(Hyper)inflation vs deflation scenario

Economics Economics Questions
, , , ,
1

To increase my understanding of Austrian economics I wanted to compare the views of the inflationists and the deflationists. Some propose that the most likely scenario to happen in the (near) future is high- or hyperinflation while others argue that deflation might occur.

Deflation:

Bank assets decline due to defaults on loans (mortgages, bonds?, corporate loans) so banks do no longer hold the reserve requirements. Any new money that’s coming in, therefore, would be used to match the reserve requirements again. Otherwise the bank would be insolvent. Therefore, credit dries up and through the fractional reserve banking system a deflation of the money supply will occur. Since in the boom-period, new money was mostly coming in THROUGH fractional reserve loans of other banks. When credit dries up, all banks are affected.

This could lead to falling prices (since the money stock decreases), except for wages ofcourse. This would result in a severe depression with enormous unemployment.

(Hyper)inflation:

When credit dries up, central banks prop up the banking system by offering more cheap credit, monetizing bad loans, etc with newly printed money out of thin air. This way they try to fight a possible deflationary situation. Additionally, governments try to stimulate spending by conducting huge inflationary “economic” stimuli. However, the rapid increase in the money supply will be inmense, resulting in a high or hyperinflation.

Are these views correct? Which of the two scenarios is most likely to happen according to you? Did I miss anything out?

Central banks prop up the banking system by offering more cheap credit, monetizing bad loans, etc. This way they try to fight a possible deflationary situation. Additionally, governments try to stimulate spending by conducting huge inflationary “economic” stimuli.

Are these views correct? Which of the two scenarios is most likely to happen? Did I miss anything out?

To increase my understanding of Austrian economics I wanted to compare the views of the inflationists and the deflationists. Some propose that the most likely scenario to happen in the (near) future is high- or hyperinflation while others argue that deflation might occur.

Deflation:

Bank assets decline due to defaults on loans (mortgages, bonds?, corporate loans) so banks do no longer hold the reserve requirements. Any new money that’s coming in, therefore, would be used to match the reserve requirements again. Otherwise the bank would be insolvent. Therefore, credit dries up and through the fractional reserve banking system a deflation of the money supply will occur. Since in the boom-period, new money was mostly coming in THROUGH fractional reserve loans of other banks. When credit dries up, all banks are affected.

This could lead to falling prices (since the money stock decreases), except for wages ofcourse. This would result in a severe depression.

(Hyper)inflation:

Central banks prop up the banking system by offering more cheap credit, monetizing bad loans, etc. This way they try to fight a possible deflationary situation. Additionally, governments try to stimulate spending by conducting huge inflationary “economic” stimuli.

Are these views correct? Which of the two scenarios is most likely to happen? Did I miss anything out?

2

From what I gather, the deflation scenario is the right one, with a huge but.

BUT, that’s only if the money printing doesn’t over power all the forces forcing deflation.

After all, should the Fed decide to print so many new dollars that for every man woman and child on the planet there is a trillion trillion dollars, that would be a flood of money that will wipe out every other factor in its path and certainly produce hyper inflation.

OK, now that we recognize that the Fed has that power, will it use it? Of course it will, because it announced that it will. It is commited to producing inflation. The CPI [that the Fed relies on and that tells them that we are having deflation] is a horrible measure of inflation [do a search about this] and inflation is already nice and high. But the Fed wants it even higher. They want to bail out everyone. They want to give the govt enough money to pay all its debts and finance all its wild spending.

So the q is now not will we have inflation or deflation, but will we have high inflation or super high inflation.

3

Yes. Well, so it’s correct that both views have the same perspective in the start? However, the difference lies in the power of the FED and how it will use its power. If it will retreat, a deflationary scenario is more likely. And if it continues with what it already started, then we should see a inflationary scenario.

I think Mark Thornton believes in a similar scenario of super high inflation.

What will the consequence be in the daily reality of both scenarios? Will it be more or less the same or will the effect be very different?

