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Understanding Inflation and Deflation

December 18, 2002

What if I said the words "file cabinet," and you thought I was talking about a 1983 Buick Skylark? That would be a bit of an interesting conversation, wouldn't it?

That's sort of where we stand when it comes to talking about inflation (and its opposite, deflation). As I mentioned in a previous piece, the definition of inflation has changed over time and is now accepted to mean something very different from its original definition. Dictionaries only reflect what is currently popular, so such definitions should not be blindly accepted.

Originally, inflation meant an increase in the supply of money and credit. Then it morphed into: a rise in the general level of prices caused by an increase in the supply of money and credit. And now it has come to mean the CPI (Consumer Price Index).

This had caused much confusion. It can also lead to flawed analysis and some very bad policy decisions. In my opinion, the currently accepted definition of inflation is full of assumptions, fallacious reasoning, and faulty conclusions.

This piece will attempt to point out the reasons why the current definition is wrong, why it's so important that we return to using the original definition, and then comment on some possible outcomes in regard to inflation and/or deflation.

Inflation and Mothers-In-Law

I received a humorous email the other day that I'd like to employ in an effort to illustrate the faulty reasoning mainstream economists have used in changing the definition of inflation. The email was about the funny things that people write on insurance forms to explain their car accidents. In this particular case, a man and his mother-in-law had been involved in a car crash. Their car was found at the bottom of an embankment. He was fine, but she was injured. Later, the man was asked to fill out an insurance form, explaining the chronology of events that led to his mother-in-law getting injured. He put down:

"I pulled away from the side of the road, glanced at my mother-in-law in the passenger seat next to me, and then drove over the embankment."

(I know, I liked it too.) While that may indeed be a true chronology of events, we should all hope that there is something missing in the interpretation.

Now let's add an embellishment to the story. Let's say that we take this information to a mainstream economist and ask him what happened. (This is our first mistake, by the way. Economists sell answers. Keep in mind that there can be right answers and wrong answers; economists just sell answers. Ask an economist a question or ask for a forecast, and you will get an answer. When he stops providing answers, he is out of a job.)

The first thing our economist does is to assume that the correct answer can be found from our given set of data: A) Man pulls away from road, B) glances at mother-in-law, C) mother-in-law injured after man drives over embankment. By concluding that the answer lies within the data, the economist assumes that there are no exogenous events and no additional information. Next, our economist comes to the conclusion that each of these data points has a causal relationship: pulling away from the road caused the driver to look at his mother-in-law, which caused him to drive over the embankment and injure her. The economist eliminates any thought that these events might be correlated or coincidental. For example, did the driver divert his attention from the road to look at his Mom because she was telling him a story? Did one of the tires blowout while he looked at his Mom? Was the road icy? After looking at his Mom, did the driver return his eyes to the road to find a car stopped directly in front of him and he swerved to miss it?

These questions, and thousands of others, never come up. The economist just assumes: event A caused event B, which caused event C. Further, he concludes that because it happened that way this time, it happens that way every time. He further concludes that the only way a mother-in-law can get injured is if a man has pulled away from the side of the road. And he also concludes that every time a man pulls away from the side of the road, a mother-in-law must get injured. Then he goes even further down the road to nonsense and for some reason concludes that A and C are the same thing. Therefore, if the economist wants you to pull away from the side of the road, he simply says, "Go ahead and injure your mother-in-law."

So, in summation, his formula is "A causes B, and B causes C, therefore A=C."

You wouldn't get away with that one in eighth grade math class.

But that's where we are with inflation. Mainstream economists have generally made very similar conclusions from the following set of data: A) Increase in the supply of money and credit causes B) more money and credit to be chasing after the same number of goods, which causes C) a rise in the general level of prices of consumer goods. And therefore, A=C. Again, the idea that A=C is just nonsense. A, B, and C are each very difficult to define, but does that mean they should become interchangeable?

By the way, I don't accept the notion that inflation (an increase in the amount of money and credit) must necessarily leads to higher consumer prices. I'll explain why below. But first it will be important to discuss further the definition of inflation. This may seem like nitpicking, but later I hope to show why it's not.

