The Inflation/Deflation Debate At Financial Sense Newshour

The first holiday-rerun installment of the Financial Sense Newshour focused on the inflation/deflation debate. All the participants were able exponents of their views, and the entire podcast is well worth listening to if you have time. [Note: The link to the Daniel Amerman/'Mish' Shedlock debate on the main page isn't active; a copy of the .MP3 file for the debate is here.]

What struck me about the debate was that each side claimed that history was on theirs. The deflationists said that there has never been a popped-bubble economy that has not led to a wholesale destruction of credit. Moreover, no bubble-economy-popping credit crisis has not led to a long-term drop in credit. Lenders always become more reluctant to lend, and borrowers always become more reluctant to borrow. Both the supply of credit and the demand for credit shrivel over time. There is never a short-term pause followed by a resumption of the credit spree. The popping of the bubble economy is too shocking, and its scope too wide, for the old attitudes to remain intact. What was prudent becomes risky, and what was normal becomes foolhardy. Since the bulk of the money supply is credit in our fiat system, this turn of the debt-tide means deflation is built into the monetary system. The central bank cannot inflate by itself; it can only increase the bank-reserves monetary base. It need the co-operation of the banks and their borrowers to expand credit to turn the monetary base into real money. Bank reserves are not spendable currency: they have to be used as the base of newly-created credit to expand the money supply. [If you need to, see this Wikipedia primer on money creation through the fractional-reserve system.] If both lenders and borrowers are refractory because they've been badly burned, then bank-reserve expansion will not lead to money-supply increases. The central bank will be "pushing on a string." The deflationists argue that the ballooning of excess reserves in the Federal Reserve system is proof that string-pushing is upon us, and that the credit system is maimed to the point where it cannot be counted on to inflate the economy out of its current difficulties. The U.S. is stuck in the same hole that Japan has been in for the last twenty years. Japan has had mild deflation during some of that timeframe, even though Japan's currency is not gold-backed.

The inflationists contend that history is on their side too, because every fiat currency is eventually inflated away. Since there is no gold brake on a fiat currency, there is no counteractionary impediment to the government inflating at will. The only brake is the pain of inflation itself, which tends only to be felt during an all-out inflation crisis. This license holds true particularly when there's widespread economic pain with little inflation on the horizon. Then the government has a lot of incentive to inflate and almost no (immediate) disincentive to do so. There's only one exception to the rule of "fiat money = inflation," and that's the above-mentioned Japan. Even in Japan, the deflation was mild and only intermittent. Moreover, deflation only took root at all because Japan is a creditor nation. Inflation is bad for creditors, because it depreciates the dollars received when the loans come due. As a creditor nation, one where creditors' viewpoints tend to prevail, Japan went with (what essentially was) price stability. On the other hand, the United States is a debtor nation. There has never been a case where a debtor nation with a fiat currency permitted even the slightest burst of deflation, except by accident, and there has never been a serious deflation in any nation with a fiat currency.

Thus, the deflationists concludes that all the relevant lessons of history point to deflation as the U.S.' fate. The inflationists conclude the exact opposite.


Evidently, the web of history has its tangles. I can say that both sides' appeals to history are solid.

Believe it or not, this leaves a wide path open for the incurable optimist. All it takes is defining each position as an "extreme," noting that they're opposing extremes, and express faith in the great American principle of moderation. The leadership, well-intentioned if not always wise or alert, will deploy pragmatic skill to sail the Ship of State between the shoals of both extremes and get the American economy moving again once the dust settles. Just wait and see; it'll be A-OK in a few years. You betcha.

The trouble is, the Pollyannas have a point. When crises hit, we look to extremes because they make sense and aren't mealy-mouthed. Normal moderation looks like temporizing. In addition, when an unexpected disaster hits, at least some of the so-called "extremists" were the ones who foresaw it coming. Optimists are discredited. It's this brew that inclines us to believe that moderation is counter-productive, even obsolete. We have a need to believe that it's one way or the other, that the normal slack that makes moderation work is gone.

