Why inflation?

In the more eschatological corners of the financial blogosphere, a debate has raged for centuries: Inflation or deflation?

I recommend Michael Shedlock as a thoughtful and passionate proponent of the deflationary view. (See e.g. here and here, but he’s been making the case for years and it’s worth searching the archives.) Also, Karl Denninger recently offered a nice deflationary tract.

I’m more certain of monetary and price volatility than I am of inflation or deflation. But on balance, even as commodities crash and the dollar rallies, my best guess is inflation.

Do read today’s excellent post by the always excellent Brad Setser, The changing balance of global financial power. Take a look at his graphs, showing the external official claims of “democracies” vs “autocracies”. You’ll notice that the autocracies are owed a great deal more money than the democracies are. Mostly, money is owed by the democracies to the autocracies in the form of debt denominated in the democracies’ currencies.

[Note: For the purpose of this piece, it matters only that policy in the “democracies” be sensitive to public pressure. The internals of the “autocracies”, and whether they are justly characterized as such, is not relevant to the argument, and not anything I want to get into here.]

Inflation helps debtors at the expense of creditors. In democracies where those who can vote are, on balance, debtors, one would expect collective indebtedness to favor inflation. Not all citizens are debtors, there would be domestic winners and losers. But on balance, voters gain by printing currency. If that’s a good argument for free trade, why should it not be an argument for weak money?

There are, of course, institutional constraints, “independent” central banks and all. It is one thing for a nation’s central bank to stand above the fray with respect to competing domestic interests, but quite another for the bank to put foreign interests or economic ideals above a collective national interest. That’s especially true if the alternative to devaluation is deflation. Under a deflation, American workers (those who remain employed!) would have to work more to pay off their fixed dollar debts. Individuals can declare bankruptcy and default, but collectively we cannot default on official debt (pace Felix Salmon, whose heretical idea I adore). One way or another, as reckless debtors or noble taxpayers, Americans would have to work harder under a deflation than they had signed on for when they took on the debt. Americans are having a hard time coming to grips with their nominal debt burden, public and private. I think it implausible that they would accept a large increase in the real interest rate they must pay. Officially it is the policy of the American central bank to maintain price stability and full employment regardless of the external value of the dollar. If the Fed faces a choice between deflation and high unemployment, or tolerating a significant inflation (with or without high unemployment), I’m pretty certain it would choose the latter as the less-bad option.

Japan’s experience in the 1990s and the US’ in the 1930s are often cited to suggest the inevitability of deflation, despite monetary policy heroics. But in both cases, the deflating country had a large, positive international asset position. To the degree money was owed by foreigners in domestic or pegged currency, the “national interest”, looking past winners and losers, was to tolerate deflation.

All of this ignores the secondary consequences of a partial default through inflation and devaluation. A wise polity would weigh the immediate collective benefit of reduced debt load against costs including higher future interest rates (foreign creditors get spooked), more expensive tradables, and a nationalistic backlash by creditor states. Of course, it would also have to consider the secondary effects of tolerating deflation, such as a spike in bankruptcies combined with a large tax spike to avoid a sovereign default. It seems to me that the adverse consequences of deflation would be sharp and domestic, while high prices and interest rates can be billed as “facts of nature” in a market economy, and other people’s hostile nationalism often helps domestic politicians, who can provoke some hostile nationalism of their own.

It is not impossible that the Fed will square the circle, maintaining something close to price stability while the US gears up its tradables economy and foreign creditors silently ease our debt burden via real appreciation. Obviously, that’s the best outcome (at least for the United States). But if deflationary winds do blow, if the Fed is faced with the choice of tolerating a spiraling credit contraction, falling prices, and bankruptcies or overshooting with “quantitive easing” into inflation, well, as Ben Bernanke famously put it

[T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

FD: My investment portfolio includes inflation hedges such as precious metals and short positions on long bonds. My portfolio return over the past several weeks has been large and negative, and if you take anything here as investment advice please expect a similar outcome.


50 Responses to “Why inflation?”

  1. BSG writes:

    A fine analysis, as usual. A few points, for your consideration:

    The “secondary consequences” you mention may turn out to be quite significant considering that many debtors have a variable interest rate and/or short term loans. I wouldn’t be surprised if a spike in interest rates that could result from reflation has an even greater adverse effect on debtors than mild and slow deflation.

    An analysis of this would be complicated at least by the extraordinary willingness of our mercantilist creditors to supply us with cheap cash (which Brad Setser has so admirably been tracking) as well as the different constituencies carrying various types of debt, with the big elephant in the room being the US govt.

    The Fed’s clumsiness and/or recklessness (IMHO) is also a factor. If they drop a recent and probably tentative reluctance to reflate, I think the likelihood is greater that they would overshoot and cause hyperinflation, which will have well known disastrous consequences.

    All of this is also complicated by what I think can be fairly described as phony statistics (sorry for the apparent hyperbole – I do think that is a correct description.) I am aware of the academic arguments for things like hedonics and substitution, but given the arbitrary nature of the adjustments and the fact that they are always one-way, I don’t find those credible. I don’t mean to digress, it’s just that if the Fed acts as if inflation is much lower than it really is, the risk of hyperinflation is even higher. (As an aside, the “adjustments” made to unemployment and GDP figures may have the opposite effect, but probably to a lesser extent.)

    I realize that you’re presenting what you see as likely rather than what you advocate (at least that’s what it seems like to me :-), so I wonder if you can also address what you think it would take to achieve, and the effect of, stable prices. Are inflation and deflation really the only realistic options?

    With such a big mess and with varying effects and consequences of a policy tilt one way or another, aiming for price stability may be the safest. Given the post- Volcker Fed’s performance, I think that if they act as though they are tolerating deflation (by their apparently poor measures), we may end up with mild inflation.

  2. RueTheDay writes:

    The Fed is walking a tightrope here. IMO, they actually want a slightly higher inflation rate right now for two reasons:

    1. It looks like the commodities bubble may be bursting. If oil were to start a precipitous slide to $60-$70/bbl, the CPI would follow, and given the seemingly never-ending bad news from the financial sector, deflation would suddenly become a real as opposed to hypothetical threat. A little extra inflation gives them some cushion. Then again, Russia could throw a wrench into the gears, sending oil (and inflation) to new highs.

    2. The Fed recognizes the need to recapitalize the banks as quickly as possible, while also recognizing that it can’t keep the alphabet soup facilities open forever. A steep yield curve is the quickest way to drive bank profits. Keeping short rates in the 2% range with 5% inflation will drive long term rates up and bump up the slope of the curve. Then again, too much inflation will drive long rates too high forcing the Fed to raise short rates, thwarting their objective.

    A difficult situation indeed.

  3. JKH writes:

    Random observations:

    Monetary policy is asymmetric with respect to the potential problems of inflation and deflation. This is evident in the fact that explicit or implicit inflation targets are always greater than 0. This implies that monetary authorities view the problem of deflation to be more difficult to reverse and potentially more damaging than the problem of deflation. Their preferred outcome is very moderate and “controlled” inflation.

