Modern monetary systems operate
on the ability to turn debt into money. Mises' business cycle theory showed
that this process results in unsustainable distortions in the productive
structure of capital and of relative prices between different capital goods.
Mises also showed that, and left to its own devices the credit expansion
would unwind in a credit contraction as relative prices corrected. However,
central banks have for the most part been unwilling to let the system correct
on its own. Instead, they respond with a further round of inflation, trying
to solve problems inherent in the relative structure of prices by
increase aggregate demand.
A debate has been going on
recently on several web sites among those who accept the preceding premises
but disagree whether the inflation process can be pursued to its ultimate
conclusion -- hyperinflation -- or whether market forces will at some point
prevent further inflation and cause a credit collapse (deflation).
I will take on what I consider a
few of the biggest errors of the deflation side in this post.
The most obvious error in many
deflationist writings is to point to the large amount of debt and stop there.
All of us agree that the debt levels are unsustainable, but there are two
ways of getting rid of debt: default or inflation. A cascading chain of
cross-defaults would be the deflation outcome, but this is by no means
assured. Historically there have been far more hyperinflations than
deflations. Debt can be inflated away.
Deflationists have claimed that
debt cannot be inflated away as long as people are not willing to borrow, and
that once debt reaches a certain level, the ability to borrow goes away.
Whether this is true or not, the Fed has made it clear in a series of
speeches that they are ready to monetize anything and everything by turning
on the printing press and buying assets, gold mines, or whatever else it
takes to prevent nominal prices from falling.
Another deflationist argument is
that wage competition from China is deflationary, and that inflation cannot
occur in the US as long as there is wage competition.
There are two factors that
influence money prices: changes from the money side and changes from the
goods side. The inflation/deflation question concerns changes from the money
side. An increase in the supply of computers, for example, causing a fall in
the price of computers, is not deflation, or at least it is not credit
deflation. Salerno
calls it "growth deflation"; in any case it is a completely
different beast. Growth deflation does not lead to bank credit deflation, or
prevent inflationary bank credit expansion. In the same way, wage competition
due to an increase in the supply of skilled labor in other countries might be
considered growth deflation but it is not credit deflation.
Some deflationists have said
that inflation cannot occur while workers are facing competition from Asia depressing wage rates. Inflationists are not saying that real wages cannot decrease.
On the contrary, real wages and real income tends to decrease for most people
during high inflation and hyperinflation. The reasons for that are wages tend
not to keep up with goods prices; tax brackets for business and wage earners
generally are not indexed to the actual rate of prices increases, causing
taxflation; it becomes more difficult for business to produce and invest
during an inflation so the supply of goods decreases; and inflation causes a
wasteful boom and bust cycle in which productive resources are mis-used and
become idle.
There is no conflict between
real wages decreasing while nominal wages increase. If the Fed inflates the
at, say a 15% rate, then real wages would remain constant if nominal wages
inflated at 15%, and real wages would fall if nominal wages inflated at a
lower rate than 15%. If China continues its currency peg, then China would
either have to inflate at a sufficient monetary volume to keep the peg at the
same nominal level, or if they inflated at a lower volume, then to increase
their purchases of US dollars. Nominal wages could increase in the US and/or in China due to monetary inflation, while real wages decreased and while the relative wage
ratio between US and Chinese workers either increased, decreased, or remained
the same.
Another similar argument is that
price increases cannot occur in the US for goods manufactured in China. China will always offer these goods at lower prices than they can be produced in
the US, thus causing "deflation". This is also wrong for the same
reasons cited above concerning nominal and real prices.
Another factor, brilliantly
expounded by Antony Müller in a recent
daily article, is that the type of currency fixed rate that we have with China can only work for a while. Chinese central planners have as their motive for adopting
the peg the belief that they can develop economy by building up their export
sector. Because the US cannot entirely offset purchases of Chinese goods with
the sale of US-made goods to China, there is a reverse capital account flow
to make up the difference. The Chinese, in effect, loan the US money through their purchases of US bonds (mostly government and Fannie/Freddie mortgage bonds).
As China accumulate more
dollar-denominated debt, the US must pay an ever-increasing amount of interest.
