Some False Hope on the Deflation Front

A Wall Street Journal article, “Japan Worries It Faces the Return of Deflation,” contained an argument I found unconvincing:

In the U.S., some economists say deflation may occur if market conditions deteriorate much further and job losses proliferate. But Teizo Taya, an adviser for Daiwa Institute of Research and a former policy board member of the Bank of Japan, says it’s unlikely that the U.S. will experience Japan-style deflation.

One reason: Japan faced an unusual situation, where wages remained stagnant even though companies posted higher profits because they were keeping costs low to compete with rivals in China and other nations.

That discouraged consumers from spending. Wages in the U.S. and some European nations have been rising and higher expectations of inflation are built into the economy. “One, two, three years of recession won’t change that,” Mr. Taya says.

There may be reasons to think the US won’t suffer from deflation, but this is not one of them. The US has had stagnant real wages since the mid 1970s, and inflation has dropped sharply of late as commodities prices have fallen. However, a decline in the dollar or a resumption of agricultural goods inflation (consumers are seeing some effects on a delayed basis because some packaged foods makers held off as long as possible passing on price increases) could revive inflation worries.

Nevertheless we have in fact seen a pattern that in many respects already resembles Japan’s. Our last upturn was the first postwar expansion ever to have less than half of GDP growth going to labor in some form. The normal level is slightly above 605; the lowest in any previous growth period was 55%. The latest stats I saw were that the labor share this time was an unprecedentedly low 29%. And what was taking up the balance? Again, like Japan, corporate profits.

The US, like Japan, faces competition from cheaper emerging economy labor and also has a workforce with very little bargaining power. We masked that with massive consumer borrowing, so the average Joe had a rising standard of living without a true increase in income. Now that access to the consumer credit machine is highly restricted, and households are learning how hard it is to pay down debt, they will be less likely to be as profligate even if banks become more generous when the credit crunch is past (and we also have the possibility of the implementation of stricter bank regulations to hinder banks from lending too much to reckless or naive consumers, such as usury ceilings and tougher rules on not letting people borrow more than they can realistically repay).

And the idea that labor can get wage increases during this slump is wishful thinking. My brother works for a Cerberus owned paper mill, one of the lowest cost in the industry. Their contract proposal is for four years with no wage increases, a reduction in conditions that call for overtime, a cutback in health benefits, and an end to the Christmas shutdown (this isn’t a sop, by the way, mills need shutdown for maintenance, Canceling the shutdown is bad operational protocol.). In other words, this is tantamount to a pay cut. I am sure he is not alone.

Now there are reasons to think we won’t have deflation, just not the ones stated in the article. First, the standard prescription for actual or threatened deflation is to devalue the currency, as Roosevelt did. That produces substantial reflation. Second, labor is pushing for a reversal of some of the restrictions on collective bargaining implemented over the last 26 years. If workers do secure more rights relative to management and shareholders, that makes deflation far less likely (they will not, for instance, accept a Japan type situation where corporations reap large profits and employees see no pay increases).

Third, many economists believe that deflation can be averted. Jim Hamilton gives a typical argument:

Some of my colleagues still talk of the possibility of a liquidity trap, in which the central bank supposedly has no power even to cause inflation. Their theory is that interest rates fall so low that when the Fed buys more T-bills, it has no effect on interest rates, and the cash the Fed creates with those T-bill purchases just sits idle in banks.

To which I say, pshaw! If the U.S. were ever to arrive at such a situation, here’s what I’d recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we’re at it! Print an arbitrarily large quantity of money with which you’re allowed to buy whatever you like at fixed nominal prices, and the sky’s the limit on what you might set out to do.

Of course, the reason I don’t advocate such policies is that they would cause a wee bit of inflation. It’s ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we’re flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.

I am not at all certain that solutions are anywhere near so simple. One clever reader called Hamilton’s remedy equivalent to saying you could cure cancer with a bullet to the head. And I suspect that observation is correct. There are conditions where the cure for deflation may be every bit as unpalatable as the disease.

But the broader point is our experience with deflation in the modern era is limited (mild deflation was common in much of the 19th century, and England also had a short and nasty episode after World War I) and generalizations should probably be made with a great deal of caution.

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  1. River

    Yves, I have a difficult time understanding the mechanisim that would be used in a devaluation of the dollar since it is an entirely floating currency; ie, not backed or pegged to any other currency or commodity.

    From Wiki: ‘Executive Order 6102 is an Executive Order signed on April 5, 1933 by U.S. President Franklin D. Roosevelt “forbidding the Hoarding of Gold Coin, Gold Bullion, and Gold Certificates.” It required all persons to deliver on or before May 1, 1933 all gold coin, gold bullion, and gold certificates owned by them to the Federal Reserve. Under the Trading With the Enemy Act of October 6, 1917, as amended on March 9, 1933, violation of Executive Order 6102 was punishable by fine up to $10,000 ($166,640 if adjusted for inflation as of 2008) or up to ten years in prison, or both. Because of this forced immediate sale of gold to the Federal Reserve at the government set price of $20.67 per ounce, this Executive Order is often referred to as the Gold Confiscation of 1933. Shortly after this forced sale, the price of gold from the treasury for international transactions was raised to $35 an ounce; the U.S. government thereby devalued the U.S. dollar by 41%.’

    Perhaps the problem is that we are really discussing a possible depreciation of the dollar, not a devaluation of the dollar?

    ‘Devaluation is a reduction in the value of a currency with respect to other monetary units. In common modern usage, it specifically implies an official lowering of the value of a country’s currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency. In contrast, (currency) depreciation is most often used for the unofficial decrease in the exchange rate in a floating exchange rate system. The opposite of devaluation is called revaluation.

    Depreciation and devaluation are sometimes used interchangeably, but they always refer to values in terms of other currencies. Inflation, on the other hand, refers to the value of the currency in goods and services (related to its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation.’

