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    Default Deflationista takes on iTulip to prove deflation is here!

    Deflationista takes on iTulip to prove deflation is here!

    by Roger J. Deflationista (iTulip) October 31, 2008


    The Fed faces an impossible task. In the face of recession and the worst credit crunch since the 1930s the Fed's crash program to boost the money supply and raise inflation expectations is a failure. I prove it using the most up-to-date inflation, money supply, and bond rate data issued by the Fed today.

    If the Fed has succeeded in boosting the money supply surely the key money supply measure M2 is up. Fat chance! Let's take a look at the carnage!



    Looks like M2 is up for the year and up for the period ending Oct. 31, 2008. Must be an anomaly–something wrong with the data.

    What about MZM? Surely that declined, what will all of the deflation we've been having.

    What is MZM and why it's the best measure of the money supply?
    A measure of the liquid money supply within an economy. MZM represents all money in M2 less the time deposits, plus all money market funds. - Answers.com

    MZM has become one of the preferred measures of money supply because it better represents money readily available within the economy for spending and consumption. This measurement derives its name from its mixture of all the liquid and zero maturity money found within the three "M's." - Investopedia
    Here's the collapse of MZM, then.



    Well that's disappointing. MZM is up strongly for the year with a sharp spike in the current reporting period ending Oct. 31, 2008.

    Fine. But we all known that the banks are sucking wind. Bank credit must be way off, what with all of the stress in the banking system. Bank credit has crashed, right?



    Oops! Bank credit is through the roof. Huh.

    Well, so what? That doesn't prove anything. All that money sitting in bank and money market accounts making up M2 and MZM and all that bank credit created by the Fed doesn't mean squat.

    The Fed can't make consumers borrow it! The Fed can't make banks lend it! If that were the case then the CPI wouldn't be falling. That's the measure of all that money chasing goods and raising prices, not languishing in bank accounts. Here's where we'll find our deflation. All the Fed's printing is for naught.



    Well whaddaya know. The CPI after falling for a couple of months is up again.

    But that's temporary, a lagging indicator. That's inflation from before the recession set in when demand was still high. That's the last we'll see of inflation! And to prove it, we'll look at inflation expectations priced in to inflation-indexed Treasury bonds (TIPS). You can't fool the bond markets! That's thousands of savvy fixed income investors voting pro or con on future inflation. No doubt TIPS interest rates are way, way down, pricing in deflation that will go on for years and years. Why I'd bet dollars to donuts TIPS rates are below 2% now.



    No, no! That can't be! TIPS interest rates going from 2016 all the way out to 2032 are spiking? iTulip warned me about this back in early September in Future inflation fears topple TIPS but I didn't believe it. Now PIMCO is piling into them.

    Suckers! Don't they know deflation is in the cards? What does that stupid bond market and PIMPCO know, anyway?

    Just look at 30 year mortgage rates. They are falling through the floor signalling that deflation is ripping through the US economy.
    Bankrate: Mortgage rates surge to three-month high
    Oct. 30, 2008

    NEW YORK (MarketWatch) -- Mortgage rates bounded higher this week, with the average 30-year fixed mortgage rate soaring from 6.32% to 6.77%, according to a Bankrate.com weekly national survey. The average 30-year fixed mortgage had an average of 0.39 discount and origination points, it said. The average 15-year fixed rate mortgage jumped to 6.46%, while the average jumbo 30-year fixed rate climbed to 7.95%. Adjustable mortgage rates were mixed, with the average one-year ARM dipping to 6.09%, and the average 5/1 ARM increasing to 6.67%.
    Oh, I give up. No signs of deflation anywhere, just a short term spike in the dollar from panicky holders of euros, rubles, reals, pesos, and rupee piling into T-Bills to get into dollars but still avoid US banks like the plague. Everything else points to rising inflation.

    Oh, well. Back to the drawing board!

    - Roger J. Deflationista

    See also: The truth about deflation

    Happy Halloween from the iTulip crew!



