Economics

Dare to Deflate

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Deflation Is Good.

However you choose to define it—falling commodity prices, contraction of money supply and credit marked to market, decline in the velocity of money, a $2 gallon of milk—Mish Shedlock of Mish's Global Economic Trend Analysis and Botanica says the debate is over: Deflation is here, and it's awesome:

Deflation is not a threat because deflation is here by any practical measurement. Deflation is also here by impractical measurements such as falling prices…

Moreover, deflation is not a threat in a second sense. Deflation is needed to purge the excesses of the last credit cycle. Attempts to defeat deflation by force will only prolong the agony while accumulating government debt, just as happened in Japan's two lost decades.

Finally, deflation is not a threat in a third sense. Falling prices are a natural state of affairs because of rising productivity over time. Inflation is a direct (and unnatural) state of affairs caused by the Fed and fractional reserve lending.

There follow many paragraphs and visual aids in support of this thesis. Most of this material will be familiar to regular Hit & Run readers, but some is new. (Disposable Personal Income, welcome to Subzero World.) Then a closing peroration worth quoting in full:

In light of all of the above, the deflation "denial phase" should now be over for all but the most stubborn inflationistas. The "recognition phase" has finally arrived. The Bernanke "panic phase" is waiting on deck.

Please note that Bernanke's Deflation Preventing Scorecard is a perfect zero. Lord knows what Bernanke will try next.

The Real Threat

We are already in uncharted territory, and the risk is what the Fed, Congress, the Treasury department, the Administration, and central bankers globally do to prevent something that needs to happen: the liquidation of malinvestments and debt.

Thus the "real threat" (and risk) is not deflation, but rather the foolish attempts by Keynesian clowns to circumvent what needs happen.

Japan is proof that such efforts are futile. Note that Japan is once again back in deflation, and all the government has to show for its efforts is debt equaling 150% of GDP. Falling prices, lower wages, lower asset prices, and especially debt liquidation are not to be feared, they are a necessary part of the healing process, lest the country stagnate for years.

On the what-will-Bernanke-think-of-next question, forcing banks to lend would be the next logical step, but the Fed chairman probably wouldn't take it because 1) it could actually be controversial and 2) his pattern so far has been to put bank solvency above all other concerns. Bernanke's wisdom from the Great Depression—which in practice is not as nuanced or interesting as it seemed in theory—doesn't seem to draw a clear distinction between a zombie bank and a lending bank. Both need to be kept alive until the Great American Economic Machine comes to our rescue, at which time the fatter and more robust banks can start lending into a boom. If the Fed were seriously interested in getting banks to start lending now, it could stop paying them interest to keep money in their vaults. It isn't doing that. So we have a policy that combines big cash infusions for banks with an austerity program for everybody else. Theoretically, you could keep that policy in place for a long time. It even makes sense, if your only goal is to make banks healthy.

Read Reason on Japan's lost decade and on the return (or not) of inflation.

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  1. I shudder to imagine what effect this will have on Peter Schiff’s television career.

    1. Peter has solidly forecasted and forewarned about the economy the last several years. I don’t think he’ll be worried about this report.

      1. Yes, but all he ever warns about is inflation. He’s like a broken record.

  2. I’m still predicting massive inflation over the next 5 years.

    1. We still have several megatons of reserves that the Fed has injected into the system. When banks start lending against that you’ll see your inflation.

  3. zombie bank

    I know this bank. It’s in the Monroeville Mall.

    1. Great. Now I have the Dawn of the Dead mall music stuck in my head.

  4. And yet, Mish is still wrong over the long term.

    We all knew and expected there to be temporary “deflation” because of a rather large and much needed market correction. Big fat deal! Yep… I can get an apartment for cheaper now this year than I could 2 years ago. This is awesome for basically anyone who’s in a position to capitalize on things such as that. And by all means, everyone should if possible.

    Yet, the value of the dollar continues to tank against world currencies & commodities.

    ALSO… A hell of a lot of everything about the economy is still completely fictitious regardless of what any current scorecards are saying.

    The minute interest rates are raised, we’re right back where we started – so Bernanke will avoid raising rates and certainly won’t raise them to anything close to the market level, and as a result, all that money they’re pretending won’t wind up in the system… umm… will.