    ‘Currency depreciation is the loss of value of a country’s currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system. It is most often used for the unofficial increase of the exchange rate due to market forces, though sometimes it appears interchangeably with devaluation. Its opposite is called appreciation.’

    Great post and thanks for taking up the discussion of this subject.

  2. Yves Smith


    Agreed my use of terms could have been more precise. Currency devaluation is a standard remedy for deflation. The question then becomes whether and how the Fed puts it into effect. And merely doing nothing might be sufficient, since (with our large current account deficit) the dollar needs to fall and had been on that trajectory for the last few years.

    My view is the dollar will fall once the acute phase of the crisis has passed. But given that AIG is getting more dough, and the housing market is still a ways from bottoming, the acute phase could persist for much longer than most expect.

    The reason for continued dollar strength is only in part flight to liquidity/quality, but also in large degree due to unwinding of dollar based funding. This mechanically resembles the unwinding of yen-based carry trades, but the triggers for the unwinding are different.

    Now the fall could start sooner (for instance, if the Chinese make big noises at the confab on the 15th about the need to replace the dollar as reserve currency). Note the Chinese also are lobbying (if I read their demands correctly) for a fixed currency regime.

  3. EvilHenryPaulson

    The dollar will fall within 6 months.

    The reason? The only way to make money in this market is by reversing large shifts that made money earlier to state it in lay terms

    The markets do not have to face any reckoning of production and trade flows until early next year, and until then financial flows rule the roost (or as you put it the acute phase of the credit crisis)

  4. River

    Yves, thanks for your response and I certainly agree with your observations.

    I do not believe that China will be successful in getting a fixed currency regime. China’s economy is slowing rapidly and they face possible social unrest, as do many other countries with rapidly increasing unemployment. As you know China has recently proposed what amounts to a barter system with Russia for trade, one way of circumventing dollar hegemony. We might see more of these types of agreements between countries in the future.

    I have my own thoughts about what a successful world currency would be but central banks will not permit any non Keynesian solutions at this time. Any solution that would limit the power of CBs to manipulte fiat currencies will be met with derision…untill CBs hang themselves with the long rope which they have been provided. Perhaps the Keynesians will be swept away in the ongoing train wreck?

    I sometimes wonder if the current economic crisis was not engineered to cause a currency crisis leading to greater dollar hegemony, perhaps even the dollar as a world currency? I always doubted the success of globalization as long as a patchwork of individual currencies existed…Probably just my naturally conspiratorial nature at work :)

  5. mr. magoo

    How about a US government that hasn’t a hope of paying its debts, some $62 trillion worth and rising daily. It will run up more than $1 in ’09 alone. What does it do when it can no longer sell its bonds, a day that is fast approaching? It has only two choices, default or inflate.

  6. Richard Kline

    So EvilHenryPaulson, ‘preciate that link to Andy Xie’s analysis; it is excellent, and the tightest capsule of the big picture I’ve seen anywhere. I agree with him end to end. I took the liberty to snip a mouthful from Xie:

    “Central banks around the world cut interest rates last month, despite high inflation, hoping to boost demand. This will, in all likelihood, merely lead to greater inflation. Rate cuts stimulate demand by encouraging borrowing, but they can’t work magic. With household balance sheets so damaged, credit demand will only return when households are again on a sound footing.

    Weak demand, however, won’t erase inflation. First, energy and food prices remain elevated due to supply and demand issues – demand in the ex-Soviet bloc is rising rather than falling, and demand among oil exporting countries is especially strong. Second, manufacturing prices won’t fall. Ten years ago, as multinationals moved factories from developed economies to China, prices converged towards China’s production costs. But, now China’s costs are rising, and its production capacity is shrinking, both of which will cause prices to rise. Third, IT is fully integrated into production costs.

    The dollar’s strength has also had a big impact on commodity prices. Many speculators have invested heavily in the “long commodities and short dollar” trade. As the dollar strengthened, they unwound their positions in commodities too, causing prices to tumble. As I argued above, though, the constraints on the supply side and demand in emerging economies will favor high energy and agriculture prices for years to come.

    . . .

    As the technical factors run their course, speculators will come back into energy and gold. Real interest rates are already negative, and rate cuts could accentuate this.”

    Much, much more in Xie’s cogent remarks. I put this in to highlight his conclusion that manufacturing costs are unlikely to fall. I would add that _wages_ are also unlikely to fall significantly in nominal terms. This is the major underpinning to the deflation argument, that surging unemployment will lead to wage levels being undercut, driving a deflationary spiral. Governments understand this too well, and they are going to stimulate and directly intervene to put a floor under the wages of those employed. Asset price declines will drag down demand, but won’t end demand, and moreover won’t drag down costs. The most likely scenario to me is stimulus chasing costs in an initially slow inflationary spiral which will be exacerbated by eroding currency values. In real terms, inflation will erode spending power, however.

    Over the last eighteen months, I have heard more pure nonsense on the inflation/deflation? topic than anywhere else. Nice to have this well put by someone who has thought things through for once. And btw EvilHenryPaulson, if you are inclined and at liberty to do so I would be interested to hear your summary of the Nomura presentation.

  7. River

    Default or inflate?…

    There exists a ‘sweet spot’ for the economy that works well for creditors, and ok for debtors. The sweet spot is about 2% per annum. 2% will discourage savings and encourage consumerisim.

    Lower inflation, disinflation or deflation hurts all but those who are in cash. The creditors watch as assets that they have financed decrease in value. Friends of Paulson are hurt so this must be avoided.

    Higher inflation or hyper inflation hurts creditors a great deal. Debtors pay off their debts with dollars that have decreased in value since the loans were granted. Friends of Paulson are hurt so this must be avoided.

