From http://jessescrossroadscafe.blogspot.com/2009/06/some-common-fallacies-about-inflation.html
There are several fallacies making the rounds of the economic
community, often put forward by pundits on the infomercials for
corporate America, and also on the internet among well-meaning but
badly informed bloggers.
The first of these monetary fallacies
is that 'the output gap will prevent inflation.' The second is that a
lack of net bank lending or other 'debt destruction' will require a
deflationary outcome. Let's deal with the output gap theory
first.
Output gap is the economic measure of the
difference between the actual output of an economy and the output it
could achieve when it is most efficient, or at full capacity.
The
theory is that when GDP underperforms its potential, with
unemployment remaining high, there can be no inflation because demand
is weak and median wages will be presumably stagnant. This idea comes
from neoliberal monetarist economics, and a misunderstanding of the
inflationary experience of the 1970s.
The thought is that
sustained inflation is due to a 'wage-price' spiral. Higher wages
amongst workers cause prices to rise, prompting workers to demand
higher wages, thereby fueling inflation. If workers do not have the
ability to demand higher wages there can be no inflation.
While
this is in part true, it tends to confuse cause and effect.
The cause of a monetary inflation, which is a broadly based inflation across most products and services relatively independent of demand, is often based in a monetary expansion of the currency resulting in a debasement and devaluation.
A monetary expansion is relatively difficult to achieve under an
external standard since it must be overt and often deliberative. A
gradual inflation is an almost natural outcome under a fiat
currency regime because policy-makers can almost never resist
the temptation of cheap growth and the personal enrichment that comes
with it.
There can be short term non-monetary
inflation-deflation cycles that tend to be more product specific in a
market that is not under government price controls. But this is not
the same as a broad monetary inflation or deflation.
The key difference is the value of the dollar which has little or
nothing to do with a business cycle or product demand/supply induced
inflation/deflation.
In the modern era the Federal Reserve can
increase the money supply independent of demand by the monetization
of debt, with the only restrictions on their ability to increase
supply being the value of the dollar and the acceptability of US
sovereign debt. This requires the acquiescence of the Treasury and
the cooperation of at least one major money center bank.
People
tend to invent 'rules' about how the money supply is able to
increase, and confuse financial wagers and credit with money. This is
in part because the average mind rebels at the reality behind modern
currency and the ease at which it can be created. Further, people
often invent facts to support theories that they embrace in an a
priori manner.
In a pure fiat currency regime, the swings
between inflation and deflation are almost always the result of
policy decisions, with the occasional exogenous shock. A government
decides to inflate or strengthen their money supply relative to
productivity as a policy decision regarding spending, central bank
credit expansions, banking requirements and regulations, among other
things.
As a prime example of a rapid inflation despite a
severe economic slump, what one might call uber-stagflation,
is the Weimar experience.
Since pictures are worth 1000 words,
let me be brief by showing you a few important charts.
The basic ingredients of the Weimar experience are...
A high level of official debt issuance relative to economic growth
High
unemployment with a slumping real GDP
Wage
Stagnation
I
should stop here and note that although the statistics at hand
involve union workers, in fact unemployment was widespread in the
Weimar economy. The saving grace of being in the union was that one
was more often able to retain their jobs and some level of nominal
wage increases.
Anyone who has read the history of the times knows that unemployment,
underemployment and slack demand was rampant, and that hoarding was
commonplace as people refused to trade real goods for a rapidly
devaluing currency.
Rapidly Rising Prices Despite
Slack Demand and High Unemployment
So
much for the wage price spiral and the output gap.
A
Booming Stock Market, at Least in Nominal Terms
Booming
Price of Precious Metals as a Safe Haven Even While Basic
Material Prices Slumped
Notice the plunge in the price of copper as the economy collapsed and gold and silver soared.
If
one can obtain a copy, as it is out of print, one of the best
descriptions of the German inflation experience is When Money
Dies: the Nightmare of the Weimar Collapse by Adam
Fergusson.
From my own readings in this area, the people who
tended to survive the Weimar stagflation the best were those who:
1.
Owned independent supplies of essentials including food and shelter
and were reasonably self-sufficient.
