Want the news summarized?
Subscribe to The Morning Report.

Fellow Voice contributor and all-around knowledgeable guy Seth Hettena has written a thoughtful letter making the case for a longer-term deflation in prices.

Below are a couple of responses to specific points he made; I will wrap up by offering a theory as to what the big sticking point is on the inflation versus deflation argument.

Seth writes:

The bond market, which is extremely sensitive to inflation, is a good place to look for just such a forecast of inflation rates. One such forecast is known as the TIPS spread, which is the difference between 10-year Treasury notes and 10-year Treasury Inflation Protected Securities (TIPS). There’s not much of a difference between the two. Why? Despite the massive infusion of government dollars into the financial system, the bond market is forecasting little to no inflation over the next 10 years.

Why is this? Because the bond market puts far less faith in the government’s power to print money than Toscano does.

There is no question that the bond markets are priced for a long-term deflation. I can only assume that Seth is implying that this is a good reason to believe that such an outcome will actually take place. I don’t see it that way at all.

This is the same bond market that wrongly priced in endlessly low inflation in the late 1960s and early 1970s, only to later wrongly price in endlessly high inflation in the early 1980s. Now, it’s pricing in an indefinite deflation. Just as the mortgage-backed securities market priced in infinitely rising home prices in 2005, or the stock market priced in a raging and durable global boom in 2007. The market gets it wrong all the time, especially at turning points.

So yeah, a lot of people think deflation will be with us for a long time, and market pricing reflects that. But as we’ve seen countless times, just because a lot of people believe something doesn’t mean that they are right.

In Part II of his deflation essay, Toscano notes that “The Fed is now printing money in order to lend directly into the mortgage market.” Well, not exactly.

The Fed is buying mortgage-backed securities from to lower mortgage rates and increase liquidity, but banks must still provide the mortgages.

These aren’t measures designed to “get around” the banking system. The Fed buys and sells securities through its open market operations in New York, which our new Treasury Secretary Tim Geithner used to run.

These trades are made through 19 (as of September) banks and bond dealers known as primary dealers, who then lend to other banks in the system. It still has to work through the banking system, not around it.

Nor does the Fed print money. The Treasury does. What the Federal Reserve does when it buys securities is credit a bank’s reserves.

This is really just a semantic quibble. I have used “money printing” as shorthand for the creation of money out of nothing. I suppose I should have made that more clear. But there is no functional difference between the crediting a bank’s reserve account and handing that bank a stack of newly printed money. Both cases entail the creation of money out of nothing, which is the main issue I am trying to bring to light.

As for getting around the banking system, what I mean is that the Fed is itself becoming the lender (lending into the mortgage markets, e.g.), and thus doesn’t need the banks to lend of their own volition. That the banks are a middleman in such a transaction is irrelevant.

Banks are required to maintain money in reserve, usually around 10 percent, to protect deposits. This is where the Fed has been putting its money, in the reserves of banks. And that, I think, is where the money has remained (unless it got paid out in dividends or ridiculous bonuses). Banks have stopped lending because many are no longer solvent. They are merely trying to hang on while they weather the storm.

I agree with this, and this is why I mentioned the various means by which the government is doing an end-run around the banks willingness (or lack thereof) to lend, thus getting money directly into the hands of those who will spend it.

Japan is often cited in debates about inflation because the country experienced a prolonged bout of deflation from which it has not fully recovered. Toscano says that the government of Japan could have ended deflation by dumping large amounts of cash on its citizens, but it wasn’t politically feasible.

I don’t think it was economically feasible, either. Dropping cash on the street corner would bypass inflation and move us directly to dangerous and destabilizing hyperinflation (think Germany post WW I).

The dropping-cash-on-a-street-corner tactic was intended to be an exaggerated example of how the government might get newly printed money directly into the hands of consumers, for what that’s worth. Anyway, I think it’s just wrong to state that getting money directly people somehow causes instant hyperinflation.

To begin with, our government is doing it right now: the Fed is printing money to buy mortgages, which is basically not that different from dropping money on a street corner, if we can assume that street corner in question happens to only be inhabited by people who are about to buy homes. The Fed is (indirectly, I admit) also dropping money onto corners inhabited by credit card users, small business owners, and students. If the Fed buys Treasuries and the government turns around and spends the money into the economy or offers a tax rebate, this is really not much different than a nationwide street corner money drop.

