Inflation versus Deflation

I’ve been asked frequently whether I view inflation or deflation to be the more likely outcome to the credit crisis. My view has been that deflation is more likely, but that circumstances could certainly change.

Left to its own devices, with no government intervention, we would collapse into a debt-deflation spiral. Why? Because as the economy turns and risk premia rise, highly-leveraged banks would be forced to sell assets in a scramble for cash to cover short-term loans, which would in turn drive down asset prices further, setting off further collateral calls from lenders and investors, forcing more asset sales and so on. In fact, this is what’s happening right now, and the government is intervening about as much as it can to stop it.

The debt deflation spiral turns into price deflation because the inability to borrow causes demand to collapse. Firms and consumers hoard cash to pay off debts instead of investing in their business or consuming. The value of cash rises and everything else falls. Eventually, things get so cheap and the potential returns so high, that “strong hands” step back in to the market, stopping the cycle.

We are particularly vulnerable a prolonged debt deflation now, because the US economy is more leveraged than it has ever been, particularly the financial system and US consumers.

Ironically, the US government is not that highly leveraged as a percent of GDP, at roughly 60% today vs. well over 100% during World War II, and businesses are not leveraged outside of the norm.

We got to this point because, after the Great Depression, we have set up our entire system to avoid deflation at all costs. We have used monetary, fiscal and currency policy to fight potential contractions in private credit. In other words, we have relentlessly fought off deflation with inflation, levering up our economy to the point where it can’t go any further. I would argue that we are not facing a shortage of demand, as much as we are retreating from artificially high demand fed by artificially abundant credit.

Consumers will be forced to deleverage, first as housing prices fall and then as baby boomers prepare for retirement. Additionally, we are likely to see a contraction in the GSE programs and new regulations that limit “subprime” lending in all forms. The financial system will also be forced to deleverage, first as asset prices fall and then as a new regulatory regime limiting the leverage of banks, hedge funds, and GSEs is implemented. The US government does have scope to leverage itself, which is what it is doing.

The fear among the inflation hawks is that the recent large government deficits and expansion of the Fed’s balance sheet will eventually result in high inflation. While this is possible, it would take a concerted effort by our government to let inflation spin out of control. Why? Because as the economy improves, the government will face political (and fiscal) pressure to sell its bank investments back into the private markets and the Fed will face pressure to shrink its balance sheet back down and to trade its recently-acquired risk assets for Treasuries. These sales will restrict growth in the monetary aggregates. While I don’t have a ton of confidence in the economic skills of our elected officials, I give them more credit than to think that they will purposely send us down the road of hyperinflation.

In addition, without a re-leveraging of the financial system or consumer balance sheets, we are unlikely to return to renewed credit inflation in the near-to-intermediate term. I therefore believe that we are more likely to see a period of price declines in the near term followed by a long period of subdued inflation and relatively low interest rates.

2 thoughts on “Inflation versus Deflation

  1. Thanks. I think I’m starting to understand this…
    Inflation happens when the ratio of money to productivity increases (money supply goes up faster than productivity or productivity goes down faster than money supply).
    To increase the money supply either people have to leverage themselves by taking out loans and credit (they borrow money from the banks who, in turn, borrow it from the Fed who just prints it then demands it back plus interest), OR by the government leveraging itself by increased deficit spending (money which it also borrows from the Fed who prints it).
    You mentioned in a previous posting that the Fed and the govt. have an interest in having an inflationary environment so they will fight the deflation tooth and nail – how do they benefit from that inflationary environment? I still don’t understand that part.
    So whether we will get deflation or inflation will depend on how much borrowing there plus how much government deficit spending there is. Is that right?
    Assuming that is true, clearly more borrowing by the public is not likely for the next few years I would think. People make money and they can either use it to pay for NEW things or to pay down their debt for OLD things. Right now, people are so leveraged that most money they will earn will go towards paying down debt. So, even if the govt. does drop the interest rate to 0% the way Japan did, people are unlikely to borrow much. I would think that is an unlikely source of inflation. In fact, it will be a strong deflationary force as more money flows out of distribution and back to the banks and other lenders.
    But what about government deficit spending?? Right now, it seems President-elect Obama may continue to try to spend our way out of this problem. The bailout is pumping Trillions of dollars into the economy by purchasing preferred stocks or bad assets (an INFINITELY bad idea if I understand it properly).
    If Obama continues programs like a second stimulus package and increases govt spending in other ways, won’t that be a strong inflationary force?
    Also, what if the economy continues to get substantially worse? It is looking more and more likely that lots of companies will go out of business, millions will get laid off in various industries, and spending will decrease as people use their money to pay down debt rather than purchase new goods and services. What happens then?


  2. There are two types of inflation: expansion of the money supply and expansion of credit. Right now the money supply is expanding, but it is being offset by a contraction in credit, netting out to mild deflation. Private credit continues to contract, so the government is expanding its credit borrowings to offset the contraction in private credit. By injecting money into banks as equity, there is a multiplier because banks are leveraged, but again, it’s only offsetting the falling value of the banks’ assets. The proposed “stimulus” is just shifting demand around and only becomes inflationary if the debt issued in monetized by the Fed. If its borrowed from abroad, we’ll run a trade deficit of a like amount and the net effect to GDP will be zero. It supports demand only if its financed by the cash savings of people hoarding cash. Otherwise it crowds out private investment.
    I don’t think the downward pressure on the economy stops until housing prices are at or below equilibrium, and I think we’re still a year (give or take) away from that. That said, the government has taken the right steps to prevent an out-of-control death spiral. I think the real economy will stink for at least the next six months, but that it could have been alot worse.


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