    Monetary policy is also asymmetric in emphasizing policy response to CPI inflation over asset inflation (i.e. asset bubbles). Nevertheless, it still emphasizes policy response to the risk of asset deflation over the risk of asset inflation (This is happening right now with housing).

    The US net international investment position is quite small (about $ 2 trillion net liability) relative to US household net worth (about $ 56 trillion, including the effect of netting out the $ 2 trillion international liability). This suggests that asset inflation/deflation effects are more important for the US domestic balance sheet.

    Thus, US voters are large net owners nationally (and “globally”) at the level of “outside assets” and “outside equity”, to the tune of $ 56 trillion. Some of this net household wealth is reflected in intermediated debt claims owned by households (e.g. pensions; directly held debt securities), in addition to equity claims and direct real assets. This mixture makes measuring the effect of inflation or deflation on debt as well as other categories difficult to pin down at the macro level. Nevertheless, much of the total gross debt outstanding amounts to pure financial intermediation (e.g. mortgages; bank deposits). The effect of inflation or deflation on this portion is an issue of intra-national and, to a lesser extent, international distribution of wealth and risk. It presents a potentially lethal risk when combined with the parallel aspect of income distribution.

  4. I read Mish regularly and usually agree with him. However, I cannot make an intellectually respectable case for deflation. It ain’t gonna happen.

  5. Fullcarry writes:

    I find Americans conviction of impeding deflation rather amusing. I am quite certain there are no other people in world like that.

  6. groucho writes:

    Steve, while Bernanke claims to have the “keys to the printing press”, in reality it’s the Congress(and currently foreign CB’s) that decides how large the deficit will grow and the FED’s ability to monetize said debt.

    Trees don’t grow to the sky, so we know there is a printing cap which is greatly reduced vs the Japanese experience since the US has no savings and or trade surplus.

    Any attempt to monetize beyond those constraints will lead to an Argentinian outcome which the FED(if not Treasury) is well aware of.

    The ability to continue the inflation game by the FED is clearly out of their control. Foreign CB’s and global trade trends will determine if we end up in a deflationary or hyper-inflationary outcome.

  7. RueTheDay writes:

    There are two very real constraints to the “printing press” mechanism. Domestically, at some point people begin indexing stuff to the inflation rate – treasury bond coupons, industrial contracts, wages, tax brackets, etc. Internationally, creditors begin demanding new debts be denominated in something other than dollars. Once this happens, the printing press ceases to have the desired effect.

  8. bklynrntr writes:

    If we could always inflate our way out of a mess, I wonder why, over thousands of years of human history, we only managed to work this out in the 20th century? it doesn’t seem like its intellectually difficult to work out, print more money and hope the economy absorbs it, yet it seems that its only in the last 70 or so years that we actually tried it.

    I think the reality is that politicians/kings/emperors etc have always tried to print more money when the going gets tough because that’s the easy way out. Its just that,most of the time, it doesn’t work because the economy doesn’t always absorb the extra volume of cash floating around and deflationary forces win out eventually.

    Ithink that we were lucky in the 1970’s to get away with inflating our way out of a debt mess, but we may not be so lucky this time because 1) we now depend on anti-inflation forces to accept what they’ve never accepted before (China and Asia generally hate inflation), 2) in the 1970’s the labor pool was essentially a closed one because it was the US and europe essentially, today its global, so downward pressure on prices/wages is stronger today than in the past. In other words, inflationary forces today are weaker than they were the last time.

    On the other side of the equation, deflationary forces re massive today. As with any tun in the credit cycle,when debt levels start to fall, the deflationary pressure is enormous. Debt levels today are massive compared to 30/40 years ago as a percentage of anything you care to mention. 2 this debt is held by foreigners to a greater extent today than before so if they only stop buyingthe paper, the upward pressure on interest rates is massive. Forty years ago,the creditor was ourselves, that is a huge difference. I think the balance of risk is towards deflation

  9. Inflation benefits debtors and there are more debtors than lenders, but policy is made by the wealthy.

    I’ve maintained for a long time that the Fed under Greenspan had policies which benefited the rentier class. I don’t think this is as explicit at the moment, but the Fed is still run for the benefit of the banking sector, not the general public.

    The fact that there is persistent inflation, and has been since the onset of the industrial revolution, shows that there are other forces at work as well.

    I claim the basic cause is the need for capitalist firms to “grow”. Capital must be paid back with interest and one way to ease the burden is by raising prices. The capitalists like to call it “wage-price” inflation, but it is really “price-wage” inflation.

    Producers raise prices so they can show increased revenue, even if it is in deflated currency. After all contracts don’t usually have currency deflators built in. Higher prices cause labor to demand wage increases, but this lags behind both in time and the amount that can be obtained.

    The Fed mandate to control inflation while boosting employment is contradictory and the labor goal was added as political pablum. The Fed never worries about employment.

    The US currency has been weakening for decades and the public has been trying to compensate for their decline in buying power by borrowing. The picture is clouded because the right likes to quote the drop in the cost of manufactured goods, but this is a small part of the average family’s expenses. Cost increases for home, health, education and transport have all outpaced the stated inflation rate for a long time.

    Now the day of reckoning has arrived and no one knows how to keep the Ponzi scheme afloat.

  10. zanon writes:

    RueTheDay: Those contracts with COLA clauses are usually indexed to CPI, and CPI understates the loss of buying power caused by inflation. CPI may lesson the pain, but it won’t fix it.

    People also talk about the “wage-price” spiral, which the US experienced in the 70s, as being an harbinger of high inflation. “Wages don’t seem to be rising so inflation is under control”. This is baloney — wages reflect worker’s ability to bargain, and price inflation conflates monetary dilution (or concentration) PLUS price changes due to other factors.

    Whatever inflation or deflation the US is experiencing how is driven by the Fed printing money and giving it to banks through its various new facilities, and the destruction of money supply as those same banks write off bad debt. Who will win?

    Let me put it another way. If the Fed really wanted to stop home prices falling in the US, it could just print a $5M check and mail it to every man, woman, and child in the US. End of problem. BUT, the dollar would certainly lose its status as the world’s reserve currency, China would not be happy to take a 95% haircut on its FX holdings.


  11. VoiceFromTheWilderness writes:

    Look, American political debate is completely off kilter because the real drivers of american politics are never discussed openly and honestly.

    If your thesis is XYZ will never happen because it’s not in the best interest of the American citizen, then the last 30 years would never have happened.

    Remember the great Ownership Society of those halcyon days of 2005? As anyone whose been paying attention knows, but has only today has found light of day in the New York Times, the reality is that american citizens own less not only of their homes but indeed of their whole country than at any time since WWII, and critically for my argument, this has been going on for some time.

