Saturday, 29 May 2010

The inflation debate or why you can have inflation in a deflationary environment

From one article to the next, one site to another, the inflation debate is raging.

On the website Pragmatic Capitalist, the author of the blog TPC is arguing that the "inflationistas" are wrong in relation to the risk of inflation down the line due to the massive money printing exercise we have been witnessing.

It is indeed a very complex debate and in this post, I will try to add my contribution on the subject. The discussions surrounding the inflation debate will lead us to question the definition of inflation and inherently the definition of sound money.

To summarise the ongoing debate, is the massive liquidity injections we have witnessed in the world inflationary or not?

For TPC on its blog, it is not inflationary at least in the US do to the ability of the US to print money at will, same apply to the UK.

"First, the government doesn’t actually print money (at least not in terms of money creation). They simply press a button on a computer that changes accounts up and down. It’s not like they find a gold miner and print up a note and “monetize” anything. Most importantly though the government never actually has nor doesn’t have dollars. They simply change accounts up and down as they tax and spend. So what does the Fed do? They target the Fed Funds Rate via monetary operations with the belief that they are the grand wizard behind the whole operation. The Fed’s interest rate mandate or target of “price stability” actually means they can’t monetize the debt."

"Now, this is generally the point in the conversation where the inflationistas begin talking about the “effective default” of the USA via dollar devaluation. The problem is, each time the crisis flares up the price action in markets makes it abundantly clear that there is no inflation, but rather continuing deflationary fears. Einhorn’s comments regarding inflation are no different than the other inflationistas who continue to scream “fire” in a crowded theater despite no signs of fire. Of course, there has been no inflation because there is none. The inflationistas have made the same error that Mr. Bernanke made when he supposedly “saved the world” in 2008. Mr. Bernanke assumed that banks were reserve constrained while Mr. Einhorn assumes that adding to reserves is inherently inflationary. But as we see very low levels of borrowing (due to the private sector’s lack of debt demand – caused by the continuing balance sheet recession and de-leveraging) we see zero signs of inflation."

In this lenghty article TPC replies to the comments made by David Einhorn from Greenlight Capital.

TPC also add the following comment:

"In terms of government spending (or blanket Keynesianism as most doubters prefer to call it) it’s largely an accounting identity. Private sector deficit is public sector surplus. If government never spends private sector funds are slowly drained. Just imagine a one time 100% asset tax. What would happen to the economy? It would die of course. Contrary to popular opinion, government must spend before it can tax. Not vice versa. Therefore, a certain level of government spending is necessary. The recent CBO findings show that government spending was the primary reason why the economy didn’t sink into a black hole over the last year. We also know from borrowing data and bank conditions that monetary policy has failed entirely. Of course, I have argued that the government spending has been very poorly targeted and resulted in more malinvestment and ineffective output than should have been the case, but that shouldn’t surprise anyone when you allow the bank lobbyists to control legislation. Spending is not the answer, but we must understand that spending at the government level also isn’t the enemy. Regardless, these blanket statements that government spending is always bad is flat out wrong."

The issue and I agree with TPC in relation to Government spending is the quality of the spending. Government spending can be necessary provided it is acting as an investment such as infrastructure spending. In many countries, UK, France, Greece, the US, there is a lot of waste in goverment spending which have to be addressed.

We previously looked at what Canada did in the 90's in a previous post which lead to a decrease in the debt levels to GDP and boosted the economy. Of course there were short term massive pains but it generated long term gains.

The debate about inflation as highlighted by the response of TPC to David Einhorn's comments, is as well a debate between the Austrian School of Economy versus Keynesians believers.

I was recently given to read an article relating to the monetary situation of Europe following the First World War up to the Second World War and beyond. This article was written by Jacques Rueff, French Economist, Memories and Reflections on the age of inflation, 1956.

Jacques Rueff was very conscious about the risk the dollar faith economy would lead to.

In this article of the Daily Reckoning, published by Bill Bonner, Bill Bonner highlights the insight Jacques Rueff had in 1976, warning of the risk of a "faith dollar based economy".

"Since 1911, there existed in England a system of unemployment insurance that gave an indemnity to jobless workers, known as the "dole." The consequence of this regime was to establish a minimum salary level, at which workers would prefer to ask for the dole rather than work for less. It appears that in the beginning of 1923 salaries, which had been declining with other prices in England, suddenly hit this new minimum. There, they stopped falling, and since then, they practically ceased to move."

That's why France runs such high unemployment rates today; its dole is bountiful. When you add up the costs of "charges sociales," paperwork, and the minimum wage, more than one in ten potential workers is not worth the money. But no right thinking politician is about to suggest the obvious solution: get rid of the dole. So, Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for 'things' meant that salaries - in real terms - would go down. That was the greasy scam behind Keynes' General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them.

