The geopolitics of inflation, an introduction

Summary:  inflation is probably not what you think it is.  Especially today.  Note the comments for quotes about this from major economists.  To see how this applies to us today, go to Debt – the core problem of this financial crisis, which also explains how we got in this mess.

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This essay sketches out in simple terms the nature of inflation and its relevance to today’s geopolitical situation.  This is just a sketch, nothing technical.  A hundred pages could not adequately explain these things.   You will see link to previous chapters in this series at the end.

As Milton Friedman said, inflation is always and everywhere a monetary phenomenon. Rising commodity prices are not inflation, or even inflationary.  More important is what happens next, after commodity prices start rising.  Rising commodity (or import) prices strain the social fabric and distort the economy.  The poor suffer most, since food and energy can comprise 1/4 or even 1/3 of their spending (everyone has their own CPI; the national CPI is an average).  Many industries suffer from rising raw material costs, as raising prices usually depresses unit sales.  All cry for relief from the Central Bank, our monetary wizards.

The central bank can ease their pain, accommodating rising prices by increasing the money supply.  This allows wages to rise, easing the pressure from rising costs.  This relief is, however not free.  The “cost” or “price” is allowing rising prices to ripple throughout the economy.  This is inflation.  Wages are the key factor, the channel between rising commodity prices and inflation.  People cannot spend what they do not have, so rising prices in one sector force down other sectors.

Inflation is bad, and tight money prevents inflation.  So all is fine, under the guidance of a wise central bank.  But — what if commodity prices continue rising?  Then the situation becomes more interesting.

For example, as we see today, rapid global growth can increase consumption faster than capital investments can increase the supply of commodities.  As food and energy consume more of people’s budgets, expenditures on other things must drop.  Discretionary purchases go first, and so the economy slows as those business reduce spending (capex, headcount, hours, wage rates — it all adds up).  Eventually some people cannot make their monthly loan payments (credit cards, auto loans, mortgages, etc).  Now the financial sector suffers from rising defaults.  This is deflation, caused by rising commodity prices and too-tight monetary policy.

To recap this greatly simplified explanation:

  • Rising sector prices plus tight money can create deflation.
  • Rising sector prices plus easy money can create inflation.

Price pressures can come from sources other than commodity prices.  A devaluation of the currency increases the cost of imported goods.  Fortunately, the US imports relatively few goods or the severe fall in the value of the US dollar would might already have forced an unpleasant choice on the Federal Reserve’s governors.

Which is worse for a high-debt economy like ours, inflation or deflation? To grossly oversimplify… The 1970’s had the “great inflation”, a bad decade for America in many ways. The 1930’s had deflation, and saw the Great Depression.  That is an easy choice!

Fed Chairman Bernanake is an expert on the Great Depression, and well understands the danger of deflation to the United States.  He — that is, the government — has powerful tools to fight inflation and deflation. However, success is not necessarily easy, painless, or guaranteed.  There are other factors influencing the outcome, making it difficult for the Fed to induce inflation to offset rising commodity prices.

  • Globalization acts to cap wages in industries exposed to foreign competition (e.g., manufacturing, software engineering, call centers).
  • High rates of immigration caps wages for affected workers (low skilled workers, computer programmers, engineers).
  • The net result might be that wages fail to rise with inflation. That could be painful for America.

Worse, these things are far more complex than painted by this little analysis.  To mention just one of the many other relevant factors:  the US is addicted to borrowing from foreigners; going cold turkey would be painful.  Worse, we need to convince our foreign creditors to continuously “roll over” our loans, since we cannot repay them. This means keeping interest rates sufficiently high and the US dollar sufficiently strong.

The next chapters will discuss the causes of inflation today, and what it might mean for the world.

Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information about this subject

  1. Is the US Government deliberately underestimating inflation? (8 November 2007)
  2. What you probably do not know about China’s food crisis (21 April 2008)
  3. Higher food prices, riots, shortages – what is going on? (29 April 2008)
  4. A giant breaks his chains and again walks the earth: inflation    (10 June 2008)

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26 thoughts on “The geopolitics of inflation, an introduction

  1. “As Milton Friedman said, inflation is always and everywhere a monetary phenomenon. Rising commodity prices are not inflation, or even inflationary. More important is what happens next, after commodity prices start rising. ”

    You’re contradicting yourself. You set up inflation to be “always and everywhere a monetary phenomenon,” but then you describe it as being a price level phenomenon. Do you take “price level” to be a synonym with “monetary”? If so, why?
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    Fabius Maximus replies: This is just Econ 101. The Wkipedia page has a nice, brief explanation of inflation (only 5,000 words), with links to the wider context of economic theory.

    I provide these two chapters (this and the one before) because so many folks interested in geopolitics seem unfamiliar witht the dynamics and effects of this potent force.

  2. Dan, when economists say that inflation is a “monetary” phenomenon, then they do so because they wanted to highlight that there can be no inflation without
    – an increase in the amount of money (printed money, coined money and some especially liquid forms of deposit money) or
    – increased money circulation speed

    The increase in the amount of money (most easily understood as money printing) is what Bernanke does since months by injecting so much liquidity into the banking sector.

    The formula goes like this: amount of money x circulation speed of money = grand national product * price level.

