Inflation vs. deflation: a chaotic relationship

Economists, financial speculators and bloggers across the web are engaged in a grand debate about whether the future of the US holds massive inflation or deflation. There are good arguments for both sides. Deflationists like Robert Prechter remind us that the money supply is more than just the monetary base which Bernanke controls directly. Much more. That’s because we have a funny money supply that allows (nay, encourages) fractional reserve banking. Fractional reserve banking is a scam whereby banks and other special people (i.e. not you and me) can loan out more money than they actually have in their possession. Much more. As in at least 10x more. In fact, they loan out as much as they possibly can because they get to collect interest on that vaporous money they lent. In other words, they get something for nothing. Where does the extra money come from that they loan out? From thin air. In other words, banks and special financial institutions have virtual, temporary printing presses that work exactly like Ben Bernanke’s printing press with one major difference: When Bernanke prints more money it’s (generally) forever money. Conversely, when financial institutions conjure up credit from thin air, it’s supposed to be temporary money which is automatically destroyed when the loans are repaid or defaulted on.

Because of this, the money supply actually consists of a combination of what Bernanke has printed up (again, it’s called the Monetary Base) and the amount of debt outstanding. Over the past 30 years, the monetary base has increased, especially in the past 3 years, so that it now stands at about 2.5 trillion dollars. Since our national debt –all of it money that has been spent into the economy- is 14 trillion it’s pretty clear that the monetary base is not the entire money supply. In fact, it’s not even the big part of the money supply. So herein lies the argument for deflation. People in the US and abroad have created massive dollar denominated debt. This has increased the dollar based money supply which has resulted in its dilution relative to the stuff available for sale. Diluted money does not buy as much stuff as undiluted money and so the result is higher prices. The deflationists argue that we have had higher prices for 30 years not because of Bernanke printing money but mainly because of exponentially rising debt in all sectors (government, housing, business, etc.). Folks like Prechter argue that people are now realizing all this debt is a bad thing and they are either paying it off or walking away from it. These acts make that debt based money evaporate back into thin air from whence it came. The result is a reduced overall money supply even with Bernanke printing his a$$ off. Prechter claims that Bernanke and his printing press is fighting a losing battle against credit deflation because the debt portion of the money supply is far larger than the monetary base – $50 trillion of overall debt to $2.5 trillion of monetary base.  If Bernanke tried to print, for example, 10 trillion dollars from thin air in order to offset $10 trillion of debt reduction, interest rates would rise causing the housing market to crash.  This would cause more defaults on the single largest asset class - real estate - thus causing enough deflation to more than offset any money printing Bernanke can possibly do.  Thus, the argument that Bernanke can print unlimited amounts of money is flawed.

Inflationists tend to ignore the fact that our money supply is mainly made up of debt. They focus strictly on Bernanke and his printing presses. This includes people like Peter Schiff and Ron Paul. They tend to ignore the fact that Japan has been printing like crazy for the past 20 years and now has a debt to GDP ratio of more than 200% yet it still has a deflationary environment. Each side of the argument believes that they are dead right because, they claim, the math supports them. Conversely, I see plenty of room for shades of grey.

How can I ignore their math? Actually, I don’t. I simply add factors that they are ignoring. Given that we have a money supply consisting of monetary base + debt, the deflationists win the math argument hands down. As soon as people stop borrowing money and start saving more and start walking away from debt, the resulting deleveraging MUST show up as a deflationary force. That’s the math of it, period. And there can be no argument that the leverage in play right now is very high. When Bear Stearns went under the forensic accounting discovered that they were leveraged 32:1. In other words, all it had to do was to lose about 3% of the overall value of it's assets before it would be rendered insolvent. As another example, the Fannie and Freddie debt that the government took over is leveraged at least 50:1 and some say even 70:1. That leaves a lot of room for deflation when those houses are walked away from and then have to be marked way down to current market prices. If only that were the extent of it! Unfortunately, the entire economy is infested with leverage and thus the potential for deflation is everywhere. Look at all the states which have underfunded their public pensions. Those are basically debts that will be defaulted on. People who thought they were going to get a full pension spent more money yesterday because they thought their futures were assured by the pension. Now that they are waking up to the fact that these were “fairy tale promises”, they must stop spending so much today in order to make up for the new found shortfall that will hit in their retirements.

So all of the above would seem to make me a staunch deflationist and I would be except for one teeny weenie little problem: our money has an intrinsic worth of zero. It is backed by nothing at all. If people decide not to accept it in exchange for their goods and services then there is nothing you can do about it. You might as well wonder why people in China do not accept dollars for purchases in their markets. The dollar has no value over there. They do not recognize it as having any local purchasing power (zero) in exactly the same way as nobody here in the states will accept Chinese Yuan for groceries or a big screen TV from the big box electronics store. Now, if Chinese Yuan were backed by a fixed amount of gold and if there were a way for people to exchange the paper notes for metal bars upon demand then I assert that only a fool would not accept them in trade. But, by definition, nobody backs their fiat currency with gold or anything else and so the global money supply has an intrinsic value of zero. It is only worth what people think it is worth. The perception of the value of fiat currency is not generally a binary thing. In other words, people don’t view it either as having value or not. They assess some level of variable value to it in order to come up with the price for milk, eggs, cars, houses, gasoline, etc. So it is entirely possible that, despite a massive reduction in the overall money supply due to credit deflation and deleveraging that prices for things stay steady or even rise simply because people assign a lesser value to the money supply that remains.  While this does not change the deflationary argument from the standpoint of economists who just look at the number of dollars relative to the goods for sale to figure out if something is inflationary or deflationary, common people think of inflation and deflation as rising or falling prices respectively.  In the scenario I just mentioned we could see deflation in the money supply while still seeing rising prices including those of gold and silver.

In short, the inflation/deflation argument (at least from the standpoint of asset prices) is more likely to be decided by the mood of the people and more specifically the confidence that the people have (or fail to have) in our government than by any form of math done on the money supply itself. For example, if government does things that reduce the ability of people to trust it then the money is likely to lose buying power despite any deflationary forces that exist. In other words, the future of the purchasing power of the money supply is at the mercy of the mood of the herd which is a chaotic function at best. This is just something to keep in mind the next time you hear someone violently argue either for inflation or for deflation: they don’t really know and none of their math really means very much (assuming inflation is defined as rising prices and deflation is defined as falling prices). Enlightened observers will keep a close eye on the mood of the herd for clues about the future buying power of our currency.