Deflation???

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MCFLYFYTER's picture
MCFLYFYTER
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Deflation???

I finally found a great article about inflation.  It explains why it seems to be a deflationaryperiod now, and why it is not.

 

 

"We witnessed a stock panic in late 2008, an exceedingly rare event.  The dictionary definition of this is “a sudden widespread fear concerning financial affairs leading to credit contraction and widespread sale of securities at depressed prices in an effort to acquire cash.”  Panics are bubbles in fear which drive investors to liquidate everything they can at any price.  They get so scared they only want to hold cash.

 

When all investment assets are sold heavily in a short period of time, prices naturally collapse.  But this is not deflation if it is not driven by a contraction in the money supply.  For stocks, commodities, and houses, prices fell sharply in the second half of 2008 because there was a sudden huge oversupply relative to demand.  Many more investors wanted out than wanted in, so prices plunged.  They had to fall until a new equilibrium was reached, low enough to retard supply (investors too disgusted to sell anymore) and raise demand (from other bargain-hunting investors)." 

 

 http://www.zealllc.com/2009/biginf.htm

 

 

 

 

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Woodman
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Re: Deflation??????

I'm still unsure about this deflation vs inflation thing and not convinced either way yet.  I don't understand enough about the different measures of money to tell if this article is using the right data.  Seems to me if one accepts most of our money is debt or credit based, and we've had a collapse in credit possibily greater than the increase in new money from the Fed, the money supply is contracting and that's deflation.  Are there simple numbers out there that can be compared? 

 

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Re: Deflation??????

Mish had some comments on that zeal article here:

http://globaleconomicanalysis.blogspot.com/2009/01/is-big-inflation-coming.html

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Re: Deflation???

Mish has another more recent article that does an even more thorough job of explaining why it is deflation, not inflation that is now awaiting us.  

http://globaleconomicanalysis.blogspot.com/2009/01/peter-schiff-was-wron...

This article should be required reading for all gold bugs and hyper-inflation believers. The argument about inflation or deflation does not really make a lot of difference to end-of-the-world scenarios however. The main difference is that goldbugs get crushed before or at the same time as everyone else, rather than afterwards.

My personal view is that mish is correct, and further that both peak oil and the end of population growth will both prevent an exit from deflation/stagnation for a very long time. It would be the ultimate irony if capitalism chokes to death in deflation rather than evaporating in hyperinflation as many seem to believe it will. 

 

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Re: Deflation???

Hello, I'm a computer engineer not an economist and one of the reasons I like this site is that it tries to explain things for simple minds like mine. I don't like fuzzy numbers and charts.

Looking at the inflation vs deflation, I only see money thrown by the government into the market.

  1. bailing out banks, automakers and other industries
  2. unemployment rising -> unemployment benefits
  3. various "stimulus" programs - tax exempts, etc.

In the same time, the government has less revenue due to higher unemployment and lower corporate profits (= lower taxes) .

So, where is the government getting all the extra money? Logically, the unemployment benefits should be lower since unemployment is higher, but was there any government to lower this or other government salaries? Nobody will vote a government that promises lower salaries.

So, the only way I see is that the government will simply print money to maintain the illusion of growth, or at least to "satisfy" its promises.

What am I missing?

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Re: Deflation???

Ok, I read Mish's article in which he argues against inflation.

First, he compares the situation now with 1931, but in 1931 US was on gold standard so it's not directly comparable. This kind of  comparision assumes that the market decides freely about inflation or deflation. But as far as I understand, inflation is created by government at government's will. And now they are willing to bailout banks and so on, so they are willing to create inflation.

Second, he points out that although the government has poured a lot of money into banks, the banks won't lend those money. His only explanation is "fear" but this I cannot buy. Fear can be attributed to masses but not to bankers which have nothing to loose. The most likely scenario is that those money have not quite covered the banks bad debts so they don't lend any money because they have no money to lend.

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Re: Deflation???

what you are missing is that the money supply is contracting. The money supply is about 97% bank loans (debt-money) and 3% debt-free money (cash, coins etc). As people default or pay pack loans, the banks are not making new loans. This means that the debt bearing part of the money supply is shrinking. Less money but the same amount of goods and services means that those goods and services go down in price.