    The circulation speed of money is almost a constant and grand national product doesn’t change rapidly in industrialized, mature economies. That’s why there’s a strong connection between amount of money and price level (and their respective changes).

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    Fabius; your occupation with commodity prices is no good idea in regards to the inflation topic. Commodity prices don’t cause inflation. Commodities become more expensive due to inflation (often with the intermediate step of exchange rate), but that’s quite the same for many non-commodities as well. The only difference is that most commodities can adapt very well and quickly in price.

    Your explanation on deflation seems plain wrong to me. It’s simply not part of established economy theory and seems to be inconsistent anyway. Rising prices are an opposite to deflationary price changes. Deflation = money becomes more valuable over time = decrease in general price level. Price increases anywhere in the economy might tighten the households’ budgets and change trade-off decisions in favour of the cheaper goods/services, but would not cause deflation.

    I believe you also misunderstood income with money supply.
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    Fabius Maximus replies: I do not want to turn this discussion into a seminar on Econ 101. One correction:

    “The circulation speed of money is almost a constant ”

    The “circulation speed” of money is called its velocity — and it is not constant. The 1970’s monetarists believed it to be, and learned in the 1980’s it was not. This was one of the factors that sank monetarism as an operational doctrine.

    “Commodity prices don’t cause inflation”

    How nice that you read my post. That is what I said.

    As for the rest, I will break one of my personal rules. I detest appeals to authority, but …

    RGE Monitor re-posts some of my material. It is an expensive subscription service. From their “about” page:

    “RGE Monitor was founded in 2004 by a prestigious team of economic and political experts. Today, thousands of senior managers at first-tier public and private financial institutions rely on our insights. Our clients include prominent asset managers, hedge funds, commercial banks, investment banks, policy organizations and universities. Thanks to our innovative content and services, RGE Monitor has been named one of the world’s best economics websites by BusinessWeek, The Economist, Forbes and the Wall Street Journal.”

    “… RGE Monitor delivers ahead-of-the-curve global economic insights that financial professionals need to know. Our analysts define the key geostrategic debates and continuously distill the best thinking on all sides. This intelligence, along with exclusive analysis from internationally-known experts, is accessed through a …”

    This does not mean that I am correct, even about these Econ 101 basics. However, the discussions on RGEM are usually quite technical and the level of expertise at RGEM quite high.

  3. I have long advocated studying early Modern history for precedents for the present era. Simply put, since we apparently are moving into a post-Wesphalian era, it makes sense to consider that which immediately preceded Westphalia.

    One aspect of this era was the inflation set off by the discovery of Spanish gold.

    This inflation had many consequences, but one was the undermining of the British monarchy and the rise of Parliament.

    Simply put, the monarchy’s income came from landed rents, which were fixed. As prices generally rose, its effective wealth decreased. Because they had seized the monastery lands, the Tudors escaped the full impact of this; but the Stuarts felt it front on. As their need for more money grew, they had to turn to Parliament for new revenues. Parliament demanded concessions in return. This struggle caused the Civil War and ultimately culminated in the Glorious Revolution.

    This was a highly unsettled period in British history, during which London arose as a great metropolis, agriculture was enclosed, and enormous disparities in wealth existed.

    There are many parallels between the early modern period and the present. But should inflation revive, that would be one more.

  4. “Fortunately, the US imports relatively few goods…”

    I thought the trade deficit reached a high point just a couple of years ago (~800 Billion). That generally means that we are importing a lot of goods (unless you are suggesting we are importing services). Don’t get me wrong, I don’t think the trade deficit is as big a deal as a lot of people, but that sentence doesn’t seem to make much sense (unless you are talking % GDP).

    Also the thing that’s nice about reasonable inflation is that it encourages re-investment in assets, instead of simply hoarding dollars.
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    Fabius Maximus replies: You are confusing the level of imports with the balance between imports and exports. They are unrelated. We have a low level of imports, compared to say Germany. But we export far less, hence the trade deficit.

  5. Fabius is right in his description. One definition of money is “part of a relative pricing system and an accounting store of value.” Also inflation was defined by John Kenneth Gailbrath as “To many dollars chasing to few goods.” Good article Fabius.
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    Fabius Maximus replies: Thanks. This is a great aphorism, although I have never been able to track its origin. It is most often attributed to Milton Friedman, the father of monetarism.

  6. The correct definition of inflation if you are a regular follower of the contribitors to http://www.financialsense.com goes something like this “money creation by a goverment at a rate in excess of its GDP growth rate” Money Supply is typically referred to M1,m2 or M3. Money created without being anchored to some store of value and not being redemable is something more than a promise at the least is inflationary or something far a far worse consequence to a state. Gold has stood as reliable bench mark standard for a monetary system in prior times and for more conservative goverments. Today the western world is based upon a system of fiat currencies (not backed by a standard like gold) but only floats relative to each other while together sinking (devalued) to zero over time because of excess creation or delution of money supply. By bypassing a standard of value and printing excess money to wage war is an old trick at the cost of the nations wealth and the lives of its lives of its citizens. With a little research you will find for an extended time now that M3 money supply for the US and the key nations of the world is growing in the range of 16% and higher (very inflationary). With so much money floating around “bubbles” pop up…in recent times in sequence Tech Bubble, Housing Bubble, and now commodities like oil, gold, materials, food and anything of physical value.

