Monday, January 19, 2009

Inflation v. Deflation

Dear Diary:

For the record, on the Inflation vs. Deflation debate, I know that you know that I've personally held the view that since core asset prices began to slide in 2007, that deflation was more likely than inflation. We predicted the demise of commodities (fully requited) and the diminuation in precious metals (partly requited) too, that disinvestment would trump investment implying further destruction of core asset prices. We believed this for the simplistic reason that we believed we'd witnessed "Peak Credit", causing such massive destruction in core asset prices (particularly real estate, and equity) combined with destruction of wealth and bank capital from paper backed by these real estate (and other unsecured and poorly-secured consumer-related) assets was, and would continue to be far greater than any measure of recapitalization or monetary conjuring the authorities could implement or that lawmakers could politically countenance. This was the crux of a debate with Steve Waldmann at Interfluidity last Spring, and has continued on-and-off with the inflation-fearors - most passionately the Austrians - through to the present.

It was, I believe a contrarian view until Q3 08, when the world seemingly en-masse discovered revulsion, risk-aversion, and wholesale fears of deflation - fear not seen since Q3 02. Despite the swinging of the pendulum towards the deflationary outcome, chatter amongst sound money types (of which I AM one though our concept of sound money was collectively one which would have insure we were never in this situation in the first instance) has remained decidedly critical of Bernanke, and the Fed, and all official attempts to ameliorate the collapse of the financial system as we know it, on moral, philosophical and financial grounds, the latter being mostly predicated present or future inflation risks. The derision is shared by many I respect such as Willem Buiter, and Martin Wolfe, not to mention a number of Austrians with whom I correspond off-line.

As much as I agree philosophically, I am more forgiving and sanguine - of both the the authorities modus operandi and at least in the near and medium-term, of the consequences since I believe that with the money markets seized as they were, and after the Lehman lessons, letting any large financial institution liquidate at THIS time, into a disorderly market - i.e. not guaranteeing all deposits, and senior bank debt, and probably most junior albeit with possible haircuts, would entail unmentionable panic, bank runs, and unspeakable systemic dislocation as EVERYONE withdraws deposits and tried to sell bank debt in lieu of government securities, further complicating adjustment, and reinforcing the most pernicious of deflationary forces. Such an outcome in my opinion is wholly untenable, and probably even unnecessary. This doesn't mean I agree with TARP or asymmetrical Treasury initiatives to help friends of Hank , or their methods, but it does mean that I am not nearly as harsh on the Fed for ballooning its sheet, attempting to do what it can in the immediate term, and again, sanguine about it's ultimately inflationary impacts. Of course, I believe the authorities should have contemplated the inevitable arrival at this point in time when when they unleashed these forces, and dismissed the germanic disdain for unbridled credit growth. But the key point is that I've viewed efforts as band-aids and non-inflationary since they are merely triaging the hemorrhaging of asset prices and capital THAT ARE ALREADY OUT THERE - houses already built, capital already expenditured and consumed. As result of this, no one is going to build new housing, time shares or officer buildings, plant & equipment or such. No American consumer is going to be permitted to become more indebted or consume much beyond what he takes in. No financial institution is going to expand their balance sheet when everyone and everything is deleveraging from Peak Credit. And in any event the official sums proposed are too small in relation to that which has been destroyed, and will continue to be destroyed as assumptions about debt service, future growth, consumption and asset prices reverts to long-term means. Moreover, there should be no shock whatsoever that consumption has fallen off a cliff. It is not mysterious, but merely a return to that which the people can afford sans Refi and HELOCs, sans tax-cut, sans expanding credit, sans increasing vendor financing, sans rising asset prices. It seems to me I can recall others than myself who saw the faux-prosperity and faux-recovery from 03-07 for what it was: massively-goosed by non-extrapolatable, non-recurring items that would.. inevitably.. unwind.

But that was then. And this is now, and I still find few of those skeptical financial calvinists I respect articulating a similarly sanguine view, excepting Dr Roubini who seems to favor the bold actions without fearing the inflation that so many others seemingly fear. Recently I came across a post about the ballooning Fed balance sheet in Doc Hamilton's post (tnx NT!), he does a super job of teasing out the costs and benefits of Fed actions, and proposes modification by eliminating the payment of interest on reserve balances. There follows a super exchange in the comments section on the mechanisms of inter-CB swaps, and other exchanges about the inflation-deflation debate. Buried in there were some comments by Dr Perry Mehrlingat Columbia (who Capital Chronicle has pointed out has a CV with esteemed accomplishments of a length approaching Tolstoy's War&Peace), who finally articulated the 1,000,000,000,000-dollar question that has been on the forefront of my mind:

Everything in the post is correct, and very much on the minds of every Fed watcher. The question is, what does it mean? I have what may be a contrarian view.