    The idea that American politics is controlled by what’s in the best interest of the american people is made laughable by any number of recent event. 80% want out of Iraq. How’s that going? 70% want investigations into administrative malfeasance. So that’s going to happen… when? You think the Fanny/Freddie bailout or the Hope Now bill are for the benefit of American citizens? Please, spare me.

    It matters not one whit what is in the benefit of American citizens, and the rise of the Republican Party, their immunity from any check on their flagrant not just law breaking, but indeed treason, has been proof since the 80’s that the American public thinks this is a great setup. Boy howdy, yes sir, I think it’s great that this country is run for the benefit of CEO’s of Multinational corporations. Where do I sign?

    The ONLY interest that matters in assessing the future direction of american policy is the interest of large corporations, and wealthy individuals, and also those who foolishly think they are and vote in the direction that they think large corporations and wealthy individuals want them too.

    Whether it is in the interest of large debt holder in the US to inflate, in order to reduce payments to the chinese and the saudi’s and the russians, or to deflate in order to maximize the value of the loans they have out, is not something I can really say. But please, at least make your argument in terms of actual realities. Otherwise I have some real estate I’d love to sell you.

  12. zanon writes:

    VoiceFromTheWilderness: I don’t think American has been run particularly well for the past 30 years either (or for the past 150 years, to be honest) but I don’t think it’s at all accurate to say that it’s run “in the interest of large corporations, and wealthy individuals” and leave it at that.

    To be perfectly honest, I think the US would have been run better had this been true, but the truth of the matter is that the US is run by the various Agencies, and those Agencies are frequently at odds with each other. Also, public opinion *matters* — no one wants to look bad on the pages of the NYTimes — but financial regulations like TAF, TSLF, PDCF, etc. are way beyond the understanding of most people and reporters, so I don’t see them entering the popular consciousness one way or the other.

    I think the Fed and the Treasury are the two main players here on the US front, and as others have noted, the Fed are bankers and will do what makes most sense from the perspective of the Banks.

    I have no idea what goes through the Treasury’s mind.


  13. FG writes:

    A couple of notes on the inflation/deflation debate:

    – the Feds definition of inflation is increasing prices. Michael Shedlock’s definition of deflation is “Deflation is [..] a net decrease in money supply and credit.”. These 2 conditions can happen at the same time. In addition, you can force inflation to be positive, but you can’t force credit to inflate.

    – One more definition of inflation would be the aggregate end demand growth. You can force prices to increase, but you can’t force salary up. Hence increasing prices would destroy demand, resulting in deflation. This seems to be what is happening now.

    – Many who consider that inflation can always be forced by a “determined government” are missing half the current equation: The US is financed by foreign CB who already have massive dollar reserves. This being the case, printing too much money is a foreign policy issue. It could lead foreign countries to turn off the tap. This would force interests up, and therefore force credit to deflate.

    Bottom line, the direction of prices is uncertain, but what really matters is what happens to credit, and right now it is slowing and about to deflate. In fact it needs to deflate, that’s what deleveraging is.

  14. Murph writes:

    Love your full-disclosure statement. Wish everyone was so honest ! Thoughtful article, as always – thank you.

  15. 2222 writes:

    Can average individual citizens who vote in established democracies understand that inflation would be in their favor as debtors? I thought you leaned toward the behaviorist crowd rather than the rational expectations crowd.

    When prices start going up and wages do not, do you not think that the American people are going to want to stomp inflation? Are they really going to reason that inflation is their friend? I think not. The government may WANT to blow China’s currency peg through dollar devaluation, but our people at some point will want the government to extinguish price inflation.

    The Fed might intentionally start the inflationary fire or fail to extinguish it, but the citizenry will want it put out! I believe we will see a version of the late ’70s inflation with a stomp-out-the-fire response of the early ’80s, whether it is in our best interest or not as a debtor nation. There is a fallacy at the root of your argument IMO. That fallacy is that the powers that be at the Federal Reserve, et al, can CHOOSE how to solve this problem.

    I think we will have deflation BECAUSE our democracies will see inflation as something that has to be solved rather than as a solution to their aggregate indebtedness.

  16. Benign Brodwicz writes:

    To paraphrase (and correct) Milton Friedman: “Inflation is always and everywhere a labor market phenomenon accommodated by monetary policy.”

    In a fractional reserve monetary system, the Fed does not have a printing press, it has a monetary base and the ability to let reserve positions and credit discipline go entirely to pot. “You can’t push on a string”–people don’t want to borrow, you can’t increase total credit (credit = money).

    In the 28 years since Reagan, Volcker and the first neocons broke the back of the 1970s inflation, the labor market has been beaten to a pulp. Those at the top have expropriated those lower down and income inequality has blossomed. With confidence currently at generational lows, there is no way a wage-price spiral is going to get going now. Wall Street dick-heads are leaving finance en masse for lower paying occupations, and the pattern of “skidding” (to lower pay) is endemic, anecdotally, in the labor market. Been there myself.

    With American national debt-to-income ratios at saeculum highs, there is no desire or ability to take on more debt–moreover, the regulators and bankers in their wisdom are raising credit standards!

    On the wrestling mat of employee-employer wage negotiations, a sumo wrestler is facing a bantam weight. Businesses are feeling their margins pinched on the non-labor supply side and will resist wage increases intensely. Labor will be crushed.

    With continued deflation of their most precious assets, their houses and their 401(k)s, American workers will increase their willingness to work, driving down wages.

    Ben thinks he can “adjust the dials,” “turn on the printing presses” and save the day, but he can’t, short of giving the money away… and that would quickly produce hyperinflation… which would only delay by a short interval our economy deflating as our creditors crushed our economy by shutting off the spigot of new lending and sending our interest rates through the roof.

    The political power is with the corporations. Here’s my forecast (blogging is fun!): American labor will get paid less, much less; the dollar will fall but inflation will not accelerate; deflation will occur domestically that with the falling dollar internationally will make American assets and production attractive to foreign investors. We’ll become the “investment capital of the world” again, as Ronnie liked to say in the 1980s (if we’re lucky).

    The debt-financed consumption binge is over, and we’re on to the hangover.

    “Ding dong, inflation’s dead!

    Which inflation!

    The one from thirty years ago!

    Ding dong, the labor market’s dead!”

  17. Mises writes:

    The inflation/deflation debate is one of the most confused IMO. This occurs mostly because relative deflation and inflation are often neglected concepts. It is also important to note that the focus on prices is a mistake. For example inflation can occur even if there are no price increases, assuming prices were meant to have fallen, like in the case where inflation is perpetuated due to the flawed argument that money printing must accompany any real growth.