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    Last edited by FRED; 11-02-08 at 02:03 PM.
    Ed.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Cute. Thanks for the laugh.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Terrific stuff. I am glad that "Deflation" has become a popular theme - that means Im on the other side of the market. If everyone was convinced that Inflation was going to be the problem, gold would be selling at $3,000 instead of $720. As someone who just bought another large chunk of gold, Im perfectly satisfied with everyone being convinced that deflation is on the horizon.

    The more people there are worrying about deflation the better - the more money the Feds and all the other CBs will pump.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Thanks for the timely data. It's always better to know what is happening than to speculate about what could happen.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    so whadaya think, are we headed for INflation or DEflation?

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    I'm wondering why MISH is so convinced that inflation is not possible? I think his position is that interest on the growing national debt will just consume any new money being pumped into the system. FRED, I'm new here so I apologize if this has been answered and I just haven't found the post yet....

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Quote Originally Posted by BDS4 View Post
    I'm wondering why MISH is so convinced that inflation is not possible? I think his position is that interest on the growing national debt will just consume any new money being pumped into the system. FRED, I'm new here so I apologize if this has been answered and I just haven't found the post yet....
    I can't speak for MISH, but interest on the national debt isn't going to "consume" the money pumped into the system because when the government pays interest on the debt, the money it pays isn't destroyed. Government interest payments are a budget issue (and eventually a solvency issue) for the government, but they are not really a money supply issue. If you hold a government bond and receive an interest payment from the government, then you can go out and spend that interest payment -- the money does not disappear from the money supply, and your ability to spend the money will continue to support prices. In fact, when the interest payments become too large -- and the government is facing insolvency -- you should expect inflation as the government monetizes its debt.

    For future reference, you can estimate the numbers surrounding interest payments on the debt from figures in the FY2009 federal budget published by OMB here. In table S-7, it says that net interest payments totaled $237 billion in FY2007. However, this doesn't include interest payments that the government "pays itself" for the portion of the national debt held by government agencies (according to table S-13, about 44% of the debt in FY2007). I don't have an exact reference for the interest the government "pays itself", but I can estimate it from other data. For instance, the Trustees of the Social Security and Medicare Trust Funds report that they held $2.6 trillion worth of government account series bonds at the end of 2007, from which they received $129 billion in interest -- real close to 5%. Returning to table S-13, in FY2007 the government owed itself $3.9 trillion total, so if I use the 5% interest rate estimated for the Social Security and Medicare Trust Funds for the entire $3.9 trillion, I get about $195 billion to add to the $237 billion of net interest, or a total of $432 billion in interest payments.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Quote Originally Posted by ASH View Post
    I can't speak for MISH, but interest on the national debt isn't going to "consume" the money pumped into the system because when the government pays interest on the debt, the money it pays isn't destroyed. Government interest payments are a budget issue (and eventually a solvency issue) for the government, but they are not really a money supply issue. If you hold a government bond and receive an interest payment from the government, then you can go out and spend that interest payment -- the money does not disappear from the money supply, and your ability to spend the money will continue to support prices. In fact, when the interest payments become too large -- and the government is facing insolvency -- you should expect inflation as the government monetizes its debt.

    For future reference, you can estimate the numbers surrounding interest payments on the debt from figures in the FY2009 federal budget published by OMB here. In table S-7, it says that net interest payments totaled $237 billion in FY2007. However, this doesn't include interest payments that the government "pays itself" for the portion of the national debt held by government agencies (according to table S-13, about 44% of the debt in FY2007). I don't have an exact reference for the interest the government "pays itself", but I can estimate it from other data. For instance, the Trustees of the Social Security and Medicare Trust Funds report that they held $2.6 trillion worth of government account series bonds at the end of 2007, from which they received $129 billion in interest -- real close to 5%. Returning to table S-13, in FY2007 the government owed itself $3.9 trillion total, so if I use the 5% interest rate estimated for the Social Security and Medicare Trust Funds for the entire $3.9 trillion, I get about $195 billion to add to the $237 billion of net interest, or a total of $432 billion in interest payments.
    mish can make it about nine words into one of your erudite and precise posts before dismissing it as 'keynesian claptrap' as he does when he encounters something he cannot comprehend.

    i prefer to listen to prof. ash.

