Deflation or inflation – the clues are in human history

Alasdair Macleod – 9 October 2009
There is much debate about deflation and inflation, particularly about the outlook. Are we headed for deflation or inflation?

First, one must discuss definitions. Today, inflation is taken to refer to a price index representing goods and services commonly bought by households. It was not always so. Before the Great Depression inflation was taken to refer to an increase in the quantity of money in circulation, which is an entirely different thing.

As Milton Freidman said, “inflation is everywhere a monetary phenomenon”. The reason that a rise in a retail or consumer price index is not necessarily inflation is that changes in general price levels reflect changes in overall supply and demand, as well as changes in the quantity of money in circulation. The two things are not the same. Confusion over this point leads people to associate inflation with increasing economic activity, and deflation with recessions. It is true that prices will tend to rise on rising demand, and fall on falling demand, but this is not inflation in the monetary sense.

This is a very important point, because central banks, who purport to know what they are doing with money, do not make this distinction. The resulting policy errors often result in them getting hold of the wrong end of the stick. Referring to the general price level is rather like driving along the motorway with your eyes glued on the rear-view mirror. The information is no longer relevant. Worse, it assumes that inflation only occurs when there is demand in the economy. When that demand disappears, interest rates are cut, and if that doesn’t work, money is printed.

That is where we are today. But any historian will tell you that severe inflation occurs in times of economic difficulty. It occurs when an economy stagnates, hence stagflation. It occurs when governments suppress economic activity through incompetence or excessive taxation. Suppressed activity reduces government income, and the path of least resistance is to print some more money. “Inflation is everywhere a monetary phenomenon”.

The dwindling band of deflationists should take note. If the economy lurches downwards again, there will be a collapse in overall demand. This will depress prices, as goods will be sold for what they will fetch. That is the price component due to overall changes in the level of demand, and has nothing to do with the monetary definition of inflation. The response from central banks will be to print more money. Helicopter Ben Bernanke has told us so, and with the collapse in true savings, due to zero interest rates, this printing will continue to finance government deficits.

There is a lesson in this from Roman times. From about 220-280 A.D., various emperors debased the coinage from silver, to part-silver, to very little silver. Eventually, the emperor Diocletian inherited a coinage that was tin-plated copper. It was rather like how the gold standard operated in the last century up to the late 1960s: the stock of gold covered more and more paper and credit. Diocletian then made the mistake of showing the currency to be entirely fiat, by removing any pretence at silver. He issued copper coins without even the fig-leaf of tin plate. The result, when he minted mountains of the stuff to finance both an expanding army and the building of his new capital city at Nicodemia, was roaring inflation. The central banks today are now entering Diocletian’s world.

At least human nature doesn’t change, even if the value of money does. But is there an alternative, whereby the US Government can borrow rather than print? Consider these facts. Foreigners own $3.4 trillion of Federal debt, and they are sellers rather than further buyers. The American public owns $4.1 trillion and the government itself through various US Government accounts owns $4.4 trillion. The budget deficit for the fiscal year just ended is $1.4 trillion, and on optimistic forecasts the deficit will be over $1 trillion every year for the foreseeable future. The amount of debt to be absorbed by the public is already appearing to be very large relative to public holdings. But this is only the on-balance sheet funding. There are also 75m baby-boomers hitting retirement starting now, and this contributes to off-balance sheet costs for welfare, pensions, healthcare etc. estimated at over $100 trillion.

So we are asked to believe that the US public, who over many years have managed to accumulate only $4.1 trillion of government Treasuries, will increase their savings to fund these escalating numbers and absorb any sales from disillusioned foreigners. If they were to expand their savings at anything like what is required it will so disrupt the balance between savings and consumption that the budget deficits would increase even further. And that is without even thinking about the affect on interest rates, or the compounding interest costs.

These forecasts assume economic recovery. They do not include the possibility of a renewed economic downturn; a possibility which is gaining momentum as the inventory-led bounce peters out. The Federal government is simply unable borrow enough to fund its obligations assuming all goes well, let alone if they don’t, so they will have to print money. Like Argentina, like Zimbabwe. In real terms it may be deflation and in dollar terms massive inflation, so a hyperinflationary depression is now emerging as a likely outcome.

In this case, arguing deflationists and inflationists will both be able to claim an intellectual, but pyrrhic, victory.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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