Deflation or inflation? The debate that shapes monetary policy

Alasdair Macleod – 25 August 2010

Now that there is considerable concern in most commentators’ and economists’ minds over the economic outlook, they are forming into two uneven camps: those more afraid of deflation than inflation, and vice-versa. The deflationists are in the overwhelming majority, and include nearly all Keynesians and monetarists – the establishment. Those afraid of inflation are a rag-bag of refuseniks, including Austrian economic theorists. Readers will not be surprised that I see uncontrollable inflation as the likely outcome of current economic policies, given my derision for the theories of Keynes and Friedman.

The purpose of this article is to show where the establishment is wrong about deflation and to identify the inflation risks. For the purpose of this analysis, we will assume the global economic outlook deteriorates further in the coming months, and fears of deflation drive the central banks’ monetary response. This is a recipe for stagflation.[i]

Most economists make the mistake of conflating the two separate issues of inflation and deflation into a single outcome. The deflation they fear is the Irving Fisher debt-deflation spiral, defined as an imploding cycle of falling asset prices driving loan foreclosures. Since such a collapse has the knock-on effect of increasing bankruptcy and unemployment, consumption will suffer and drive down demand for goods, leading to a fall in price levels for most of the goods in the consumer price indices. Ergo, a collapse in bank lending is deflationary.

It is hard not to be seduced by this argument, but like many economic generalisations it is too simplistic, placing too much emphasis on the likely extent of the deflation.

There is no doubt that a fall in the general level of consumer demand has a negative effect on general price levels, but this effect is uneven. Goods and services in over-supply will obviously be hardest hit. For the consumer, these are generally capital goods rather than consumables. Services that are unnecessary for everyday life are also vulnerable. The reason these categories are in over-supply is that the markets for them have been fuelled by credit, either from finance companies or from home-equity withdrawal. Until recently the credit bubble was expanding, leading to an over-allocation of economic resources to these sectors. However, finance for consumers has now been contracting for about two years, so these goods and services are now suffering chronic over-capacity. It is this over-capacity which is now causing problems, and while there is bound to be some overspill effects into the general economy the more basic consumer sectors are fundamentally in better supply/demand balance.

This is because Man has got to eat. Even the bankrupt and unemployed still require food, heat, transport and other basics, so aggregate demand for these items will not fall by much. Indeed, agricultural commodity prices are now rising for very good reasons, even though the global economic outlook is deteriorating rapidly. Economists play down this dichotomy, by pointing out that food is a small component of the consumer price indices, but they make the mistake of being slaves to this inadequate measure of inflation.

So whether prices rise and fall will to a large degree depend on a product or service’s necessity. But all this assumes the yardstick for measuring prices (paper money) is itself constant. We all assume it is, but in practice it is not: we think in hard currency terms, but deal in fiat money. And the one certain bet we can make on future central bank action is the continual use of the printing press. So, the purchasing power of our paper money is set to fall at a pace likely to at least offset the fall in prices for many goods not in chronic oversupply. Indeed, this is a fundamental purpose of central bank policy.

Deflation is therefore far from certain as Keynesians and monetarists might have you believe. Furthermore, central banks are likely to offset contracting bank credit with aggressive production of narrow money. If the rate of bank credit contraction speeds up – as seems possible – so will the production of paper money. This money will be issued through three broad mechanisms:

  • There will be further “quantitative easing” through the purchase of government debt by central banks. The distribution of the resulting fiat money into the economy will be through government spending. As a result of economic deterioration budget deficits will expand rapidly, as tax receipts collapse and welfare spending increases; so QE will become an increasingly important source of funding for government spending as deficits balloon.
  • By utilising currency swaps, central banks will have the facility to help fund each others government spending. Central bank co-operation will have funding government deficits at its centre.
  • Central banks will inject money into the financial system to prevent systemic failure and underwrite asset values.

These are the practical and impelling reasons for escalating money production. The theoretical reasons can be summed up as targeting price stability. In this deteriorating economic environment it means supporting prices for assets generally (pace Irving Fisher), while governments intervene to subsidise demand for goods and services in chronic oversupply. To achieve financial stability requires no less than central banks underwriting asset values, which can be done in two ways: by buying private sector debt and tolerating default, and by buying assets such as listed stocks and bonds to maintain their values. This is indeed a summation of the Federal Reserve Board’s strategy since the credit crunch, and the Federal government’s cash-for-clunkers scheme typifies intervention by subsidy.

So the reasons for a global escalation of monetary inflation are compelling for both practical and theoretical reasons. Even the cost of government’s intervention by subsidy is funded by the printing press. The authorities have honed their interventions over the last eighteen months, so believe they know what to do. And since financial markets around the world are interdependent, no central banker dares not to join in.

How inflation will be transmitted to prices

We can therefore assume that there will be a rapid expansion of money in circulation in the major currencies. Other currency-issuing central banks will have to join in through currency intervention and by expanding their money supply, or risk a rapid rise in currency exchange rates. There is therefore likely to be an attempt by all central banks to keep currency exchange rates reasonably stable. The effect is that every paper currency will suffer escalating monetary inflation.

So the question arises, if quantities of all fiat currencies are being expanded at the same time, how will this be reflected in price inflation, given that monetary inflation will not be transmitted to prices through relative currency devaluations?

The first step on the path of price inflation is through costs faced by producers of basic goods. Bearing in mind that the risk of severe deflation is generally restricted to sectors in chronic oversupply, basic goods are unlikely to see their costs of production fall. These costs are labour and raw materials; labour costs are maintained by inflexible labour markets, but raw material prices are free to rise. And it would be a mistake to expect substantial falls in key commodities, because there is not the build-up of speculative long positions that fed the collapse in base metal and energy prices in 2008.

Raw material prices are already developing inflationary characteristics. Agricultural commodity prices are rising sharply, partly because they have been low for a long time, and partly because the world’s population has fundamentally changed. Not only have the numbers increased to nearly seven billion, but nearly two billion of them living in emerging nations have seen or expect to see a substantial improvement in their standard of living, while fewer are employed on the land. And while emerging nations have access to metals and energy to varying degrees, they anticipate future shortages so have strong incentives to stockpile.

In the context of renewed weakness in the consumer economies these nations have a simple choice: either hold on to dollars et al and hope that lower commodity prices will offer more favourable stockpiling opportunities, or take the view that dollars et al should be dumped in return for strategic commodities while paper money still has any value. Whatever the rhetoric, an acceleration of monetary inflation in the major currencies is bound to encourage the latter view.

If history is any guide, rising price inflation will generate labour unrest, notwithstanding high levels of unemployment. Those actually in employment no longer have the desire or ability to borrow to make ends meet, so will press for higher wages. This leads us onto the well-trodden path of stagflation.

How long it will take for stagflation to morph into hyperinflation is anyone’s guess. The last time we had stagflation was just over thirty years ago, but it was halted before it went out of control. It took dollar interest rates of over 15% to achieve this, a policy option which would be far more difficult today. The levels of private sector and government debt now are of a greater magnitude compared with thirty years ago, and to deliberately bankrupt whole economies by raising interest rates sharply is inconceivable.

But we should take one step at a time. A deteriorating economy is bound to provoke an acceleration of monetary inflation. The deflationary effect on prices is broadly limited to assets, capital goods and consumer sectors suffering chronic oversupply. But for all other goods price inflation – stagflation – is already in the pipeline with lots more to come.


[i] The first reference to this portmanteau word, according to the Oxford English Dictionary gives its true definition: “1965 I. MACLEOD Hansard Commons 17 Nov. 1165/1 We now have the worst of both worlds – not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of ‘stagflation’ situation.”

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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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