It seems to me that what we are seeing is simply the balance sheet consequences of the Fed's decision to take the wholesale money market onto its own balance sheet. Banks (and other entities) that used to lend to one another, are now lending and borrowing through the intermediation of the Fed. This is so not just domestically but also internationally (the huge swap line), since foreign banks used to fund dollar asset holdings in the dollar money market.

In this view, inflation seems much less likely. Why not? If the original wholesale money market borrowing and lending was not inflationary, then why should its substitute be inflationary? Indeed, the real question is whether the expansion of the Fed's balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary.

Posted by: Perry Mehrling
at December 22, 2008 05:12 AM

So finally, I see what I feel intuitively in words. They look right. And I want to know: If this is NOT right, why not? If inflation is just around the corner, how and in what form will it emerge? Who's balance sheet will expand to create the money sufficient to offset the destruction in already-consumed asset prices and consumption beyond one's means that is, by all accounts, unfinance-able at this and probably future points in time. If there is a plausible alternate reality, please paint it for me here and now, both technically and anecdotally.

Yours truly,


P.S. - Diary, you haven't told anyone about my secret fondness for Mr Trichet, have you? He needs a hug I think....


David Pearson said...


I'll take a shot at it using the Latin American analogy:

The main driver of inflation is not money supply but velocity. In Latin America, velocity is a function of perceptions about fiscal deficits.

Once a government enters into structural deficits the market estimates how they could be financed. In the absence of domestic savings (always the case), the markets assume that the Central Bank will monetize the deficits. What's important is that this monetization is PERMANENT (balance sheet will not shrink in the future) and ACCELERATING. That view causes capital flight AND flight to hard assets. The less foreign financing for the deficits, the more monetization expected, which leads to yet more capital flight.

Velocity causes inflation, and monetization causes velocity.

Assume the above is correct. How is the U.S. different? Our deficits are structurally large and growing. Our savings are not sufficient to finance these deficits. The Central Bank has agreed, in principle, to monetize them, and we are at the point where foreign savings may be in short supply.

The difference is everyone still believes that Fed balance sheet growth is not permanent. Once that changes...

212213 said...

C: "since I believe that with the money markets seized as they were, and after the Lehman lessons, letting any large financial institution liquidate at THIS time, into a disorderly market - i.e. not guaranteeing all deposits, and senior bank debt, and probably most junior albeit with possible haircuts, would entail unmentionable panic, bank runs, and unspeakable systemic dislocation as EVERYONE withdraws deposits and tried to sell bank debt in lieu of government securities, further complicating adjustment, and reinforcing the most pernicious of deflationary forces."

I think the Feds could force a haircut on bank lenders and counterparties without a crisis, or forced asset liquidation. I think they could use Eugene Fama's proposal: "the FDIC can draw a line in the bank's liability structure, with debt holders and stockholders below the line getting nothing. The line should be drawn so that the market value of the bank's assets covers the liabilities above the line. (This is what the FDIC does when the new equity comes from a private investor.)" Here is a link to Fama's post on this.

C: "If inflation is just around the corner, how and in what form will it emerge? Who's balance sheet will expand to create the money sufficient to offset the destruction in already-consumed asset prices and consumption beyond one's means that is, by all accounts, unfinance-able at this and probably future points in time."

I think the Feds will generate inflation by printing money to buy massive amounts of assets at 2 or 3times intrinsic value. I think it will take a while for the Feds to build up to the massive levels of printing that are required though, but they'll get there. I think the inflation will cause a backlash because most voters suffer from stagnant wages, so inflation hurts their standard of living.

"Cassandra" said...