It is true that the gov is printing new money. This will be inflationary when the banks decide to lend it out, since this new money can be lent out many times over via fractional reserve banking. However the banks cannot lend it out if people won't borrow it. Until people decide to borrow it, the money supply can't reinflate. But people won't borrow it until their asset prices go back up (houses, cars etc), and their wages go up and become secure again. catch 22.

This is what is called a liquidity trap. No-one wants debt any more.Note that even if people did start borrowing again it will not be inflationary until such time as the debt-money supply has exceeded its 2007 levels.

The only way to reinflate the economy is to give people money directly, except that even then they would likely choose to save it rather than spend it.

 

 

 

 

 

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Re: Deflation???

I like your explanation, skep. The only other thing is black swans...Iran, Pakistan, etc...and that the price of oil and what we eat and (unfortunately) burn could go up, along with gold, perhaps.

 

SG

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Re: Deflation???

oil and gold won't go up till economic activity picks up. I can't see economic activity picking up while the world is in the process of reconfiguring from a consumer economy to ... whatever is next.

What is next? As I have said elsewhere here I think for various reasons (peak oil, end of population growth, aging) what comes next has to be an economy that is not based on growth and capitalism, but at the same time is not based on communism. Tricky one - it'll take the world a while to figure this one out. Until then, appetitie for risk is going to be very low.

 

 

 

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Re: Deflation???

Sorry, I still don't get it. You say "This will be inflationary when the banks decide to lend it out,". But banks have already given the credits - thus the money is in a form or another in circulation.

I try to make an example, so you tell me where I'm wrong.

Let's assume that during the realestate bubble I want to sell my house which is valued at 200k. I found my buyer Joe who has no money of course but who will get a credit of 200k from the bank. The bank doesn't have itself this money but can produce a check nevertheless. So I get a 200k check from the bank and Joe gets my house. Few months later it turns out that Joe cannot pay the loan and moreover the house is valued now only at 100k (so it makes no sense to pay it). Joe defaults on his loan, and the bank takes the house. Next, I go to the bank with my 200k check demanding cash. The bank says: "sorry I have no cash, I only have this house but is worth only 100k". Now there are two things that can happen:

1. the bank goes bankrupt because it cannot cover the check. I get my house back as payment for half of the check and it's all in the initial state, the 200k money have dissapeared.

2. the bank has insured the credit at AIG and the government through AIG gives 100k to the bank. So, I get my house back plus 100k in cash.

Now, which of the two scenarios happen nowdays? The first one doesn't produce either inflation or deflation while the second one clearly produces inflation.

 

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Re: Deflation???

"But banks have already given the
credits - thus the money is in a form or another in circulation."

Nope, money sitting in a bank is not in circulation. Unless someone withdraws the money and buys something, the existance money will not push prices up.  One could say that if everyone knows there is loads of money in the bank waiting to be spent, that may push prices up just because people think it might get spent in the future. However if they turn out to be wrong, prices would fall back again.

 

I try to make an example, so you tell me where I'm wrong.

"Let's assume that during the realestate bubble I want to sell my
house which is valued at 200k. I found my buyer Joe who has no money of
course but who will get a credit of 200k from the bank. The bank
doesn't have itself this money but can produce a check nevertheless. So
I get a 200k check from the bank and Joe gets my house. Few months
later it turns out that Joe cannot pay the loan and moreover the house
is valued now only at 100k (so it makes no sense to pay it). Joe
defaults on his loan, and the bank takes the house. "

 At this point 200K has gone from the money supply, as a result of joe's default. Even though the bank has the house, the money is still gone, and this is deflatioanry.

"Next, I go to the
bank with my 200k check demanding cash. The bank says: "sorry I have no
cash, I only have this house but is worth only 100k". Now there are two
things that can happen:

1. the bank goes bankrupt because it cannot cover the check. I get
my house back as payment for half of the check and it's all in the
initial state, the 200k money have dissapeared."

You don't get your house back. You get as much of your 200K deposit back that the government has agreed to cover. This is no in itself inflationary. What has changed?