2. Had savings in foreign
currencies that were backed by gold such as the US dollar and the
Swiss Franc
3. Possessed precious metals
4. Belonged to a trade
union and/or had essential skills or government position which
guaranteed a wage
5. Were invested in foreign equity markets, and
even in the domestic German stock market for a time
People
will argue now that the Fed understands that inflation is caused by
perceptions, and that by managing those perceptions inflation can be
avoided because even those prices are rising and the currency is
being devalued, if they ignore it the inflation cannot reach harmful
levels.
This is what I call the "psychosis school"
of behavioral economics.
Granted, perception is
important, and managing perception may delay outcomes for a period of
time. But unless the underlying cause of the problem is remedied
during what is at best is an extended interlude, the resulting break
in perception will ignite a firestorm of cognitive dissonance, loss
of confidence, and social unrest.
In summary, in a purely fiat
currency regime a sustained monetary inflation or deflation is an
outcome of policy decisions regarding fiscal policy, monetary policy,
and economic balance and output.
As long as the government is able to generate debt, deflation is a
highly unlikely outcome. And when the government reaches the
practical limits of debt creation, the underpinnings of the currency
give way and the economy tends to collapse in a stagflationary
slump.
There are no predetermined outcomes. Deflation,
stagflation and hyperinflation are not 'normal' but are certainly
possible if the central authority is permitted to abuse the real
economy and the money supply for protracted periods of time.
What
about Japan? Japan is the perfect example of a policy decision made
by a fiat currency regime in what was decidedly NOT a free market,
but under the de facto control of a highly entrenched
bureaucracy, a single political party, and large corporate giants in
pursuit of an industrial policy that favored exports and domestic
deflation.
The difference between the Japan of the 1980s and
the US of today could not be more stark. Choosing a deflationary
policy and high interest rates as a debtor nation is economic and
political suicide. It would be interesting to see what happens if the
US elites try to take that path.
We will know if there is a
true monetary deflation in the US because the value of the dollar
will start increasing dramatically with regard to other hard assets,
other currencies, goods and services, and precious metals and
commodities. Prices will decline especially for imports as the dollar
gains in purchasing power.
Remember that a true monetary
inflation and deflation would only show up over time. Even in the
Great Depression in the US, as demand slumped and prices fell, the
stage was set for a significant devaluation of the US dollar and a
rise in consumer prices well in advance of the eventual recovery of
the economy that caused the Fed to tighten prematurely. As I recall
the actual contraction in money supply lasted two years. This again
highlights was [what?] an amazing piece
of bad policy that Japan represents in its 'lost decade.'
People
embrace beliefs for many motivations. So often I find they are not
'rational' and based on a scientific study of the facts, even on the
most cursory level. Fear and greed and prejudice are often
motivations that are surprisingly resilient, even in the face of
overwhelming evidence against them. Leadership understands this
well.
There are often appeals to private judgement. I do
not care what you say, this is what I believe, what I think, what I
feel. This is appropriate in the supra-natural realm, but in the
natural realm there may be private judgement but the facts are
public, and the outcomes are well beyond the complete control of the
most fully-managed perceptual campaigns, at least so far in human
experience.
"The lie can be maintained only for such time as the State can shield the people from the political, economic and or military consequences of the lie. It thus becomes vitally important for the State to use all of its powers to repress dissent, for the truth is the mortal enemy of the lie, and thus by extension, the truth is the greatest enemy of the State." Joseph Goebbels, of the perception modification school of economic thought
What is truth? It is difficult to estimate but not completely
out of reach.
Our own view is that a serious stagflation with further devaluation of the US dollar as it is replaced as the world's reserve currency is very likely, after a period of slackening demand and high unemployment. A military conflict is also a probable outcome as countries often go to war when they fail at peace.
Weimar was not an anomaly although the level of inflation was
indeed legendary. Argentina, post Soviet Russia, and most recently
Zimbabwe are all similar examples. Serious
Instances of Monetary Inflation Since World War II
There
are many, many variables in play here, and policy decisions yet to be
made. It is highly discouraging to see Obama's
Administration fail so miserably to do the right things, but
there is always room for hope, less so today than six months ago
however.
Argue and shout grave oaths and wave our hands though
we might, we are in God's hands now.
Let's see what
happens.
A very special thanks to our friend Bart at Now
and Futures who makes these charts, among other
things, available on his highly informative web site for public
review. If you are not familiar with his work you might do well to
view it. We do not always agree, but he demands attention because of
the rigor which he applies to his work for which we are grateful,
always.
Posted by Jesse at 2:19 PM