In the more eschatological corners of the financial blogosphere, a debate has raged for centuries: Inflation or deflation?
I recommend Michael Shedlock as a thoughtful and passionate proponent of the deflationary view. (See e.g. here and here, but he's been making the case for years and it's worth searching the archives.) Also, Karl Denninger recently offered a nice deflationary tract.
I'm more certain of monetary and price volatility than I am of inflation or deflation. But on balance, even as commodities crash and the dollar rallies, my best guess is inflation.
Do read today's excellent post by the always excellent Brad Setser, The changing balance of global financial power. Take a look at his graphs, showing the external official claims of "democracies" vs "autocracies". You'll notice that the autocracies are owed a great deal more money than the democracies are. Mostly, money is owed by the democracies to the autocracies in the form of debt denominated in the democracies' currencies.
[Note: For the purpose of this piece, it matters only that policy in the "democracies" be sensitive to public pressure. The internals of the "autocracies", and whether they are justly characterized as such, is not relevant to the argument, and not anything I want to get into here.]
Inflation helps debtors at the expense of creditors. In democracies where those who can vote are, on balance, debtors, one would expect collective indebtedness to favor inflation. Not all citizens are debtors, there would be domestic winners and losers. But on balance, voters gain by printing currency. If that's a good argument for free trade, why should it not be an argument for weak money?
There are, of course, institutional constraints, "independent" central banks and all. It is one thing for a nation's central bank to stand above the fray with respect to competing domestic interests, but quite another for the bank to put foreign interests or economic ideals above a collective national interest. That's especially true if the alternative to devaluation is deflation. Under a deflation, American workers (those who remain employed!) would have to work more to pay off their fixed dollar debts. Individuals can declare bankruptcy and default, but collectively we cannot default on official debt (pace Felix Salmon, whose heretical idea I adore). One way or another, as reckless debtors or noble taxpayers, Americans would have to work harder under a deflation than they had signed on for when they took on the debt. Americans are having a hard time coming to grips with their nominal debt burden, public and private. I think it implausible that they would accept a large increase in the real interest rate they must pay. Officially it is the policy of the American central bank to maintain price stability and full employment regardless of the external value of the dollar. If the Fed faces a choice between deflation and high unemployment, or tolerating a significant inflation (with or without high unemployment), I'm pretty certain it would choose the latter as the less-bad option.
Japan's experience in the 1990s and the US' in the 1930s are often cited to suggest the inevitability of deflation, despite monetary policy heroics. But in both cases, the deflating country had a large, positive international asset position. To the degree money was owed by foreigners in domestic or pegged currency, the "national interest", looking past winners and losers, was to tolerate deflation.
All of this ignores the secondary consequences of a partial default through inflation and devaluation. A wise polity would weigh the immediate collective benefit of reduced debt load against costs including higher future interest rates (foreign creditors get spooked), more expensive tradables, and a nationalistic backlash by creditor states. Of course, it would also have to consider the secondary effects of tolerating deflation, such as a spike in bankruptcies combined with a large tax spike to avoid a sovereign default. It seems to me that the adverse consequences of deflation would be sharp and domestic, while high prices and interest rates can be billed as "facts of nature" in a market economy, and other people's hostile nationalism often helps domestic politicians, who can provoke some hostile nationalism of their own.
It is not impossible that the Fed will square the circle, maintaining something close to price stability while the US gears up its tradables economy and foreign creditors silently ease our debt burden via real appreciation. Obviously, that's the best outcome (at least for the United States). But if deflationary winds do blow, if the Fed is faced with the choice of tolerating a spiraling credit contraction, falling prices, and bankruptcies or overshooting with "quantitive easing" into inflation, well, as Ben Bernanke famously put it...
[T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
FD: My investment portfolio includes inflation hedges such as precious metals and short positions on long bonds. My portfolio return over the past several weeks has been large and negative, and if you take anything here as investment advice please expect a similar outcome.
| Steve Randy Waldman — Friday August 15, 2008 at 12:46am | permalink |
The "secondary consequences" you mention may turn out to be quite significant considering that many debtors have a variable interest rate and/or short term loans. I wouldn't be surprised if a spike in interest rates that could result from reflation has an even greater adverse effect on debtors than mild and slow deflation.
An analysis of this would be complicated at least by the extraordinary willingness of our mercantilist creditors to supply us with cheap cash (which Brad Setser has so admirably been tracking) as well as the different constituencies carrying various types of debt, with the big elephant in the room being the US govt.
The Fed's clumsiness and/or recklessness (IMHO) is also a factor. If they drop a recent and probably tentative reluctance to reflate, I think the likelihood is greater that they would overshoot and cause hyperinflation, which will have well known disastrous consequences.
All of this is also complicated by what I think can be fairly described as phony statistics (sorry for the apparent hyperbole - I do think that is a correct description.) I am aware of the academic arguments for things like hedonics and substitution, but given the arbitrary nature of the adjustments and the fact that they are always one-way, I don't find those credible. I don't mean to digress, it's just that if the Fed acts as if inflation is much lower than it really is, the risk of hyperinflation is even higher. (As an aside, the "adjustments" made to unemployment and GDP figures may have the opposite effect, but probably to a lesser extent.)
I realize that you're presenting what you see as likely rather than what you advocate (at least that's what it seems like to me :-), so I wonder if you can also address what you think it would take to achieve, and the effect of, stable prices. Are inflation and deflation really the only realistic options?
With such a big mess and with varying effects and consequences of a policy tilt one way or another, aiming for price stability may be the safest. Given the post- Volcker Fed's performance, I think that if they act as though they are tolerating deflation (by their apparently poor measures), we may end up with mild inflation.