    Anytime the Fed is required to set interest rates out of the sweet spot they become unhappy because friends of Paulson are being hurt and their phones are ringing off the hooks. Afternoons on the links are impossible. Friends of Paulson have all the phone numbers that we mere mortals do not have.

  8. Matt Dubuque

    In terms of wages, which are a key component of inflation expectations, keep in mind the historical big picture. Turn off the TV and think of the BIG trend.

    The US exports a lot of airplanes. This is a critical export industry.

    The median wage at Boeing is around 30 dollars per hour.

    Let’s assume the median wage in Chinese aircraft manufacturing is $1.25 per hour, WITHOUT medical benefits.

    We can say that this median figure for Chinese aircraft manufacturing wages has risen sharply from $1.00/hour a few years ago.

    Still, ASSUMING the average wage at Boeing falls to TWO dollars per hour, we are STILL dramatically overpriced in this wage market because of the medical benefits.

    Downward mobility.

    The Americans don’t get it.

    The Chinese do.

    Matt Dubuque

  9. jomama

    Right now I’m sticking to my hypothesis that there aren’t enough printing presses on the planet to keep up with $ destruction.

    That say’s nothing of the Liquidity
    Trap even if they find those presses.

  10. Dr Deflation

    Oh yes – income trimming is in full force! At my high-tech company, one which you would think is relatively immune, they severely cut benefits on the stock purchase plan, and cut the results bonus (company does well – you get a bonus) by 30%. The reasons cited were that we were over competitive.

    Regarding deflation, one problem I have is how confident everybody is that we can deflect it. The U.S. regularly enjoyed bouts of deflation pre WWII, and sure we avoided it post WWII due to a baby boom, technology boom and credit boom. But is it really that easy in the crackup after all that?

    Say that millions of Baby Boomers realize they have, on average, a mere $46k for retirement, and we have a system with seven time (IIRC) the amount of debt that is the norm for a functioning economy. Can one committee with a printing press so easily fix that?

  11. SlimCarlos

    @ Yves:

    >> But the broader point is our experience with deflation in the modern era is limited… generalizations should probably be made with a great deal of caution.

    Agree entirely. And our experiences with inflation are rampant. There is just about no issuing country today that has not seen its currency either massively devalued or blown away altogether. Most issuing countries have seen their currency detroyed on several occasions.

    >> One clever reader called Hamilton's remedy [of printing money] equivalent to saying you could cure cancer with a bullet to the head.

    Here I disagree. Destroying the money is not the same as destroying the economy. Indeed, right now the money is destroying the economy, and this is untenable, for it puts the cart before the horse. Money should/must be at the service of the economy, not the other way around. The good folks at GS won't like this, but, well, screw them. With a robust economy one can always bootstrap a means of exchange. With no economy, there will be nothing to exchange. Your choice.

    @ River:

    >> I have a difficult time understanding the mechanisim that would be used in a devaluation of the dollar since it is an entirely floating currency; ie, not backed or pegged to any other currency or commodity.

    Yes, we do have a paradigm problem, don't we? In '33, there was an external reference metric for the dollar which allowed for devaluation. Now the dollar is the reference system. In this mindset, “changing” the dollar is like “changing” the meter or the mile. It is difficult to get your head around, isn’t it?

    That having been said, the fact that there has been no external reference system for the dollar substantially contributed to the clusterf*ck we now find ourselves in. Credit growth spiralled northwards, but how to measure sans reference frame? I mean, the numbers seemed big, but who was to tell? And if you can’t tell, you can’t control, can you?

    My strong sense is that the monetary system on the either side of this thing will look very different to the one we have now. It will be less political, more stable and provide some mechanism for natural disipline.

    Oh, and that the dollar as we won’t it likely won’t exist.

  12. tompain

    Hamilton’s argument seems pretty bullet-proof to me. If the government wants inflation, it has absolute power to make it happen. Those union workers can be given nominal wage increases that leave their real wages stagnant or even shrinking.

    Is this a bullet in the head as a replacement for cancer? I don’t know the answer to that, but I do know that the reason we have no experience with deflation in the modern era is that it has never occurred since we’ve been off the gold standard. It won’t occur now either. The incentive for the government to print more money is simply too strong – and the government is already moving in that direction. Inflation is a sure thing. It’s just a matter of time.

  13. River

    SlimCarlos said…’My strong sense is that the monetary system on the either side of this thing will look very different to the one we have now. It will be less political, more stable and provide some mechanism for natural disipline.’

    SC, I certainly hope you are right in your prediction, but the Keynesians running central banks around the world will not give up without a terrific fight.

    Whenever I have considered the problem of who should be in charge of a hypothetical ‘world currency’ I come up with a blank. Perhaps a committee of economists from various countries? A group could end in deadlock when an important decision had to be made, so, then what? One very wise person; ie, Solomon? But who picks the wise one?

    For a start enforced regulations to stop asset bubbles from forming would help.

    In the past economic quandries were sometimes settled by nationalism, trade barriers, tarriffs, and wars. A better solution must be found. I wish us all good luck.

  14. Anonymous

    Good thinking Yves.

    This banking system relies on consumers demanding credit (debt) with its associated interest (servicing the debt).

    This banking system also projects (long term) the currency value to zero by inflating to infinity. Deflation periods are only momentary hiccups along the way until liquidations occurs causing a reset or start-over in the somewhat failed banking system.

    So, with less or no consumer (domestic and/or worldwide) demand for more debt the banking system comes to a screeching halt. In steps the Treasury to take the place of the consumer’s demand for debt to keep the banks functioning.

    Taxpayers, investors, dollar holders pay the service fees without even consuming as the printing presses run to produce currency needed to service the debt.

    All this is known and the US debt will be isolated to the domestics while foreign entities struggle with forming the next Ponzi……er, I mean financial system. Bartering between foreign countries in just the outer fringes of isolating and avoiding US debt.

    [Feel free to correct me if I’m wrong]

  15. Anonymous

    I am not so sure why deflation is a problem, nor why inflation is preferable.

