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Rich Toscano

Rich Toscano

Rich Toscano is a registered representative of and offers securities through Girard Securities, Inc., a registered Broker/Dealer, a Registered Investment Advisor, and member FINRA/SIPC.

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John Simon

John Simon is a registered representative of and offers securities through Girard Securities, Inc., a registered Broker/Dealer, a Registered Investment Advisor, and member FINRA/SIPC.

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The US Government Will Not Choose Deflation

The modern-day monetary system employed in the United States is based on currency that can be created at the bureaucratic touch of a button. In charge of that button is a group of people with a firmly entrenched belief that deflation is the worst of all possible monetary outcomes.

We believe that this state of affairs is simply incompatible with the existence of the type of protracted "deflationary spiral" about which it has become all the rage to worry. Deflation is a choice in the current monetary regime, and it is a choice that our government simply cannot make.

Before we explain our reasoning, let's deal with the definitional problem inherent in this topic. The word "deflation" is used by some people to describe a generalized decline in prices. To others, the word describes a decline in the money supply. The word "inflation" correspondingly refers to an increase in prices or an increase in the money supply, depending on whom you ask.

This dual definition has caused a lot of confusion in the inflation-deflation debate. We don't particularly care which is the "right" definition, but we do think it's important to understand that these are two separate (though related) phenomena. Where necessary, this article will specify which type of inflation or deflation is being discussed. (If no specification is made, then we are referring to both types -- this is a reasonable shortcut given that changes in the money supply are a major causal factor in price changes).

We believe that the current monetary system, political climate, and prevailing analytical framework are incompatible with a prolonged period of either monetary or price deflation. Our thinking is based on two fundamental premises:

  1. That the monetary and fiscal powers that be are extremely motivated to prevent a lengthy deflation.
  2. That they are entirely capable of doing so.

The Government Can Inflate

Let's begin with the second premise first. It should be pretty much beyond argument that in a pure fiat money regime, a sufficiently motivated government can always cause monetary inflation. And a sufficient amount of monetary inflation can always be depended upon to cause price inflation.

To use an example that is extreme to the point of absurdity, but that illustrates our assertion, imagine if the government sent every household in the United States a check for $10 million, with the proceeds to be supplied by the creation of new money by the Federal Reserve. This would by definition be monetary inflation, as the supply of money in the economy would skyrocket. And there is just no doubt that this vast increase in money held by the public would cause rampant price inflation as each household rushed out to spend its newly acquired dollars. It wouldn't matter whether the economy was in recession, or whether the banking system was deleveraging, or pretty much anything else for that matter. Inflation would follow.

If exaggerated thought experiments aren't your thing, consider the following excerpts from Federal Reserve Chairman Ben Bernanke's seminal 2002 speech about preventing deflation (emphasis ours):

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....

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? 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...

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)....

Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral...

Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices...

A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money...

Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets...

Back when this speech was delivered in 2002, Bernanke's policy suggestions for curing a deflation seemed incredibly radical. Today, as we will discuss below, they have largely become the norm.

We do not deny that there are deflationary forces in play, or that a prolonged deflation would likely result if those forces were allowed to run unchecked. Rather, our assertion is that it is well within the capabilities of our government to overcome the deflationary forces should they choose to do so. They have the ability to create money and force it into the economy via multiple vectors. To the extent that their efforts do not overwhelm the forces of deflation, they can do more of the same, to an ever more dramatic extent, until their goal is achieved.

This is simply a fact of life in a monetary regime in which new money can be created out of nothing.

The Government Wants to Inflate

A sufficiently motivated government with a fiat currency system can always inflate. That leaves the question of whether our particular government, with our particular monetary system, in our particular political, economic, and analytical climate, will be sufficiently motivated to cause inflation even if they are forced to resort to the radical monetary policies and open currency debasement described in the prior section. We believe the answer is a resolute "yes."

