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Inflation and Deflation

I’m not as panicked as Kevin, SayUncle, and PDB about the vast expansion of the money supply.  While I would not sell myself as any economic expert, the risk in inflation the money supply is, well, inflation.  But my understanding is that the reason to do this is to prevent giving rise to a much worse beast, which is deflation.  We’re already experiencing deflation in a lot of sectors, like Housing, which was the match that lit this fire.

If this recession is fundamentally a problem of people over-borrowing, and business being over leveraged, and falling asset prices, one easy way out of the problem is to inflate your way out of it.  The problem with deflation is that it gives people an incentive to hoard money.  Not to spend, or invest it, but just to sit on it, because it’ll be worth more tomorrow than it is right now.  That’s very damaging to the economy.

Inflation is painful to people who have saved, which isn’t many of us these days.  Too much inflation is indeed a bad thing, but if the problem is too much debt, and declining asset prices, an inflationary cycle would actually help alleviate the problem.  Unfortunately, runaway inflation is also a big problem, and stopping it can be highly painful.  I suspect this massive expansion in the money supply is going to have detrimental effects at some point, as the fed will have to tighten the spigot to deal with inflationary pressures.  That’s going to suck, but I suspect it will suck a lot less than the consequences of deflation.  Given that, I’ll worry about what effect a rapid expansion in the money supply is going to have when it comes time to cross that bridge.  The really scary part to me is, everyone, even expert economists, seem to be playing this by ear.  No one seems to really understand what’s going to get us out of this.

23 Responses to “Inflation and Deflation”

  1. Dave R says:

    “Inflation is painful to people who have saved, which isn’t many of us these days.”

    In other words, inflation is a disincentive to saving, now and going forward. Which means the Fed and federal government are betting everything on keeping the plates spinning in a consumption economy.

    “Too much inflation is indeed a bad thing, but if the problem is too much debt, and declining asset prices, an inflationary cycle would actually help alleviate the problem.”

    Entertain the possibility that the problem is that previous inflation drove investment money into a bubble that valued a good (say, real estate, homes and mortgages) above and beyond its sustainable value. Austrian economists would say that bubble will inevitably correct to market value, either sooner or later. The Keynesians bet that they can manage or sustain that bubble so it never corrects, which what allows them to say declining asset prices are the problem to be avoided. In other words they are betting they can inflate their (and our) way out of an already inflated bubble with no ultimate downward correction. (Or some would say a managed, soft, everybody-wins downward correction, but that’s equally implausible.)

    Anyway, I do thank you for coming closer to admitting something publicly that Keynesians always cloak in dry language in footnotes. That is that inflation amounts to a tax on savers and redistribution to borrowers and spenders. You can find that in economic textbooks, but strangely its never admitted to on television or in magazine articles. Just once I’d like to hear a Fed Chairman say, “yes, we’re inflating away the wealth of retirees, people on fixed incomes, and the working poor. That’s the price we’re willing to let them pay for an inflationary economy. Dumb bastards should have gone to college and gotten a real job in public service or management in a Fortune 500 company.”

  2. William says:

    So you’re saying that while our problems have resulted from people borrowing too much, we shouldn’t let deflation occur, because that would encourage people to save money?

    As a country we’re hopelessly overextended, and creating more money so that we can keep up the charade sounds like something Bernie Madoff would come up with.

  3. Sebastian says:

    I should note that I don’t really like the idea of inflating our way out of problems we never should have gotten ourselves into in the first place. I think moderate, predictable inflation is not that terribly harmful, and may even be helpful since it serves as in incentive to invest savings, in order to beat inflation. But what happens in runaway inflation? People will seek shelter in assets like real estate, gold, and other stores of real value.

  4. Sebastian says:

    So you’re saying that while our problems have resulted from people borrowing too much, we shouldn’t let deflation occur, because that would encourage people to save money?

    The problem with deflation is it encourages hoarding money, meaning even if people save it, it will just sit there, doing nothing to drive investment, which is important for future growth. Banks will also have this incentive, and we see that banks in this crisis are indeed hoarding cash rather than lending it. We want banks to lend money to people for creation of wealth. We want investors investing their money. If everyone just sits on their cash, the economy grinds to a halt.

  5. William says:

    Deflation is usually a good thing–for example, the price of computers has deflated quite drastically over the last 20 years, but that hasn’t stopped people from buying them. For an entire 30 year period in the 19th century (1866-97), we had persistent deflation and economic growth.

    I’ll grant you that hyperdeflation would be a disaster, just as would hyperinflation, because it would make doing everyday business difficult.

