Home > Debt, Deflation, Economic Fallacy, Economics, Financial Crisis, Inflation, Mortgage > Economic Fallacy III: Looming Deflation?

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 leastthat 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)

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 …).

  1. 2011-03-24 at 10:47

    You could still be right. We will see.

  2. 2010-06-03 at 01:00

    I think that ultimately both the inflationists and the deflationists will be proven correct. This is the view of the best macro economic hedge fund manger, Felix Zulauf

    Here’s a transcript of an interview in May 2010 where Zulauf describes how hyperinflation would follow deflatio:

  3. jdg
    2010-03-26 at 03:49

    So why the heck are banks hording their money and not lending? Why the heck are they now letting families live mortgage free for months so they won’t have to take the hit on their books?

    I personally think we will have biflation….inelastic goods will be in demand; food, oil, etc but everything else will be rock bottom.

  4. 2010-03-21 at 18:05

    I agree with part of your conclusion: “I certainly wouldn’t underwrite a deflation scenario…” But I think some of your arguments are faulty.

    I’m not happy with your claim that when someone who owes money to a bank defaults that the “money is still out there”. Assume that A borrows $B from bank C and pays the money to D for some asset, like a house. D pays the money into bank E. This means that A owes $B to bank C and bank E owes $ to D. To keep it simple, say A then TOTALLY defaults: i.e. can’t pay the money back, plus the house turns out to be worthless.

    D is no worse off. That is, bank E is still in debt to D. But the bank C is definitely worse off. Bank C regards itself (righly) as having lost money. And banks with toxic assets or inadequate capital won’t lend. That is deflationary.
    And most important of all, the physical asset underlying the various debtor / creditor relationships between A,C,D and E has effectively vanished.

    Also, even if the “amount of money out there” IS constant, this does not preclude big changes in the velocity of circulation of money, and hence big changes in GDP. The velocity of circulation of money in New York declined by about three quarters between around 1929 and 1932.

    • 2010-03-21 at 21:22

      Hi Ralph, thanks for commenting. You are right that there are other scenarios where a default causes side-effects, e.g. a chain reaction, very like e.g. when a neighbour has been mugged at night all other neighbours tend to go out less too, i.e. banks lend less even if they haven’t been “bitten” yet etc. Also when debt has been securitised things change too, depending on whether the bond/CDO etc. was bought outright or on credit again, and in most cases with maturity mismatched short term credit. I will come to that more complex stuff in upcoming posts which also cost more research and annoations so they are slower in being published. Take each of my posts only for what they state, and in these particular articles I wanted to dispel the notion that default per se was deflationary as is time and again parrotted in the media and even in academia. I want to be the thorn in the side iof all those who tell the populace at large that these things are so darn complicated that it takes rocket scientists to figure out what went wrong. All those reckless bankers and their academic mouthpieces hide behind smoke screens and I am the flue. This blog’s main purpose is to enable a layman, so to speak, to take any argument apart and, hopefully, understand it fully, then find it flawless so that he (or she) can confidently use it in political or economic discussions. And if I feel someone proves me wrong at the respective core of an argument I hope I will be unpretentious enough to acknowledge it.

  5. Michael Kotov
    2010-03-19 at 21:05

    Actually I dont agree with you. If you go to site http://www.shadowstats.com you can see that the M3 money supply has been falling in the United States for the past year. This means that there is less money in the system right now as companies are paying down debt, which is deflationary by itself. This is because a lot of the money came not from banks but from market firms, such as real estate brokers and hedge funds. This is known as a market-based financial system, vs the traditional bank based. In such a system banks only play a secondary role, and institutions such as hedge funds and investment brokers play a primary role.

    Also you talk about money not being spent being invested. But that means that someone must want to borrow that money. Now the bank reserves with the Fed are at 2 trillion +, yet no one wants to borrow or lend it.

    bubbles are an important part of the modern economy
    since it is based mainly on glamour, consumption and speculation.

    • 2010-03-19 at 21:28

      Thanks Michael for commenting. I cherish that discussion. I totally agree (and put it in my Bloom of Doom series) that there’s excess reserves (historically unprecedented) and M3 seems to have abated, and probably largely for the reasons you mentioned. So I totally agree that “on paper” the larger monetary aggregate M3 has been deflated while at the same time M0/M1 have shot up vertically. So in this first step I have argued, somewhat obliquely, that if inflation is the expansion of the monetary base, hey presto, look at M1 – there it is. And secondly I have tried to dispel the notion that falling prices, bursting bubbles etc. destroy the money that was once spent on them – they certainly do not (see also Economic Musings III). These two arguments will be the stepping stones towards the reasoning why all this potentially is hyperinflationary both in prices as well as in broader money supply. This whole subject is rather complex and technical and since I want to keep this blog readable in a way, to give an example, that someone could take an argument from this blog and ask it in a town hall meeting without fear of being shot down, I need to proceed gingerly and systematically. So once I have finished my research so that I can fully annotate that follow-up post the picture will be complete I hope. And should you care to comment on that one then I’d feel honoured …

  6. 2010-03-19 at 20:19

    The money supply can settle some arguments. The only measure that’s appreciably shrunk has been M3, which is no longer tracked by the Fed. M2 has grown a little all through the crisis, and M1 has grown a fair bit.