David, As always, I pay close attention to your incisive comments. Accepting for the moment that "velocity" IS is the main driver, (and excuse my ignorance) but it still seems that

(1) it remains uncertain that the ballooning of the Fed balance sheet IS monetization since if I understand Dr Merhling correctly, it is sort of sterilized as the Fed is merely swapping assets of less certain integrity and liquidity for reserves of more certain integrity but which are or are likely to remain ultimately reserves of the banking system. The reserves the Fed now holds are in any event unlikely to be "spent", in fact can't be spent, since there is no reasonable market for them. And as I've suggested, the replensihed bank capital is barely sufficient to support assets at existing albeit still-bloated gearing levels, hence is unlikely to be "spent" or attempted to convert to hard assets, as are Japanese USD reserves, and probably PBoC/SAFEs since such conversion could/would only exacerbate their winners curse.

(2) Why should/must/will this monetization be seen as accelerating? It presently seems that forces of Peak Credit and deleveraging (as Mehrling's comment suggests) are presently dissuading capital flight as both banking system assets and liabilities are if not extinguished, revalued making a dollar of remaing dollar of capital MORE valuable, despite the monetization. YET, few seem keen on exchanging such dollar capital for hard assets of anything be it pipelines, a ton of lead, 1000 units of Starrett City, a Minnesotean taconite deposit, or Saskewatchewan heap of potash.

(3) Are not domestic savings rates inherently mean-reverting, a function of real interest rates, and aren't real interest rates - even with ZIRP - reasonably positive given the minus sign in front of price indicies? Given the secular trend in savings rates their nadir, aren't increases in such savings rates contractionary, which with the destruction of energy demand, and appetite for Teutonic Ultimate Driving Machines dampen fears of continued savings shortfalls and speculation of the inevitability of capital flight? Are there not reasonable examples of such populations' austerity - e.g. BC & Alberta where once traction was gained, created somewhat virtuous feedback loops?

(4) Say velocity does increase, (resulting from expectations and changes in risk appetite and asset preference) surely housing and commercial real estate would be viewed at superior to paper, estimates of Fiscal Cost associated with swapped collateral would evaporate and the Fed could quite quickly exchange now-less-impaired claims claims on hard assets, and drain.

Are there not some some alternative scenarios - neither uber-deflatonary or hyperinflationary, whereby the stable or creeping nominal price level meets the nominal asset-price falls without ? And what might they look like?

These are stream-of-consciousness thoughts that spring to mind in reading your reply. P.S. - Do drop me a message to my e-mail as I've wanted to pick your brain from time-to-time and haven't had a way of doing it. Tnx!

The Conservative Pagan said...

Your picture is just great. I was too amazed with your pic to read your work. I know it's from a movie, which one?

David Pearson said...


Your responses are valid and hard to take issue with individually. I'm left thinking, "deflation reigns until it tips into inflation". This may seem a bit disingenuous, but maybe not.

The main thing, I think, is to be consistent on what you mean by deflation. Sustained stagnation, Japan-style, just doesn't cut it. Its the outlier, the six sigma event. Instead, debt deflation typically leads to severe job and output loss, steep price level declines, and costly negative externalities (i.e. Argentine crime waves).

So even with a nominal interest rate of zero, debt service burdens rise during true deflation. Combine that with the inconvenient truth that stimulus must grow to have effect; and the abundance of liabilities that mushroom without growth (social security), and you have accelerating need for government financing.

So severe debt deflation can and likely will lead to sovereign default fears. Its only a small hop from there to the expectation that government will avoid default by seeking permanent financing from the Central Bank. That permanence is what gives monetization its dilutive effect, and ultimately what frightens animal spirits from holding currency. (Note: none of this has anything to do with the output gap, private credit growth, or any of the other factors commonly thought to produce inflation.)

So we know, from historical experience, that debt deflation tips into inflation. And I think we know how. The only question is, is this the right analogy? Will we (the U.S.) reach the tipping point? I think so, mostly because we have no private savings, and to create those savings would just lead to more deflation. So the savings cure just worsens the disease. That's the main reason why, politically, the system will choose the alternative: Central Bank financing.

One last thing. The government is like an insolvent company in that borrowing more money does not solve the problem. Temporary Central Bank financing is the same as borrowing. What the "company" needs instead is equity in the form of higher taxes (deflationary forced savings) or "equity" in the form of a permanent "grant" from the Central Bank. If its not permanent, it doesn't cure insolvency.

I'll drop you an email as well...

cipherprime said...

If the gov't moves to take a vacation or remove Mark-to-market rules, you will see about $1T of stimulus released (slowly or not) into the economy.

That would be inflationary.