    Bob Murphy’s case for inflation is a hell of a lot better than Mish’s especially if you extend the timescale out beyond this year.

    1. We all knew and expected there to be temporary “deflation” […] Big fat deal!

      Bob Murphy’s case for inflation is a hell of a lot better than Mish’s especially if you extend the timescale out beyond this year.

      +1

      1. They said the same thing in Japan 20 years ago. Deflation hasn’t stopped.

        The minute interest rates are raised, we’re right back where we started

        Nope. The minute interest rates rise, the cost of financing increases and demand goes down, meaning prices fall. Volcker raised interest rates to STOP inflation, not start it. That’s the problem: ZIRP isn’t stopping deflation.

        The case for inflation is good, the case for deflation is better. The case for decreased purchasing power is the best and hasn’t changed since 1913. When inflation does hit, you can bet that tax rates will increase even more than the inflation rate (which one comes first is immaterial).

        1. Sixth Digit:

          My “+1” was only in response to the sections I quoted…

          I think everyone agrees we’re in a massive deflationary phase right now, that doesn’t mean that inflation won’t come about in 3-5 years time.

    2. And yet, Mish is still wrong over the long term.

      LIVE IN THE NOW!

  5. If the Fed were seriously interested in getting banks to start lending now, it could stop paying them interest to keep money in their vaults.

    Which then might unleash some of that theoretically pent up inflation. Which then might blunt the “deflation” beast.

    But letting a problem solve itself makes for a rotten political career. The hero is not a hero because he lets nature take its course.

    But isn’t it true that the the only thing that’s really in “deflation” is real estate? In which case I don’t see why there’s any concern because the market went way too freaking high.

    The problem is that letting problems solve themselves makes for rotten career prospects in any semi-democratic society.

    Somebody tell me how to remove this aspect of democracy from the system, while keeping the benefits of open debate, and I’ll tell you how to get rational decision makers in D.C.

    1. But isn’t it true that the the only thing that’s really in “deflation” is real estate?

      Nope. Wages, for one.

  6. The thing is that while banks are not lending, the money used to service the principal uncreates the loan.

    It destroys the money by the act of paying down the loan.

    Most economists do not factor this mechanism of the fractional reserve banking system into the overall picture.

    Therefore, the money supply is shrinking at a very fast pace if new money is not being created though debt.

    I have been seeing deflation as the only possible outcome so far.

    Inflation would make it easier to pay off mortgages.

    Maybe a weeks pay would do it in that case lol.

    1. Can you explain to a non-economist how this works? I’m not following how money is getting destroyed, or the idea that raising interest rates will alleviate deflation (see mark below).

      Is it that low interest rates discourage lending, and money isn’t being created (fast enough) if there isn’t sufficient lending going on?

      btw, I never did understand why interest rates stayed so low during the housing boom. It’s as if they expected deflation back then, or at least no significant inflation.

      Which makes me wonder what they (the banks) knew. Because I always thought that inflation expectations were a major component that drove home mortgage rates. And not expecting at least some inflation on average seems a-historical.

      1. The money is not “destroyed” so much as taken out of circulation if the bank does not re-lend it. This is the “velocity of money” problem that is making the monetary stimulus less effective: the Fed can print all it wants but if it does not circulate in the economy (the rate of which is termed velocity) then there is no marked impact.

        The reason interest rates remained low throughout the housing boom is bcse the Fed relies on “niaru”-dependent analysis (non-inflation accelerating rate of unemployment – nothing to do with India or jackets)…. under which they consistently lowered the unemployment rate at which they would look to raise rates because of a persistent disinflation based on falling import prices. Essentially, we relied on overseas employment — for all intents endless — for the production of consumed goods. In a closed/one economy world the growth rate of the 2000s would have meant higher prices more quickly and a rise in rates which would have cooled the economy earlier. Instead because of the dollar recycling mechanism — China and other EM countries lending their trade surplus dollars back to us to keep their currencies cheap and their employment boom booming — resulted in ever lower interest rates here and higher economic activity — and more borrowing and more consumption (esp of foreign goods)… This was the bubble that not only the FED did not appreciate, it encouraged.

