Wikinvest Wire

The Economist on deflation

Saturday, November 15, 2008

Like many others in recent months, another anonymous economist at The Economist makes the same mistake of confusing 1990s Japan-style deflation with 1930s U.S.-style deflation and, in the process, adds to the growing fear that, somehow, a negative CPI implies that the value of paper money is increasing, causing debtors to hasten repayment of their loans resulting in a dreaded "debt deflation".


In a world full of pure fiat money, that central banks and governments can borrow and print into existence at will and with virtually no limit, people are really going to think that their money is gaining in purchasing power and change their behavior?

According to this report, apparently so:

A commodity-led fall in inflation ought to be good news for rich economies. It boosts consumers’ real incomes and fattens firms’ profit margins. Yet there is something pernicious about inflation falling too far, too fast. Because falling prices make debt more expensive, indebted households would be more anxious to pay off loans, even as other consumers were benefiting from a boost to their purchasing power. If deflation took hold, the gap in demand left by those fleeing debt would not be filled by cash-rich consumers, who tend to be less free-spending.
IMAGEA deadly mix of falling prices and high leverage could foment a “debt-deflation” of the type first described by Irving Fisher, an American economist, in 1933. In this schema, debt-laden firms and consumers rush to repay loans as credit dries up. That hurts demand and leads to price cuts. The deflation in turn increases the real cost of debt. It also means that real interest rates can’t be negative, and so are undesirably high. That spurs yet more repayment so that, in Fisher’s words, the “liquidation defeats itself.”
Perhaps a reference more recent than 1933 would have bolstered their case.


Anonymous said...

I understand your argument that more money will come into existance. I have been following both the inflation and deflation argument closely.

The only part I haven't seen you clarify (or itulip, or Schiff etc) is how does this money get into the hands of the common folk?

I, as an individual, don't value a $20 bill based on how many there are in the world, but only based upon how easy it is to get my hands on one..., or how many are in the hands of the common person.

If one guy has 20 trillion dollars sittin in a garage somewhere, I don't see how this affects value I place on money.

Without huge gains in income, how does the average joe feel that his 20 bucks is worth less (i.e. easier to come by).

Just like home prices drop to what the median income is....regardless of how rich the richest of us are.....prices for products like cars, food, gas, etc don't rise when a few people have lots of cash, but when lots of cash are in lots of hands.

I just don't see the "helcopter" that will drop all this cash in the hands of many, truly sparking inflation.

Average Joe.

ndd said...

You can't get a deflationary spiral without wage deflation as well. If wages stay the same or grow, consumption will quickly pick up. That is what happened during the brief post WW2 deflations such as in 1954. Those deflations also never went beyond (-1.5%) on a YoY or less basis.
In the Great Depression, wages also were cut -- dramatically in many instances. With reduced wages, the ability to pay off debts imploded.

Now, a possibility that might happen now (and might have been happening for the past decade or more!), is that layoffs increase dramatically, and the new jobs pay less than the old ones. Then you could get a deflationary spiral of sorts, it seems to me.

To defeat that spiral, you would need to get cash to the consumer/debtors -- not to the bank/lenders.

Tim said...

"I just don't see the "helcopter" that will drop all this cash in the hands of many, truly sparking inflation."

Even though only about 15-20 percent of the last $150B(?) stimulus was spent, that was still a big chunk of money and shows up clearly in the Q2 GDP data.

But, that was just the warm-up - soon there will be more rebate money to spend and lots of "make-work" jobs that will produce real income for many people.

Personally, I think the Treasury Department should just issue a debit card to each and every U.S. citizen and then add money to each account as they see fit to stimulate the economy (no cash withdrawals allowed).

little larry sellers said...

I fail to see how all this money couldn't get into the hands of common folk. I mean, if the money keeps increasing in value and asset prices keep declining, wouldn't the hoarders eventually start buying real estate, businesses, toys and gadgets, etc at fire sale prices? It's not like the money will be stuck in somebody's account in perpetuity.

Personally I think the whole deflation argument represents certain elements of the media grasping at straws to justify creating unprecedented amounts of money out of thin air. It's like Tim said- it makes no sense for us to print seemingly limitless amounts of currency at will, only to have it increase in value. If that is the case, we'll all soon be rich without having to do anything! Let the REAL fairy tale economy begin!

Anonymous said...

Deflation wears many hats….
Will China use its dollar reserves to buy US/NAFTA imports, instead of US treasury debt instruments?
Where else are they going to spend US currency?
The dollar can decline on an international exchange basis, yet increase in value domestically.
Manufactures have excess/idle productive capacity.
Increased exports may not necessarily mean fewer goods available domestically.
Stagnating and negative income growth combined with less credit available individually
will ration the consumption of goods and services..
Deflation (as seen in Japan) resulted in the manufacturer’s inability to increase prices.
But NOT necessarily, a decline in product prices. How is that possible??
Mass consumption and mass marketing changed the game.
The competition moved from price competition to innovation. This means improving reliability and increasing
the number features a product offers. (I.E. A Camera built into your cell phone.)
I predict - in the (near) future,
Critics of government use of Hedonic pricing will have many opportunities to be disappointed.