    ISn’t capitalism supposed to bring the promise of cheaper goods? Why then is swo much of policy designed to prevent this from happening.

    What am I missing here?

    This is an honest question. The argument about deflation has always confused me.

  16. cent21

    I think it’ll be stagflation – that is, we’ll default on the bonds, and inflate on the way to trying to prevent that.

    It’s a question of solvency. We’ve over-spent and over-invested, and done it with leverage. We’ve had easy money along the way that pumped up asset prices. So, we’ve got a combination of a busted tulip mania with recession that’s on the way to becoming a depression.

    I think there might be some way for governments to take steps to keep consumption and production moving, after all, the economy has established it is able to run at a certain level of activity as long as we don’t push past commodity limits. In terms of human capacity, we’ve got more than can be applied. But how to do that within our orderly structure of capital investment at the moment, I’m clueless. I’d guess the trick is finding the razors edge and sitting on it lest we fall off either side, but then I suppose we risk being sliced in two.

  17. marksparky

    My understanding is that deflation (or perceived deflation) intensifies a recession–people think there money will be worth more in the future, so why buy now? This further depresses consumer spending and trade. Nobody can sell anything since it will be cheaper next week.

  18. SlimCarlos

    @ River:

    Just Googling about today and I ran upon the following article. Which is good, for it saves me the ignominy of being the one to suggest a new monetary order backed by gold, which, however loopy by today’s standards, would in fact be apolitical, stable and provide natural discipline. So I am glad someone else said it…. (ha ha).

    Gold, greenbacks & the G-20

    By John Browne
    Sunday, November 9, 2008

    This coming Saturday, leaders of 20 top economic core nations (the G-20) meet in Washington. Invited by President Bush to discuss the world's financial crisis, hopefully they will address the necessity of a new world monetary order to counteract the failing faith in paper money.

    Near to the forefront of policymakers' deliberations will be the role gold should play in any lasting solution.

    ….. [snip]

  19. River

    SlimCarlos…Agreed. I cannot say what I think for fear of being accused a gold bug…which brings heaps of scorn instantly.

    Gold would relieve the world CBs of most of the problems of fiat currencies and manipulation there of. It would also relieve the CBs of most of their political and economic powers…so, they will continue to fight it. Imo, gold will be chosen in the final analysis because it will require fewer mechinations from a possible ‘world currency committee’. After all, there are not many ways to manipulate gold compared to fiat currencies.

    Interestingly, both China and Russia have been busily and quietly accumulating large hordes of gold. I think the SCO member states saw the handwriting on the wall long ago…but I have a conspiratorial nature :)

  20. SlimCarlos

    @ River:
    >>Agreed. I cannot say what I think for fear of being accused a gold bug

    I deny any implication that I may have any gold bug leanings and resent the suggestion with force!!

    That said, from a sober distance, a return to a gold-backed monetary system would satisfy all requirements now missing from today’s system, a syatem which amounts to a pornographics exercise in buggar- thy-neighbour practices. Apolitical, naturally constraining excess, stable.

    It won’t come easily, as you say, for the vested interests are entrenched. But any walk down the lane of monetary reform can avoid the topic only with effort. The writing is already on the wall, even if it is concealed by three and a half decades of now worn paint.

    But I am not a gold bug!! Let me make that absolutely clear!!

  21. Anonymous

    marksparky said: “My understanding is that deflation (or perceived deflation) intensifies a recession–people think there money will be worth more in the future, so why buy now? This further depresses consumer spending and trade. Nobody can sell anything since it will be cheaper next week.”

    So what would we do in the meantime? Not eat? Not rent a house? Not buy gas for the car?

    I am still befuddled. I have thought about what you said myself, but I still come back to the conclusion the world would not end if there was deflation. In fact, with gradually declining prices, wage pressure would fall – at least that is what seems to me should happen.

  22. SlimCarlos

    @ River:

    And just to prove I am not some lunatic gold bug, see this:

    With gold futures prices fluctuating from $253 to $1,034 an ounce during the past nine years, pegging currencies to bullion “would probably not produce the price stability that the advocates of the gold standard seek,” Frederic Mishkin, an economics professor at Columbia University’s Graduate School of Business and a former Federal Reserve governor, wrote in “The Economics of Money, Banking and Financial Markets.”

    Gold Standard Is Wrong Salve for Global Ills:>

    See? Now, the lunatic gold bug may counter that it was not so much the gold price that fluctuated wildly over the period mentioned, but rather the unhinged dollar. It’s difficult to say. But the lunatic gold bug may, as he grips you by the collar and presses you up against a wall, demand that you look at the margins of gold mining companies. “These haven’t really changed for years,” he would say. “Put differently, the value of gold as compared to inputs needed to mine it, namely, oil, steel, chemicals and labour, have remained fairly steady. So what’s bouncing up and down? Gold? Or the dollar?”

    Loopy thinking to be sure. Along similiar reasoning, look at the Euro — it has erratically varied from about 65 to 145 against the dollar. Why would any European country want to hitch their wagon to that team of horses? Obviously — the Euro is unstable and thus unreliable as a monetary anchor.

    Of course the dollar hasn’t fluctuated at all over this period. Ten years ago it traded for a dollar and, guess what? It still trades for a dollar.

    What a great system.

  23. Anonymous

    What you guys really want is ‘controlled growth’. Greed hates controlled growth. Limited inflation dependent on population growth (2%-5%} doesn’t allow for banks to make obscene amounts of profit and that is a non-starter.

    This banking system is made to inflate (compounding interest) until it implodes like it is doing now. There is no other possible ending without starting a new monetary system.

    They took the ball and chain off of the US$ when they removed the gold backing leaving dollars to be printed at will.

    Then Brent Woods allowed debt expansion worldwide.

