Over the past few months, as the economies and markets of the world have tumbled and their respective governments have tried to dull the pain and spark recovery through various stimulus and bailout packages, 2 sides have emerged as to what lies for the future: Inflation or Deflation.
So where is the __flation? Prices are actually pretty stable overall. Sure certain things are now priced higher such as gold, other metals, certain consumer goods, and intangibles such as Risk. Other things are priced lower including oil, real estate, palladium, and certain consumer goods. But overall the aggregate of prices of all goods and services in this country is stable with the CPI and PPI pointing to only moderate changes (there was a dip after oil fell from its artificially high $140s/bbl).So with all the turmoil going on around us, why is there of all things price stability? Nobody seems to be answering this question but they do seem to be predicting the future. First I'll briefly go over the arguments for either scenario and then try to throw in my own 2 cents.
The case for Inflation:
Simply put, inflation is when prices of goods and services.. let's call that everything.. when the price of everything goes up. There has been inflation throughout history, and even though many people argue that leaving the gold standard to a fiat paper money or Nixon closing the gold window caused inflation, there has existed this phenomenon since ancient civilization. (For more on this read the book 'An Analysis and History of Inflation' by Don Paarlberg)
Yes, it is true having a fiat currency based on nothing else but the full faith of the gov't certainly accelerated the pace of inflation, it is not the cause in and of itself. In fact the greenback and other fiat currencies (Euros, Pounds, Yen, basically everything now) are the seeds for the hyperinflation scenarios many economists fear.
In order to salvage the economy, governments of the world are providing fiscal stimulus, lowering interest rates, bailing out large firms, and spending on a massive scale - all without substantially raising taxes. In order to fund all this the gov't is printing trillions of new dollars. And the gov't can print as many new dollars as it sees fit!
But like everything else, a dollar (or any other form of currency), is subject to the law of Supply & Demand. We all learned in high school economics class that the price of something is achieved by the equilibrium of supply vs. its demand. This is only half true: you must also factor in the supply and demand of the currency so the new formula should read: Supply(good) x Demand(good) / Supply(money) x Demand(money).
Simply put, the more money that exists, the less valuable each dollar is. The less valuable a dollar is the more expensive stuff is -- it takes more dollars to buy the same stuff... inflation!
Imagine for a moment that the richest companies and people in the USA got together and decided to be 'charitable' and spread their wealth evenly amongst American families and for the sake of argument let's assume that as a result each family in America suddenly received $5 Million in cash. What would happen to prices of stuff? Many peoples' initial reaction is that stuff will get cheaper.. this is wrong and is a great example of the flawed economic thinking of most Americans! Prices of stuff will go up.. a lot!
To see why think about a Ferrari that costs $500,000 today. If everyone had $5 Million then they could all go out and buy 10 Ferraris! Therefore, the price of those cars must go up dramatically! A loaf of bread could reasonably cost $1000 or more in this scenario.
So when the gov't creates all this new money it dilutes the value of all dollars. If you look at the money supply or amount of money in existence throughout time, we are now at historic highs and the graph looks exponential to the upside. At the same time, the real value of the dollar (or its buying power) has declined nearly 95% since the early 1900s. Even anecdotally, I can remember my grandpa telling me that a stick of gum cost a penny and an apple cost a nickel when he was a kid.
Additionally, there is the argument that the gov't (publicly or privately) wants and even needs a policy of inflation in order to pay off its interest and debt. If you owe $1 Trillion to some other country, wouldn't it be better if that $1 Trillion was actually worth less? We made need massive inflation as the ONLY solution to paying off our gov't debt and obligations without defaulting!
The case for Deflation:
Recessions and depressions are deflationary by nature. As the economy contracts and jobs are lost, both consumers and businesses slow spending (decrease demand) causing producers to cut prices and in turn slow production causing a cycle of even more job cuts and wallet tightening. At the same time, we are in the midst of mopping up a credit crisis and as result there is a massive deleveraging push that will go on for years. Deleveraging means reducing the debt ratio. Debt destruction is in effect money destruction. Converse to the inflation argument, the less money that exists the more valuable each dollar becomes and thus prices decrease = deflation!
