The Main Flaw in the Deflation Case
Below is an extract from a commentary originally posted at www.speculative-investor.com on 16th July 2006.
Some very smart people are forecasting deflation for the US; or, perhaps we should say (with tongue firmly planted in cheek) that some people who are very smart except when it comes to the inflation/deflation topic are forecasting deflation. Furthermore, some of the analysts who are arguing eloquently for a deflationary outcome right now have been making the same argument, just as eloquently, every year for the past 15 or more years. And yet, being wrong for 15 years in a row hasn't lessened their resolve. The question is: why? What is so irresistible about the idea that deflation is imminent that causes smart people to be wrong year after year after year?
In many cases the error is one of definition in that the person thinks of deflation as a fall in the general price level. But although falling prices are an effect of deflation, when prices fall it is usually for some reason totally unrelated to deflation (for the uninitiated, deflation is a prolonged contraction in the total supply of money and credit). In fact, over the past 50 years not a single price has fallen in the US due to deflation because the total supply of money and credit has been in a relentless upward trend.
Taking a topical example to further explain the above, the downward pressure on the prices of some goods stemming from the low cost of manufacturing in countries such as China does not cause deflation and is not a deflationary force in any way. If anything, the lowering of the prices of some goods due to the cheapness of manufacturing in China creates the potential for higher INFLATION in the countries that import a lot of these goods, as does the lowering of the prices of some services due to the relative cheapness of well-educated English-speaking workers in India. The reason is that the hiding of the evidence of inflation, which is what the downward pressure on prices resulting from globalisation tends to achieve, gives central banks greater freedom to inflate. Remember: a central bank's reason for being is to inflate (expand the supply of money) whilst keeping inflation FEARS at a low level, so anything that helps to cover-up the effects of inflation, or create the illusion of a deflationary threat, makes the central bank's job easier.
Which brings us to what we see as the main flaw in the deflation case and the reason that a few smart people continue to forecast deflation.
A theme that appears to be common to the most eloquent arguments in favour of a deflationary outcome is that consumers, at some point, will have to start reducing their collective indebtedness, and when this happens the total supply of money and credit will begin to contract (deflation will occur). Given the current enormous height of the collective debt burden it seems likely that the point at which the debt accumulation of consumers tops out cannot be far off, which is, we think, why the idea that the world is about to plunge into a deflationary quagmire has proved to be so seductive. After all, there must be some limit to how much debt people will be able or willing to take-on and, with the savings rate in negative territory and debt repayments constituting an uncommonly-high proportion of disposable income, we simply MUST be close to that limit.
The problem is, the argument for deflation outlined in the above paragraph is based on the incorrect premise that the consumer is the engine of inflation. And when you start with an incorrect premise and then apply perfect logic you are GUARANTEED to come to the wrong conclusion.
The central bank, not the consumer, has always been and always will be the engine of inflation. There are times, such as the past decade in the US, when a massive build-up of consumer debt is the major contributor to growth in the money supply, but in such cases consumers are simply responding to stimuli provided by the central bank (it is only possible for a credit bubble to form if the central bank does something to facilitate the massive expansion of credit, such as hold interest rates at artificially low levels for lengthy periods). Furthermore, if consumers stopped borrowing more money into existence, or heaven forbid actually began to pay-down their debts, the central bank would still have little difficulty keeping the inflation going.
Some of the means by which the central bank could keep the inflation going were outlined by Ben Bernanke in the 21st November-2002 speech that made him a household name (in our household, anyway). As far as we were concerned Bernanke was, in the aforementioned speech, just stating the bleeding obvious, but it was very significant that he could publicly discuss one of the current monetary system's major defects -- that the monetary authorities have the power to create an unlimited amount of money and therefore to reduce the purchasing power of the money by any amount they wish -- without causing hardly anyone to question the integrity of the system and without causing the devout deflationists to abandon their dearly-held view.
Bernanke's November-2002 speech garnered a lot of attention in the financial world, but similar sentiments were expressed just as clearly in a little-known speech by Alan Greenspan in January of 1997. According to Greenspan:
"When there is confidence in the integrity of government, monetary authorities -- the central bank and the finance ministry -- can issue unlimited claims denominated in their own currencies and can guarantee or stand ready to guarantee the obligations of private issuers as they see fit. This power has profound implications for both good and ill for our economies.
Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank.
That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims without limit."
Note the liberal use of the terms "without limit" and "unlimited" in the above. Note, also, the qualification: "When there is confidence in the integrity of government". Once confidence collapses it becomes counter-productive for the central bank or the government to issue more "claims" (money and money substitutes). When that point is reached you don't get deflation; you get a total collapse and a new monetary system.
Right now the inflation argument is an easy sell thanks to the sharp rises in commodity prices over the past few years. However, it wasn't an easy sell when we were trying to sell it in 2001-2002 and there will again come a time when it won't be an easy sell.
We suggest you print the above-referenced speeches and refer to them the next time the deflation argument appears to be gaining the ascendancy.