    $432 bil in interest is only 3% of gdp.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Great writeup, but dont expect any deflationistas to actually believe it. It seems like the deflation camp is populated by die hard believers who will not be swayed by any amount of actual facts.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Quote Originally Posted by nathanhulick View Post
    Great writeup, but dont expect any deflationistas to actually believe it. It seems like the deflation camp is populated by die hard believers who will not be swayed by any amount of actual facts.
    yeh, mzm, m2, bank credit, inflation, bond prices... all lies made up by the gov't to keep you from getting rich when deflation takes your gold to $100!

    never did follow the logic over there at the mish zone.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Bart,

    ..."Interbank loans have not crashed."...

    isnt the Fed to Private bank rescue funds in this number.

    I dont believe that interbank trend, as the price (spread) of interbank loans as gone up, so the volume would drop.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Quote Originally Posted by icm63 View Post
    Bart,

    ..."Interbank loans have not crashed."...

    isnt the Fed to Private bank rescue funds in this number.

    I dont believe that interbank trend, as the price (spread) of interbank loans as gone up, so the volume would drop.
    To the best of my knowledge, that figure does not include Fed to private bank loan data. Although the rates and spread did go up substantially (and are coming back down), the data does show that it did not substantially affect interbank loans.

    In my opinion, other factors like confidence (one definition of money being an idea backed by confidence) play and played a larger role in the current financial crisis.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Quote Originally Posted by ASH View Post
    I can't speak for MISH, but interest on the national debt isn't going to "consume" the money pumped into the system because when the government pays interest on the debt, the money it pays isn't destroyed. Government interest payments are a budget issue (and eventually a solvency issue) for the government, but they are not really a money supply issue. If you hold a government bond and receive an interest payment from the government, then you can go out and spend that interest payment -- the money does not disappear from the money supply, and your ability to spend the money will continue to support prices. In fact, when the interest payments become too large -- and the government is facing insolvency -- you should expect inflation as the government monetizes its debt.

    For future reference, you can estimate the numbers surrounding interest payments on the debt from figures in the FY2009 federal budget published by OMB here. In table S-7, it says that net interest payments totaled $237 billion in FY2007. However, this doesn't include interest payments that the government "pays itself" for the portion of the national debt held by government agencies (according to table S-13, about 44% of the debt in FY2007). I don't have an exact reference for the interest the government "pays itself", but I can estimate it from other data. For instance, the Trustees of the Social Security and Medicare Trust Funds report that they held $2.6 trillion worth of government account series bonds at the end of 2007, from which they received $129 billion in interest -- real close to 5%. Returning to table S-13, in FY2007 the government owed itself $3.9 trillion total, so if I use the 5% interest rate estimated for the Social Security and Medicare Trust Funds for the entire $3.9 trillion, I get about $195 billion to add to the $237 billion of net interest, or a total of $432 billion in interest payments.
    Thanks to ASH for that reply. So clear that even I understood. With prices falling on homes and potentially other items initially, what will stop people from just saving anything beyond the items of basic need due to the fear of losing capital? I read somewhere that in the GD, this was an issue (hoarding cash, gold) for quite a time. Is there a catalyst that will break this loose or do things just finally reach a point that "deals" are seen globally and people just start spending again?

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    One more item, I probably mangled MISH's message - he did say that deflation at this time wasn't possible due to the national debt. The rest was my expansion and maybe inaccurate. I'm not a true believer in either camp but am just seeking information to build an opinion.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    I meant inflation wasn't possible.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Quote Originally Posted by BDS4 View Post
    One more item, I probably mangled MISH's message - he did say that deflation at this time wasn't possible due to the national debt. The rest was my expansion and maybe inaccurate. I'm not a true believer in either camp but am just seeking information to build an opinion.
    Again, I can't say I know MISH's position, so I might be responding to a strawman argument.

    One possible claim is that in order to pursue inflationary policies (e.g. reducing taxes, handing out money, and increasing public spending), the government will need to fund some very large deficits by borrowing. Someone in the deflationary camp might claim that since America's national debt is large -- and since inflationary policies tend to devalue the dollar -- the government might be unable to find willing buyers for its bonds, and therefore will be unable to borrow the money and engage in the required deficit spending. This line of reasoning might also say that the government will prefer to suffer through a deflationary depression rather than create inflation by monetizing the debt (selling bonds to the Federal Reserve rather than the public), because that is currency suicide, and it will destroy our ability to borrow in the future, as well as force an abrupt equalization of trade (because vendor financing will no longer be available).