    Now, there is not enough gold in the world (gains of sand for that matter) to back the outstanding debt. Gold backing might work between countries’ central banks (trade) but not as general currency at this time.

    After inflation you get the ultimate deflation….which is liquidation.

  24. Anonymous

    I vote for BOTH inflation and deflation.

    I can hear the printing presses running from my porch. 1 Trillion to Imperialism in Iraq plus 2+ Trillion to financial fascism assures inflation is bearing down.

    Deflation is also upon Americans because we have been shielded by our position in the world to not really have to compete on cost. I doubt that this will continue as musch going forward. We (as a country and as individuals) are essentially bankrupt. Our abuse of the dollar as the Reserve Currency is about to end, rightfully so.

    Where are the consequences for the people that made this happen?

  25. Juan

    anon 4;12,

    Turn it around. Think of deflation as one _consequence_ of recession/depression, a phenomenon deriving from the latter and, through its effects on rate and mass of profit, taking on the character of cause.

    At least so early as the bullionist controversy of the late 18th – early 19th centuries, we have had notions of money determining price (and within modern policies, money determining the economy) no matter that these ignore surplus value creation relative to total capital or one-sidedly imagine the demand side to be determinant.

    Still, even within the postwar era of demand management we can see that the rate of price increase drops during recessionary episodes, i.e. deflationary pressures, while mitigated, have remained an inherent part of the cycle.

    So perhaps we should consider the limits to mitigation, especially when – owing to multi-cyclic accumulation of debt, tendentially weaker rate of profit, expansion of unproductive labor, etc – mitigating policies may no longer be particularly effective but instead exacerbate.

  26. Richard Kline

    So Dr. Deflation, there were indeed regular bouts of deflation in the US pre-1941. Why? Monetary policy was controlled by a de facto cartel of NYC banks whose policy was a notably contractive, hard money program. They rationed credit to their friends, and starved or froze out ventures in which they had little stake at the first whiff of inflation. Capitalism, as we see from this program, is _not_ designed to make goods cheaper but rather to enforce a positive return on capital. —But that was then: post-1941, the US has had a policy of permanent low inflation interspersed with bouts of genuine inflation. The banks went along with this because the Fed has always manipulated spreads to give them a positive number, and pumped them liquidity to try their luck in the Casino. But this is part of why the banks have no interest in lending to the real economy in a pinch as opposed to funneling their throughput out into speculation: they get little positive return on lending to the real economy at neg real rates.

    So Matt, buddy . . . the craft unions at Boeing have just been going through a nasty and prolonged negotiation with management this Fall. Result: Their nominal wages did not fall. Did you even look at this before making the analogy? I’ll take facts on the ground over a plausible argument any day. Like other firms, nominal wages will stay much the same until and unless the concerns go broke—at which point the Guvmint will bail them out. The threat to wages at Boeing lies in the fact that the US airline industry is essentially insolvent, with other carriers elsewhere not far behind. But these will not be allowed to fail, and throughput will continue, if at lower levels. YIelding slightly fewer workers. Making the same nominal wages shrunk by the pervasive inflation which follows from endemic bailouts. The new lot in Congress will push the minimum wage, unemployment benefits, and ultimately will guarantee pensions in return for a longer vesting period, i.e. work until 70, but perhaps with a decline in hours costed in. All of that will prop the floor under nominal wages. Which is the point.

    The world will not be returning to gold so long as the state system is functioning, and there is nothing in this crisis which endangers the latter. We are more likely to get something on the order of a multi-national World Bank which periodically sets a ‘policy basket’ of relative valuations, with some mechanism such as Neo Special Drawing Rights as the signaling medium. This will not be important most of the time for any actual lending but rather as a signal to private capital as arbitrage targets. And private capital will take it by and large for the sake of stable rules at the Casino. If won’t work well, but nothing of this complexity ever does. It will work at least as well as what we have seen _IF_ private capital punishes national currencies which stray too far from target. With several major currencies internationally, there will be enough money moving to make punitive flights possible. Eventually, we’ll get a new first amongst equals, and a tacit peg will develop. Sure, it could be a rebuilt dollar; it could as easily be something else. That seems the most likely scenario, to me.

  27. Richard Kline

    Fiat currencies . . . Look, fiat currencies do pose systemic problems. This is undeniable. Find a system that doesn’t. Gold standards are long-term moderately deflationary, which is not a viable macroeconomic modality as long as we have positive population growth. Fiat currencies if managed with some perspicacity are vexatious but no more so than the alternatives. The problem isn’t that one has an acceleratior; the problem is that the idiot behind the wheel drives 90 mph in a 30 mph zone.

    ‘Growth’ is a tricky process. I’m not saying that _I’m_ all for it. But governments with citizenries who vote will find a way to be for it so long as that condition holds. Totalitarianism can enforce a gold policy; is that the alternative proposed?

    That 29% share of profit growth to the citizenry cited by Yves has been a big part of the problem. The citizenry got themselves played for blind suckers by the hard right, and we have all gotten what they deserved in consequence. Darn that dream. A moderately inflationary policy, if problematic, is moderately stable so long as throughput is distributed rather than concentrated. There is a policy prescription. Not my preferred, but the one we are most likely to get.

  28. Edwardo

    Hello Richard,

    I enjoy reading your analysis on these matters, and I thought I’d offer that your following comment…

    “The world will not be returning to gold so long as the state system is functioning”

    is itself worth commenting on if only to say that, as per the work of John Robb of Global Guerillas, the state system will not be functioning in a manner that should give comfort that the world will not return to gold.

  29. River

    edwardo…Jon Robb? Yeah, the guy has an interesting take on what is happening.

    Jon said that states are being hollowed out by overt thugs and covert thugs. Also that the state as an institution will become an entity that does little for it’s populace.

    Observing what is ongoing right now in the US I have difficulty disagreeing with Jon. The crooks are in charge and no one is doing a damn thing about it.