Over time, an increasing proportion of the reverse capital accounts flow goes
toward interest payments to service the debt. This proportion of the whole
can only increase at the expense of the portion going to purchase goods. This
process would hit the wall at the point where 100% of the outflow went to
service previous debt and 0% toward the purchase of goods. At some point,
probably before the 100% limit, the currency peg no longer serves as an
effective mechanism to subsidize Chinese exports.
Another reason for the
unsustainability of the peg is that the US consumers are increasingly
purchasing things that they cannot afford to pay for in terms of what value
they are able to produce. That is not a sustainable state of affairs. China, then, is in the process of increasing their capital base to produce goods for people
who cannot afford them. These capital investments must be regarded as
mal-investments in the Misesean sense of the term. They are unsustainable.
The deflation arguments that
depend on the low real prices of Chinese goods are either misunderstand the
difference between real and nominal prices, or assume that the process can go
on forever when it cannot.
A final point on the
deflationist argument that there could not be a crash in the dollar because,
there is not enough volume of alternative currencies for people to buy. This
argument ignores that fact that supply and demand can be balanced at any
volume through price changes. At some exchange rate any supply of
dollars could be sold for anything else. If the rate were 1 trillion dollar
per Yen, then the entire US federal deficit could be paid off with 11 Yen.
If the other major central banks
in the world did not want the dollar to crash, or did not want their currency
to appreciate against the dollar, then they could continue to do as they have
been and purchase ever-greater amounts of dollar reserves. By some estimates,
the US trade and government deficits are equal in quantity to around 100% of
the total world's total savings. But that does not mean that the US is borrowing all of the savings in the world. Instead, central banks are printing a
portion of the money that they use to purchase US debt. This is the exporting
of US inflation - other central banks are doing the job for the Fed. If
things were to continue in this direction, with all the major central banks
inflating, then we could stave off a dollar crash in terms of the exchange
rate but we would experience world-wide hyperinflation.
In reality, the purchasing power
of a money never gets infinitesimally small. Some time before that, when
enough people see that it is going to zero, there is a run out of the
currency. This has happened to many countries in recent years, and there is
no reason that it could not happen to the dollar.
A similar argument to the
preceding one is that there are no other currencies that are sufficiently
attractive. The dollar will always be the "belle of the ball". Marc
Faber, in this
stimulating piece, has some interesting things to say about that:
Also, since most of the crises experienced over the last
15 years, beginning with the Persian Gulf crisis of 1990, were related to
problems outside the United States, there was a flight of safety into U.S.
Treasury bonds not only by domestic investors, but also by international
ones. This, in turn, tended to strengthen the U.S. dollar in times of crisis.
But, what if the Fed were to embark on a massive money printing operation
because of a really nasty economic surprise or financial accident in the United States? Would foreign investors still consider the U.S. dollar and U.S. bonds to be safe? I doubt it.
Under such circumstances
a far more likely outcome would be a tsunami of dollar selling and, along
with it, selling of U.S. dollar bonds. In the wake of massive selling of
dollars and dollar bonds by foreign investors, interest rates would likely
rise. In turn, this would force the Fed to monetize even more. A further loss
of confidence in the dollar would follow.
The question here is,
what would the dollar sell off against, and what would investors perceive as
a safe haven in such a situation? The Euro? Not very likely! Asian
currencies? Possibly, but if China were to weaken simultaneously with the U.S. economy it's unlikely that Asian currencies would be viewed as a safe haven. I suppose
that in a crisis of confidence arising from an economic or financial problem
in the United States of a scale that would lead the Fed to print money in
massive quantities, only gold, silver, and platinum would be regarded as
truly safe currencies notwithstanding their current weakness.
Jim Puplava, proprietor of the Financial Sense web site has been
one of the foremst proponents of the inflation view. The following articles
and interviews are worthy of study:
·
The Core Rate
analyzes the mismeasurement of inflation. Changes in the the CPI have
resulted in a measured rate of inflation about 2% below the rate that would
have been measured before the changes.
·
the
always insightful Dr. Marc Faber talks about inflation and hyper-inflation (MP3 transcript).
·
Three
segments of Puplava's "big picture" (1, 2, 3) in
which he explains his forecast of a hyperinflationary collapse of the dollar.
·
John
Hathaway's article A Process of
Elimination: A Speculation on Gold and the Credit Cycle
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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