In general though, absent that, deflationary pressures will rule

Demosthenes said...

David - don't send Cassandra an email. The dialogue between you two is one of the best articles I have read (and I have read hundreds - on inflation v deflation). Keep the discussion public!

CosmicDancer said...

This is the first time I am visiting your blog and it has very interesting and well thought out posts and comments. Here are my thoughts.

I am worried about inflation not in US, but in EM assets in a few years time. The simple logic:

The developed world is taking rates close to zero and printing money to offset impact of deleveraging and deflation. The EM world is almost forced to do the same.

However, many emerging markets are not structurally broken and still have many industries or whole economies growing at a healthy pace - in high single digits or even double digits in some sectors. Just as money escaped Japan when they went towards ZIRP, it is likely that money will escape the developed world (with weak economic outlook) and escape to emerging markets (with higher visibility of growth and profitability).

Some of the big structural trends in the world are intact - I am referring here to

1) demographics
2) globalization (in terms of technology transfer, "greed"/"lifestyle" transfer to emerging middle/wealthy class in EM thanks to global TV/movies/internet/media and capital transfer)
3) breakthroughs in technology (just read up any geeky websites in almost any area of science who are not that focused on financials markets are the financial media & blogs are currently obsesssed with).
4) Green earth spend - rising awareness of need for alternate fuels, need to control carbon emission, etc + likelihood of Govt directed spending on fiscal stimulus reaching these politically "right" areas.

Put the structural factors above (imagine in an upward sloping line) as on overlay on deleveraging in western world (a downward sloping line) -at some point in next 2/3 years (just a gut feel) we are looking at a high probability of an asset boom/bubble in select areas of EM & technology.

Any thoughts?

Anonymous said...

The Conservative Pagan, it's from Kung Fu Hustle. Fun movie.

David Pearson said...

BTW, the inflation/deflation discussion here relates to work Michael Pettis has been doing in his blog. He writes on China, and believes that China and the U.S. today are analogous to the U.S. and Europe during the Depression. The idea is that China overproduces and has a problem finding demand. It will behave like we did: spiking unemployment, deflation, resort to protectionism to capture domestic demand, etc.

The U.S., Pettis argues, is like Europe then. Our problem is too much consumption fueled by debt. Ironically, Pettis thinks we have an easier time of it. Rather than having to find demand for our labor, we just have to find a way to repudiate our debts as Europe did. The construct fits with the idea that the outcome for the U.S. is inflation. Ironically, it also fits with Bernake's idea that Europe was better off because it abandoned the gold standard first.

The rub in Pettis's argument is that, unlike in the GD, we have 80% of our economy in the service sector, and much of that employment is arguably "surplus" in the same way as employment in China's tradables sector.

Below is the Pettis link. Apologies to Cassandra if its already been cited here.

212213 said...

Cosmic D: "at some point in next 2/3 years (just a gut feel) we are looking at a high probability of an asset boom/bubble in select areas of EM & technology."

Steve Leuthold has theories similar to yours, you might want to read his stuff.

DP: "The U.S., Pettis argues, is like Europe then. Our problem is too much consumption fueled by debt. Ironically, Pettis thinks we have an easier time of it. Rather than having to find demand for our labor, we just have to find a way to repudiate our debts as Europe did. The construct fits with the idea that the outcome for the U.S. is inflation."

I think repudiation will occur not just through inflation, but also explicitly through liberalizing the US bankruptcy laws, eg, eliminating the 2005 anti-individual debtor reforms and the prohibition on cram-downs of mortgages in an individual debtor's primary residence and expansion of state law homestead exemptions. I think we might also see the US government repudiate some debt with "implicit" guarantees, which are about as valuable as non-contractual obligations of broker-dealers to provide liquidity to holders of auction rate securities.

Macro said...

I would second David Pearson's mention of velocity, and addd that the Fed's activity is not inflationary at the moment becomnes it becomes in the context of sharply decelerating velocity.

Put another way, the Merhlinghat comment suggests that the Fed's balance sheet is merely serving as an centralized exchange for bank lending; while there's more to the baffling array of Fed programs than that, this aspect of it is surely not a priori inflationary.

As for Trcihet, et al, I maintain that they only look "good" in comparison with BB and Hank; in empirical terms, their forecasting has been (inexcusably) pisspoor, and thus richly merits public criticism which is broadly lacking in the (English-speaking, at the very least) public domain.

rahuldeodhar said...