    We all post comments about what the future will hold based on the assumption that the crooks will go away and someone with some integrity will replace them…But, we have no reason to believe that, do we?

  30. SlimCarlos

    @ Richard:

    >> The world will not be returning to gold so long as the state system is functioning, … We are more likely to get something on the order of a multi-national World Bank which periodically sets a 'policy basket' of relative valuations, with some mechanism such as Neo Special Drawing Rights as the signaling medium. … It will work at least as well as what we have seen _IF_ private capital punishes national currencies which stray too far from target. …

    No doubt they will first try something like this, but stability will not be forthcoming — multi-polar systems rarely are. It will be a race to the bottom and the only way “private capital” will be able to “punish national currencies which stray too far from the target” is to take their kit bag away from paper money altogether. Which is likely what will happen over the medium to longer term. And where will said private capital go? Among other places, gold.

    So states will have their hands forced. Won’t happen tomorrow, but it will happen. The reset button will get punched.

  31. Mencius Moldbug


    What’s the reasoning behind your argument that population growth requires monetary dilution, ie, growth in the money supply?

    I know a lot of people think this, but I don’t really know why. Does it just strike you as obvious? Or is there some specific line of reasoning? In particular, are you familiar with Mises’ argument that any supply of money is adequate?

  32. Anonymous

    Deflation is not well understood, it is not a purely monetary problem, nor can it be cured by simply printing more money.

    Deflation is very much a contraction of actual economic activity, which means then there is less work, less ability for people to buy, and thus the great production levels of a year before become extremely problematic, as they start creating surplus and thus driving down prices no matter how much money is in the Treasury, Fed, or the entire banking system.

    This is why Keynes solution was to put people to work, not print money. His point on money was that the lack of should never be reason for stunting any viable or even non-viable economic activity. That’s problematic for a lot of reasons today, but the thing to take away is deflation is not simply a monetary phenomenon, thus it does not have monetary solution, though after 30 years of monetarism triumphant, no one can yet get passed it.

  33. Anonymous

    Richard Kline said: “I’ll take facts on the ground over a plausible argument any day. Like other firms, nominal wages will stay much the same until and unless the concerns go broke–”

    Richard, In Michigan with unemployment rising there are plenty of people here that are accepting less pay to keep customers, myself being one of them. Wages will be driven down before a company will go broke. Ford recently laid off or bought out 125,000 workers averaging $28 dollars an hour to be replaced with 70,000 workers making $14 an hour as another example for the point Matt Dubuque makes.

    Firms don’t go broke without reducing wages first.

    Matt Dubuque is right. Wage competition is here and it is deflationary.

  34. SlimCarlos

    @ anon (8:22)

    >>Deflation is very much a contraction of actual economic activity, which means then there is less work, less ability for people to buy, and thus the great production levels of a year before become extremely problematic, …

    No, this is incorrect. Deflation is a general decrease in prices.

    Fact is, most contraction in economic activity are coincident with inflationary tendencies, this as the gov’t prints money, usually in vain, to expand economic activity.

    Economic contraction is economic contaction. Deflation is deflation. Conflating the two, as is often done, does not further the discussion.

  35. Anonymous

    i didnt say economic contraction was deflation, I said deflation was primarily economic contraction caused by demand, not supply.

    Monetarism does not define or even help understand much of what we call economics, which were all going to have very good lesson about.

  36. Edwardo

    Yes, river, John Robb. Indeed, there is no reason to think that the wave of egregious criminality will come to an end anytime soon. And not to bring politics into this discussion, but the folks who appear to be, how can I put this delicately, “mentoring” the President-elect, appear, with few exceptions, to be the very same grifters that delivered us unto our present desperate circumstances, Bob Rubin or Rahm Emanuel anyone?

  37. Anonymous

    College costs next year will be higher. Medical and insurance costs will probably be higher. How about gas and electric bills- are any of you expecting a big cut in your monthly bills next year? The assessed valuation of your house in 2008- was it WAY lower than in 2007 and will you be paying WAY less property taxes next year? What is your expectation of state and local income and sales taxes- will you benefit from a decrease in 2009? And honestly, is there any major packaged food item at the grocery storye that you expect to drop in price in 2009? Other than gasoline and real estate, I cannot see deflation at the level of the individual, even when the economy is sinking.

  38. Richard Kline

    So Edwardo, glad you find some of my remarks ‘chewable’ at least. : ) I haven’t read Robb, and I might find it interesting to do so supposing I had the time. But I could not disagree more strongly regarding the immediate future of the nation-state as an insitution: the present crisis _strengthens_ the state rather than weakens it. Really; think it through. Look at all the bailouts, and spend-a-thons we see and see called for. The state is expected to and will take up the economy as its principal brief. Where are all those bands of rugged individualists yearning to strive free? Huddled in their cubicles, hoping that the ‘assembly email’ doesn’t come to their inbox, that’s where. I may dislike the nation-state as much as and more than they next person, but it is purest wish fulfillment to opine that this crisis will do it in. Sorry to be the first to pass that on.

    Institutionalized nation-states are surprisingly robust. When, seldom, they fail, they do so because of intractable factional quarrels, typically between either sections of the elite or irreconcilable ethnic constituencies. Do you see any of _that_ in the offing in the US? I certainly do not. Consider the election that we just had in the US. One faction lost big time, they are about to be kicked out of power, and all that bad-liquor blather about ‘martial law’ and etc. will prove to be so many misaligned pixels. Rather than mobbing the plutocrats and bankers, the great unwashed are fawning over the New Fresh Prince, hoping that he mana of his personal majesty will suffuse the present gloom. Or something. We just saw a vote for a new face on old policies, and that’s not Revolution #9 is what it’s not.