4

At this point, inflation is the only way indebted governments can “repay” their creditors and “fulfill” entitlement obligations to their citizens. The problem is creating “controlled” inflation – just the right amount so it’s “unnoticeable” or easily explainable to both creditors and citizens, to avoid a collapse of the currency and/or public unrest. If you owed a lot of money and you had the ability to “legally” print them in your basement, why would you choose not to?

In addition, other governments would not sit idly while some of them bid for real resources with printed money. So they will print to bid, too. A currency race to the bottom (devaluation of currency → inflation of asset prices) is practically inevitable.

Inflation is definitely much more likely. However, the only thing certain is the timing uncertainty and volatility as the fake liquidity sloshes around the globe.

Z.

5

More has been promised in the future than can possibly be delivered so we are in for many years (decades?) of failures to repay. The question is what flavour of “failure to repay” will governments choose? Ultimately they can choose deflation&default or inflation. Its a political descision, so the answer to your question lies in the minds of people who do not know what they are doing, currently they are deluding themselves into believing that there is some middle way, i.e. growing their way out of the crisis.

If the politicians were smart they would choose default.

6

This. Part of the FED’s plan is to inflate the price of everything except housing (which is currently way overvalued due to the housing bubble). By preventing any drop in housing prices, banks and financial institutions can remain solvent and the FED can avoid a collapse of the financial sector.

Of course in reality all they are doing is perpetrating market distortions which were created during the bubble and preventing the market from reallocating resources properly.

7

There is the possibility that both situations can occur at the same time, with respect to goods.

For essential goods, inflation appears to be the course we’re headed on. Food, clothing, energy, etc. have already been inflated and seem to continue down that path.

For non-essential goods, deflation can occur. As individual subjective values shift towards essential goods, non-essential goods drop in value. This means some folks with the means to acquire these non-essential goods can make a considerable profit in the long run. I think some real estate falls into this category. Some of the best long term investments can occur during these hard times.

The obvious risk is if it goes too far and we get a total economic collapse. That situation typically accompanies political upheaval. The next regime could declare all property public - which screws over everyone. Of course the economic prospects of that regime are likely to be poor, but that may take up to a century to play itself out.

Austrian economics doesn’t predict exactly what will happen, but it does describe the process involved. If you hold the Fed and US Government to their word, then they will do whatever they can to avoid overall economic deflation. They are playing a game to solve the housing bubble crisis, which they used to solve the dot com bubble crisis, which they created to solve the previous problem, and so on. Eventually, however, the game is over and reality sets in. The only thing the Fed can do is come up with the next scheme to delay the inevitable. The next card in their hand appears to be “controlled” inflation - if such a thing is even possible.

8

You missed the most likely scenario: That is the Japanization of the USA where the central bank inflates at a rate slightly higher than the deflation rate which amounts to a huge redistribution of realy wealth from savers and successful producers to debtors and failed producers. The biggest debtor of course is the central government which is also the biggest failure as a producer as it creates nothing. The results of Japanization are certainly not as bad as hyperinflation where the currency gets destroyed and the government must impose price controls to prevent complete social breakdown, BUT are only a little worse than a massive deflation where wealth gets redistributed from debtors and squanders of resources to savers and producers. In a massive deflation, wealth flows to producers who are producing products and services in line with the preferences of consumers that the bust revealed in the first place.

The Recession of 1920-1921 was breif and really bad where there was a lot of deflation.

Contrast the Recession of 1920-1921 with the Great Depression that went on as measured by the stock market for 21 years.

Contrast that with what happened/is happening in Japan since 1990.

9

Good points, but how well will the Fed keep the rates within the confines of Japanization?

Personally I think they overshoot their mark and head into hyperinflation. Their reliance on the CPI as an accurate measure of inflation is just one reason why I hold this position.

The other thing to remember about Japan was that they actually had the savings to keep up with the rate of inflation. I don’t believe the U.S. is in the same position; they are a massive net debtor nation. Of course I won’t completely ignore the fact that the U.S. will use their influence to take down as many other countries with them.