    In the case of the US today, there is no doubt the environment has been inflationary. Aside from the fact that the CPI has been persistently positive for many decades as have the monetary aggregates year over year, in recent times we’ve seen some of the strongest credit expansion which created the highly levered economy we’re dealing with to date. The situation might be different if contractions were allowed to occur but they are not. For example, had major firms been allowed to collapse there would’ve been an undoubted contraction in credit but still would not necessarily represent absolute deflation. This type of contraction is more of a stabilization through means of relative deflation than real deflation which would require the confiscation of funds from the system. They key is to realize that an unwinding of past unsound credit expansion is not tantamount to real deflation. To protect this contraction from occurring requires even more inflation than was initiated in the prior.

    As it currently stands, this type of contraction has not been allowed to occur. The fed has basically debased their entire balance sheet, and whether or not monetary aggregates have grown recently is not telling since they hide this key information. Hidden liabilities like a guarantee of all investment banks and or a debasement of the current assets ensures greater inflation risks and a weaker currency, ceteris paribus, on top of the already inflationary system. These measures also effect the fed’s creditability and can lead to further problems with monetary demand. In general, private demand for US currency and debt is dwindling and domestic demand has at best stayed flat for both but the slack has been picked up largely by foreign governmental institutions. The quality of this pick up can signify whether or not this can be expected to be sustained and since these aren’t US allies (as noted by roubini) and are working against their citizens the outlook aint great. This issue is crucial to domestic price inflation risks since more than half the US currency and debt rests abroad and is causing double digit inflation where it currently resides and the debt yields are the poorest around.

    In any case, this signals inflation has been largely exported and partially mitigated from foreign institutions rather than not present in high magnitude. Foreigners can absorb the US’s problems but not make them disappear. The question then becomes when will real pressures take their toll on these countries and prompt the US to get cut off or cut down.

    Lastly, regarding Bernanke’s comment, stimulating demand by inflating the money supply either just adjusts nominal prices or forces a depletion of scarce resources that were intended for future purposes. Why he thinks he needs to force the position on people is beyond me.

  18. anon writes:

    “the flawed argument that money printing must accompany any real growth”

    I’d be genuinely interested in understanding how a fixed stock of money used for economic transactions can continue to support real growth over time. Doesn’t seem to make common sense. By what logic do Austrians argue this?

  19. Fullcarry writes:

    Like anon I too have never understood how there could ever be any lending with a fixed stock of money. Why wouldn’t everybody just hoard money?

  20. Mises writes:

    when there is real growth something needs to give and either the money becomes more powerful or the supply grows and the power remains constant. In the first case, money becomes more powerful reflecting the real wealth of society increasing. In the second case all that is adjusted is nominal factors. Changes in the money supply can only have negative real effects or be benign. In deflation the money supply grows internally by becoming more powerful so there is no need for the external growth i.e. increasing nominal supply.

    To suggest everyone would hoard money when money becomes more powerful is unfounded. People have two choices for spending, either investment/loans or consumption as a trade off. No one hoards money indefinitely because that is pointless so i dont think that should be feared too much. Even if they do they are doing society a favor becomes they are increasing everyone else’s purchasing power. If i burn the money in my pocket, everyone is richer because ive forgone my claim to assets and now there are more assets availalbe relative to everyone elses money which increases their purchasing power.

    Aside, the key solution to why investment is still profitable is because the returns are in the same strong money that is invested. If i invest $100 and there is 5% deflation and my return on funds is 1% i have not lost out compared to hoarding as many deflation-phobes suggest. My total real return is actually 6%. The borrower only had to return some positive value on the funds for it to be profitable. Any investment that makes better use of the money will still be engaged. Its not as though you must beat the deflationary rate because your returns are in the appreciable money.

    We’ve also had long stretches of history with flat or declining prices with 10% plus growth being sustained. Check out periods in the 19th century.

  21. Fullcarry writes:


    I am making a purely arithmetic argument. How could there be a positive interest rate on money if the stock remains unchanged.

  22. Mises writes:

    put it this way. if you increase money stock, how do you turn a rate positive besides nominally?

    money is unique in that it does not act like a good. more of it only dilutes wats already there but does not add anything.

  23. anon writes:

    Mises –

    Quite a good description, thanks, but I have some concerns.

    If money becomes “more powerful”, there is price deflation by definition, and the real value of money balances increases over time. The big operational problem is that a world with systematic deflation must include negative nominal interest rates. Borrowers would not be able to pay substantially positive nominal rates on loans, since they are already paying the cost of money appreciation via deflation. Similarly, banks would not be able to pay positive nominal interest rates on deposits. Deposit rates definitely would be pushed below the 0 bound in order for banks to make a spread. Japanese banks faced such a problem. Moreover, a central bank issuing currency would also have to charge interest to holders of that currency in order to avoid deflationary hoarding of that currency. A deflationary world is a world of implicitly tight monetary policy, just as is the case when a country runs an expensive exchange rate for its currency. It causes consumers to hoard as much as possible, because the cost of consumer goods gets cheaper and cheaper in money terms. The same holds if the deflation applies to the cost of capital goods. This is what causes a deflationary depression in the worst case. A necessary condition to avoid it is to reverse the normal flow of interest and charge rather than pay depositors and lenders a rate of interest – a rather torturous and inherently unstable state of affair for money.

    So I’m not sure why any reasonable monetary authority would be persuaded to target a fixed money supply over the long term.

  24. Mises writes:

    I understand your position but believe the problem is still that you see money appreciation as a cost to the borrower. If you loan me $100 i dont own your $100 and get to benefit from the end result of its purchasing power and rightfully so. If you charge 1% for you loan then i will owe you back $101. If the $101 buys you 50% more than it did in the past, how is that an expense to me as a borrower as you’re implying? If i rent a house from you and you earn money on the house am i expensed the amount of your capital gain? Why is the rent on money any different?

    I hope this will dispell a few of your other points about interest rates or the rent on money still being able to be positive. Also if you want to deal empirically you need to look no further then technology whose real growth outpaces inflation all the time creating effective deflation.

    What messed up japan is more than a monetary phenomenon btw. its a convoluted case that is an issue in itself.

    a deflationary world from growth is more likely the result of sound monetary policy rather than “tight policy” as you put. We must make distinctions here because confiscatory deflation is different from deflation as a result of growth. By confiscatory i mean CB rates are above market rates and or measures are taken to destroy money in peoples banks from the whole system etc. Deflation as a result of growth is never a problem in itself.

    The reason the cost of capital goods volatility is tied to business cycles and why this sector deflates the hardest on these downturns is because of a capital misallocation due to artifically low interest rates. The liquidation is actually a healthy stage. The process starts when the interest rate is artificially pressed below market rates and this causes the production structure to misalign with the consumption and investment preferences relative to the given supply and demand for loanable funds. The point is that interest rates keep investment, consumption and the expected yields and therefor structure of the production structure in line. If this rate is changed without the public adjusting there preferences etc. disequilibrum is the result accross several serious factors. This is an argument for sound money if you want to prevent these processes but you should not deny the liquidation of misallocated capital even if the truth is tough to admit.


