Chuck Ponzi October 2nd, 2007
If you do any amount of reading in financial publications or blogs lately, the word inflation has been thrown around quite a bit. However, few words seem so clear in economics yet are shrouded in half-truths. What is inflation? If you ask 10 different people, you’ll get 10 different answers. Even academics differ on what inflation is, even the definition of the word. While one might suppose it is monetary expansion, another only sees its effect on prices. Others argue it is the relative growth of the first in relation to the economy that drives the second. Still others argue that “it’s different this time” and the old rules don’t apply; in a way they are correct.
It is no secret that in the past few years, we have seen substantial monetary expansion. Such is not necessarily the case today. A fellow blogger, Mike Shedlock, notes that we are in a very slow monetary growth period compared to years past in his post: “Is the Fed Deflating?”
It is very easy to prove the statement “the Fed is not massively printing” but people believe what they want to believe. However, Fed policies have been such to enable super easy credit transactions to take place by holding interest rates too low too long. When interest rates are held too low, asset bubbles build and credit/debt transactions soar. So does the velocity of money. But the Fed ignores these bubble (in fact even embraces them) as long as consumer prices are held in check.
Mish hit upon some very important points:
1. Inflation is time-lagged.
2. Bubbles are not inflation.
3. People believe what they want to believe regardless of the facts.
Inflation is Time Lagged
Inflation has a place in any money. Yes, even vaunted and irreproachable monies like gold can and have experienced periods of strong inflation when the purchasing ability of gold declined significantly. One such gold inflation periods happened with the California Gold rush in 1849, and later after the discover of dissolving ore in potassium cyanide in 1887.
Indeed, money produces nothing, it is merely a confidence play, though some have industrial uses (gold as an electrical conductor, or paper money as a combustible material to name a couple). Money is a confidence game… nothing more, nothing less. Only barter economies approach removing the “confidence” value. These tend to be terribly inefficient, and are not likely to return, regardless of what happens to our monetary supply. In fact, in today’s global liquid markets, many other assets have taken the place of money as a hedge to traditional fiat currency systems systematic devaluation.
Monetary inflation is valuable to prevent price deflation. In fast-growing economies, where gross domestic output is increasing as well as a growing population, if money were to become scarce, prices would need to drop to reflect that scarcity. To the counterpoint, monetary deflation is also valuable to prevent price inflation. If money is plentiful, removing that money from the market keeps prices from spiraling higher and higher. These facts are accepted in economics textbooks covering basic supply and demand relative to the money supply, and is well understood in all economics circles. So, if the answer is so simple, why don’t we simply measure one and react with the other?
You shouldn’t be surprised that our Federal Reserve has tried just that.
Unfortunately, other factors keep popping up that throw the next administration for a loop.
First, it was productivity as a deflationary force.
Then, it was a credit orgy as an inflationary force.
Then, it was a “savings glut”, reserve currency, or some other reason as a deflationary force (stockpiling dollars, removing them from spending).
As you can see, managing supply and demand is not as simple when poor information is available about who is holding the currency, and what they intend to do with it. Especially since there is a time-lag.
Basically, introducing currency into a system does not provide an immediate change in prices. This works in excellent principle in economics textbooks in perfect countries with names like “utopiaville” and “Gilligan’s Island” where perfect information abounds and prices immediately reflect available money. In addition, money is instantly used on whatever provides the most utility.
Unfortuately, humans are irrational, greedy, and inefficient. Prices are sticky. Expectations vary wildly and change in an instant. In this environment, a steady, stable central bank that moves slowly and ignores short-term glances while focusing on the long-term is likely to be the most successful. There are no heroes in this arena. Middle of the road beaurocracts are the name of the game. However, when forced by the situation, herculean pushes against inflation and short-term fixes such as the time when Paul Volker crushed the inflation of the 1970’s in the US with double-digit Fed fund rates.
Unfortunately, this is not the 1970’s.
Bubbles are not Inflation
This is the era of financial bubbles. These are extremely irrational price moves of assets where fundamental values detach from the current values. Increasing investment and overdependence on a specific asset class produce outsized gains, and more pile on, creating a self-fulfilling prophecy of higher prices and greater inflation.
Then it happens.
The bubble pops. It becomes self evident that the prices moves were irrational, and it painfully returns to it’s longer-term trend. Bubbles are not price inflation, they are driven by inflation. The only way that bubbles can form is by a single enabling forces: monetary inflation. Instead of the money chasing a fixed set of goods and inflating their prices, humans instead choose to purchase assets. That’s not inflation. It may look like it, but it’s only temporary, not systemic.
Before you begin to think that I am a current FED apologist, consider what I believe to be the root of financial bubbles… monetary inflation. That is controlled by the Federal Reserve.
People Believe What They Want
Regardless of the facts. Much like the crush of public opinion when the housing bubble was in full-blown effect, there is now a crush of opinion beginning to build about systemic inflation. Indeed, there is a growing believe in the infallibility of precious metals as a store of wealth. This has all the seeds of a future bubble in precious metals. If asked where I believe the next bubble will be, I’d put my money on precious metals. (and have put some)
Getting back to inflation, however, inflation is much like anything in the financial world… it acts like virus, and once it has infected enough, it spreads on its own, creating a self-fulfilling expectation of increasing prices. Expectations (or confidence) is the name of the game.
Unfortunately, like a virus, the only way to kill it or severely wound it is to remove its source of food… money. If people expect things to cost more in the future, they will stockpile that thing now, increasing demand for it and consequently prices. It is possible that much of the inflation of the 1970’s was a reaction to many Americans stockpiling food, water, and other resources in the shadow of the cold war. The same way that people fearing being priced out forever, they purchase more than they need now in the chance that they might need it in the future. Many people bought houses much larger, and in much greater quantity than their needs or abilities dictated in an attempt to remove that fear of running out.
Summing it up
Are we experiencing inflation? It depends on what you consider to be inflation. Prices are rising of many consumer goods. Conversely, a massive bubble is violently deflating. People’s incomes are not growing as quick as prices.
However, I can be confident about making one prediction. If housing prices in bubble areas do not come down fast enough, wages will need to increase faster than they have been. And, the Fed will allow the first while fighting the latter. As they say… don’t fight the FED.
