In the Inflation Camp

To many people, a deteriorating economy, sluggish bank lending, and widespread frugality indicate that deflation is by far the biggest threat we face. But as Jesse's Café Américain argues in "Some Common Fallacies About Inflation and Deflation: the Weimar Nightmare in Review," history suggests that might not be the case.

There are several fallacies making the rounds of the economic community, often put forward by pundits on the infomercials for corporate America, and also on the internet among well-meaning but badly informed bloggers.

The first of these monetary fallacies is that 'the output gap will prevent inflation.' The second is that a lack of net bank lending or other 'debt destruction' will require a deflationary outcome. Let's deal with the output gap theory first.

Output gap is the economic measure of the difference between the actual output of an economy and the output it could achieve when it is most efficient, or at full capacity.

The theory is that when GDP underperforms its potential, with unemployment remaining high, there can be no inflation because demand is weak and median wages will be presumably stagnant. This idea comes from neoliberal monetarist economics, and a misunderstanding of the inflationary experience of the 1970s.

The thought is that sustained inflation is due to a 'wage-price' spiral. Higher wages amongst workers cause prices to rise, prompting workers to demand higher wages, thereby fueling inflation. If workers do not have the ability to demand higher wages there can be no inflation.

While this is in part true, it tends to confuse cause and effect.

The cause of a monetary inflation, which is a broadly based inflation across most products and services relatively independent of demand, is often based in a monetary expansion of the currency resulting in a debasement and devaluation.

A monetary expansion is relatively difficult to achieve under an external standard since it must be overt and often deliberative. A gradual inflation is an almost natural outcome under a fiat currency regime because policy-makers can almost never resist the temptation of cheap growth and the personal enrichment that comes with it.

There can be short term non-monetary inflation-deflation cycles that tend to be more product specific in a market that is not under government price controls. But this is not the same as a broad monetary inflation or deflation.

The key difference is the value of the dollar which has little or nothing to do with a business cycle or product demand/supply induced inflation/deflation.

In the modern era the Federal Reserve can increase the money supply independent of demand by the monetization of debt, with the only restrictions on their ability to increase supply being the value of the dollar and the acceptability of US sovereign debt. This requires the acquiescence of the Treasury and the cooperation of at least one major money center bank.

People tend to invent 'rules' about how the money supply is able to increase, and confuse financial wagers and credit with money. This is in part because the average mind rebels at the reality behind modern currency and the ease at which it can be created. Further, people often invent facts to support theories that they embrace in an a priori manner.

In a pure fiat currency regime, the swings between inflation and deflation are almost always the result of policy decisions, with the occasional exogenous shock. A government decides to inflate or strengthen their money supply relative to productivity as a policy decision regarding spending, central bank credit expansions, banking requirements and regulations, among other things.

As a prime example of a rapid inflation despite a severe economic slump, what one might call uber-stagflation, is the Weimar experience.

Since pictures are worth 1000 words, let me be brief by showing you a few important charts.

The basic ingredients of the Weimar experience are...

A high level of official debt issuance relative to economic growth

High unemployment with a slumping real GDP



Wage Stagnation



I should stop here and note that although the statistics at hand involve union workers, in fact unemployment was widespread in the Weimar economy. The saving grace of being in the union was that one was more often able to retain their jobs and some level of nominal wage increases.

Anyone who has read the history of the times knows that unemployment, underemployment and slack demand was rampant, and that hoarding was commonplace as people refused to trade real goods for a rapidly devaluing currency.

Rapidly Rising Prices Despite Slack Demand and High Unemployment



So much for the wage price spiral and the output gap.

A Booming Stock Market, at Least in Nominal Terms



Booming Price of Precious Metals as a Safe Haven Even While Basic Material Prices Slumped

Notice the plunge in the price of copper as the economy collapsed and gold and silver soared.

If one can obtain a copy, as it is out of print, one of the best descriptions of the German inflation experience is When Money Dies: the Nightmare of the Weimar Collapse by Adam Fergusson. There is a copy of the book available online for free here.