    It doesnt happen by accident it happens by calculated policies of Gov’t and Central Banks to keep them in power at the expense of canibalizing the wealth of its citizens and the economic base of the state. Wars are expensive if they don’t pay for themselves!!!! Finally by the time inflation is apparent to the citizens it shows up in many visiable ways wages, food, commodities, gas, equities, home prices etc)and thus become the scape goats for bad policy. All these forms are painfull to the citizen and distructive to the state who are stuck with the bill well after the crooks have left town after eating your lunch.

    Inflation is a PLANNED state and central Bank Policy..it’s the only way goverments can renig or pay for all thier funded and unfunded promises. Central banking is so important for state control that it is plank #5 in the Communist Manifesto the population. By the time it shows up in your wallet the system is broken and the bill must be paid in a painfully way to be fixed.
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    Fabius Maximus replies: Using a site like Financial Sense to determine the “correct” definition of anything is IMO absurd. It presents material from many sources. Some excellent, some fanciful, some bizarre. It has a strong point of view, which gives it consistency and clarity — but sometimes at the cost of accuracy.

    These views are mostly conjecture and overstatements. Some unproven, some unprovable.

    For an example of the perils of relying on sites like that as a source of information consider their interview with one of the world’s great energy experts — Matthew Simmons.

    “Well, the fact of the matter is the refineries in the United States it would appear their core units are basically on average are about 85 years old. And an 85-year old man is old. A refinery that’s 85 years old should have been rebuilt.”

    He may have misspoke (easy to do). It may be a transcription error. But this interview was widely cited, even this factoid — which is clearly wrong. Some core units might be 85 years old, but clearly the average is far less than that. Neither the interviewer, editor, or core audience caught this.

  7. Fabius,
    There is a very clear pattern of price and asset inflation without corresponding wage inflation. This enriches some and impoverishes many by the need for people to borrow to maintain their standard of living (HELOC’s anyone?).

    Actually, in association with a managed decline in the USD, it may be ultimately beneficial to the working class as manufacturing jobs and other outsourced jobs return to the states. Its just the intervening decade that’s a bit of a bitch when you’ve been unemployed/underemployed.

    However, regarding the immigration & H1-b issue, there is a tipping point that exists where the US wages coupled with its higher cost of living and depreciating currency, no longer make sense for them and they return to their own countries. Anecdotally, foreigners who are here because of the wage arbitrage issue make no bones about their plans to return to their own country after 10 years as ‘millionaire’ equivalents in their native lands.

    It is arrogant of the United States to assume that there is an infinite supply of immigrants to come into this country, do unskilled & highly skilled jobs so that their employers can profit handsomely, and supply our population with growth. If we do not make the US an attractive place to live for ourselves, it will not be an attractive place for immigrants either. And we will be very much on our own.
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    Fabius Maximus replies: I agree with your first point. During the past three decades we have had inflation above wage growth for the bottom 3 income quintiles (perhaps event the bottom 4 quintiles). The result has not been pretty. Standards of living have been maintained by putting a second spouse to work and borrowing.

    As for the US dollar, I said something similar in this post: “Geopolitical implications of the current economic downturn” (24 January 2008) – How will this recession end? With re-balancing of the global economy, so that the US goods and services are again competitive. No more trade deficit, we can pay our debts, and outsourcing of jobs is no longer a major problem.

    Unfortunately there is, in practical terms, an infinite supply of potential immigrants to the US. Lower growth will reduce the flow, as will a lower standard of living. On the other hand, other factors — such as destabilization of Mexico — might increase the flow.

  8. Plaudits to Fabius for his efforts toward the reintegration of economics and politics. A century ago, before the twain were so tragically sundered, we used to understand the two of them together as political economy. This severance into two separate academic disciplines has tended to blind us to their fundamental interconnectedness. That Fabius would repeatedly cite Milton Friedman, in my view among the blindest of the blind in this regard, adds a delicious touch of irony.

    Duncan Kinder is also onto something important in the matter of inflation in the Spanish Empire following Conquistadors’ looting of American gold and especially silver – or as he more delicately puts it, “the discovery of Spanish gold.” Every few years, following the docking of the Silver Fleet in Spain, one can plot the waves of inflation washing across the European map like ripples in a pond.

    But perhaps more important to us is how the Spanish spent their newfound wealth: conspicuous consumption of imported goods, and foreign wars. The silver which paid for Spanish imports helped capitalize the English and Dutch merchant enterprises (on its way to China, which is where much of that American silver wound up – but that’s another story).

    It seems popular these days to compare the decline of the American to that of the Roman or British Empires. I wonder if the fate of the Spanish Empire might not be more relevant to our present experience.

    Jimmy
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    Fabius Maximus replies: The effect of stolen gold on Spain is an example of the “resource curse”. From Wikipedia:

    “The resource curse (also the paradox of plenty) refers to the paradox that countries with an abundance of natural resources tend to have less economic growth than countries without these natural resources. This may happen for many different reasons, including a decline in the competitiveness of other economic sectors (caused by appreciation of the real exchange rate as resource revenues enter an economy), volatility of revenues from the natural resource sector, government mismanagement, or political corruption (provoked by the inflows of easy windfalls from the resource sector).”