So the Fed and the government are already injecting money into the economy, and have promised to do a lot more of the same. Yet here we are mired in a deflation panic, which is about as far as you can get from hyperinflation.

Can the money-creating tactics being undertaken by our government eventually cause a serious inflation problem? Sure — that’s kind of my entire point. But as I discussed in the articles, our leaders believe there is little such risk, and the lag times involved reinforce this belief. So if threatened with a real deflationary spiral, I doubt they will hesitate to resort to tactics not unlike the street corner money drops. They really already have, to some degree, with the intent to do more. So I don’t see why this should be a controversial claim at all.

Incidentally, Weimar-era Germany actually provides a great example of the delay between monetary excess and its inflationary results. Germany engaged in dramatic money supply growth for years before the hyperinflationary effects of their money printing caught up with them.

For instance, the German government doubled its money supply between May 1920 and July 1921 — yet prices in Germany remained pretty much flat the entire time. During that 15-month period, when the newly created money was stoking economic activity in a way that hadn’t yet caused a general rise in goods prices, Germany actually enjoyed an economic boom that was the envy of the world. But it was all fake, and built on exactly the type of monetary pumping that our authorities are now promoting. Prices began to rise rapidly starting in July 1921 and by the time Germany’s hyperinflation really hit its stride in 1923 the seeds had long since been sown.

As for the hypothetical example of Alice, Toscano is right. Alice technically hasn’t lost money. However, a financial institution or a corporation that owned the shares of XYZ company that Alice did is required to write down the value of its investment and take a loss.

Granted these aren’t cash losses, but they still affect the share price (market value) of a company. For banks, it’s even worse. The problem many banks are having now is that they had to write down so much of their assets that they are technically insolvent.

Agreed, and I more or less mentioned this in the article. The point of that section was not to deny that asset price declines exert a price-deflationary effect, it was to counter the very common argument that a decline in asset prices is equivalent to a disappearance of money (with the implication that this vast disappearance of money is something that cannot be overcome by government reflation). None of this is in conflict with what Seth has mentioned above.

It’s true that much has changed since the Great Depression. But one thing hasn’t changed, and it’s something these charts don’t measure: the amount of leverage in our financial system. Our financial system became hopelessly addicted to easy credit and over the past few years, and our banks took on way, way too much risk.

As Irving Fisher wrote in his 1932 essay Debt-Deflation Theory of Great Depressions: “Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with the borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts.”

Ultimately, this is the strongest case for deflation. By saving banks from failure, we may delay their inevitable collapse, but we reward failure and scare away investors and fresh capital, the oxygen of our financial system.

Anyone fortunate enough to be sitting on cash now isn’t likely to put it in a U.S. bank or buy U.S. bonds. As a result, the destruction of our financial superstructure will continue no matter how much the Federal Reserve inflates its balance sheet.

Well, I can’t really disagree with any of that. This gets to what seems to be at the core of many deflation-leaning comments that I have received.

There are many reasons to believe that demand could decline, or at least cease to increase, for a long time to come. No argument here. The disagreement seems to stem from the fact that the long-term deflationists assume that the US Dollar will be a reliable measuring stick of that decreased demand.

I do not believe this will be the case, because our government is hell-bent on assuring that it does not play out that way. To the extent that real demand declines to a certain extent, they feel it’s their duty to make sure the currency loses purchasing power to an even greater extent. And thanks to their ability to create endless amounts of money and to shunt that money pretty much wherever they want, they are perfectly capable of doing so. (The fact that I think this policy is horribly misguided is, incidentally, immaterial).

So: people are saving, and worrying, and losing jobs, seeing their assets decline in value, and watching the financial system kind of implode. They will purchase fewer things. But that purchasing takes place in dollars. And given our government’s inflationary bias and unlimited money creation ability, it’s perfectly plausible that economic activity could decline as the currency of the realm lost purchasing power even faster. Economic contraction and debasement-driven inflation have been constant bedfellows throughout history. And they will be yet again. Maybe soon.

— RICH TOSCANO

Leave a comment

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.