The reason we can be so confident is that the government (and we include the Federal Reserve in that designation) has already shown that this is so. Chairman Bernanke has already followed through on many of the policies threatened in his 2002 speech. Our monetary leaders at the Fed have:

  • slashed rates to very near 0%;
  • begun a program to monetize (i.e. created new money in order to buy) "large quantities" of mortgage-backed securities and agency debt;
  • lent directly into the commercial paper market;
  • suggested that they will directly monetize Treasuries;
  • taken over or guaranteed the obligations of several huge and bankrupt financial institutions;
  • created various facilities to take assets of questionable value from banks and trade them for Treasuries;
  • created yet more facilities to goose consumer and business credit by monetizing asset backed securities; and
  • nearly doubled the size of the monetary base (the "raw material" of money creation, over which they have direct control) within a few months.

This is in addition to the efforts of the Congress and Treasury, which include among many other expenditures:

  • the infamous TARP program to buy stakes in banks and their toxic assets;
  • expansion of FDIC protection;
  • money market fund guarantees;
  • the automaker bailout;
  • Hope Now and other housing bailout attempts;
  • the now laughably small early-2008 stimulus package; and
  • soon enough, the vast stimulus programs being proposed by President-elect Obama.

According to a New York Times article written in late November, the government had at that point already spent $1.4 trillion and committed $8 trillion. This latter number is equivalent to 58% of our annual GDP (which was $13.8 trillion in 2007) and is almost certain to grow. Whether these are "expenditures" vs. "investments" and whether this distinction matters is outside the scope of this article. These numbers are cited here to indicate the vast magnitude of the government efforts already underway.

It's very clear that our fiscal and monetary leaders are willing to do whatever it takes to head off deflation, and that any rule or convention that gets in the way is summarily tossed out the window to the cheers of onlookers.

What's more amazing is that these radical and exceptionally aggressive reflation attempts have taken place in response to a minor decline in consumer prices and no decline at all in the money supply. The graph below shows that the Consumer Price Index (CPI) has indeed fallen, but that it has neither fallen very far nor for very long.

Moreover, the vast majority of the decline to date has taken place as a result of a sharp drop in energy prices. The next graph indicates that there has not been any notable decline in the CPI net of food and energy prices. We are baffled as to why falling energy prices are considered to be a bad thing for the US economy, but that's a topic for another article. The point here is to illustrate that there is as of yet very little in the way of widespread price deflation.

The price declines so far have been fairly minor and very narrowly based, but they do qualify as price deflation. Monetary deflation, on the other hand, is a no-show. The next charts display the money supply as measured by M2 and MZM, the two broadest measures of money supply provided by the Fed. Both measures show that while money supply growth did flatten out earlier in 2008, it has since picked up again in a robust fashion.

Of course, these are backward-looking indicators, and there are reasons to believe that the economic downturn may exert more price-deflationary pressures in the future. But the violence of the government's reaction to the so-far mild consumer price deflation and a temporary flattening out of monetary growth just goes to show how committed they are to preventing a serious deflation from getting underway.

It's clear why our government is so desperate to prevent deflation from getting a foothold. Conventional wisdom holds that deflation is, to quote Bernanke's 2002 speech, "highly destructive to a modern economy." Further, because deflation increases real debt burdens and can potentially cause people to put off spending, deflation is seen as self-reinforcing. Therefore, the mainstream economic view is that deflation -- being both highly destructive and self-reinforcing -- must not be allowed to take hold, lest the economy be dragged into a deflationary downward spiral from which it is difficult to emerge.

Whether this view is correct or not is immaterial here. Right or wrong, this is the mainstream view on deflation and policymakers will act accordingly. The idea that deflation becomes more powerful and intractable the longer it goes on leads to an extreme policy stance which holds that deflation must be preemptively vanquished at all costs, and that the inflationary effects of such policy are something to worry about later.

Regardless of the economic framework employed, one thing that's beyond doubt is the fact that the US is heavily indebted, with much of this debt owed to foreigners. Deflation hurts debtors by increasing the real value of their debt burdens. Conversely, inflation helps debtors by magically paying back some of the real value of their debt via currency debasement.

For a long time, our policymakers have bent over backwards to soothe any short-term economic pain, regardless of the long-term problems this caused. The monumental stimulative efforts underway are a clear signal that this hasn't changed. In this political climate, it is exceedingly difficult to believe that policymakers would allow a prolonged deflation given that such an outcome would help our foreign creditors while inflicting economic pain on the over-indebted American voting populace. Politically speaking, it's much easier to allow inflation to eat away at the real value of that debt. Inflation is additionally the most politically viable way for the government to pay back its own massive debts without having to resort to tax increases or spending cuts.

