Inflation Outlook: deflation fears are irrational
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Mises Excerpt: The
course of a progressing inflation is this: At the beginning the
inflow of additional money makes the prices of some commodities
and services rise; other prices rise later. The price rise affects
the various commodities and services, as has been shown, at different
dates and to a different extent. This first stage of the inflationary
process may last for many years. While it lasts, the prices of many
goods and services are not yet adjusted to the altered money relation.
There are still people in the country who have not yet become aware
of the fact that they are confronted with a price revolution which
will finally result in a considerable rise of all prices, although
the extent of this rise will not be the same in the various commodities
and services. These people still believe that prices one day will
drop. Waiting for this day, they restrict their purchases and concomitantly
increase their cash holdings. As long as such ideas are still held
by public opinion, it is not yet too late for the government to
abandon its inflationary policy. But then finally the masses wake
up. They become suddenly aware of the fact that inflation is a deliberate
policy and will go on endlessly. A breakdown occurs. The crack-up
boom appears. Everybody is anxious to swap his money against "real"
goods, no matter whether he needs them or not, no matter how much
money he has to pay for them. Within a very short time, within a
few weeks or even days, the things which were used as money are
no longer used as media of exchange. They become scrap pater. Nobody
wants to give away anything against them. It was this that happened
with the Continental currency in America in 1781, with the French
mandats territoriaux in 1796, and with the German Mark in 1923.
It happened with the dollar in 1973. It will happen again whenever
the same conditions appear. If a thing has to be used as a medium
of exchange, public opinion must not believe that the quantity of
this thing will increase beyond all bounds. Inflation is a policy
that cannot last - Ludwig von Mises, the Theory of Money and
Credit
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It might be reasonable to think that after
writing about a subject once, there'd be no need to write about it again.
But it just ain't so. I don't mean to say that readers don't get it. Rather,
the writer screws it up. After all, writing I've learned involves communicating
my thoughts. Sometimes, however, I don't even understand them. More often,
my thoughts are never complete. I'm always learning something new that
changes the way I see the same idea as before. In other words, my perspective
is constantly changing. I'd like to imagine it's progress but haven't
sought a second opinion on that yet.
So consider this an update on our inflation
outlook, which is still largely the same. If you haven't seen our past
perspectives on the subject of inflation versus deflation, here is a short
list of the core essays I remember writing about the debate. Although,
I haven't reread them since writing them, so there may be some perspectives
we've long since abandoned:
I guess if there's a pattern there, I'm
a little early this year. Kidding aside, the three I'm most proud of are
Inflation vs Deflation, Inflation Paradox, and the Money
is No Good.
In a 1948 Congressional address, Howard
Buffett warned of the same fate - as Mises describes in the box to the
right and as we argue is our plight today - fifteen years after the gold
standard was canned and a couple of years into the notorious Bretton Woods
deal that ended almost precisely in the manner Buffett warned it would.
Nobody listened as he tried to build a case for the connection between
freedom and gold money.
At any rate, our view is not that deflation
is impossible, but that it is unlikely until after the worst of the dollar's
collapse is behind it.
Note in the Mises excerpt how important
a role perception plays. Can public opinion be swayed today? By what goes
on in the press these days, it would seem so. By the way, some of you
may know Mises wrote an entire text on the theory of money and credit
without using graphs to explain any of it. In fact, he even made a point
of avoiding the use of the word inflation in that work which is all about
it.
I used to think about inflation and deflation
constantly. I still do. So do you, I think. We all do. It's important
for valuation and strategy. Nevertheless, some gold bulls have determined
that gold is as likely to go up in a deflationary environment as it is
in an inflationary environment. I couldn't disagree more, though for years
during the nineties, I too believed that gold could go up in a deflation,
because it was the only asset with no liability, etc., and people would
hoard it regardless. But regardless of what is the key question. It's
hard to imagine circumstances where participants lose confidence in the
dollar that don't fit the model described by either Buffett or Mises,
or even just the historical record post 1933. If we're talking about a
shift in monetary value, subjectively, from currency to gold during such
times, it can't be isolated to gold.
