Wednesday, June 10, 2009

The Inflation Riddle

The single most important discussion in economics at the moment is whether or not there will be inflation in the U.S., and if so, when that will happen. The Bush and Obama administrations along with the Fed and the Treasury have made their positions crystal clear: they believe that inflation is a near impossibility in this economic environment.

The government, the Fed and the Treasury have for months now been trying to tell the world that things are getting better and that the measures they have taken to ease the crisis are working. Geithner even went to China and gave speeches telling everyone how much confidence the Chinese still had in the U.S. economy, even as the Chinese sold long-term U.S. Treasuries and bought short-term U.S. Treasuries instead (which is a clear sign of a loss of confidence).

Governments around the world are currently engaging in what they call “quantitative easing”, otherwise known as money printing. The most famous example of this is probably Germany after World War I. Germany had a huge war debt to pay, and that debt was strangling the German economy. The Germans decided to simply print more money and be done with it. After that policy was implemented, people started using money to light fires in their furnaces because it was worth so little.

Nowadays, even the Bank of Switzerland is printing money. The U.S. government is the worst offender, and is currently flooding the U.S. economy with money. In a matter of months, the Fed has suddenly expanded its balance sheet 40 times, after having stuck to a policy of stability for six decades. This is truly revolutionary and truly disturbing.

Take a look at the recent expansion in the Fed's monetary base:

Why are governments doing this? It has to do with the theoretical approach to the creation of inflation.

For people who are unfamiliar with a range of theories in economics, such as the entire economic team of the Bush and Obama administrations, there is a dogma concerning inflation:

Inflation can only be created by a wage and price spiral

This is what the government believes, or at least is strongly hoping for. In other words, for inflation to start growing, people would have to start demanding higher salaries (which is not exactly easy in a country essentially without unions or labor laws) and people would have to start consuming goods and services to a much higher degree. So, all of a sudden, we would have higher salaries, more consumption and the good times would again start to roll. The government sees this as an unlikely scenario. On that point, I absolutely agree.

So, if you believe that the preceding scenario is the only scenario under which inflation can be created, printing money might make sense for a while. However, I, and many others, do not believe that this is the only scenario under which inflation can occur.

You can look at the problem of what inflation actually is in 2 ways:

1. inflation is ONLY a wage and price spiral where too much money is chasing too few goods and services, OR

2. inflation is an excess of money in the economy

In order to find out which of these two statements is true, a simple theoretical model can be constructed. If statement 1 were true, there would be no examples in history where inflation was created without a wage and price spiral. Is that so? The answer is unequivocally: NO.

Inflation has been created without a wage and price spiral countless times in economies around the world. Some examples are: Argentina at the end of the 90:s, Zimbabwe currently, Germany in the 1920:s and 1930:s, and so on and so on.

However, what these countries do have in common during the abovementioned crises is money printing. For different reasons, these countries have been printing money in order to get out of a crisis, and that has created massive inflation. This is exactly what the U.S. is doing today, so why should the U.S. be different?

The statement that inflation can only be created by a wage and price spiral is most certainly untrue. It has no basis in empirical evidence, and in fact, much evidence to the contrary exists.

I believe that inflation is simply an excess of money in the economy. Is an excess of money being created by the Fed right now? You would have to be some sort of lunatic to answer "no" to that question.

People tend to focus too much on microeconomics when thinking about inflation, which is what makes them believe in the wage and price spiral theory. They believe that consumers tend to steer the economy with their spending. This does not have to be true in many cases, though.

If a central bank such as the Fed starts printing money and flooding the economy with it, that money is going to go somewhere. It does not have to go to consumption of goods and services, it can go to the financial markets and spur speculation.

That this happened in the last few months would be a good bet, because the recent attempts to save the economy has mainly been a huge bailout of financial companies, transferring massive amounts of wealth over to them.

If all this money had been transferred to American citizens in the form of living allowances or something like that, we might have had some sort of price spiral, but that didn’t happen. When Wall Street got all the bailout money, it started to push up prices of stocks again in the early spring, and a massive stock rally occurred.

So, I believe that the rise of the stock market has to do with an inflation of prices brought on by the financial bailout. This will most likely put additional upwards pressure on inflation. This is a kind of price spiral too, and this taken together with the excess of money in the economy makes inflation even more likely.

To sum up: the U.S. will experience massive inflation soon as a result of the money printing activities and the recent stock rally is an illusion brought on by the financial bailout.

Moreover, I advise that the winner-takes-all voting system should be destroyed.


Anonymous said...

So, let me ask you a question in regards to this inflation;

Peter Schiff is advising people not to pay back their student loans because, according to him, inflation will "eliminate" the loans.

Can you explain that to me and tell me if you agree with him and could this analysis apply to other debts like credit card debt, mortgages, etc, etc.

Jacob said...

If inflation rises, the value of money will go down. If the value of money goes down, the value of debt goes down. However, for someone who has student loans, his or her income would also have to rise according to the pace of inflation for the student loans to become cheaper for the individual.

