3: Inflation to Deflation - and Back Again
The aspect of the current situation the author believes will present some of the most serious challenges is the threat of a progressive fall of the price level, commonly termed "deflation," which occurred in a number of preceding crises. Deflation seems to catch markets unaware: central banks focus on keeping inflation low, not seeming to consider that it can go below zero, a point at which prices diminish, and income must diminish as well.
The author believes that the era of low inflation has much further to run. Inflation occurs when interest rates rise because the demand for capital exceeds its supply. The decrease in demand for goods has led to a decrease in production, which in turn is a decrease in capital to finance production. It occurs in a growing economy, and the economy is not growing.
(EN: My sense is that the author is considering functional inflation, and is disregarding that nominal prices and wages also increase when currency is debased, which is a serious concern when governments are deeply in debt. I have not seen much analysis to compare the two factors - to illustrate that the low inflation rate suggested by the numbers is not merely the counter effect of a loss in the value of money at the same pace as inflation would otherwise have occurred.)
The author suggests five main "forces" that make prices and wages more "downwardly flexible" in the present situation:
- There is greater competition in the domestic economy. This applies not only to the supply of goods, but the supply of labor.
- Technological change has interconnected markets, in the flow of information and the flow of goods, eradicating the monopoly of geography
- New competitors from Asia have underpriced western producers, and flooded the markets with goods that cannot be made as cheaply
- Potential competitors with much lower cost bases abound, in established and emerging economies, making firms reluctant to increase prices even when there is no immediate threat of competition
- There is little expectation of inflation on the part of consumers, and they will have little tolerance of it should it occur.
As such, suppliers are reluctant to increase prices, and seek to compete by keeping them low. This prevents inflation without much effort on the part of regulatory agencies. But as the situation continues, it brings with it the significant threat of running into the negative.
Inflationary challenges
The functional cause of inflation, the supply of products in relation to their demand, is geared to reduce inflation, there is still concern about other aspects. Governments have accrued tremendous debt and increased their money supply, and may see debasement of their currency as an easy way out. Faith in the value of their currency may fail regardless of whether they do so. Likewise, there is much faith and fact to the increase of commodity prices and the effects of increased competition from growth in emerging markets.
Short-term consequences of public borrowing
There is concern about increased public borrowing, and the belief that increases in public borrowing will diminish the value of money and lead to inflation.
The author suggests that this idea holds no merit because public borrowing has no effect on demand. It does not: the need for goods and services is entirely independent of a government's financial situation. It is actually driven by the financial situation of the consumers, who are unable or at least reluctant to purchase goods for lack of income - but the lack of income is for lack of work.
As the economy recovers and unemployment decreases, people will be put to work creating the very goods that they will purchase with their wages.
There is, of course, the assumption that wages and prices will increase in lock-step: that suppliers may offer lower wages and demand higher prices. But as unemployment drops, labor itself becomes a scarce commodity, compelling firms to pay higher wages to obtain the level of labor they require.
And in any case, a disparity between wages and prices represents a profit to investors - and given contemporary models of taxation, the government will claim its share regardless of who gains the most from the recovery.
Government debt, itself, is capped by public anxiety, and as such it is highly unlikely that any government will have the ability to infinitely expand its deficit - but this, again, is an entirely separate matter from the functional inflation in the marketplace, in which the demand for goods is indifferent to the politics of the day.
Long-term consequences of public borrowing
The argument that public borrowing impacts inflation in the short term does not stand scrutiny. However, there remains the question of long-term consequences.
Suppose that when the private-sector demand recovers, the public sector continues to increase taxation and debt. This is a legitimate concern, but there is evidence that governments are able to reduce expenditures to address the public debt.
Consider that in the mid-1940s debt in the UK was 250% of its GDP, and in the US the peak was 108%, both as a result of depression-era spending and the buildup prior to the second World War. Three decades later, the UK figure was reduced to 50% and then US figure to 25%.
(EN: I was curious about the current ratio of debt to GDP. AS of November 2012, it is 106%)
The author provides additional examples from France, Japan, Germany, and Finland, making the general observation that, in the long run, things somehow seem to work themselves out.
Monetary incontinence
Another significant characteristic of economic collapses is the flood of huge sums of money into the monetary system by central banks. The theory follows that it is inevitable that an abundance of money will lead to an abundance of inflation.
