Have We Experienced Deflation?
With the financial turmoil of late 2008, many commentators who have previously called for a deflationary bust like the Great Depression are now claiming victory. They point to the lower stock market prices, housing prices and higher trade-weighted dollar values as indicators that we are in a deflationary period. But are we really?
Defining Terms
Definition of terms is always required before meaningful answers can be given. If we look to google for definitions of inflation, we see that most explanations are offered in terms of “rising prices”. Some definitions do correspond more closely with ours, which is:
an increase in the supply of money relative to the supply of goods in a given economy.
This definition comes with a significant advantage in understanding the role of money in an economy, most of which is driven by including the word ‘relative’. That word helps us understand that inflation and deflation are descriptions of what happens when the ratio of money to goods changes. Under this definition, you can get inflation from a drop in money supply, so long as you have an even larger drop in aggregate goods supply. You can also have deflation with a rising money supply, and all it takes to have that is an even larger increase in goods supply.
The word ‘relative’ also keeps us looking at whether we have too much money chasing too few goods, and if we do, then we’ll call it inflation.
Another advantage of this definition is that it forces us to note that goods and money cross borders: we have to count an influx of Chinese goods and an outflow of US dollars to understand whether we might have an inflation or a deflation on our hands.
Shadow Stats
During the Clinton years, just as during all administrations from FDR through JFK and into the present day, some government numbers have been redefined to make the population think things were better than they were. This sort of manipulation keeps confidence high, and confidence is an important component needed to keep a consumer economy running at full steam. If government understates inflation, it benefits from:
- Keeping entitlement payment increases low, and
- Overstating real GDP growth,
both of which make the sitting government look like they are doing a better fiscal job than they probably are. This is incredibly tempting for governments, so we need not blame one party or another for harvesting such lucrative political fruits.
One place to see how this works is at John Williams’ Shadow Stats. John has tracked reconstructed government measurements to reflect the real numbers without the manipulation over time. This means we can use his data to see more of an apples-to-apples history. I’ll make use of three of Williams’ charts below.
Money Supply
So, setting aside our “relative” measures for the moment, let’s just look at what is happening with money supply in U.S. dollars. John’s “M3 continuation” chart helps:
Money Supply measures as reported by the Fed, except M3, which was discontinued and reconstructed by John Williams
Money supply measures are still growing. For those watching the financial markets, we all know about the bailouts, and we can see how those are affecting M1 since the Fed started pulling out all the stops. If we measured inflation by measuring only money supply, then this chart doesn’t seem to indicate there has been deflation.
Consumer Price Index
But what about prices? There is an interesting aspect to the money supply chart above. What if the M1 increase is explained by people fleeing the stock markets and piling into cash? Isn’t that deflationary? Many people argue that if prices are crashing because of the economic turmoil, then who cares what the money supply chart says?
Remember, our definition specifies inflation in terms of the money and goods ratio, not in terms of prices themselves. Yet, we can still look at what is happening with prices to see if the piling into cash argument has any merit. Once again, John Williams has a chart we can look at:
Official CPI measures, with Williams’ de-manipulated numbers overlaid
The numbers show that consumer prices are still rising. Yes, the rate of price increase has slowed, but the price direction is has still not gone negative in this decade! Not once! Even the suspect government numbers still show a continuous, even if slower, rise in prices. I circled them on the chart above so you can see what I’m getting at — even by unbelievably low and suspect measures, we’re still not seeing general price declines.
Money Relative to Goods
What happens when we start to look at goods supply?
GDP changes when you back out the proper amount for inflation
When we account for inflation properly, we find out that some of the GDP officially reported by the government was probably just inflation reported as increased productivity. This is why Williams shows us in a recession for quite some time, even if the markets didn’t know it.
So, when we look at money supply relative to goods supply, this doesn’t support deflation either. The basic facts are:
- Money Supply in dollars has nearly always grown at a positive rate
- GDP is probably somewhere between flat and -3%
- More money with declining goods supply is inflation by our definition
- The expected result of inflation is rising prices for goods…
- Which is exactly what the CPI reports
So, money supply is increaing, prices are rising, and new supplies are not coming online because our economy is actually shutting down. So, where is the deflation, exactly?
Asset Prices & Deleveraging
Valuation of assets have come down considerably, and people seem to want to call this deflation. We don’t think it is deflation, because we can still see rising money supplies, we don’t see rising goods supply, and we see the rising consumer prices just as we’d expect.
However, it is true that prices have fallen greatly in the stock markets and in housing. Other durable [and most all future financed] goods are seeing price declines, too. What all of these items have in common is that most of them are bought with borrowed money, or what finance people call ‘leverage’. Since the credit crunch, borrowing has become difficult and many people have been forced to sell some things to repay loans on other things, and this includes stocks that were bought with borrowed money.
Are Credit and Money the Same Thing?
With all this deleveraging, lots of credit has been destroyed. Banks are leveraged just like the people they loan money to, so when people who owe banks money default, then banks find the rest of their portfolio is now overleveraged, and they need to raise money to meet their own regulatory margin requirements.
The question comes up about whether credit is the same thing as money, and whether destruction of credit counts as deflation. I think the answer is “no”. Credit is the ability to make new loans, and thus the ability for banks to make new money. Halting credit is thus a great way to prevent new inflation, but does it actually destroy non-credit money out there? Not really.
Are Defaults Deflationary?
What about defaults, don’t they destroy money? Actually, they don’t. They can seriously impair the bank’s ability to keep lending new money, but the money that was lent before is already loose in the real economy. Default means that the loan will never be paid back, and thus that loan money will never be destroyed by the normal mechanism of debt repayment to the bank.