Vespucian said...

It seems to me that there are two different but overlapping questions that will decide everything.

One, will all of the money being "created" by fiat get into the hands of mass consumers?

Two, will a decrease in the velocity of money overshadow any surplus of currency?

It seems to me that inflation/deflation debate largely hinges on these two issues (or perhaps single issue).

George Kesarios said...

Deflation today has more to do with credit destruction than the mere printing of money.

That's where the inflationists have got it wrong.

We are in the period of rapid deflation due to credit destruction.

The world needs more fiat money than originally thought. The problem is that the central banks had their eye on inflation for so long, they forgot about deflation.

little larry sellers said...

*WARNING: long, rambling, possibly incoherent post ahead*

The problem with the credit destruction argument George presents is that numerous steps are being taken domestically and abroad to offset that one deflationary indicator:

1) Americans are already deeply in debt, but rather than letting their creditors fail, we are bailing out banks and lenders with HUGE, unprecedented injections. Also, we are twisting their arms to get them to lend again.

2) Foreigners will no longer finance our debt. One way we maintained dollar strength was for foreign governments to buy our treasuries and investors to buy our debt securities. Neither of those things will happen nearly as much anymore, and the resulting shortfall will mean money creation to make up the difference so we can continue spending unabated.

3) Furthermore, foreigners may start dumping their existing dollar reserves, either to finance programs or just get rid their holdings. This also floods the world with more dollars.

4) The US government and both parties DO NOT want deflation. They want a service economy with rising asset prices and easy credit. They will use every tool at their disposal to make this happen, no matter how hideous and Frankenstein-like the result is.

5) Tying in with the last point, credit deflation means a lot of jobs are going to disappear in our service economy. To offset this, I expect the government to fund massive work programs, which not only come with an enormous price tag but also immediately get money into the hands of "common folk".

6) The government is going to attempt to prop up house prices by keeping people in their homes by reducing their mortgage payments. They will have to create money and hand it to the banks to make up the difference and the whole idea represents ENORMOUS moral hazard, probably with unintentional consequences galore.

7) Finally, I have heard talk of new, partially gold backed currencies on the drawing board in places like Russia and the Gulf states. This hasn't yet happened and may not happen right away, but the very existence of major gold backed currencies would weaken fiat currencies.

Bottom line: don't underestimate the government's ability or desire to take drastic measures to foster inflation. I'd rather see deflation than inflation, but that outcome seems rather unlikely to me. Credit destruction is big, but the steps taken to combat it will be even larger in terms of dollar creation. This will be especially true once the government feels really desperate.

Tim said...

George - I largely agree with you, up to the part about governments and central banks being unable to stop credit deflation. They're getting quite good at plugging the holes, the loss of confidence, etc. is another matter.

Larry - it occurred to me that it would be in the interest of the U.S. to perpetuate this constant state of panic indefinitely so that the dollar will always be a safe haven, maintaining its status as the world's reserve currency.

Vespucian said...


I think the loss of confidence part you mentioned is one of the "keys" to this. If spending/lending continues to slow, that, by definition (as I understand it), reduces the velocity of money. Reductio ad absurdum to make a point: Even a pentillion fiat-dollar infusion will not result in inflation if the velocity of money is zero.

Your thoughts?

Tim said...

When I said "loss of confidence" I meant equity markets - the transition from profligate spenders to savers will not happen quickly.

Anonymous said...

Bailout 2008, a poem by David Jeffrey

Like a bloodied warrior,
laying broken and torn.

Like a dying soldier, hopeless and forlorn.

But the blood, it be green,
the color of money.

And the soldier is an economy,
and it is anything but funny.

Broken are it's people and shattered are their dreams.

Thanks to the ultra rich and their full proof schemes.

It is a tragedy with more pain to come.

Finance will be Hell, and their wills will be done.

Anonymous said...

Food for thought....

J.P. Morgan Chase is releasing several thousand employees. It is simultaneously rehiring these employees at entry level, or near entry level positions where possible . That is the definition of "wage deflation".

I'm sure that template is manifesting itself all over the place.

Additionally if you take a gander at the ratio of disecretionary vs. non-discretionary cash flow numbers you see a disturbing truth.
We have been in a spiral of deflating non-discretionary spending proportionally to income. This is a direct result of high acrsoss the board productivity demonstrated by the employment percentage in critical mfg. vs. non-critical and service sectors. Further, as the bulk of domestic personal income today is related to these discrectionary cash flows the possibility exists of a implosion. Bear in mind the Chinese have spent relentlessly on factory automation and other cap-x projects that have made them exceptionally productive. Simply put. We have overbuilt automation relative to population. More simply put we produce more than we need. Perhaps when Alan Greenspan said roll the printing presses perhaps this is the "deflationary spectre" he saw in the post 00' tech bust and unwittingly gave birth to the housing bubble and commodities bubbles.

Just a few thoughts...

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