From my own readings in this area, the people who tended to survive the Weimar stagflation the best were those who:
1. Owned independent supplies of essentials including food and shelter and were reasonably self-sufficient.
2. Had savings in foreign currencies that were backed by gold such as the US dollar and the Swiss Franc
3. Possessed precious metals
4. Belonged to a trade union and/or had essential skills or government position which guaranteed a wage
5. Were invested in foreign equity markets, and even in the domestic German stock market for a time

People will argue now that the Fed understands that inflation is caused by perceptions, and that by managing those perceptions inflation can be avoided because even those prices are rising and the currency is being devalued, if they ignore it the inflation cannot reach harmful levels.

This is what I call the "psychosis school" of behavioral economics.

Granted, perception is important, and managing perception may delay outcomes for a period of time. But unless the underlying cause of the problem is remedied during what is at best is an extended interlude, the resulting break in perception will ignite a firestorm of cognitive dissonance, loss of confidence, and social unrest.

In summary, in a purely fiat currency regime a sustained monetary inflation or deflation is an outcome of policy decisions regarding fiscal policy, monetary policy, and economic balance and output.

As long as the government is able to generate debt, deflation is a highly unlikely outcome. And when the government reaches the practical limits of debt creation, the underpinnings of the currency give way and the economy tends to collapse in a stagflationary slump.

There are no predetermined outcomes in a fiat monetary regime. Deflation, stagflation and hyperinflation are not 'normal' but are certainly possible if the central authority is permitted to abuse the real economy and the money supply for protracted periods of time.

What about Japan? Japan is the perfect example of a policy decision made by a fiat currency regime in what was decidedly NOT a free market, but under the de facto control of a highly entrenched bureaucracy, a single political party, and large corporate giants in pursuit of an industrial policy that favored exports and domestic deflation.

The difference between the Japan of the 1980s and the US of today could not be more stark. Choosing a deflationary policy and high interest rates as a debtor nation is economic and political suicide. It would be interesting to see what happens if the US elites try to take that path.

We will know if there is a true monetary deflation in the US because the value of the dollar will start increasing dramatically with regard to other hard assets, other currencies, goods and services, and precious metals and commodities. Prices will decline especially for imports as the dollar gains in purchasing power.

Remember that a true monetary inflation and deflation would only show up over time. Even in the Great Depression in the US, as demand slumped and prices fell, the stage was set for a significant devaluation of the US dollar and a rise in consumer prices well in advance of the eventual recovery of the economy that caused the Fed to tighten prematurely. As I recall the actual contraction in money supply lasted two years. This again highlights was an amazing piece of bad policy that Japan represents in its 'lost decade.'

People embrace beliefs for many motivations. So often I find they are not 'rational' and based on a scientific study of the facts, even on the most cursory level. Fear and greed and prejudice are often motivations that are surprisingly resilient, even in the face of overwhelming evidence against them. Leadership understands this well.

There are often appeals to private judgement. I do not care what you say, this is what I believe, what I think, what I feel. This is appropriate in the supra-natural realm, but in the natural realm there may be private judgement but the facts are public, and the outcomes are well beyond the complete control of the most fully-managed perceptual campaigns, at least so far in human experience.

"The lie can be maintained only for such time as the State can shield the people from the political, economic and or military consequences of the lie. It thus becomes vitally important for the State to use all of its powers to repress dissent, for the truth is the mortal enemy of the lie, and thus by extension, the truth is the greatest enemy of the State." Joseph Goebbels, of the perception modification school of economic thought

What is truth? It is difficult to estimate but not completely out of reach.

Our own view is that a serious stagflation with further devaluation of the US dollar as it is replaced as the world's reserve currency is very likely, after a period of slackening demand and high unemployment. A military conflict is also a probable outcome as countries often go to war when they fail at peace.

Weimar was not an anomaly although the level of inflation was indeed legendary. Argentina, post Soviet Russia, and most recently Zimbabwe are all similar examples. Serious Instances of Monetary Inflation Since World War II

There are many, many variables in play here, and policy decisions yet to be made. It is highly discouraging to see Obama's Administration fail so miserably to do the right things, but there is always room for hope, less so today than six months ago however.

Argue and shout grave oaths and wave our hands though we might, we are in God's hands now.