    But a little deflation isn’t going to bring down the economy–it’s going to encourage people to pay off their debts and save money. Those savings aren’t going to go under a mattress (again, this isn’t hyperdeflation, so banks aren’t charging people to hold their money). Before long, the accumulated savings will turn into loans for investment, and things will return to normal.

    There can’t be a “return to normal” if we just try to spend our way out of this. If there’s a bubble in one asset class, and instead of letting it fall we try to inflate everything else, we hit a new normal. In the meantime we rob the savers and reward the government (since they’re the ones printing the money, they get to spend it before it loses value) and the borrowers. It’s classic wealth redistribution, with a little “grow government” thrown in. No thanks.

  6. William says:

    Here’s a good article on the subject, from an Austrian perspective.

    http://mises.org/article.aspx?Id=1241

  7. N.U.G.U.N. says:

    “Inflation is painful to people who have saved, which isn’t many of us these days. ”

    That’s the problem, the inflation is stealing from everyone who has saved. Everyone who has a 401K, IRA, etc. Is losing their savings.

    ” Too much inflation is indeed a bad thing, but if the problem is too much debt, and declining asset prices, an inflationary cycle would actually help alleviate the problem. ”

    Potentially, just as bankruptcy will do the same. Inflated currency is the national equivalent to bankruptcy. The result is that you lose your national credit. No more deficit spending.

    Deflation is not always a bad thing. It can “strengthen” those who are in a strong position. Deflation is the natural balance to overpriced assets. If the average home is really not worth $450,000 when most families are earning $75,000. Then the prices of homes falling is actually a corrective measure.

    “I suspect this massive expansion in the money supply is going to have detrimental effects at some point, as the fed will have to tighten the spigot to deal with inflationary pressures. ”

    The big issue is trust, there is now lot of money in circulation. But banks are not keen to loan it out. The next problem you have is a bank receiving a loan at 1-2% but the commoner receives a 7% loan. Eventually, the demand is going to come thru from such people that the government loan directly at that 1-2%.

    “That’s going to suck, but I suspect it will suck a lot less than the consequences of deflation.”

    I am of the opinion that inflation just continues the problem. When people are not prone to save (and why should you if the value of your savings is incapable of meeting it’s value today). Then people and businesses will not save. Creating constant bubble after bubble on a continual path to inflation.

    Meanwhile, deflation might be painful, but it can correct an imbalance. Meanwhile, a gold standard balance can help achieve a balance between inflation and deflation and encourage saving and a stronger economic system.

    ” The really scary part to me is, everyone, even expert economists, seem to be playing this by ear.”

    Experts are the people I have the least respect for…

    – I cashed out my 401K right before the dot-com bubble. I was told I was crazy, I got $3,500 for one year. And if I did it six months later it would have been $600.

    – I sold my house at the height of bubble. If I didn’t sell when I did, I’d be one of those foreclosures by now.

    – I took out $15,000 from my IRA last year. Cashing out all the mutual funds except for one that I’d have gotten high penalties on. Had I done that today, I’d only have $6,000.

    Now people will say if you “stayed in” for the long run, you’d be better. BUT…if you’ve lost non-regainable assets (which a lot of this loss is). If it’s gone, it can’t grow. Granted, right now is a great time to invest. Were I more thrifty, and didn’t utilize said funds to pay down credit card bills. I could now dump that $15,000 back into stocks and buy way more than I would have if I stayed in. If I now bought, I’d have far greater growth potential.

    What has always bothered me is that all of the experts during these times always dissuaded people from leaving. They always denied the coming bubbles. But I always saw them. So I am left wondering, how come I foresee these things but the “experts” do not?

    I can only conclude that a) the experts are not so expert, b) the experts are insidious and have ulterior personal motives, c) the experts are stupid, or d) the experts know the bubbles exist and are gambling trying to maximize their profits at our expense playing a game of chicken – knowing when to jump off at the right time and let others suffer the losses.

    – N.U.G.U.N

    PS – A little deflation on guns and ammo would do my personal armory wonders! *LOL*

  8. Sebastian says:

    Computers have also dramatically increased their utility as the price has dropped. Next year’s computer won’t be the same as this year’s computer. That gives people an incentive to keep buying. If the same computer will be half the price next year, as opposed to this year, and will have the exact same features, unless your existing machine breaks, you’ll probably wait for the price to stop dropping. I think that gets harder when you talk about real-estate, or assets, because they aren’t consumable. Housing stock typically won’t get destroyed. Purchasing decisions can be put off for a long time. I would see little reason for someone to buy a house if prices are dropping. That would be fine if housing wasn’t such a major contributing factor to household net worth, and wasn’t used to secure loans. That seems to be a nasty feedback loop. At some point, buyers will be attracted back into the market, but with many households suddenly faced with paying down massive debt because of a decline in real-estate values, that’s going to be a drag on the economy for a long time. It’ll take a long time for prices to rise back up previous levels.

