Inflation Versus Deflation: The Debate Continues

Two very good posts I suggest you read immediately: one by Michael Shedlock, “Implications of the Slowing Global Economy” which at its close makes the case for deflation, and a rebuttal from Steve Waldman, “Why Inflation“.

Both are thoughtful, and as much as Waldman has the stronger argument, I suspect he will not be proven correct, at least near term.

Central bankers know in overlevered economies to break glass and print money. Bernanke has written at length as to how damaging even modest deflation is to borrowers and how it impedes investment and growth. He has famously observed that a determined central bank can always reflate, and hews to the conventional wisdom that Japan is in the mess it’s in due to not cutting rates fast enough when the bubble economy started imploding.

Yet I have a sneaking suspicion both Shedlock and Waldman will be proven right, that we will get a dose of deflation before the Fed turns on the printing press and debases the dollar (that was one of the consequences of the 1934 reflation).

Why? The Fed has been making bad judgment calls for some time that nevertheless get applauded, so they have little reason to question their moves to date. They have tended to wait too long to act, then move in too extreme a fashion. Bermanke & Co. were famously slow to recognize the severity of the subprime crisis. They suffer from what Willem Buiter calls “cognitive regulatory capture” in that they identify too strongly with the viewpoint of banks and Wall Street, that is, they lack sufficient detachment. They also suffer from a lack of expertise in the areas that are the epicenter of the crisis, such as securitized credits and credit default swaps. With all due respect to Timothy Geithner, the head of the New York Fed, no matter how much he talks to and trades with investment banks and broker/dealers, he and his colleagues cannot possibly have the same understanding of their business as they do of banks they supervise. (Worse, even the management of the investment banks may not fully understand what is up at their firms, as Michael Lewis has suggested. He contends that the products have gotten so complicated that only product experts can understand them, and top management doesn’t have the in-depth knowledge needed).

So the Fed cut too far, too fast. 75 became the new 25. And as Caroline Baum has noted, if the Fed knew it was going to create its alphabet soup of facilities, it wouldn’t have cut as deeply as it has. But it cannot undo the past.

But now the Fed is talking hawkishly (and maybe it hopes the hawkish talk will obviate the need to do anything). But if the Fed was with Waldman’s program, it would be thinking about cutting, or at least not raising rates.

Even though the Fed is supposed to be independent, it has been annexed by the Treasury department. Waldman argues that the national interest will be served by devaluation because deflation hurts workers, since the real value of their debt rises. As noted earlier, Bernanke is acutely aware of this issue.

But what he misses in his political calculus is how high commodity prices have put the Fed on tilt. More dollar weakness, even with a faltering global economy, presumably means at least somewhat more costly basic materials. Those are highly visible to consumer/voters. Higher real cost of debt, on the other hand, is far less obvious and plays out over time.

So I suspect the policy bias will continue to be to avoid debasing the dollar (unless we get a real price break and oil goes to $75 or lower, which would give the Fed much more latitude) until we start seeing second-order effects from deflationary trends, such as higher consumer defaults and heightened stress in the financial system.

But no matter how you slice it, the average worker is going to see his standard of living fall.

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  1. Richard Kline

    Something which continues to puzzle and interest me concerning this financial rollover is the extent to which secondary deflationary effects have _not_ penetrated the US economy deeply to this point. Certainly the comparatively modest job loss figures thus far influence that outcome heavily, but there is more to the issue that doesn’t play out clearly to examination. Hmm.

    Regarding ‘whether by fire or by ice?’ i.e. inflation or deflation, those respective outcomes both are predicated upon a relatively coherent trajectory in a national economy, speaking broadly. It is just exactly that kind of ‘event space’ which we do NOT presently have: we do not, really, have a national _financial_ economy. In some degrees, the US doesn’t even have a national real economy considering the extent to which we import both commodities and finished goods. Regarding a most relevant point in a recent post by Brad Setser (linked here yesterday IIRC), China’s continued purchase of $ denominated debt significantly ‘governs’ US macroeconomic outcomes—but this is just one such ‘external’ input which really isn’t external anymore because there is no _internal_ economy insulated from the effects of these purportedly exogenous inputs.

    All that’s a (typically) longwinded way of saying that it may be that we can’t get a clean trajectory up or down given the extent to which major macrofinancial impacts on the US are nominally offshore in their inputs. Our ‘phase space’ includes oil price and supply issues, foreign sovereign macrofinancial policies with major money behind them, and trade volumes and directionalities of finished goods of high value going both ways. And these inputs don’t engage in a balanced way as a national economy is more nearly bound to do; they don’t mesh with each other overall so they don’t produce a comparatively smooth space of effect. The result is that we are more likely to get _discontinuous_ financial vectors with little lead time and by no means shared directionality. The bump in oil future open interest is just that kind of ‘queer wave’ that I have in mind. Aggregated vectors like that in an unsmooth macrofinancial space may go up, down, and way sideways by turns _regardless_ of what the Ready Feddies try to achieve pushing rate buttons on Big Blue’s interface. This crisis may very well be like no other only moreso in that we may not get a clean clear trend but a series of jagged, non-cumulative lurches in areas and issues given little attention before they rupture. Hmmmmmmm.