Deleveraging has/is not only occurring at the corporate level with banks and funds selling assets to raise cash, but also on the home front. Consumers have increased the personal savings rate from nearly zero to now over 5% in a very short amount of time. While personal savings would have provided a cushion PRIOR to the current events, it certainly is not helping to spark the economy - spending now would help stop the downward spiral.
As consumers and businesses reign in spending and increase savings it lowers the velocity of money. The short definition of that being how often a dollar changes hands. The gov't could print a 100 trillion more dollars but it wouldn't spark inflation if they are only kept in a vault never to be used or accessed by others. (alright maybe the mere knowledge of the existence of such a sum of new money would cause a drop in the dollar but who knows!)
The world stock (and other securities) markets have dropped severely since it's late '07 peaks. This has effectively wiped out and destroyed trillions of dollars (and euros and yen and pounds etc.) which in turn is both deflationary as it reduces the amount of money (in this case liquid wealth- one can easily and quickly convert shares or bonds into cash) in existence but also contributes to the downward pressure on the economy as a whole and unemployment.
The federal reserve, as well as foreign central banks, have lowered their interest rates to nearly 0%, indicating that inflation is merely an after thought right now. If you trust the gov't and your central bank then this is more evidence of deflation. If you distrust them then perhaps it will blow up in their face and will scramble to raise rates if the inflation bug bites.
So there is compelling evidence for both inflation or deflation to grab hold of us in the coming months and years. There is an enormous tug of war going on right now between the opposing pressures right now which, ironically, is keeping overall prices stable for the time being.
As new money comes off the printing presses by the trillions, trillions of existing dollars are being destroyed by crumbling markets.
I do agree that some time (sooner than later) one of these pressures will become stronger and the rope will snap leading to either a hyperinflation or great-depression style deflation.. either of which will wreak untold havoc on the economy and the security of the world.
We can be heading for the edge of the cliff with either our feet on the accelerator (inflation) or on the brakes (deflation), but either way we're going off the cliff and it won't be pretty.
©2009 Adam., all rights reserved. You must have written permission from the author in order to republish this work.
Published: Thursday, March 12, 2009
Last modified: Thursday, March 12, 2009
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Reader Comments:
Posted By: Walt Thiessen
Date: 2009-03-12 12:41:05
What makes you think that prices are stable? The fact that they haven't changed in the last five minutes?
Price stability is measured over the course of years, not days (except perhaps during hyperinflation). Over the past year, property values across the country have plummeted by roughly 20-25%, over 50% over the past three years,75-80% in some areas of the country like Miami, FL. The price of oil has dropped over 75%, and even now it is bouncing back and forth within the range of roughly $35 a barrel and $50 a barrel. I would hardly call this "price stability."
In other words, we're already experiencing deflation, and we are not done. As investors flock to the dollar as their choice of safe haven in the form of Treasuries, the Fed is already pouring trillions of new dollars into the economy. God help those same investors when the whipsaw of inflation replaces deflation. They'll get clobbered.
Your claim that _flation is about prices is wrong, although I grant you that it's understandable since that's the way most people use the word. In truth, _flation is about changes in the money supply. Those changes can take 1-5 years to show up in prices, which means it's too early to see the changes in prices due to the new money being poured into the economy. Nor do prices rise or fall uniformly. They never have, because monetary inflation does not uniformly enter an economy. Instead, it dominates certain sectors of the economy that get the bulk of the new money first.
It's true that inflation and deflation have been around for years. Unfortunately, historians didn't realize the connection to the money supply, so where and how the money supply was manipulated is rarely mentioned by those same historians. Even when gold and silver dominated, the money supply was manipulated whenever a new king took the throne. He'd call in all the coins bearing his late father's likeness, melt them down, then reissue them all slightly smaller, keeping the remaining gold for his own treasury. As he spent that money he'd captured via debasement, the "inflated" money supply led to inflated prices, particularly in those areas of the economy where he spent the money.
