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Inflation, deflation & the future of money

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  • Sat, Oct 18, 2008 - 03:10am

    #1
    switters

    switters

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    Inflation, deflation & the future of money

The question of whether we are headed for a deflationary or an inflationary recession/depression seems to be one of the hottest topics on this forum and elsewhere in the financial blogosphere.  I’ve read a lot of arguments supporting both theories, and what I’ve come to realize is that there is significant confusion and disagreement on how inflation and deflation are actually defined.  

This is obviously a problem because it’s impossible to say whether inflation or deflation is occurring or will occur without a definition of the terms we can agree on.  I don’t claim to know the answer to this question myself, but the definition most people seem to agree on is this:

[quote]Inflation and deflation are monetary phenomenons. Monetary inflation occurs when the supply of money increases faster than the supply of goods and services. This is different from the concept of price inflation, which, depending on several variables that may impact inputs along a given production chain, can cause an increase in the price level for certain goods and services at any given time. Otherwise said, monetary inflation causes price inflation, but a price rise isn’t always a result of monetary inflation.

With monetary deflation you have the opposite effect, in that it relates to a contraction in the money supply. If the supply of money contracts, while the supply of goods and services either remains constant, increases, or contracts at a slower rate, then that can lead to price deflation. Otherwise said, a contraction in the supply of money will in most cases cause asset prices to fall, but falling asset prices are not always the result of a monetary deflation (the oil price can rise if the supply of oil is falling at a faster rate than a money supply contraction, for instance).[/quote]

I suggest reading the full article that excerpt came from here: http://www.safehaven.com/article-11593.htm

Most people who claim that we are experiencing deflation now point to the fall in asset prices like real estate, stocks and commodities as evidence.  Yet during this same period we’ve seen a rather dramatic increase in the monetary supply without any increase in the supply of goods and services.  This is the textbook definition of inflation.  

The decline in asset prices is being caused by massive deleveraging of debt following the collapse of debt instruments tied to bad loans.  It is not being caused by a decrease in the supply of money, as we would expect with true monetary deflation.

So, according to the definitions for deflation and inflation used above, we are currently in a period of inflation – not deflation.  And what should we expect in the future?  Here’s another quote from the same article:

[quote]In a fiat money world with governments controlling the money printing presses you can be sure those governments will do everything in their power to fight off depressions. Anyone who continues to doubt this must have been living under a rock the past couple of months.

With much of the world holding the same toxic instruments and in similar, but not as horrific shape as the US, the ability of the US Treasury to tap its foreign creditors and borrow its way, to the tune of trillions, out of this mess has been severely impacted. On the domestic front, the savings rate is approximately zero, and increasing levels of unemployment will cause tax receipts to collapse. The only alternative will be the printing of money.

The US is the world’s greatest debtor. Money printing will bring on monetary inflation, which will wipe out those debts, savings, as well as the US dollar. That is the real scare that markets today, as well as foreign creditors, should be pricing in. It is only a matter of time. To borrow a line from the classic film ‘The Usual Suspects’: The greatest trick the Devil ever pulled was convincing the world he didn’t exist.[/quote]

I don’t claim to be an authority on any of this.  I simply post it as a way of stimulating a discussion.  I would love to hear your thoughts on it, whatever they are. 

  • Sat, Oct 18, 2008 - 03:24pm

    #2
    ds

    ds

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    Re: Inflation, deflation & the future of money

[quote=switters]

Most people who claim that we are experiencing deflation now point to the fall in asset prices like real estate, stocks and commodities as evidence.  Yet during this same period we’ve seen a rather dramatic increase in the monetary supply without any increase in the supply of goods and services.  This is the textbook definition of inflation.  

[/quote]

Here is where sorting out this question gets even trickier. When you say "money supply" are you referring to M1, M2, M3 or some other definition? Derivatives are not officially included in any of those definitions, yet derivatives are used to manipulate corporate balance sheets and they are financial securities that directly impact the money supply in many ways.

Furthermore, in our system, money is debt (which depends on credit). So what is happening now is that there is a tremendous contraction in the money supply due to the credit problems (involving derivatives and more). This contraction is not reflected in the official money supply definitions, but it is so obvious that even the Fed is fighting it with everything they have.

So right now we are in a severe money supply contraction and we are seeing deflationary trends.

That leads to the question of how long the deflation will last and what comes next. Will hyperinflation follow? 

Personally, I would think that Roubini would be sounding the alarm if hyperinflation were really a serious threat. Another bubble of some type seems a more realistic outcome, and Bernanke is already talking about that danger.

  • Sat, Oct 18, 2008 - 03:54pm

    #3
    srbarbour

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    Re: Inflation, deflation & the future of money

[quote]Yet during this same period we’ve seen a rather dramatic increase in
the monetary supply without any increase in the supply of goods and
services.  This is the textbook definition of inflation.[/quote]

That, switters, is because the text book definition of deflation has nothing whatsoever to do with the real world.

Inflation is, outside of the academic world, never discussed in these terms.   Worse, the academic definition is a flat out absurd declaration that begs the question — e.g. Requires you to have accept monetarist, and related, economic theories.

Even sillier, these definitions were invented largely because economist found it too troublesome to calculate actual inflation and deflation.  So the redefined the terms to make things easier on themselves. 

 

Here is a definition of inflation/deflation that more closely matches that used in the real world.  These also reflect what Governments attempt to measure with their flawed inflation statistics:

Inflation –  Any general increase in prices within a constrained economy.

     e.g. Early this year, America was experiencing inflation.

Deflation – Any general decrease in prices within a constrained economy.

     e.g. For pretty much a year now, America has been experiencing deflation within the housing market.