    To me, the likely answer to the question, “Inflation or deflation” is “Yes.” And, “When you’re not kissing a boojum into the bargain, too.”

  2. Danny


    Lewis’ point is spot on. These products were created by uber quant nerds with PhD’s, which most people selling and trading don’t have the faintest clue as to what they actually are, outside of the basics. A good read is Paul Wilmott’s blog,

    He is the editor of a quant magazine which is highly respected, and he has come out and excoriated the banks for hiring quants with little to no finance experience to create these monsters.

    Also, I don’t think Shedlock will be wrong. He has come out and said that if the Fed starts to print, he will change his mind. He just doesn’t think it is going to happen, which I also disagree with. You have to love the notion that we have free markets when you have to make investment decisions based on the actions of technocrats who have spent their lives in ivory towers. I wonder if Greenspan will hire Bernanke after he gets tossed? He’ll get a little market experience then….

  3. Anonymous

    Welcome back Yves, I most definitely missed you, which is not to say that I didn’t appreciate the yeoman’s effort put forth by the guest bloggers.

    ‘Some Assembly required’ is very good, as so is Mr. Waldeman, not that I find the other of any less value.

    I find my sympathies lie more so with Steve than with Mish…mostly because I don’t believe the Fed is capable of exercising the necessary ‘restraint’ from letting the printing presses ‘run wild’ in a decidedly feeble attempt to ‘bail out’ the economy/investors.

    I concur with your analysis that the Fed has acted to rashly when it comes to dealing with this, um, self-inflicted wound.

    There is ‘no way out’ unless we alter our economic system to reflect the ‘new realities’ it now faces.

    Debt driven society is on the verge of collapse…we need to convert to a labor driven social model. A model where labor confers the benefits of civil society.

    That said, the ‘catch’ is that a job that pays a living wage is guaranteed to every able bodied member of society.

    Sound weird, sure it does…but not if you consider the fact that Mother Nature doesn’t have a cash register.

    Both ‘resources’ and labor are ‘free’, the primary reason societies collapse is ‘income streams’.

    Since we do what we do for a paycheck, it only stands to reason that everyone should be treated equally, and that everyone should surrender their labor for a paycheck, provided by society.

    If we were to eliminate income streams, we could achieve 100% employment AND do away with that social scourge, taxes.

    Since everyone would draw their paycheck from society, there would be no need for you to pay them too.

    No more rent, no more mortgages, no more health insurance…because healthcare professionals would be paid to do what they do by society.

    Oh, and banking would become an ‘internal function’ of the ‘field of endeavor’ you surrender your labor to. Um, since a place to be would become your ‘right’, there would be no more debt either…because individuals would not be able to ‘transfer funds’ between one another.

    There’s an extremely ‘practical’ reason for this provision, all crime is ‘cash and carry’.

    Since our current system threatens the collapse of civilization as we have come to know it, I put this forth as an ‘alternative’ to helplessly watching the ‘clock of civilization’ turn back a thousand years.

    Naturally, this all works out of the law. In order to protect society from the ‘self-interested’, we would need to remove the law from the reach of the same.

    We need ‘leaders’ not ‘legislators’.

    Only the people can alter the law, and then only by an overwhelming majority.

    It’s time to take the next step.

  4. Independent Accountant

    “Independent Fed”? Hahahahahaha, the Mogambu Guru would say. By the way, Thomas DiLorenzo has a post on that topic today over at The Fed and Treasury had an “accord” before you were born. The Fed had the period of the peg during WWII.

  5. Anonymous

    Ask Arthur Burns if the answer to inflation is more inflation. I am completely mystifyed by the apparent lack of education displayed by today’s leading economists.

    The cure for inflation is recession induced deflation. The current mess is a macro-result of fevered attempts to repeal this tautism. The world is not linear, What works as an anti-dote, monetary stimulus, in measured amounts when inflation is controlled becomes a poison when the disease is out of control.

    The financial turmoil is all about rebalancing the risk return relationship. At this point, printing money is likely to eventually lead to 15 pct interest rates, after continuing damge to the economic core.

    Gotta love the bankers.

