Inflation or Deflation

August 19, 2008

Many prominent and respected pessimists (a.k.a. realists) like Nouriel Roubini are not concerned about inflation, instead they applaud lower interest rates and government intervention as necessary to restrain the chaotic forces of the free market and valiantly battle the ominous perils of deflation. They are right, but only after they are very wrong, let me explain.

Defaulting mortgages will cause house prices to decline, but that’s not deflationary. Remember, inflation is not increasing prices and deflation is not decreasing prices, inflation is increasing money supply and deflation is decreasing money supply. Using that definition, defaulting mortgages are actually quite inflationary, because they result in less dollars being recycled back to the banking system. Falling prices for anything isn’t a problem if money supply is stable.

Of course bankrupt financial institutions are extremely deflationary because new loans will not be issued, but if Bernanke’s rescue plan includes convincing the government to run up massive deficits so he can hand over billions worth of treasuries to every troubled institution in exchange for soiled toilet paper, I’ve got news for you, when you take into consideration how unlikely it is congress will spend any of the money wisely, that’s inflationary. If his plan works and lenders open up the spigots once again, it could even be extremely inflationary.

It’s also almost unimaginable to expect more dollars will help the economy recover without first dealing with the current account deficit, which means once political careers are pegged to this deficit stimulus nonsense we will get more and more worthless inflationary stimulus until the world is so awash with US dollars they become almost worthless, and that’s not just extremely inflationary, that’s hyper-inflationary.

The number of US dollars held by foreigners absolutely dwarfs any potential second, third or fourth stimulus package, if a panic ever developed to spend that money before the US government completely debases the currency it’s pretty much guaranteed nobody will be worrying about deflation. Of course that would also help to bring the current account deficit in line, but not because Americans will have returned to their good habits of the past, but because it will push millions into poverty and result in a massive transfer of purchasing power to emerging economies, ie. Americans will be too poor to buy anything from foreigners.

In that scenario, after years of industry dependence on government handouts, it’s terribly unlikely the bailouts will end before a New Zealand style collapse under the weight of all that debt.

That’s deflationary.