12 November 2008

Nailing our Thesis on Inflation and Deflation to the Door

Apparently some people who divide the world into Inflationistas and Deflationistas took exception to the blog from yesterday which showed most of the usual money measures and noted that we are not seeing any real contraction yet, merely a slowing in growth in some measures.

We should add that we prefer to address inflation and deflation from a money supply perspective, fully acknowledging that there is a dimension called 'aggregate demand.' There is a qualitative difference between a general deflation caused by slack demand versus one caused by a contracting money supply, and vice versa for a general inflation.

It was particularly amusing to see the Adjusted Monetary Base attacked as a standard of the Inflationistas. It was included in our set of charts only because some of those promoting the deflation argument pointed to it as a sign of hoarding, and therefore having a negating affect on the other money supply figures. So we took a look at it both short term and long term. It is in the bounds of normality.

It is the hallmark of a dogmatic or fundamentalist mindset when the same data is used to both attack and defend the same proposition from completely opposite directions.

In a purely fiat regime, a monetary inflation or deflation is a policy decision. That decision may involve restrictions and limitations on the creation of money, a set of artificial boundaries, but that is the extent of it. It is a matter of resourcefulness and will.

You can't make the banks lend. Like hell I couldn't. They would lend or dry up if you used the right policy tools, and they know it. Its all of a choice. Its intent. Lending involves risk, and if you can make decent returns without risk and the policy wonks give you that choice you will take it.

Without a binding external standard the size of the money supply is bound only by the acceptability of one's currency by those with real goods to exchange for it.

Now, just because deflation in the money supply has not yet shown up does not mean it won't. Fiat decisions cut in both directions. As we stated, we know how to cause a deflation with some reliability.

Additionally the alternatives are not between deflation and hyperinflation. The opposite of hyperinflation is a hyper-deflation in which there is an undersized money money, most of it being held by a small oligarchy and is used to control the broader public.

There is a wide middle ground between these two alternatives that is much more probable.

To complicate things there are a number of exogenous events that may significantly impact the dollar in particular. Right now the US dollar is the world's reserve currency and many international trade arrangements, notably oil, are predominantly priced in dollars. This creates an artificial support and demand for the dollar. If this were to disappear, the demand for dollars would likely subside, placing a downward pressure on the optimal money supply levels. But keep in mind that exogenous events can cut both ways, for and against.

By definition exogenous means not able to predict reliably from the model. But this is one of those things we are watching and closely. Will there be a new formal Bretton Woods II? Will the key world players continue accept the Fed as its global currency administrator? One can speculate the possible outcomes and their implications, but not with certainty until something happens.

Having said all that, it would be less than straightforward not to note that inflation is the natural and most probable outcome for a fiat currency unconstrained by an external standard.

What tosses so many is the example of Japan and their persistent deflation following a real estate bubble. The cause of this is a series of continuing policy decisions. Discouragement of consumption, encouragement of exports, a static and aging population that is racially homogeneous and discouraging of immigration. A strong emphasis on savings at low rates. It has been and will continue to be a policy decision determined by one of the most powerful and entrenched bureaucracies in the developed world with a strong commitment to industrial policy and central planning.

We do not wish to be a deflationist or an inflationist: we want to be on the right side of the market as it unfolds. There are people we respect on both sides of the discussion from a theoretical perspective including the more extreme hyperinflation. Roubini and John Williams are at polar extremes for example. What does one do? Look at the data, the arguments and sort them out objectively. Even the great Roubini puts his pants on one leg at a time.

So, we'll try our best to stay out of the religious debates, long on rhetoric and short on thought. Its hard to be an agnostic amongst fundamentalists but its where the scientific method leads us for now.

Some comments from earlier this year on hyperinflation: Hyperinflationary Depression in the US in 2010 - John Williams