  9. Right, I did simplify a bit. Neither comment section nor motivation allow for long texts. And yes, I gave thevariable the wrong name – this might be because my native language is German.

    You’re referring to external experts, then I can refer to my university degree on economics.

    Money and inflation theory differ a bit across the Atlantic in the past two decades; the Federal Reserve Bank’s point of view has been damaged a lot by repeated failure (financial market crashes originating in the U.S. about every nine years). The ECB uses different methods, including a partial orientation on M3 and monetary theory.

    Experts disagree all the time on interpretations (often because variable values are not certain), but wrong theories are quickly exposed as such because of the scientific principles. I know no theory that would support your interpretation. One of the most common explanations for deflation is even directly contrary to your concept; it’s about an excess supply of goods.

    I’ll be on a travel in the next days; but maybe you would still show a single scientific theory that concludes that high commodity prices can cause a deflation? I think you can’t, because economic science is extremely quantitative since decades and the math would oppose your conclusion.
    I checked some of my standard literature, less than five years old – and there was no mention of anything that resembled your conclusions in the inflation/deflation/money theory chapters.

    Even if you could provide such a theory; your presentation of “deflation” as what you describe is misleading at least, as deflation is commonly known as something without most of your specifics.
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    Fabius Maximus replies: I still do not understand your objection, as this is all Econ 101 material. I did not give a general theory of deflation, but an example of how it might occur during current circumstances. Nor did I say that there was only one “right” view of inflation; see the Wikipedia page for brief descriptions of the various schools of thought about this.

    Deflation is a decrease in the general price level, as seen in the Great Depression. Like inflation, there are many paths to inflation. Excessively tight monetary policy vs. events — like that caused by bank failures during the 1930’s — is one straightforward cause. Excessively tight monetary policy might do so today, through widespread loan defaults forcing an economic contraction. I described the process, in a simple but standard way.

    This is too simple an issue to bother with, in my opinion. Nor have you stated any specific objections, just general disagreements.

  10. Given the incentives (no one wants to owe money in a time of deflation), inflation looks a lot more likely. Given this, and our current situation, and absent some sort of financial sector collapse (and concomitant money supply contraction), I would have thought that deflation is very unlikely.

    I mean, just check this graph out: Graph of MZM
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    Fabius Maximus replies: Llooking at one graph tells us nothing, esp without knowledge of the underlying dynamics. This is MZM, Money of zero maturity — equal to M2 less time deposits, plus all money market funds. It measures the supply of financial assets redeemable at par on demand. Most of this rapid rise in MZM results from movement into money market funds from other financial products (asset-backed commercial paper, auction rate instruments, etc).

    This is seen by the low rates of growth in the Reserves, Adjusted Monetary Base, and (perhaps most significant) M2. Looking at the overall picture, some experts have the opposite concern: that the Fed has an excessively tight hand on the money supply, given the rising rate of loan defaults.

  11. Looking at one graph shows changes in the measure the graph represents. MZM shows MZM, plus compounded rates of change.

    However, I have no wish to engage in the tedius defintional nit-picking that has characterised the comments on this post so far.

    The current environment for the US dollar seems inflationary. The rising price of commodities suggests inflation. The current head of the Fed’s academic career suggests a prediliction for inflation over excessive monetary tightness. Rates of interest vs rates of inflation suggest inflation. The US’s position as a debtor nation suggests that inflation is more likely than deflation, if the US government has anything to do with it. Your own analyses seemingly suggest inflation (1, 2, 3).

    Anyway, why don’t you link to some of those analysts who believe that we’re facing possible deflation via hawkish monetary policy, or outline the argument yourself?

    1. “A giant breaks his chains and again walks the earth: inflation
    2. “Is the US Government deliberately underestimating inflation?
    3. “Higher food prices, riots, shortages – what is going on?

    [snip — no investment discussions, please]
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    Fabius Maximus replies: My point was not nitpicking, but goes to the key aspect of monetary analysis. Movement in one monetary aggregate that does not appear in the others probably results from non-systemic factors (such as the move I described into money market funds) — esp. when a higher-level (broader) measure is not confirmed by the lower (core, base) numbers.

    The key point of this series is that the situation is complex, not simple as so many faux-experts describe.

    (1) The rise in commodity prices does not mean inflation. That was the point of this post.

    (2) Inflation today is centered in the emerging nations, esp. those using the Bretton Woods II “system.”

    (3) The US is experiencing forces that could result in either inflation or deflation.. Rising commodity prices, a falling currency, and debt defaults.

    (4) Inflation is usually a choice. We can only guess what path America will choose.

    The last is perhaps the most important thing. One of the major themes of this site is that too many experts pretend to be Mr. Wizard, making confident predictions about things that are inherently unknown. If we lost our tolerence for this, we would be a far stronger society.

    Speculation, clearly labeled, helps us see the many possible futures. IMO experts who pretend their inspired guesses are prophecy hurt us more than they help.

