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Wednesday, July 19, 2006 1:39 AM

Deflation Strawman

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Once again Steve Saville is at it.

In The Main Flaw in the Deflation Case he proposes a strawman that simply does not exist. It amazes me that after everything that deflationists such as myself have written, that not a single inflationist can accurately state the deflationist point of view.

They continually build and attack deflation cases that as best as I can tell, no one has proposed. Time and time again we go through this. It is tiring. Some have proposed that Saville was referring to me in that article but rest assured I have not been talking about deflation for more than two years. Regardless, here is the latest strawman:

A theme that appears to be common to the most eloquent arguments in favour of a deflationary outcome is that consumers, at some point, will have to start reducing their collective indebtedness, and when this happens the total supply of money and credit will begin to contract (deflation will occur). Given the current enormous height of the collective debt burden it seems likely that the point at which the debt accumulation of consumers tops out cannot be far off, which is, we think, why the idea that the world is about to plunge into a deflationary quagmire has proved to be so seductive. After all, there must be some limit to how much debt people will be able or willing to take-on and, with the savings rate in negative territory and debt repayments constituting an uncommonly-high proportion of disposable income, we simply MUST be close to that limit.

The problem is, the argument for deflation outlined in the above paragraph is based on the incorrect premise that the consumer is the engine of inflation. And when you start with an incorrect premise and then apply perfect logic you are GUARANTEED to come to the wrong conclusion.

The central bank, not the consumer, has always been and always will be the engine of inflation.
Let's stop right there.

In In Praise of Saville I said:
It sure is nice to see someone properly explain what inflation is, what it is not, and why measuring the CPI is fraught with so many problems as to make it useless. Steve [Saville] wrote:

The correct definition of inflation is an increase in the supply of money that CAUSES a decrease in the purchasing power of money, but we usually define it as simply an increase in the supply of money. This is done, in part, for the practical reason that it's impossible to measure changes in the purchasing power of money on an economy-wide basis.

It is not possible to measure changes in the overall purchasing power of money because it is not possible to come up with a meaningful number that represents the average price level within an economy. There are, of course, price indices such as the CPI that purportedly represent the average price level, but these indices are generally worse than useless because they are calculated in such a way that they are guaranteed to paint a misleading picture.
I have on numerous occasions said that inflation was an increase in money supply and credit. How many times do we have to say it? It really gets tiring. I am glad that Saville agrees because unless one can agree on a definition, then there can be no meaningful debate.

I agree with Saville that the consumer is not the source of inflation.
So why does Saville post the strawman that he did?
Perhaps he was responding to someone else. If so who?
That is another problem with many inflationists. They attack ideas that as best as I can tell no one said. If someone said the consumer is the source of inflation then who was it? I will agree with Saville that idea is absurd. I will also tell Saville that is not the basis for most deflationist beliefs. It's easy to attack a strawman that does not exist.

Does that mean the consumer is out of the picture?
No, of course not. That is what Saville does not seem to understand.
Banks can print but they can not force consumers to either borrow or spend. If bankruptcies expand faster than borrowing, the net of money supply and credit will contract. That is deflation.

There is one other twist that I have talked about and that is the velocity of money.

In Inflation: What the heck is it? I wrote:
Some argue that Japan never went through deflation. One basis for that argument is that "money supply" as measured by M1 never contracted over a sustained period. The other argument is that prices as measured by the CPI never fell much. Once again we have a flawed argument about consumer prices and a flawed argument that only looks at money and not credit.

Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. Those are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark.
Now given that we hopefully agree on what inflation and deflation are, we can discard the strawman that Saville proposed.

The question then is to what extent the Fed can prolong that monetary expansion if consumers refuse to borrow or banks refuse to lend.

In that respect the consumer IS the key.
It is a key the Fed can not control.

Japan printed money for years and no one wanted it.
Yes, the US is different than Japan. We are far worse off and much deeper in debt. That adds to the deflationist case.
Wage fundamentals are much worse now especially with outsourcing and the internet. That adds to the deflationist case.
Ultimately it comes down to the question of "will the banks destroy themselves and their wealth" to bail out consumers deep in debt.

The answer to that question is "Of course not. Why would they?"
I have heard time and time again that banks can at will cause hyperinflation.
I have admitted that yes they can in theory, time and time and time again.

The real question is then is: "Will they"?
That is what we are debating. We are not debating if they can, we are debating the likelihood of it happening.
I have heard all of the inflation answers before.

We have not had deflation since 1930 and will never see it again.
The Fed will bail out consumers.
The Fed will do this.
The Fed will do that.

It seems that everyone feels the Fed is all powerful, and that the Fed can defeat the business cycle by forever printing money.
That is the fallacy of the inflationist arguments.
It can not be done. The root cause of the great depression was an overexpansion of money and credit. "Helicopter Drop Bernanke" could no more cure that by printing more money than I could take on Michael Jordan in one on one basketball at his prime.

So why has there been persistent inflation since 1940? The answer to that is the k-cycle. Please read The Kondratieff Cycle Revisited for a more in depth look at the k-cycle.

Three fourths of the cycle there is inflation. Each season is long (18-24 years). By the time we get to deflationary winter, many (most) people that have only known inflation all their lives dismiss the idea. No one believes that deflation can happen. They have seen nothing but inflation all their lives. Prechter's huge mistakes were not allowing sufficient time for each season, and for thinking that gold will fall in deflation.

Yes I agree that the Fed could eventually induce hyperinflation by dropping money out of helicopters. OK, so would they? The reason they would not do so is because it would bail out consumers at the expense of banks. Does anyone really believe the Fed would bail out consumers at their own expense? I don’t.

Yes, I believe they will try to help consumers, not by dropping money out of helicopters but by lowering interest rates. However unless jobs are created, with salaries that will allow consumer debts to be paid off, the Fed loses. Asset bubbles in the stock market and then in housing kept the consumer ready and willing to spend. What's next?

If housing is the bubble of last resort, what would happen if the Fed turned on the pumps? I suspect money would go into gold and silver, but no jobs would be produced, certainly nothing like the housing boom produced. That last sentence should explain why many deflationists like gold. That answer is also why it would be game set and match for the Fed. Yes the Fed could in theory drop money out of helicopters, but only if they wanted to destroy themselves. There is theory and there is practice. If consumers are finally at the end of their ropes as I suspect, inflationists are in for one rude shock.

Mike Shedlock / Mish

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