  6. Anonymous

    Can there be any doubt? Deflation kills, inflation maims. I think Bernake is where he is exactly because of what he openly said back then, for all who wish to hear..

  7. Unsympathetic

    The Fed does not have a printing press. The Fed has a jawbone.

    Treasury can sell T-bills – but, as we saw with the Chinese threat last week to dump 100% of their agency debt.. which resulted in the very public backstop from Treasury with a “verbal pledge” precisely equal to the dollar-denominated agency debt held by the Chinese.. if overseas investors don’t purchase, the Fed has NOTHING.

    If the Fed prints without regard to the state of the economy, the entire economy falls apart.. and they know this.

    Inflation? How? More precisely, as measured against what? We’re already at around 11% when you use numbers based in reality, not the government’s gratuitously fake indexes.. what, exactly, would constitute the “inflationary” period, then? 20%?

    Waldman’s analysis is from a level higher than 30,000 feet.. and manages to use lots of large words while saying not a whole lot. Well, aside from commenting that inflation is the lesser of two evils – um, thanks for the tip. Taking a page from Greenspan’s better days, perhaps?

    Bernanke, the neocon central banker, is failing – and I, for one, couldn’t be happier.

  8. Rick

    With all due respect to the quants who may perversely and arrogantly believe that it is their complications that [helped] create the mess we’re in (in structured finance), the blame – in my opinion, as a lawyer – falls more squarely on the lawyers and the salesmen/bankers. Even now, as defaults are taking CDOs over their individual edges into events of default and into insolvency proceedings, the bankers (who haven’t lost their jobs) are forced to go back to their lawyers and literally ask “how do the documents work”?
    Clever lawyers, charged only with layering the structures with paper, and capturing the hearts of their clients with yet another “hide the ball” provision that shaved still another basis point from the “perceived risk”, created 200 and 300 page indentures, never to be read (even by the rating analysts, who (speaking from experience) rested assured on the faulty promise “this one is merely a dupe of the one you just rated”). So now, those self-same lawyers (at least those who still have their jobs) are patiently explaining the clever provisions in the indentures and the asbestos like coverings on their own legal opinions… at $450/hr.

    The heretofore undiscovered “return policy” on the auction rate securities demonstrates the embarrassing reality: the banks sold products they are now repurchasing as “defective”, not because the quants had overcomplicated them, but because the lawyers had assured them that “the investor had been adequately informed of the risks”. Rather than fight it out in court, the banks are acknowledging that “a screwed pooch buys no more”, at any level of capitalization.

  9. Anonymous

    It seems to me that we do not have as much control over our own destiny as we may believe. (See cognitive biases at Wikipedia). I would ask regarding the inflation/deflation question: What do our creditors want? They do not appear to want to be paid back with cheaper dollars. They will fight inflation of the USD. How? By limiting purchases of US Treasuries going forward, causing (long-term) rates to rise and the dollar to continue to strengthen, and in the process keeping their exports more affordable. The rise in long term US rates will be the “shock” Minsky describes as debtors engaged in distressed selling of assets to pay off debt. The paying of debt thus contracts the money supply and decreases velocity. Attempts to inflate using short term rates will be ineffective since consumers are over-indepted, and banks are tightening lending standards. Thus, deflation has the edge. Let us hope for at least a stable versus unstable deflation.

  10. "Cassandra"

    Yves, Ken Rogoff best articulates the evolution of how both views might be requited (deflation, or at least deep recession first, yet still insufficiently deep and likely without the associated required policy repairs ’round the world, causing the next upcycle to unleash greater inflationary pressures than ought optimally to be case.

    A look back to the seventies saw two slaughters of the commodity bulls – one merely a flesh wound but sufficiently deep and prolonged to shake all the specs out of the market, followed six years later by the Volckerian death blow. Rogoff doesn’t begin to suggest when this down-cycle might end, though I’ll wager given the unfolding revulsion he too is making longer odds on an early exit

    I also think CBs faith in their infallible ability to reflate is truly misplaced, and that decoupling is (at least in THIS cycle) little more than a pipe dream, for the US growth engine is far more – perhaps irreparably so – encumbered today. And while in the more than four decades of my lifetime we’ve yet to witness (in the USA and Europe) the plausible but elusive “pushing on a string” despite economists mechanical pronouncements of its arrival in 1988, 1994 1998 and 2002, I suspect that in 2008, it is here. I believe this is so because globalization and fiscally-driven inequality made each exogenuous stimuli – whether tax cut, debt-driven refi or increased leverage ratios/ deficit spend, or vendor finance, suffer from diminishing marginal returns causing further intervention or credit-induced boosts to (at best) merely sustain the patient on life-support. This is little different from the Japanese experience of a politically-induced stretching of their bubble adjustment over a decade. Inflationists seemingly argue that a similar adjustment stretch is inevitable, but given the current condition of the patient, inflationists must argue how such stimuli will overcome these hurdles, which I don’t think they’ve adequately done.

