One of them will. That’s if things work out really well. Two or three will if things go according to the Austrian theory of the business cycle.
Americans have been living in the eye of the monetary hurricane. Prices have been stable. In July, both the Consumer Price Index and the Median CPI were flat compared to June.
There are five flations to consider.
DeflationInflationStagflationMass inflationHyperinflation
We had better consider all of them.
FLATION: MONETARY OR PRICE?
We should always keep in mind the fact that there are two ways to define flation: (1) as a change in the money supply; (2) as a change in the price level.
This assumes two more things: (1) we can accurately define money; (2) we can accurately identify the price level. Both are questionable.
The Federal Reserve three years ago dropped M3. It said that M3 was useless as an indicator of future prices. That was a long time coming. The FED was correct. M3 was the most misleading of these M’s: M1, M2, M3, MZM. It always vastly overstated the looming rise in the CPI. There is no doubt which M is best in this regard: M1. For my detailed Remnant Review article on this, go here.
Furthermore, there is more to an M than predicting future consumer prices. There is also the question of predicting the business cycle. There is no agreement here among economists.
Then there is the price level. Which basket of goods and services should statisticians use? What relevance should a statistician place on any of a hundred commodities and services? This weighing will change when consumer tastes change. No index survives intact over time. They all are revised when there are major changes, from the CPI to the Dow Jones averages.
I look for trends. I use M1 and the Median CPI.
The crucial fact is monetary policy. According to the Austrian theory of the business cycle, the cycle is completely the outcome of prior central bank monetary policy. Booms and busts are the result of central bank monetary inflation, followed by reduced expansion. The other schools of thought reject this theory. The other schools of thought are wrong. For an introduction to this issue, see Chapter 5 of my mini-book, Mises on Money.
DEFLATION
Most of those who forecast deflation have in mind price deflation. A few think monetary deflation will take place because of bankrupt banks, but the position is difficult to defend. The FDIC can keep bank doors open. There are no runs on banks involving currency withdrawal. There are only runs involving the transfer of digital money to other banks. This does not affect the money supply.
Price deflation can come through the free market. It results from steady increases in economic output in an economy with stable money. Here is my slogan: “More goods chasing the same amount of money.” A gold coin standard economy provides such a world, as long as central banks do not protect insolvent banks. So does 100% reserve banking, which we have never had. This is not the scenario offered by deflationists.
Here is their scenario. Banks create credit. Fiat money lowers interest rates. People borrow. This is consistent with Austrian economics. This credit structure cannot be sustained indefinitely. Austrianism also teaches this.
Here is where the schools of opinion depart. The deflationist says that people in general cannot pay their debts. They default. So, prices fall. Not just prices of market sectors that were bubbles, but all prices.
There is a problem with this argument. If you find that half of the things you regularly buy cost less, you buy the same amount, or maybe a little more, and then buy more of something else. This includes the purchase of capital goods.
You don’t put currency in a mattress. You buy something with the money that falling prices allows you to keep. You buy more of B when the price of A falls . . . or more of A.
Simple, isn’t it? But those who call themselves deflationists do not understand it or believe it.
The same money supply is out there. Someone owns each portion of it. You own some. I own some. We both would like to own more . . . at some price. But the credit contraction of a popped market bubble does not affect the money supply if the central bank or the Treasury or the FDIC intervenes and prevents a fractional reserve bank from going bust and taking all of the digital money with it.
This is economic logic. If the logic is incorrect, then there should be detailed theoretical criticisms of it. Or, given the weaknesses of human thought, maybe logic does not correspond to reality. Economists are famous for constructing detailed theories that do not conform to reality. But the free market theory of price changes as the result of the supply and demand for money in relation to the supply and demand for products and services is straightforward. It undergirds all of economic theory. Throw it out, and what remains of economic theory?
If a central bank creates a boom with fiat money, and then ceases to inflate, it can create deflation. How? By refusing to bail out busted banks. It allows the money supply to contract as bankrupt commercial bank deposits disappear. Fractional reserve banking implodes. That will create a deflationary depression. We have not seen anything like this since 1934: the creation of the FDIC.
Don’t bank on this just yet.
INFLATION
Monetary inflation produces price inflation. On this, Chicago School monetarists and Austrian school economists agree.
If the central bank expands the money supply, prices will rise. This takes time. Economists debate about the lag time: 6 months, a year, 18 months. But monetary expansion will raise prices. The new money has to go somewhere. It has to wind up in someone’s bank account.
If the central bank expands the monetary base by buying assets of any kind, it creates money to buy them. The recipients of those assets spend the money. If the Treasury gets it, Congress spends it. (In both theory and practice, if Congress gets its collective hands on money, it spends it. All economists are agreed on this point.)
The expansion of money by the central bank is the source of economic booms and specific asset bubbles. The expansion of money temporarily lowers the interest rate. Someone borrows this newly created money.
America suffered from monetary inflation from 1914 to 1930. Then, with a 3-year hiatus of collapsing banks, we have suffered from 1934 until today. The dollar has fallen by 95% since 1914. No, I don’t believe the CPI tells us this exactly. But I can follow the trend. The trend is up for prices and down for purchasing power.
For as long as the Federal Reserve creates money, we will have price inflation. The only thing that can retard this is if the FED raises reserve requirements or commercial banks send excess reserves to the FED. The monetary effects are the same: increased reserves are the result. This reduces the multiplier of fractional reserve banking.
Price inflation of under 10% per annum is what I call inflation. But before we get to this, we will suffer from stagflation.
