The Deflation/Inflation Debate

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by Alasdair Macleod, GoldMoney:

“Naïve inflationism demands an increase in the quantity of money without suspecting that this will diminish the purchasing power of the money.” ― Ludwig von mises, The Theory of Money and Credit

It is hardly surprising that with equity indices stalling, the financial community is increasingly worried that the long, steady bull market is coming to an end. Naturally, this makes investors look for reasons to worry, and it turns out that there are indeed many things to worry about.

In fact, there are always things to worry about. Ever since the Lehman crisis, the Four Horsemen of the Apocalypse have been casting long shadows across the financial stage. But as financial assets have continued to rise in value over the last nine years, bearish fund managers, spooked by systemic risks of one sort or another and the perennial threat of a renewed slump, have been forced to discard their ursine views.

As often as not, it is not much more than a question of emphasis. There is always good news and bad news. As an investor, you semi-consciously choose what to believe.

There are causes for concern, of that there is no doubt. Mostly, they arise from the consequences of earlier state interventions on the money side. Governments are slowly strangling private sector production with increasingly rapacious demands on taxpayers and have been resorting to the printing press to finance the shortfalls. In reality, there is a finite limit to government spending, because it impoverishes the tax base. Yet governments, with very few exceptions, seek to conceal this truism by increasing spending and budget deficits even more. In this, President Trump is not alone.

Bankruptcy is the end result. And don’t believe the old saw about how governments can’t go bust. They can, and they do by destroying their currencies, as von Mises implied in the quote above. The naïve inflationists referred to by von Mises justify their stance by believing that inflation is invigorating, and deflation is devastating. Any and all statistics pointing to a slowdown in the growth of money supply or in the economy is therefore taken to be a forewarning of deflation.

Inflationists are simply recycling Irving Fisher’s debt-deflation theory, which is no longer relevant. Fisher held that in an economic crisis, bad debts forced banks to liquidate collateral, pushing down collateral values. And as previously sound loans lose their collateral cover, banks are forced to liquidate those as well.

But it is no longer the case. Central banks have removed the discipline of gold, so they can intervene to prevent financial and economic crises, rather than let them run their destructive courses. They have fully embraced inflationism, giving them the excuse for monetary and credit expansion as a cure-all.

Therefore, when the next crisis occurs, central banks will take steps to ensure that in aggregate the quantity of money does not contract. It is the one forecast we can make with absolute certainty. And every time a crisis happens it takes more monetary heft to get out of it. But that’s not an issue for a central bank with two overriding objectives, not the targeting of inflation and unemployment as such, but to ensure a recession never happens, and to finance, through money-printing if necessary, escalating government spending.

Minor wobbles are not the credit crisis
We must discriminate between the momentary problems faced by central banks and the inevitable crisis at the end of the credit cycle. Dealing with problems as they arise has become routine, the justification for continual inflationism. The credit crisis is a different matter. Central bankers do not seem to realise it, but the credit crisis is their own creation, the way markets eventually unwind the distortions created by earlier monetary policy. So long as central banks suppress interest rates and expand money and credit, there will be periodic credit crises to follow.

The trigger for the credit crisis is always the same. The general price level threatens to rise uncontrollably, reflecting the loss of the currency’s purchasing power. This forces the central bank to reluctantly raise interest rates to the point where business assumptions about the returns on capital, based on borrowing costs, turn from profit-making to loss-making. At that point, if not before, the accumulated mountain of debt becomes fatally undermined.

The timing of the rise and level of interest rates that triggers the crisis is set by the speed with which monetary inflation feeds into prices. And the severity of the crisis depends upon the size of the debt mountain being liquidated.

This has nothing to do with the minor wobbles along the way. Ahead of a cyclical credit crisis, central banks routinely deal with the fires breaking out in an increasingly desolate economic landscape. They are very good at it. The share prices of European banks, such as Deutsche Bank and Credit Suisse raise concerns over systemic risk, but the ECB and SNB will always ensure credit is available to them. And if we are worried about systemic risk in key European financial behemoths, why is it that stock prices for major US banks such as JPMorgan, Goldman Sachs and Bank of America are so strong?

There is also a narrative being promoted which posits that a slowdown in broad money supply is giving an advance warning of recession. The chart below, of US M2 plotted weekly, puts it into context.

Yes, there has been a recent slowdown in the rate at which M2 is growing. But it has hardly diverged much from the average rate of increase, shown by the black line, for the last five years. And it’s not worth repeating the chart for M1 Money Stock, which is remarkably similar, despite the Fed reducing the size of its balance sheet.

How bank credit is used is rarely questioned
What charts of money supply do not tell us is where money is deployed between two groups of borrowers. Newly created money, mainly bank credit, is allocated either into the financial sector, which is not included in GDP excepting fees and commissions, or into non-financial activities, where goods and services are included. Furthermore, missing from GDP is all the intermediate business-to-business activity that goes towards manufacturing and delivering the goods and services included in GDP. And it is B2B which borrows to invest.

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