My thoughts are more aligned with fluid dynamics when thinking of money flow. This is not a laminar flow or a standard textbook turbulent flow. This is, to my mind, a special case of turbulent flow. I think big money will swamp certain markets testing the regulatory strengths of gate-keepers - while we have dry patches of liquidity crunch at some other places. The "tipping point" (as David puts it) is going to be realisation of true value of US treasuries. That will start a true "dance of the headless chickens" in the big-money space.

SBG said...

Which of the outcomes-- deflation or inflation-- should we be hoping for?

zanon said...


Let me try.

The Federal deficit equals the increase in desire for the private sector to net save, all else equal.

If the private sector wants to put more money in savings accounts, that money must come from somewhere. It can either come from transactions in the private sector (which reduce aggregate demand, and it is what we are seeing now) or it can come from the Government running a higher deficit (spending more/taxing less).

If the increase in the deficit is smaller than the increase in demand for private saving, money will move from private transactions to private saving accounts, and aggregate demand will fall, and CPI will tick down.

If the increase in the federal deficit is larger than the increase in demand for net private savings, that extra money will spill over into private transactions and show up as an asset bubble, a credit bubble, or just plain higher CPI.

Whether money sits in savings, or is being used for transactions is, I believe, "velocity".

This also impacts whether a fiscal stimulus should be based on taxes or spending, and what kind.

A payroll tax, which is easy to turn on, easy to turn off, and broadly distributed, would be an excellent way to increase the deficit and meet this demand for increased private savings while maintaining aggregate demand.

Long term fiscal projects, for roads, bridges, power plants, etc. will take a while to turn on, and will be impossible to turn off (no one will cancel a half completed bridge just because inflation hits 9%). In the meantime, the deficit will increase the hard way, through unemployment, as the Government spends money on benefits and takes in fewer taxes.

Given the political realities, I see deflation continuing through 09, as the spending-focused stimulus takes a long time to warm up, and the deficit continues to grow the hard way. I see inflation picking up in 2010, as the stimulus now takes effect, but the deficit has already reached its target level. And we go into 2011 with inflation, but lower growth rates as a greater proportion of the economy's goods and services have been deployed based on political desire in 2008-9, than private demands in 2011.

Anonymous said...

The ultimate stabilization must come through workforce protection. A medium term job guarantee or guarantee of close to 100% of wages will bring consumers back from the dead and give companies and banks a vision of recovery. Inflation and deflation are imaginary in this context, as they relate to market perceptions not reality (i.e. is 10% inflation any different than a 10% pay cut, no, but tell that to a worker, who would feel much more comfortable with the former).

zanon said...

anon: A government prepared to act as an employer of last resort would certainly be a very fiscal way of reducing unemployment!

whether this is inflationary or not depends on the rate the Government chooses to pay.

zanon said...


Sovereign governments never *have* to default (although they can, of course, *choose* to default).

A sovereigns ability to print as much currency as it wants means it will *always* be able to make debt payments denominated in its local currency. (This may be inflationary, it may not).

A sovereign willing to unilaterally convert foreign denominated debt to domestic denominated debt (a "debt for equity" swap, but for currency issuers) will also not default, although the change in terms may have some argue that this is a default.

No one has to "finance" anything. Currency issuers have no need of financing.

The above activity may or may not be inflationary.

212213 said...

Zanon: "A sovereign willing to unilaterally convert foreign denominated debt to domestic denominated debt (a "debt for equity" swap, but for currency issuers) will also not default, although the change in terms may have some argue that this is a default."

Unilateral redenomination of a debt instrument is a default unless the terms of the instrument allow it. I'd like to see a US homeowner try to unilaterally redenominate their USD mortgage in Zimbabwe dollars and let Chairman G. Gono and his board inflate away their mortgages.

zanon said...

212213: Your point is well taken, but the US Govt can put US homeowner in jail, while Chairman G. Gono is sovereign, and therefore out of the US Govt's reach.

Unless of course the US invades and takes over Zimbabwe, but then it would not be sovereign any more.

t said...

Firstly, the Fed is no longer sterilising all its purchases. That is clearly and deliberately inflationary.

Secondly, if MV=PT, and they are raising M to combat a near-zero V, then when V does pick up, there will be a very big increase in P and T (inflation).

