causes some inflation, then job done; they will see their debts eroded over time. If it does not, then at least they can meet their payroll without incurring further debt.
Providing bail outs with money that they don't have and must be borrowed from the very institutions that they are bailing out so indenturing sovereign states to these institutions is a concept that Lewis Carroll might well have struggled with.
Massive inflation and the destruction of the dollar is the answer to your very excellent question.
And, the answer is "Yes." We have already seen deflation with regard to gold, and, inflation with regard to fiat. So, I am not sure why this is still a question.
Or, can speculators not take "yes" for an answer?
Actually I see deflation of all assets in regards to the value of MY cats. Point is that although my kittens are not as liquid as gold, I have placed a minimum value on them which is currently rising in regards to everything else including gold. In other words, although gold may be regarded as money historically, it's still remains a human perception and not a natural phenomena bounded by universal laws.
Listen, the fact that there was never secular inflation until money was debased from gold, implies that there is somethinmg about the material quality of gold that is not reproduced in dancing electrons on a computer terminal. If you think thiis something is only our perception of gold versus our perception of dancing electrons, you are now a mainstream economist - change your name to Ben or Paul.
Fiat "Money" = Dancing Electrons
I like that.
I don't even know what you mean. According to your logic, speculators are now "gold standard" economists. You are as much of a gambler as those hitting red 32 right now.
Yes. Money is a human perception...like starvation. All animals can starve, only humans perceive starvation as an social abstraction.
To wit: not as a lack of food, but as a lack of money.
Agree here, if you hold gold and you classify deflation as a drop in prices, the deflation has been massive as the gold price has risen 4 fold in 10 years and keeps on going. So for gold holders the deflation argument is over.
For Fiat currency holders, you can rest assured that the supply of fiat will increase as the Fed tries to create inflation to counteract the general deflation.
So, if you hold gold, your sitting pretty with deflation while everything gets cheaper, if you hold fiat, your f...ed with inflation
The deflation measured in gold is, simultaneously, inflation in the form of Fiat prices. Which is to say, if the price of gold increased four fold, the purchasing power of fiat fell by the same proportion. I AM NOT SURE WHY THIS IS SO DIFFICULT TO UNDERSTAND!
This argument only continues because people insist in swallowing the CPI as a measure of inflation. What friggin' dolts! You have been robbed, and you stand here debating whether it happened!
Only Austrians could be this dense!
There is a time to short the dollar and a time to short gold.
If I buy a stock, in a real sense I am shorting the dollar.
If I short a stock, I am long dollars.
There's timing to these things (and politics)
PS: Rothbard was/is wrong...
PPS: Gold is money too - and the only true measure of value.
Nice photo. Gold is a monetary commodity and is real money, but it isn't legal at this point. The legal tender laws rule that out. If it were used as a money in transactions, then it could be counted toward an increase in money supply. Good comment. You may enjoy my article, "Money: A Semi Fictional Fable."
The government has several ways to expand the money supply & create inflation in an under the radar type of way.....funding of the ongoing wars, the bp disaster, ever increasing cost of obamacare, etc. Unfortunately, this type of inflation is not productive & is unsustainable.
The contraction in lending is the most powerful of all the current forces. Our banks should be, and still are, bankrupt. If lending comes to a standstill, the money supply doesn't level off, it drops in a negative multiplier fashion up to -10x. Asset prices still have a long ways to drop before they stabilize. No amount of stimulus is going counter the law of supply & demand. The death spiral has a long ways to go. The money supply will drop dramatically.
It might be the case for while that we'll have inflation in all of the areas where government dollars flow....food, energy, healthcare, etc., and deflation in all areas where government dollars don't flow.
Our government has shown it wants to keep printing. If so, the G20 countries are going to start dumping dollars & cost of financing our debt could go suprisingly high. We would then have a double whammy on inflation.
I'm hopeful obama will did the right thing & stop the spending now. About 50% of USD's are outside of the U.S. That's a pretty weak position to be in. I think it's soley up to obama (& the G20 countries) in the next month or two whether this depression will be hyperinflationary or hyperdeflationary in terms of the USD's.
