Which is more likely – deflation or inflation?

Conventional economic wisdom, as illustrated by the cover of last week’s The Economist, says deflation is a major threat.  However, this blogger, ever the contrarian,  figures inflation, perhaps even hyperinflation, is a more likely threat.

 The idea that deflation is a threat appears to be  based on the concept of inflationary expectations and the desire by those who make decisions on behalf of he government to maintain mild inflation to help deal with government debt.

That high inflation is a threat is based on the formula MV=PQ, known as the quantity theory of money although I prefer to call it the connectivity formula as it connects the financial and real sides of the economy.

 The case for deflation is made in the November 9, 2013 issue of The Economist. (http://www.economist.com/printedition/2013-11-09)

The above formula tells us that the money supply times the velocity at which it changes hands is equal to prices, or a price index, times the quantity of goods and services produced.  It is not clear everybody accepts this formula but I think it contains a lot of truth.  If one of the four variables changes then to maintain the equality one or more of the others also has to change.  For example if the quantity of goods and services goes up then the money supply also needs to go up.  If the increase in money supply exceeds the increase goods and services, then velocity must go down or prices must go up.  Through recent decades prices have gone up and we have had inflation.

 The  current economic crisis is probably mostly a crisis in Q.  While there are still a lot of mineral and energy resources in the earth’s crust we have extracted the most easily accessible.  What is left is difficult to extract and requires a lot of energy.  In the past economic growth has covered a multitude of economic sins.  It is not clear that the economy will be able to return to the type of growth we have experienced since the start of the industrial revolution.

 During the depression of the 1930s the monetary authorities deliberately restricted the money supply (a reduction in M) and this led to a reduction in Q, a recession and a number of financial institutions failed.  This time they are not going to make the same mistake and have been trying to increase the money supply calling it quantitative easing. Large amounts of money have been pumped into the economy.  Consumer prices have not increased and it is tempting to say the formula is not valid.   It could be that velocity has fallen (there are complaints that corporations are sitting on piles of cash) and that price increases have been in paper financial instruments.

 We should note that Wikipedia gives four major examples of deflation in American history and all of them involve contractions in the money supply.  Maybe the formula holds.

 If the formula is correct and with all the excess money floating around the economy, then there is quite a bit of  potential for something unpleasant to happen.   If not high inflation, then a financial crisis in which the money supply is reduced.  In either case the paper used for those financial instruments might have been more useful as firewood.

 Inflation is complicated by the fractional reserve creation of money.  As can be seen from the formula the money supply needs to flexible up or down according to variations in the quantity of goods and services produced.  But our money supply is created when banks make loans upon which interest is charged. Rather than flexibility there is pressure for the money supply to increase continuously.  The result is a Ponzi scheme which collapses from time to time.  Oops, here comes another financial crisis.

 The goal should be price stability or a zero inflation rate.  As loans are in nominal terms when prices go up people who have borrowed benefit at the expense of those who have loaned the money.  If you are a lender, the higher the inflation rate, the more purchasing power you lose.  Deflation works the opposite way, in that a borrower has to repay more purchasing power.  As governments are major borrowers it is hardly surprising that those who set economic policy are anxious for moderate inflation.  Inflation is a tax if not theft.

 Those  charged with setting government economic policy fear that low inflation could easily slip into deflation.  That would  make repaying government debt more difficult and in the past deflation has been associated severe recession.  The difference this time is that there is lots of money available to facilitate the exchange of goods and services.  Hyperinflation would wipe out a lot of savings, fortunes and pensions.

 Whatever happens it looks as if there is a lot of potential for increasing economic chaos.

Government debt default and the money supply

A United States debt default will hit the economy as a reduction of government spending and it could also  hurt by forcing changes in the money supply.

The first thing to say about debt is that there is so much of it around the world that there is a high probability most of it will be written off either by defaults of inflation.  This debt is not so much borrowing from children as a transfer of purchasing power within this generation, some/most of which will never be returned. And those with the most are likely to lose the most but will still probably be more comfortable than the rest of us.

The second thing to say is that the probable root  cause of the economic crisis is in the real side of the economy as well as the financial sector.  We have used up most of the easily accessible energy and mineral resources and those that are left take a lot more work to extract.

If the United States defaults  some of its debt the government will have less money to spend.  As government spending is a component of gross domestic product there will be a reduction in economic activity.  Government spending currently makes up about 20 percent of GDP but only a small part of this will likely be cut immediately.

The effect of a debt default on the money supply is more complex and uncertain.  A drastic reduction in the money supply would bring a lot of economic activity to a halt.

Money is based on loans issued by the banks, involves fractional reserves (they are required to keep a percentage of deposits as reserves)  and dependant upon what is called high powered money which is subject to a multiplier because of the fractional reserves. (for and explanation of how money is created see these links, one, two.)  In a default one issue would be how much the losses fall upon institutions subject to fractional reserves because losses would reduce their reserves.  A reduction in their reserves would bring down the quantity of loans they could make – by a multiplier.  Thus the money supply in the economy would be reduced and without money the exchange of goods and services becomes difficult.

Under normal circumstances a reduction in the money supply would mean a reduction in the real economy.  But the real economy is already in trouble as noted above.

At this point I need to remind you of the formula MV=PQ.  The money supply times its velocity or the rate at which it changes hands is equal to prices or a price index times the quantity of goods and services.

In an attempt to stimulate the economy central banks have been using “quantitative easing” to inject more high powered money into the financial system so the banks will have more money to lend.   If the above formula is correct then there should have been a reduction in velocity or an increase in prices (inflation) or economic activity.  It may be that velocity has fallen but there is little evidence that inflation or GDP has increased.

If the formula is correct then something has to have happened to one of the other variables.   One possibility is that at least some of this extra money has gone into the financial markets and inflation has hit stocks.  If this is correct, then a reduction in money supply could hit the financial sector.

So there you have it a U.S. default would probably lead to a reduction in economic activity and it could also cause problems in the financial markets.  I just had a horrible thought.  What would happen if a lot of the major countries were to default at the same time?

Greek debt world wide

An editorial in this week’s The Economist calls for Greece’s official creditors to write off a big chunk of the Greek debt so that country can start over again.

Debt is not a problem restricted to Greece.  It is a problem for most of the countries around the world.

So much debt, government and consumer, has been for projects that will not earn the income with which to repay the debt.  There is little hope  any of this debt will ever be repaid and therefore it will eventually have to be written off or defaulted.

The down side of this is that a lot of people are going to lose their savings.

Once the big crash happens I hope the survivors will be smart enough to find a way of creating money that is not based on debt.

 

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