Inflation or Deflation (Taking Money Back - Part 2)

I was just rereading my previous blog post Taking Money Back and I think I could have done a better job connecting the dots. In the first paragraph, I talked about rising food and oil prices. In the second and third paragraph, I talked about monetary inflation and how this new credit and money was chasing too few investment opportunities. I didn't really explain how this is leading to higher food and oil prices. But before I get to that, I want to provide some more background.

There is a great debate among many economists that I read on whether we're experiencing inflation (the creation of money and credit) or deflation (the destruction of money and credit). And this is just among those who would consider themselves followers of the Austrian School of Economics. In one corner, there are people like Mike Sheldock of Mish's Global Economics Trend Analysis that argue we're seeing deflation. He points to the destruction of credit in the financial markets, the fall in housing prices, the downward pressure in wages of American workers, and the falling stock market. On the other side are people like Peter Schiff of Euro Pacific Capital who believe the Fed is inflating. He points to the rise in gold and commodity prices, the increases in M3 and other monetary measures, and the fall of the dollar. It is pretty interesting how economists that have very similar views on the market, the government, and central banks could disagree so dramatically on such a basic issue.

My opinion is that they are both partially right. As I pointed out in my previous post, we've seen global savings double in a very short period of time. This was due to massive inflation by central banks across the world. The Fed kept interest rates far below the market rate for years creating enormous amounts of credit and liquidity. The Bank of Japan had the most accomodating monetary policy imaginable with 0% interest rates. The Chinese and Middle Eastern countries were accomplices to the Federal Reserve with their dollar pegs that resulted in them inflating to keep up with the United States. This led to global savings doubling in such a short time. This wasn't simply real savings resulting in people deferring consumption in order to save for future consumption (what individuals do when they decide to save for a house instead of spending it on the movies). This was massive amounts of new money being created and lent out.

The reason this worked for so long is because we had massive productivity increases with the advent of computers, the Internet, and the growth in the BRIC economies. This helped mask the inflation. All these productivity gains should have caused prices to drop dramatically, but central banks fear falling prices and governments love inflation because it allows politicans to finance their pet projects. So we had years of massive inflation, but prices of most things we consume rose only modestly as the increases caused by the new money was somewhat offset by productivity gains and low wages of foreign workers. The purchasing power of savers should have rose dramatically, but instead it barely kept up.

But all that new money had to go somewhere and somewhere it went. Fixed income savings of $70T wants to get a good return. And getting a 1% return on treasuries when even the CPI is higher isn't a successful recipe for pension funds and insurance companies. All that money went into the biggest credit bubble the world has ever seen. And there's been plenty of good articles and blogs about this subject. I highly recommend This American Life's episode titled The Giant Pool of Money.

So now the housing bubble has popped. Billions if not trillions of dollars of credit are being destroyed. When somebody defaults on their house and the bank can only sell it for 60% of the mortgage, that other 40% is just gone. That's true deflation. That is destruction of money and credit. The money came into existence out of thin air when central banks and the financial system created it and when that loss is written off, it just goes back into thin air. This is the deflation Mish is referring to. But what is the inflation Peter Schiff is referring to? Ah, this is where it gets connected back to rising oil and commodity prices. While there may be some credit deflation happening, most of that $70T is still in existence and it's trying to find a new place to go to find a return. The interest rates on treasuries are very low partly because the Fed has dropped the fed funds rate to 2%. That is a negative real return on money when compared to even the understated CPI. If these investments can't get a decent return on bonds, some of it is going to go to other places like precious metals and commodities.

But this is still only part of the story. The United States created so many dollars in the past and the world just doesn't need that many more. China and the countries that supply us with oil receive enormous numbers of dollars, way more than they need to buy stuff that we produce that they want (i.e. the trade deficit). And because the dollar has been the world's reserve currency for decades, all the wealthy countries in the world have already accumulated huge numbers of dollars. And they are beginning to wonder why they should keep accumulating this paper. And basic supply and demand says that if the demand for dollars is decreasing, the prices of things denominated in dollars will rise. And they are. The entire world wants more oil and food. They want fewer dollars.

So that's pretty much the story and we can expect it to continue for a while. Even if there's lots of deflation happening in the credit markets, that deflation is small compared to what will appear to us like inflation if all the countries that have accumulated trillions of dollars start sending them back to us to purchase real goods. The purchasing power of the dollar will keep going down until the imbalances are fixed. And then it may overshoot because markets often overshoot. Politicans will predictibly blame "evil" speculators and the "dangerous" free market. Funny that they didn't blame speculators and the free market when housing prices were rising. At any rate, the blame lies fully with the government. None of this could ever have happened under a gold standard.