The author disagrees: he maintains there are different sorts of money. Since money has no connection to any physical commodity, central banks can pump out as much of it as they please, without any functional limit. In essence, they are printing money, creating dollars without affecting value - but under the central banking system, money is being exchanged for other assets in the system.
In essence, fiat currency is non-voting and non-redeemable shares in a central bank.
(EN: This all seems very weird and oblique, but seems to suggest that because money has no value in the first place, then there is no consequences to creating more of it. What's of greater concern is the money that is created in the commercial sector - treating debt instruments as if they had equity value. That is, writing a million dollars worth of loans creates a million dollars worth of equity in the form of salable debt, but the value is not realized unless and until the loans are repaid.)
Broad money
Central bank money is "small change" in the monetary system, as the bulk of money consists in the liabilities of private commercial banks. If central bank money has any impact at all, it is through other parts of the financial system.
Under normal circumstances, there is a reasonably stable relationship between central bank money an private bank money. As such, if there were a greater supply of central bank money, you should expect to see a surge of lending and asset purchases to convert banks' stagnant assets into income-earning assets.
However, the present crisis is different to normal times - banks are afraid that if they loan their money, it will not be repaid. They have little need for central bank money. As such, the federal reserve rate is not an independent phenomenon, but reflects the degree to which banks want money - when there is little demand, the rate falls.
In such a situation, the relationship between central bank money and private bank money breaks down. The reserve can only lower interest rates to zero, at which point they have no further power to cajole banks into lending or investing additional money.
(EN: This also does not take into consideration that the private banks demand of money is, in turn, driven by the demand for credit. It cannot be taken for granted that there is unlimited demand of credit, as the productive sector will likewise seek to borrow money only when they can make productive and profitable use of it.)
This is not pure theory: it is exactly what happened in Japan, where their central bank injected huge amounts of money to boost the supply to the economy. The central bank increased its money supply by 60%, but the total money supply increased only by 7%
If banks have an overabundance of money when the economy recovers, then it can be expected that lending will resume and inflation will pick up - but there is no need for this to happen. Central banks can withdraw their money from the system and the total money supply will address the decrease.
Actually wanting inflation
There is a school of thought that maintains the thesis that inflation is good for the economy and should be promoted, at least to a certain level.
Clearly, inflation is good for long-term debtors whose interest rate is fixed at a level beneath the current level of inflation: they will repay their debts with cheaper dollars than they borrowed. However, lenders stand to lose, which means that they restrict credit and raise the interest demanded to compensate for the increase they anticipate.
A second alleged benefit of inflation is the stimulation of economic growth: money that lies fallow loses value, and it is in the interests of those with wealth to put it to work in the economy to stave off the gradual degradation. However, this view overlooks the potential to invest in nonproductive vehicles that will preserve value against a falling currency: for example, investing in precious metals preserves value without stimulating the economy, as would offshoring funds to a stable economy.
The author suggests that "sustained restraint on government spending" will bring deficits sharply lower and stabilize the ratio of public debt to GDP below panic levels. Inflation is not necessary to cancel debt - repayment is.
Were there to be the sense in financial markets that a given government was considering inflation (currency debasement) as the way out of the crisis, they would flee government securities, or raise the rate of return required to purchase them significantly. In essence, the government could obtain no further credit except at massive interest rates. There would also be a loss of interest in holding or accepting the currency, and a decrease of investment in domestic industry.
Nor is it likely this will occur: for the past 3- years, governments have fought to bring down interest rates because they believe that high levels of interest do significant harm, and there is no sign that they will change this point of view. (EN: This places a great deal of faith in government, which it does not otherwise seem to merit. Politicians change their positions at a whim, and are not known for integrity.)
Theoretical debates
Two additional debates are considered as arguments of theory: because inflation is based on beliefs about the future, predictions can be influential even if they do not come to pass.
For example, consider the "China effect," which suggests that the demand for goods in developing markets have an upward pressure on process (namely for oil and commodities, that creates inflation), overlooking that these are inputs that will produce goods that must be traded on the market (which would lower prices). The author finds this "heretical to the point of economic illiteracy" yet is being accepted as conventional wisdom.