    SlimCarlos, I certainly agree with you that multi-polar systems are unstable and do not succeed for any length of time. There is a case that could be made that a system of six relatively comparable poles would be stable, but for things such as national economies whose status changes so rapidly no such organization would last. We have seen bipolar political systems form which are quite stable on the time scale of political systems. Interestingly enough, it is unlikely that any (quasi_ monopolar political system is stable; certainly we haven’t seen that option.

    What that means for a currency regime is harder to judge. In my comment above I indicated that, like you, I expect a multi-currency basket to be tried, but to break down. Unlike you, I expect it to break down into a tacitly newly designated reserve currency. The euro has to change to be a good candidate, but that has long struck me as the most likely outcome; this is far from assured, though. I would place no bet on the timeframe or pathway to the outcome I just described except that I would expect a designated reserve currency to be stable and understood within ten years. If would be interesting, however, if we had a bipolar reserve currency regime. I don’t know whether this would be possible to achieve, but offhand it might be stable.

    It is a long argument regarding why gold doesn’t hold water; I don’t have time to do it justice. But here are two morsels to knosh on before you spit them out. First, there isn’t enough of it. Gold would be a cormorant collar on ‘growth.’ Not that I’m a staunch partisan of growth, but every trained economist in the world is. This was one of the principal reasons it was abandoned, and central reason why it will not be readopted in any functioning industrialized economy. Second, finance has everything to do with throughput: the key is to get volume up, and siphon off your share. Wall Street doesn’t give a damn about the base as long as money moves and the check clears. This is why ‘digitized drachams’ are so much in their interest. Gold sitting in safes is _not_ money in motion, and as such it is directly inimical to the interests of all speculative investors, invested speculators, and government fiscs. Real wealth in a modern economy isn’t owning a thing, it is occupying a node with high volume throughput of stable high value. Wealth holders in modern economies grasp this; gold holders do not. Wealth holders will do all they can to reproduce systemic conditions which keeps them holding nodes and throughput going through. Just chew on that, is all I’m asking.

    Mencius Moldbug: “What’s the reasoning behind your argument that population growth requires monetary dilution, ie, growth in the money supply?” I never said that; go back and read my comment I suggest. It is unfortunately typical, guy, that you either misread or misquoted what I said; I’m not saying that to harsh on you, but it’s something you might want to consider. If a community has population expansion, there has to be output expansion or living standards generally fall. We in the US have chosen moderately inflationary stimulus to ensure a modest overshoot in economic expansion. This is not a monetary argument in any way: For the record, I think that most monetary argument occupy a collapsed conceptual space between the misinformed and the silly because they discuss one facet of a multi-faceted process—economic activity—which can only be represented with even minimal adequacy in a multi-facet form. Money is probably the _least_ important major vector in economic activity for modern industrialized economies; not an unimportant one but the least important one.

    Regarding which, Anon of 8:22 I’m glad to hear you pipe up. The perspective you advance is one I share completely. Deflation and inflation are _aggregate processes in an economy_. They certainly are not purely monetary processes, and they are not principally defined by price movements per se. I just don’t get why folks DON’T get this. Monetary vectors certainly can impact deflationary or inflationary trajectories; if sufficiently massive, monetary movements can be the principal cause in deflationary or inflationary episodes. They are not the only causal vector, and they are not typically the principal such vectors in modern economies. Output and demand are much more relevant. It might be said that money simulates output and demand factors, though money has its own dimensions which complicate its utility as a simulational medium.

    Stupid pre-capitalists print money; stupid acme capitalists balloon credit; ‘smart’ acme capitalists put people on payrolls, even if they have to forcible borrow the money of the wealthy do to so at first. Bunches of ‘smart’ acme capitalists are calling for Keynesian payroll support to prevent deflation, and that is what we are most likely going to have as an immediate outcome. The intermediate outcome is highly inflationary due to the broad macroeconomic context of the US, i.e. we don’t have the dough to pay down the debt such a program will incur, and putative production increases from the stimulus do not look likely to push a tide that high on their own. Longterm, we are headed straight for a major currency and debt crisis. How we and the rest of the world resolve that is far from clear, but will dictate whether we in the US get a stable economy in ten years or a widening series of ‘events.’

    So Anon of 8:26, it may interest you to know that I grew up in Michigan, specifically in Dearborn, where my natural father ran a city department: Ford taxes raised me. I trained as a welder, too, a generation ago, stopped to consider what of it, got on a plane going west from Michigan, and never went back. But not everyone can take my personal solution, what? : ) And btw I’ve never made $28/hr straight time in my life, there or here. There will unquestionably be major rises in unemployment, and those unemployed will have less income than previously. On the other hand, supposing that we get a bailout, there will be far less unemployment than otherwise, and that is the point of my previous comments. Michigan will likely experience deflation; nationally, we likely will not. Inflation and deflation are macro scale processes, which do not determine individual micro scale outcomes. In fact, that has always been a major problem for macro economics: what might be ‘good’ in aggregate is often very much ‘ungood’ for some specific constituencies, who end up taking it on the chin.

    I’m not saying this to wave airily at anyone’s misfortune or bitter choices, Anon of 8:26. My goals lie in getting a clearer representation of the big picture. Supposing that we get, eventually, a significant public works project that soaks up some of those unemployed in construction, that is the kind of thing which keeps the temporarily unemployed in aggregate generating demand and output rather than dragging down demand producing nothing. If the Guvmint bails out the Big Three, that is a fireworks display celebrating inflation rather than deflation as our trajectory; you decide whether that is something to celebrate. I would very much like to see the Big Three broken up into the little Six Plus, with the passel of tyros told to make the best of it. This country used to be good at engineering and industrial design until cartelization and market saturation led management to decide not to invest appropriately in such things. Competition might cure that for some, and the rest are a bunch of losers, what?