In every historical report where we also have a record of how the money supply was handled by those in authority, we are always able to see how changes in that money supply adversely affected prices. Just because we are rarely privileged to examine that evidence in historical accounts doesn't mean it wasn't happening.
Once our current deflationary period reaches its lowest depth, it will reverse as the newly issued money takes hold and enters the economy. Watch for rapidly rising prices in certain segments of the economy over the next 1-5 years. That will tell you who got the new money. Meanwhile, you can expect the Fed to keep pouring in new money, trying to stimulate the economy. When all that money finally "hits" watch out! That's when hyperinflated prices could easily kick in...inflation which is actually happening right now, even though prices don't show it yet.
Posted By: Jahfre Fire Eater
Date: 2009-03-12 16:07:15
HI Adam,
Between your article and Walt's comment I have a bunch of things to say.
Your're looking in the wrong place for answers or asking the wrong questions. Watching for a particular result is a waste of time. Look at the goal. The only way the US Government can get out of the black hole of debt we've entered is by massive inflation. That is, according to their Keynesian/Friedmanite monetary policy and their flawed view of the way things work.
The only way they know to inflate is with the interest rates and bailouts. The problem for them is that in this global situation the US would have to engineer a massive inflation that every major currency in the world becomes involved in. Keeping it all relative but wiping out any existing debt everywhere in the world.
The recent tactics are not intended to "jump start" our economy or "lead us to a recovery" those are just well chosen marketing terms. The recent programs are meant to keep the illusion of stability going as long as possible. If the major failures began to pile up it would be a matter of days before the entire world had to redo from start, economically. Political upheavals would be widespread. All that will eventually happen anyway but if the USA can lubricate the world for just long enough we may come out of the mess on par with rather than under the boot of our creditors.
Trying to make any sense of the recent actions without understanding their purpose isn't productive analysis.
A more important question is when the administration eventually realizes that their theory was wrong about how to cause inflation, what will they try next?
The current theory is that the financial plumbing is clogged. All they need to do is continue forcing waste down that drain and the plumbing will return to its original pristine state. These are folks who really didn't pay attention to the finer details of trickle down economics.
First of all, there isnt a "clog". All of the downstream pipes are choked with weeds and masses of bacteria that thrive on the fertilizer that has been coming down the pipe for so long. There is just no where for anything to go. The system is no longer a system, it is an artifact. It needs to be dug up, studied and replaced with plumbing that is willing and able to receive additional trickle down. Then inflation can happen.
But no, they will never realize that is a viable course, they will stick with their "clog" analogy but will change the theory. They will eventually decide that putting money in the top isn't working to create inflation so they will begin delivering the money directly to the consumers. In their view, bypassing the "clog" will suck it right through and everything will begin to flow as it used to.
But wait, giving money to Americans directly will not necessarily cause world-wide inflation so even thought that is going to happen, it probably will not be the next obvious choice. No, that will be increasing foreign aid. Giving money directly to foreigners will happen before giving it directly to Americans.
But, before any of that, they will attempt to rev up the military industrial economy to support new offensives against tactics and geography with no clear objectives other than to expend munitions and damage assets, ours, or theirs, we'll pay for it all, just keep breaking things. Oh, and if some people get killed, well, war is hell.
We are not facing a clog or a slipped cog in a machine. We are facing consequences. The illusion that consequences can be indefinitely avoided was the engine of the great inflating wealth from nothing bubble. The reality is that consequences must be suffered before lessons can be learned and a functional economy constructed to replace the one we are now watching collapse.
There is no recovery. There is no recent past economic state that is stable or sustainable. There is no situation to recover to, we have to reconstruct, not recover. We can't reconstruct until they quit propping up this failed system. We still got a long way to fall, especially if the give-aways and war actually manage to reinflate on last bubble to eat all bubbles before the consequences are finally suffered.
-Jahfre Fire Eater