There is a powerful combination at work. Mainstream economic pundits, academics, and policymakers are united in their opinion that deflation must be prevented. They are providing a theoretical justification for highly inflationary policy, and right or wrong, this justification is widely accepted as truth. Meanwhile, from a politician's standpoint, inflation is a far more viable and easy path than deflation. This combination of real-world incentive and theoretical justification induces our monetary and fiscal leaders to overwhelmingly favor an inflationary outcome.

The Government Will Inflate

The evidence certainly suggests that the government is extremely committed to preventing deflation. But there is no need to guess, as the sweeping reflationary policy already enacted over the past several months shows this to be the case. The US government will act as necessary to prevent a protracted deflation from taking place. The pure fiat currency system, combined with the prevailing wisdom that deflation must be prevented "at all costs," allows them to do so.

Again, we are not arguing against the fact that there are powerful deflationary forces in play. There are. But a government with a printing press and a virulently anti-deflation philosophy is an even more powerful force.

There are lag times between government action and economic reaction. The deflationary forces may hold sway for a while yet. But as long as that remains the case, the government will respond with ever more desperate and radical reflationary policy. This is because the government and the Fed are reactive rather than anticipatory, as their conduct throughout the credit bubble and its aftermath have demonstrated beyond doubt.

To the extent that their desired inflation is not yet taking place, they will feel obliged to take even more dramatically inflationary steps. They will not stop until they get feedback that inflation is well underway and that deflation has been safely vanquished. By the time that happens, the lag times dictate that it will likely be too late to effectively reverse the inflationary aftermath of their policy.

It's not clear how long the deflation scare will last, but we strongly believe that the longer it lasts, the more extreme the government policy will get, and the more dramatic the eventual inflationary overshoot will be. The deflation thus sows the seeds of its own violent demise.

Under the current system, with the current set of people at the helm, a protracted deflation is not much of a threat. The far more real danger is that the government's extremist policy and pro-inflation bias will lead to a serious loss of dollar purchasing power at some point in the future.


Below we will enumerate some of the typical arguments in favor of a long-term deflationary outcome along with our counter-arguments to each.

Pushing on a String

This objection is based on the idea that you need willing lenders and borrowers to cause monetary and price inflation. The contention is that you can lower the Fed funds rate or increase bank reserves, but you can't make banks lend nor can you force people to borrow. Without willing lenders and borrowers, the money supply won't expand. Further, even if new money is created, deflation will still be the result if everyone chooses to sit on their money instead of spending it (or to put it in econo-nerd terms, if velocity is low).

The problem with this argument is that it presupposes that the Fed will stick to only manipulating the Fed funds rate and goosing bank reserves. We've already seen that this simply isn't true. The Fed is now printing money in order to lend directly into the mortgage market. Once that money is spent to buy a house, it's in the system. The Fed has additionally lent into the commercial paper market, getting money directly into the hands of businesses that wish to spend it, and they are are setting up another facility to monetize consumer credit card and small business debt.

Similarly, if the Fed follows through on its plan to monetize Treasuries, then the government will spend that money into the economy via its stimulus packages. By sending out rebate checks, the government can effectively force people to borrow indirectly by borrowing on their behalf and giving them the money. If it came down to it, the government could issue everyone debit cards backed by newly printed money. But they need not even get the all the money into the hands of consumers -- they can themselves undertake huge spending programs (infrastructure projects, etc.) and become a giant consumer whose activity offsets the decreased consumption of individuals.

These are all mechanisms to get around the banking system and to get money directly into the hands of people or entities who will spend it. The Fed itself is the "willing lender," and the "willing borrowers" consist of businesses, home buyers, consumers, and of course the US government, which will never turn down a loan. The net effect is that the money is forced into the system (increasing the broad money supply) and that it is being spent in the real economy (increasing velocity).