In the end, we don’t really need to answer these questions. Instead we can look back at the charts of money supply, goods supply, and general price levels to see if the gargantuan defaults and credit destruction of 2008 was deflationary. If money and credit are the same thing, we should find that the money supply, since it doesn’t include the credit part of the equation, was a terrible predictor of general price levels in the economy. But that’s not what we found. Prices are still rising, in general, except on assets that are bought with leverage, like houses and stocks and commodities futures contracts.
Money Velocity
Many people focus on money velocity, and I agree that it is important. The idea here is that if people have money but don’t spend it, then the economy behaves as if people didn’t have as much money as they do. So, this is a multiplier effect on how much money is in the economy.
This, in turn, is why people focus on “inflation expectations” — if people think something will be more expensive tomorrow, then they buy it today, but if they think it will be cheaper tomorrow, then why not wait? If all the money in the economy turns over 5 times a year, then we need five times as many goods and services than we would if the money turned over once per year. If it turned over that fast but we didn’t have the extra goods and services, then prices would probably rise as a result.
People that think we are in a deflation focus on the slow movement of money in our economy and claim that these forces are larger than the bailouts and the 8 trillion dollars of new programs the Fed and Treasury rolled out this year. And I would argue that these factors certainly have slowed inflationary outcomes quite a bit, which we can easily see by looking at the plunge in the CPI this past Fall.
The trouble with the money velocity analysis, in my mind, is that it only prevents an inflationary outcome as long as the money velocity can stay low indefinitely. The root inflation problem, however, is that the money got printed in the first place and set loose on our economy.
The deflation theorists claim that hoarding of cash prevents the inflationary outcome, but my rebuttal is to ask, “for how long?” Sure, money can be hoarded today, but the purpose of money is to buy stuff. Someday people who hoarded money WILL spend it, and that’s when the previous money printing will matter again. When is that day? I’m not sure, but I’m afraid we’ll find out in the next year or two.
The International Aspect
Our structural deficits with China and oil producers have a huge impact on our daily lives, even though most of us don’t realize it. The reason we’ve been able to overconsume and underproduce for so long is that our currency is still the world reserve, and no viable alternative has been identified yet. It may also be due to China’s reliance on food imports to feed their massive population.
Essentially, we’ve imported goods from China, and exported inflation to China. Is that sustainable? What if China decided they can do without our food exports? What if their economy collapses and they can’t afford to buy our paper to keep the U.S. Treasury bubble going? Can this imbalanced situation last forever, or has something got to give? And if the latter, what will happen when something does give?
Really, this turns out to be the same kind of thing that we saw with money velocity. China is adding goods to our economy, and sucking money out of it. This is a powerful deflationary force on the U.S. in the present, but the dollars are being pent up in the Chinese central bank (and other nations, notably energy exporters). Those dollars don’t disappear, they just sit there and wait.
Importing deflation to mask heavy inflation
In other words, the U.S. economy has been inflating like mad all this time, but only seeing small price increments in comparison to the true structural deficits of our domestic economy. Deficits DO matter because they indicate that we, as a nation, consume way more than we produce. The only reason they haven’t appeared to matter is because China and other nations have been able and willing to allow us to export our inflation to them. Will that last forever? It is hard to believe it could.
The trouble with the financial crisis of this past Fall is that it might lead to a serious disruption or complete breakdown of the dollar standard and the international banking system. At that point, countries might become unwilling or unable to finance our continuing deficits. If that happens, we’ll begin to actually experience the current inflationary effects of our deficit-financed lifestyles, but we also may see all that foreign central bank cash flowing back to our shores in a run out of the dollar.
So, have We Experienced Deflation?
So, the answer to this essay’s question is “no”, we have not seen deflation. Yes, asset prices have fallen as people hoard the new cash that is being printed and scramble to cover their terrible and highly leveraged bets. Yes, money velocity seems to be a bit lower as people who can save or cut debt have started to do so. We may even see a bit of deflation in the future, depending on whose numbers you believe. But, so far the money supply is still growing, domestic output is not increasing, exports are shrinking, imports are also shrinking (but not as fast), and the general price levels are still rising, even by the understated government reports.
Deflationists like to pretend that in order to have inflation, we absolutely must have the 1970’s wage-price spiral, or that we could only have inflation if the stock market is rising, or something else. They argue that printing money can’t create inflation without a special “mechanism” to get it out into the economy. Well, there are a pair of special mechanisms. The people who get the printed money can just SPEND it or LEND it. While neither is happening in overwhelming amounts today, there is no reason to think they will never happen in the future.
Part of observing a collapsing financial system is to understand that some of the old models are going to break or give false readings. The economic models we’ve used for the last 100 years were designed and tested during periods of increasing resource availability. The only time America didn’t have increasing resources was during the 1970’s. This was after the U.S. peaked in oil production and but before the globalist response started to bring foreign resources to America in exchange for dollars. As that globalist system breaks down due to scarce resources everywhere, the models built against the backdrop of growth will keep giving false readings like the ones deflationists are getting today.
The real danger is still inflation. The problem isn’t that we might hyperinflate our currency in the future, it is that we may have already done so — that we’ve abused our dollar’s reserve status so much in the past (especially the recent past!) that a hyperinflationary outcome may have already been guaranteed. We could stop it if we found a new and plentiful resource of real wealth to match the dollars we already printed and stashed in the world’s central banks, but the meaning of peak oil is that such a find is not going to be possible.
It is hard to predict what will happen with China and our oil supplier nations, but it does seem unlikely that they will continue to give us something for nothing. There is an old saying that when goods don’t cross borders, armies do. At this point, war may be the only way to extend the dollar’s reign as the world’s reserve currency and avoid a hyperinflationary collapse of the dollar.
