23 June 2009

A Postscript on the Question of Inflation and Deflation

First, thanks to the many readers who mailed in a link to the book by Adam Fergusson at the Mises Institute. It is a good read, and free is much more attractive a price than $1,000 which is the price for a hard copy in good condition on Amazon. I purchased my own copy some years ago at a bookstall in Brighton. The online version is available here.

As to the discussion on inflation and deflation, I feel the need to make it clear that that inflation / deflation is a "policy decision" in a fiat currency regime with nothing preordained. In other words, either outcome is possible within a wide range of gradation. Most outcomes in the real world follow a similar pattern, not black and white but many shades of gray.

But not all things are equally possible. "Life is a school of probability."

If the Fed came out tomorrow and raised short term rates to 22% we would see a stronger dollar and the beginnings of a monetary deflation.

This arbitrariness of a fiat currency is intellectually difficult for most people because their domestic money has a natural patina of 'confidence' and objective value to it.

It is an assumption, one of those shorthand beliefs that help us through day to day life without having to intellectualize and analyze every aspect of every decision. It comes from using that currency as a store of wealth and medium of exchange, almost every day of our life (presumably even an American can take a day off shopping occasionally) and assuming that it will hold its value in the short term.

So we tend to invent 'rules' for the creation of money that preclude 'arbitrariness' and help us maintain our assumption set against 'black swan' thinking. When an assumption begins to conflict with the underlying reality it can become a 'prejudice.'

It is this very arbitrariness that is the goal of the central bank and statists whose preference is aggressive financial engineering. The limitation on the Treasury/Fed in a fiat regime is ultimately the value of the dollar and the sovereign debt. While people accept it, they can print it. This is a soft limitation with much more latitude than a hard external standard.

Having added the important caveat of possibility, given that the US is an enormous net debtor, it would be suicidal for the monetary authority to choose deflation as the Japanese did for their own particular reasons. We may experience a brief period of deflation as did the US in the early 1930's in which the money supply actually contracts, but this is much less likely now because the Fed has no external standards with which to contend.

There is a technically possible, rather conspiratorial line of thought that suggests that the wealthy elite who control the central government would opt for deflation in order to enhance their personal cash assets, driving the rest of the US into a form of debt serfdom. The probable response from the public would be in the tradition of the storming of the Bastille or the Winter Palace.

Almost all money issuing entities will choose inflation if they have the option. Sometimes they lose control of the process, the confidence game, and fall into a more serious and pernicious inflation and even hyperinflation. But this is not 'the norm.'

Our own Fed is rather arrogant these days, fully confident they know how to stop inflation given the Volcker experience. This may cause them to fall into a serious policy error on the inflationary side. In many ways our fate is no longer in their hands, but in those of our creditors, such as the Chinese and the Saudis.

Paul Volcker gave the odds of inflation in the current crisis as 99% for, allowing only for a serious policy blunder against it.

I wanted to highlight the Weimar experience to debunk the 'output gap' and the 'bank lending' restraints on the inflationary outcome. Much of what we hear on the financial channels smacks of propaganda, the 'confidence game.'

Yes the Fed faces the headwinds of slack demand and a very low velocity of money, which the Austrians will assert doesn't DO anything, but is rather of the nature of a economic speedometer. Speedometers don't' DO anything either, but their output is certain to be of some interest to the driver and their passengers.

This is less of an issue than one might think, keeping in mind that monetary inflation is the creation of money supply in EXCESS OF DEMAND. As the velocity decreases, so does demand for money, similarly the expansion of credit. So any monetization of existing debt, or government obligations by the Fed, becomes more potent so to speak.

As for the need to create more debt, let us just say that the Fed and Treasury would have yeoman's work to monetize the debt obligations the US already has, which recent estimates put at north of 40 trillions. Even with inflation at their backs, the government will be pressing the default button, selectively but surely, in the coming years.

The most probable outcome is stagflation, perhaps quite serious IF the economy and financial system is not reformed. This could have the vestiges of a monetary deflation were we not a net importer and net debtor.

This is an important distinction between the US experience and that of Japan whose industrial policy is well known to be in the bureaucratic clutches of MITI and the various kereitsu.

Japan sought to stimulate the economy and avoid deflation while aggressively exporting the fruits of their domestic productivity and consumption to support their long standing industrial policy. One cannot have their natto and eat it too. These were conflicting objectives and resulted in a decades long stagnation. This was a policy blunder of the first order.

So, deflation is possible, but not probable. If people understand that, I will feel that I have done a good job in raising the level of understanding about monetary economics.

But isn't all this debate and too often name-calling amongst the bloggers a distraction from the real problem facing the average person, in the same sense as Paris Hilton, Survivor, big time wrestling, the McLaughlin Group and American Idol?

The banks must be restrained, and the economy brought back into balance, before there can be any sustained recovery.