Editor’s Note: This is the second part of a two-part analysis of the specter of deflation. Part I can be seen here.
In Part I of this series, I explained why a protracted “deflationary spiral” was an unlikely outcome based on the government’s desperation to prevent deflation from taking hold combined with its ability to create a limitless amount of money from nothing. Below, I address the various arguments that are often made by those who think a deflationary spiral is inevitable.
Pushing on a String
This objection is based on the idea that you need willing lenders and borrowers to cause monetary and price inflation. The contention is that you can lower the Fed funds rate or increase bank reserves, but you can’t make banks lend nor can you force people to borrow. Without willing lenders and borrowers, the money supply won’t expand. Further, even if new money is created, deflation will still be the result if everyone chooses to sit on their money instead of spending it (or to put it in econo-nerd terms, if velocity is low).
The problem with this argument is that it presupposes that the Fed will stick to only manipulating the Fed funds rate and goosing bank reserves. We’ve already seen that this simply isn’t true. The Fed is now printing money in order to lend directly into the mortgage market. Once that money is spent to buy a house, it’s in the system. The Fed has additionally lent into the commercial paper market, getting money directly into the hands of businesses that wish to spend it, and they are setting up another facility to monetize consumer credit card and small business debt.
Similarly, if the Fed follows through on its plan to monetize Treasuries, then the government will spend that money into the economy via its stimulus packages. By sending out rebate checks, the government can effectively force people to borrow indirectly by borrowing on their behalf and giving them the money. If it came down to it, the government could issue everyone debit cards backed by newly printed money. But they need not even get the all the money into the hands of consumers — they can themselves undertake huge spending programs (infrastructure projects, etc.) and become a giant consumer whose activity offsets the decreased consumption of individuals.
These are all mechanisms to get around the banking system and to get money directly into the hands of people or entities who will spend it. The Fed itself is the “willing lender,” and the “willing borrowers” consist of businesses, home buyers, consumers, and of course the US government, which will never turn down a loan. The net effect is that the money is forced into the system (increasing the broad money supply) and that it is being spent in the real economy (increasing velocity).
To be clear, I agree that velocity is a major component of price deflation and inflation, especially over shorter time periods. I also agree that velocity has dropped like a rock as a result of the deleveraging, market crashes, and recession. But velocity has a lower limit — people need to spend at least some money to live. The printing press, when wielded by a government that is firmly committed to inflation, has no upper limit. There could definitely be some lag between the increased money supply and the pickup in inflation. But in the end, the limitless power of the printing press prevails.
As Bernanke’s 2002 speech (discussed in Part I) foreshadowed, they are creative, they are determined, they are strongly biased toward inflation, they don’t care about rules or convention, and they will continue to find ways to get money into the economy. The deflationary alternative is simply not a viable option for them. The “pushing on a string” argument would be valid in an environment in which central banks were being cautious and disciplined and sticking to the long-accepted conventions of central banking. This is no longer the world in which we live.
Japan
Japan’s long period of deflationary stagnation is often cited as “proof” that deflation can become an unstoppable force even under a fiat currency system. This argument makes the assumption that because Japan didn’t put an end to deflation, that must somehow mean that they were unable to do so.
This is not correct. Japan could have ended their deflation, as described at the beginning of Part I, by handing out huge stacks of money to everyone. Deflation can always be ended, and inflation always engendered, by the creation of sufficient amounts of money. I believe that Japan simply could not go down this road because it was politically unfeasible.
Inflation and currency debasement are great for debtors but bad for savers. Japan was (and still is) a nation of savers, so debasing the currency was not a politically viable option for Japan in the 1990s. As a result, the Japanese money supply has grown very slowly — since the early-1990s bubble burst, the Japanese M2+CDs monetary aggregate has typically increased at a very modest 2%-4% pace annually. This mild growth in the money supply was not sufficient to overcome the price-deflationary forces at work after the bursting stock and real estate bubbles. Japan chose to undergo some price deflation rather than take the politically unfeasible step of debasing their currency.
The modern-day US, in contrast, is history’s biggest debtor nation — here, it is politically unfeasible not to debase the currency.
Japan did eventually embark on “quantitative easing” in 2001 when they supplied commercial banks with newly created reserves. However, their quantitative easing was much milder than ours and was more narrowly targeted than the Fed’s “monetize everything” strategy. The newly created bank reserves weren’t lent out into the economy, which is to say that they didn’t cause an increase in the broader money supply measures. (Part I of this series, in contrast, describes all the ways in which our government is already making sure that their new money gets into the economy).