  12. Stop calling that “Econ 101”, please. It isn’t at all. You attempt to give credibility to it that it doesn’t deserve. It’s not “Econ 101” that high goods prices cause deflation. Not in any way. It’s nonsense. Your description is not “standard” in any way.

    You write of commodity shortage, but that causes inflation – excess supply can cause deflation. You write about “rising sector prices” – there’s no situation in which can add to deflation. The only thing you got right about deflation is the so-called “tight” money supply.

    Read on wiki about “deflation” – that text is OK. It doesn’t mention the nonsense of high goods prices causing deflation under any circumstances.
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    Fabius Maximus replies: I hope you will excuse me when I rely on the extensive research I do for these posts instead of yoru assertions. Not only have I discussed this at length with some competent economists, the folks at RGE Monitor have posted this article. I know from bitter experience how quickly their readers correct me about any — even small — errors of economic theory or history. Nothing received yet.

    The effect of exogenous shocks, like rising oil prices, is not straightforward. I suspect you did not follow the sequence of events I described. Debt defaults are the channel from rising commodity prices AND tight money to deflation. Debt defaults are a powerful deflationary force — in one sense they are pure deflation, destruction of money. So it was in the 1930’s; so it might be today.

    You raise, implicity, an important point. I try to provide readers with new insights, either my own or from others. Venturing beyond consensus thinking increases the odds of error in fact and reasoning. As a checking mechanism, this site welcomes critics, unlike other sites — including high-quality sites like the Small Wars Council or RealClimate — that censor postings and/or ban critics.

    What’s more, I try to engage critics — despite the absurd increase in the already absurd time required to run this site. My critics the best check on the content.

  13. (1) I never said that price rises “means” inflation. I said that rising prices suggests an inflationary environment. Why do rising prices suggest inflation? Because — Econ101! — when too much demand chases too little supply, prices rise.

    (2) I think that’s pretty obvious.

    (3) The debt defaults question I already addressed: the financial system might collapse and throw us all into a defationary depression, or the central banks could prevent that from happening. Which is more likely? Think of my mock investment advice — if deflation is more likely, go long the dollar: lend me money at 0%, I’ll invest it in tangible assets, and in three years time I’ll pay you back the principle. Sounds like a good deal to me!

    (4) Exactly, it’s choice. If the dollar appreciates in value, how will you pay back your loans? How will you pay for the retiring baby-boomers?

    Do I know what will happen? Of course not! And neither do you (even if you have had a couple of pieces picked up by RGE Monitor!), nor does anyone else. All we can do is look at the evidence and try to figure out where we’re going and where the dangers are.

    Sheesh… forget I mentioned it!
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    Fabius Maximus replies:

    (1) You said “rising price of commodities suggests inflation”, and I replied to that. In this comment you say “prices”, which is a very different thing. Commodities are only one sector, and should not be confused with “prices.” As we see today, with commodity prices rising but many other prices falling – so the net rise is quite small (and may grow smaller still in a recession).

    (2) I agree with you, but it is not obvious to everyone!

    (3) You might be correct. All I say is that inflation/deflation are largely choices. We can guess which path America will choose (my guess is the same as yours), but our choice is not inevitable.

    (4) Yes, we agree.

    Your last point is perhaps the most interesting.

    “Do I know what will happen? Of course not! And neither do you… ”

    Your harsh comment seems odd, since this post does not say or imply that “I know what will happen.” It does the opposite, with no forecasts. Even the analysis is describe as tentative.

    ** It opens with “This essay sketches out in simple terms the nature of inflation and its relevance to today’s geopolitical situation. This is just a sketch, nothing technical.”,

    ** It ends with “Worse, these things are far more complex than painted by this little analysis.”

    You conclude by saying “All we can do is look at the evidence and try to figure out where we’re going and where the dangers are.” I agree; in fact that is one of the major themes of this site.

    Success comes from skating to where the puck will be. Speculation about the future helps us see the range of possibilities that lie before us, and their consequences. The “standard” form of these posts is to outline a scenario and describe the choices we will face under these circumstances. Sometimes I give forecasts, but always (at least I try for “always”) clearly labeled as guesses.

  14. Ok — apologies for the abrupt post. I was a bit puzzled by the overly didactic response to what I thought was a harmlessly speculative and perhaps even slightly throw-away initial comment. You are quite right: imagination and a spirit of open-minded investigation are the important necessities for our survival and future prosperity.

    Rising prices in general suggests inflation. Whether this particular commodity boom reflects inflation in actual fact is of course debatable. There may be other explanations. I think a lot has to do with increases in demand from emerging markets, plus all the other things like lack of investment and supply shocks. However, a weak dollar is going to contribute at least something. If real interest rates are negative…

    And whether or not the rest of our economic picture is inflationary is also another matter. Like you say, a tight monetary policy combined with rising commodity prices could cause other prices to fall, as food and energy spending crowds everything else out from comsumers’ budgets. Financial collapse, or even just extremely tight credit markets, could cause a monetary contraction and thus a downwards price spiral.

