Economic Fallacy III: Looming Deflation?

There is a wide-spread fear, not the least among leading Fed staff and many economic pundits, that we are in a period of deflation, not inflation, or, when it comes to testifying in Congress, we are only not in a period of deflation because the Fed, unlike 1929 and the years following, actively prevented it by (re)inflating the money supply, stimulating credit etc.

However, they say, things haven’t yet worked out so well that the threat of deflation has already been banned successfully. But was there ever any threat?

(Find more statistics and indicators etc. in our References section!)

Let’s keep it short at first (maybe CrisisMaven will expand on this at some future date, but the main point is actually quite simple):

The argument goes as follows: wasn’t it the allegation of all these people warning of a bubble that that bubble was a kind of (or caused by) inflation (though not reflected in the CPI as that does not comprise housing or stocks)? So why, if this bubble burst, credit had to be written off and hence banks’ balance sheets are being shortened, why then do these inflation “peddlers” now at least not come to their senses and acknowledge we are now in a period of (potential) deflation and, while it may not have been prudent to follow a lose money policy “back then”, certainly even by their own standards now is the time to (re)inflate and “keep credit stable”?

Well, it’s simple: it’s not true. It’s an economic fallacy. Here’s why:

Where does the notion that we might have deflation ever come from?

From what CrisisMaven found in literature it seems to stem from two ideas. For once anyone can see that in a recession or depression prices seem to decrease rather than increase, at least at first, for several compounding reasons. People certainly spend less as they either can’t afford to or as they feel insecure and tend to save more or for both reasons combined. In any case, demand for many goods will fall and hence their prices will too, as per the law of supply and demand. So whoever wants to call shrinking prices deflation and rising prices inflation is welcome to do so. However, there is no such thing as an average price level, so when people re-arrange their budgets they don’t just decide to spend nothing at all, they only spend differently, e.g. buying a different type of bread, no vacation but instead they may buy more books for the first time in their lifes about how to write a resume etc. That “cheaper” brand of bread might well see rising demand and hence might become more expensive as a consequence. Caviar might go down and potatoes up – at least, we want point out, it is not that straightforward and any aggregate such as the CPI must in the next month then be false as it “measures” consumption patterns that might have held true in the previous month but not now when caviar is on the decline and potatoes became hot.

But apart from these price decreases (which are a good thing by the way so that the people who became poorer because of the downturn can still afford to buy anything at all. Who argues for raising prices now should also explain why turnover would not shrink further in that case and whom, either on the manufacturer or the consumer side, that is meant to do any good. But these are finer points.), the greater fear lies obviously with the believe “money could go out of fashion” and hence more needs to be “printed” to fight the otherwise inevitable contraction and “deflation”.

So to understand why many believe now is the time of (potential) deflation, let’s first look at how the economy became inflated in the first place. When someone bought a house in, say, 2003 for 100,000 dollars, then “flipped it” in 2005 for 200,000 dollars he (we forget about down-payments and fees to keep the figures clean) he now had 100,000 dollars more to spend (on probably another house or two). While he would have paid back his first mortgage in a normal scenario, in the hey-days of housing speculation he would have immediately bought a second house so that we can neglect monetary contraction as a result here. That would only happen if one party takes up a new mortgage while another retires a previous one at least the same size. But in the housing bubble that (as a general rule) didn’t happen – each new mortgage was always considerably higher than the one retired, if any net retirement happened at all and more mortgages were taken out by the minute. The new buyer of the old owner’s first house raised the new mortgage again by bank credit, probably even in unsustainable ways such as teaser rates or liar loans. So not only was the house price by then clearly “inflated” (for want of a better term) by historic measures, but he was also a buyer who in normal times would not have taken up credit (to that extent). So the monetary base was inflated from several angles, higher prices and broader customer base than would normally have qualified for credit to boot. Now, even if a little later the housing market collapsed, that money hasn’t gone away – it is still out there – both buyers paid e.g. surveyors, builders, the former owners, fees, a caterer for the house warming party etc. with it, and these counterparties still have that money. So there is now more money “out there” than in 2003 despite the housing market contraction.

Deflation by credit default?

Ah, yes, deflationists argue, but on the other hand banks had to write off credit, so that “money” has vanished to the same or even greater extent (taking into account future loan payments). And that is plain wrong!

Let’s assume, both home “owners” (the one buying the old house and the one that instantly bought two more after “flipping” that former house) are by now in default and foreclosure, they don’t make payments, they may have even “walked away”. Now, one might argue, but hasn’t the bank had to write down the whole of these two mortgages so that while on one hand there’s now a builder and a surveyor and the very orignal home and land owners who owned prior to 2003 who enjoy the (inflated) money supply of 2003 to 2005, while equally there are now banks 300,000 dollars “the poorer” so that all-in-all the monetary expansion was (at least) cancelled out?

No – a big resounding no! And this is the illusion that many debaters seem to have here. For arguments’ sake, let’s say both mortgages were for thirty years and went awry in year one. Now, let’s assume in another scenario, they hadn’t gone awry but their home-owners still paid their monthly dues, and all was fine. Now we are at the beginning of year two, with 29 years still to go in both cases. The banks who hold non-default mortgages (of the latter two “good” debtors) they didn’t have to write down, do they have more money than if they held written-off defaulted mortgages? Not at all, in each case each bank still misses 29 years of future payments, only in one case they’re hopeful they’ll get them all, in the other they already know they’ll never recoup their original investments. So is there de-facto monetary contraction a.k.a. deflation when a mortgage defaults? Not in the least – that money is still out there, but, what is worse, the Fed (and the state) has additionally already made up for the next 29 years’ loss in many cases by re-funding banks, buying up shoddy paper etc. So the banks now have MORE money on their hands even than in any non-default “healthy” scenario!!! So in the last analysis the money “out there” has even doubled wherever there was something similar to the nowadays quite normal default-and-bail-out scenario just described. What’s more, with helicopter-we-won’t-let-it-happen-again Ben this is historically unprecedented.

St. Louis Fed – Series: AMBSL, Adjusted Monetary Base (Money Created)

So, to cut an already long story short: money was inflated in the past twenty years (actually since the 1960s, forcing Nixon to finally completely debase the dollar in 1971 after which the party really began) to historically unprecedented levels and in the past three years it was expanded once again to now even “unprecedented-unprecedented” levels. All we now have to ask is: is it likely that an expanding money supply, given the law of supply and demand, when it meets an even shrinking base of goods, will likely lead to price increases or decreases? (I am not a market-timer so am loth to make predictions as to what happens exactly when -if it were so easy, we’d all be Warren Buffetts-, and it has been argued again and again that allegedly “we see no prices rising” -which is wrong, by the way-, but I certainly wouldn’t underwrite a deflation scenario, whether in the classical terminology of monetary contraction or the “modern” of across-the-board price decreases for all consumer goods or asset classes etc. – And look at gold …).