As an analogy, the author considers physics, though he admits to being no expert. However, it's plain to see that there is a chasm between the laws that seem to apply at large sizes and those that apply at the minute subatomic level, at which quantum mechanics provides some demonstrable, but entirely counterintuitive, hypotheses. Physicists have tired, and failed, to define a grand theory that will bring these two aspects together.
He feels there is a similar dichotomy in monetary affairs, with valid analyses of different facts of the economic system that hold true in specific contexts, but do not quite fit together.
As such, the factors that can be examined to explain the increase in prices (increased demand for industrial inputs) are assessed through a different body of theory than that which suggests a decrease in prices (increased supply of industrial outputs) - and that considering each in isolation makes cause-and-effect seem paradoxical.
There are, in effect, two opposing and contradictory conclusions about the future state of supply and demand, and those who decide the interest to be charged for lending money must resolve them, often by gut feel. As a result, the changes in the supply and demand of capital do not correspond to the changes in supply and demand of goods, though the two must eventually be resolved in practice.
The competitive climate
By some theories, inflation has been held at bay by increasing competition in the marketplace.
One factor is the privatization of industry in some nations and its deregulation in others. The sense is that the ability to privatize and deregulate further is nearly run dry, as has its ability to counterbalance inflation. The author concedes that there is a firm limit when everything is privatized and deregulated, but that we are far from it.
Likewise, there is also the notion that technology, primarily the Internet, has likewise held down inflation by making products available to consumers who would not ordinarily be aware of them or able to purchase them, and that the supply of new customers who are just now coming online. The author also disputes this theory, as the Internet is far from ubiquitous.
Globalization is also another factor: when China, India, and other economies first entered the global market, the influence was disruptive, but as with any shock the world market balanced out, and there are no billion-consumer economies that have not already joined the party. The author also disputes this perspective suggesting there are many consumers and producers in these markets who are yet inactive, and many other nations (virtually all of Africa and South America) that could enter the world market.
The downward trend in consumer spending is likewise not a permanent factor: there are still consumers aplenty who have shown a willingness to spend when the price is right, and under the present economic conditions, they tend to be bargain shoppers. As such, this is also an area of opportunity when conditions improve and customers loose their purse strings.
(EN: There's been some analysis of consumer debt and a theory, albeit with anecdotal support, customers are paying their debts from the excesses of 1995-2005, and that when those debts are serviced to a satisfactory level, capital will return to the markets.)
The author does not argue that the rate at which these factors provide "favorable price shocks" has indeed slowed down, but he completely dismisses the notion that they are in fact tapped out - there's still a lot of opportunity.
Higher oil and commodity prices
Another factor that drives inflationary panic is the price upsurge in oil and commodities that began in 2008 - the reasoning being that these factors increase the cost of production, and those costs are passed along to the consumer when they are converted into salable products.
This played out in the 1970s, when upsurge in oil prices (one increase of 300%, a second of nearly 200%) shocked the economy into deep recession. However, it did not play out in 2008-2009, when oil prices doubled in a year and agricultural and metals doubled in two years. Meanwhile, consumer inflation rose by only 3% over the same period of time.
One factor that mitigated the impact is that the cost of inputs is less of a factor in developed economies than it had been forty years prior: manufacturing has shifted to developing economies, where the rising material costs are affordable given the extremely low cost of labor, mitigating the impact on consumer prices. While established economies did see the rise in the consumer price for energy, the overall consumption of energy in established economies is a smaller portion of their GDP.
A second factor is that the competitive conditions are utterly different in 2008 than they were in 1970. Limited trade meant that the 1970s consumer was unable to access cheaper products made in overseas markets and were compelled, by this lack of access, to merely accept the increased cost of domestic producers.
(EN: This point is much more salient when you consider two industries that had become more global: automobiles and textiles both suffered greatly from foreign competition. Which is to say that the customer still got cheap goods from abroad, but domestic manufacturers suffered greatly.)
The deflation danger
While there are many who are concerned about inflation in the present crisis, the author considers deflation to be a more likely threat.
He mentions some of the warnings in his previous books, and suggests that "now we are in it." As evidence, consider falling consumer price indices in 2009 in the US, China, Japan, and Europe - with the exception of Britain due to the effects of weak currency.
The most proximate cause is the drop in commodity prices, which had spiked the year before. This was an atypical occurrence that masked the underlying rate, which can only be extrapolated, and as such it is difficult to determine with precision.