Are There Different 'Kinds' of Inflation?

Often, commentators split the term up into two different 'kinds' of inflation: monetary inflation and price inflation. But this makes no sense if we think of how the word inflation is used in everyday language. To inflate means to fill with more of, or expand, or increase the volume of something. It does not mean up or rising. For example, if you inflate a balloon with helium, tie a knot in it, and release it, yes, it does indeed rise to the ceiling. But if you inflate a balloon with your own hot breath, it falls to the floor. In both cases the balloon was inflated, but inflation has nothing to do with direction. Inflation does not automatically mean 'up'. You can also inflate a balloon with water, or whipped cream, or pudding (if you've never had a pudding-balloon fight, you haven't lived) and in all cases it will fall to the floor.

Or how about, "Hey, come over here and help me inflate and deflate this teeter-totter." Inflate does not mean up or rising, and deflate does not mean down or falling.

Prices are something that go up and down. If we're going to use two words to describe rising prices, why don't we just say "rising prices," rather than price inflation? It would eliminate all confusion. A correct definition of price inflation would be "more prices," not higher prices. The term makes no sense. We already have terms like money velocity, a rising/declining currency, supply, demand, competition, scarcity, an expanding economy, a contracting economy, etc., to try and determine what is going on in the economy and take an educated guess at future events. And it's not like any of us are very good at that as it is. We don't need to be making the task more confusing. And this is the biggest problem I have with changing the definition of inflation: we already have words in the language to describe these other events, but we don't have a word to describe an increase in the amount of money and credit. So it is simply for the reasons of eliminating confusion and improving our own ability to decipher events that we should keep the sole definition of inflation as an increase in the supply of money and credit.

Otherwise, we will always have to rely on commentators to include the correct adjective when using the word inflation, which rarely occurs. If they don't, an intelligent question can be turned into one that sounds idiotic. For example, a reasonable question right now would be, since money and credit have been increasing and since that supposedly causes more money to be chasing after the same number of goods, and since that supposedly causes prices to rise, then why isn't the CPI going up faster? That's a reasonable question and one I'll attempt to answer later. But in today's parlance where inflation ostensibly comes in two different flavors, then the question could be shortened to: There's been inflation, so why haven't we had inflation?

We run the risk of turning discussions into gibberish. And there aren't just two definitions. We now have people talking about wage inflation, house inflation, insurance inflation, healthcare inflation, etc. Those are all prices.

I searched for information on when the change in definition occurred and could not find much of anything. (If anyone can help in this regard, please drop me a line.) But as early as 1951 Ludwig von Mises was already lamenting the fact that the term had changed in meaning (see Semantic Confusion in this speech). The Bureau of Labor Statistics tells us that the CPI was initiated during World War I, mainly because of supply-demand imbalances caused by the war effort. So again, it is an index of prices, not inflation. Prices can go up and down for any number of reasons. (Perhaps after the Weimar inflation and many of the Latin American inflations, people just assumed that higher prices mean inflation, who knows.)

Okay, enough rambling about what the definition is, let's ask some critical questions and then get to why I think the correct definition is so important.

Questioning The Consensus Thinking

Let's return to the consensus thinking about inflation and examine what I think are a myriad of false assumptions, poor reasoning, and poor conclusions. Again, the consensus thinking about inflation is this:

  1. Increase in the supply of money and credit causes
  2. more money and credit to be chasing after the same number of goods, which causes
  3. the general level of prices of consumer goods to rise.



And therefore, A=C.