Thirdly and notwithstanding the second point, if overseas players perceive printing, the currency will be less well regarded, and a currency event may ensue. Thus you have inflation via a currency event. Witness Sterling after the old lady discussed the intent to follow a QE course.

t said...

I should add, the second is the monetary route, the third is the currency route. I think we will see the third.

Anonymous said...

Historical correction for David Pearson:

"Rather than having to find demand for our labor, we just have to find a way to repudiate our debts as Europe did."

Europe did not repudiate debts after WWI (Although France eventually did.) Nor did Europe repudiate debts after WWII. In fact, it is believed that Europe's failure to repudiate debts to the U.S. after these wars that lead to U.S. hegemony in financial and real markets.

zanon said...


"Secondly, if MV=PT, and they are raising M to combat a near-zero V, then when V does pick up, there will be a very big increase in P and T."

Yes, which is why it's important to raise M in a way that you can quickly and easily undo when V picks up. Larger G fails this test. Payroll tax holiday passes.

"Thirdly and notwithstanding the second point, if overseas players perceive printing, the currency will be less well regarded, and a currency event may ensue."

Dollar exchange rates may fall, and the US may lessen it's trade deficit, and Lord knows, maybe even start manufacturing for export again. Certainly, this represents a decline in the (currently very favorable) terms of trade that the US enjoys, but it's hardly the apocalypse.

But so what? The US does not need to sell Treasuries to "finance" its deficit.

212213 said...

"Europe did not repudiate debts after WWI (Although France eventually did.) Nor did Europe repudiate debts after WWII. In fact, it is believed that Europe's failure to repudiate debts to the U.S. after these wars that lead to U.S. hegemony in financial and real markets."

That is wrong. In 1934, the UK refused to pay its WWI debt to the US after the US passed the Johnson Act rejecting the UK's attempt to make partial payments. After the UK defaulted, so did other European countries.

Shairon the Parliamentarian said...

Why is it that I can't seem to keep up with inflation, yet I'm doing spectacularly well keeping up with deflation? Maybe I should buy some at the money vix calls and some 2x reverse spx etf calls and some gold options and sell oil and go sort Kroner. That should hedge me, no?

Mencius Moldbug said...


As usual you ask exactly the right question.

(And are to be praised, as well, for the accuracy of your predictions. In retrospect, the right bet for your "partially fulfilled" PM prediction would have been to go long the GSR - silver, as the less monetary metal, was pulled down by commodity-price deflation, whereas the inflationary and deflationary forces on gold turned out to be in rough balance.)

To cut to the chase, I think that when we see inflation - probably on about the schedule zanon describes - it will not look like inflation of the credit-bubble excess variety, driven by asset-price appreciation. It will be bottom-up inflation of the crushing, nasty, '70s wage-price spiral variety. As in the '70s, it may be accompanied by asset-price deflation. Ugly all around.

Like many, I suspect that prices of industrial commodities may have bottomed. The wave of demand destruction has hit these markets. The following wave of supply destruction, which you would expect the price drops to cause, has not. Nor has the (lame and inadequate, but still nontrivial) wave of stimulus cash.

And demand has dropped - what, to 2005 levels? Maybe 2004? The government responses that are kicking in will not restore the boom, but they should at least turn panic conditions into a more or less stable state of Brezhnevian stagnation.

The weird world of the Warsaw Pact did not experience any asset-price booms to my knowledge. But it was certainly not free from inflation. When I look at the future, I see an endless parade of gray (or possibly green) bureaucrats. I don't see fun. But I do see inflation.

CosmicDancer said...

Interesting comment from Warren Buffet about potential inflation problem.

Here is the Q&A the url below that has the full interview. Enjoy.

SG: We all know that in the long run everything is going to work out, but as you analyze President Obama’s economic plan, what do you think are the trade-offs? What are the consequences?

WB: Well the trade-off… the trade-off basically is that you risk setting in motion forces that will be very hard to stop in terms of inflation down the road and you are creating an imbalance between revenues and expenses in the government that is a lot easier to create than it will be to correct later on, but those are problems worth taking on, but you don’t get a free lunch.

Zanon said...


You and I are sadly in agreement.

What pains me is that this dystopic future state is so unecessary. You really cannot expect better from Krugman, Summers, or the truly sad Geithner, but Murphy, Huizinga, and Mankiw can and should do better than "the spending will likely be wasteful". Those guys have Keynes on their side if they just updated their thinking from 1930.