Major point, Dryam. For every $ destroyed by falling real estate, charged off credit cards, etc., 10 $'s are destroyed. Yes, the negative multiplier. The horror of reverse fractional reserve. But if banks are levered to 30 to 1 or 60 to 1, its -60X!
It seems unlikely that the debt based money system can survive this. It would be dead now without changing the accounting rules for bank asset values[March 2009?]. Maybe the system can muddle through by just changing the rules when reality bumps up against them?
Then there are the actuaries and math types who say its just a matter of time before $ destruction through debt liquidation crashes the system. Kinda like once the "Doomsday Machine" is triggered; the wheels are set in motion for a rendevous with the event horizon of the black hole.
ZH-ers are getting their affairs in order....gold, H2O system, freze dried
Econophile I love your work but there is more than one way to skin a cat. You do not need a change in money supply to cause inflation or deflation.
I would argue we are going to have inflation simply due to capital destruction.
Thanks for the compliment. But, it's money supply, not capital assets, that leads to inflation/deflation. Perhaps you could explain.
I second kudos for Econophile.
What happened to the banks when "assets" on balance sheet (all the derivative trash) just ... vanished? Deflation, me-thinks (in the near term at least).
What happens when there are millions of homes on the market and artificial housing price support? Deflation hanging around the corner as supply-demand imbalance is (maybe) being steered to "soft landing."
- Ned
Won't the proposed EU austerity force U.S. austerity?
Inflation, yes. Deflation, yes. Hyperinflation, probably. Why is this so hard to understand? China and other developing countries in the East are inflating. As they inflate, they are exporting deflation and disinflation, (pick your poison.)
The US will tolerate this as long as the Chinese buy our Treasuries and we allow them to buy some US assets.
There is one wild card though. For those of you questioning whether the US is a fascist State, China is really not a free country. Regardless of what politicos are saying the Chinese economic miracle is built on the backs of a billion impoverished workers. Who is the Chinese Samuel Gompers?
Thank you for pointing out the reality of China.
It amazes me how the iConsume USA crowd seems to have some idyllic vision of happy Chinese workers living in freedom and Zen like harmony and don't realize or care to realize that the majority are SLAVES.
Me too ebworthen. But what amazes me even more is how the indoctrinated masses of the USA seem to have some idyllic vision of happy American workers living in freedom and Christianity-like harmony and don't realize or care to realize that the majority are wage slaves.
Regards
You forgot cancer stricken...
http://www.chinahush.com/2009/10/21/amazing-pictures-pollution-in-china/
Thanks for tackling this issue.
Here's my take on it. I've hated to see two great market observers - Mish + Gary North - have such bitter disagreements. I've no idea about either of them as traders or money managers (I suspect that they're mediocre at best), but as observers, they're trenchant.
Inflation is asymmetric. Government workers have been overwhelming beneficiaries of Fed printing and implicit backstops on government debt. Housing is of course the beneficiary of powerful inflationary forces. Higher education workers also benefit from inflation. Insurance benefits from this.
Nothing, of course, needs to be said about financiers who have unlimited free money. They live in a fantasy world. You can see it with your own eyes in TriBeCa. That neighborhood might as well exist on a different planet from the East Village or Chinatown. That's where the inflationary royalty go to play.
They live in an inflationary bubble, while the peasants struggle with deflationary forces - as untermenschen.
In addition, a lot of new money and credit goes overseas. It takes a long time for that money to re-circulate back to the US. We see inflation (in both the Austrian and Keynsian senses) striking China with sudden force today. That new credit will eventually recycle back to the US, as Chinese interests buy up failing American businesses, government assets, and land.
That will be inflationary. But right now, we aren't affected by it.
Another example of asymmetric and tough-to-measure inflation occurs through warfare, smuggling, and other grey/black market activity. The military and the intelligence agencies dump pallets and pallets of money onto their warlord allies all over the world. Those dollars often take a long time to cycle through the economy, and in many cases, never return to the banking system.
It's been my perspective since 2008 - and I've written as much under my real name, back then - that the Mish / North split is fundamentally based on politics.
No, the banks won't lend, unless they're forced to.
Mish believes that the government won't force the banks to lend. He trusts that the rule of law will hold together. He believes that the politicians can be induced to promote austerity and that the Fed can be convinced to take action to rescue the dollar (at least temporarily).