  11. doc holiday

    Link: Anniversary of Nixon’s price controls

    ” I think this is what happened in the US in the 1930s. Following a period of rising inflation in the 1920s – and for many of the same reasons: a rapid expansion in the US money supply caused by massive reserve accumulation in the 1920s – the overextended banking system was unable to survive the economic downturn, and a previously inflationary period was suddenly converted into a period of sharp deflation. There was even a 2-year period at the end of the inflationary period (1927-29) in which the US was absolutely swamped with speculative inflows.”

  12. Anonymous

    I would ask regarding the inflation/deflation question: What do our creditors want?

    Excellent point, especially given the assumption that the creditors are benevolent.

  13. Anonymous

    I find all this discussion a bit too noble. The Fed only has enough vision to react to the curves in the road. Given that it is now a de-facto Treasury sub dept., which is in turn a de-facto “Save Wall St.” organization, the Fed will simply do what is most beneficial to its constituents, the average worker and the country be damned. Please think in short term knee-jerk scenarios only. Yves mentioned basic materials costs being “highly visible to consumers” but I think we are way too far down the road for that to have any effect on Fed decision making. Congress may be sensitive to the consumer but to think that the Fed does at this point in time is illusory thinking in my opinion. Corporate interests are in charge here, period.

  14. Sivaram Velauthapillai

    Everyone loves to blame others for all their problems. After all, how many like to blame the mortgage bond sellers instead of the investors who bought them? All those embroiled in the inflation/deflation debate loves to blame the US Fed Res but the fact the of matter is that they have performed exceptionally well so far.

    In particular, everyone seems to have missed the point that the Fed hasn’t printed much money. Typical move in the past (under Greenspan and others) has been to inject huge quantities of money by monetizing US Treasuries (i.e. buy them for cash) yet that isn’t happening now. In a brilliant move, they SOLD US Treasuries through this crisis. Sure, they took on increased risk with the mortgage (and other) assets they took on; but if there is any inflation, it certainly isn’t coming from the US central bank. A lot of the readers here probably think it’s the worst thing ever but the US Fed Res swapping Treasuries for mortgage assets might go down in history as one of the greatest moves.

    Furthermore, many fail to grasp the flexibility of the US economy. US GDP growth has been nowhere near as bad as the bears claimed (and certainly nowhere near what the superbears were betting on.) For example, the Canadian economy has done far worse than the US economy even though a chunk of the Canadian economy should get a lift from commodities. Similarly, Europe is doing worse; so is Japan. And word from Australia sounds bad. Manufacturing exports are doing fairly well right now. The technology sector, which generates a huge chunk of their revenue overseas or through exports, has been holding up.

    What can muck all this up is the government–the future government. If Obama slaps on tariffs or harms trade or if McCain starts a bogus war (likely Iran or a proxy war in Georgia), it’ll mess everythign up. The former will cause deflation and the latter will inflation. Until then, the US economy is humming along.

  15. Anonymous

    Creditors, benevolent or not, might have no survivors to collect from if they favor full repayment. It seem to me that this is a case of shared sacrifice.

  16. David Pearson


    Inflationists don’t necessarily argue that stimulus will “work”. Most of us think its doomed to fail — i.e. an increase in nominal demand will occur concurrent with a decrease in real demand. We’ve seen this in emerging markets time and again.

    For inflationists, the question is not whether monetization will work, the question is whether the Fed will think it will work.

    Ironically, the most important deflationists inhabit the Central Banks of the world. Almost universally, they believe 1) inflation will evaporate of its own accord, without Central Bank tightening; and 2) any deep recession may cause a deflationary crisis, and therefore must be fought tooth and nail.

    Call it “policy asymmetry” — deflation must be fought, inflation just “waited out”. The end result, of course, is successive peaks in inflation, each higher than he last.

  17. Anonymous

    We all know the ills of inflation, however, for an engineered deflation to occur the opportunity has already been lost. If about a year ago the economy was allowed to go into a natural recession cycle and find its natural footing then deflation would have been plausible. At the moment, deflationary talk is a best a short-term game to end within the next couple of months and at worst laughable.

  18. Yves Smith

    One comment on the “what do our creditors want” point. The problem with keeping the US dollar up and the US as a customer for the goods of countries with pegged currencies is that it requires letting our debt to GDP ratio rise even further, and it already is at a level that is simply unsupportable.

    Brad Setser has teased out an implication that hasn’t gotten the attention it deserves. Our friendly foreign funding sources aren’t merely providing the dough for us to buy their goods. They are also financing our interest payments to them.