10

Don’t you confuse inflation/deflation now with higher prices/lower prices?

Like your input though, I think we are on the same page for the non-essential and essential goods story.

So we have 3 scenarios now: deflation, high/hyper inflation, and “controlled inflation” japanization. Other people who think the japan-scenario is the most likely one?

Obviously, a lot of people expect that the Fed and the US government is aiming for “controlled inflation” but that the risk of engaging in such a policy is enormous.

11

My misuse of terminology was intentional.

Inflation and deflation are terms used to describe the value of money based upon supply and demand - most typically caused by printing money in the case of inflation. Price operates in a similar fashion, and applies to any good or service.

When trying to determine where the dollar is on the inflationary/deflationary scale, I think you have to look at other goods. Gold and silver are the most common to be utilized for comparison, and have a long history as a medium of exchange. The price of a good may appear to be stable when you’re using the dollar. If, however, you use another commodity what appears to be stable is not.

The CPI tries to do the same thing in terms of dollars, but it ignores some goods/services that are viewed as too unstable to produce accurate results. While that may be true month-to-month, when looked at it over a year or two these variances tend to cancel out. What you are left with is a trend. Food prices have been trending upward over the past two years. The same is true of energy and other commodities one might deem as essential. Since the CPI ignore these data, the Fed is left with a metric that doesn’t represent the complete picture. It’s actually more convoluted than that, but that’s a topic for another thread.

Some commodities are out performing gold. Sugar, for instance, has been on a very aggressive increase over the past year. So in comparing this commodity with gold, you might call the value of sugar as being inflationary. Real estate, on the other hand, is losing value with respect to gold, and the price of real estate could be viewed as being deflationary. While the supply of gold is unaffected, the comparative value of the other commodities are changing as individuals change their subjective value.

Perhaps there’s a more precise terminology that is used to explain this process. Some would just call this price instability, which is essentially the result of government intervention. Technically the terms inflation and deflation are related to fiat currency.

12

Thanks for your explanation.

I have another point. Where does newly created money (inflation) end up? The most obvious is real estate, by giving out mortgages. Another obvious one is the (government) bond market, with government bidding up prices through spending.

But what about corporate or business loans? Businesses and corporates obviously could buy raw materials like silver and cotton. Why is it not the case that there is also a ‘bubble’ in many commodities like silver??? It seems like another spot where inflation could end up.

But if we use gold as a reference point, the monthly silver price is lagging behind the monthly gold price since 1980. Is that how we can decide whether prices of certain commodities are a bubble or just caused by overall inflation?

13

I have a “theory” that the supply of money needs to be split between credit and money for these discussions to make sense. If we were on a gold standard the supply of money would be the physical amount of gold. The supply of credit would take into consideration loans and various multipliers that I don’t fully understand.

The important point is that an increase in the supply of credit or credit inflation is different from an increase in the supply of money or monetary inflation. Credit inflation is temporary and will probably turn into credit deflation and vice versa. Monetary inflation is permanent. Once you print more money or dig up more gold, you’ve permanently devalued the currency. I also think monetary inflation is more powerful then credit inflation, dollar for dollar.

So here is how I would answer your question: We are trying to fight credit deflation with monetary inflation. Eventually the credit deflation is going to wear off and all we will be left with is the monetary inflation. And this will lead to higher prices.

14

Don’t worry, not even the people at the Federal Reserve Bank and the Dept of Treasury understand what inflation relative to credit is either. But you should be thrilled as you seem to understand what inflation is relative to money better than they do.

15

If we had to choose between inflation or deflation, deflation is better… in Mises’ “The Inflationist View Of History”, Mises said “Deflationary policy is costly for the treasury and unpopular with the masses. But inflationary policy is a boon for the treasury and very popular with the ignorant. Practically, the danger of deflation is but slight and the danger of inflation tremendous.” But this is only if we had to choose between inflation or deflation because in reality, a true Austrian economist is in favor of neither because inflation and deflation deals with government tampering the market’s choice of a medium of exchange.

http://mises.org/daily/4143