Wednesday, December 19, 2007

Inflation is the solution, not the problem

Fundamentally, inflation must be suppressed: Greenspan wants homeowners helped - BBC

Back in the days when Kings ran the Western World, inflation, or, as it was then, in my view, more accurately termed, clipping coins, was a solution to the problem of over-indebtedness- depreciate the value of the currency sufficiently that debt service becomes easier. The other solution, (leaving aside, as Mr. Greenspan et. al. have done, the notion of avoiding the imbalances altogether) was to liquidate- deflate the amount of debt. Of the two, the Kings learned that inflation tended to be less disruptive to the current power structure as the losses were distributed widely.

The anti-Monarchical early Americans took a dim view of the Kingly prerogative to depreciate the currency on his whim and, with a few temporary exceptions, maintained a stable currency with the US$ fixed at 1/20th of an ounce of Gold. Liquidation was the preferred solution under this view.

Liquidation remained the preferred solution until the Great Depression struck. Power, as it is wont to do, became concentrated and inflation was once again seen as a solution. Under Franklin D. Roosevelt the price of Gold was raised from $20 to $35 in an effort to ease debt service burdens.

During the intervening decades, the US Financial System was reformed into an unrestrained inflation machine. First the citizens of the US lost their ability to demand specie (Gold) from the banks and thus force a liquidation or deflation and then foreign governments too lost their ability to demand specie.

Thus the imbalances which grew during the 60s and early 70s, in part a result of Vietnam War debts, were, in a sense, resolved through $ depreciation. Efforts to maintain a fixed link between the US$ and Gold during that period would have engendered liquidation. Let me repeat that to stress the point, efforts to maintain a fixed link between the US$ and Gold during periods of US financial imbalance engenders liquidation, i.e. deflation.

And, it seems, this maxim still holds true.

Consider the chart below.

As you can see, "stress" in interbank lending markets (measured here as the spread between LIBOR and OIS) peaked earlier this year in late August/early September and declined into early November only to turn up again, setting new highs, in early December.

Coincidentally, the US$ price of Gold, which had traded under $700 for most of 2007, rose significantly from September to early November- the period during which interbank lending stress eased. Interbank lending stress rose once again during the most recent period when the price of Gold did not advance.

It seems to me one could argue (and I am) that a depreciating currency, in this case, the US$, as was the case back when Kings clipped coins, is a solution to the stress caused by financial imbalance, and vice versa, that any strengthening of the US$ increases stress and raises the possibility of liquidation or deflation.

It's good to know some things never change.

Alas, some thing do change- notably, the views of those who run the show. These days, in many instances, faith in the "cure" is stronger than faith in avoiding ill health, as Greenspan's embrace of the virtues of mitigating the effects of a burst bubble, rather than pricking it early on, demonstrates. But, I believe this faith is misplaced. There is no "cure" if one defines "cure" as a return to previous conditions before imbalances had become unmanageable. There are only solutions like inflation or deflation.

Thus I find Greenspan's recent calls for inflation to be suppressed, and for the state to coincidentally forestall the liquidation of mortgage debt most confusing. To truly suppress inflation, one should avoid the imbalances that beg such a solution. Now that the imbalances are there, and given the near universal distaste for a deflationary liquidation, suppressing inflation is akin to trying to stop a process already in progress- kind of like prescribing
diarrhea medication to the constipated.

If the powers that be really want to relieve the stress in interbank lending markets (and the indigestion metaphor seems quite apt here), they might consider letting the US$ fall further. Judging by the graphs above, this does seem to help.


Ruby said...

I am a new student of moneatary policy and so my view may be immature and misplaced, but it seemed to me that deflation would be the best "cure".

Dollar depreciation = inflation.

I've learned that these situations are cyclical, and a purge must occur to reboot the financial systems. Understandably, people don't want the pain. But what good is a continuous dull ache?

Hey, either way, I'm good with my stash! I only started buying physical only three years ago, and this wave of inflation has been pretty good to me. But at what cost do I get my pleasure? When two pancakes, two eggs and a cup of coffee cost $9.50 at a roadside diner, that can't be good.

I always have to read your stuff multiple times, but I hope I'm not missing your point here. You're saying don't start the bubbles in the first place, but now that they're here, you are willing to go along with "clipping the coins".

Dude, say it ain't so!!!

ps. You will absoutely dig that Mandlebrot book. It is blowing my mind for sure.

Dude said...

The problem with deflation (which, as an aside, I favor, in the sense that it would apportion the losses to those who made them, although with the caveat I will now explain) is that, given a situation of extreme imbalance, such as exists today, it leads to very disruptive conditions.

In our modern economy, when so few are able to provide for themselves, this disruption would be fatal for many.

My argument is that this mess was made under the assumption that inflation was the solution. I doubt this mess could have grown so large if people were truly worried about deflation, and now that it is so big, assuming the powers that be want to stay in power, inflation is the answer.

Ruby said...

Dude, call me harsh, a cryin shame during such a season of kindness and giving, but I say bring on the deflation. People are already hurting, I'm seeing things getting worse from Peak Oil - inflation or deflation.

We need a disruption. We're not living right. And things that can't continue forever don't continue forever.

Maybe I'm being flippant. I could say I'm not scared to die, but hold a gun to my head and I just might not be so brave, but.....

I just don't see how more inflation cures inflation.

So, I will continue to study. I picked up a whole load of books on a holiday trip down the west coast here to smelLA. I have a chronic used bookstore habit and I got copies of: Human Action by von Mises, Bear Markets by Harry Schultz, Finance and Enterprise in Early America by Donald Adams, Jr., The Great Wave by David Hackett Fischer, and a bunch of other stuff unrelated to economics. I wish I could just download it all in one session!

OK, Dude, have a happy holiday! forget about inflation or deflation or subflation.... What's really important are the moments we're living now, and remembering how lucky we are....

Dude said...

Hold your horses, Ruby!

I never argued that inflation cured inflation, my point was more subtle.

To the extent we have (and we do) a financial system which is geared to inflation AND to the extent the Fed has already allowed credit creation to get out of hand, allowing prices to rise (that is stopping their intervention policies) will allow markets to clear.

Of course, for the new prices to become a new equilibrium, credit creation would need to slow.

I suspect your confusion is a result of my "loose" use of the term inflation to refer to both credit creation AND rising prices, I should have been more specific.

And a Happy Holidays to you as well.

Ruby said...

Greetings Dude 08!

I understand credit creation -> increase money supply -> rising prices, so that is probly not my problem understanding your post.

I think it is that your point is since we have a system of fiat paper designed for inflation, then a little more inflation will relieve the stress from the recent excesses, i.e., you say allow prices to rise and slow credit creation. But isn't it that once you have an increase in money supply, through credit creation or printing press, you can't really stop rising prices... (unless all that money and credit is exported which is a flow that is currently reversing)

At any rate, I'm starting to read my truckload of books that I brought back from my Christmas holiday. What fun! I put doom and gloom aside this season and pretended that eveything is gonna be OK. Did you ever see that movie Brazil? I'm living in my mind, too,.....for a little while longer!

tooearly said...

history shows that periods of extreme inflation are far more disruptive than those of deflation