    Setser warns that at some point, they amount they are providing to us that goes for funding past deficits, versus current purchases of goods, will become unattractive either on a practical or political level (and also remember, losses on FX reserves, as ugly as they might be, will rank second to internal issues).

    Nouriel Roubini has raised another point: our big creditors (save Japan and Taiwan) are not our friends geopolitically. They may not decide to tank us, but they most assuredly might jerk our chain, hard. They might correctly deem some economic disruption to be cheaper to put into effect and less uncertain as to outcomes than a hot conflict.

  19. "Cassandra"

    I am not certain whether America, beholden to kleptocrats and mercantilists for finance, are in a much worse position than Europeans now beholden to increasingly extreme Russian nationalists for more than three-quarters of their gas. One thing is certain, the Americans have painted themselves into their corner whereas the Europeans are victims of resource geography.

  20. James

    What were finding out is yes deficits, both trade and CA, do matter. Am I the only one who finds it odd that many of my friends were allowed to buy not one, but two homes in the last couple of years at the age of 25? As yves points out to continue this system that kind of credit expansion has to come back. I just dont see that happening and Im not convinced weve even seen the worst of it. The chinese leadership along with the US leadership, political and corporate are desperatly trying to keep this system intact, but the writing is on the wall.

  21. Peripheral Visionary

    I simply do not see the Fed resorting to the printing press. Even if deflation is seriously bad news for the economy, I just do not think that the elite of the Federal Reserve Board could stand seeing themselves as being seen in the same class as Zimbabwe and the Weimar Republic.

    At some level, there is a deep-rooted belief that they are the pinnacle of monetary experts, and to stoop to measure typical of a banana republic would be more than they could bear–I think, even in the face of crippling deflation, they will not print, if only to try and save face.

  22. Yves Smith

    Peripheral Visionary,

    Bernanke has written extensively about the Great Depression and also made extensive study of Japan’s deflation. He (and Greenspan) regard even slight deflation as very detrimental.These statements come from a 2002 speech before the National Economics Club in 2002:

    With inflation rates now quite low in the United States, however, some have expressed concern that we may soon face a new problem–the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation–a decline in consumer prices of about 1 percent per year–has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors…..

    So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds…

    The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself….

    Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the 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.

    Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation. (boldface ours)

    Bernanke has thus said very clearly, and repeatedly using the printing press metaphor, that the Fed will engage in aggressive monetary expansion IF the economy is or appears on the verge of falling into deflation.

    The speech provides a nice recap of some of the themes from Bernanke’s papers on deflation (I’ll confess I have sampled only a few). For instance, he speaks favorably of the US reflation in 1934:

    A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market.

    Informed readers like our hedge fund manager Scott Frew have noted that the Zimbabwe stock exchange has also done well in local currency terms.

    Although many observers note that the Fed exercises influence only over the short end of the yield curve, Bernanke also discussed how to muscle down rates of longer maturities if the found itself having to go to zero short term rates (the dreaded ZIRP land):

    One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities.9 There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

    Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

    Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities.

    Apologies for the length of these excerpts, but they serve to illustrate the lengths to which the Fed is prepared to go if it thinks deflation is imminent.

  23. STS


    You’re right about the lawyers’ and accountants’ role in this mess. SIV’s are just more of the same Enron accounting lies that were supposed to be over. And the asymmetric, “heads I win, tails you lose” compensation for fund managers is another low-tech root cause.

    Sure the quants are financially naive — so are all economists, basically anybody who thinks their little model says much of anything about the real world falls into this babes-in-the-woods category. But quants didn’t hoodwink their bosses — they just provided plausible deniability and a fashionable hook for the usual swindlers’ sales pitches. “Look at how smart and sophisticated our trading signals are! (Pay no attention to my fees as they siphon off your net worth …)”

  24. James

    And this why Bernake has helped put us in the position we are today. The US needs a regulator not a monetary quack. We cant even imagine the ramifications if this was ever tried on a massive scale. Its silly and ill thought out arguments from quack economists that let the banking system think it is being protected at all costs with no consequences. As of right now I gurantee all the IBs, HFs, banks, etc would gladly do this all over again because they never get enough punishment on the downside. The continuous validation of this system is a huge problem.

  25. Anonymous

    Cassandra: “increasingly extreme Russian nationalists”

    Russian is not as bad as most assume. It threw away communism and adopted many features of a regular democracy (including elections). At this point it deserves the benefit of the doubt.

