Presently there is an increasingly raucous debate brewing between those who believe there will be long-run inflation, and those who see an extended period of deflation. I have elaborated my position here and elsewhere, which is basically that we're currently at the head-end of a deflationary period which risks collapsing into a broader deflation cycle. The actions of the Federal Reserve in concert with other world central banks strongly suggests that monetary policy leaders also fear deflationary forces.
This subject is particularly interesting being that it has generated the most email I've received on any topic since I wrote about the Second Life virtual world economy. Following are a few examples...
The first is a typical article of many that are appearing with increasing frequency on seekingalpha.com. It is entitled First Comes Deflation, Then Comes Inflation. It starts out reasonably enough, but upon reading it quickly becomes apparent that the author has an ideological bias. And, that is ultimately the problem with so many of these economic debates: ideology. Many are tied to an outcome for deeply ideological reasons -- for some, those border on matters of religious faith. Others have specific financial outcomes riding on a particular outcome, so the end up wrapping themselves in whatever dogma supports their desired ends.
But there is a theme emerging. Many who point to the prolonged, exaggerated inflation scenario don't really understand the theories upon which they are basing their arguments. Put bluntly, they are wrong. They repeatedly point to the Fed (and now others) "printing money" as sufficient reason to cause inflation. That argument is a monetarist one. Unfortunately, the quantity theory of money also incorporates a strong demand-side function, expressed as velocity. When that demand outpaces the supply, then there is deflation regardless of how much money is "printed up".
A well reasoned author and frequent commenter on seekingalpha responded to the above linked article. I believe he hits the nail squarely on the head, and he also expresses my frustration with the inflation-is-coming-I-tells-yas-so-buy-gold-now crowd:
Ideologues can't admit they are wrong and let go of their slander-script.
The error lies in thinking only the supply of money determines its value. Name any other commodity whose value depends only on its supply, and not on demand for it as well.
For the millionth time, demand for money is not a constant. It is money illusion in spades to think that it is.
Money is not wealth, it is not the "real" form of wealth with others being fake, nor is it a scam itself, with only "real" assets having value. Money is merely one asset among others, with a small and relatively stable *transactions* demand and a huge and quite unstable *safety* or investment demand.
When the investment demand for money changes dramatically, the objective exchange value of money changes too, if the quantity of money does not immediately change in exact proportion to that shift in demand. Even if the quantity of money is increased dramatically, its value can still rise, if the demand is increasing even more.
Why is the demand for money rising? Because real interest rates are rising, and doing so dramatically. This is making long dated claims fall in value compared to short dated claims. Risk premia are also rising dramatically, making safe claims rise in value compared to uncertain claims. Money is rising in value dramatically, compared to every kind of commodity that bubbles were blown in, making *nominal* claims more valuable than *real denominated* ones. (Being paid in dollars a year from now is worth *more* than being paid in steel a year from now, for example).
All of this is an entirely predictable consequence of too many people believing simultaneously that real assets would be worth infinity and dollars worth nothing, and every one of them being hopelessly wrong.
Who was going to pay them all if they were right? Were central banks ever going to print enough money to justify all the bubbles you-lot blew? No, it was pure slander on your part, and chutzpa.
From March of 2005 to March of 2008, the Federal Reserve did not allow the M1 narrow spendable money supply that it directly controls, to move one inch.
That broke all of your bubbles. Real estate first.
In case nobody has noticed, the whole trade that blew up and caused the credit crisis, was exactly this insane belief that any real asset - like a house - would always be worth infinitely more than any amount of nominal debt used to carry it. Sorry, no, untrue. Bid prices high enough and the debt is worth more than the real asset.
What will it take before you-lot get this slanderous inflationary brainstorm out of your system? How about grinding you to atoms for a decade? Whatever it takes.
Bonds at the current huge spreads are going to pay. None of your bubbles are.
Your unwillingness to simply lend on nominal claims to investment grade credits, will choke off all fuel for any of your bubbles forever, and they will not go anywhere. Not until bond owners are first *paid*.
Savings capital will be paid in full for its services ,and in real terms. Every attempt to avoid that will blow up in your face. Nobody is going to ride in and reinflate your cockamamie schemes. Not until you disgorge all of it and pay bondholders back every dime stolen from them, twice.
It isn't complicated. You just don't like it. Tough toenails, you are wrong.
I don't agree with this commenter exactly in that I obviously think there is a greater risk of deflation than he does. But he elaborates well the problem with the self-described "inflationists". They don't seem to realize that for their outcome to be realized they are demanding another, new bubble. Bear in mind that many of these folks came out of the real-estate-bubble[head] camp. They argued, along side folks like me, that a mega-real-estate-bubble had inflated and was becoming dangerously close to popping. They railed against Greenspan and Bernanke for creating the bubble. They welcomed its popping as a beginning to a return to sanity.
But that's where they got off the rationality train and boarded another bubble-cheerleader express. Most of them are in the gold & precious metals camp, as the seekingalpha author is. Others like Peter Schiff embraced a worthless dollar theory and started cheering for the euro to replace the dollar as the world's reserve currency, and to buy all things European and euro denominated. Yet others are holding out for $500 oil. And then there are all those who simply want real estate to re-inflate.
Suffices to say, I've yet to meet one in this camp who recognizes the ironic hypocrisy of their position. They are wishing for a bubble to replace the bubble.
I received another, more reasoned email from a reader who firmly believes that we are more likely to inflate further, then default, and finally deflate. This reader also believes that stagflation is unlikely-to-impossible. I, however, believe we have actually just emerged from a stagflation which lasted from 18-24 months, maybe longer. A lot of that depends upon how gamed the government stats really are -- and I think all of us can agree that the government stats are at the least "lacking".
The main issue I have with the overall conclusion that the US will default is that it is not necessary. The same can be accomplished without a default, which is arguably what occured in the 1930s. In essence, the rest of the world has much more to lose in the case of a US default than we do. We derive roughly 4/5 of our economic activity from internally generated GDP. That means we keep 80% of our standard of living after a default, give or take, with oil being the only real problem for a while. Europe, on the other hand, loses from half to 3/4 of theirs. Japan loses 80% of theirs. And so on.
Also, after a default there would not be deflation. There would be little left to deflate. The US stopped deflating by the late 1930s, but didn't start really re-inflating until the 1960s. And that brings me back full-circle: monetary theory.
See, the reason we didn't inflate after the Great Depression and WWII for decades even though they drastically increased the money supply was because we were growing. That's really the key. Growth. If an economy is growing, then it needs more money or it deflates by definition. If an economy experiences increased demand for money, then it needs more money, or that money becomes more and more valuable and deflates prices. It actually has nothing to do with the gold standard, etc. It has to do with the theory of money, which is really unrelated to which form of fiat money is. Keep in mind that a gold-standard system is still a fractional-reserve banking system, and the money is still fiat. It's just a different sort of fiat. The only non-fiat money system is one without any money at all, which seldom exists in societies with more than a few thousand people.
I know this was one of my longer articles, but I hope this prompts some reasonable debate. I, for one, believe it's very important to move past the ideological and self-serving conclusions such as typified by the seekingalpha article's author. We are headed towards rough times, and it is in all our interests to cut the bull and deal with this thing for what it is.