Just because Japan chose not to force money out into the broader economy does not mean that they could not have done so. Japan’s status as a net creditor nation prevented them from creating inflation by flooding the economy with money. Our status as a net debtor nation compels our authorities to do just that.
Lost Financial Asset “Wealth”
In the aftermath of the severe asset market declines of recent months it is common to hear the argument that all the money printing and stimulative government spending can’t make up for the huge amounts of “wealth” lost in the financial markets. The government could print up $2 trillion new dollars, the argument goes, and it wouldn’t even come close to making up for the $10 trillion of wealth that was lost in the markets.
This argument has two problems. To begin with, of course the government can make up for the lost wealth. They can create as much money as they want. If $10 trillion of wealth (as recently estimated by Merrill Lynch) was lost in the markets, then the government can print $11 trillion. And so on.
But the bigger problem with this argument is its assumption that a given decline in asset prices is equivalent to the destruction of that amount of money. This simply isn’t the case.
This concept is most easily illustrated with an example. Let’s examine the case of Alice, a hypothetical asset owner who I will say owns 1 million shares of XYZ company. Last year, the stock was worth $3 per share. Now it’s worth $2 per share.
The value of the Alice’s stock holdings have thus dropped from $3 million to $2 million. It’s true that Alice is now $1 million less “wealthy” than she was prior to the stock price drop. People usually only look that far, and assume that the stock price decline has resulted in the disappearance of $1 million from the economy.
But if Alice actually wanted to use her asset wealth to buy something, she’d have to sell her stocks first. It’s important to consider both sides of that transaction.
Let’s look at two scenarios. In the first, Alice sells her stocks to Bob before the crash for $3 per share. In the second, she sells them to Bob after the crash for $2 per share. If Alice decided to sell her stock to Bob before the crash, she would be paid $3 million. If she sold the stock to Bob after the crash, she’d only get $2 million.
However, in the first scenario, Bob would have to pay $3 million, whereas in the second, he would only have to pay $2 million. So while Alice is $1 million less wealthy than she could have been had she sold a year earlier, that $1 million didn’t disappear. It’s just that Bob got to keep it. Alice has $1 million less than she would have had she sold to Bob a year earlier — but Bob has $1 million more than he would have had he bought Alice’s shares a year earlier.
In other words, no money has been destroyed — it’s just been moved around. There has been no change in society’s aggregate ability to spend.
Even if the stocks didn’t have to be converted to money to harness their value, but were instead “bartered” for something, the same principal would apply. If Alice were trading stocks to Bob in exchange for food, a decline in stock values would mean that she got less food in exchange for each stock share. But it would also mean that Bob had to part with less food to acquire the same amount of stock.
Prices in an economy go up and prices go down. Relative values change. The decrease in the price of a particular item, even if it is a financial asset, does not destroy the ability to purchase — it just moves purchasing ability from potential sellers of that item to potential buyers.
There are some price-deflationary effects of a widespread decline in asset prices. All the stock holders who were still holding their declining stocks would definitely feel less wealthy than they did before the price drop. It’s likely that they would accordingly reduce their spending and boost their saving, which would exert a price-deflationary effect due to reduced monetary velocity and an increased demand for cash balances. In other words, while there was no change in society’s overall ability to spend, there might well be a reduction in society’s willingness to spend. But this phenomenon is very different than the actual destruction of money or spending ability.
Lower asset prices might also make it difficult for banks holding those assets on their balance sheets to lend new money into existence. But while this puts a potential damper on new money creation, it does not destroy any existing money. This ability or lack thereof to create new money would show up in changes to the money supply — but as we saw in Part I, the money supply is growing at a fairly healthy pace.
So widespread asset price declines do exert price-deflationary pressures via decreases in velocity and banking-sector money creation. Both these phenomena can be dealt with by the government as described in the “Pushing on a String” section above.
But asset price declines do not, as suggested by so many commentators, cause a one-for-one money supply decrease equivalent to the amount of the lost “paper wealth”— or anything even close to it.
Credit Deflation
Some people argue that the “credit deflation” — the reduction in lending and borrowing — will overwhelm any money-printing the government can undertake.
We’ll begin by once again pointing out that the government can create as much new money as is needed to stoke inflation.
Additionally, this argument blurs the distinction between money and credit. Credit and money are not the same thing. Imagine a desert island where the money supply consists of a single $10 bill. There is, to put it another way, $10 worth of ability to purchase. The $10 belongs to Alice, but she lends it to Bob. Bob turns around and lends it to Charlie, who lends it to Dave. There is now $30 worth of credit in the economy, consisting of three separate $10 loans. But there is still only that one $10 bill. All the lending has moved the $10 around, but it hasn’t created any new ability to purchase.
