Deflation or Inflation?

Scylla and Charybdis Redivivus

Well, which is it to be? Is the world heading into another bout of inflation, or will deflation be the order of the day? Neither option is attractive.

Ever since governments assumed the power to print money with no hard precious metal backing, inflation (hidden theft) has been a major risk to national and global economies. In the last three decades of the previous century controlling and reducing inflation has been the major focus of most central banks in the developed world.

However, many argue that deflation is a more serious threat.
Deflation comes in two forms: benign and ugly. Benign inflation occurs when an economy is steadily growing in productivity, leading to a gradual decrease in the cost of living over time. We have seen this and example of this form of deflation from the electronic revolution. Generally, every year for the same or lower cost you could buy a more sophisticated cell phone, full of more features. This is benign deflation. It is production led. It discourages debt and rewards saving.

Ugly deflation is where an economy is shrinking, incomes are falling, unemployment is rising, people are not spending and the prices of goods and services are generally falling. Ugly deflation is demand led--that is, it is led by falling demand, leading to lower standards of living, or increasing poverty. This is the form of deflation we are facing now. Ugly deflation. It is what stops Ben Bernanke sleeping at nights.

Hyper inflation and ugly deflation are both alike very, very bad news.

Economic pundits are arguing which is likely to emerge as a result of the current global delevering (debt reduction), on the one hand, and the policy responses on the other--which have essentially involved huge increases in deficit spending by governments and monetary stimuli by central banks.

Clearly right now inflation is not a problem. Prices are falling. But every so often commentators will put their heads above the parapet to argue that hyper-inflation is just around the corner.

Here is a taste from Henry Blodget:

The economy is cratering, so the Fed is printing money. When the Fed prints money, this eventually produces inflation (more dollars, same amount of goods).

Ben Bernanke assured us yesterday that, this time, the Fed's money-printing won't eventually lead to inflation because the moment the economy begins to recover, the Fed will stop printing money and start burning it. Specifically, the Fed will start selling assets instead of buying them and thus shrink the money supply.

Unfortunately, Ben is unlikely to keep this promise.

Why?

Several reasons:

* First, it will be hard to confidently assert that the economy in full recovery. Remember, in 2007, Ben (and most other people) thought the economy was in great shape as far as the eye could see. He and most other observers missed that disastrous turning point. So why do we think he'll correctly spot the next one? Especially because, if he blows it by jacking up rates too early, he'll kill the recovery.

* Second, there will be intense political pressure to MAKE SURE that the economy is in rip-roaring health before hammering consumers and businesses by raising interest rates. Everyone loves low interest rates. And they'll only stop screaming about your taking them away when they're fat and happy (which will be long after inflation really gets going).

* Third, the US government desperately needs low interest rates to fund its soon-to-be-monstrous debt load, so there will be another source of pressure on Ben to keep rates low. When we finish with all this stimulus, we're going to owe a boatload of money. We're really going to allow our Fed chief to send interest rates to the moon and jack up our refinancing costs?

* Fourth, many of the assets that Bernanke has been buying to print money won't be easy to sell. This time around, the Fed isn't just buying easy-to-sell Treasuries. It's buying trash mortgage assets, et al. To reduce the money supply, it will need to sell them to someone. But who?

Those reasons, particularly the last three, are pretty substantial. We, at Contra Celsum, lean towards the coming hyper-inflation school.