Anonymous said...

I see two drivers for inflation :

on a medium term basis : protectionism. Geithner words on China manipulating its currency, or French MinFin complaints about the low value of the pound show that the topic is hot. In democracies, especially in the US, tariffs is a crowd pleaser, and I bet that popular pressure will bend any "academic" resistance to protectionism. In the US, it will bring a resurgence of manufacturing (after all, the manufacturing infrastructure is already there in towns like Detroit). However, even with salary cut, american workers won't produce as cheap as Chinese workers (if only because they are older and less physically fit). So you get inflation.
The same mechanism will apply to Europe, but probably with a longer preliminary period of deflation (No, not because of JCT, but because the leverage problem is actually greater in Europe than in the US because of Eastern European countries)
Inflation in China will occur because of the perks (free healthcare, etc...) that the government will deliver to the workers so that there a no social explosion.
In other terms, the sharing of added value was extremely favourable in the last 20 years, and it is about to swing back.

on a longer term basis : cheap resources depletion. Natural resources are not going to lack, but they won't come cheap any more. The cheap oil well are going to get exhausted and will be replaced by higher cost production. Fight against global warming will also increase the cost of what we are used to consume (through internaliziation the global warming externality in the price of most products).

don said...

If one assumes from the start that what we have globally is overproduction and over capacity in the East, and over consumption and over dependence on debt driven consumption in the West, then I would assume from this that for inflation to take hold - there would also need to be evidence that these two related structural imbalances are being resolved.

What would that resolution look like? Would it amount to a greater balance, i.e., more consumption in the East (and with it less production and dependence on exports), and more production in the West (and less dependence on imports and dept).

From this I pose the question: were these two related structural 'problems' be corrected - will it have come about by way of inflation or deflation?

It seems to me that any discussion around inflation vs. deflation is stuck on effects rather than causes. What I mean here is that global structural imbalances have more to do with the cost of labor than does it with the price of credit, currency moves, etc.

So . . . as far as the cost of labor is concerned, how would that cost be re-aligned from how it is today to allow for the resolution of the structural crisis? Are we to assume that, for instance, the Chinese workers will be paid much more, while the US and European workers much less? Furthermore, are we then also to expect more leisure and consumption in China, with less in the US, where workers will have to work harder for less?

Without resorting to some new bubble creation to allow re-inflation to materialize, then what's left but what I describe above?

Now, perhaps what I describe above will eventually develop, but it won't if it does at all it won't for quite a long time, and the re-adjustments will be quite severe. So . . . it would seem to me that the arguments for inflation tend to be wholly too optimist, i.e. that the Fed and government stimulus work, and to such an extent that inflation results - not only in the US but globally.

212213 said...

"Without resorting to some new bubble creation to allow re-inflation to materialize, then what's left but what I describe above?"

Hot war, cold war, or trade war. A war between Pakistan and India could destroy a lot of excess capacity.

Pietro Paolo Mazzini said...

If we end up with 5% inflation or 5% deflation, it will hurt, but it will be survivable. All of the discussion has focussed upon the intentional, and possibly manageable, introduction of inflation by central banks or governments to direct economic development or resource distribution in a particular direction.

My greater concern is what happens if the situation continues to spiral, and we reach some tipping points that force us into much more severe circumstances? What can happen that is beyond our control? Going back to the quote of the Warren Buffet interview, what if everything DOESN'T work out in the end.

Of course, I'm talking about low probability events, but their potential impact could be catastrophic. For example, if China continues to sink into depression, resulting in political conflict or civil violence, how will that impact global supply chains? What will that do to the price of consumer goods globally, and as a result, inflation?

Political breakdown in China is just the example that readily comes to mind. Is anyone interested in brainstorming other potential land mines out there, whose probability of surfacing, and acting as a tipping point has increased due to the financial duress the world is now experiencing?

William Mitchell said...

Here's a scenario that ends in inflation of a sort.

Suppose US fiscal and monetary policy is simply to call China's currency bluff: push inflationary policy ever harder, until their central bank gives up.

This would cause a dollar crash and consequent abrupt rise in the cost of many consumer durables. This doesn't speak to money supply, just to price levels as observed by ordinary folk.

Fred said...