        End the Fed

      2. Ebenezer,

        Mike is talking about the destruction of debt, which is happening a great deal faster than the introduction of additional greenbacks into the economy, in fact, the velocity of cash moving into the economy is practically at a standstill whereas the destruction of debt is increasing as banks begin to accept writedowns in the value of their holdings and accept stricter lending practices (reducing the debt available to consumers). The only thing thats possibly increasing spending is the government and as Mish noted from the Japan example, even spending to a debt as high as 150% of GDP has not put a significant inflationary pressure on their economy. Only a significant reduction in supply versus available dollars could induce inflation in a contracting economy.

      3. I’m not following how money is getting destroyed

        Money = cash + credit

    2. In the “normal” state of things, loans paid off will equal new loans made, so the monetary supply remains stable. Market mechanisms have a balancing effect, and this contraction is part of that balancing. But Obamanites have mucked it up with their stimulating and injections.

      It’s like treating a hangover with a fifth of bourbon.

    3. Thanks for all the info. It helps some, but mostly convinces me that I don’t know much about economics and how fiat currency really works.

  7. Aussie central bank just raised rates a quarter point. Fed will have to follow or suffer devaluation. There’s your inflation right there.

    1. Yeah, but the Ausie dollar has gotten hammered, so we still have a way to go before we care + it’s not a major benchmark for us so… you’re wrong.

  8. Didn’t the Australian central bank get a portion of the $553 billion of the Fed’s central bank liquidity swaps? Wasn’t that supposed to keep interest rates low in World markets? Are the Aussies now saying , “thanks for the money, and by the way, fuck you”.(?)

    And, how did those swaps effect the dollar’s exchange rates?

    I don’t think anyone can accurately predict the markets until we know exactly where the money from the Fed went (and is going), and what their (Fed) balance (and off balance) sheet looks like.

    1. Are the Aussies now saying , “thanks for the money, and by the way, fuck you”

      Yes we are. Time to put another shrimp on the barbie. G’Day!

      1. To: The Aussies.

        Keep an eye to the sky for those B-2s

      2. Actually, Aussies say “prawn” not “shrimp”… but no one seems to know (or care).

  9. Tim, why haven’t you said anything about the latest CIT bankruptcy talk? GS stands to get a billion off the top, while the Fed loses 2.3. Plus, GS was so heavily hedged with credit default swaps on CIT, that they (according to Bloomberg) actually stand to profit from CIT’s bankruptcy.

  10. The only signs of a deflationary period ended last December. We haven’t really had a month after that of significantly decreasing price levels. We have had a month-on-month increase in the price level, though.

    1. Well, yes but

      the Chinese Central Bank governor and other officials have been worrying aloud about the dollar for years. Their problem is that much of their national wealth is tied up in dollar assets.

      how is this situation going to change any time soon? I mean if the Chinese want their money back from the US, for all the goods they’ve shipped us.

      To replace the dollar, you need another economy (or group thereof) with a similar size, scope, and power. Who besides Europe could China find that from?

      You realize, without China the whole concept is DOA. And with China, they have to replace the US economy.

      I don’t see Russia, Brazil, and all the Gulf States together doing that. Sure lots of people would love to “get over” the US dollar, but until the US economy shrinks a lot more relative to the rest of the world — I don’t see it really happening.

      1. You realize that could happen very quickly.

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  12. Freakin scary dude, seems like the whole world is going to hell in a handbasket!

    RT
    http://www.complete-privacy.net.tc

  13. Ah, the rare dual-troll.

  14. Deflation riiiiight.
    That must be why OPEC is threatening to end dollar based oil.

    1. OPEC could denominate oil in ounces of gold for all it matters. Won’t change the supply and demand for oil one bit.

      1. Right but that’s not the question. We’re worried about the supply and demand for dollars.

        1. No, “we” arent. Dollars themselves have no* supply/demand. They are for buying stuff. Its all fungible.

          *okay, there is some amongst traders

    2. If they do, I predict a great big yawn, heard round the world.

  15. The best thing about deflation is how it makes household debt more expensive while driving wages down. Awesome!

  16. Tim,

    If we define it has “contraction of the money supply”, which you open as on option, how can deflation possibly be here? M0 has doubled in the last year.

