This week, Jim Puplava interviewed Nicole Foss, aka “Stoneleigh” of The Oil Drum, and later The Automatic Earth blog. She believes we are experiencing deflation and that it is about to get much worse. The interview left me with some nagging questions.

What is the definition of deflation?

She offers several:

1. The excess claims to underlying real wealth are extinguished, and that is deflation by definition
2. deflation is the contraction of money and credit relative to available goods and services.
3. a wave of debt default, which is deflation by definition.
4. when people realize that … these excess claims exist, there will be an almighty resource grab, underlying real wealth grab, and that is deflation

I think number 2 is the right one.

Number 1 and 3 are poor statements, because they leave out the fact that inflation or deflation measure a ratio of economic product available versus the power to purchase it.

The worst definition of all is the fourth, and I think that one is wrong.

Are we in a deflation now?

The current wave of debt default has been offset by increased government debt, so the message of this chart is that Bernanke has been successful in making sure that very few net claims have been extinguished … at least so far.

So, I’d say we’re in a stalled economy, but not a deflation. One could make an awfully good case for stagflation by adding the gold price against this chart.

Is cash the same as “real wealth”?

Elsewhere, Stoneleigh has explained:

We are still near the beginning of a deflationary spiral, as the credit hyper-expansion of the last couple of decades morphs into contraction. Whereas currency inflation divides the underlying real wealth pie into ever smaller pieces in a form of forced loss-sharing, credit hyper-expansion creates multiple and mutually exclusive claims to the same pieces of pie. The appearance of great wealth is created, but it is illusory. As expansion comes to an end, the excess claims are rapidly and messily extinguished in real wealth grab. The dynamic is Enron-esque and the result will be a long and extremely painful economic depression.

As credit (ie excess claims) represents probably 99% of the effective money supply, the removal of credit causes the money supply to crash. This is deflation by definition, as deflation is the reduction of the money supply relative to available goods and services. ‘Printing money’ (monetizing debt) will not help under these circumstances as injections of liquidity disappear into a black hole once a cash-hoarding mentality has taken hold.

I have a really hard time with what she is saying here. If “excess claims” are “extinguished in real wealth grab”, then why is there simultaneously “a cash-hoarding mentality”?

The cash is part of the claims, right? If there are excess claims, then why wait for yours to be “extinguished”? Wouldn’t people instead use the cash to participate in the “real wealth grab” today, before their claim can be extinguished?

I agree with her, that it is going to end like a ponzi scheme, but I think the US dollar is part of the fraud. From where I sit, she is predicting a financial panic, but claims that everyone will be running to the entrance instead of the exits.

I don’t get it. It feels like she is mistaking the cash for real wealth here, but that seems like a foolish thing for someone who gets so much of the rest of it right.

What’s so important about “Multiple and Mutually Exclusive Claims”?

I think the crux of Stoneleigh’s problem is rooted in her fixation on “multiple and mutually exclusive claims” on wealth.

Of course inflation and fiat money represent excess claims on wealth, but I’m unclear why she thinks massive defaults are the only way out. Clearly, Ben has been printing and so far interest rates are preternaturally low.

The only thing I can spot in her writing is this idea that default represents the only way to clear out the excess claims, but since money and credit are divisible and fungible, I don’t see any reason why the claims can’t be watered down over time. Markets have been discounting claims based on risk since the invention of markets, so I don’t understand why Stoneleigh has decided this can’t work in the near future. It seemed to work after Lehman, after all — we’re still here…

What Will Force the Inflation Trends to Change?

I’ve made a chart of US money supply compared to world oil supplies. This is the data I could find easily, and I don’t think US money supply is a bad proxy for global money here. In fact, I think the red line would be even more extreme if we used a dataset that matched up with Stoneleigh’s money and credit definitions.

If Stoneleigh predicts these trends are about to change, then what indicators can we look for to predict changes in the chart above?

Peak oilers know that the blue line has leveled off forever. The response to the US peak in the 70s was to go out to the rest of the world and leverage their resources under the banner of “free market” globalization. That’s a one-time trick that we won’t be able to repeat.

On the money side, it seems an open question. Will money follow energy down the slope of depletion? Certainly there is no physical limit on money and credit, so Stoneleigh needs to convince us that there is some limit, some reason why the constant inflation since 1913 will not (can not) continue.

All the chart tells us is that since Nixon broke the link with gold, inflation has become more and more extreme. Yes, 2008 was quite a challenge to the inflation regime, but in the end, we only had a few quarters of mildly negative CPI (depending on whom you ask):

Still, inside our infinite-growth economic model, slow growth is awful, and mildly negative growth is a complete disaster! But, will those disasters make money and credit disappear faster than the goods and services that come to us courtesy of the earth’s post-peak oil bounty? Hard to say.

All I know is that the resources are definitely limited, and the growth economy is faltering badly. The only response so far is to keep up business as usual, and the instruments of that response have been loose money policy.

If we believe that bad money chases out good money, then gold may disappear from the streets soon, and US dollars may be about as valuable as, well, mere pieces of paper. That doesn’t sound like deflation to me.

This entry was posted on Monday, September 6th, 2010 at 1:05 pm and is filed under Money and Inflation. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.