The Main Flaw in the Deflation Case, Part 2
Below is an extract from a commentary originally posted at www.speculative-investor.com on 10th August 2006.
In our 17th July commentary, under the heading "The main flaw in the deflation case", we attempted to debunk the view that deflation (a contraction in the total supply of money and credit) will soon occur. In this earlier discussion we noted the theme common to the most persuasive arguments in favour of a deflationary outcome -- that the public's ability to borrow new money into existence will reach its zenith in the not-too-distant future -- and then explained that while this line of thinking appeared to be logical it missed a crucial point. The point is that the central bank, not the public, has always been and always will be the engine of inflation.
Interestingly, our assertions that the central bank will always be able to prevent deflation typically generate more open disagreement from our readership than anything else we write. Back in the dark days of 2001-2002 we were never surprised that our regular arguments in favour of an inflationary outcome would attract skeptical (to put in mildly) feedback because at that time commodity prices were near multi-decade lows. However, with the evidence of an inflation problem having since emerged for all to see we find it more than a little strange that the case for deflation retains a groundswell of support. This, of course, is great news if your name happens to be Ben Bernanke because the Fed will have plenty of freedom to continue the inflation (to continue the expansion of the money supply) as long as inflation EXPECTATIONS remain low and deflation fears lurk just beneath the surface.
Our 17th July discussion attracted more than the usual number of well-considered comments/questions and we've decided to address many of these in point-form in today's commentary. So, here we go:
1. Many people assumed that we had Robert Prechter in mind when we referred to the smart people who have been wrongly forecasting deflation for a long time, but this is not the case. We know, and know of, quite a few smart analysts who are forecasting a deflationary outcome. Furthermore, we generally don't consider the deflationists to be our analytical opposites. Like us, they usually appreciate the problems that have been caused by government manipulation of money and credit and are often advocates of hard/honest money. The main difference we tend to have with deflation forecasters revolves around the central bank's ability, under the current monetary system, to prevent deflation if it chooses to do so.
Our analytical opposites are the Keynesians. A Keynesian is someone who believes that:
a) It is possible to have sustainable growth without savings
b) Consumers, as a group, can borrow and spend their way to prosperity
c) The Great Depression was caused by insufficient aggregate demand and insufficient inflation
d) The legitimate role of the government and its central bank is to use fiscal/monetary policy to smooth-out the business cycle
e) Markets can't be trusted but governments can
2. A widely held view seems to be that inflation is associated with good times and deflation with bad, but this is completely wrong. Under the current monetary system both are destructive -- deflation because it increases the cost of servicing debt and inflation because it leads to the misallocation of scarce resources.
3. The advocates of the deflation case often claim that we are over-estimating the power of the central bank, which probably means that we haven't made ourselves clear. Our view is that the central bank can't do many things, but what it can always do is reduce the purchasing power of the currency.
As long as the laws of supply and demand remain in force then someone who can increase the supply of some 'thing' by an unlimited amount will always be able to reduce the value of that 'thing' if that's what they choose to do. The central bank has the power to create an unlimited amount of currency, so those who argue that the Fed will be unable to prevent the dollar's purchasing power from rising are claiming, in effect, that the laws of supply and demand don't apply to money. Such claims are patently false.
4. When the Fed inflates it doesn't actually support market prices in any meaningful way; all it does is reduce the relative value of the thing in which prices are denominated. For example, if the Dow Industrials Index is trading at its current level in 5 years time and the US Dollar's purchasing power is half of what it is today then the holders of the Dow stocks over this 5-year period will have suffered a real loss of 50%. The real return is all that matters.
5. If the only effect of inflation were a predictable loss in the currency's purchasing power then inflation would never be a big problem. The reason it is a big problem, and the reason it is a deliberate policy rather than just something that happens naturally, is because it:
a) Facilitates the growth of government and the associated loss of individual freedoms
b) Causes a transfer of wealth (inflation benefits the asset-rich at the expense of the asset-poor, debtors at the expense of creditors, and non-savers at the expense of savers)
c) Results in there being less total wealth within the economy than there would have been in the absence of the inflation
6. Further to points 4 and 5 above, inflation is never a solution. It is, however, an INEVITABLE consequence of the current monetary system. It is inevitable because the current monetary system is, in effect, a giant Ponzi scheme (a scheme that can only continue as long as there is enough money coming in from new investors to pay previous investors), and once you've created a Ponzi scheme you can't just stop paying people for a while. This is why there won't be an intervening period of deflation between now and when inflation eventually destroys today's money; rather, the inflation will continue -- interrupted by the occasional deflation scare but not by actual deflation -- until a monetary collapse occurs.
7. The current monetary system's Ponzi-scheme-like nature stems from the fact that each new dollar borrowed into existence creates a liability in excess of one dollar due to the obligation to pay interest. This characteristic has, over the decades, resulted in the obligations to pay dollars becoming many times greater than the total supply of dollars, so the dollar supply must continue to expand in order for the system to survive. Or, putting it another way, if there ever was a chance for the Fed to allow the US to experience a 'cleansing' period of deflation that chance is long gone. The issue, therefore, is not whether the Fed will ATTEMPT to maintain the inflation (it doesn't have another option), but whether it will be ABLE to maintain the inflation.
In theory the Fed will be able to keep the inflation going for the simple reason mentioned in point 3 above. Furthermore, there is empirical evidence that the Fed is quite capable of expanding the money supply on its own should the public stop borrowing new money into existence. For example, the Fed added 170 billion dollars to M2 money supply within the space of a few days in the immediate aftermath of the September-2001 attacks by terrorists. The Fed was able to arrange this 170B monetary injection at a moment's notice, so just imagine what it could do given a few months to prepare.
8. Our argument that the inflation will continue until there's a total collapse in today's confidence-based monetary system prompted the response that a monetary collapse and deflation are effectively the same. However, 'deflation' and 'monetary collapse' are actually polar opposites. Deflation is, by definition, an increase in the purchasing power of money CAUSED by a reduction in the supply of money. In other words, an effect of deflation is that money becomes more valuable. A monetary collapse, on the other hand, results in money losing so much value so quickly that it ceases to function as money.
As far as we know, no monetary system has ever collapsed as a result of deflation. When they collapse it is invariably because of inflation.
8. Even though deflation and a monetary collapse are opposites, from a practical investment standpoint does it really make any difference?
The answer is yes; it makes a huge difference. The best-performing investments during a period of deflation would be US Government bonds, but these would be amongst the worst performers during the lead-up to a monetary collapse. Also, under the current monetary system it is almost certain that gold's purchasing power would surge during a period when inflation expectations were running wild, but during a period of deflation gold would, at BEST, maintain its purchasing power.
Before we leave this topic it's worth reiterating that inflation is only a useful policy as long as inflation expectations are under control. However, once enough people begin to 'front-run' the policy, that is, once enough people begin to act today in anticipation of tomorrow's loss of purchasing power, expanding the supply of money becomes counter-productive. If it were possible for deflation to occur while keeping the monetary system going, then this is when it would occur.
We therefore don't think it will make sense to seriously question the Fed's ability or desire to inflate until there is evidence that inflation expectations are beginning to spiral out of control. Such evidence will likely include bond yields moving into double digits and the gold price moving above $2000.