  25. anon writes:

    I’m vaguely familiar with the “good deflation” of the 19th century and more so with the good deflation of technology costs.

    I do believe that deflation or money appreciation is a cost to the borrower. If the borrower is investing in a project, he must produce dollars of higher value at the end of it than when he borrowed the money. This is just as much of a cost as is interest under conditions of 0 % deflation/inflation. I see it no differently than the case of the effective economic equivalence of either a rate of interest or a hedged foreign exchange differential in a fully hedged foreign exchange investment (the FX differential being isomorphic to inflation or deflation in the value of money). Whether the return or cost is in the form of interest or an FX differential, it is the same economic effect on the result.

    Good deflation does exist – e.g. technology. But that’s embedded within a more general inflationary process; i.e. it’s good to the degree that it tempers some overall experience of inflation, which would be worse without it. But consider the case of a truly generalized deflation.

    First, consider the more normal case of a generalized inflation. If you assume a closed economy for simplicity, a generalized inflation would work across all expenditures on GDP and by definition would have to be balanced by inflation across factor costs (otherwise GDP output wouldn’t equal national income). This is why evidence of wage inflation is so important to the identification of true inflation (and one reason why the Fed is still holding off on tightening).

    So a truly generalized deflation would include reductions in wages, net of real productivity growth. It’s the productivity growth that produces “good deflation”. In any event, I have to pay back the loan in dollars that are worth more. I may be able to afford it if my productivity has improved, but that’s still a cost – it’s eaten up the real value of my productivity. And if my productivity hasn’t improved, my nominal wages will be lower due to the general deflation, and I will have fewer dollars with which to pay you back – a more obvious cost – but both are costs.

  26. Mises writes:

    whenever you borrow money you have to make better use of the money if you want to cover the rental cost. That is a fact of borrowing money, think about renting a house or anything. why are you burdended as a renter by the end value of the house? rental costs are inevitable though, why should someone loan you something for free. just to see the point think about a zero interest loan with 10% deflation. If i loan you $100 and you do nothing with that hundred and pay it back, there was no expense to you due to the deflation. there are borrowing costs however in general but that is always the case. my point is the borrowing costs are not greater as a result of deflation and the lender still has incentive to lend for rent.

    if the demand for money becomes greater and people increase their cash balances spending will fall as will nominal wages but real wages remain the same. you may have less but they arent worth less. in any case people should be allowed to exercise this prefernce of cash building or what not.

    seeing rises in nominal wages is not the only sign of inflation. the fed is wrong to view this this way. unemployment can be the factor that gives as increases in spending are reflected in prices but not wage rates as real economic strains are felt and rising nominal income is entirely absorbed into resources rather passed onto labor costs as in the case of stagflation and a resource shock or past misuse due to business cycle waste or oversubsidization, etc. this is a seperate issue though and has other complicating factor so not entirely relevant or necessary to get into.

  27. anon writes:

    Suppose you buy a house for $ 300,000 with no money down (yes!). You mortgage the full amount at 4.14 %. Assume your mortgage allows you to compound the interest and not make any cash payments until year 10, when you pay off the entire amount. Your final cash payment will be $ 450,000.

    Suppose also that your house has shown no appreciation in value. Then the total cost of your house, paid 10 years after purchase, is $ 450,000. However, you’re showing the house on your household balance sheet at a value of $ 300,000. The change in your household wealth after 10 years, compared to what it would have been by leaving the money in the bank, is a net loss/cost of $ 150,000.

    Now suppose in a deflationary environment the interest rate is 0 per cent. Your final cash payment will be $ 300,000. Suppose your house has declined in value to $ 150,000. The change in your household wealth after 10 years, compared to what it would have been by leaving the money in the bank, is a net loss/cost of $ 150,000.

    The cost of paying back higher value dollars without interest in a deflationary environment is the same as the cost of paying equal value dollars with interest in a stable in a stable price environment.

  28. anon writes:


    “my point is the borrowing costs are not greater as a result of deflation”

    It is quite normal to interpret lending or borrowing costs according to their inflation adjusted equivalents. The typical adjustment is to subtract the rate of inflation from the rate of interest. If the interest rate is 4 per cent and the inflation rate is 4 per cent, then the inflation adjusted cost of borrowing is 0 per cent.

    The math doesn’t stop at 0 per cent inflation. If the rate of inflation is negative, then the adjustment is to subtract a negative rate – i.e. to add the equivalent positive rate of deflation. If the interest rate is 0 per cent and the deflation rate is 4 per cent, then the deflation adjusted cost of borrowing is 4 per cent.

    Deflation like inflation affects the economics and the effective cost (i.e. inflation/deflation adjusted) of borrowing and lending.

  29. IG writes:

    Is it right that ‘inflation favours debtors over creditors’?

    Surely it is negative real interest rates that benefits debtors over creditors rather than inflation per se. If inflation rises and interest rates rise by the same amount, there is risk for debtors. A debtor runs the risk of losing their investment if they cannot support the increased borrowing costs.

    So the debtor that can cover increased borrowing costs is favoured by inflation as the principal is devalued but not the debtor that cannot support increased borrowing costs.

    The benefit for debtors over creditors is when the central bank does not increase interest rates to reflect inflation, creating a negative interest rate situation.

    It is the central banks negative real interest rate approach that really favours debtors over creditors, rather than inflation itself.

  30. anon writes:


    A positive inflation rate or an increase in the inflation rate always favours debtors over creditors, other things equal. It reduces the inflation adjusted (real) cost for debtors and the inflation adjusted (real) return for creditors, relative to 0 inflation or a lower inflation rate. A reduced cost is obviously preferred to a reduced return.

    If other things are not equal and if interest rates rise along with inflation, there is no change in the resulting relative position of debtors compared to creditors.

    The ability of the debtor to service his debt has no bearing on the inflation-adjusted advantage of debt compared to credit. The debt advantage is independent of the debtor’s asset position and income available to service the debt.

    Negative real interest rates are an arbitrary threshold for gauging the extent of the benefit to debtors. Any positive rate of inflation will result in an advantage – just less of an advantage if real rates remain positive rather than negative.

  31. anon writes:

    In other words, the inflection point for the relative benefit of debt over credit is not negative real interest rates but rather inflation versus deflation.

  32. Mises writes:


    was not around yesterday, was not avoiding responding. Anyways let me get to addressing your points.

    To start, your example outlines how goods prices decline over time in deflation. Your claim is if you borrow to buy a good now and its worth less in the future you’ve lost out and this is somehow problematic to the overall economy. This really just explains that the opportunity cost of buying now versus buying in the future is greater during deflation. The same case, as mentioned before, can be made for those who borrow to buy computers or tvs today. I personally dont see this as an issue and id be interested in you highlighting more about why this is so detrimental to economic health.

