Will We Have Inflation, Deflation, or Hyperinflation?

This article is presented in four parts. It deals with what I feel is the primary question investors must now answer: is our future to be inflation or deflation? The answer has vast implications to our investment planning and decisions for the near term, and possibly for our long term. It is a very complex question with a lot of moving parts involving economics and politics.

Like it or not, it is economic theory that is driving macroeconomic policies and political decisions that determine whether we will have inflation or deflation. Since not all of my readers are sophisticated traders I have tried to present the issues in a direct and hopefully understandable way. To those sophisticated readers, please bear with me.

Part 1

The Problem

The economy is not acting according to plan. At least not the plan devised by the Fed or the Obama Administration. According to the plan we should have liquidity flowing through the economy and the credit crunch should be over. In fact we should have moderate inflation by now. Government likes inflation because it gives the false impression that things are doing better than they really are: people confuse rising prices and wages with economic gain. As well, debtors, especially the government, can pay down debt with newly minted dollars. But the signals from the economy are mixed: mild inflation yet we still have a credit crunch as credit has continues to contract. Initial enthusiasm for a “recovery” is now giving way to concerns about deflation.

So what is it to be: inflation or deflation?

The Dispute

There is a rather significant running argument going on in the Austrian economics theory community about whether we are experiencing inflation or deflation. Further there are the gold bugs who are predicting, as they have for many years, hyperinflation. The deflationists are led by Mike Shedlock, known as “Mish” who argues that we are seeing deflation and that it will continue for some time. The inflationists are a variety of folks, but the loudest voice and harshest critic of Mish is Gary North. The most credible inflationists are Bob Murphy, a well known Austrian school economist, and Frank Shostak, chief economist for MF Global, formerly the trading arm of Man Financial, the world’s largest hedge fund. They insist that we are seeing inflation now and that more is coming.

I will side with the inflationists but I think Mish makes some valid points and that his timing has been good. I would say that some inflationists have been excellent on theory, but less accurate on timing. I call my position Modified Inflationism.

Predictions: All Signs Point to Yes

It’s easy to make predictions, but difficult to get it right. A recent Freakonomics column in the NY Times by Stephen Dubner gave this humorous quote on economic prognostication:

The future will be different from the present to some degree and some point, and I have anecdotes and hearsay to prove it.

My point is that it is not easy to make accurate predictions about the future, and when intelligent people make them they are sticking their necks out, a brave thing to do, but fraught with uncertainty which few of them are willing to acknowledge. We need to consider the implications of randomness in our world where it is hard to know if the prognosticators were right or just lucky. I am not saying that it is impossible to differentiate between luck and skill, but that it is very difficult.

I have found that the best economists and prognosticators derive from the Austrian School of economics, to which I subscribe. These free market gurus stem from a remarkable intellectual tradition, and are the only ones, I believe, to have created a valid theoretical background on human social behavior, which, if one thinks about it, is what economics is.

The problem with forecasting inflation is that we need to be able to predict what the Fed will do under certain circumstances, and how the Fed’s bosses, the politicians, see the world.

With those caveats in mind, I am going to stick my neck out.

What is Inflation?

The first thing we need to understand is what inflation is. It is not rising prices, but rising prices are an indication and one result of inflation. There are impacts other than rising prices. The most significant impact is that capital is misdirected into activities that, but for lower interest rates, would otherwise be unprofitable (malinvestment).

Inflation is purely a monetary phenomenon. It is an increase in the supply of money, assuming that demand for money remains the same.

If everyone woke up one morning with twice as much money as the day before, then people would be buying goods at an increased rate and, since the supply of goods aren’t infinite, prices go up. The fact that we all have twice as much money doesn’t mean we are all wealthier, it just means that we have more pieces of paper to spend. For those who wish to understand why our paper money is not wealth, then please see my article, “Money: A semi Fictional Fable.”

The greatest problem people have with understanding inflation is confusing it with rising prices. For example, the argument goes that if oil prices increase it causes inflation because oil’s use is so pervasive in the economy that it causes all prices to rise. But that isn’t the case. If money supply remains constant, and if I have to spend more money on gasoline, then it means that I will have less money to spend on something else. Thus there is less demand for the goods that I would have otherwise bought and their prices decline. This is a response to supply and demand of goods: some prices go up, some go down. But it isn’t inflation.

Deflation is the opposite of inflation. All things being equal, if the supply of money declines, then prices will also decline because there is less money chasing the same amount of goods.

