Saturday, June 13, 2009

Inflation/deflation; lies, distortions, and economics

So this post is kinda an exploration of inflation and deflation, what causes each, and why you can have economists proclaiming that we needn't fear inflation despite the fact that the government is printing and spending record amounts of money out of thin air (at last count, roughly 4x the record deficits during the Bush administration, which itself was criticized for out-of-control spending). I don't think I have all the answers; I'm not an economist, or a financial planner, and I didn't even really take an economics course in school (I did econ on independent study in HS, which mainly consisted of playing games on the computer between acing the trivial tests). Nonetheless, I'm going to take the opportunity to explain my thoughts on the subject, educated or not, and perhaps they will be enlightening.

To begin, the value of goods/services (which I'll call goods) in currency generally varies with two factors: the supply of the goods, and the supply of currency. Basically, the more of a good you have, the less it will cost, and the more money there is to buy the same amount of a good, the less it will cost. We can also consider the traditional supply/demand relationship when examining price, but if that is constant, the price will only fluctuate with supply of goods and money. If the supply of goods is also constant, than the only thing which affects price is the supply of money; this is the basics of inflation/deflation.

Now with fractional reserve banking, the situation becomes a little more complicated; not because the basic ideas have changed, but because the definition of "money" has changed a bit. Since people can borrow far more money than actually is on deposit (this is how fractional reserve banking works), and that borrowed money can be spent interchangeably with normal money, the supply of money is more or less the supply of money and credit (in government statistics, this is the M3). As you can imagine, this has been shrinking recently as lending standards have swung back toward rational in all but the government-subsidized or controlled lending institutions, and credit has been severely reduced. This, by itself, would create deflation: there's less money to buy goods, so they should fall in value.

As an aside, deflation can be a good or bad thing, depending on your perspective. In one sense it's good, cause everything is cheaper, people can buy more stuff, etc. On the other hand, if you're heavily in debt, deflation can make it harder to pay back money as monetary amounts go down semi-uniformly. So if you have savings, deflation is good for you; if you're living recklessly and have accumulated massive debt living above your means, deflation is bad for you. Also, deflation can be bad for businesses that rely on discretionary spending, because people tend to wait on purchases more. Ok, back to the general topic...

The question arises: how can the government print nearly $2 Trillion dollars to waste on agenda items, fraud, and handouts to insider cronies, not to mention the $2+ Trillion the Fed has handed out to banks as rewards for creating the current recession, and not have that create inflation? Well, first, the amount created and handed out is less than the credit removed from the private banking industry, so in spending money terms, the supply is still decreasing. Second, there are no good places to invest money in the economy currently, since the housing market still has a ways to fall and everybody who manages money knows that the US economy will not start to really recover until housing bottoms out; and with the government making sure the recession is not over quickly, most people are stashing their money in "safe" places (eg: Treasuries), and there's not a lot of private lending going on. These two factors mean that on the whole, the supply of "money" is still shrinking, which means we should see some deflation.

So when, if ever, does the massive print/spend push come back to haunt us? Well, as close as I can figure, when the economy finally bottoms out and starts expanding again, we'll see all those newly-created dollars being used as fractional reserves for more lending (at which point there could be a bigger bubble than the previous one). Alternatively, and probably before that point, investors holding US debt could lose faith in the ability of the US to service its debt, at which point they would demand higher yields for long-term debt (as is already starting to happen). The servicing of the national debt is already a large percentage of the government's annual spending, so if the interest rate for that debt goes up substantially, it could overwhelm the budget, causing the fear to become a reality. At that point, we get hyperinflation, and/or the government defaults, the currency becomes worthless, and bad things happen; but in the interim, we keep merrily skipping along toward the abyss.

So at this point, we would expect to have gradual deflation until credit expands again, followed by greater inflation, then possibly followed by an eventual collapse of the currency; and events could unfold that way. However, I'd also point out that the actual economics are more complicated and subtle: for example, if you borrow money for commercial ventures, do you really spend it uniformly (creating uniform inflation), or do you spend it on specific things? If you're speculating on the market with 30-1 leverage, what are you buying (which drives up the price for that thing while everything else remains constant, eg: oil)? As housing prices "deflate" from their bubble levels and consumable prices go up, is it accurate to say we have "deflation"? All of these factors (and many more) contribute to the complicated actual machinations, and make it hard to analyze what's actually going on.

Where do we stand? Well, aside from this being a somewhat rambling post, I think it would be foolhardy for our government to print and spend while ignoring the negative consequences. I also think that as Ron Paul is fond of pointing out, we'd me much better off without the Fed and their artificial currency manipulation, and with a fixed-value currency based on a physical commodity (eg: gold standard) or fixed amount in circulation, so as to have a stable currency to conduct business in. I think it's clear that fractional reserve banking contributes to more exaggerated swings in asset valuations, and government attempts to compensate for those swings are just making the problem worse (while siphoning public money to corrupt insiders, of course). Finally, I think it's silly for the government or its proxies to claim that increasing the national debt by approximately 20% in one year alone is anything related to responsible or good for the country, and there will be consequences. Of course, that's just my opinion, and I could be wrong.


  1. If you link currency to a precious metal, your currency’s value is affected by arbitrary fluctuations in the value of the particular metal. If you have fiat money, its value is affected by arbitrary bad monetary policy decisions. If monetary policy is sound, fiat money is preferable.

    Your article points out that the loose monetary and fiscal policy we’ve had in response to the credit crises has merely offset the decrease in M3 due to deleveraging. It seems to me if the Fed and Congress are diligent about hitting the brakes when the time comes, all of this borrowing and printing money might work out well. The famous saying is the Fed needs to take away the punch bowl just as the party gets really going.

    I too am skeptical, especially about fiscal policy because there’s no independent fiscal policy board. (I think there should be.) I really doubt when the economy starts going and prices start rising Congress will respond with a one-time anti-stimulus tax requiring middle class families to send in $600 to be put toward the public debt and help slow down the economy. If they did that, though, I would think stimulus packages would be an okay idea. A great idea would be to encourage middle class families to save up their own "stimulus" funds so that ups-and-downs of the economy would not require radical action on the part of the gov’t or Fed Reserve.

  2. I agree that in theory fiat money is better, if there's a constant amount of it, because it doesn't vary with the perceived value of any other asset. However, history has shown that any country with the ability to create more of its fiat currency will do so until the currency collapses, due to the inherent greed of human nature, and putting political interests higher in priority than long-term stability. Given that, I'd rather take my chances with the asset value fluctuation.

    Nothing in history (recent or otherwise) suggests that the Fed will be willing or able to remove excess currency from the system once it has been created. Congress and the President would rather remove the Fed governors forcefully than allow this course of action. It's like saying public health care could work if it were drafted and controlled by someone adamantly opposed to socialization of the health care industry (an argument I have made myself): it may be true, but with our government and political system, it's really just a straw-man fantasy, and it would be worse if done within our current system than not doing it at all.

    I don't think the "stimulus" waste bill would be a good idea, even if Congress took back the money from the people once the economy recovered (which would just amount to wealth redistribution); primarily because I don't think the economy was/is suffering from a lack of prodding, but rather from large systemic imbalances created from years of easy money and massive leveraged risk. Until those imbalances are corrected (which will take time, and be delayed by government meddling), the economy cannot get back to "normal". Everything the government is doing, every single thing, is hurting the economy, delaying the recovery, and shrinking the prospects for long-term renewed prosperity in the US.