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xpromache
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Re: Deflation???
Quote:
Quote:

"Let's assume that during the realestate bubble I want to sell my
house which is valued at 200k. I found my buyer Joe who has no money of
course but who will get a credit of 200k from the bank. The bank
doesn't have itself this money but can produce a check nevertheless. So
I get a 200k check from the bank and Joe gets my house. Few months
later it turns out that Joe cannot pay the loan and moreover the house
is valued now only at 100k (so it makes no sense to pay it). Joe
defaults on his loan, and the bank takes the house. "

At this point 200K has gone from the money supply, as a result of
joe's default. Even though the bank has the house, the money is still
gone, and this is deflatioanry.

How is the 200K gone? I still have the 200K check in my pocket. (on a side note: I'm from Europe, cheques are not very common here and I'm not sure it makes sense what I say about using them, but you get the idea).

Quote:

You don't get your house back. You get as much of your 200K deposit
back that the government has agreed to cover. This is no in itself
inflationary. What has changed?

I assume that if the bank still has 100K (the value of the house), I can get it back when the bank goes bankrupt. I'm not talking at this point 1 about the government guarantees.This is indeed not inflationary but this is not what happens today.

The point 2 is what happens today, the bank is insured against defaults and the government ultimately insures all the financial institutions (just see the last post from Chris).

 

I agree with you that keeping my 200K in the bank will not create inflation but once I'm out of work I will start spending them.

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Re: Deflation???

"How is the 200K gone? I still have the 200K check in my pocket."

Well, before joe bought your house, the money supply was say 100,000,000. The bank lent joe 200K out of thin air, he gave it to you, and you gave him your house. Now the money supply is 100,200,000. Joe has no money, and you have 200K on deposit at the bank.

The banks cash reserves are say 1,000,000. Joe defaults. The bank writes off 200K from its reserves - the bank lost the money it lent. Now the money supply is back to 100,000,000, where it started before the bank made it's loan. However the bank still owes you 200K. if you want it back then they give it you and their reserves are now down to 800,000. If they only had 199,999 of reserves, then they are bust.

 If joe never defaulted, then joe got a house, you got 200K, and the money supply stayed at 100,200,000.  In time the bank will get interest from joe, further increasing the money supply.

 

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xpromache
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Re: Deflation???
scepticus wrote:

"How is the 200K gone? I still have the 200K check in my pocket."

Well, before joe bought your house, the money supply was say 100,000,000. The bank lent joe 200K out of thin air, he gave it to you, and you gave him your house. Now the money supply is 100,200,000. Joe has no money, and you have 200K on deposit at the bank.

The banks cash reserves are say 1,000,000. Joe defaults. The bank writes off 200K from its reserves - the bank lost the money it lent. Now the money supply is back to 100,000,000, where it started before the bank made it's loan. However the bank still owes you 200K. if you want it back then they give it you and their reserves are now down to 800,000. If they only had 199,999 of reserves, then they are bust.

If joe never defaulted, then joe got a house, you got 200K, and the money supply stayed at 100,200,000. In time the bank will get interest from joe, further increasing the money supply.

If the bank had 1000K deposits, it means it doesn't give the 200K out of thin air. So the money supply will remain the same after I sell my house: I have 200K, the bank has 800K and the other 99000K are somwhere else.

However, if the bank has no deposits but still gives me my 200K cheque, then, assuming that the bank is helped by the governemnt with 100K, the total money supply will be 100100K: I have 200K the bank has still nothing (having sold the house for 100K to somebody else) and 99000K are somwhere else.

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scepticus
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Re: Deflation???

xp, you have missed the point about fractional reserve banking. If the bank has 1,000,000 reserves, and a reserve requirement ratio of say 10%, then it may make 10,000,000 worth of loans, inflating the money supply by a factor of 10.

That is the whole point - the credit is created out of thin air, and it only works if 

 (1) The borrowers pay the lan back with interest (the money earned in interest will suffice to cover the costs of a few defaulters).

(2) The depositors who provided the reserves don't all ask for their money back at the same time.

 If this is not clear, I suggest you go to youtube and lokup the 'money as debt' video.

 

The 1,000,000 reserves in your example are already spoken for - they have been used to back other loans and are therefore not available to repay your 200K.

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MCFLYFYTER
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Re: Deflation???

So, the US will suffer severe deflation, and the rest of the world will suffer severe inflation? 

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