  9. Sebastian says:

    As long as inflation is predictable, and of a manageable size, it won’t tend to impact savers all that much. During normal times, the money in my 401K grows faster than inflation because it’s being invested.

  10. J. Dock says:

    You’re right.

    It is deflation that has Paulson, Bernanke etc freaked out. They will take even hyperinflation over deflation, if it comes to it.

    What’s going to stop “it” is having a productive economy, emphasis on “productive.”

    If you dig stuff out of the ground, make something out of it, and sell it for a profit, you have a productive economy, generally speaking.

    The money supply charts seen on the blogs referenced are, in the words of Jeff Macke, “charts not seen in nature” which is Jeffspeak for seeing the initial run-up side of a bubble. This is one side of the “mountain” and the other side always awaits.

    THAT is what freaks me out about those charts. Deflation looks damn near guaranteed… ugly, ugly deflation.

    I notice that something common to all accounts of the Great Depression is the statement “we thought it was all over and done with, when the worst part started” or words to that effect.

  11. BillH says:

    Inflation is theft, plain and simple It is the reason that in hyperinflation times you see people spending their currency as soon as they get it in hand, in order to preserve some of the “value” in tangibles. If I “invest” with you today and you “return” to me in dollars ten years from now that have inflated, you are not returning the value I put in. Inflation is the tool of leviathan, and it doesn’t have to be in German or African percentages, the end result is us little guys get poorer. That’s one of the things the Fed and the Treasury are hoping nobody calls them on… spend 2 or 3 trillion, make a lot of cronies rich, then run the presses to “pay it all back”. It’ll be bipartisan, I’m sure.

    Ask your folks how they came through the 70’s, and if they’d want to do it again (although it looks like we won’t have a choice).

  12. Sebastian says:

    If I return to you more money in real dollars, then it’s not theft, it’s a good deal for the investor. The problem with too much inflation is that it gives people incentives to move money into assets, instead of investing it in growing the economy. But as long as the inflation rate is small, but predictable, it’s not a problem. There will be inflationary and deflationary cycles. It is the nature of things. What our system today presupposes is that a small and predictable amount of inflation is preferable to deflationary cycles and periods of runaway inflation.

  13. William says:

    Computers have also dramatically increased their utility as the price has dropped. Next year’s computer won’t be the same as this year’s computer. That gives people an incentive to keep buying.

    I see your point, but look at it the other way too–increasing utility can be a disincentive too, especially for new computer owners. Wait a month, get a faster computer. And yet I bought my first desktop and my first laptop when I needed them, even though I knew that better models would be out by the time the package arrived at my door..

    Purchasing decisions can be put off for a long time. I would see little reason for someone to buy a house if prices are dropping.

    That might be true if you looked at a house as a pure investment, but if you want to buy a house to live in, low prices are exactly what you want to see. There are tons of reasons to buy a house now, especially now when house prices are down and rents are relatively flat. A friend of mine recently got a great deal, and I wish buying made sense for me now… because in a few years, when it does make sense for me, I doubt I’ll be able to get the deals that are available now.

    That would be fine if housing wasn’t such a major contributing factor to household net worth, and wasn’t used to secure loans. That seems to be a nasty feedback loop. At some point, buyers will be attracted back into the market, but with many households suddenly faced with paying down massive debt because of a decline in real-estate values, that’s going to be a drag on the economy for a long time. It’ll take a long time for prices to rise back up previous levels.

    It is indeed a nasty feedback loop, so let’s get out of it. Let’s not print more money to bailout the irresponsible, thereby encouraging them to be irresponsible again. Let’s let prices fall, let the overextended people get burned, and allow things to stabilize. If people suddenly have reason to save their money, that will drive banks to make loans, without interference from the government.

    As long as inflation is predictable, and of a manageable size, it won’t tend to impact savers all that much.

    Replace “savers” with “spenders” and “inflation” with “deflation” and the statement is just as true.

  14. William says:

    If I return to you more money in real dollars, then it’s not theft, it’s a good deal for the investor.

    Sure, but if I earn $10 at work today and wham, the government doubles the money supply overnight, they’ve just stolen $5 from me.

    There will be inflationary and deflationary cycles. It is the nature of things. What our system today presupposes is that a small and predictable amount of inflation is preferable to deflationary cycles and periods of runaway inflation.

    That may be goal, but it’s not the Fed’s record. Business cycles are inevitable, and government tinkering is just like government tinkering elsewhere–generally not beneficial.