    There’s no way that real deflation can erupt under these monetary circumstances. The money supply has to collapse, which it hasn’t. Given that the Fed itself considers M3 to be unreliable, the deflationists have really been sitting on a thin perch.

    Of course, some may argue that the money supply would have collapsed had it not been for the Fed taking action. But that point just opens up another question: as long as the Fed is ready and willing to do so, how can real deflation erupt?

    • 2010-03-19 at 20:33

      Well Daniel, indeed: I have no qualms about speculating that if the Fed had not intervened deflation (in the sense of monetary contraction and then falling prices for many goods) could have happened. In fact, that’s as natural as when someone starts healing from a consumptive disease – they lose weight. But as you say, the money supply M1 has skyrocketed and while it has not all been funneled into the economy yet, my argument is that it will (I can’t see why not – then, pray, what have they ever created it for at all?). And when it does another law kicks in: whenever there’s considerable, noticeable, fearful, whatever you may call it, inflation where people are afraid to hold onto the money they get (e.g. in wages, through sales, inherit it etc.), they immediately spend it leading to an actual money scarcity in circulation! This is a natural reaction. And time and again politicians then demand more money to be printed because “see – there’s not enough to go ’round”. It’s like if someone has a fever and shivers to suggest to raise body temperature. This then is the last leg towards hyperinflation and we’ll see it in our lifetime.

  7. John
    2010-03-19 at 19:24

    You can’t print up enough money to compensate for the losses in collateral that banks and lenders have suffered. They will soon have to recongnize these losses because the people they lent to are broke and out of jobs and many are soon to be without pensions. Good luck on your inflation dreams.

    • 2010-03-19 at 19:43

      Hi John, didn’t I recognise that in that post? Yes, banks suffer, but they have been recapitalised. In other words: the money they originally lent has been spent – so someone somewhere still has it. It has not vanished as it would if it were repaid. Repaying is potentially deflationary, defaulting is, all other things being equal, always inflationary! PLUS the money has been redistributed to these insolvent via bail-outs, “quantitative easing” and other shenanigans. So at least it would have effectively doubled. However, as you can see from the St. Louis Fed’s chart, it has even tripled and is growing at a straight almost vertical line. I doubt even Zimbabwe was as bad! They actually found it easier now to abandon their money for the US dollar. If Hitler had dollarised Germany I would have been worried if I was Rossevelt. All I’m asking is: how on earth can one call a tripling (so far) of the money supply deflation?

  8. 2010-03-19 at 02:43

    The flaw in your analysis is the reduction in credit made available to businesses.
    Business lending is falling off a cliff and this is ultimately deflationary.


  9. 2010-03-18 at 21:00

    It irritates the hell out of me the inflation / deflation issue. For there are a few truths to consider in REALITY rather than the fictions on paper:

    1. the money that I pay into a pension fund when I’m twenty or thirty will NEVER have the same purchasing power by the time I get it ‘back’ as my pension

    2. inflation is simply too narrow and too short-term a measure

    3. as soon as inflation is measured long term, the reality of the loss of purchasing power of the CURRENCY becomes apparent; but then that’s what is supposed to be disguised!

    4. whether we call “it” in- or deflation: those who don’t have enough to survive and have had their homes repossessed should be asked for their needs, not the economists who describe and generalise without referring to the essentials of ‘money’ and ‘currency’. I’ve just come across an interesting post on the difference between money and currency on http://bit.ly/aTzHuB.

    What becomes apparent is that all the ‘credit money’ has led to controlling ‘legally enforcable debts’ and interest payments. Money has changed from ‘medium of exchange’ to ‘tool to control’.

    For money makes the world go round. And he who creates it rules the world. And that changed in 1694 from king to central bank. In London, England.

    Yours in economic irritation,

  10. 2010-03-18 at 14:33

    As far as I understand the “deflationists”, they point out to the fact that in a delevarging phase debt is being paid back. THAT money actually “disappears”. You are right that – somewhat counterintuitively – debt DEFAULTS are more “inflationary” than regular and “orderly” deleveraging because the money actually does not “disappear”. But that is not the point they make. The deflationist view is: no net “credit money creation” due to deleveraging, due to lesser lending, due to lesser credit demand and capital impairments on the side of the banks. As an addendum: Base money does not buy bread or anything else for that matter and “excess reserves” held at the FED neither.

    • 2010-03-18 at 15:08

      Hi Fabio, nice to see you back. Am still working on the “debitists” by the way 🙂 Your points are all true, but the “pure” deflationists IMHO erect a myth when they say debt has been paid back net. Some debt has been destroyed by default, leaving, as I argued, the money “out there” to chase ever scarcer goods, while more credit has been created, be it monetised sovereign debt, “recapitalised” banks etc. Even if the state bought equity instead in fact that expanded the money supply as that equity had once before been bought by someone else and the proceeds spent. So in effect the Fed and the government double the money wherever they bail out an insolvent bank in which ever form while they add more money on top of that via stimulus programs. And I equally agree that the monetary “base” per se does not buy bread, it has to be spent via the transmission of bank credit or … state spending. But that does not mean that it won’t eventually take these routes. In fact, the discussion about “forcing” banks to lend is pointing to the scenario where those who created this enormous glut want it spent and not held in reserves forever. But if my intuition is right, we will see this in the coming months, years at the latest.

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