    Are we seeing that? I know lending is sluggish, but it looks to me as though Bernanke is equipped and ready to step into the breach to supply more liquidity and whatever else is needed. And I’m not an American, but as far as I’m aware, the US is still experiencing inflation, though not of 1970s proportions (I’m sure that you will have read Palley’s recent essay on the non-existance of the inflation-wage spiral). But has the US really seen any price decreases in recent months? And is US monetary policy really tight? With negative real interest rates, I just can’t see how anyone could describe Fed policy as anything other than expansionary (even if the Fed’s actions are totally necessary).
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    Fabius Maximus replies: Thank you for taking the time to reply at such length and detail. Comments like your are what make this site work. Our dialog has prompted me to write a post about the contribution of comments to this site!

    As for current inflation, aprox 1/3 of the CPI basket (from memory) shows falling prices. For example, drugs — as pressure from Wal Mart and buyers radically compresses margins. And used car prices are in freefall, which will inevitably force down new car prices. In general, consumer essentials are rising in price, while consumer discretionary goods are stable or falling. Since people are more aware of the former than the latter, the perception is that prices are rising more strongly than in fact.

    Low rates and stagnet growth in the key monetary aggregates (those unaffected by credit) both suggest tight money. If we were experiencing strong inflation, the Fed could maintain low short-term rates only by expanding base money. Since that is not happening, monetary policy is neutral to tight.

    That the Fed has been able to avoid using its monetary ammo this far into a credit crisis shows rare — even extraordinary — skill. We will need such skill, IMO, to get through what lies ahead of us.

    The current situation is confusing as the US economy is experiencing strong forces on both sides. Rising commodity prices, a falling currency, debt defaults, and a slowing economy — all of these have been in the past associated with inflation/deflation. Folks who focus on one of these draw strong conclusions, ignoring the other off-setting factors.

    Paley describes one of the major fault lines in modern economic theory. The other is the treatment of aggregate debt levels. I believe these are better seen as the edges of the envelope of modern theory, where the ruline paradigm (per Thomas Kuhn) breaks down.

  15. Interesting article.

    We have a situation here in the UK, where the chancellor of the exchequor has advised that he will not cut rates to ease inflation. He asked has asked public and private sectors to reign in wage increases. This is causing many problems. As trade union put pressure on the government to meet wage increases of up to 4.0% or face the action of a strike.

    Interesting times ahead.
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    Fabius Maximus replies: Thanks for the news about this from the UK! I totally agree with your conclusion!

  16. Vimothy raised so many good points, they cannot be fully dealt with in the comments. One however is esp important to understand about this site.

    “even if you have had a couple of pieces picked up by RGE Monitor!”

    Mentioning this was not intended as an appeal to authority (well, not much). More important is that it exposes these articles to intense, expert criticism. That is the key to the operation of this site, as seen in the large number of posts in which the comments are a multiple of the word count count of the original post. Since these posts are on the edge of our understanding, that is a good thing — a sign of success.

    These posts are littered with “updates” fixing errors. As Prof Donald Foster said, when admiting a major error in his work: “No one who cannot rejoice in the discovery of his own mistakes deserves to be called a scholar. ” Even those of us who are not scholars can follow his lead and advice.

  17. You claim that this “high commodity prices can lead to deflation” thing is Econ101, but you only mention your RGE connection (no scientific site) and “Venturing beyond consensus thinking”.

    Tell me a single scientific source (something more solid than a doctor’s thesis) that supports your assertion, please. If you did such “extensive research”, then you should be able to provide a single source for your claim that it’s “Econ101”.

    I finished my economics studies few years ago, never heard of that. My books don’t know about that. Web sources that I looked at don’t know about it. My colleagues only laughed. It’s not Econ101 – it’s a non-scientific thesis at most according to my checks on it.
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    Fabuis Maximus replies: Your reply has several intersting dimensions to it.

    (1) You put “high commodity prices can lead to deflation” in quotes. You must be quoting yourself, for I did not say this.

    (2) That you do not respond to what I say, or even accurately repeat it, suggests that you are not listening. This is a common phenomenon on the Internet; I call it shadowboxing. You might have seen this on your own website. Experience has shown me how many hours can be burned discussing things with someone who is not listening.

    (3) That your colleagues laughed suggests that you gave them the same burlesque view that you repeat here, rather than what I actually said. You say “”high commodity prices can lead to deflation”, which is like saying 2 = 9.

    I said that in a high debt economy like ours, rising commodity prices PLUS tight money can result in loan defaults and recession, which cause deflation. That is like 2+3+4=9. The conclusion “This is deflation, caused by rising commodity prices and too-tight monetary policy” is meaningful to a non-economist only when accompanied by the full equation. If you had said this to your collegaues, they would have probably replies “Yes, of course.”

    (4) Looking at the first step in the process, high prices in one sector depressing prices in other sectors is easily visible today. High oil prices have depressed used car prices (see th Manheim data). High food and energy prices force retailers to cut prices. For more on this see “Doing Whatever Gets Them in the Door”, BusinessWeek (19 June 2008) — “Merchants are going back to basics — cutting prices, broadening product lines, and even teaming up.” Excerpt:

    “Discounts are deeper than they were a year ago. Nordstrom (JWN) has slashed prices, starting at 40%, vs. 33% last year. Sales have begun earlier. … Of course, this is no ordinary downturn. Yes, tax rebates from the federal government pushed retail sales higher in May than many economists had expected. But consumers will be paying lofty prices at the gas pump and supermarket long after the stimulus checks stop arriving. That leaves less for discretionary buying. … Sheila McKusker, who notes that, in 20 years of tracking the retail industry for market researcher Information Resources, she’s never seen such a profound or sudden shift in shopping behavior.”

