Inflation or Deflation? Nobody knows what path will we take.

The news and Internet are filled with confident predictions of inflation, classic example of fighting the last war.  In the midst of debt deflation, with high levels of unemployment and 70 year low levels of capacity utilization, worries about near-term inflation are totally unfounded.  Looking in to the future and the picture changes.

  • Inflation will be likelyif we have a strong recovery.
  • Or we might have severe deflation, against which government takes drastic action to fight it (which would be the wise course, even though it creates high inflation).

A quick history of the inflation/deflation storyline on the FM site.

In June 2008 I wrote that deflation was likely unless the Fed increased the money supply to compensate for high commodity prices (esp oil).  They did not, and now we have deflation (technically debt deflation).

In October 2008 I wrote about the serious debt deflation that was even then evident.  We all know what’s happened since then.

And now?  Rising unemployment and falling real wages (for the first time in 50 years) are a bad combo for households, since their debts remain the same.  These are the drivers of a deflationary spiral, as defaults and bankruptcies further slow the economy.  As I note in this post, government stabilizers are our only recourse at this time.  (Government action does not “fix” the economy, despite politicos’ claims.  It is a palliative, minimizing the suffering until the economy heals)

What about the future?

Unanticipated inflation is the magic sauce of monetary policy, able to work miracles. However it requires marks, people unaware of the possibility of inflation and its consequences. That was true of Germany and Austria in the early 1920’s, as it was of Americans in the late 1960’s and 1970’s (our first peacetime inflation).  However, inflation was the formative economic experience of the boomers. Like “survivors” of the Great Depression, they have waited their entire lives for a repeat of this formative experience — what would be their greatest opportunity to gamble and win!

As people prepare for the “obvious” inflation, the government’s benefit from that inflation decreases. Consider the situation (exaggerated for emphasis) in 2 years (to pick an arbitrary number), when (if) the recovery comes. Everybody (including elderly widows in Smallville) will own only hard assets, inflation protected securities, or short-term debt. The average maturity of the Federal debt will be 2 weeks (vs. about 4 years today). Under these circumstances the government must avoid inflation at any cost, as the resulting increase in its interest cost would be lethal.  Just like Japan today, with its debt of 2x GDP and short average maturity.

For more information

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp interest are:

Posts about deflation:

  1. The geopolitics of inflation, an introduction, 17 June 2008
  2. Debt – the core problem of this financial crisis, which also explains how we got in this mess, 22 October 2008
  3. New recommendations to solve our financial crisis (and I admit that I was wrong), 23 October 2008
  4. The Coming Global Stag-Deflation (Stagnation/Recession plus Deflation), 28 October 2008
  5. A situation report about the global economy, as the flames break thru the firewalls, 26 January 2009
  6. Economic theory as a guiding light for government action in this crisis, 10 March 2009

2 thoughts on “Inflation or Deflation? Nobody knows what path will we take.

  1. FM: “Unanticipated inflation is the magic sauce … However it requires marks … As people prepare for the “obvious” inflation, the government’s benefit from that inflation decreases … Under these circumstances the government must avoid inflation at any cost …

    A wonderfully insightful comment (for me anyway) – Thanks!

  2. Its only obvious,oil,commodities increasing,you must raise interest rates,enough said. J Tobias
    FM reply: Sure it’s obvious. We might get another depression, but commodity prices would drop. — Nothing in economics is obvious.

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