To be clear, we agree that velocity is a major component of price deflation and inflation, especially over shorter time periods. We also agree that velocity has dropped like a rock as a result of the deleveraging, market crashes, and recession. But velocity has a lower limit -- people need to spend at least some money to live. The printing press, when wielded by a government that is firmly committed to inflation, has no upper limit. There could definitely be some lag between the increased money supply and the pickup in inflation. But in the end, the limitless power of the printing press prevails.

As Bernanke's 2002 speech foreshadowed, they are creative, they are determined, they are strongly biased toward inflation, they don't care about rules or convention, and they will continue to find ways to get money into the economy. The deflationary alternative is simply not a viable option for them. The "pushing on a string" argument would be valid in an environment in which central banks were being cautious and disciplined and sticking to the long-accepted conventions of central banking. This is no longer the world in which we live.


Japan's long period of deflationary stagnation is often cited as "proof" that deflation can become an unstoppable force even under a fiat currency system. This argument makes the assumption that because Japan didn't put an end to deflation, that must somehow mean that they were unable to do so.

This is not correct. Japan could have ended their deflation, as described at the beginning of this article, by handing out huge stacks of money to everyone. Deflation can always be ended, and inflation always engendered, by the creation of sufficient amounts of money. We believe that Japan simply could not go down this road because it was politically unfeasible.

Inflation and currency debasement, as mentioned earlier, are great for debtors but bad for savers. Japan was (and still is) a nation of savers, so debasing the currency was not a politically viable option for Japan in the 1990s. As a result, the Japanese money supply has grown very slowly -- since the early-1990s bubble burst, the Japanese M2+CDs monetary aggregate has typically increased at a very modest 2%-4% pace annually. This mild growth in the money supply was not sufficient to overcome the price-deflationary forces at work after the bursting stock and real estate bubbles. Japan chose to undergo some price deflation rather than take the politically unfeasible step of debasing their currency.

The modern-day US, in contrast, is history's biggest debtor nation -- here, it is politically unfeasible not to debase the currency.

Japan did eventually embark on "quantitative easing" in 2001 when they supplied commercial banks with newly created reserves. However, their quantitative easing was much milder than ours and was more narrowly targeted than the Fed's "monetize everything" strategy. The newly created bank reserves weren't lent out into the economy, which is to say that they didn't cause an increase in the broader money supply measures. (The prior section, in contrast, describes all the ways in which our government is already making sure that their new money gets into the economy).

Just because Japan chose not to force money out into the broader economy does not mean that they could not have done so. Japan's status as a net creditor nation prevented them from creating inflation by flooding the economy with money. Our status as a net debtor nation compels our authorities to do just that.

Lost Financial Asset "Wealth"

In the aftermath of the severe asset market declines of recent months it is common to hear the argument that all the money printing and stimulative government spending can't make up for the huge amounts of "wealth" lost in the financial markets. The government could print up $2 trillion new dollars, the argument goes, and it wouldn't even come close to making up for the $10 trillion of wealth was lost in the markets.

This argument has two problems. To begin with, of course the government can make up for the lost wealth. They can create as much money as they want. If $10 trillion of wealth (as recently estimated by Merrill Lynch) was lost in the markets, then the government can print $11 trillion. And so on.

But the bigger problem with this argument is its assumption that a given decline in asset prices is equivalent to the destruction of that amount of money. This simply isn't the case.

This concept is most easily illustrated with an example. Let's examine the case of Alice, a hypothetical asset owner who we will say owns 1 million shares of XYZ company. Last year, the stock was worth $3 per share. Now it's worth $2 per share.

The value of the Alice's stock holdings have thus dropped from $3 million to $2 million. It's true that Alice is now $1 million less "wealthy" than she was prior to the stock price drop. People usually only look that far, and assume that the stock price decline has resulted in the disappearance of $1 million from the economy.

But if Alice actually wanted to use her asset wealth to buy something, she'd have to sell her stocks first. It's important to consider both sides of that transaction.

Let's look at two scenarios. In the first, Alice sells her stocks to Bob before the crash for $3 per share. In the second, she sells them to Bob after the crash for $2 per share. If Alice decided to sell her stock to Bob before the crash, she would be paid $3 million. If she sold the stock to Bob after the crash, she'd only get $2 million.