  26. Dean

    During a contracting cycle (our present situation), governments should not interfere with the adjustment process:

    The generally accepted appropriate government action during the contracting cycle is:

    1. Do not prevent or delay liquidations
    2. Do not re-inflate
    3. Do not support wages
    4. Do not support prices
    5. Do not stimulate consumption
    6. Do not subsidise unemployment
    7. Do not prevent bank runs
    8. Encourage higher savings

    If these precedent conditions existed, then I would agree very quickly with the deflation scenario. But is not happening folks. A casual look at this list shows that the Fed is undertaking all the wrong steps.

  27. Dean

    A strong dollar will kill the export business, which in turn will increase our trade deficits which in turn will weaken the currency.

    What we are witnessing at the moment is an all-out effort to bring down the cost of sweet crude, hoping that it will translate to significant enough savings at the pump, so that voters will not cast a rejection vote.

    Both the reported strengthening of the dollar and the re surging “deflationary” theories are artificial constructs and will not survive beyond a few weeks time.

    Regarding deflation, if any of your arguments are true then you just made the case for Ben and company to flood the system with liquidity via another rate drop. I suspect that his reasoning will the same as yours, namely that fears of inflation have been abated and since he “now sees more deflationary pressures” than otherwise, a further discount rate easing is appropriate and necessary to avoid a recessionary economy. So for all of you deflationistas, just remember that you just made the Fed’s case. Now, if you have some brains to keep your mouths shot and your opinions to yourselves you might have a distant but fighting chance.

  28. Yves Smith


    I don’t flatter myself that the Fed takes heed of written here. If they don’t pay attention to Willem Buiter, they certainly don’t pay attention to chatter on blogs.

    The worst aspects of policy actions so far are that they are trying to shore up assets and keep just about any existing institution alive. There is NO reason Countrywide should not have been permitted to fail, and the Bear case is highly debatabe. The Fed did not know enough to make an informed battlefield decision and took the road of caution (personally, they should have given Bear 28 day funding per the initial plan and examined counterparty exposures, but my impression is they got some sort of advice against that once the rating agencies downgraded them on Friday).

    But having said that, I think you underestimate how significant the bad debt overhang is. Debt to GDP is considerably higher than at the worst point in the Depression, and by a large margin (260% of GDP then versus 350% now). This is not an ordinary contraction. And we were a creditor nation then, less in need of cooperation of foreign funding sources.

    The conventional reading is that the mistake the Japanese made (and our situation is more like theirs that we care to admit, the expected losses as a % of global GDP is higher than for the Japanese bubbles) was not cutting fast enough, deep enough. You can believe that deleveraging is deflationary without thinking that monetary measures are the way out.

    The reason I think Bernanke’s analysis of the Depression is misguided is that the 1934 reflation took place AFTER there was substantial deflation, AFTER FDIC insurance was created, and after a lot of other New Deal measures were in place (many, but not all of which were admittedly ineffective). The role of the FDIC in getting depositors back into the banking system is crucially important.

    The Japanese believe (and I think they are right) that the mistake they made was not recapitalitzing the banking system fast enough. We have the worst of both worlds: we have socialized some of the losses without wiping out equity holders and instituting reforms. But things would have to get much worse before Sweden-style measures (which were quite successful in their early 1990s banking crisis, and included injecting equity into failed banks) would be acceptable here. And in Japan, the impediment to recapitalization was also political.

    I think more failures should be permitted to proceed. They are salutary (up to a point) and in the long run inevitable. But as much as I question many of the Fed’s remedies and their undue loyalty to current institutional structures and players, they are not wrong to be worried about deflation.

  29. Yves Smith

    For the record, I think Greenspan and Bernanke were nuts to be even mentioning deflation in 2002 (although that gave Greenspan cover for negative real rates to goose the stock market, which was one of his pet hobbies. Greenspan had long taken an undue interest in stock prices, which was not the Fed’s job). The dot com bust was an equity market phenomenon. Yes, it lead to some misallocation of business investing, and was going to produce a recession. But bank balance sheets were not damaged and a recession is not the worst thing in the world. The damage would have worked its way through on its own.

    So given the overreaction early in this century, it is easy to see the Fed as having cried “wolf” once too often.

  30. Dean

    Yves Smith:

    You are certainly articulate and a deep thinker. Because the deflation vs. inflation question has many complexities, I try to keep it as simple as possible aiming straight at the essential. Our collective problem is summed up in a four letter word: DEBT. Both as a nation and as consumers we are saddled with it and its servicing takes an ever bigger piece of the total revenue pie. Using another over-simplification of our human fallacies and propensities, I think the most likely outcome will be to try to lessen its impact by diluting its strength. Since only inflation (arguably a controlled form is better than runaway hyperinflation) can accomplish such, I therefore come down on the side of its existence as the predominant theme in our economic affairs for the years to come. Sorry for the simplification and calculated naivete of my approach, which robs the opportunity for a spirited and informed debate, but I feel the end justify the means.