Let's ask many of the same questions that we did in the mother-in-law example. Firstly, the data we are using is probably about as reliable and as full of holes as the mother-in-law example. Can we really say that we have the entirety of the data needed to reach a sound conclusion? Are there no chances for exogenous events? What about things like wars, strikes, a currency devaluation somewhere in the world, weather, etc? Is it really as simple as A to B to C? Couldn't these things only be correlated, or even just coincidental? Couldn't the supply of goods go up or down for any number of reasons unrelated to money supply? It is very difficult for central bankers to steer money exactly where they want it. To assume that more money is chasing after the same number of (or relatively fewer) goods assumes that the inflation (increased money and credit) comes through on the demand side of the economy. We don't automatically get to make the assumption that it will happen that way every time. It also assumes that more goods haven't been produced overseas by and up-and-coming competitor, or a competitor that had their currency devalued, etc. And can't demand go up or down for any number of reasons? You could have inflation and yet the number of goods has increased faster than the desire to purchase them, resulting in lower consumer prices. Or what if people stuff their new money under the mattress or use it to pay down debt?

And from B to C, why do we get to assume that consumer goods will be the things to rise in price? What about asset prices? What if much of the new money goes into foolish businesses that produce nothing the market wants? What if much of the new money and credit goes into investments in foreign countries? And what about things like productivity improvements, foreign competition, tax rates, etc., these play no part in prices?

Rising consumer prices are but one of the potential symptoms of inflation, much like a pain in your left arm can by a symptom of a heart attack. But we certainly wouldn't say that a pain in your left arm is the same as a heart attack. Nor would we say that in order to be having a heart attack, you must be having a pain in your left arm. And conversely, we wouldn't say that if you have a pain in your left arm then you must be having a heart attack.

It is quite possible to have an increase in the supply of money and credit and yet have falling consumer prices, for any number of reasons. New era manias are nearly always accompanied by low increases in consumer prices. During a mania in share prices, everyone wants to start a company and sell shares to the public to get rich. Much of the easy money comes through first on the supply side of those industries that are the hottest. This results in lots of people being employed (only to be fired later), but it also results in massive overcapacity because people are trying to sell shares to the public rather than sell goods to customers in a profitable manner and with honest accounting.

Let's consider an example of a relatively closed system, meaning we'll try to eliminate as many outside influences and exogenous events as possible. The dot-coms and the telecom sector were certainly recipients of much of the inflation (increased money and credit). Most of that money stayed in the US. Many new companies were formed. In other words, much of the inflation came through on the supply side of these sectors in expectation of supposedly huge demand that was going to develop. This actually led to a decline in consumer prices -- remember when everything on the internet was free? Remember everybody unprofitably fighting for eyeballs? That was at least partially the result of inflation. We even had those emetic commercials where they would pay you $20 to come to their site. But then when the new money and credit stopped coming through to the dot-coms, unprofitable companies went away, supply went down, and consumer prices actually went up (you will have to pay for more and more content on the internet). So when inflation comes through on the supply side, the results can actually be the opposite of what is commonly believed -- consumer prices go down, not up. Not to mention that, in a bubble, demand is wildly overestimated and supply is wildly underestimated.

Credit of course is different from currency, but even if the inflation were solely in currency you could still get lower consumer prices because of the wealth disparity, among other things. As an absurd example, assume an island economy with 10 people who have $100 dollars each, or $1000 in total money supply. Then, give everyone $20 more dollars, so each person has $120 each, $1,200 total money supply. A total of 20% inflation. Now let's say one of the islanders is a promoter and manages to convince each of the others to invest $60 in his internet companies. That one guy is the sole selling shareholder. The companies disappear in three months and he keeps all the money (Gary Winnick?). We now have 9 people with $60 dollars, and one guy with $660. What if the rich guy just decides not to spend any, what if he just waits for lower prices? What if he buries $500 in the ground (the velocity of money decreases)? Prices could go down for an undetermined amount of time. The only point of such a crude example is to show that inflation does not have to mean an increase in consumer prices.

When inflation comes through on the supply side, the important thing is to stop the inflation so that the supply/demand equation can come back into a market balance. In the dot-coms this has happened, or is in the process of happening. In the telecoms, for example, it has not. This is extremely dangerous because we end up with a system that rewards the worst and the stupidest, rather than the best and the brightest. How so? Because the first into bankruptcy gains an advantage over competitors and can undercut them on price. Hardly anyone goes out of business in bankruptcy anymore. JP Morgan and Citibank are there to offer everyone DIP financing (aptly named) and keep them in business. This is not good. Worldcom should have been liquidated. Its honest competitors should have been rewarded for their honesty. Instead, they will be punished. As long as new credit keeps coming through when there is too much supply, it can simply result in lower and lower prices, and perhaps some companies going through bankruptcy more than once.