    I think someone making that argument has the order of events wrong. Right now, it looks like we'll be able to do the borrowing necessary to pursue inflationary policies, but that doing so will put us into a position where the dollar weakens, and future borrowing becomes expensive. Before all this borrowing, our debt:GDP ratio was bad, but not as bad as some other leading industrialized countries (like Japan). So, I think the deflationist argument surrounding the debt is that we won't be given enough rope to hang ourselves, but it sure looks to me like there will be enough rope.

    As for whether monetization will be used as a last resort... I think the consequences are so awful that there is legitimate room for debate. Still, I believe that the inflationists have convincingly demonstrated that there is a policy bias to avoid another deflationary depression at all costs, so I still come down on the side of inflation on this one.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Quote Originally Posted by ASH View Post
    Again, I can't say I know MISH's position, so I might be responding to a strawman argument.

    One possible claim is that in order to pursue inflationary policies (e.g. reducing taxes, handing out money, and increasing public spending), the government will need to fund some very large deficits by borrowing. Someone in the deflationary camp might claim that since America's national debt is large -- and since inflationary policies tend to devalue the dollar -- the government might be unable to find willing buyers for its bonds, and therefore will be unable to borrow the money and engage in the required deficit spending. This line of reasoning might also say that the government will prefer to suffer through a deflationary depression rather than create inflation by monetizing the debt (selling bonds to the Federal Reserve rather than the public), because that is currency suicide, and it will destroy our ability to borrow in the future, as well as force an abrupt equalization of trade (because vendor financing will no longer be available).

    I think someone making that argument has the order of events wrong. Right now, it looks like we'll be able to do the borrowing necessary to pursue inflationary policies, but that doing so will put us into a position where the dollar weakens, and future borrowing becomes expensive. Before all this borrowing, our debt:GDP ratio was bad, but not as bad as some other leading industrialized countries (like Japan). So, I think the deflationist argument surrounding the debt is that we won't be given enough rope to hang ourselves, but it sure looks to me like there will be enough rope.

    As for whether monetization will be used as a last resort... I think the consequences are so awful that there is legitimate room for debate. Still, I believe that the inflationists have convincingly demonstrated that there is a policy bias to avoid another deflationary depression at all costs, so I still come down on the side of inflation on this one.
    well reasoned, as always. there is always the possibility that the fed has something up its sleeve we have not thought of. these central banks are thick as thieves. never would have guessed that the fed was gonna buy brazil's bonds to slow the crash of the real. so who knows what they might do before they have to do anything so old school as debt monetization. that may be many years away.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Quote Originally Posted by BDS4 View Post
    Thanks to ASH for that reply. So clear that even I understood. With prices falling on homes and potentially other items initially, what will stop people from just saving anything beyond the items of basic need due to the fear of losing capital? I read somewhere that in the GD, this was an issue (hoarding cash, gold) for quite a time. Is there a catalyst that will break this loose or do things just finally reach a point that "deals" are seen globally and people just start spending again?
    Hi BDS4. I think inflation vs. deflation scenarios have been more ably analyzed than I could by others -- ad nauseam -- in previous iTulip threads (there are links to several such threads in this post). You and I are in mortal danger of being tersely directed to take it elsewhere by exasperated senior iTulipers who have seen this topic hashed over repeatedly already (although we may be granted some leniency, since FRED started the thread). That said, I'm happy to talk about it, because I haven't personally attempted an expository summary of the issue before. Here's my summary of what I've read.

    So, the question is -- what will happen if Americans start saving and stop spending? I'm going to ignore the behavioral aspect of this issue (whether American culture really would switch from consumption to saving, if offered "free money" to continue spending) and take that as a stipulation. Absent effective government intervention, and absent global markets, there would indeed be a deflationary recession. It would be deflationary because of reduced demand from private consumers (less money chasing goods, services, and assets), and it would be a recession because reduced demand begets reduced economic activity (which could reduce demand further, as jobs are lost... and so on). However, there is government intervention, and there is a global market.