    (5) This article has received over three thousand hits, in additional to previous circulation among the economists I rely upon for advice. None of the economists or financial experts in that audience have found this difficult to understand — or profound, Just basic intro material.

    That does not prove that your view is incorrect, but suggests that this is not the glaring error you seem to consider it.

  18. Deflation can result from almost any destabilizing event, if it results in a contraction of bank credit — usually through loan defaults. Credit is a channel connecting the initial event — rising commodity prices, Asian inflation, or economic warfare — to deflation. That’s why the Central Bank response to even non-economic events (e.g., Y2K, 9/11) is so important.

    A nice example is a June 2008 report by Russell Napier (author of Anatomy of the Bear: Lessons From Wall Street’s Four Great Bottoms). It is 23 pages and quite technical, describing various ways the currently unprecedented global imbalances might get resolved.

    Here is the nickel version. Foreign inflation, largely in nations pegging their currencies to the US dollar (e.g., China, Saudi Arabia), will force them to upwardly re-value their currencies vs. the US Dollar.

    This would usually be inflationary for the US, as a dollar then buys a smaller amount of imported commodities and goods. However, allowing their currencies to rise means that “Foreign central banks will eventually begin to liquidate holdings of US Treasuries, and a deflationary economic adjustment in the US is likely to follow.” That is, the inflationary effects might be overwhelmed by the deflationary effects. Central bank policy in such events requires extraordinary skill in navigating between too-loose and too-tight monetary policy, with the Goldilocks’ balance difficult to find.

  19. Inflation = the devaluation of a currency caused by an excess of money in circulation. The root cause of this is money created by financial institutions when extending credit.

    Central banks attempt to [indirectly] fight inflation by manupulating the interest rate to make money more or less expensive to lend, rather than fighting it directly by controlling the creation of money. As a result, inflation will always increase over time.

    Human nature being what it is, there is always someone willing to offer easy money.

    As an example, you own an organic farm – (something with minimal inputs – sun, rain, and animal manure), and you’re self sufficient in labour and animal manure – the sun and rain are free. All things being equal, it shouldn’t cost you any more than what it cost an organic farmer 100 years ago to produce what you produce, and yet you ask more for your produce. Why? because your national currency is worth less now than it was back then.

    The only money governments create is the notes they print and the coins they mint. That is a tiny fraction of the actual money in circulation. The rest is created by private banks when extending credit.

    In short, the amount of money in circulation bears little or no relation to the actual goods and services produced.

    Like many things, it is fixable, but unfortunately there is no political will and too much apathy on the part of the citizenry to do anything about it.
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    Fabius Maximus replies: (1) Inflation is usually defined an increase in the general price level. Devaluation of the currency and/or excess creation of currency are two of the many causes of inflation.

    (2) “Central banks attempt to [indirectly] fight inflation by manupulating the interest rate to make money more or less expensive to lend, rather than fighting it directly by controlling the creation of money. As a result, inflation will always increase over time.'” History is hostile to “never” and “awalys.” The post-WWII German central bank is a counter-example. They are now running the ECB, which seems likely to be a 2nd counter-example.

    (3) “The rest is created by private banks when extending credit.” Since banks in America no longer issue their own currency, this is not correct. You are perhaps referring to the fractional reserve banking system, which is a process operated by and totally under the control of the US government.

  20. I think need to look at an increase in prices from two different viewpoints, an increase or decrease in prices caused by supply and demand is not inflation or deflation. For example: RAM chips being more expensive due to a shortage of them, or cheaper due to a glut of them.

    The devaluation of a currency caused by the excess creation of money is the primary cause of inflation IMO.

    Money and Currency are similar but not the same. Currency is notes and coin, and no private bank issues them anymore, either in your country or mine. Money generally exists as ones and zeros in a computer these days, and the primary manufacturer of this form of money are private financial institutions, as a loan – not the government. You can check the wikipedia article on fractional reseve banking under money creation: fractional reserve banking.

    You say its operated by an totally under the control of the government, but it is not clear to me how this is so.
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    Fabius Maximus replies: An increase in RAM prices is not inflation because it is not a general increase in prices, just a change in one price.

    As for the money-creation effect of fractional reserve banking, the reserve ratio is set by the government. Also, the government sets the interest rate which it pays on reserves. These two factors control the money creation “multiplier” of banks. If set at 100%, banks operate only as storehouses of value (as if we used gold coins instead of money) — and there would be no money creation by banks.

  21. True, but when private financial institutions create money by issuing credit, the executive branch of government has abdicated the right to collect seigniorage on the majority of money created, thereby missing an opportunity to tap into a revenue stream that, used wisely could be used to minimise the taxation burden of ordinary citizens, it would not however be a substitue for taxation.

  22. The relationship between rising commodity prices and easy money (inflation) or too-tight money (deflation) is a commonplace in current economic literature. Don Coxe of the Bank of Montreal calls the collision (or coexistence) of inflationary and deflationary forces “like being burned by dry ice.