    Now, I think M2 is down, due to a decline in the velocity of money (another of your options), and M2 is probably a better measure of inflation/deflation, but you left open the possibility of using M0 with your comment, and it isnt deflated.

    1. as, not has. Dammit squirrel, where is a preview button for me to not use.

  17. The best thing about deflation is how it makes household debt more expensive while driving wages down.

    That is why you pay off your household debts during inflationary periods.

  18. I have a hard time equating “demand destruction” with “deflation”.

    The so-called credit freeze was not exclusively a refusal of banks to lend; some significant portion of the reduction in bank lending is people (and businesses) actively deleveraging.

    If you buy your own groceries, it’s hard to say there is much “deflation” out there.

    1. I buy my own groceries and I see the deflation first hand. The grocery bill is down because I can see the falling prices. A handful of items are up, but the bulk of them are down. Milk prices have dropped about 40% from a year ago.

  19. Again, it’s just a tremendous mistake to not be looking long-term about this stuff. Yes, today… in 2009, the banks aren’t lending out much money and they’re deleveraging their assets, thus M2 is shrinking (moderately). But M0 has exploded… And it’s only a matter of time for this to flip around again, and the moment it does I hope you don’t have any money in USD.

  20. Sean,

    Instead of hyperinflation, I think the velocity of money will be controlled and we will have a 12-dip recession over the next 10 years as the M0 slowly leaks up to M2.

    the 2010s in the US will be like the 1990s in Japan.

    1. The 00’s in Japan have been deflationary, too.

      Increased regulation of banks (a foregone conclusion, IMO) is going to slow the velocity of money, no matter what words come out of a politician’s mouth.

      1. You seem to be waving your hands in the face of a serious move away from the dollar. The less it is a reserve currency, the harder it will be to run a current account deficit. With a “New Bretton Woods” apparently emerging among the G20, the new reserve currency will take the place of a rapidly falling dollar. There’s very little anyone can do about it, either.

    2. Has the Japanese equivelant of Mo finished leaking up into their equivelant of M2 yet? It’s been 20 years now. What’s the deal?

      1. My comparisonn was more to their economy, I dont know if they blew up M0 like we did or not.

  21. Actually, if you look at CPI-U since the beginning of the year, it’s rising. There isn’t a deflation threat at this point – there was a deflation due to what looks like a step change in the velocity of money last Oct-Dec, but on a month by month basis, the CPI-U has been trending up since then. The 1 year rolling CPI-U change is going to shoot up in the next couple months since the big step changes from last fall will be falling out the range.

  22. the Chinese Central Bank governor and other officials have been worrying aloud about the dollar for years. Their problem is that much of their national wealth is tied up in dollar assets.

    Two things to keep in mind about the so-called dollar trap that the Chinese are supposedly caught in.

    (1) We are not their largest trading partner. Europe is.

    (2) They hold a lot, possibly even a majority of their foreign reserves in non-dollar currencies, and are spending dollars as fast as they can on hard assets around the globe.

    1. and are spending dollars as fast as they can on hard assets around the globe.

      And what happens when they stop doing that?

  23. Dammit, we need domo for all this high finance talk.

    My take is that people who are looking at “demand-pull” inflation or whatever are missing the point. I think we are rapidly approaching “crisis of confidence” hyperinflation.

  24. If the Fed were seriously interested in getting banks to start lending now, it could stop paying them interest to keep money in their vaults.

    The banks are buying lots of Treasuries. So they ARE lending 🙂

  25. Deflation is generally undersirable.

    The least bad response to an unexpected increase in productivity is a lower price level. So, there are some situations where a falling price level is the least bad option. But that is about it.

    If velocity falls, that is another way of stating that people want to hold more money. A deflation of prices and nominal incomes will increase the real quantity of money to accomodate this. However, an increase in the nominal quantity of money is always a better response.

    Unless the demand for money has fallen, having the quantity of money fall is a bad idea. Eventually, prices and money incomes will fall, so that that real quantity of money rises to meet the demand, but it is better just to avoid this process.

