Wednesday, April 13, 2011

Inflationist deflationist debate

For the last 2 years, I've seen several debates between two groups. The deflationists are those who believe we are heading towards a worst than the 1930s deflation where prices of real estate will crash down, the DOW plunging to 5000 or lower and we will barely see any increase in oil and food price.
On the other hand, we have the inflationists who believe we are headed towards hyperinflation - Wiemar Germany 1922-1923 style. I tend to be in the later group and I will provide my own explanations.
Of course, outside of that is somewhat a large majority of people who agree with CNBC et al that a recovery is in the making.

One of the recent battle was between a guy name Gonzalo Lira in Chile (hyperinflation) and Rick Ackerman in Colorado, USA  (deflation):
Both Gonzalo Lira and Rick Ackerman posted several articles on this subject over the last 2 years. It's actually this article from Gonzalo Lira that was republished at that gave him some fame:

First, before I go on with why I believe the odds of hyperinflation are greater, I need to share with you a few of the books that contributed to establishing my stand.
  • The Creature From Jekyll Island by G. Edward Griffin is an excellent work. 2 words can give a quick overview of the conclusion you can come out after reading it: cartel and bailouts.
  • Economics in One Lesson by Henry Hazlitt and several other great books from the Mises institute on Austrian Economics and the business cycle.
  • Rollback from Thomas Woods 
  • How an economy grows and why it crashes by Peter Schiff 

As we know, the printing press is driven by the Federal Reserve. There are 2 things that most be considered:
  1. The Federal Reserve is a political animal
  2. The increase in the money supply (artificially lowering the interest rate) misallocate resources that eventually will starve/affect economic activity that desperately needs investment. Food being one of them.
Let's look at the first item: the political animal
It is the very reason why the Federal Reserve was created. It allowed Congress to spend and make endless promises to their constituents and paying for them via inflation which is usually blamed by the public on speculators, farmers, oil tycoons or you name it, but never on the government itself. On the other hand, it allows bankers to endlessly lend using fractional reserve banking and to receive bailouts. By inflating, the Federal Reserve allows both parties, bankers (or should I say banksters) and politicians to achieve their main goal. However, inflation is terrible for savers who put their money into treasury bonds or CD (certificate of deposits that should be rightly called in this case "certificate of depreciation"). Many retirees have put their money in treasury bonds and the like with an artificially undervalued interest rate, not really catching up to the real inflation, particularly when you account the income tax they will have to pay on it.

For the government, deflation is terrible as revenue plunges. As for the bankers a lot of bankruptcy happens where they end up with devaluating assets in reposition. Getting a bailout for this is the best way as it limits inflation to the bankers specific needs (undo their losses), but there is a limit to how many bailouts Congress can do in a given time without a threat of being voted out by the public. Subterfuge might also be used.

For the public that did not borrow but actually saved, deflation is great as cheap houses and cheap anything is available for them. They are able to buy more and they are not taxed on the increased value of their savings. To claim that lenders loses during inflation might be true of false, it all depends on the type of lender. Is it a private corporation or individual, if so, this lender loses. Is it a bank, if so, they probably win as they have the ability to make more loans via the benefit of fractional reserve banking. With $1000 of deposit, they are allowed to make loans up to $9000 hence, making 9 times their money on interest than you or I would do. It is for this reason that a slight inflation just enough to extract wealth without triggering a complete loss of confidence in the currency is the ultimate target.

But other parties are greatly benefiting from this great federal cow such as the military contractors or any other industries linked to any new federal spending Congress comes up with every year. Essentially, the federal reserve is a tool to extract wealth from the poor and the middle class and redistribute it to industries, bankers and other agencies linked to this spending. It is a common cow that is sucked up by these groups which to me, replicates the famous "Tragegy of the commons" ( It is a large social programs for the rich and industries. For the same reason that socialism cannot work on the basis that it replicates the tragedy of the commons, the same applies to this Federal government cow which is made possible by the Federal Reserve. When the farmers saw the grassland that they were sharing starting to disappearing, their urge was not to stop. Any of the farmers would think, if I stop, the others will benefit more.

The Federal Reserve might resist continuing this printing frenzy (so called quantitative easing) when it will see high inflation, this will likely trigger a deflationary trend that will scare them all and they will revert to coming back with the same kind of program as in 2008. Only this time, the lag time for the inflationary period to come back will be much shorter, they are getting much shorter and we discuss this more with the 2nd reason below.

