Saturday, September 30, 2006

Inflation vs Deflation

Over at Mish's blog I've been having a lively inflation/deflation debate. Here's some of it.

Ok I've heard the "Imbalances" argument over and over again. It has been popular for at least 20 years since Regan lamented about our national debt. Remember Ross Perot and how we did very well lamenting about the trade deficit back in the early 90s? Well, we're still here...

The big hole in their argument is that on an interest rate basis and on a purchasing power parity basis, which are the ony two things that matter with regards to currency values, the dollar is doing fine. Europe and Japan are very expensive and interest rates are lower. It's as simple as that. China, India, Russia and Brazil are cheaper but nobody trusts their financial system to handle institutional size investments. Face it, no country in the world treats wealthy people better than the U.S (with the exception of Singapore, and Hong Kong) and they know it, which is why they keep their money here.

That's it. Sorry to let all you guys waiting for the great economic "turning". As things get cheaper here because the consumer taps out there will be deflation because the U.S will be on an even better basis Purchasing Power Parity wise and the dollar will probably strengthen because all those dollars will start getting sucked up for debt repayments exceeding income growth.


The real problem is Ben Bernanke and his "electronic printing press" comments. The guy could try something really stupid and just start printing endless money. Up till now our financial system has been based on debt creation. That has a limit, at some point you reach the point where nobody can pay or doesn't want to pay anymore out of current income anymore and then the defaults start. The bigger the bubble, the more people who were able to borrow wildely, the fewer people left with money around to buy the dips and soften the drop out.

Now Benny has made some speeches were he said that there are all kind of wild "unconventional measures" he is willing to try in the event of a possible deflation.

However, when they started their anti-deflation campaign in 2002 all this money started really flooding into gold and to some extent, the Euro. The offical reason rates were raised in 2004 was inflation. I think that there was also some fear of the dollar collapsing. They had to raise rates quite a bit to pop the commodity bubble and to keep gold from launching into outer space.

I think they are still scared of gold and the euro enough to keep rates above whatever the ECB is offering. If they weren't why did they raise rates since mid 2004? Buffet probably doesn't trust Bernanke and the Bush admin and is hedging his bets just in case they try something monumentally stupid.


From what I've read, there are a lot of VERY intelligent people posting on these boards. How come such massive gaps exist between what each believe will occur in the future, when, for the most part, they all agree on what I described in the first paragraph?

I think the main difference is that the inflationists are unaware how money is created. I don't even think they know how money is created. They just point to the trade deficit and the national debt and demand the creditor debtor relationship between the rest of the world and the U.S re-adjust and think it will be a hyperinflationary dollar decline that will do it. A lot of this inflationist sentiment is driven by a obsession with the Weimar germany analogy of the present American government and a strong desire to see the end of U.S hegemony.

The truth is is that not withstanding Bernanke's crazy talk about electronic printing presses, the government does not print money and hand it out. It is created out of thin air by the fed and handed by the fed to the government in exchange for a treasury note. The more debt we are in, the larger the money supply. If debt levels fall then the money supply decreases and there is deflation. All this money needs to be paid back with interest and must be continually replaced by new debt. There is no other way the government creates money so when lending slows down, barring some really stupid "new paradigm" Congress/Bernanke deus ex machina" there will be deflation.


Just for completeness, there is another important way that money is created, which is by the multiplier effect, that is that banks can lend 90% of their reserves out, the money then winds up in other banks who can lend 90% of their reserves out, etc.... This isn't that important though because there is so much money floating around in the world dollar pool because of the deficit that now all those dollars floating around are starting to overwhelm the domestic money supply as far as the amount of power they have over the economy


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