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