Outside the fractional reserve banking system, lending does not create purchasing power. For every borrower who gains purchasing ability, as in our example on the island, there is a lender who had to forfeit that purchasing ability.
It’s different for banks. They can actually lend money into existence — but in so doing, they are creating credit and money at the same time. The money they create will become part of the money supply.
So it’s really money, not credit, that is the proper measure of society’s aggregate ability to purchase.
With that said, there are some ways in which a credit contraction can put downward pressure on both prices and new money creation.
Credit doesn’t increase aggregate purchasing power, unless it also leads to the creation of new money, but it does tend to move that purchasing power from “strong hands” to “weak hands.” The money is being lent by someone who doesn’t want to spend it to someone who does. So credit is an accelerant to monetary velocity, and a credit contraction can accordingly induce a price-deflationary effect.
Reduced willingness to lend on the part of fractional reserve bank could also slow the rate at which new money is lent into existence. Money supply could theoretically deflate if old loans were called in and not replaced by new money growth — but the money supply charts above show that this is clearly not happening.
So as with asset price declines, credit contractions exert price-deflationary pressures via decreases in velocity and banking-sector money creation. But while credit contractions have deflationary elements, it is simply not valid to compare the amount of money being created by the government to the amount of credit being destroyed.
Debt Defaults
Some argue that debt defaults destroy money, and that the government’s money-printing can’t make up for all the defaulted debt.
But debt defaults do not destroy money. Let’s look at an example in which Alice lends Bob $10. Simply put, Alice gave her $10 to Bob, with the understanding that Bob would pay it back.
But Bob doesn’t pay it back — he spends it on lattes at Starbucks and then defaults on the loan. Alice is out of luck — but you will notice that no money has been destroyed. The $10 is sitting there in the till at Starbucks, soon to make its way elsewhere throughout the economy.
The deflationary effect of debt defaults is that they inhibit future lending. While in the example above there has been no change to the amount of money in the economy, lender Alice in specific is now out $10. She has $10 less to lend to future borrowers. Given that credit is a velocity accelerant, as described above, this decrease in lending could have price-deflationary effects.
Defaults could also affect future money supply growth. Banks, as stated earlier, can lend money into existence. So a bank that slows its lending due to having been burned by defaulting borrowers will effectively be creating less money than it would have otherwise.
The results end up as described in the two prior sections. The reduced lending resulting from debt defaults could slow down velocity or money supply growth. But it is not the case that a default on a certain amount of debt is equivalent to a like decline in the money supply.
Recession
Many people think that inflation cannot take hold in a recessionary environment in which demand is being destroyed. But this view doesn’t take currency debasement into account. Real demand for goods and services can drop even as currency debasement causes nominal prices to increase.
To provide an overly simplified illustration, if real demand were to drop 10 percent but the government was able to engineer a 12 percent loss in purchasing power of the currency, then nominal prices should increase 2 percent.
There are numerous examples of countries undergoing economic contractions alongside substantial monetary and price inflation. A mild version of this phenomenon, dubbed “stagflation,” took place right here in the United States in the 1970s. Some notable examples of more severe contractions accompanying more dramatic inflations include present-day Zimbabwe and Argentina earlier this decade. In these cases, people lost confidence in the currency as a store of value. When people lose confidence in a currency (almost always as a result of excessive money creation), demand for the currency will drop, velocity will increase, and price inflation will follow regardless of the economic climate.
But an Argentina-like loss of monetary confidence is certainly not required to cause inflation in a recessionary environment. The “Pushing on a String” section above describes numerous ways in which the government could stoke monetary and price inflation even in an environment of declining private sector demand.
Foreigners Won’t Let Us Inflate
One argument maintains that our foreign creditors will not sit idly by as we debase our currency. But this is precisely what they’ve done for years, and their ongoing support of our increasing indebtedness (evidenced by enormous foreign Treasury purchases of late) shows that they continue to do so. They are driven by their own short-sighted, mercantilist policies; the potential for long-term purchasing power loss on their dollar-denominated holdings clearly hasn’t been a concern for quite some time. And it apparently continues not to be a concern. I am vigilant for signs that this may change someday, but so far no such signs are forthcoming.