Money Supply and the Credit Crunch

To cause inflation then, we need to increase the supply of money. To have deflation we need to decrease the supply of money. There are many complexities to the theory and disagreements within the Austrian community, but I’ll stick with my general definition for the moment.

This article is not meant to be a treatise on money and banking, but a few concepts are important to understand.

It is relatively easy to see what money supply is doing. While there are many components to it, and it is a complex topic, there are measures of money that most people use.

Money base[1] is the primary monetary measure of currency in banks and circulating in the economy, and bank reserves held at the Fed. When the Fed starts pumping money into the system, this shows up as money base.

This chart (BASE) shows what the Fed has been doing since the October 2008 crash. As you can see they doubled the money base, and then increased it again to 2.5X by Q1 2010.

The rate of year-over-year (YoY) change in money base is shown in this chart below. You will note the volatility as shown by the verticality of the increases and decreases.

This shows how the Fed was countering the contraction in money supply and credit during the initial stages of the crash. The idea was to provide enough liquidity for financial institutions so they wouldn’t go bankrupt. Economists refer to this as “quantitative easing,” (QE) or monetary stimulus which is a concept of Monetary theory (Milton Friedman and Irving Fisher), of which Ben Bernanke is a follower. Mr. Bernanke also seems to also be Keynesian in his acceptance of fiscal stimulus.

The crash, the rapid decline of real estate asset values, and the questionable value of real estate and consumer loans, led to the credit crunch. As we all know credit dried up, consumers retrenched, business contracted, loan defaults took off, and only the biggest institutions had access to credit at the Fed’s commercial paper window (Commercial Paper Funding Facility). At one point the Fed was responsible for about 90% of the U.S. commercial paper market—almost $350 billion. Major institutions were also backed up with TARP money.

Money base must find its way into the economy to affect the supply of money. The M1 money supply measure (currency in circulation plus demand deposits) immediately jumped.

But the problem was that much of this cash didn’t find its way into the economy. Take a look at what banks did with the new money: they held much of it as excess reserves (EXCRESNS):

The significance of excess reserves is that it is a good indicator of liquidity in the system. These reserves are considered “excess” when they exceed the regulatory requirement for the reserves a bank must hold. As you can see, prior to the crash, excess reserves were nil, reflecting banks’ willingness to lend.

The reason for high excess reserves was that banks were not lending, for very good reasons.

First, their own balance sheets were in jeopardy. Their loan losses grew and in order to meet regulatory requirements, they were uncertain how much capital they would need. Banks didn’t understand the depth of the crash and the impact of the world’s biggest debt induced boom would have on their loans. An uncertain future caused banks to pull in their loans in order to preserve capital. It was obvious that as their loans soured, good borrowers were harder to find. Bankers respond rationally to uncertainty: protect their depositors and their loans. If you don’t think a lender will be able to pay you back, you won’t lend money.

Second, they were unsure what the response of the regulators would be regarding capital requirements, especially what is called Tier 1 capital. It made good sense to hold on to the vast amounts of credit the Fed was providing in order to hedge regulatory uncertainty.

As I have been saying, there were valid economic reasons for banks to hold large reserves; there was nothing “excess” about them.

The impact of high excess reserves shows up as a decline in the M1 multiplier which means that bank lending collapsed. The M1 Multiplier is the multiplier effect of fractional reserve banking from an increase in the M1 money supply. If banks only have to keep 10% of deposits on hand and can lend out 90%, the money effect is multiplied many times. If Bank A has $100 of new money, it can lend $90 to Customer A. Mr. A spends the money which ends up in Bank B, thus increasing their deposits and enabling them to lend out 90% of it, or $81, and so on. The multiplier (10:1) basically turns $100 new dollars into almost $1,000 as it goes through the economy.

Post crash the M1 multiplier collapsed:

This shows the credit crunch as bank lending dropped off a cliff.

The below chart of commercial banks loans (TOTLL) shows what happened to loans:

It is easier to see from the YoY percentage change:

This is the classic credit crunch. No one can get a loan from banks. Large corporations were able to go directly to the Fed, but most businesses and consumers could not get a bank loan.

Consumer credit, the mother’s milk for consumer spending (70% of GDP) dried up:

When consumers don’t spend, the economy goes into recession.

Tomorrow, Part 2. The inflation and deflation arguments.

After Part 4, I will publish the entire article as one downloadable PDF.

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[1] See the Wikipedia article on the definitions of money aggregate measures. http://en.wikipedia.org/wiki/Money_supply