    To explain my side further, there are two main cases that bring this about that id like to address. Note that all cases still outline the fact that assets lose value not loans as we’ll see. Firstly, lets say people start to build cash but are not reinvesting or reloaning the cash because of real uncertainty and problems in the loans markets. Interest rates will rise, borrowing will become more expensive, and asset prices will decline as a result of the lack of spending and falls in income as well. This must be viewed as a necessary market adjustment as the loans market needs to be repaired with high interest rates, and asset prices need to decline to make spending worthwhile again. People dont build cash like this for no reason. They do so because they dont see better opportunities to spend and the economy must make the necessary repairs to revive sound opportunities in the eyes of cash holders. Right now the housing market in the states must adjust as an example. Housing prices falling may seem bad but this is a necessary adjustment to get back on sound foundations. Those who borrow at the top made poor decisions of where to spend the funds they borrow. They incorrectly predicted the supply and demand of where they chose to find equity and will feel the loss as result, and is it should be so. This is clear in the next case as well.

    The second case, and what started this discussion, involves growth. If the productivity or the volume of goods improves the marginal value per good declines. If someone borrows to buy assets when the supply of assets is smaller than now the value of their assets will be diluted all else equal. However, this is again just the reflection of increasing general societal wealth and is not problematic. The average consumer benefits as do all cash holders and the opportunities for future cash holders. More importantly a borrower is not expensed by this as result of borrowing but rather it is where and why he chose to spend the money that brought about the asset loss, not the fact he borrowed (the same thing happnens to those who purchase assets without borrowing). If he was borrowing to find positive equity, he must be able to predict some future supply and demand dynamic the market is unaware of. Not all borrowers can be expected to find positive equity in the assets they buy. In the case of increasing goods, he has failed at his task and is stuck consuming the item, like all those who purchase computers but must resell them for cheaper if they chose to. This is just like computer dealers must do more than consumers if they plan on making money on their assets. What most importantly needs to be realized is monetary adjustments dont change the fact that the marginal value per good is less when we have growth. No amount of inflation will stop this from being so when the supply of goods increases.

    Further, to say we should stop the supply of goods increasing is also ludicrous. Again, consumer prices declining helps the average consumer and the overall economy. If goods are falling from the sky to reject them because of the argument asset holders will lose relative equity is ridiculous. Those who borrow to buy consumer goods for equity lose out, sure, but so what. Why should they be benefiting from such action unless they aid the market in correctly predicting a future supply demand dynamic.

    Lastly, when you say that lenders and borrowers must factor the deflationary effects into terms is not a necessity. Sure for whatever preferences they have they may do this and the deflationary benefits can be split however they choose if they choose to do so. However, the lender has no need to account for deflationary effects, but is obviously concerned with protecting against inflationary effects. On the other hand, like ive said before the borrow is not expensed from the perspective of the loan as a result of deflation, only what he chooses to use the money for may result in a loss. It is ridiculous to say, as i mentioned before, that if a lender is loaning $100 and we have 5% deflation that as he takes the loan, regardless of the interest rate, that he is instantly charged 5% for the loan as result of deflation. Deflation has not added 5% to the price of the loan.

  33. Mises writes:

    one more thing that should be mentioned is that even when you sell your asset for less in deflation the money you receive is worth more than the apparent nominal decline. For example, i may buy a computer today and its worth half as much when i sell it in a year, but computer prices may have halved or close to, aside from used versus new factors, and i can rebuy at the new lower prices. Similarly if all goods are decreasing when i sell my asset i can purchase more goods than may be apparent from the nominal loss my asset suffered.

  34. anon writes:


    Surely you believe that inflation and deflation have some effect on the level of nominal interest rates, and lenders and borrowers take inflation into account in agreeing to an interest rate. Why else would we consider real rates of return? Why else did mortgagors agree to pay 13 per cent rates in the days of high inflation? It’s no different in the case of deflation. Inflation or deflation affects the market clearing price for interest rates. Banks work on the spread, so that that extent they’re only indirectly interested. But you must believe that the fact a borrower must repay in more valuable dollars would have an effect on his demand for borrowing. So I’m not sure what we’re debating on that point.

    This discussion started by my question about how a fixed money supply could accommodate growth. I’m not sure, but I think your answer is that this is consistent with persistent deflation and there’s nothing wrong with persistent deflation.

    I would agree that there’s nothing wrong in an economy where the rate of inflation (or deflation) is constantly 10 per cent and every wage and price in the economy is indexed to that rate. That’s a stable, predictable system.

    The problem is instability in the rate of inflation or deflation. The higher the rate in either case, the more it affects expectations, and the greater the risk of spiralling instability. And not everything is indexed to the rate in the real world. The higher the rate in either case, the more risk there is to a world in which the costs and benefits of either are unevenly distributed. For example, those who take out longer term fixed rate mortgages will be at a relative disadvantage in a world that subsequently lurches toward persistent deflation. It is very likely that their employment/wages will decline as employers seek to cut all types of cost in the face of declining/deflating revenues in such as world.

    There’s nothing wrong with growth. If the rest of the economy can replicate the productivity of computers, that’s fine. That’s a world of persistent deflation in prices but not in incomes. That’s because growth is offsetting deflation. But that’s a uniquely specified world. Monetary policy can’t wish for that kind of world and set the money supply accordingly. They’re more likely to get the unstable, spiralling type of deflation without offsetting productivity and where the distribution of costs and benefits will be quite chaotic and net destructive.

  35. Mises writes:

    Anon, it doesnt matter whether or not the deflation is expected. The problem only arises like a said in confsicatory deflation. The reason why you’re mistaking the argument is you are looking for the converse to inflation. Inflation, as an unexpected increase in the money supply effects loans negatively. Deflation as an unexpected decrease in the money supply does effect loans negatively as well and this is what you are describing. The difference comes from things like growth deflation which do represent the same characteristics.

    (have to do a quick response cuz on the way out but if this doesnt answer you concern, please highlight your concern in this context and ill get back to it.)

  36. Mises writes:

    meant to say “do not” represent the same characteristics.

  37. anon writes:


    You’re right. I am looking for the converse of inflation.

    You said:

    “By confiscatory I mean CB rates are above market rates and or measures are taken to destroy money in people’s banks from the whole system etc.”

    It would be helpful if you were to elaborate on your idea of confiscatory deflation and the difference versus growth deflation.

  38. Mises writes:


    back earlier than i thought. By CB rates above market rates i mean the fed is purposefully destroying money to drive the market rate of interest above equilibrium levels, the rate at which the supply for loanable funds equals the demand for loanable funds. To avoid restating an argument already well explained ill refer you to Salerno’s piece on defaltion:(read pages 14-20) http://mises.org/journals/scholar/salerno.pdf

    im not trying to divert from the debate i just think youll benefit from a more thorough outline.

  39. anon writes:


    Thanks for pointing to the Salerno piece. It is interesting, and well written, with some interesting history. My initial reaction:

    This is a piece on deflation exclusively, without a comparison with Austrian inflation taxonomy. As a result, it loses perspective.