    Government intervention can take several forms. The government can mail citizens tax rebate checks, or bump up unemployment benefits, or find other ways to put public funds in the hands of consumers. The government can also create money in the banking system and reduce the cost of credit to encourage banks to increase lending. Either of these measures will create some demand indirectly, although if the American people have truly given up excessive consumption cold turkey, then these measures will only serve to replace some of the consumer demand for necessities that is lost as a result of personal insolvency. Cheaper credit can also fuel borrowing for investment, but there is no guarantee that the investment will be domestic. You could get another asset bubble going, but it might be overseas. Japan's mild but lengthy recession is the poster child for "pushing on a string" -- a case in which domestic demand from a nation of savers did not rise much in response to cheaper lending, and the investment which was engendered was mainly overseas (the yen carry trade). This is more likely to be a problem once deflationary expectations (the belief that saved dollars will be worth more tomorrow than today) become entrenched, which is one reason the government will try like the dickens to reflate.

    Faced with a population of savers, the government can also directly create demand, serving as the consumer of last resort, through increased public spending. The government can also institute capital controls (e.g. taxes on foreign investment) and tax preferences to discourage a carry trade from developing. Finally, the government can intentionally devalue its currency in a bid to increase export activity and reduce foreign competition with domestic industries. (Protectionist policies of this type are not generally productive, as they tend to reduce both the volume of trade and economic efficiency -- but that's not to say the protectionist policies aren't tried.) In extremity (deflationary expectations have set in, despite the government's best efforts to reflate), the government can intentionally create inflation by outright debasement of the currency (e.g. through monetization of the government's own debts). This means that the government would pay its bills by creating money directly, rather than collecting taxes or borrowing from the public. This would be the ultimate catalyst to get people to spend rather than save, because this would massively devalue the dollar, creating inflation and the expectation of future inflation. Expectations of inflation mean that savers expect the purchasing power of their savings to drop over time, which gives them an incentive to spend today rather than save for tomorrow. (Note, however, that monetization of the debt is basically currency suicide, so it would only be used as a last resort, in the face of a Great Depression type scenario or actual federal insolvency. The other types of government policy I outlined are also inflationary, and would be tried first because the government has a better chance of staying in control of the situation.)

    Aside from the potential for a carry trade and the possibility of trade wars, the existence of global markets also entails the large-scale movement of capital in to and out of the American economy. In the midst of a global financial crisis, you would expect international capital to seek a safe haven. If dollar-denominated American assets look more likely to hold their value than various alternatives -- judged in the currency of foreign investors -- then you would expect foreign capital to flock here. That would entail the exchange of foreign currency for dollars to buy the assets, creating higher demand for the US dollar, which would have a deflationary impact on the economy. Conversely, if dollar-denominated assets look like a worse risk to potential foreign investors -- for instance, because of suspicions that the US will be unable to honor its debts without devaluing its currency, or because the growth prospects for the US economy are judged to be worse than foreign alternatives, or because of suspicions that the US will intentionally devalue its currency to get people to spend rather than save -- then you would expect capital flight. This would result in a flood of dollars, as dollar-denominated assets are sold and the dollars are exchanged for other currencies. I believe this dynamic is the main reason why iTulip says deflation is unlikely to result from this crisis. As a net debtor with a large current account deficit, flatlined savings rate, and skyrocketing public debt, the United States makes a poor destination for flight capital. Although the short-term need for dollar funding has caused a spike in the dollar's exchange rate, iTulip expects significant capital flight to result from this crisis in the long run.