The foreign “recycling” of US trade deficit money into Treasuries and other dollar-denominated assets must end eventually. But when it does, that will be an inflationary event, not a deflationary one. Foreigners would most likely express their disapproval by buying fewer dollar-denominated assets, resulting in a drop in the dollar’s foreign exchange value. This would exert upward, not downward, pressure on prices in the United States. The decrease in foreign Treasury purchases would also lead to higher rates and a potential situation in which the government couldn’t borrow the money it needs for all its stimulative deficit spending. In this case, there’s a good chance that the Fed would inflate the money supply to fill the funding gap and buy down rates rather than take the economic pain that would accompany higher long-term interest rates and a sharp cutback in government spending.
The winding down of the dollar recycling game will almost certainly lead to inflationary problems, when it eventually happens — but in the meantime, the United States can continue its reflationary policies for as long as it has the support of its foreign creditors.
The Fed Doesn’t Want Inflation or a Dollar Crisis
Another argument goes that the government will not choose to invoke a serious inflationary crisis or cause a serious dollar decline. I agree that this is clearly not an outcome that the government desires. But these are the same people who denied the stock bubble in 2000, then denied the housing bubble in 2005, then denied that the “subprime crisis” would have any negative impact on the overall economy in 2007. The people manning the bureaucratic institutions of our government rarely spot a problem until it’s already become a problem. And to the extent they spot a potential problem, they do not act to head it off if doing so would inflict the type of short-term economic pain that they try so desperately to avoid.
I am fairly confident that our leaders feel that they are in control and that they are risking neither serious inflation nor a dollar dislocation as a result of their unprecedented debt accrual and monetization. Moreover, they’ve repeatedly come out and said that they are more worried about deflation than inflation, and as monetary authorities of an over-indebted society they have reason to be.
The government prefers inflation and feels confident in its ability to manage that inflation. They have already shown that they will not let fears of inflation or dollar problems scare them into sitting back and letting deflation — the worst of all outcomes, to them — run its course unhindered.
The Fed Will Reverse Course
This is more of an argument as to why inflation won’t be a problem, as opposed to why deflation will. But I’ll throw it in for good measure anyway: some people acknowledge that current policy is highly inflationary, but suggest that Fed will be able to quickly reverse course before inflation becomes a problem.
Even if they wanted to do so, the Fed could have trouble quickly reducing its balance sheet considering that they have loaded themselves up with illiquid assets that were largely rejected by the private sector. But the bigger problem with this argument is that it assumes that the Fed would actually reverse course early enough to prevent the inflationary effects of their policies from coming to the fore.
The Fed, along with the government in general, is panicked. They have an extreme preventative bias against deflation, and they are taking extraordinary measures to fight the current deflationary pressures. But these policies work with a lag, and if the government has to choose, they will for reasons noted throughout this article always pick inflation over deflation. It’s likely that the government will not even slow its reflationary efforts until the inflation has already gained a significant and noticeable amount of traction. By that time it will be difficult to reverse the inflationary effects of their previously expansive policy.
The venerable James Grant put it nicely in a recent WSJ Op-Ed:
Yes, today’s policy makers allow, there are risks to “creating” a trillion or so of new currency every few months, but that is tomorrow’s worry. On today’s agenda is a deflationary abyss. Frostbite victims tend not to dwell on the summertime perils of heatstroke.
But the seasons of finance are unpredictable. Prescience is rare enough in the private sector. It is almost unheard of in Washington. The credit troubles took the Fed unawares. So, likely, will the outbreak of the next inflation. Already the stars are aligned for a doozy.
Conclusion
We in the United States have been dumping our dollars into the world for years and we continue to do so. We owe a staggering amount of foreign debt denominated in dollars and we are gearing up to borrow even more. Our legislators and the stewards of our currency are rabidly hostile to deflation — they are hostile, in other words, to the idea of the dollar gaining purchasing power. They have shown via word and deed that they will do whatever it takes to prevent deflation from taking hold. And when deflation is viewed as even a remote possibility, there are effectively no limits to the amount of money the government can create nor to what they can do with that newly minted money.
Under these circumstances, I just don’t believe that the dollar is going to gain purchasing power in any sustainable way. The current deflationary storm could continue for a while yet, but the longer it goes on, the more violent and severe its reversal is likely to be.
Deflation is a choice within the current monetary regime. It is a choice that our government has shown it will not make. There are serious long-term risks inherent in our dysfunctional monetary system, to be sure — but deflation isn’t one of them.
Editor’s Note: You’ll want to read Part I here if you missed it. Rich may also respond to (or otherwise parry) your questions, concerns or challenges in future posts. So feel free send him an email at rtoscano@pcasd.com with your thoughts.