Tuesday, November 4, 2008

Inflation, Deflation and Chaos

Too many pundits are confused about the condition of the economy. It’s no wonder. The economy – the global market – is a chaotic system. Those of you who have read James Gleick’s Chaos understand that when multi-quadrillions of individual decisions and transactions are occurring, patterns develop, evincing a form of order that becomes predictable, sort of.

The science of chaos began when scientist Edward Lorenz was attempting to develop a computer model for weather. One phenomenon he observed was that when a tiny individual variation occurred, it could cause a huge reaction somewhere else in the system. It was called the “butterfly effect” after the idea that a butterfly flapping its wings in Tokyo could eventually cause a hurricane in the Caribbean. The problem is figuring out which butterfly is going to influence what kind of result. The scientists are still working on that one – there are too many butterflies, birds, sneezes and every sort of variable imaginable to contribute to the cause of who knows what. If it were possible to take into account every variable, accurate prediction would be possible. Alas, it is not. We still can only make educated guesses.

A butterfly flapped its wings in March with the bailout of Bear Sterns, setting in motion a chain of events the results of which remain to be seen. Those who warned of a moral hazard were correct. And the failure to go with the flow and bail out Lehman Brothers was another variable that changed the direction of the result, whatever that might have been or may be. (See You might call that event a “tipping point” – much like the final grain of sand that causes an avalanche.

One variable influencing the economy is the supply of money and credit. Another variable is the aggregate view of businessmen regarding the direction of the economy and the investment choices they make based on that view. Another variable is consumers’ aggregate views about their own personal situations and futures. Another variable is the scarcity of natural resources. And there are many more, each of which can influence the other. Even the propagation of popular misconceptions is a variable because, notwithstanding the truth, those misconceptions can influence other variables.

One popular misconception is the definition of inflation. The popular understanding is that inflation is a general rise in the price levels of goods and services. That definition leaves one to wonder what caused the prices to rise and it allows demagogues to lay the blame on their favorite scapegoats. But when one understands inflation as monetary inflation, it is easier to identify one cause for a general increase in prices – an increase in the supply of money and credit, which is the Austrian economists’ definition of inflation and the one to which I subscribe.

Inflation does not necessarily cause a general increase in prices. There could be other, countervailing influences that keep the prices of goods and services down in an economy. And an increase in money and credit does not necessarily result in a runup in prices of consumer goods such as it did in the 1970s. In the past decade the prices of many (but not all) consumer goods in the U.S. were kept low by foreign imports while excessive credit caused a massive runup of prices in the real estate market. In the 1920s, consumer price levels remained low while there was a stock market boom fueled by inflation. So prices can increase in one segment of the market while they remain stable, or even decrease in another.

Deflation is the reverse of inflation. It is a contraction in the supply of money and credit. Today, we are experiencing a contraction of credit in a wide variety of areas. That contraction has originated within the banking system and it is affecting real estate prices and vice versa. Bank contraction of credit will also affect credit cards, commercial loans, municipal loans, student loans, etc., which in turn will affect consumer demand for goods and services, business investment, local and state taxes, university finances, etc., which eventually will influence the prices and business activity in the areas affected. They will be lower that they otherwise would have been.

“They will be lower that they otherwise would have been.” That is another concept that you need to get your arms (mind) around. Inflation does not cause prices to go up. It ultimately causes prices to be higher that they otherwise would have been. How do you tell, then, if there is inflation when the prices are stable? The answer is that you watch the supply of money and credit and you do not define inflation as prices going up. Otherwise, you could fail to be on the lookout for where the consequences of inflation will show up (as in – another bubble).

Another point of confusion is the fact that it takes months and sometimes years for an increase in the money supply to work its way through the economy and affect the general price levels. Thus an increase today may appear to have no effect. Indeed, some analysts predict that price inflation is a long way off because the countervailing deflation from the unwinding of the credit markets will take a very long time. As demonstrated over the past few months, however, the consequences of a decrease in the supply of money and credit can happen relatively quickly and be immediately visible.

We are in the middle of a deflation caused by a contraction of bank lending at the same time the Federal Reserve is inflating by pumping money into the system, trying unsuccessfully to get the banks to lend. (Check out these commentaries for more information: http://www.gold-eagle.com/editorials_08/ash110308.html and http://www.gold-eagle.com/editorials_08/degraaf110308.html and http://www.gold-eagle.com/editorials_08/captainhook110308.html .)

The pundits have been busy debating whether we have inflation or deflation. Those who fear the consequences of inflation argue that the Fed needs to stop pushing money and credit onto the banks, worrying that once the banks do begin to lend, the money will hit the market causing price to be higher than they otherwise would have been and/or creating another bubble somewhere. Those who fear the consequences of deflation argue that prices are not going up and they support the Fed’s efforts to unfreeze the credit markets to forestall a recession or, worse, a depression. Deflation is clearly occurring with the consequences visible in the near term. Inflation is also occurring with the consequences to come. Investors need to worry about both – how far down the current deflation will take the economy and, at the same time, where the inflation that is occurring simultaneously will take us in the longer term. It is confusing, but that’s chaos for you. You need to look for patterns.

Deflation historically has caused recessions and even depressions, stock market declines and crashes, bank and business failures. It also is an era of relatively low interest rates as the authorities attempt to forestall market corrections for the mal investments that resulted from the preceding inflation and get business activity moving.

Inflation historically has generated the boom and bust cycle, which tends to get progressively worse with each cycle – first inflation, then deflation, then inflation, etc. until inflation cannot be brought down. The “crack up boom” occurs, the currency is destroyed and with it the middle class, and a depression occurs. The aftermath of hyperinflation and currency destruction is a time ripe for a man on horseback.

A deflation brought on by market forces and allowed to return to equilibrium through the market, even if it causes a depression, is always preferable to resisting the deflation with inflation, which can end in a crack-up boom, hyperinflation and a depression. In the former case, the depression is painful but short-lived. In the latter, society as we know it could be over and, at a minimum, many things will be influenced in a direction that you will not like.

The Fed's attempts to forestall deflation by inflating are beginning to take effect. Banks are starting to lend again although demand for credit has been dampened. This might signal the end of the deflation scare that has panicked Washington. At some point down the road we should begin to see evidence of the consequences of the inflation in the prices of commodities and other assets and in an increase in market interest rates. If a public inflationary mentality develops, that would be the time to be alert to the signs of a crackup boom.

Those with a thirst for knowledge should read an account of Germany’s 1923 inflation and follow its consequences through the 1930’s. The Great Inflation is a great, concise book but it is out of print. Maybe it’s in your library.

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