``The chief source of the existing inflationary bias is the general belief that deflation, the opposite of inflation, is so much more to be feared that, in order to keep on the safe side, a persistent error in the direction of inflation is preferable. But, as we do not know how to keep prices completely stable and can achieve stability only by correcting any small movement in either direction, the determination to avoid deflation at any cost must result in cumulative inflation." Friedrich A. Hayek
Many say that huge debt loads carried by the world today would lead to deflation.
While there is some truth to this, the answer isn’t straightforward.
This mainstream view is best represented by economist Irving Fisher’s description of the events of the Great Depression, which we covered in 2008[1], ``Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes A fall in the level of prices, in other words, a swelling of the dollar.”
This simplistic narrative makes an impression that all debts are similar. Yet, this does not take into consideration the many other factors that hold sway to such an outcome, such as the monetary standard that the Great Depression operated on, regulations that limited interstate branch banking (McFadden Act[2]) which prevented banks from diversifying portfolios, the legal tender laws from central banking which prohibited the US banks from issuing their own notes[3], ‘bank holidays’ which denied depositors access to funding which equally increased uncertainty[4], and importantly the boom bust cycle or the clusters of malinvestment created by earlier monetary policies to uphold certain political interests.
According to Murray N. Rothbard[5], (bold emphasis mine)
``But a more indirect and ultimately more important motivation for Benjamin Strong's inflationary credit policies in the 1920s was his view that it was vitally important to "help England," even at American expense. Thus, in the spring of 1928, his assistant noted Strong's displeasure at the American public's outcry against the "speculative excesses" of the stock market. The public didn't realize, Strong thought, that "we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis." An unexceptionable statement, provided that we clear up some euphemisms. For the "decision" was taken by Strong in camera, without the knowledge or participation of the American people; the decision was to inflate money and credit, and it was done not to help the "rest of the world" but to help sustain Britain's unsound and inflationary policies.”
So such storyline, which looks intellectually formalistic, sells well to the mainstream. What seems plausible is accepted without question or examining its basis.
But of course not all debts the same.
There are debts that are funded from savings and there are debts financed from ‘money from thin air’. The distinction is important because this defines the conditions that affirm or debunk the dynamics of Fisher’s debt deflation.
Dr. Frank Shostak[6] explains, ``when Joe lends his $100 to Bob via the bank, this means that Joe (via the intermediary) lends his money to Bob. On the maturity date, Bob transfers the money back to the bank and the bank in turn (after charging a fee) transfers the $100 plus interest to Joe. Observe that here money never disappears or is created; the original $100 is paid back to Joe.
"A fall in normal credit (i.e., credit that has an original lender) doesn't alter the money supply and hence has nothing to do with deflation."
``Things are, however, quite different when Joe keeps the $100 in the bank warehouse or demand deposit. Remember that by keeping the money in a demand deposit, Joe is ready to employ it at any time he likes.
``Now, if the bank lends Bob $50 by taking it from Joe's demand deposit, the bank will have created $50 of unbacked credit, out of "thin air." By lending $50 to Bob, the bank creates $50 of extra demand deposits. Thus, there is now $150 in demand deposits that are backed by only $100.
``So in this sense, the lending here is without a lender. The intermediary, i.e., the bank, has created a mirage transaction without any proper lender. On the maturity date, when Bob repays the money to the bank, that money disappears. The money supply falls back to $100, dropping by 33%.”
Robert Blumen[7] argues from the gold standard perspective,
``Suppose that on an isolated island the total money supply consisted for 1000 oz of gold and there are no fractional reserve banks. Now suppose that people lend either other various sums of money. Total debt could expand if the same money were lent and re-lent by the borrower more than once (which happens with a lot of securitized financial instruments). Suppose that total nominal debt reached 2000oz of gold, twice the money supply. Now if all of this debt defaulted (not realistic but for the sake of discussion), would there be any general deflation? No, because the money supply remained the same.”
In short, bank credit deflation as described by Mr. Fisher is conditional to debts funded by fractional banking system which causes contraction in the money supply.
According to Joseph Salerno[8],
``During financial crises, bank runs caused many banks to fail completely and their notes and deposits to be revealed for what they essentially were: worthless titles to nonexistent property. In the case of other banks, the threat that their depositors would demand cash payment en bloc was sufficient reason to induce them to reduce their lending operations and build up their ratio of reserves to note and deposit liabilities in order to stave off failure. These two factors together resulted in a large contraction of the money supply and, given a constant demand for money, a concomitant increase in the value of money.”
Yet if large debts presumptively results to a reduction in demand or a slack in credit takeup which leads to ‘deflation’, as linearly thought by the mainstream, inflation would be an imaginary event or that we would be seeing a fall in prices everywhere (see figure 8).
Figure 8 St. Louis Fed and TradingEconomics.com: Fall in credit and inflation
The upper window in figure 8 is a favourite chart by perma bears who love to spook themselves with the deflation phantom. It shows of the falling demand for credit, which according to them should be ‘deflationary’.
Yet since 2008, commercial and industrial loans have serially declined, yet inflation has been rising, after a short “foray” in the deflation territory in middle of 2009 until the end of the year.
So the deflation theory does not match real events. The reason for this is that there are many other factors, as government spending, QE, zero interest rates, steep yield curve, globalization and etc... that influences these financial, economic and political conditions.
But I see more problems for the perma bears. Commercial and industrial loans at all banks seem to cease declining and could be bottoming out. And if I am right, where the response to the yield curve will prompt for a material improvement in the health of the credit conditions by the end of the year, this chart will be excluded in the presentation for deflation.
Last word, today’s markets have been tidal driven, and there is little substance to argue for a micro based ‘decoupling’. Although inflationism has relative effects, global markets generally move in synch with the actions of the US markets. But this can be differentiated by the degree of gains or losses.
As such, the only way for the Philippine or Asian markets to outperform is for the US markets to trade sideways or head higher. Asian markets can’t and won’t defy a US crash. Nevertheless, we remain bullish with Asian markets for the simple reason that we don’t see a crash in the US markets or a redux of 2008.
[1] See Demystifying the US Dollar’s Vitality
[2] Wikipedia.org, McFadden Act
[3] Wikipedia.org, Federal Reserve Note
[4] Wikipedia.org, Emergency Banking Act
[5] Rothbard Murray N., Reliving the Crash of '29, Mises.org
[6] Shostak, Frank, Does a Fall in Credit Lead to Deflation? Mises.org
[7] Blumen, Robert Massive Debt Deflation in Store? Mises Blog
[8] Salerno Joseph T. An Austrian Taxonomy of Deflation
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