    Growth deflation, hoarding deflation, and credit deflation are all fairly straightforward.

    But I find the confiscatory paradigm to be more an explanation of one very involved “example”, that being Argentina. It is impossible to distinguish between whatever the purported theory is, and a recounting of a particular episode of heavy handed government intervention. Also, the example depends totally on the country’s foreign exchange risk.

    The entire essay depends on the thinking underlying the core Austrian value of “central bank-phobia”. It seems to be more a validation of that thinking as much as proof of the broad brush benefits of deflation. My suspicion is that the underlying theme of the paper concerns central bank intervention more than the particular case of either deflation or inflation.

    It seems that Austrian theory rejects not only central banks, but the creation of any credit whatsoever by commercial banks, given that the creation of such credit automatically implies fractional reserve banking at the margin, an idea that Austrians loathe and reject. Obviously, the issues I’ve raised about the effect of deflation or inflation on credit are redundant, if the overarching theoretical opposition rests on the rejection of the idea of credit itself. I’ve never understood how this implied rejection of credit by Austrians squares with any reality.


    “This is precisely what occurs when the Fed creates new fiat money for whatever reason: the first recipients of this newly-created money, whether they be the government and its subsidized constituencies or banks lending newly-created dollars at interest and their client firms borrowing at artificially low interest rates, are able to acquire titles to real property without the necessity of having first produced and exchanged property on the market. The result is a concealed and arbitrary redistribution of real income and wealth in favour of those who receive and spend the new money before prices have risen at the expense of firms and labourers whose selling prices and wage rates rise only after a lapse of time during which most of the prices of the things they purchase have already risen. Even if the Fed were to create just enough additional money to offset a growth deflation and maintain consumer prices roughly unchanged, it would still be distorting the market’s distribution of property in favour of those who were immediate recipients of the monetary injection and were able to take advantage of the falling prices.”

    And this is interesting:

    “A Goldilocks Fed continually varying the money supply to maintain the purchasing power of money forever constant—even if it could be trusted to do so—is just as non-optimal as computer firms supplying only the number of PC’s that pegs their price at, let us say, the 1980 level.”

    The argument is that all prices – including money – should be allowed to vary. But the argument that the price of money should be allowed to vary (including deflation) is not quite the same as an argument in favour of necessarily fixing the money supply (which was my original question). In fact, the author admits that the money supply did in fact grow over the period of the 19th century “good deflation”. But how can it grow without somehow accommodating credit and some element of “fractional reserve banking”?

    So I wouldn’t change what I wrote earlier, but note that I haven’t debated anything related to the core Austrian mission of the abolition of central banking and fractional reserve commercial banking.

    That said, it is very interesting paper and worth re-reading (several times) and thinking about. Thx again.

  40. Mises writes:

    Heres a more complete way of making the argument.

    Like i said before, negative inflation is the unexpected rise in the money supply. The opposite of this is an unexpected contraction in the money supply. Both of these cases will distort contracts, economic and monetary calculations.

    On the other hand, the opposite of growth deflation is not a monetary phenomenon like that of the inflation discussed above. The opposite is resource shocks or real economic contraction while the money supply stays constant. To say money printing must accompany growth is to say forced money destruction must accompany recessions. I hope this helps put the ideas in context. A key note is that growth deflation and recsessionary inflation are not monetary phenomenon and this is why the money factor just adjusts to the changes in the real economy but does not cause monetary distortions and the corollary effects.

    Youre right to say money supply did grow in the 19th century, and the banking was not entirely sound, but the key point is that it grew much slower than growth so was not fully accomodative in this sense and prices on net fell for almost a century. The money supply need not grow though and all unsound credit expansions should be rejected from the perspective of overall economic health. There is no conceivable economic benefit to allowing unsound credit expansion besides the individual benefits reaped by some at the expense of the general economic welfare of the rest. If unsound credit is able to drive down the market rate of interest we also have wasteful boom and busts, (as noted by the flow chart i posted in a previous response) and even if not the inflationary effects are just they typical redistribution of wealth and distortion of monetary calculation (the evils of inflation arent really denied im assuming). If inflation is distributed equally the negative flaws of inflation are essentially mitigated but so is any real factor inflation might effect so the process is pointless. Unsound credit expansion just creates relative insolvency and although this may make society appear to be richer no extra money ever makes us richer since money is not a good.

  41. Mises writes:

    something you may find interesting if you’re genuinely interested in understanding some of the basis behind Austrian macro ideas can be found in this chapter by professor Garrison. http://www.auburn.edu/~garriro/cbm.htm

    this is just an introduction. some of these ideas are being expanded in other ways but i think this will start to help you understand how their views rest in the context of others.

  42. anon writes:

    Thx. I’ll have a look.

  43. RueTheDay writes:

    I don’t want to hijack this post, but I think the question of whether speculators or supply/demand fundamentals were driving oil prices has just been definitively answered.


    One trader held 11 pct of Nymex contracts

    By June 6, Vitol had amassed contracts equal to 57.7 million barrels of oil, about three times the amount the United States consumes daily. On that day, the price for a barrel of oil spiked $11 to settle at $138.54, per barrel, valuing Vitol’s oil holding at nearly $8 billion.

    The commission’s data show that at the end of July, just four swap dealers held one-third of all Nymex oil contracts that bet prices would increase.

  44. Jeff MacKenzie writes:

    OK Randy. You made this space available for guest comments and I am not a financial person as you will no doubt twig to about two paragraphs into this missive. But here goes…

    I’m an architect, and in the past followed the economy only as interest rates whipsawed and affected my work cycle. I became interested in derivatives trading after reading a novel(the name and author of which escapes me) which I picked at random off a library shelf. The plot concerned a banker in Delaware who received a revelation that he must tell all his acquaintances that derivatives were going to collapse the economy and to take a position in treasury bills to pile up the wealth before Armageddon happened. The premise seemed so fanciful I dismissed it out of hand. Yet over the years I glanced at the derivatives picture, and what I’ve seen in the past three years is to me, the reader of this non-scholarly book, quite alarming.

    I am posting to this website in the hope that some of you, behind suppressed laughter, will set me straight. I would very much like to feel this is something I don’t have to worry about. yet a total collapse of the global monetary system does inspire a few shivers.

    The total amount in notational value of derivatives is over half a quadrillion in unregulated, over the counter trades–per the BIS estimate. This amount, as Randy has pointed out, is not the total money in play, but large chunks of it can be, subject to counter party risk.

    I see these trades as nothing more than highly complex bets that often require special math to interpret their true value to the parties involved. They have demonstrated in the subprime crisis, in Orange County a few years ago and even before that, in the collapse of a huge investment fund trading in Russian futures, their ability to wreak havoc in the financial system. When I tried to point this out to my brother and my cousin, who have degees in economics(my cousin used to teach it and has a phd) and my brother in law, who is a retired stock broker, they refused to believe the derivatives market was this large and demanded proof as to who was doing this volume of trading. Other than the BIS statistics, this proved difficult, although I think I met their objection when I cited a Hong Kong bank whose programmed trading ran into the trillions. Apparently(correct me if I’m wrong) the sheer volume of trades is accomplished by computers to create the billions of individual transactions which otherwise would take too much time if done by hand.

