deflation fears are irrational
22 January 2003
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 [p. 428] 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 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, Human
Action, Chapter 17, "Indirect Exchange, the anticipation
of expected changes in purchasing power
by Ed Bugos
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.
What is the dollar's liquidity premium?
A JP Morgan slide show
last September began with the following quote on the cover
price of gold is driven by (and is the reciprocal of) the
real rate of return from capital markets." Summers
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.
Why do we
insist the likelihood of deflation is so low when everyone's talking
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
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
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 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
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
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
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
- 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
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
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
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.
Edmond J. Bugos