    There is no need for there to be deflation in order for debts to be repaid. There is no need for deflation in order to liquidate any malinvestments.

    The notion that deflation is needed as a “purge” is a mistake. People who made bad investments can suffer losses. Resources can be shifted from less valued uses to more valued uses. And total debts can be reduced, kept constant, or increased, all in the context of steady growth in nominal expenditure.

    Frankly, I think half of this “analysis” is just one version or another of the fallacy of composition. You know, failures to follow Bastiat’s dictum to look at both what is seen and what is unseen. What one person pays, another recieves. For every borrower there is a lender. And so on.

    1. If velocity falls, that is another way of stating that people want to hold more money. A deflation of prices and nominal incomes will increase the real quantity of money to accomodate this. However, an increase in the nominal quantity of money is always a better response.

      That’s true for a step change in the velocity of money, but what about a temporary shock, such as when people get spooked about the future of the economy and seek to hold cash? In this case, you can expect velocity to rebound, and when the velocity rebounds, there’s going to be inflation. Waiting out the shock may be a better strategy than micromanaging the money supply.

      I think it’s been wrong to view a net increase in MV as essentially benign – there’s a relationship between it and asset bubbles that you lose when you aggregate P. Some goods reprice more quickly than others so their prices will rise rapidly compared to the rest of goods. If these goods are considered suitable investments (ex stocks, real estate), they’ll appear to have very good returns and attract futher investment, and there you have your bubble.

      Persistent deflation is a bad thing, but trying to prevent even a little bit of it on the leading edge of a recession is likely to result in more damage from the unintended consequences of micromanaging the money supply with incomplete information.

      1. If there is a temporary decrease in velocity, this is a temporary increase in the demand for money. By far the best response to this is a temporary increase in the quantity of money. The quantity of money should increase with the increase in the demand for money and then decrease with the demand for money falls.

        A temporary deflation of prices, so that the real quantity of money rises to meet the temporary increase in demand, and then, with demand falls again, an _inflation_ to get the real quantity of money to fall again to the now lower, returned to normal demand for money is a _horrible_ solution. That approach does involve inflation. (Of course, it is a reflation from a temporarily low level.)

        The only think worse than this fluctuating price level would be for production and employment to fluctuation instead. People want to hold more money, so we work less and produce less output. Yes, the lower incomes will reduce the demand to hold money to the limited supply. Great. We want to hold more money, so we all take a vacation. Makes sense?

        “Micromanaging” the quantity of money is exactly what should happen. Imagine we were thinking about the price and quantity of hamburgers. Would you really insist that a temporary increase in the demand for hamburgers should _only_ impact the price? I think it will (and should) impact both price and quantity depending on elasticies of supply and demand.

        Well, the marginal cost of creating money is about zero, and so it potentially has a perfectly elastic supply. Because money has no price of its own so that price adjustments require inflation or deflation, it is much better to just let the quantity of money adjust to the demand to hold it.

        As for all this business about asset prices and bubbles, you are basically confusing an analysis of changes in the quantity of money given the demand, with changes in the quantity of money that match changes in the demand.

        The market process that corrects excess supplies or demands for money is very disruptive. Avoiding both inflation are deflation is desirable, and that requires monetary institutions that adjust the quantity of money to meet the demand conditional on stable growth of nominal expenditure.

    2. It’s not the least bad response. It’s the only proper response.

  26. For every borrower there is a lender.

    But when there are fewer borrowers and fewer lenders, what happens?

    1. Franklin:

      If there are fewer borrowers and lenders, what happens?

      Those who would have lent spend more and those who would have borrowed spend less.

      I think the problem with most “analysis” of excessive leverage or deleveraging is that there is an assumption that money not lent or funds repaid are held. Perhaps, but then that is a change in the demand for money, and if not matched by a change in the nominal quantity of money, it requires changes in prices and nominal incomes so that the real quantity of money adjusts to the demand. Because prices don’t adjust quickly and smoothly, this is very disruptive.

      If, on the other hand, the nominal quantity of money adjusts to meet any increaced demand, then gross debt drops and there is just a change in the pattern of expenditure, and no need for a change in aggregate nominal expenditure and pointless inflations or deflations of prices.

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