    I know it sounds paranoid to be considering such things but hey, there it is. I see it playing out thus: the subprime thing will eventually achieve a modicum of stability(although the Fed’s backing of Fannie and Freddie doesn’t seem to have eased their crisis as yet–they took a 2 billion writedown in the quarter after the Fed got behind them) because the bankers see it as a matter of public perception. If the mortgage system becomes really fouled up then it will translate to a lack of confidence in all the other areas, so they are making a special effort to shore it up.

    But I think the real issue is the weak dollar–good for exports but bad for petroleum trading as oil is bought and sold with dollars worldwide. One of the reasons cited for the Iraq war and one I think makes the most sense is that Saddam was threatening to trade his oil for Euros, which would effectively undercut the dollar as the currency of choice worldwide.

    (It is also quite possible that the Georgian thing is an attempt at distracting the world from the global money instability.)

    Our economy is largely propped up by the dollar’s role in oil trading. But more important, most of the quadrillion or so derivatives out there are also bought and sold in dollars.

    If the dollar suddenly becomes worth far less than half a Euro, all those investors will see their carefully structured hedges devalued and huge losses will make the subprime thing look like a lemonade stand. They will start suing for restitution and courts can turn an already tangled mess into an unrecognizable mass of atomized fragments, vaporized wealth.

    When they lose confidence in the dollar the Fed has to get behind it and print more money, as it did for F and F. But how much can the Fed print before the investors start cutting their losses? A hundred trillion? Two hundred? At some point it starts looking like Zimbabwe, and they will turn to other currencies, but those are in turn so tied to the dollar that its collapse will start devaluing them as well. So the whole system, like a house of cards, will come down, and it may be many months or even years before something takes its place.

    But what happens in the meantime, when paychecks mean nothing and basic institutions stop functioning and people get hungry and desperate?

    I sense, in subtle Freudian slips like ‘meltdown’ and ‘conflagration’ that the stewards of the money system are becoming more frantic as weeks pass.

    To sum up, we have a hidden, poorly understood and largely unregulated economy of overly complex transactions that even the parties involved often don’t understand. This economy dwarfs the world GNP. When even a small part of it(the subprime area) wobbles it causes extreme unpleasantness in the financial markets. Because its unregulated, if even a quarter of this total market fails, there is no effective global oversight(no single board or commission with the necessary power) to halt the trading there is not enough money to shore up the too big to fail investors and prevent a total collapse. And this shadow economy has been growing like topsy. Are we all of us on a downbound train here?….

    Anyway, that’s my take, and I pray that I’m such a neophyte that I’ve got it all wrong or backwards or something.

  45. RueTheDay writes:

    Jeff – The chances of an Armageddon-like economic collapse (e.g., a second Great Depression) are almost nil. There is a lot of pain ahead, IMO, in terms of rising unemployment, falling output, and price volatility. However, a complete collapse isn’t going to happen. The central banks have the tools available at their disposal to prevent it, and are willing to use them. The second part is key. The Fed had those same tools available in 1929, but hesitated to use them for purely ideological reasons (the libertarian-esque dogma of private property, contracts, and free markets uber alles). No one in power believes in that nonsense anymore, thankfully, and so will not hesitate to stem a disaster on pseudo-moral grounds. Interestingly, Japan’s lost decade of the 90’s was also largely ideologically driven, albeit for different reasons (a cultural desire to avoid the embarrassment of failure at all costs) that when applied to the banking sector prolonged the problem unnecessarily.

  46. Mises writes:


    you’re self contradicting. How can japan make the mistake of avoding failure at all costs when this is exactly what you’re advocating should be done.

    Anyways, printing money or bail outs does not cure insolvency. It just puts the tax payers or the cash holders behind it. Balance sheets need to be restructured. Monetary policy cannot save an economic downturn, it can only perhaps cause one through encouraging capital misallocation. Keynes said in 1927 or something we’d have no more economic disastors thanks to his ideas, and look how far thats taken us. Irvine fisher, friedman’s idol was the biggest fool of the depression never realizing what was actually go on. No offense to milton friedman or keynes but its crazy to say somehow you can print or spend your way out of a real disaster. All that happens is nominal bankruptcy is perhaps avoided with high inflation as the trade off or you waste future resources to try make the now look a little better. Ill never go bankrupt either if i can print to pay my creditors and obligations, but then again why should they keep loaning me money or engaging in business if they get paid back in worthless paper? Further the moral hazard and prolonging of dislocations by this method only ensure greater disasters to come. The problem is the FDIC does not have enough capital, nor do banks to pay their promises. To backstop the problem with the fed isnt going to solve the problem, just socialize the losses while propping up failing institutions and avoiding a healthy restructuring.

    FYI, the great depression was more initiated from monetary policy and mostly exasperated by fiscal policy. As it stand today, the fed only has so many good assets. If they want to avoid hyperinflation they need to do things like they’ve done, make loans to banks but also sell off treasuries to compensate. The issue is they are running out treasuries and will be stuck with illiquid assets so when another firm goes bankrupt or is on the verge the monetary base is gonna fly to stop this as will inflation and a loss of confidence in the system which can spell disastor for a nation highly depending on foriegn capital and foreign confidence in the dollar. the US should be much more concerned about keeping the foreigners on which they depend happy, by not creating and exporting their inflation which can lead themselves towards the second collapse of an international dollar standard (bretton woods being the first). Although they wont run out of gold, huge domestic inflation, larger deficits, and then super high interest rates will be the consequences. how can a levered, capital dependent country maintain their assumed levels of prosperity under such circumstances?

  47. RueTheDay writes:

    Mises – Japan could have avoided the prolonged nature of their economic slide by having the government take the zombie banks over and selling off their assets in an orderly manner. This isn’t an all or nothing proposition. Loose monetary policy is the correct approach in the aftermath of a financial collapse, but it is not the ONLY thing that must be done, nor can it be continued forever.

  48. groucho writes:

    steve, OT. Have you read Jamie Galbraith’s piece in Mother Jones “How to burn the speculators”?

    Mises, you’re making a great case for allowing goods and services price decreases(sometimes called deflation)to act as the information content for productivity and general fairness in market pricing with non-distorting feedback loops.

    With our current digital technology, now is the time to allow division and subtraction to work it’s magic in economic prosperity. Rising standards of living are much easier and far, far fairer under a “deflationary” world.

  49. Alessandro writes:

    Mises, excellent posts and great links thank you.

  50. daddysteve writes:

    Thank you Mises for fighting the good fight Drive the Keynesians and their inflation back to the pits of economic hell where they came from.