  15. Richard Allen says:

    Read a history of the Weimar Republic and see where inflation leads.

  16. RAH says:

    AAAGH!!! Inflation is not good. If Sebastian has seen his investments increase beyond inflation it is because the inflation was low the last 10 years.

    What Sebastian is referring to is the multiplier effect of money in circulation. If you take your 1000 dollars and save in a saving account the last few years you got 1.5 % if your were lucky. Meanwhile the bank was loaning that same money out at 5-9%. The banks did start charging account balance for checking and savings accounts so banks did charge account holders to keep their money.

    Say the bank loaned out your money that it paid 1.5% at 5.5% to pay for a car dealer’s inventory. The car dealer sold that inventory and paid back the loan. Other firms have even shorter pay back terms on inventory. The shorter term the greater the velocity of money and the more that each dollar was used multiple times. The multiplier effect.

    If money is converted into gold coins, paper or guns that are held and not sold the money is not multiplied. That is why hoarding money is not good. Because the same dollar does not produce more money.

    The problem is when the money is loaned and the risk of default is greater than anticipated. The sub prime housing loans was that situation. The home owner based on the accelerating value of his home attempted to multiply that asset increase, he was told to take out a loan of 125% of the value of the home and pay interest only. He was supposed to invest that money at a rate higher then the interest only mortgage rate. Problem was that instead he spent it on consumables like cars, boats, clothing and entertainment. None of that spending was capital investment that increases value. Guns are an exception. But guns had not gone up 30% a month in value until recently.

    The now homeowner had his interest only loan which had a low beginning rate and now has an increase rate based on inflation and changing increasing interest rates. His spending had adjusted for the lower amount for housing and his investments are not generating income so he cannot pay the adjusted increase rate, which could be increased from 1% to 5 % of a loan, which is at 125% of the value of the home. Now the real estate market slows and starts to decline and he owes a loan, which is now 175%, the value of the house, He has credit cards bills and his spouse gets laid off. He can’t afford the 5% new rate and he has no financial interest in the house. He defaults and gets an apartment. The bank loses money and since that mortgage was split 20 times in mortgage backed securities the question is who owns the home and now the MBS values have dropped to 10 cents on the dollar. The banks don’t even know the extant of the loss since the home has not been sold and bought yet and yet they write down close to 75-100% of the value of the home.

    Inflation starts out low but increases on top of increases, so there is a ratcheting effect like compound interest. Again no reason to invest in capital that would earn money since the future value of that money is lower than today’s money. So he spends again on consumables, until rates hit a high enough rate like 15-18% and people start putting money in to gain that rate. And those who spent the money on consumables are unable to pay for anything on credit or get a loan.

    Houses are deflating back to their real value, which is a correction and not deflation. The other problem was the banks in November refused to loan to other banks. That was a crisis in confidence. That was very serious. Our entire system is based on the confidence and trust and when that fails and banks retreat turtle like in the shell, businesses who depend on inventory loans can not get inventory that generates profits and then stores loses and go under and the next one happens and then the small floor tiler can not get credit to buy material and his materials cost go up since vendors that sell tile are going out of business and he can’t float the cost of material until he is paid and he then has to take less jobs and he does not spend as much and the recession spirals down.

    The spending was to generate confidence that money was out there to be spent invested and used. The federal banks were priming the pump. The increase has huge inflationary risks ahead. Worse the assumption that the federal gov’t has unlimited money is false and when the confidence crisis happens to the US government then a major crash will occur. What happens when the public does not believe the currency is any good? We go to a barter system, which reduces the multiplier effect, and permanent down turn occurs and people; turn to subsistent survival systems.

    The doctor get paid in food and services and the new products stop being produced. Families crowd together in homes; I think you get the idea.

    Yes we can afford inflation but that was the bet that Bush did with Medicaid drug funding and the farm bill while spending money on a war. The new trillion-dollar stimulus so excessive that inflation has a risk of going to 10- 22 % in a few years. That is unsustainable.

    The major recession is underway with lay offs, lower production and reduces sales. That is going to happen and that actually will keep the threat of inflation suppressed but inflation will occur when the upswing happens in a year.

  17. lud says:

    General inflation is government theft which punishes responsible saving and spending. General deflation in a managed economy is the symptom of a natural correction to artificial bubbles in the price of some things. It rewards responsible saving and spending.

    It is critical to the civilization-manipulating tyrants who seek to control everything that you believe deflation is bad. As long as you believe that, they are free to continue inflating forever, because you won’t oppose any of their inflationary conduct out of terror at the deflationary boogieman.