Let's see what happens.

A very special thanks to our friend Bart at Now and Futures who makes these charts, among other things, available on his highly informative web site for public review. If you are not familiar with his work you might do well to view it. We do not always agree, but he demands attention because of the rigor which he applies to his work for which we are grateful, always.

As far as my two cents goes, one could easily argue that the dollar's long-standing role as a reserve currency means that there are a great many "unnatural" holders of the U.S. currency around the globe. Generally speaking, they require more incentives than Americans to remain invested. In a world where the U.S. is no longer seen as the leader it once was, where the risks stemming from hyper-expansive fiscal and monetary policies are increasingly apparent and growing by the day, and where many old truths are no longer being taken for granted, it is not a stretch to think that today's demand for the currency could easily evolve into tomorrow's rapidly growing supply.

Comments

[Suzanne]

Inflation?
What's barter then? Take a look at the rich and famous property swaps, and transfers of late. RE market may have values that are still recorded, but there's no cash transactions. Nor is there even bank financing. It's all transfer of properties being swapped. Sounds like barter to me.

Got Deflation?

[Alexandra]

That's a discussion only academics can be fond of, and it shows that they still haven't grasped the size of this tragedy.
Why should anyone care whether his/her (economic) life and possibility to sustain herself is destroyed by losing her job in a deflationary environment, as opposed to losing her purchase power in an inflationary environment.
While the path by which this economic extermination happens may be of interest to academics, the outcome, at least it seems to me, is exactly the same for the people concerned.
They will be annihilated - and that is to be understood literally.

[Chris Roland]

I think it's dangerous to make the current situation an academic discourse. It means so much more during the event, after it makes sense to debate and remonstrate and all the rest, but for now we're in a real crisis, and need solution, not a deeper understanding of what went wrong.

[SS]

EVER HEARD OF RESERVE CURRENCY?

The status of the dollar will attenuate its fall but not eliminate it; this is quite different the the German Mark during Weimar.

[Rocky]

So far the academics have not had to bear much of the burden of the American economic catastrophe. Very few colleges have gone broke, although a few small ones have. Retired college professors are still getting their defined benefit pensions and their medical bills are still being paid. But if things get much worse, we may even have book burnings in the streets. It wouldn't take much to touch off riots in every major city in the country. Many American cities experienced inner city upheavals in the late 1960's, when the economy was far more stable than it is now.
Let's face it, we have very bad government leadership in recent years and now we are paying the price. There is no magic wand to undo the problems our government created at home and abroad. We can't bring back the many thousands of Iraqis killed in over six years of turmoil that the US unleashed. We can't bring back the thousands of US troops that have died in a war that should never have been started by the US. And we can't even bring to justice the people most responsible for starting the war. There was more effort made to pass a Federal Marriage Amendment earlier in the decade than to bring some control over the massive real estate speculation going on. Sarbanes-Oxley failed to protect investors from the rampant speculation and inadequate disclosure in the financial services industry. 50 state insurance regulators all failed to figure out what insurance companies such as AIG, PMI, MGIC, FGIC, MBIA, AMBAC and others were up to, but over two dozen states did manage to pass anti-gay marriage amendments of their own. The butcher's bill has now come due.

[nmtdoc]

As others have posted, the human tragedy will be much the same either way. However many of us are trying to understand these issues so we may protect what is left of our savings. To that end I would like someone to explore the larger macroeconomic issues. Do we really have the same situations globally that existed during the Weimar Republic? With no gold standard and most if not all central banks in stimulus overdrive why should one currency crash while the others don't. It seems a better case can be made that all fiat currencies are equally problematic. Should we hedge against dollar devaluation by converting some dollars to other currencies, or will we just be chewed up chasing yield in the FOREX markets? Is it possible that we get massively increased volatility, and alternating bouts of inflation/deflation as market participants run from one side of the boat to the other. It is currently in vogue to to be down on the dollar, and maybe for good reason. I found Charles Hugh Smith's article "Good Cop, Bad Cop" over at OF TWO MINDS thought provoking and worth reading as it relates to the current balance of global power.