In fact, both gold and the CRB trace the
same path historically. And if during such times, where there is a loss
of confidence in the dollar that results in such rising commodity values
and prices, someone is able to make the case for deflation, they are making
the oversized assumption that somewhere along the line there is a policymaker
that's infallible. For, how else is a fiat paper monetary regime going
to be restricted? To think that somehow, forces beyond our control will
result in a contraction in the money supply and deflation in terms of
the dollar is to delude yourself. I hope you'll understand why by the
end of this report.
Inflation/Deflation: It's About Value
This essay is for the reader that
understands why the definition and process of inflation go well beyond
what is implied by the CPI and PPI, but is perhaps confused by the array
of propaganda nonetheless.
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What is the dollar's liquidity premium?
A JP Morgan slide show last
September began with the following quote on the cover page:
"The relative price
of gold is driven by (and is the reciprocal of) the real rate
of return from capital markets." Summers and Barsky
As in Larry Summers ex-Treasury
secretary. He is correct on that score. This concept forms the basis
for our hypothesis about the dollar's investment premium, or more
accurately, its liquidity premium.
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Why
do we insist the likelihood of deflation is so low when everyone's talking
about it?
What it boils down to after a close examination
of all the logical paths is the value of the currency that we're inferring
to be the money. Is it over or under valued? That's the question. For,
aside from the question of the dollar's value, there's nothing but inflation,
everywhere in fact. There always has been. And if we're right that the
dollar is overvalued, how on earth could policymakers keep a check on
prices even if they tried?
Major historical events can be mapped around
the history of money and inflation. In fact, if you asked me, the world's
entire history could be mapped around the struggle between the State and
market over money, its role as well as its possession. Jefferson may have
said it better. Still, the point is that fiat monetary regimes are inherently
inflationist, and inflation is politically expedient. Greenspan said as
much in his controversial gold speech that had nothing to do with gold.
Nonetheless it would be simplistic and
naive to think that all of our problems could be solved by eliminating
money, since after all, that thinking is precisely the root of the problem.
The Fed is after all in charge of alleviating the discipline of money
- shifting risk - as if to say money isn't necessary but a central bank
is.
The State has always tried to overcome
the market's grip on the affairs of money, and the twentieth century was
no different in that regard. Moreover, it's always in the name of making
life easier that it succeeds. Inflation is a political doctrine. As long
as the government has control over money, it won't go away. Indeed, either
our governments have become extraordinary deceivers or people have become
extraordinarily ignorant. For, not only do we believe the government when
it says there is no inflation, but also, the fear of deflation has spread
through the investment industry like I would imagine the fear of retribution
spread through Massachusetts in 1690's America during the Salem witch
hunts. In both cases the fear is irrational.
There is another irony inherent in fearing
deflation in our kind of economic system. Think about it for a moment.
A government that thrives on inflationist policy has the good fortune
of a population that believes it must step on the inflation gas pedal
to avoid deflation. If you don't understand the irony, note the "government
that thrives on inflationist policy" part.
Okay, in this world of derivatives, futures,
multiple markets and financial intermediaries it may be easy to fall into
the trap. It's probably enough to make the average person's head spin.
Maybe a little parable and narrative will
help.
Consider, for instance, a closed economic
system controlled by a profligate Monarch. Assume also that we begin monitoring
the Kingdom when it is using a one ounce gold coin for money, and that
our act of observing doesn't influence the experiment.
The King's hedonic lifestyle and the Queen's
exuberant shopping sprees have pushed the Treasury to the brink. Concern
now grows over the economy, which has come to rely on credit expansions.
An entire street of vendors grew prosperous by the Queen's generous whims
alone. But now after they've stocked up on record inventories of the Queen's
favorite shoe, there is no sign of her. The King and Queen are tapped
out. Weeks go by, and still, there's no sign of her. Prices fall. The
specter of deflation is in the air. Now that everyone's afraid of shoe
price deflation, the King declares new coinage.
A new coin will be created, which will
stimulate commerce. Only, it won't have an ounce of gold. It will have,
say, three quarters (the King's old okay). Suddenly, there is more money,
25% more in this instance. Guess what happens to prices? They go up. Why?
