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July 11, 2014

Inflation, Deflation, and Monetary Policy

A recent story about the spike in prices of food and motor fuels serves as a reminder that the Fed's insistence that inflation is low falls rather short of being the truth. I've said for a long time that inflation isn't low; it's being deliberately hidden by the Fed, because the Fed has a strong motivation to convince everyone that inflation is under control.

But before I get into the details of why this is so, we need to step back and discuss what monetary inflation and deflation really mean.


Inflation is a phenomenon that occurs when the value of a given unit of currency becomes debased in some way, and prices then rise to offset the currency's loss in value. The standard definition of inflation is given in terms of rising prices rather than falling currency value, but that's misleading. The value of goods and service don't increase so much as the currency's value relative to those goods and services decreases, so inflation is more of a monetary phenomenon than a market-price phenomenon.

The more the currency loses value, the higher prices denominated in that currency rise. The classical example of hyperinflation is the the 1921-1924 hyperinflation in Weimar-era Germany, though in modern times Zimbabwe's currency has undergone the same radical devaluation.

What causes a currency to become devalued? There are many causes. With specie currency like gold and silver coins, debasement is usually physical -- in former times coins were "shaved" or "clipped" or adulterated with baser metals. The clippings could then be melted down and recast into new coins, but the clipped coin could still be passed off at full value (until the merchants got wise and started weighing and/or assaying the coins). This is why coins began to have milled edges -- it made the practice of clipping easier to spot. A variant of the "shaving" debasement strategy is one carried out by the treasury or mint itself: reducing the amount of gold or silver in a coin, but leaving the face-value of the coin the same. This happened often to the Roman denarii -- as the Imperial stocks of silver bullion waned, each coin was reduced in weight but mandated to retain the same value. (In modern fiat-money times, coins are generally manufactured out of base metals like nickel, tin, and zinc, but even so, the value of the metal is sometimes still higher than the face-value of the coin.)

In a fiat money regime, debasement is usually the result of creating too much currency for the economy to absorb. If the money supply exceeds some thresh-hold (it's very complicated to figure out exactly what that thresh-hold is), you have more units of currency chasing the same amount of goods and services -- which means that the real unit value of the currency will drop and prices will go up.

Another way a fiat currency can become debased is to arbitrarily re-value your currency relative to the market, or relative to other currencies. If an issuing authority declares the value of a quatloo to be three quatloos to a dollar, even if the market is trading at five quatloos to a dollar, the currency will be debased because it's not actually worth what the issuing authority says it is. Prices go up, and the government usually responds by implementing price-controls, and in turn the goods and services simply become unobtainable at any price because producers won't continue to produce at a loss.

No good or service has an absolute value. The value of a good or service is what someone is willing to pay for it. Currency is a specialized good, and is subject to the same law. If the stock of currency grows faster than the value represented by that currency in the wider economy, the currency is in an inflationary state.

Generally, you want your currency to be a a bit inflationary. If you want your economy to grow in a currency-based monetary system, money has to come before growth (because money has to exist before it can be loaned or borrowed). The fiat money systems of the world -- which at this point is nearly all of them -- are designed to be deliberately inflationary for just this reason.

However, a problem arises when too much currency is created too fast. It tends to lead to a death-spiral as prices skyrocket and more currency is created to catch up to prices. Interest rates are affected by inflation as well as investors insist on higher premiums to make up for the debasement of their existing holdings and offset the risk of new investment.


Deflation occurs when there is not enough currency in circulation to meet the needs of the economy. Here again, the classical definition focuses on falling prices rather than an insufficient currency stock, but deflation is primarily a monetary phenomenon.

It is the economic version of anemia: too little blood is reaching the body. Each unit of the currency goes up in value relative to the goods and services available, but because the stock of currency isn't growing fast enough, it starves the economy of investment capital. There isn't enough money to build out existing business, to create new ones, or to hire new workers. (This is in part what happened during the Great Depression of the 1930's.) Inventories shrink, but new goods aren't being produced due to the lack of investment capital. Eventually the economy grinds to a halt as production withers away.

Specie currencies are more prone to deflation than fiat currencies for the simple reason that fiat currencies are not based on scarce (and thus valuable) resources like gold, silver, or what have you. There's only so much gold and silver to go around, and sometimes the supply of bullion can be interrupted for long periods. (Sometimes this is even done deliberately by rival nations or speculators.) Also, because the value of gold and silver is set outside the control of government or authority issuing the currency, it limits the kinds of monetary policy the sovereign can conduct, especially during times of crisis.

This situation is why the United States and much of the rest of the world went to fiat-money systems. Specie and hard-money currency systems posed problems for sovereign issuers that limited the scope and growth of their economies. Particularly, sovereigns fear deflation, especially after the trauma of the Great Depression. Because deflation tends to be more harmful than inflation (except in cases of hyperinflation), specie-based currencies have largely been abandoned.