    BTW I agree with what you say and I am even reinforcing the slight bias you exhibited towards inflation as the most likely outcome.

    Dean Plassaras

  31. Gregor

    An incredibly well written post.

    I think it’s fair to say the hawkish chatter from FED folks only 8-10 weeks ago has now totally disappeared. In its place are lots of concessionary remarks, nodding towards weaker growth and unemployment. Alot of this has come in just the last 10 days. Today even.

    I’m fairly confident the FED wants a more stable USD. But not a higher USD. They want stability b/c Treasury has lots and lots of funding needs, and the weakness of the USD was starting to get out of hand. However, this ramp in the USD is also disorderly.

    Interesting. As soon as the FED seemed to find some comfort at 2.00% FF, now comes the USD which I think is going to be a problem for them if it ramps too hard, too fast. The new box they are is created by the currency. Same dilemma. Different vehicle–tight/loose vis a vis FF/currency.

  32. Richard Kline

    Yves: “The Japanese believe (and I think they are right) that the mistake they made was not recapitalitzing the banking system fast enough.” I completely agree with that statement, both regarding their assessment, and even more it’s accuracy. Dead banks and uncleared bad loans suffocated their economy for a decade and still leave rot and stench in many places. —And the US is more likely to repeat that mistake than avoid it because that is the result of ‘doing nothing’ or more accurately ‘doing as little as possible,’ which is again much easier than doing something different.

    I’ll be clear that I’m a poor prognosticator for reasons diverse. Sticking to the generic level, then, here is one outcome I think I can guarantee: Whatever action US public financial authorities take will in its effects be overmastered by the unintended consequences which result. That is not necessarily always the case in macro level policy actions. However, so many, many things in the US economy and financial system are presently at levels distant from equilibrium or long-term trend stability. We are guaranteed to get disproportionate impacts from any actions—even if the actions happened to be the ‘right’ ones reassessed in retrospect.

    So what to do if even the ‘right’ thing will be ruinously costly? Decide what is most important to save, put your resources into saving that, and look to get the rest of the system to stabilize around that base of constancy. Too bad that the Treasury has decided to save asset prices. : (

  33. Jeff

    I think unless you are blind to what’s happening in the credit and debt-financed asset markets, deflation is already here. That is, if your definition of deflation is a fall in the total outstanding amount of money *and credit* (both
    explicit and available standby credit).

    I used to be on the inflation camp up to the point of it becoming overly fashionable — and when the size of the balance sheet writedowns that would be coming in the US started becoming apparent.

    I simply ask the inflationists to give some reasonable scenario of how we can get to fast/hyper-inflation from here given the absolute shriveling of what had become the de facto high-powered money base of the economy over the last 15 years — conduited mortgage and other asset-backed credit. And in turn, the crumbling and re-sizing massively downwards of bank balance sheets — the money multiplier working is now in reverse.

    Yes, I do understand that the banks and the Fed don’t like that. And give me something a lot more meaty and substantively than “the fed is printing” (when it clearly is mere swapping right now) or the gov’t “wants to inflate all of this away” — no s**t, I understand that. Give me the mechanism of transmission-to-reflation please — we’re exactly up ‘blank’ creek here with the money center banks and investment banks holding on by their teeth in the last year or so primarily because the Fed has not come close to being able to inflate, or more accurately, re-flate the debt and the asset markets. Sure, they may have managed to inflate some areas of consumer prices (or maybe the commodity run-up was the remaining encumbered capital in Marc Faber’s metaphorical sloshing bowl of liquidity looking for a home), but w/o out a much more widespread general re-inflation, consumer price spikes generally turn into a zero-sum game — more $$ for gas, food, and electricity means less for everything else, inc. homes, apartments, appliances, cars, clothes, etc.. In this way, consumer price inflation could actually *exacerbate* the deflation in asset and credit markets. I actually think there’s a better argument for the specific specific species of price rises we are seeing (or at least were seeing) to actually be contributing to the downward spiral in asset prices.

    Add to that the fact that a just-burst RE bubble of epic proportions and in your faceness of the current credit crunch don’t usually presage a general inflation of any kind whatsoever.

    Can anyone honestly say right now that there are too many dollars in peoples’ hands out there chasing too few goods (inflation)? Or do you see with your own eyes just the opposite (deflation) — overcapacity everywhere — from the seven local starbucks to your local GM dealer? Is the man on the street hoarding his dollars (deflationary mindset)….or seeking to unload them for physical goods as fast as he can (inflationary mindset) — I think we would all honestly answer these questions the same way.