 

Parts of the economy can deflate while others inflate at the same time.  Consumer prices in general increased thus far this year, while housing prices having been deflating all along.

Right now it appears general deflation has set in.  It is likely to continue in the near term and in absence of direct government attempts to ‘print their way out’.   A sovereign default though, would instantly reverse this trend (for a period anyway) because the dollar is primarily backed by T-bonds.

[quote]

So, according to the definitions for deflation and inflation used
above, we are currently in a period of inflation – not deflation.  And
what should we expect in the future?  Here’s another quote from the
same article:

[/quote] 

If we use monetarist definitions of inflation we can’t expect anything.  These economic theories have repeatedly failed to provide any meaningful predictive ability.  Especially durring a recessionary event.

  • Sat, Oct 18, 2008 - 04:09pm

    #4

    Ray Hewitt

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    Re: Inflation, deflation & the future of money

That leads to the question of how long the deflation will last and what comes next. Will hyperinflation follow? 

Wouldn’t we all like to know the future with precision. My strategy is to take advantage of the deflation while it lasts as best my means allow to prepare for the inflation to follow when it comes. As time passes, we’ll see early warning signs and get a better idea of how bad it will be. There are some wild cards that could hasten events: a derivative implosion, an attack on Iran and a mass exodus from dollar assets by foreigners. We live in interesting times.

  • Sat, Oct 18, 2008 - 04:40pm

    #5
    babylon

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    Re: Inflation, deflation & the future of money

A good post by switters explaining the proper definitions. I have read many posts on this forum, and agree that there is some confusion on what inflation and deflation actually refers to.

 It is a bit worrying that the authorities appear to be firefighting the deflationary trends with disproportionate amounts of new money.

Are we experiencing aggregate delfation in the money supply (even with the extra trillions) due to economic downturn and reigning-in of debts, or is it due to a surplus of goods & services. If the former is true, then where does the money go? 

The principal of deflation assumes that money is removed from circulation. Where does it go? I assume back to the fed in interest payments

Strange that we are seeing a relatively strong dollar, but in the UK (where i come from) we have inflation and a weakening pound.

  • Sat, Oct 18, 2008 - 05:04pm

    #6

    Ray Hewitt

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    Re: Inflation, deflation & the future of money

These economic theories have repeatedly failed to provide any meaningful predictive ability. 

srbarbour

I think you are unfamiliar with the Austrian School of Economics (mises.org). The Austrians maintain that boom and bust cycles are caused by bank credit and monetary expansion. As sure as night follows day, contractions follow at some indeterminent time. They don’t have confidence in the predictability of statistics and see them as pseudo-science. Prices are not uniformily distributed and they don’t necessarily all move in the direction with the money supply. For example, during the 30s, the money supply was expanding, but prices were stable because of improvements in productivity. So it is within Austrian Theory to see prices rising in some sectors and falling in others whether the money supply is falling or contracting. It is confusing which is why Austrians are opposed to market intervention. Intervention leads to bad calculations about future prices, causing imbalances that build up over time until they reach a critical threshold.

The people who understand Austrian Theory, including me, saw this coming years and decades ago. And it is entirely predictable how this will end.

In Mises’ words:

There is no means of avoiding the final collapse of a boom brought about by
credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of
further credit expansion, or later as a final and total catastrophe of the currency system involved."

For that reason when we consider the herculean extremes to which central banks have gone to prevent the market from correcting itself, we’re looking at a collapse far beyond anything ever seen in recorded history. That’s about as best anyone can predict at this time.

 

  • Sat, Oct 18, 2008 - 05:50pm

    #7
    switters

    switters

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    Re: Inflation, deflation & the future of money

[quote=hewittr]

That leads to the question of how long the deflation will last and what comes next. Will hyperinflation follow? 

Wouldn’t we all like to know the future with precision. My strategy is to take advantage of the deflation while it lasts as best my means allow to prepare for the inflation to follow when it comes. As time passes, we’ll see early warning signs and get a better idea of how bad it will be. There are some wild cards that could hasten events: a derivative implosion, an attack on Iran and a mass exodus from dollar assets by foreigners. We live in interesting times.[/quote]

What measures are you speaking of in terms of "taking advantage of deflation"? 

  • Sat, Oct 18, 2008 - 06:39pm

    #8
    ds

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    Re: Inflation, deflation & the future of money

[quote=switters]

What measures are you speaking of in terms of "taking advantage of deflation"? 

[/quote]

Deflation means that cash is appreciating (because the supply of money is contracting). Therefore, holding cash is a great way to take advantage of deflation. Gold hasn’t been so great in times of deflation.

  • Sat, Oct 18, 2008 - 06:50pm

    #9
    switters

    switters

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    Re: Inflation, deflation & the future of money

[quote=ds][quote=switters]

What measures are you speaking of in terms of "taking advantage of deflation"? 

[/quote]

Deflation means that cash is appreciating (because the supply of money is contracting). Therefore, holding cash is a great way to take advantage of deflation. Gold hasn’t been so great in times of deflation.

[/quote]

I’m aware that cash generally outperforms commodities during deflation.  I thought perhaps hewitt was referring to something else.

Also, there seems to be controversy about how gold will perform even in a deflationary recession.  The paper price has fallen considerably over the past week, but the physical supply is extremely tight.  That suggests that the demand for bullion, on the retail level at least, is high.

 

  • Sat, Oct 18, 2008 - 06:51pm

    #10

    Ray Hewitt

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    Re: Inflation, deflation & the future of money

Switters

I have some debts to pay off so I’ll have better cash flow when inflation returns. I’m referring to prices, not monetary aggregates.

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