    Here are two excerpts from reports by David Rosenberg, economist at Merrill Lynch, who has written much about this.

    (1) “Discretionary spending is getting increasingly displaced by the necessities of life as these items go up in price. The amount that consumers, as a whole, are spending on energy, debt payments, medical care, food, and taxes has soared to nearly 65% of total personal income. That is a record amount…” (10 June 2008)

    (2) “In fact, what seems to be happening is that the inflation in basic essentials, in an environment of stagnant wage growth, is actually causing the deflation in the other more discretionary goods and services since consumers have little left over to drive demand in these cyclical areas — autos and trucks being a classic case. So as Mervyn King (Bank of England) said, and I totally agree, the story remains largely a relative price story. … Not only is there no evidence at all of monetary inflation, but there is also no sign at all of wage inflation. … I will become far more nervous over a sustained inflation breakout if unit labor costs were to turn up meaningfully…” (27 June 2008)

    Also note this excerpt from “The End of the Inflation Scare?”, Louis-Vincent Gave, GaveKal (27 June 2008) – They are a-team monetarists; subscription only.

    “But of course, the surge in commodity prices cannot be the sole explanation for the recent surge in inflation numbers around the world. After all, an event like the spike in oil prices could also prove to be highly deflationary, since it takes money from the private sector and gives it to the public sector which will typically waste it (i.e.: Chavez financing Castro, Ahmadinejad subsidizing Hamas and Hezbollah, etc…).

    “For a commodity price spike to be inflationary, it needs to be accompanied by excess money creation. If it is not, all that we witness is a change in relative prices across the economy (i.e.: oil prices up, auto and house prices down). This is why Milton Friedman once said that “inflation is always and everywhere a monetary phenomenon” while, around the same time, Jacques Rueff made the observation that “inflation is subsidizing expenditures that give no returns with money that does not exist”.

    “So given that we are now living through a surge in inflationary prices, the questions we should ask ourselves is a) where the excess liquidity creation of recent years has come from? and b) whether excess liquidity continues to be pushed into the system, hereby guaranteeing further increases in inflation in the coming quarters and years?”

  23. More on rising commodity prices forcing deflation in other prices, from today’s report by economist David Rosenberg:

    “For those perplexed over how it is that the bond market has not imploded {i.e., interest rates risen} because of the ongoing runup in oil prices, the answer is that this runup has created a deflationary backdrop in other parts of the economy — especially the automotive sector.

    “… And in another sign of the deflating effect that inflating energy prices are exerting on various segments of the macro backdrop, see page B3 of the WSJ: the title says it all — “Fuel Costs Push AirTran to Cut Wages by 10%”

  24. More evidence that commodity price increases are not causing inflation to substantially rise, because wages are flat. From economist David Rosenberg, 21 July 2008:

    “The PI surged 1.8% in June but the core PPI was only +0.2%; the CPI soared 1.1% and the core was up a more modest 0.3%. The ability to pass on raw material costs though the production chain and into the consumer sphere remains severely limited.

    “The bigger picture for the inflation landscape has not changed, in our opinion. Higher energy and food prices will be with us for some time, but we expect pass-through to core CPI will be minimal and limited to one-time price adjustments.

    “The bottom line is that the wage pressure needed to create a wage-price spiral are simply not there. And, the rise we expect in the unemploymebnt rate to 7% by mid-2009 will ensure that they remain under wraps.

    “With the consumer likely on the verge of the first recession in 18 years, we believe that a large and deflationary output gap is in the cards — the largest disinflationary impulse unleashed in the economy since the early 1980’s.”

  25. More on the relationship of commodity prices, wages, and debt defaults, from economist David Rosenberg, 25 July 2008:

    “All one has to do is pick up the newspaper to see that autos, housing, or practically anything you wnat to buy is experiencing ‘fire sale’ conditions. it is important to note that commodity bubbles in an environment of stagnang growth in wages and the money supply, as we are now in, are actually deflatinoary since they put more pressure on the consumer and the profit margins of corporations that have commodities as key inputs into the product or service they sell. That is why we find it very difficult to depict the current or prospective backdrop as inflationary.

    “The end of a two-decade secular credit cycle that turned parabolic in its late stages (from 2001 to 2006) is a very important development. The forces that are now building to downsize balance sheets in the banking sector and lower debt in the consumer space are going to be deflationary in terms of the constant selling of assets and consumer durable goods that this liquidation process entails.

    “This fits into the true definition of deflation more than anything else, since inflation or deflation is always a monetary event. In other words, the amout of money that households have to spend either through wages or credit is what ultimately determines the general level of prices.”

  26. Inflation is a purpose driven act by the Fed Res to increase credit money by reducing the interbank lending rate for member banks (aka Fed Funds Rate) and reducing the Reserved Required Ratio.

    The intended result of inflation is economic growth through new commercial and new consumer debit formation.

    Often, rising prices happen consequent to inflation as credit money (aka rented cash, aka debt) plus existing money in circulation (notes plus coins) bid up prices of the relatively fixed supply of things available for sale at any moment.

    On an aside, Wikipedia is the last source of relevancy for economic and political intelligence.

    Referencing Wikipedia for such is akin to asking an enemy of one people for his opinion about them.

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