    None of this would be an issue if our currency were backed by anything other than a belief that the US government will still exist later. http://the-moneychanger.com/articles_files/mmm_files/bimetallism_standard.php

    ” From 1833 through 1873 – four decades – the London price of silver valued in gold ranged from $1.297 an ounce (1833, against an official US price of $1.2929 an ounce) to $1.36 an ounce (1859). That’s a gigantic, colossal deviation of – 4.86 percent! Today a 4.86% fluctuation in fiat money exchange rates in one day would put everybody to sleep, let alone four decades that quiet.”

  18. Sebastian says:

    Except that you’ll have inflationary and deflationary cycles using gold as a currency as well, only those cycles will be a lot more severe. The main problem with gold is that you have to mine it. Plus, what really backs the value of gold other than people’s perception that it has value? I consider it no better than fiat currency.

  19. RAH says:

    The gold standard has problems and that is a different arguement than inflation. Bernake and company suffered the decades of inflation that Reagan finally whipped through a recession and squeezing of the economy.

    The excess stimulus are the seeds of a future inflationary problem.

    We are suffering a real recession that has not be seen in a long time and the effects will be greater.

    .

  20. William says:

    Except that you’ll have inflationary and deflationary cycles using gold as a currency as well, only those cycles will be a lot more severe.

    Could you back this statement up? I haven’t thoroughly studied the history, but it seems to me that I hear a lot more about the inflationary and deflationary cycles of the 20th century (post-Fed; i.e., 1930s, 1970-80s) a lot more than I hear about the ones pre-Fed.

    Plus, what really backs the value of gold other than people’s perception that it has value? I consider it no better than fiat currency.

    Sure, its value is based on perception, but the difference is that it’s outside of government control. If the government controls the money supply, all hell breaks loose (i.e. huge deficits, runaway spending… sound familiar?) because they can get away with it. If the money supply is outside the control of government, politicians can’t debase the currency as easily. Milton Friedman proposed a middle-ground approach (use fiat currency and make the money supply grow by a constant rate each year), which would probably work if it were possible to keep the politicians from messing with it.

    Remember the words of William Pitt the Younger:

    “Necessity is the plea for every infringement of human freedom: it is the argument of tyrants; it is the creed of slaves.”

    It’s the same thing as gun control–just because all the experts, politicians, and journalists tell you that it’s necessary and for your own good doesn’t make it so.

    Bernake & co. have increased the money supply dramatically, and unless they cut it back down somehow, we’re going to be dealing with serious inflation (i.e., not 2-3%) for a long time. And that’s not good for anyone, including people with stocks in their 401(k)s — last time we had it, stocks didn’t do so hot (0% real return from 1965-1983).

  21. Dave R says:

    Except that you’ll have inflationary and deflationary cycles using gold as a currency as well, only those cycles will be a lot more severe.

    Unless you can point me somewhere (and I’d be interested), I consider this just plainly wrong. Until the Great Depression, American recessions were short (short and sharp at worst, but didn’t drag out). They did sometimes involve bank runs, which are never fun, but even including bank runs they weren’t as bad as twentieth century depressions.

    The Great Depression was the worst we’ve ever had, and most economists agree that it was extended years beyond its natural span by FDR’s policies of tax and spend, makework projects and excessive regulation on business. Well, guess what’s coming down the pike in the name of stimulation and propping up the banks?

    On the Fed’s end, the Great Depression was the first recession where we had a Fed, which is to say the first depression the Keynesians were in control. Their negative contribution was a result of their assumptions, that you’re echoing here. 1970’s stagflation, same deal, same authors. But they’ve largely won the public battle for hearts and minds, so when regulation fails its easy to blame the free market for failing.

    Plus, what really backs the value of gold other than people’s perception that it has value? I consider it no better than fiat currency.

    Gold has retained value even while it wasn’t a currency; paper from any government won’t. That alone makes it “better,” or at least different, than fiat currency.

    The truth is there’s nothing magical about a gold system; the virtue is that it can’t be hyper-inflated. If the government wants to confiscate value (which is what inflation is to the Treasury as long as they’re in the business of issuing bonds), they have to do so explicitly as FDR did.

  22. Sebastian says:

    Gold has no inherent value other than people’s belief that it has value. Traditionally, it’s been used as currency because it has excellent properties for making coins even with primitive equipment. But other than a few industrial uses that it has today, it has no inherent value.

    See Brad DeLong’s paper on the problems with The Gold Standard. Also, for a monetary history of the United States, I would suggest Milton Friedman’s book of that title.

  23. William says:

    Heh. I didn’t know of anyone who actually read that. Guess I should… but I’m going to read Rothbard’s as well and see who wins =)

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