Because the value of the coin falls. Though it may not fall by 25% against
everything. It might hold its value in terms of the inventories that are
surplus at the moment for instance. Its value will be relative and determined
by each specific transaction. If the King doesn't tell us how much gold
has been shaved off, it might take a little more time, but its value would
still fall sooner or later. All the while, the King's CPI index would
undoubtedly report that inflation was under control!
Nevertheless, what happened to deflation?
Is it accurate to say the King's debasement prevented deflation? Yes.
But there's an important point here. It was predictable because the economy
had come to rely on the expansion of credit. In other words, how could
the King, who brought this on his kingdom, refuse his subjects who too
have been spoiled by a profligate monetary system? The economy has become
corrupt. It is in fact more than predictable, in some sense it's inevitable
that any man-made objection to expand the money supply in a fiat regime
based on inflation like ours is a pit stop, at best, fraud at worst. If
there was one thing we learned from the German experience of hyper inflation
it is precisely the rejection of restrictionist policy for this reason.
What, will we all wake up one day
and say, we've had enough of this life of excess, let's allow the market
to build sound money now?
Yet that's essentially what's required
to accept a deflationary fate. One day we'll have to accept deflation.
However, the history of human progress is littered with crises because
we tend not to deal with problems until they turn into a crisis. So until
either the world is filled with an unprecedented moral courage, or until
deflation is shoved down its proverbial throat, inflation policy will
be the preferred method of postponement. It would be a
stretch to believe that contemporary democracy would abolish the Fed and
cry out for sound money. After all, none of its participants seem to even
acknowledge that it's their own interests the government has in mind when
it chooses to inflate/debase. It's as if there's a silent contract between
the agent of inflation and its customers. People willingly allow the Fed
to inflate so long as it can persuade them inflation doesn't exist.
The Fed really only needs our permission
to carry on the inflation. But make no mistake about it, the Fed's job
is to sustain the inflation, not fight deflation. It's mere existence
is enough to prevent real deflation. Though even if the moral capacity
existed to make the transition to sound money, we'd still have to contend
with inflation because such a transition would involve the market's determination
of what money is.
While in a closed system it may be hard
to drum up confidence in the value of the coin (or currency today) after
debasing it, in an open system of trade, it's still perhaps hard, but
there's a way. If the King would open his Monarch to trade, for instance,
and through this scheme were able to persuade foreigners to invest in
his Kingdom of excess and counterfeit profits, the value of the coin might
even perhaps rise for a time, depending on the success of his promotion.
In other words, if "the real rate of return from capital markets"
appears strong, the coin will attract new demand (liquidity).
And if so, he might just continue shaving
off more and more gold to continue stimulating the so-called economy.
And when the excess becomes so decadent that there is almost no gold left
in the coin, and he's pushed the Treasury again to the brink such that
it has constrained his ability to continue the counterfeit expansion,
deflation fears would once again set in. But they wouldn't survive long,
because the coin is in fact worthless. Not only does it have no intrinsic
value, but its monetary value has been spent. It has become so worthless
that the market is about to decide on something else for money altogether,
and there's nothing the King or his subjects could to do about it except
hope that the economy produced enough garbage in the boom to sustain them
for a while. They could call it productivity, and talk about how it'll
absorb the inflation.
Anyway, assuming people don't fall for
it, at that point all prices would rise, because people have become "suddenly
aware of the fact that inflation is a deliberate policy and will go on
endlessly." The economy would
no longer thrive as it did when the inflation was "under control."
And so, at that point, people would no longer fear deflation while rooting
for inflation. The wrong prices would be rising! They would learn to despise
the inflation. Until we reach that point, we're likely to be surprised
at the Fed's creative ability to stimulate inflation each time
the threat of deflation appears to mount.
You see, until people decide they want
deflation more than inflation, they are unlikely to get it through the
current institutional setup. Well, it's not that simple. But up until
now, their experience with inflation has been good. It's been so good
that Americans now routinely beg the government to "do something
for their economy." They mean inflation, more of it, but the
good kind. Not the kind that makes the value of the currency fall. Rather,
the kind that stimulates commerce and, uh, of course, stock prices! The
kind where the perceived rate of return in capital markets is real and
caps the relative price of gold (this is how they kept inflation in check
through the nineties).