The author's argument is that the underlying rate of inflation has fallen into the negative: the collapse in the level of aggregate demand due to decreased consumer spending has left suppliers with surplus capacity, and they have reduced prices as a means of competition.
Such actions have a ripple effect, in that the demand for materials and labor will decrease, hence unemployment will rise. Not only has employment risen, but the author suggests that wages have been reduced, or increased at a rate below inflation (effectively, a passive pay cut that seems like an increase in nominal wages but results in decreased purchasing power).
And where payrolls are cut, the money available to consumers to spend on goods is correspondingly decreased, adding to the downward demand for finished goods, then decreased demand for materials and labor, then further pay reductions, etc.
In effect, payrolls are the harbinger of deflation, even without any help from lower commodity prices or decreased profit margins. The more employers who attempt this shell game, the more favorable the conditions for sustained deflation.
This pattern can be readily seen in previous recessionary periods, domestically and abroad. And given the present economic conditions, the author foresees the potential for the US economy to fall into this pattern "quite soon."
The consequences
Neither inflation nor deflation is necessarily a disaster - supply and demand fluctuate even in a stable market. However, the present market is not stable.
The present danger is that the expectation of falling asset value will inhibit borrowing and spending and persuade people to sell assets to repay debt (as the assets will be worth less in future) = the result of which is "debt deflation," which was seen in the Great Depression as well as the Japanese recession of the 1990s.
In theory, both inflation and deflation can be addressed by adjusting the money supply. In practice, adjusting the money supply has not been effective at stopping inflation or deflation.
(EN: There is not rationale for this observation - but I strongly suspect it comes from principles of monetary policy that were based on commodity money. In a system of non-commodity money, releasing more currency to the market does not release anything of value, and as such has no impact on the supply and demand of products. Halve the money supply, and the money price of products doubles, but their quantity is the same. More importantly, wages double, but the amount of labor, which creates products, remains the same.)
The author believes the reason to involve the uncertainty of future value, as expressed in the interest rates. The central bankers do not know how much money is needed in the system, and they are reluctant to take decisive action - instead increasing or decreasing interest rates in small increments.
The principle that drives the incremental approach is that interest rates charged for loans are driven not only by the present rate, but expectations of how the rate will change. That is, borrowers and lenders compensate for the expected future change in capital value, and a large adjustment to the base interest rate will cause expectations to be overly conservative.
The consequence of the incremental approach is that dramatic action is never taken quickly enough for fear of creating such a panic. And the author feels this to be the case with "quantitative easing" in the present crisis: incremental changes have not effected a resolution, but the small increments, over time, have become substantial.
As such, deflation is foreseeable, and there will likely be more than one instance of rapid and dramatic deflation, as the factors that are pushing the economy toward deflation will not exert their full force simultaneously. As such, he predicts a cycle in which periods of sharp deflation will alternate with periods of mild inflation, as the collapse of demand and the resulting rise in unemployment feed upon one another in a cyclical fashion.
Ultimately, we should not expect deflation to be solved by a single action, but will be "grumbling along for a good time yet" with periods of apparent, but temporary, abatement.
The new policy regime
Policy regimes have a great deal of influence on economies. When the policymakers act in accordance with a given set of principles, it locks an economy into a trend so long as those principles are perpetuated. That is to say that the present economic patterns and cycles will continue under the present policy regime - and will not change until the regime changes.
Moreover, change may not be for the good - and if it changes in the way the author suspects, things can get much worse than they currently are.
Specifically, the author believes that when, in future, the economy recovers and asset prices show signs of a boom, the monetary authorities will seek to suppress them again, even if this means that consumer price inflation turns negative. The implication is greater fluctuation and less stability in the broader market.
Resurgence in inflation seems unlikely in the near future. Even if there is a "commodity-induced bout" of inflation, it seems "to my mind" (EN: that is, without substantiating evidence) that inflation will be generally dead for many years to come.
The present regime is set of perpetuating an economic model that results in a cycle of deflation, and their opposition insists on superficial changes. Bandages are fine for superficial cuts and grazes, but cannot stop internal hemorrhaging.
What has happened to the world economy is not superficial, but represents a profound weakness in the economic systems. The trouble with markets is deep-rooted and severe, and nothing is being done, nor is anything even remotely proposed, to address the root of the problem.