    And regarding Obama re: Emanuel, Rubin et. al., Barack is not bringing these guys on board because he needs new ideas but because they represent what he already thinks. He has a stated policy program, readily available to anyone who can read for eighteen months. He isn’t remotely progressive, and will not move voluntarily to anything that looks progressive, economically or otherwise. He’s a wholly owned corporate subsidiary and Wall Street ‘neoliberal’ through and through. Y’all didn’t know that??

    As a final note, over at Paul Krugman’s blog, we have him breathlessly running down historical points bolstering stimulus theory prescriptively for the Liberal Messiah he awaits. *sigh* Now, there is nothing out and out false in what he is saying; indeed, he is running a textbook summary of these issues as only a fluent writer of textbooks could. —But all without the slightest consideration of the overall debt picture for the country, or concerns regarding currency. His entire economic theory space _doesn’t_ include the debt and currency vectors which are extremely relevant to what the outcome of his proposals might be. Stimulating at 7-10% of GDP proceeds very differently where there is a surplus as in China than it would in the US where we have massive and destabilizing debt and a misaligned currency. I am not arguing against stimulus in so many words in saying that, only that a picture which only includes half the information which generates an outcome for what is represented could be called half-witted. Please, Paul, harness the currency and debt to your models and _then_ tell me what you project as an outcome. I’m open to persuasion, but I won’t fight with a man with half his wits tied behind his back.

  39. Simon

    The argument that the Fed can always create inflation by monetizing debt and the Congress is always willing to run up debt by spending more and taxing less is simply irrefutable.

    But it is also true that a Fed which has monetized an enormous amount of debt can then drive interest rates very high to mop up those inflationary pressures once the crisis is over.

    If the Fed is ideologically committed to moderate inflation, then moderate inflation it can and will get. But the cost will be high real interest rates, which will have a very negative long-run effect on investment and thus growth. But then if no one really care about the long-run, that isn’t a problem.

    Many people have the notion that there is something incredibly difficult about the Fed steering between inflation and deflation so as to achieve stable prices with a slight inflation bias. This is not so.

  40. Simon

    I see some confusion above about why deflation is bad. In a perfectly stable system, moderately declining prices are no problem, provided the deflation rate is low enough to allow for positive nominal interest rates. For example, if the equilibrium real interest rate is 3%, then 2% deflation translates to 1% nominal rates. Whereas deflation at 4% is a problem, because nominal rates can’t drop below 0%.

    Modern economists prefer a bias towards moderate inflation, as opposed to zero inflation or moderate deflation, because most economies are NOT perfectly stable. They have ups and downs. If the nominal rate is 1% under equilibrium conditions, then the Fed has no way to lower rates to cope with downturns in demand. Whereas if the equilibrium state is 2% inflation, 3% real rates and 5% nominal rates, then the Fed has plenty of firepower to cope with downturns.

    Collapses in demand are the problem, and deflation is the symptom. Unexpected deflation (as well as unexpected reductions in inflation) increases the effective rate of interest on existing debt, which aggravates the problems of collapsing demand. Most demand in a modern economy is discretionary, and thus subject to changes in consumer moods about the future.. Moods which can change suddenly and violently. Supply, by contrast, cannot change suddenly. So it is essential for someone to even out the changes in demand. Otherwise, the result will be a spiral downwards as employers begin laying off workers, workers stop spending in anticipation of layoffs, employers lay off more workers because of the reduction in spending, more reduction in spending, more layoffs, etc.

  41. Anonymous

    If only we could have real deflation or a true depression, us who hold cash would be in seventh heaven. To me, it seems that so-called “deflation” is increasingly a measure of the loss of asset value in INVESTMENTS. But what about the actual prices you pay and will pay in the mid-term for tangible and necessary items?

    College costs next year will be higher. Medical and insurance costs will probably be higher. How about gas and electric bills- are any of you expecting a big cut in your monthly bills next year? The assessed valuation of your house for tax purposes in 2008- was it WAY lower than in 2007 and will you be paying WAY less property taxes next year? What is your expectation of state and local income and sales taxes- will you benefit from a decrease in 2009? And honestly, is there any major packaged food item at the grocery store that you expect to drop in price in 2009? Other than gasoline and stock/real estate INVESTMENTS, I cannot see deflation at the level of the individual, even when the economy is sinking.

  42. Jeff

    “College costs next year will be higher. Medical and insurance costs will probably be higher. How about gas and electric bills- are any of you expecting a big cut in your monthly bills next year? The assessed valuation of your house for tax purposes in 2008- was it WAY lower than in 2007 and will you be paying WAY less property taxes next year? What is your expectation of state and local income and sales taxes- will you benefit from a decrease in 2009? And honestly, is there any major packaged food item at the grocery store that you expect to drop in price in 2009?”

    Anon 12:51 — actually, you are wrong. Prices are coming down across the board. Commodities deflation is now getting into packaged foods. Restaurants have been cutting menu prices. Year over year college costs have grown the slowest this year than in the last 25 years. Sports teams are holding the line or cutting ticket prices. Wage pressures are now only downward relentlessly. Municipalities are starting to adjust property tax rates — they were a couple years behind the boom in prices in raising taxes and now are behind the bust in prices.

  43. Anonymous

    It is good to be optimistic. On MSNBC today the analyst commented on the anomaly of rising food prices- 6% annual rate as I recall. I have not observed menu prices decreasing, but you may be correct for your area. College costs should not be growing more slowly- this is supposedly “deflation”- they should be reversing. Wages have been going down for years in real terms because of union losses, competition, static Federal minimum wage, and less hours worked. Property tax rates are commonly handled in this manner- if your house was appraised for less than the year before-then the mill rate is adjusted upwards so you pay at least as much as the previous year. We should be paying way LESS property taxes next year if there is deflation. I will not debate the cost of sporting event tickets, but this is inconsequential in terms of annual household expenditures. Thanks for the response, I am not necessarily in complete disagreement with you, but just pointing out that deflation and depression should mean I will have LESS total demands on my pocketbook next year. I doubt I will be so lucky.

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