Friday, December 19, 2008

Inflation vs. Deflation


For the first time, I accidentally and irretrievably erased an earlier, much longer and colorful version of a post.

So, you benefit as I make this version shorter and more direct.

Since September, watching the world financial system has been like watching an overtaxed steam engine that is rattling and threatening to explode under the pressure.

I have been reading way too much about the crisis. Unencumbered by any serious education in economics, I think I can boil things down to one essential question: is the U.S. facing inflation or deflation?

You can see this argument being waged fiercely every day on places like "Seeking Alpha."

And although most of the best minds think it's deflation, the Oracle of Amsterdam believes the correct answer is, inflation.

Coming soon to a country near you!

It's a matter of first principles:

1) "Inflation is always and everywhere a monetary phenomenon."
2) The Federal Reserve and Treasury together control the money supply. And they are committed to printing as much money as is necessary to prevent a deflationary spiral.

(tw collins)

The nightmare of serious deflation is that nobody spends anything because they're waiting for lower prices tomorrow, and nobody is willing to borrow because debts are ever-harder to pay back. So it leads to massive unemployment and Depression 2.0.

Of course hyperinflation gives you Zimbabwe. But a little inflation ain't all bad. Sure, it's an endless aggravation for people who see their savings being eroded and facing prices that are always on the rise.

But at the moment, some inflation would be welcome in order to put a floor under housing prices and stabilize the rest of the market. And it will make it easier for everybody to pay back their debts.

Mild deflation would be okay too, but the Fed thinks, probably rightly, that they can't take the chance of dicking around trying to achieve something they don't know much about.

So the Fed/Treasury is printing money. The base money supply has been increased by 76 percent since last December.

That has a lot of effects, some predictable, others are unknowable and yet to come.

(some russian guy)

(patricia proven)

Most notably, there's no inflation yet! House prices are falling, stocks and (most) bonds are down, consumer prices are falling, everything is on sale.

The money is piling up in the vaults of big banks, and they are spending it on only one asset class: U.S. treasury bonds.

The more people that buy them, the lower the interest rates go, so it's nice that these big bailout packages are being paid for at a very low rate.

But so many people are piling into the treasuries that at one point interest rates actually went below zero.
That means, people were paying money for the privilege of letting the U.S. borrow money from them!

That's irrational, and it's one sign that treasuries are in a bubble. I think it may pop at some point.

The threat of that; the low return on bonds; and the big potential returns in other investments, should lead some money elsewhere eventually.

Also, the investors sitting on cash have to recognize that inflation is a threat, too, and start buying *something* or watch their pile slowly become worthless.

Gold has responded predictably to the printing campaign, i.e. it has gone up, and I think oil will probably follow.

The dollar has also responded predictably, namely by falling. I think further falls are likely, especially once tangible evidence of inflation starts coming in.

Now, the unintended consequences:

There are trade war elements to what's going on. China has been devaluing its own currency for so long to gain an export advantage, it is shocked to see the U.S. doing the same.

Germany, the only exporter larger than China, is certainly going to suffer from the weak dollar. In the long run, the European Central Bank will probably be forced to cut rates the same way as the U.S. is...

In short, people are going to be debasing currencies around the world. A race to the inflationary bottom.

That means, again, gold, oil and other natural resources will appreciate in nominal terms.

I should point out, the real economy doesn't benefit much from mere inflation. Stagflation is the best case scenario here.

The worst case scenario is that the printing leads to hyperinflation. The Fed believes, or hopes, that once inflation is clearly back, they'll be able to raise interest rates again in time and suck up some of that newly printed money.

However, it's going to be very hard to raise rates if the economy remains in the doldrums.

If hyperinflation sets in before there's any kind of a recovery and the Fed has to raise rates in the middle of a recession: Well, that's the "checkmate" scenario, and game over. The depression will be back on.

In the stagflation scenario, things may be made worse by all the radical actions of the Fed/Treasury. For instance, foreigners may be wary of buying U.S. debt: you never know when the U.S. government will just devalue the currency and screw you.

Over recent decades the U.S. government has benefited from Japan, China and others putting their money into treasuries, helping keep interest rates low. I don't think China, especially, will ever make that mistake again.

But in the short term we should get our inflation.



Laura K. said...

are you still among the living?

Anonymous said...

Ditto of Laura's post...

Where are you T? I'm hoping you can provide some insight into this guy who tried to plow down the Queen.

The story hasn't made much news here in Australia.

Lola Granola

Toby Sterling said...

Hi guys. Just reassuring you I am in the land of the living. Taking some time to reorganize priorities, etc. A Lethe will be back !