Crisis there was, but there's no evidence that a muddle-through option isn't possible. The muddle-through position, unlike the eternal-sunshine stance, does acknowledge that the economic wreckage will have long-term aftereffects. But, it also notes that the two "inevitable" forces of catastrophic deflation and economy-eroding inflation, at least apparently, cancel each other out. If the Federal Reserve is sufficiently skilled, it should be able to navigate the economy through the coming tough stretch without either catastrophes erupting. Because the money-and-credit system is hobbled, it won't be an easy task. The Fed is likely to cause more economic volatility, that being the main aftereffect of the credit collapse. Unemployment is likely to be high, and recovery tepid, because the economy is still bent out of shape. However, a sustained period of muddle-through, one where pragmatism rules and empiricism takes the place of theory, is likely to get the U.S. economy through without damaging it permanently. There will be more high-growth decades. This next one won't be one of them, but muddling through has the promise of making the one after next return to solid prosperity.


I presented the above case because it hasn't really been made, and it does provide a counter-balance to both inflationists and deflationists.

My own opinion in the matter - which is influenced by my own priorities; I do have money in a single gold stock - is somewhere between the inflationistas and the muddle-through'ers. As this Stockhouse columnist points out, we're in one of those times when the U.S. government can borrow at negative real interest rates. As long as the U.S. Treasury can, it can benefit from inflation. Note that real T-rates fell to negative despite foreign governments' large holding of U.S. Treasury securities. Those much-feared foreign holders have not provided much of a deterrent.

Nor have the much-fabled "bond vigilantes" of the '80s. That's because today's markets are very different from those of the '80s. Twenty-five years ago, many bond buyers still remembered the near-thirty-year bear market in bonds. The three-year rally, strong as it was, could have been (and sometimes was) called a sharp bear-market rally. Lots of people still believed that inflation had merely gone dormant, and was waiting to surge back up to double-digits. Inflationism died hard in the '80s - including amongst long-suffering bond investors. Naturally, they demanded an extra inflation premium and remained quick on the sell trigger. That's how the "bond market vigilantes" sent the message that inflation was counterproductive.

In addition, the stock market provided a lot more competition for capital back then. In a long-term bull market in stocks, why buy bonds unless they're going up too? Safety? Given a thirty-year bear market? Not unless there's an added risk premium! This competition for capital also helped push up the real return on Treasuries, and sent the U.S. government the message that inflation would hurt them too.

Today's markets are far, far removed from the markets where the bond vigilantes thrived. Instead of the looming shadow of a recently-ended bond bear market, there's the cheery backdrop of a twenty-eight-year bull market. Bonds have outperformed stocks this last decade, even though inflation did pop up before the credit crisis erupted. Stocks, on the other hand, have gone nowhere this last decade. The fears and uncertainties that made the bond vigilantes vigilant back then, are gone. Instead, there's largely complacency.

What if foreigners, disgusted with the U.S. dollar dropping, decide to unload Treasury paper? There's an already-discussed contingency that can be deployed in such an emergency: commandeering U.S. pension assets to replace those foreign holders. Forcing pension plans to invest some money in U.S. government paper can even be pushed as a for-your-own-good measure, given the recent stock market collapse. As long as foreign unloading hurts the stock market more than the bond market, the feds can for-you-own-good as much as they please.

More immediately, the feds can lean on the banks to get the credit machine rolling again. The string can be stiffened up. We're already beginning to see some talk towards this end from both Congress and the Obama Administration. Credit stinginess looks prudent when GDP's still dropping like a stone. When GDP turns up, especially if the up-turn's sustained, then stinginess looks obstinate. It could be argued that last quarter's 2.2% GDP growth was a mere blip. If the fourth quarter's number is positive as well, though, there'll be a lot less reason for credit shrinkage on the supply side. If deflation fades as last year's worry, the demand for credit will pick up too.

For the above reasons - most particularly, the re-emergence of an inflation seignorage in U.S. Treasuries, the fading of widespread deflation fears, and the complacency of the bond market - I think inflation's on the horizon. I'm not a full inflationist, because a serious bout of inflation will hit the U.S. Treasury hard once the bond market cottons on to it. The U.S. Treasury needs relatively low nominal rates, given its huge borrowings, because high rates would be a budget-buster. Going all-out down the inflation road will bring back those high rates. However, intermittent spurts of inflation can be explained as the aftereffects of the credit crisis. And the 1930s can be brought up again...