Gary believes that the government will nationalize the banks and force them to lend. He takes P-Krug seriously, because that's been the ur-Keysian platform since the bailouts occurred. However, the banks have heretofore balked at ramping up lending, and consumers haven't been demanding it.
Part of this, I suspect, has to do with the restraints of the FICO system. Mish is correct that the tangle of regulation in commercial banking prevents a resumption in lending.
FICO, by the way, is extremely corrupt. If you have a little extra money, you can bribe your creditors to erase any and all negative entries. You just have to be crafty about it. It's legal, too.
If P-Krug gets his way, then North will be correct. If he continues to be stymied, Mish will win the day. Mish focuses on "main street." North is more concerned with the overall picture.
We have major inflation among the over-class, but deflation for the little wretches.
I think Gary is ultimately correct... but Mish is really good at analyzing the regulatory tangle of commercial banking.
Accurate predictions are impossible because humans have free will. Barry could nationalize the banks tomorrow, or on the pretext of some future crisis.
They have the guns, they can change the rules.
Mish, I think, is naive on that point. He trusts in the legitimacy of government on a basic level. You can see it from his ridiculous phone and fax campaigns. He really believes that this can be fixed by electing enough mobsters like Christie into office.
I'm unsure if I'd prefer a Democratic mob or the Sopranos ruling over me... I just know that I wouldn't want to hitch my reputation on the behavior of any politician that I would support.
Similarly, Peter Schiff and Rand Paul will probably be disasters as Senators. The whole point of being a Senator is to steal as much loot as possible for your constituents.
Libertarians are no good at theft, which is why they keep losing elections. They have no stomach for it.
Apostate:
Wow, what a great comment. Thanks for reading this piece. I think North is somewhat "off" and I don't understand his personal attacks on Mish. I very much appreciate Mish's independent thinking. I don't agree with all of his conclusions but the guy thinks. His timing was pretty good too. Don't know about North. But I really don't agree with North's hyperbolic prognostications that have been mainly wrong over the years. You can't predict the end of the world for 20 years and be taken seriously. As far as banking, I think Mish has been proven correct in the strict sense. We had a bailout not nationalization. The very worst happened yet there wasn't nationalization. I don't wish to argue semantics here; I think you know what I mean. Please stay tuned for Parts 3 and 4.
I liked reading your analysis, Apostate.
"Asymmetric inflation" nice.
Another force at work is credit destruction and other forms of money destruction.
got that right about Rand Paul. He's spent the past month feeling BP's testicles and loving every moment of it. Brazen apologist for what they've done.
The part about "forcing" banks to lend doesn't make any sense to me. It's like forcing a retail store to sell stuff. If banks don't lend, they don't make any money. The problem isn't the banks don't want to lend. Anybody with a high credit rating and a job can get a loan. The problem is that the people that easily qualify for loans don't want or need credit and the ones that need the credit aren't good credit risk. If the Fed buys more MBS, that will keep rates low and inject more available capital in the lending system - but without the borrower going into the bank and putting his name on a mortgage, nothing happens.
One way to think about how the Fed would "force" new lending is by demanding that banks write-down losses faster. By doing so and keeping credit flowing to the banks, they will have to make new loans, lest their balance sheets get smaller. That's the real problem with TBTF; it's a binary world that less means failure, and, so they believe, larger/more is progress. What is very clear is their margins are going to be under much more pressure for the foreseeable future and i do wonder if the new finregs are simply setting the markets up for another credit bubble by allowing TBTF to continue, albeit very much hobbled?
Re-capitalizing the SBA and pushing them to lower standards again. Totally making them government outlets. They could introduce processes to other types of loans similar to the ones pushed onto student loans.
"Ve haff ways of making you lend!"
You miss the point. Do you "haff ways of making you borrow"?
No, but they can implement tax incentives to make it extremely attractive. Like they did with HELOCs, etc.
I try to never underestimate the enemy.
Precisely why we have a debt crisis now. Demand has been stripped from our future. If they DO find a way to force borrowing, expect a worse crisis later.... and you won't have to wait long.
Exactly. My bank, JPM, has made it clear that they would be thrilled to lend me money, but in the present and likely future economy, it is not necessary or in my interest to borrow money.