Mild inflation is exactly what the Fed wants, and what the Fed wants, the Fed is likely to get. Given the massive indebtedness of US households and the massive size of the Fed balance sheet, keeping the inflation from spiraling out of control will be very easy. Even a slight rise in Fed rates will be extremely contractionary.

Hyperinflation requires a Fed that doesn't care about maintaining its inflation-fighting credibility, and that goes against the culture of the Fed. For something like 30 years, the sorts of economists who get appointed to the Fed have been harping on the importance of keeping inflationary expectations down. It goes against everything I know about human nature for this sort of groupthink to suddenly dissolve. Now Congress may indeed squawk when the Fed raises rates to prevent hyperinflation, but Congress squawking and Congress actually doing something to restrain the Fed are two different things.

Once upon a time, there was a consensus among mainstream economists that a balanced budget and gold standard were important. The Great Depression changed the consensus to believing in contra-cylical policies, with the emphasis on fighting deflation, since inflation was assumed to be of little concern other than during hot wars. The stagflation of the 1970's changed to consensus to believing that both deflation and inflation were important. And this is where we stand. Don't underestimate the power of a consensus belief among the powers that be, whether for good or for worse.

In other words, all roads point to higher real rates of interest once the crisis ends and the fiscal stimulus finally kicks in and inflation perks up. High real rates will crush both nominal and inflation-adjusted bonds, stocks, housing, commodities (including gold) and will result in at least a decade of very slow growth. This period of slow growth will eventually lead to a new consensus, which is that the Fed or another independent body must be allowed to raise taxes or force spending cuts in order to keep inflation under control, rather than the Fed being limited to monetary policy, given that elected politicians are incapable of raising taxes or cutting spending on their own. But this new consensus is at least a decade away. In the meantime, look for high real rates of interest and slow economic growth.

Fred said...

Correction: the massive size of the Fed balance sheet means that raising rates is easy--just dumps those bonds on the market and watch bond prices drop and yield rise. It is the massive household indebtedness which makes raising rates very contractionary. This is in contrast to the situation in third-world countries, where raising rates has little effect because most of the economy runs on a cash basis, with only a small amount of borrowing.

Born Again Democrat said...

A comment from the peanut gallery: what is wrong with a certain amount of controlled inflation in the coming years so long as it is coordinated with other countries and is world wide?

I see two upsides:

1. Creditors (ie, people with money) have made unwise loans to people without. They must suffer the consequences, which is to never get paid back. Inflation is a way of bringing that about without the trauma of bankrupcy.

2. Inflation reduces real wages across the economy, which increases the total volume of employment. True, people will end up working longer for less, but how else can we both "spend more" (ie, stimulate the economy, and keep up consumption somewhat) and also save more?

The poor must live within there means; the rich must accept their losses.

Then at some future date we can tax the greedy, irresponsible bastards who gambled with other peoples money and walked away with fortunes, and use those revenues to subsidize the wages of ordinary people.

Thoughts of an amateur on a subject nobody agrees on.

Namazu said...

To Cassandra's original question: if inflation is too much money chasing too few goods, and the Fed can barely produce enough M, let alone MV, to keep pace with credit destruction, might not inflation mechanism lie elsewhere? To wit, higher cost of capital and a resumed decline of the dollar (and possible de-linking of commodity prices from same) will raise costs, prices, and our (US) relative claim on global production. Wage demands would likely follow as "stuff" starts to edge out services in the consumption basket. I think multi-trillion dollar budgets and Fed balance sheets should do the trick. [If not, there's always helicopter money and time-limited vouchers.] I'd be grateful for any feedback on whether this is naive, wrong, or both.

BitterRenter said...

Inflation will begin once there has been excessive liquidation of productive capacity. We are far from stage in the U.S. automobile industry. I cannot speak for other sectors of the U.S. economy.

experiments.geekdom said...

Sorry! WRONG ANSWER. The "deflationists" are requested to please leave the room now (into oblivion).

Gold said...

Currency is currently at 20% value of gold

Anonymous said...

I think you're caught in a false dichotomy here. The most likely result going forward is not uniformly rising prices or falling prices, but a combination.

When banks stop lending, the money supply and velocity go down. When the government spends in excess of taxation, the money supply goes up, but at different points in the economy. So I would expect goods that are usually financed by the banking system, such as houses, to continue to fall in dollar-denominated value. Which prices rise is going to depend on the details of the stimulus package.




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