  34. Anonymous

    Jeff – you ask for a reasonable scenario for hyper-inflation. You then suggest just such a scenario and proceed to dismiss it.

    Go back to the Yves’ quotes of Bernanke and you’ll have your answer.

    While you seem to implicitly dismiss Bernanke’s explicit “promises,” I don’t see room for doubt that *if* the Fed is prepared to stop at nothing, it’s a trivial matter for them (as for the Bank Of Zimbabwe, as one current example.)

    The only somewhat complex scenarios involve the Fed’s preference to help their primary constituency – large financial services companies, the welfare of which they seem to have made indistinguishable from that of the average citizen (a convenient rationalization, albeit a preposterous one.)

    To spell it out for you, if all else fails, Bernanke can print some small change to rent a fleet of helicopters and it’s hello Zimbabwe from there.

    Now of course, he won’t *intend* to create hyper-inlation, but they never do – it’s just an “unforseen consequence” (the good old “whocouldaknode.”)

  35. gregor

    Jeff makes good points. And his questions are even better, as he starts to lean towards the Deflationary case.

    My response: there is enormous, unsatisfied demand for energy, food, and goods–especially in emerging countries. But, this is a global phenomenon.

    Jeff, you have to make the distinction between deflationary pressures, and, an overall deflationary paradigm. One can always find both deflationary and inflationary pressures.

    China and emerging Asia has enormous unsatisfied demand for energy. The power shortages in China this Summer are the worst since 2004. In the OECD, lower income people are seeing the quality of their diet decline. They cannot afford the amount of meat, fruit, and dairy they would prefer.

    The world’s producer’s of oil are exporting less and less oil. They are in a multi-year upswing of domestic consumption. It frankly doesn’t matter that the demand is subsidized. It always will be, until some crack-up occurs. If oil was subsidized in Saudi, Venezuela, other GCC countries at 70.00 oil, you can be sure it will be at 125.00. And higher.

    Deflation in things we don’t need: Cars and Starbucks. Inflation in stuff we do need: food and energy. The hype over the commodity crash is hype. Everything is alot higher than it was a year ago. Corn, Oil, NG, Wheat.

    The inflation/deflation debate has raged for years. The way to answer it is to distinguish between pressures, and paradigms. The housing economy was dumb. That was a dumb investment theme for this decade, and as we can see, there is no long term return on capital from monetizing houses. That asset class deserves to deflate. So does the Consumer asset class. But that is called deflationary pressure. Not a deflationary paradigm.

    The USD cannot strengthen enough to tip the US into deflation. Here is why: if it strengthens, it kills exports, which reverses the USD lower again. If it strengthens and reverses exports, we go into deeper recession, and this economy unlike Japan has no savings. You can’t drop all the current problems on top of the current savings structure, and get deflation. Dropped onto savings, like Japan’s bubble dropped, yes.

    If a person seeks a deflationary paradigm, probably better to look at Europe.

  36. Unsympathetic


    Bernanke lied.

    He’d much rather let deflation happen than hyperinflation, because hyperinflation immediately squicks his managers – excuse me, Wall Street. How? If inflation is greater than the spread between their cost of funds and what they charge, they die.

    Deflation is a good thing for bankers. Yes, it reams citizens (and all levels of government) but ultimately it’s a positive for the banking industry.. because they get cash and assets. Hyperinflation? They get cash, but not enough to repurchase the original asset(s).

    Unless you believe Wall Street is going to act against their own self-interest, bet on deflation. Don’t pay attention to what Bernanke says, pay attention to what he does.

  37. tiger11

    yes obviously the drive is deflation.
    it’s natural and organic economy trying to rid itself of what is fake.
    underlying cause is inequality. all the money in the hands of a few. then the few get unequal power and manipulate the rules of the game.
    since this causes lots of fake jobs that could never survive in a real organic economy, natural economy tries to kill off the fake jobs.
    killing what is fake is way deflationary because there is almost nothing real underneath the majic curtain.
    the government canot stop it only make it worse. you can’t fight mother nature.
    what we need to do is take away all the rules made by the few at the expense of the many like “intelectual property rights” and the like. not bail out what’s fake.
    put the money back in the hands of the people equally so we can start over. actual democracy anyone?
    lets do away with representative democracy and have all decisions made electronically by all of us.
    we would have a real organic economy for a change rather than a
    fake flim flam shell game that colapses.

  38. Text to speech

    If it strengthens and reverses exports, we go into deeper recession, and this economy unlike Japan has no savings. You can't drop all the current problems on top of the current savings structure, and get deflation. Dropped onto savings, like Japan's bubble dropped, yes.

    If a person seeks a deflationary paradigm, probably better to look at Europe.

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