Note that if ever the federal reserve made the threat of not re-starting the printing press, another point to consider regarding the fact it is a political animal is that Congress and the White House could make the threat of replacing the federal reserve with its own money, a bit like the Greenback of the civil war (more on that in another post). Enjoying their bank cartel, it is unlikely the Federal Reserve will hold to such a threat if the economy is in a deflationary black hole. I'm not saying this is a certainty, just another possibility.

Artificial low interest leads to misallocation of investments
This is another part that is key to the understanding. Under a fix gold coin standard for example, the amount of money supply is fixed and its corresponding value, at any given time, is linked with the amount of available resource: human labor, material and capital (capital being tools and machinery that increases the production capacity).
I will not go in great details about the Austrian business cycle theory, but essentially, in short, the artificially low interest rate will move some of those resources in location other than what the free market would have chosen had it be free of any government intervention in the money supply (interest rate is the price on money). The farmers, the fishermen, the companies maintaining current equipment and machinery as well as building new machinery that would increase say the output have to compete for resources with the retail sector. Oil is a three letter word and is one of those resources that they have to compete with. The interplay of multiple industries is too difficult to be illustrated with a simple example that will serve the purpose of my explanation. However, to understand more about the Austrian business cycle theory, you can start with
What this means is those distorsions are getting worst and worst with the can being kicked down the road by the keynesian money printers. Such distorsions are making the booms and bust, inflationary/deflationary cycle closer to each other and I expect this to affect greatly the food supply - which already has been affected.
Although the US government conveniently does not include food and energy in the CPI index to measure inflation, I can assure you based on firm evidence that all humans do eat and require some form of energy.

The last straw...
When you add those 2 factors we described with the velocity of money, you can see the spark that triggers the hyperinflationary bomb. Velocity of money can be seen as the "hot potato" dollars, it's when people want to spend their money faster before it loses value. When there is a lost of confidence, this is too late. Since there is a lag between the time the money has been printed and its corresponding effect in rising prices, by the time the Federal Reserve decides to stop it might be already too late.
Rising oil price choke up the economy which makes it roll back into a downturn again. Since Bernanke's solution is to start printing again to reflate the economy, it takes the economy back on its track (well what appears to be so) but after some lag time, this freshly printed money will make the price rise again. Look at the price of oil in the last 10 years. After 2001, Greenspan artificially lowered the interest rate to kick up the economy and it took several years for oil to move up but see how more rapidly the price went up after the crash of 2008 compared to its rise after 2002. Granted, we have another argument of peak oil but measured in a money that has a fix supply, such as gold, oil has not moved up (and the misallocation argument is still valid).

The Federal Reserve will see a rapid inflation roaring back shortly after trying to fight another deflationary span that will come from this new rising price. In short, it will be coming even faster and once the genie is out of the bottle, it cannot be put back. By the time they decide to stop, the lag time will be their worst enemy, a bit like driving a car with a driving wheel that has a 1 second lag time.

If the Federal Reserve does not print anymore, the interest rate will jack up to much higher level, triggering this deflationary trend they are so against. Will they choose that route or not? If they don't the federal government has to openly admit default on many of its obligation along with a drastic cut in federal spending. Although this seems awful, it is indeed the better option over hyperinflation, but it requires politicians to admit and say the truth, a very extreme rarity in Washington DC.


  1. The argument is well laid out, I want to offer just one oblique comment:

    Any argument I come across, that either directly or indirectly cites Irving Fisher in anthying other than a dismissive fashion becomes less believable to me.
    (just as I would treat an article using Marx to back up an argument).

    As to Fisher himself, Mises and others have done enough of a good skewering, so that this forefather of Samuelson and Krugman (what a misbeotten line of economics those three represent!).

    Here, specifically I mean the concept of velocity, and its use to make any argument with respect to inflation.
    Velocity should be left out of the picture, because it is a Fisherine creation not worth very much.
    As you are familiar with and reference Hazlitt's "One lessen", please see his erudite dissection of "V" here:
    Simply put, in my reading, "V" is not an independent variable, so in the equation we find it, it is meaningless.

    My comment thus:
    If you find Hazlitt persuasive here (hope you do), then restating the above argument to be able to do without the velocity point at all would be a great idea.

  2. Thanks Chris for the comment.
    I wanted to bring forth the event when people will panic out of the dollar. I will review Hazlitt's work to see how I can rephrase this (in a future post) while retaining the essence of the idea I wanted to convey.