"Full employment" was soon no longer a wish, but an obligation.

"No religion spread as fast as the belief in full employment," wrote Rueff. "...and in this roundabout way, allowed governments that had exhausted their tax and borrowing resources to ressort to the phony delights of monetary inflation. "

At the moment, TPC is right in relation to the deflation environmnent we are experiencing.

Jacques Rueff commented previously that the additional increase in money generates inflation when people receiving additional receipts, prefer to keep these receipts in their till or wallet, which means that these additional receipts of money, which are not desired, creates an excess demand, which then affect price levels.

"Au contraire, l'émission de suppléments de monnaie engendre un phénomène inflationniste si elle a lieu sans que les personnes qui reçoivent les encaisses supplémentaires désirent les garder dans leurs tiroirs-caisses ou dans leurs portefeuilles, c'est-à-dire lorsque ces suppléments de monnaie, n'étant pas désirés, suscitent une demande excédentaire, qui alors agit sur les prix."

This explains why excess credit in the US, which lead to an increase in house prices, was inflationary on many assets prices.
I strongly believe that the Austrian School Business cycle theory is the best explaination of the financial crisis which started in 2007.
Both Ludwig von Mises and Friedrich Hayek correctly warned of a major economic crisis before the Great Depression.
Hayek made his prediction of a coming business crisis in February 1929. He warned that a financial crisis was an unavoidable consequence of reckless monetary expansion.

"Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.

According to the Austrian School business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by Austrian school economic theory."

In addition to the Autrian Business Cycle Theory, it is important to take into account Irving Fisher's contribution with his debt-deflation theory:

"In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:

1.Debt liquidation leads to distress selling and to
2.Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3.A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4.A still greater fall in the net worths of business, precipitating bankruptcies and
5.A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
6.A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7.pessimism and loss of confidence, which in turn lead to
8.Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
9.Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest

Therefore a perceived inflation can happen in a deflationary environment, it can co-exist. We are witnessing it, in fact in the UK where recently inflation rose to 3.7% on an annualised basis while the UK is still entrenched in a very difficult deleveraging process.

The definition of inflation is as well a matter of intense discussion.

For the Austrian School and Ludwig Von Mises in particular, inflation is measured by the true growth of money supply.

This is what Ludwig Von Mises defined as inflation:

"Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation."

A lot of people argue around the current level of gold prices as a sign of incoming inflation, the truth is that we are still deeply in a deflationary environment, but inflation will be increasing at some point, when and only when the deleveraging process will be over.
The issue at hand is can the liquidity be withdrawn from the system at the moment? Probably not. The fear of deflation is very real and clear, hence the requirement of quantitative easing to avoid a deflation trap.

Inflation might have receded but cannot disappear given the current fractional banking system we are living in.

Alan Greenspan, former chairman of the Federal Reserve said the following at the start of his career:

"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."

The discussion around inflation is central as it leads to the understanding of sound money.

Ludwig Von Mises said the following in relation to money:

"It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the nonobservance of old customs by kings."

In addition to the above and to open the discussion on the solution to the current environment, I would like to highlight Irving Fisher's proposed solution to the issue of deflation and his critics:

"Fisher viewed the solution to debt deflation as reflation – returning the price level to the level it was prior to deflation – followed by price stability, which would break the "vicious spiral" of debt deflation. In the absence of reflation, he predicted an end only after "needless and cruel bankruptcy, unemployment, and starvation", followed by "an new boom-depression sequence":

Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebted-ness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called "natural" way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.
On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."

Reflation is currently what our governments are trying to achieve via massive liquidity injection and quantitative easing, and mind-blowing money supply increase as well as.

Remember Fisher's equation:
MV = PT where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

QE in the UK, as I said in March is not working:

MV=PT as per Irving Fisher's equation. The Bank of England bought 200 Billions worth of long dated Gilts with QE. The BOE by pumping M (M4) is expecting T to rise and it is not really happening...
As a reminder: MV = PT. M is the stock of money in the economy,V is the velocity of circulation or the speed at which money flows around the economy. P is the price level and T the value of transactions, or gross domestic product (GDP). Hence by
increasing ‘M’, QE aims to increase ‘T’.

The initial MV = PT equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.

The solution of reflation is not working unfortunately. Debt-deflation, which is currently what is being tested, will fail.

To conclude on this post, relating to the deflation-inflation debate is that we are currently in a deflationary environment which poses no short term threat of massive inflation, but creates a risk of high inflation, if there is no debt restructuring at some point, as well as some profound structural reforms in public finances in the very near future, which will push us towards a double dip recession. It is unavoidable.

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