Below is an extract from a commentary originally posted at www.speculative-investor.com on 27th April, 2008.

Credit Contraction and Deflation

Members of the deflation camp assert that the large-scale contraction of credit happening within the banking system means that deflation is upon us, even if the money supply is expanding. At the same time, another camp is pointing to the breathtakingly rapid growth in M3 money supply as evidence that hyperinflation is a near-term threat. In our opinion, both camps are wrong*.

The argument of the first camp can, we think, be summarised as follows: Inflation is an expansion in the total supply of money AND credit, whereas deflation is the opposite (a contraction in the total supply of money AND credit). At the present time the money supply may well be expanding, but this monetary expansion is being more than offset by credit contraction.

The flaw in the above argument can best be explained via a hypothetical example. Consider the case of Johnny, who wants to borrow $1M to buy a house. If Johnny borrows the money from his friend Freddy then the transaction results in a $1M increase in the amount of credit within the economy, but no inflation has occurred. All that has happened is that $1M of purchasing power has been temporarily transferred from Freddy to Johnny. By the same token, when Johnny pays Freddy back there is a contraction of credit, but no deflation. There is also no deflation even if Johnny defaults on his loan obligation to Freddy. In this case Freddy will have made a bad investment, but the money he lent to Johnny will still be somewhere in the economy. The point is that credit expansion is not inherently inflationary and credit contraction is not inherently deflationary.

But what if Johnny, instead of borrowing the million dollars from Freddy, takes out a loan at his local bank and the bank makes the loan by creating new money 'out of thin air'? In this case inflation has certainly occurred. Nobody has had to temporarily forego purchasing power in order for Johnny to gain purchasing power, but the total existing supply of money has been devalued to some extent.

The critical difference is that when Johnny borrows from a bank the transaction leads to an increase in the supply of MONEY. Inflation is the increase in the supply of money that SOMETIMES results from credit expansion; it is not credit expansion per se.

When Johnny pays back his loan to the bank the money that was created out of thin air disappears into thin air; that is, deflation occurs. But what if Johnny defaults on his bank loan?

If Johnny defaults on his loan then the bank will take a loss, but the money that was lent to Johnny will remain within the economy. From the bank's perspective it will be an investment gone bad, but an investment going bad is certainly not the same thing as deflation. It could be argued that when banks take large investment losses, that is, when a substantial amount of the banking establishment's capital gets written off, the collective ability of banks to lend more money into existence will be impaired and deflation may eventually occur as a knock-on effect. This is a valid argument, but as long as the money supply is expanding it is not reasonable to state that deflation IS occurring; it is only reasonable to state that the severely impaired balance sheet of the banking system could lead to deflation at some future time. Quite simply: there cannot be deflation as long as the money supply is expanding.

This leads to the question: is the money supply currently expanding?

The answer is yes, but not anywhere near as rapidly as many people think. The chart at http://www.nowandfutures.com/key_stats.html reveals that M3 has grown by a mind-boggling 19.5% over the past 12 months, but as was the case during the early 1990s it appears that this broad measure of money supply is currently giving a 'major league' FALSE signal. As noted in an earlier TSI commentary, the growth rates of both M2 and M3 plunged during 1991-1993, making it seem as if deflation were a clear and present danger, but the downturns in these monetary aggregates during that period were almost solely due to sharp declines in time deposits. And for the reasons previously explained, time deposits should not be counted as money.

M3 is currently making it seem as if there is a lot more inflation than is actually the case, mainly due to the inclusion of institutional money market funds (MMFs) in this monetary aggregate. Institutional MMFs have experienced incredibly rapid growth over the past year, but institutional MMFs are not money and should therefore not be counted when estimating the money supply.

Our preferred measures of money supply are TMS (the True Money Supply reported at http://www.mises.org/content/nofed/chart.aspx?series=TMS) and what we call TMS+ (TMS plus Retail MMFs). TMS and TMS+ currently have year-over-year (YOY) growth rates of around 3% and 6%, respectively. In other words, our assessment is that the current US inflation (money-supply growth) rate is 3-6%. Inflation is still occurring, but at a much slower rate than it was during the early years of this decade.

On a side note, the wrongness of M3's current signal is validated by the happenings in the financial world. Inflation-fueled booms generally continue until there is a deliberated or forced slowdown in the inflation rate, that is, the booms continue until the central bank takes steps to rein-in the inflation or until inflation slows under the weight of market forces. The downturn in the US housing market and the veritable collapse of the mortgage-lending industry -- the locations of the major inflation-fueled booms of the past decade -- suggest that a substantial SLOWING of the inflation rate HAS taken place. Or, to put it another way, if M3's current signal were correct then we wouldn't have seen what we have seen over the past year. Warren Buffett's quip that you find out who has been swimming naked after the tide goes out applies very well to inflation-fueled booms, in that investments that are totally reliant on high inflation will be revealed for what they really are once the monetary tide begins to ebb.

It is also worth noting that although inflation is a major driving force behind the commodity bull market, commodity prices are generally still very low in REAL terms. Therefore, while we are anticipating a commodity shakeout over the next few months we think the long-term upward trend in the commodity world has a considerable way to go.

In conclusion, it is clear that inflation is still occurring in the US (and pretty much everywhere else, for that matter), albeit at a reduced rate. Furthermore, if it hasn't already done so it is likely that the inflation rate will bottom-out over the coming few months and then embark on its next major upward trend. It is possible that consumers are 'tapped out' and that the commercial banks are about to reduce the rate at which they lend, but the government will never be 'tapped out' and the central bank will always be able to monetise debt.

*There is a much bigger camp that defines inflation and deflation in terms of changes in the general price level, but we will ignore this camp because to define inflation/deflation in this way is to confuse cause and effect and to overlook the most pernicious consequences of inflation. If inflation were simply an increase in the general price level (a reduction in the purchasing power of the currency) then it wouldn't be a big problem. The reason it is a big problem is that it re-distributes wealth and results in the misallocation of resources.

Economic Bust and Deflation

Although deflation (a contraction in the supply of money) would, in the current environment, almost certainly lead to or be accompanied by an economic bust, "deflation" and "economic bust" are not synonymous. In fact, under the current monetary system an economic bust is more likely to be accompanied by rising INFLATION due to the counter-cyclical monetary and fiscal policies that have become so popular. And this is regardless of the reality that such policies can only do long-term damage by leading to more mal-investment. For example, the US economy would be in far better shape than it is today if the Fed and the US Government had not, during 2001-2003, attempted to 'inflate away' the effects of the burst stock market bubble.

That the US economy managed to recover at all following the downturn of the early-2000s is testament to the remnants of capitalism, not the massive government "economic stimulus" operations that occurred at the time. The recovery actually happened in spite of, not because of, the official stimulus, but the recovery was never particularly strong because you can't fully recover from the inevitable adverse effects of rampant inflation in the face of even more inflation.

More inflation can't possibly help, but it will almost certainly be the prescription.