No wonder investors still aren't really
listening to the gold argument. They don't want to believe it. They want
to believe that the government and Fed are doing all they can for the
economy, and their dollar assets, to stimulate commerce. Believe me, they
are. Only, there's no gold left in that coin, and the entire world owns
dollars, still waiting on those positive real returns to de facto hold
down the relative value of gold.
Sure, we'd accept that if the Fed stood
aside, and interest rates spiked upward, there would be an escalation
of loan defaults. But that's just the point. The Fed's job is to inflate
those loan values and thereby sustain unsound credit expansions, and as
long as investors have confidence in the Fed, deflation is a misnomer.
Deflation is seen to be an evil greater than that of inflation today,
but only because we've become so indebted. In other words, we've become
vested for inflation and there is not one legitimate institution we'll
allow in our way, including the institution of sound money. Of course
such a society would fear deflation.
Certainly, if the Fed didn't exist the
money would be sound. But we don't want that. We'd rather our children
dealt with it.
The deflation noise today largely emanates
from sectors feeling the pinch, and it has long outgrown the manufacturing
sector. In other words, it increasingly is evident by those sectors of
the economy that are most dependent on the success of the King's prior
inflation schemes and are pressing for more. The noise is probably getting
louder because the schemes aren't working despite efforts.
The Fed has slashed interest rates to almost
zero from 6% over the past two years. But the goldilocks economic
formula where low interest rates boost consumption, equity values, and
even profits for a time has shown no sign of life. The problems surfaced
when stock values became overly expensive during 1999 and when that in
turn limited the ability of stock market gains to drive increasing earnings
momentum. Since then, declining real returns have been weighing on the
dollar and supporting gold values. In layman's terms, the ponzi scheme
broke down. And now that weakness has become apparent in the bond market,
the Fed has indicated it might cap long term bond yields in order to fight
deflation!
Meanwhile, they've been trying out a new
formula. Inflation of real estate values. But not the kind where real
estate prices reflect a growing monetary premium because the dollar is
falling apart. The kind where the housing inflation begets the perception
of strong real returns so that the dollar doesn't fall, and interest rates
stay low, and that credit could expand indefinitely. In other words, their
new formula is simply that they're targeting real estate paper markets
rather than stock markets per se. Of course they'll deny it.
We aren't arguing that gold should be money.
We are just arguing that it often is due to the persistent inflationist
dogma inherent in our society. It's so pervasive an entire generation
doesn't believe it exists. Almost like the air we breathe, except worse,
since at least we acknowledge that.
A growing chorus of analysts are accepting
the dollar's overvaluation. Yet there is also a growing chorus of analysts
that are forecasting deflation. The two forecasts contradict one another.
I think for the sake of simplicity, our
confidence in the inflation hypothesis boils down to these two main facts:
- based on a subjective analysis, we find
that the dollar is overvalued.
- based on a political analysis, we find
participants prefer inflation, uh, period.
The first one implies that the Fed has
exhausted its tools to sustain the dollar's phony value.
Anyhow, the deflation argument implies
the dollar's monetary value would be unaffected in a credit crisis, or
that the crisis would cause it to rise in value relative to most goods
as the credit crunch results in contracting "money supplies."
This idea originates from the auspices of elastic money theory.
But the theory only works in one direction
in reality, expansion. When since Roosevelt took America off the gold
standard has a contraction ever been the case for longer than six months?
The reason is always the same. No matter how governments try and restrict
or control inflationism, it never works. We've already noted the pushing
of the string analogy is more applicable to the effects of monetary policy
on real growth than it is to the ability of the King to shave more gold
off the coin of the realm, if you will. A contraction in the monetary
aggregates is a restrictionist's or deflationist's pipedream.
