Inflation or Deflation? The Great Debate Continues

by Crocker on June 28, 2009, 6:46 pm

in Economics,History

Like just about everyone else, I’m trying to read the economic tea leaves and work out a strategy for myself. I’d like to make some money – who wouldn’t? – but my more realistic goal is not to lose any more than I have already.

And the beginning of any strategy starts with a guess in connection with the most basic of questions in our current climate: will we experience inflation or deflation? The debate rages.

Conventional wisdom says that ‘quantitative easing’ and debt monetization by the Fed will inevitably result in inflation. Yet, if the economy is so far in the tank that people aren’t buying and pricing power has evaporated, will it really matter – at least in the short term?

Certainly, this has been Japan’s experience: after a decade of deflation in spite of massive government ‘stimulus’, the Bank of Japan embarked on massive quantitative easing beginning in 2002 in an effort to return the CPI to zero, which it did by 2006. After the bank ended its easing program, the CPI promptly flopped again with a slight rise in 2008 due to the bump in commodity prices. Over the past six months, however, Japan has again lapsed into deflation. The Cleveland Fed has the numbers until 2008 and the charts are worth a serious look. Bloomberg also has good information on the abrupt downward lurch in the Japanese CPI during May.

Will matters be any different here? While I’ve been an inflation hawk since I saw the St. Louis Fed’s chart in January showing the moon-shot increase in the money supply, I’m beginning to have second thoughts. While the Fed’s voyage into quantitative easing creates its own long-term issues, the more immediate trends in the economy are down – as in deflationary.

And small wonder: the federal government is doing its best to crowd the private sector economy out of existence while grotesquely multiplying our national debt – and these are mutually reinforcing activities. Thinking of it as an economic harmonic convergence that will tear the economy apart and destroy any hope of maintaining pricing power in any economy sector.

Both Dr. Housing Bubble and Tyler Durden at Zero Hedge are seeing the same thing I am.

DHB notes that the overall CPI is headed south and most sectors of the economy are headed that way.  Transportation (including the bursting of the ‘auto bubble’), wages and employment, stock market losses are currently deflationary while housing and food have been neutral but are starting to break south. Private sector education is showing price slippage as student loan programs have dried up. Only medical services and federal government wages are going up. His analysis is detailed and convincing.

Tyler at ZH calls out California as the country’s trend setter: with falling wages, imploding government and falling asset values, the outlook is not good. He makes an important point that seems to be missed by most analysts: that inflating commodity prices will further depress the rest of the economy by soaking up available money, which itself will eventually snap commodity inflation as well.

I invite readers to read through the materials at the various links and tell me I’m crazy. If I had to choose between the twin poisons of inflation or deflation, I think I’d choose inflation, which can be controlled with correct monetary policy. Deflation, however, is rooted in a downward spiral that’s both economic and psychological. The only way to combat it is to insure adequate – but not excessive – liquidity while cutting taxes and government spending.

And neither cutting taxes nor reducing govenment spending seems to be on anybody’s agenda.

  • Scott

    Compelling argument, though I still see one missing piece of the puzzle. Unlike Japan, the US is the world’s reserve currency which is very important to the price of oil. If the US economy implodes, the dollar will free-fall causing the price of oil to soar. A falling dollar will mean higher real interests rates which will further squish the economy . . . and so on and so on down the toilet bowl.

    Also, keeping in mind that the CPI fall is currently being driven by lower energy and food prices (which likely correlate highly). A reversal in oil prices will quickly change that dynamic. I still think that a “stagflation” scenario is currently the most likely mid- to long-term outcome. Stagflation is pretty darn destructive too.

    But with unprecedented government interventions occurring almost weekly, I’m pushing up the odds of a different sort of calamity–call it the “Dark Ages.”

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