    So, returning to the original question of what happens if Americans stop consuming and start saving, here's what I think. The government tries to get Americans to resume consuming by giving them money directly and by increasing the supply of credit. Separately, the government replaces some of the private demand with public spending. If Americans persist in trying to save rather than spend -- and if the government stimulus doesn't itself lead to inflation -- then as a last resort the government can choose to create inflation to get savers to spend. As I recently summarized here, the inflationist view is that the government reflation policies themselves are likely to overshoot, creating inflation directly through expansion of the money supply, and are also likely to promote capital flight because the deficit spending makes eventual monetization of the federal debt more likely. In the same post, I point out that the reflation policies need not necessarily overshoot, as the government does technically have the means to sterilize the loans it makes to increase access to credit, and it can also reduce the money supply later. I also point out that although the trend was away from the dollar prior to this crisis, it does not necessarily follow that the trend will continue post-crisis. (Some who post to iTulip take the view that the Fed will manage the money supply in such a way as to avoid significant inflation, and that by demonstrating how export-based economies seize up when the system is starved of dollars, this crisis will increase the importance of the dollar, rather than resulting in capital flight from the dollar.) Although I think significant inflation and a weaker dollar are likely, I am not a true-believer myself, and I'm watching to see who is actually right about the outcome. As for the deflationists... I have nothing to add to the criticisms in the posts linked above. I think the most basic issue is that if there's a policy choice to be made between a deflationary depression and inflation, then the government will choose inflation -- and the government can always create inflation if it needs to.
    Last edited by ASH; 11-02-08 at 01:13 PM.

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    Default Re: Deflationista takes on iTulip to prove deflation is here!

    Quote Originally Posted by ASH View Post
    Hi BDS4. I think inflation vs. deflation scenarios have been more ably analyzed than I could by others -- ad nauseam -- in previous iTulip threads (there are links to several such threads in this post). You and I are in mortal danger of being tersely directed to take it elsewhere by exasperated senior iTulipers who have seen this topic hashed over repeatedly already (although we may be granted some leniency, since FRED started the thread). That said, I'm happy to talk about it, because I haven't personally attempted an expository summary of the issue before. Here's my summary of what I've read.

    So, the question is -- what will happen if Americans start saving and stop spending? I'm going to ignore the behavioral aspect of this issue (whether American culture really would switch from consumption to saving, if offered "free money" to continue spending) and take that as a stipulation. Absent effective government intervention, and absent global markets, there would indeed be a deflationary recession. It would be deflationary because of reduced demand from private consumers (less money chasing goods, services, and assets), and it would be a recession because reduced demand begets reduced economic activity (which could reduce demand further, as jobs are lost... and so on). However, there is government intervention, and there is a global market.

    Government intervention can take several forms. The government can mail citizens tax rebate checks, or bump up unemployment benefits, or find other ways to put public funds in the hands of consumers. The government can also create money in the banking system and reduce the cost of credit to encourage banks to increase lending. Either of these measures will create some demand indirectly, although if the American people have truly given up excessive consumption cold turkey, then these measures will only serve to replace some of the consumer demand for necessities that is lost as a result of personal insolvency. Cheaper credit can also fuel borrowing for investment, but there is no guarantee that the investment will be domestic. You could get another asset bubble going, but it might be overseas. Japan's mild but lengthy recession is the poster child for "pushing on a string" -- a case in which domestic demand from a nation of savers did not rise much in response to cheaper lending, and the investment which was engendered was mainly overseas (the yen carry trade). This is more likely to be a problem once deflationary expectations (the belief that saved dollars will be worth more tomorrow than today) become entrenched, which is one reason the government will try like the dickens to reflate.

    Faced with a population of savers, the government can also directly create demand, serving as the consumer of last resort, through increased public spending. The government can also institute capital controls (e.g. taxes on foreign investment) and tax preferences to discourage a carry trade from developing. Finally, the government can intentionally devalue its currency in a bid to increase export activity and reduce foreign competition with domestic industries. (Protectionist policies of this type are not generally productive, as they tend to reduce both the volume of trade and economic efficiency -- but that's not to say the protectionist policies aren't tried.) In extremity (deflationary expectations have set in, despite the government's best efforts to reflate), the government can intentionally create inflation by outright debasement of the currency (e.g. through monetization of the government's own debts). This means that the government would pay its bills by creating money directly, rather than collecting taxes or borrowing from the public. This would be the ultimate catalyst to get people to spend rather than save, because this would massively devalue the dollar, creating inflation and the expectation of future inflation. Expectations of inflation mean that savers expect the purchasing power of their savings to drop over time, which gives them an incentive to spend today rather than save for tomorrow. (Note, however, that monetization of the debt is basically currency suicide, so it would only be used as a last resort, in the face of a Great Depression type scenario or actual federal insolvency. The other types of government policy I outlined are also inflationary, and would be tried first because the government has a better chance of staying in control of the situation.)

