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,

Cassie

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