Besides, the implication also assumes the
dollar's monetary value is determined only by changes in
its quantity. If that were the case, it wouldn't have gained in value
through the nineties. US money supplies grew by double digits in the nineties,
and they grew faster in America than in most other developed nations whose
currency values declined relative to the dollar's. The Fed explained it
away with productivity. What's the Fed doing explaining anything anyway,
you might correctly ask? Is it defending itself, or does it have a more
active role in this fool's game today?
Change in the supply of a currency does
affect its value, but not in a straight line because there is an intermediary.
People, and their perceptions. People can only judge the value of something
relative to something else, usually the most liquid medium of exchange
(liquidity always implies demand, for if there was no demand, there'd
be no liquidity). If they want to
buy a refrigerator, they need money to do it, otherwise they'd have to
have something the seller wants. So money is simply that which people
unquestionably accept in exchange for their labor. If there's a question,
it's not money, it's probably currency.
Thus, the function of money is to facilitate
exchange, and it's meant to be kept on hand in enough quantity to enable
its owner to achieve his or her daily goals. Goods then are judged in
terms of how much money they command. But when this process of valuation
is distorted by volatility in the value of the currency people think is
money, participants are probably going to be making bad judgment calls,
overvaluing one thing and undervaluing another. This is why inflation
is all about value. That's where it strikes the hardest, at heart
of the mechanism that structures a market economy: Mises' list of subjective
values for each individual.
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A common mistake in economics is to assume
that markets are inherently volatile. This is a particularly odd
claim when the data is corrupted with enormous government spurred
interventions over the years anyway.
The idea that money should be stable in value
is one of the qualities that markets tend to prefer in it. But the
idea that the government should invent a currency then stabilize
it is financial alchemy, and economic baloney.
It doesn't work. Left to its own devices,
the market would choose a stable money. It wouldn't ever be perfectly
stable, but it would be many times more stable than anything any
government could create or than anything the world has seen in over
100 years! Ed Bugos
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To imagine the likelihood of deflation
then, we'd have to imagine the subjects in the King's kingdom rejecting
his monetary schemes altogether, perhaps even in rebellion as has been
the case historically. They would have to see that inflation is a fool's
game where they're the suckers. It would have to make people sick to have
to argue with their employers constantly over wage gains. Businesses would
have to find that the cost of doing business in dollars is increasingly
prohibitive. When we get there, deflation is possible.
As a point in fact, the only deflation
post 1934 America ever experienced was "after" periods of rapid
dollar devaluation that left the dollar, well, undervalued. And at best,
they were symptoms, rather than the real thing. Mere threats, like those
overhanging the shoe salesmen in our example, or more accurately, the
threat of deflation was an excuse for mandating further inflationary debasement.
Our most recent brush with any kind
of deflation was in the early eighties, after a massive dollar devaluation.
Let me repeat, AFTER a massive dollar devaluation, where the dollar lost
almost 90% of its value against gold and other key commodities.
The dollar faces a similar devaluation
episode in its current phase on the historical timeline, and largely for
the same reasons it did then. And so deflation may be closer in terms
of time. But not in terms of the dollar's value. Not until after the dollar
devalues by thirty to forty percent would we entertain the notion of deflation
even as a symptom.
I don't want to beat this horse to death,
but the deflation prognosis makes so little sense to me, yet it is very
alive today. Obviously it's a strong horse. But it's also the, yes, time
for a cliché, Trojan Horse. I would believe it if I saw any sign
of the aspiration to establish a sound monetary regime. Even a phony rig
job couldn't pass the public mandate today. People love inflation. It's
like the air they breathe. It's the source of their confidence.
Finally, let me be clear on something else.
As gold's monetary value increases, to the extent it gradually becomes
money, we will be experiencing deflation. The price of most things will
fall in value relative to it, particularly those assets whose value is
tied to the dollar's. That is going to be our only deflation. In terms
of gold.
As for the dollar, it's like the air we
breathe, it's everywhere. We believe it's overvalued today, and we believe
that the current policy path of world governments is irreversible.
But we also believe that the dollar could
in the future again be sound money provided the right steps were taken
and after the market devalues it.
Unfortunately for America's libertarians,
this future is at the moment nowhere in sight.
Ed Bugos
Editor - The GoldenBar Report
www.goldenbar.com
January 1, 2003
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