    Aside from the potential for a carry trade and the possibility of trade wars, the existence of global markets also entails the large-scale movement of capital in to and out of the American economy. In the midst of a global financial crisis, you would expect international capital to seek a safe haven. If dollar-denominated American assets look more likely to hold their value than various alternatives -- judged in the currency of foreign investors -- then you would expect foreign capital to flock here. That would entail the exchange of foreign currency for dollars to buy the assets, creating higher demand for the US dollar, which would have a deflationary impact on the economy. Conversely, if dollar-denominated assets look like a worse risk to potential foreign investors -- for instance, because of suspicions that the US will be unable to honor its debts without devaluing its currency, or because the growth prospects for the US economy are judged to be worse than foreign alternatives, or because of suspicions that the US will intentionally devalue its currency to get people to spend rather than save -- then you would expect capital flight. This would result in a flood of dollars, as dollar-denominated assets are sold and the dollars are exchanged for other currencies. I believe this dynamic is the main reason why iTulip says deflation is unlikely to result from this crisis. As a net debtor with a large current account deficit, flatlined savings rate, and skyrocketing public debt, the United States makes a poor destination for flight capital. Although the short-term need for dollar funding has caused a spike in the dollar's exchange rate, iTulip expects significant capital flight to result from this crisis in the long run.

    So, returning to the original question of what happens if Americans stop consuming and start saving, here's what I think. The government tries to get Americans to resume consuming by giving them money directly and by increasing the supply of credit. Separately, the government replaces some of the private demand with public spending. If Americans persist in trying to save rather than spend -- and if the government stimulus doesn't itself lead to inflation -- then as a last resort the government can choose to create inflation to get savers to spend. As I recently summarized here, the inflationist view is that the government reflation policies themselves are likely to overshoot, creating inflation directly through expansion of the money supply, and are also likely to promote capital flight because the deficit spending makes eventual monetization of the federal debt more likely. In the same post, I point out that the reflation policies need not necessarily overshoot, as the government does technically have the means to sterilize the loans it makes to increase access to credit, and it can also reduce the money supply later. I also point out that although the trend was away from the dollar prior to this crisis, it does not necessarily follow that the trend will continue post-crisis. (Some who post to iTulip take the view that the Fed will manage the money supply in such a way as to avoid significant inflation, and that by demonstrating how export-based economies seize up when the system is starved of dollars, this crisis will increase the importance of the dollar, rather than resulting in capital flight from the dollar.) Although I think significant inflation and a weaker dollar are likely, I am not a true-believer myself, and I'm watching to see who is actually right about the outcome. As for the deflationists... I have nothing to add to the criticisms in the posts linked above. I think the most basic issue is that if there's a policy choice to be made between a deflationary depression and inflation, then the government will choose inflation -- and the government can always create inflation if it needs to.
    Ash, thanks again for a very informative response. It makes a lot of sense.

  20. #20
    Join Date
    Oct 2008
    Posts
    6

    Default Re: Deflationista takes on iTulip to prove deflation is here!

    consumer credit is increasing at around 5% annualised. consumer debt repayment as a % of disposable income is falling sharply. i can see repayments falling if debt is decreasing (ha), or if income is rising (ha). so then what gives?

    consumer credit.jpg

    consumer debt pc of income.jpg

    in regard to the great flation debate, a common theme among deflationists seems to be that debt has become so great (350% of gdp) that consumers are unwilling/unable to take on new debt (banks report unwillingness to lend on top of that, though bart's chart of interbank lending suggests they're lying), thereby sending fractional reserve money creation into reverse. only possible solution to that is for governments to simply give cash to consumers, as both the US and now japan have done. but another head ache is that real estate lending is actually expanding, regardless of the housing crash:

    real estate loans.jpg

    makes no sense to me

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