They will not be "eliminated", but if inflation goes up, and wages go up along with inflation, it will be much easier to pay back loans.

The problem here is that wages don't usually follow inflation in the U.S. because the U.S. has no collective bargaining and no labor legislation. In the EU, wages are often indexed to inflation, meaning that if inflation goes up, so do wages. In the U.S., there has been a stagnation of wages for 30 years, and that's during good times. In bad times, wages are obviously extremely unlikely to go up.

So, in sum, Schiff's proposal has merit, but it will most likely not apply to the U.S., even in the long term, unless collective bargaining is introduced.

Anonymous said...

So, if wages don't go up with inflation, then people's loans will almost become impossible to pay off.

then what?

Jacob said...

Then bad things will happen to anyone in society who is not rich. Such is the situation in a country that does not have a social safety net.

Garth said...

I'm in no way an expert, but I find this argument less compelling than that made by people like MIsh and Steve Keen that looking at base money supply only is short sighted, since monetary creation via lending and leverage create far more of the money in any economy than the actions of the fed. (I believe Steve Keen claims it's something like an order of 36 to 1.)

My second question is whether you can explain how the US will be able to generate hyperinflation (or even inflation) without destroying the international bond market.


Jacob said...


the point you bring up is certainly relevant. What you're talking about is known as credit expansion, and is the answer to the question of how there can be more outstanding loans in the world than there is money.

I see things a little differently, though. Comparing the monetary base to the issue of lending in general does not make sense as far as I'm concerned. Lending enables people and companies to do things they otherwise would not have been able to do, and in some sense that does create more money. But at the end of the day, that money is still tied to something more or less tangible.

When you're talking about high leverage ratios and large-scale speculation, I believe that such things are always bad for the economy as a whole. The contribution to an inflationary spiral is one of the problems associated with these things, but more importantly, it can put entire countries at risk, as it has in Iceland and Latvia.

With respect to the bond market, I believe we are already seeing clear signs of trouble. Rates all over the world are rising, as governments are having to pay higher interest rates for their loans. So yes, U.S. behavior is slowly deteriorating the bond market. What this will mean is much, much higher interest rates across the board within a year (is my guess). I would not be surprised if U.S. mortgage rates were above 10% early next year.

Garth said...

I agree that the monetary base does not relate to the creation of money in the conventionally believed manner. I believe that in times of optimism financial institutions find ways to massively overleverage, to the extent that their debts far exceed what CBs should allow. (Of course, it would be politically unpalatable, or very difficult, for the CBs to stop them.) Here's a good summary of this argument, with excellent data:

So I suppose that's the biggest difference in our views - you believe that most debt is, at the end of the day, tied to something of actual worth. I believe that most debt is not tied to anything of worth, or is for an amount far in excess of the true value of the collateral. The current housing market, with some homes effectively worthless and many others worth far less than the mortgages on them, is a good example of this.

Garth said...

I don't know why the link didn't copy. I was trying to link to 'The Roving Cavaliers of Credit' by Steve Keen. Sorry.

Jacob said...

Don't get me wrong, I agree with you that many values are grossly inflated beyond any reasonable level.

My solution, however, lies in harnessing the good aspects of debt, while creating stability through law. Take the housing market as an example (article coming on this topic):

Arguably the most stable housing market in the world is Germany's. Why? Because of the system with covered bonds. What that means is that all the banks are collectively responsible for mortgage defaults, much in the same way as the FDIC works. Housing values in Germany pretty much follow inflation in a very stable way, which is in my view ideal.

Furthermore, there's a time and place for everything. A stable market is needed for housing, and if you want to speculate, the liability should be unlimited, instead of limited. If you bring your company to the brink, you should lose your shirt.

Garth said...

I absolutely agree with your take on housing. But obviously that's not how things have been done, and I think that an unprecedented debt to GDP ratio in the US, falling housing prices, rising unemployment and extremely low money velocity collectively mean that a Great Depression level or worse deflation is very likely. The best case scenario I see is Japanese style stagnation. I don't think there's any way for the Fed to counter the huge destruction of wealth that is taking place.

How many trillions has the Fed increased the monetary base by? How much of that is actually making it into the economy? How does this compare to the trillions that have been destroyed in equity and housing markets and to the leverage still in the system?

Another good link:

I think deflation will continue until debts are paid or defaulted down to sustainable levels. Then it will be time to watch out for hyperinflation.

Jacob said...

yes, by looking at the numbers, I believe that deflation is about one third of the way through. When the current government policy fails, the other two thirds of the deflation that is inevitably coming will hit. After that it's obviously inflation time

Anonymous said...

How do you expect people to pay down their debts if they are losing their jobs or working, but making less?

I think they're going to have to change the bankruptcy and make it more flexible for consumers to simply drastically reduce their credit card debt AND student loan debt or people are just going to eventually stop paying.

There's not enough focus on consumer debt.