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.