[bobn1955]

In the graph for "Wage Stagnation", income is shown in "REAL" wages. So the nominal wages *did* climb along with everything else. So what does this prove?

[roger]

Inflation/deflation/crapflation:
California collapsing.US economy next.Wonderful
world of money.Monetary policy defining social
relations.No money no schools,no health care,no food,
no housing,NO nothing.nada, zilch.And yet....and yet
we have the knowledge & the capacity to make and to produce
all the necessity' s to live a decent life.THINK ABOUT IT!

[Patrick]

We know the powers that be want inflation, but what evidence do you have that they're competent to achieve their economic goals?

What are the conduits for delivery of the inflating money supply in the form of income/credit to the masses? Until Bernanke's helicopters appear on the horizon, the masses will continue to wither in the darkness of collapsing credit and wages while holding the fewer dollars they do possess more dearly.

[Independent Accountant]

MP:
Did you see Axel Merk's comments today at Financial Sense? Take a look. I read both of Jesse's comments and much of what he writes I have said, WORD FOR WORD.

[Tyrone]

I guess all is well...

Fed says recession easing, inflation is tame
http://finance.yahoo.com/news/Fed-says-recession-easing-apf-232707420.html?x=0&sec=topStories&pos=main&asset=&ccode=
WASHINGTON (AP) -- The Federal Reserve sought Wednesday to defuse fears that the trillions it's spending to revive the economy could spark inflation later on.

[Sean]

well meant, but wow the quality of comment here is loooooowwwwwwwwww.

[inflation]

Sooner or later inflation will kick in. It is the only option left to have a shot of getting out of this mess. It seems so simple looking at it from the outside. One wonders why it is so difficult for the MSM to see and talk about.

[vivdvew]

I read a lot of different financial blogs and have not, that I remember, seen ANY make the output gap argument. As for debt destruction, nowhere in the overly long argument, considering the amount of hard content, was debt destruction argument countered. The statement that government can always issue more debt thereby creating inflation may be theoretically true but it bears no resemblance to reality as it exist today. The amount of new debt issued by government and even the amount projected to be issued, does not even begin to approach the amount of debt and wealth that has been destroyed since the start of all this. Never mind how much more has yet to be destroyed.

While it *may* be true that inflation is to come(who knows what is to come) it is demonstrably true that we are currently in deflation.

Not to say they are necessarily wrong, but most of the people I see preaching hyperinflation are not even able to accept the fact that we are currently in deflation. So if you are unable to accept the facts as they exist today, I must view your predictions of the future in the same light as the guy standing next to the roulette table who says to always bet 13.

[Michael Panzner]

I've said this before, but it bears repeating (especially for those who might be new to Financial Armageddon or who haven't read my other work):
My March 2007 book predicted what we are experiencing now would happen first, then hyperinflation.
In fact, here is an excerpt from the table of contents:
PART TWO: RISKS
5. Economic Malaise
6. Systemic Crisis
7. Depression
8. Hyperinflation

[Independent Accountant]

Vivdvew:
Bernanke, Blinder and Krugman, the "Princeton Three" make this argument. It is standard Keynesianism.

[Mbuna]

On the comparison with Japan, not so fast- I think it can be argued, directly using your quote that in may ways we are in fact in the same boat as Japan- "...a policy decision made by a fiat currency regime in what was decidedly NOT a free market, but under the de facto control of a highly entrenched bureaucracy, a single political party, and large corporate giants in pursuit of an industrial policy..."
We are (in fact!) under de facto control of a highly entrenched bureaucracy (not necessarily single party but that is minor IMO)and large corporate giants in pursuit of a FINANCIAL policy akin to running a casino. Additionally it can be factually stated that the stock market along with many other financial markets are being successfully manipulated and therefore you cannot stake the claim that our market system is a free market system and thus different than Japan's. I argue that at this time and place they are more similar than not using your parameters. Overall this argument feels incomplete to me but I confess I have yet to find one that does feel complete. This is not the 1970's or the 1930's, the global economy is so much more linked on every level and derivatives, the financial crack of an entire sector of the economy has not been addressed here at all. I certainly don't know the answers but I have too many unanswered questions.