Now let's step outside a closed system and look at the tech sector, another recipient of much of the inflation. How many of these tech companies went and built a new factory in China? Now we're blaming China? To a large degree, it may be our own inflation that was the cause of lower priced goods coming out of China.

Are We Done Playing Musical Houses Yet?

In real estate, however, much of the increased money and credit has come through on the demand side of the sector. This has led to prices rising, because demand ratcheted up before supply. But it is an illusory demand caused at least partially by inflation. Easy credit has led to an increase in the number of buyers and huge loans against artificially high home prices. (Imagine borrowing against your shares of Cisco or Sun at NASDAQ 5000. The assets have declined massively in value, but the payments on those loans and the loan balances would still remain.)

How many people will have been lured into a debt trap once the value of their home starts falling? Trust me, unless you've had it happen to you, you have no idea what it feels like to owe $130,000 on an $80,000 house, as happened to many people in the Texas real estate bust. (In most areas, you can probably double or triple those dollar amounts for today. How many people have that much cash laying around to make up the difference?) Thinking that asset prices can forever be levitated is a pipe dream. Ultimately, the payments on loans have to be paid, and that depends on how well capital has been allocated to meet the real demand of the economy.

And I'm also guessing that there has been lots and lots of fraud to jack up real estate prices. Just as we saw with the owners of NASDAQ shares, most owners of homes want the fraud, because it makes their asset prices go up. They want their appraiser to fib on the value because it's helping to make the owner rich! Most owners want unqualified buyers to be handed downpayments from the builder because it increases demand and makes their homes go up in value. No thought given to the inevitable downside. Yet the owners who demanded the high appraisals will cry foul when the downturn comes. So will the appraisers. So will the lenders. And ultimately, I fear, the taxpayer will get stuck with the entire mess.

What Happened During The Mania?

My guess is that conditions were ripe for a speculative mania, and it would have occurred even without help from an inflating Fed. Then the government and the Fed bought into the mania because it was profitable for them also. Huge tax collections on capital gains from stock options and share sales. Presto!, budgets are balanced! (As an example, at the height of the mania, stock options and capital gains accounted for nearly 25% of the revenue to the General Fund of the State of California -- see chart on p.9 here .) But now we're seeing the other side of such nonsense, as there are shortfalls at nearly every government level.

The Fed kept inflating to keep the mania alive as long as possible. The deadly combination of speculation and inflation resulted in massive excess capacity during the boom. But at the same time, everybody thought they were getting rich from illusory share prices. This led to a decline in savings, as people began to view their stocks as savings. It also led to huge consumer spending based on the newfound wealth. Then, as the prices of equities fell, people went deeper and deeper into debt, not wanting to give up their new glorious lifestyle. Most of their "wealth" was in their homes and much of that "wealth" has been extracted through continuous refinancing, and spent. This has led to a continuance of the false demand from consumers.

So we now have the worst of all worlds. Excess capacity and excess demand, combined with huge debt loads borrowed against artificially high asset prices, and very little or no savings. Huge trade deficits. Huge and rising budget deficits. None of this looks good at all. It is not implausible or far-fetched that the whole thing could implode and end in real tears. No one knows the future and it doesn't have to be that way, but a very bad scenario should not be dismissed as nonsense.

The Importance of Defining Inflation Correctly

And now we get to the real reason why it can be so dangerous to define deflation incorrectly: It leads people to believe that because some basket of consumer prices is not rising, then the problem must be that the Fed is not inflating enough. This is very dangerous. By increasing inflation, the Fed can actually end up increasing the supply of goods and services in areas where there is already massive over-supply, and increasing the demand in areas were there is already massive over-demand. And it makes the problems get worse.