There is another kind of deflation called asset deflation that sometimes happens when the value of an asset class decreases across the board. For example, at one time aluminum was more valuable than gold because it was rarer. But in modern times that's certainly no longer true, so if you sunk your family fortune into aluminum back in the Renaissance, your heirs are probably cursing your name right now.


Gresham's Law states that bad money drives out good money. This can happen in both inflationary and deflationary monetary environments. Basically, it must means that people will spend their "bad" currency first to get the maximal value out of it, and save the "good" money for the future because it will not depreciate as fast. That's why you see socialist government inveighing against "hoarders", "wreckers", and "speculators" -- the good money is biding its time and flushing out the bad money first.

For example, consider the US fifty-dollar gold coin. These coins are collected for their numismatic value and not their currency value. In fact, these coins are useless as actual currency. Why? The value of the gold and silver in the coins far outstrips the face value of the coin. Gresham's Law would drive the coins out of circulation -- either they would be melted down for bullion, hoarded, or traded as barter (not currency!) for objects of similar value.


So that's a capsule overview of inflation and deflation. Of the two, inflation is the preferable alternative, but it has one great danger that deflation doesn't: deflation has a lower bound. Currencies almost never deflate completely (i.e., the entire money stock cannot be monopolized). Deflationary economies can still function, even at reduced capacities. Inflation has no upper bound; it can amplify and amplify until it completely destroys a currency and even an entire economy. Money can be inflated to worthlessness -- ask anyone who has a trillion-dollar Zimbabwe note.

America is caught on the horns of a dilemma vis-a-vis inflation: our currency is designed to inflate, and the Federal Reserve exists to manage that rate of inflation in such a way as to keep the economy humming. But this presupposes that the Fed can a) accurately gauge how much inflation is enough, and b) put the brakes on excessive inflation with the wave of their magic wand.

Ever since the Great Recession of 2008, the Federal Reserve has been conducting a program called "Quantitative Easing", whereby it purchases bonds from its cousins over at the Treasury Department. More than a trillion dollars' worth, in fact. But here's the thing: this is mainly just a ledger-book trick to print new money. No new wealth has been created in the economy to cover all this new money; the money has just been conjured out of thin air.

Now, as far as the wise old heads at the Fed are concerned, there's nothing wrong with this. That's how a fiat money system is supposed to work. And the Fed points at the low interest rate environment as proof that this approach is working. Surely if inflation were becoming a problem, interest rates would surge, right?

Well...not so fast. The Federal Reserve also calculates the inflation rate in the United States economy, so they are highly motivated to understate how high inflation really is. A lot of America's monetary policy depends on the USD (the dollar) maintaining its perceived value both here and abroad. That's the key word: perceived. Fiat money has no absolute value; it's only worth something because people agree to value it at a given level. But if word gets out that inflation is debasing the USD, interest rates will spike and then the hounds will truly be loose.

So how does the Fed and other agencies of the US government hide inflation? Simple: by ignoring sectors where inflation is occurring, which is to say sectors over which they have little regulatory or statutory control -- food, fuel, even other types of consumer goods. Think of how gigantic the inflation of college costs has been in the last fifteen years. (Even as the use-value of a college education keeps dropping.) Inflation isn't alarmingly high yet, but it's much higher than the Fed wants to admit it is, and is likely to go higher still at some point (it can't be otherwise, given the slow-growth economy, huge debt burden, and financing needs of governments from the federal level all the way down to municipalities).

Which brings us to the news that the Fed is, at long last, planning to end QE in October. That will leave the Fed with about $2 trillion USD worth of Treasury debt that will have to be redeemed by Treasury, which in turn will require more money-printing and/or borrowing. (This, by the way, is why defenders of QE don't call it "printing money"; they insist that it's borrowing money, which will in time be paid back. But since the money being borrowed is conjured out of thin air, and is secured by wealth that doesn't exist yet and wealth that furthermore is already spoken for by other debt, the "borrowing" fiction smells rather strongly of horseshit.)

So is inflation a problem, or not? Answer: not yet...but the red warning lights are flashing.

The government believes that it can cage inflation and keep it under control, but this presupposes a level of knowledge and control over the economy and world markets that the Fed simply does not have. If there is one main lesson to learn from the 1970's inflation, it's that inflation is devilishly hard to wring out of an economy once it has a foothold. Getting rid of excessive inflation can lead to recession, which was bad enough in the early 1980's but might be a death-blow now. We carry much more debt, and have a much more parlous financial situation at all levels of government now than we did back in the late 70's and early 80's. And unlike the dawn of the Reagan era, we don't have a burgeoning entrepreneurial class to count on for economic growth.

EDIT: Made a change to the asset deflation definition to be less wrong.

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posted by Monty at 07:53 AM

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