STAGFLATION
This was the burden of the 1970’s. There was monetary expansion and massive Federal deficits. Why, the Federal deficit was a staggering $25 billion in 1970, and as bad the next year. Unthinkable!
The dominant Keynesian theory was that Federal deficits would overcome recessions. The central bank need only inflate enough to cover part of the Federal deficit. But there were two major recessions in the 1970’s. Unemployment rose, and prices rose. That combination of events was dubbed stagflation.
That we can have economic stagnation in today’s world is obvious. Just about every mainstream economist and forecaster is predicting slow economic growth next year. The familiar V-shaped recovery is not a popular forecast these days. More typical is the forecast of Muhammed El-Erian, the CEO of PIMCO, the largest bond fund in the world. He calls this “the new normal.”
Global growth will be subdued for a while and unemployment high; a heavy hand of government will be evident in several sectors; the core of the global system will be less cohesive and, with the magnet of the Anglo-Saxon model in retreat, finance will no longer be accorded a preeminent role in post-industrial economies. Moreover, the balance of risk will tilt over time toward higher sovereign risk, growing inflationary expectations and stagflation.
This scenario is a combination of slow growth and rising prices. Today, we have no growth and flat prices. So, slow growth and rising prices is not much of a stretch conceptually.
I think stagflation is likely, once the recovery comes. But we are seeing a gigantic Federal deficit. Ross Perot in 1992 spoke of a giant sucking sound. He said that was the sound of jobs lost to Mexico. I think it is the sound of the Federal government sucking up all excess capital in the United States and much of the world. This money will not be going into the private sector.
What is the basis of a sustained economic recovery? Increased capital formation. We are seeing capital destruction.
For a time, we will suffer from stagflation. It will not be stag-deflation. It will be stag-inflation.
What do I envision? Economic growth under 2% per annum, coupled with price increases of 5% per annum or more.
MASS INFLATION
This phenomenon will appear when the Federal deficit cannot be covered by private investment and purchases by foreign central banks. This seems certain within a decade. I think it is likely before the end of the next President’s term. I think the Social Security trust fund will cease to provide a surplus that is used to purchase nonmarketable Treasury debt, as it is today. The trustees will have to sell some of these nonmarketable Treasury debt certificates back to the Treasury. The Treasury in turn will have to sell conventional Treasury debt to cover the redemptions by the trust fund.
This stage will be the indicator that the present borrow-and-spend model has failed. The FED will be called upon to supply the difference between purchases of T-debt by the public and borrowing by the government. When the FED complies, the rate of monetary inflation will rise. Prices will also rise.
I define mass inflation as double-digit price inflation above 20% but below 40%. Americans have not seen this. No industrial nation has seen this except after a major military defeat.
The disruption of the capital markets will be extreme. The government will absorb virtually all capital formation. There will be no net capital formation. There will be capital consumption.
The international value of the dollar will fall. But other Western nations will be pursuing comparable policies. It is not clear how far the dollar will fall. It depends on the competitive race to national self-destruction. Every Western nation faces the day of reckoning: the bankruptcy of Social Security/Medicare.
At this point, the FED will have to make a choice: put on the brakes or destroy the dollar.
HYPERINFLATION
The worst-case scenario is hyperinflation. Ludwig von Mises called this the crack-up boom. It leads to the destruction of the currency. The economy will move to barter or to alternative currencies. The division of labor will collapse.
No modern industrial economy has suffered this since the recovery after World War II. The West is not Zimbabwe. The West is not a backward agricultural nation that still has functional tribal organizations to help their members.
Think about the implications of your money not buying anything of value. How would you live? You are urban. You are dependent on a complex system of computerized production and distribution. It is all governed by profit and loss. The profit-and-loss system will cease to function at some point. That is when the economy shifts to a new monetary system.
This would be the destruction of wealth on the scale of a war. It would create a new social order.
I do not think the Federal Reserve will allow this. This would destroy the banking system. The FED’s unofficial but primary job is to preserve the biggest banks in the banking system. If it’s a question of providing fiat money for the government’s debt vs. destroying the dollar, the FED will cease buying Treasury debt.
That will be the turning point.
DEFLATION
Then we will get the crash. The FED will protect the biggest banks, which will swallow the assets of smaller banks. A lot of smaller banks will go under. They will take deposits with them.
We will get bank runs. People will demand currency. The FDIC will be busted. These banks will go under. So will depositors’ money. It will be “It’s a Wonderful Life” without the 6 o’clock escape hatch in the script.
You had better have your money in Potter’s Bank, not the Bedford Falls Building & Loan.
The contraction of digital money will be matched by a truly serious recession. Bankruptcies will be widespread. Unemployment may not rise, but only because the final phase of mass inflation had created so much unemployment.
This will be a period of restoration. The cost of the restoration will depend on how bad the dislocations of the mass inflation had been. If they are very serious, which I would expect, the time of recession will be tolerable if you have currency and a job. But the investment strategies of hedging against mass inflation will produce losses. An opposite set of strategies will appear. Be a debtor in mass inflation. Be a creditor in the post-inflation recovery.
If the Federal Reserve intervenes again, repeat the cycle from the top. But the numbers will be much larger.
CONCLUSION
Pick your flation. You can try to beat it, but each successive flation threatens your capital.
We are entering a period of capital consumption in the United States. I think this problem will afflict the West. The same political promises have been made. They will be broken.
He who sustains his lifestyle through these flations will be blessed indeed. Getting rich will be miraculous.
September 5, 2009
From LRC, here.