This is why an easy credit policy can be very, very bad. It can keep unworthy businesses alive and unworthy demand alive. We should be especially concerned by the remarks of Fed Governor Ben "Gee Whiz, If I Had Known I Was Going To Get Such Flak Over My Speech, I Would've Toned It Down A Little" Bernanke.

Firstly, he thinks that problems can be solved by printing money. Secondly, he defines deflation as falling prices. And thirdly, he shows absolutely no respect for markets by concluding that falling prices can be easily stopped. This man is a career academic, having never worked in the private sector. I can tell you from personal experience that all of my greatest ideas worked out perfectly on paper, just like Mr. Bernanke's. But I found out that under the crucible of a market test, I was often massively wrong. I could have swore that I had it all figured out, had thought of every contingency, every possibility, and still I was massively wrong. I would offer Mr. Bernanke the phrase that I had on my web site,

"Respect the markets. They will humble you. Repeatedly."

Mr. Bernanke could learn a lot from intelligent, humble economists who do not claim to have all the answers -- people like Dr. Marc Faber and Dr. Henry Kaufman, who show great respect for the markets and who realize that everything is not so simple. Formulas and theories are nice, but they are often not reality.

Once asset prices start falling, I do not believe the Fed can stop them. No one can. Pyramid schemes collapse, they do not continue in perpetuity. There is no evidence in history that it can be done. Our own NASDAQ experience shows they were unable to do it there. A weak dollar policy will create plenty of it's own problems which Mr. "You Mean I'm Not Supposed To Talk This Way In Public?" Bernanke doesn't even mention. Will foreigners just sit there and say 'thank you' as they get shafted? Might they move their savings to another currency or gold? What percentage of our assets do they own currently? Isn't it a lot?

If the Fed manages to keep housing prices levitated for a while longer, it will only mean more pain and suffering in the end. The way things have worked this time, falling asset prices may actually cause deflation, as people swear off debt. Or, people may do what this Fed has conditioned them to do: chase the asset that is rising in price. Paying down debt or moving on to the next speculation may interfere with the plans of Mr. "We're Gonna Start Buying Crap Off eBay If We Have To" Bernanke. A sated consumer, saddled with debt, who is worried about losing his job, may not cooperate with Mr. Bernanke's campaign to increase demand.

The Fed will certainly try to continue to inflate. And certainly the prices of some things may go up in value. But my guess is the Fed doesn't have as much power as they think they do. Even if they are successful, it will only take us closer to serious, serious systemic problems. But I do not believe housing prices can be propped up much longer. And when that goes, the real pain will begin. The sooner we take the pain, the sooner we can get back to reality and a healthy economy.

Whom To Believe?

So why should my comments be taken seriously? That's an excellent question. After all, I'm just some guy on the Internet sitting at a keyboard, wearing nothing more than my Scooby-Doo underwear and big furry Bunny slippers.

But shouldn't that be a question you also ask of mainstream economists? What do you know about these people? How is it they have all the answers? What myriad of assumptions and fallacious reasoning are they engaging in that allow them to come on television and speak with such certainty about what's going to happen in the markets and the economy? How often have they been right? Why do they have such faith in central planning when it has never worked? We were assured that Japanese central bankers had made mistakes, but that the US markets wouldn't collapse because Greenspan lowered rates quickly enough and far enough -- did that work? Three rate cuts and the market goes up? Does a country really grow wealthy by spending and taking on more and more debt? Is that a wealth plan you would recommend to your teenage daughter?

Don't Let Them Do Your Thinking For You

Think for yourself. Don't let me talk you into anything, but don't let the economists talk you into anything either. Think through many of the accepted economic bromides and ask yourself why you accept them. Even if it's worked that way in the past, does it have to work that way every time? Go back to that mother-in-law example and ask yourself if we can make such conclusions so easily.

And one more thing, just in case the mainstream economists are right, and pulling away from the curb really does mean your mother-in-law will get injured, the next time you pull away from the curb, why don't you give your mother-in-law a call on your cell phone to see if she's okay. She's probably fine, but you should be calling her more often anyway. And at least you'll get to hear her voice: "Vhould it kill you to bring my grandchildren by vonce-in-a-vhile?"

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