However, in the first scenario, Bob would have to pay $3 million, whereas in the second, he would only have to pay $2 million. So while Alice is $1 million less wealthy than she could have been had she sold a year earlier, that $1 million didn't disappear. It's just that Bob got to keep it. Alice has $1 million less than she would have had she sold to Bob a year earlier -- but Bob has $1 million more then he would have had he bought Alice's shares a year earlier.

In other words, no money has been destroyed -- it's just been moved around. There has been no change in society's aggregate ability to spend.

Even if the stocks didn't have to be converted to money to harness their value, but were instead "bartered" for something, the same principal would apply. If Alice were trading stocks to Bob in exchange for food, a decline in stock values would mean that she got less food in exchange for each stock share. But it would also mean that Bob had to part with less food to acquire the same amount of stock.

Prices in an economy go up and prices go down. Relative values change. The decrease in the price of a particular item, even if it is a financial asset, does not destroy the ability to purchase -- it just moves purchasing ability from potential sellers of that item to potential buyers.

There are some price-deflationary effects of a widespread decline in asset prices. All the stock holders who were still holding their declining stocks would definitely feel less wealthy than they did before the price drop. It's likely that they would accordingly reduce their spending and boost their saving, which would exert a price-deflationary effect due to reduced monetary velocity and an increased demand for cash balances. In other words, while there was no change in society's overall ability to spend, there might well be a reduction in society's willingness to spend. But this phenomenon is very different than the actual destruction of money or spending ability.

Lower asset prices might also make it difficult for banks holding those assets on their balance sheets to lend new money into existence. But while this puts a potential damper on new money creation, it does not destroy any existing money.

So widespread asset price declines do exert price-deflationary pressures via decreases in velocity and banking-sector money creation. Both these phenomena can be dealt with by the government as described in the "Pushing on a String" section above.

But asset price declines do not, as suggested by so many commentators, cause a one-for-one money supply decrease equivalent to the amount of the lost "paper wealth"-- or anything even close to it.

Credit Deflation

Some people argue that the "credit deflation" -- the reduction in lending and borrowing -- will overwhelm any money-printing the government can undertake.

We'll begin by once again pointing out that the government can create as much new money as is needed to stoke inflation.

Additionally, this argument blurs the distinction between money and credit. Credit and money are not the same thing. Imagine a desert island where the money supply consists of a single $10 bill. There is, to put it another way, $10 worth of ability to purchase. The $10 belongs to Alice, but she lends it to Bob. Bob turns around and lends it to Charlie, who lends it to Dave. There is now $30 worth of credit in the economy, consisting of three separate $10 loans. But there is still only that one $10 bill. All the lending has moved the $10 around, but it hasn't created any new ability to purchase.

Outside the fractional reserve banking system, lending does not create purchasing power. For every borrower who gains purchasing ability, as in our example on the island, there is a lender who had to forfeit that purchasing ability.

It's different for banks. They can actually lend money into existence -- but in so doing, they are creating credit and money at the same time. The money they create will become part of the money supply. So it's really money, not credit, that is the proper measure of society's aggregate ability to purchase.

With that said, there are some ways in which a credit contraction can put downward pressure on both prices and new money creation.

Credit doesn't increase aggregate purchasing power, unless it also leads to the creation of new money, but it does tend to move that purchasing power from "strong hands" to "weak hands." The money is being lent by someone who doesn't want to spend it to someone who does. So credit is an accelerant to monetary velocity, and a credit contraction can accordingly induce a price-deflationary effect.

Reduced willingness to lend on the part of fractional reserve bank could also slow the rate at which new money is lent into existence.

So as with asset price declines, credit contractions exert price-deflationary pressures via decreases in velocity and banking-sector money creation. But while credit contractions have deflationary elements, it is simply not valid to compare the amount of money being created by the government to the amount of credit being destroyed.

Debt Defaults

Some argue that debt defaults destroy money, and that the government's money-printing can't make up for all the defaulted debt.

But debt defaults do not destroy money. Let's look at an example in which Alice lends Bob $10. Simply put, Alice gave her $10 to Bob, with the understanding that Bob would pay it back.

But Bob doesn't pay it back -- he spends it on lattes at Starbucks and then defaults on the loan. Alice is out of luck -- but you will notice that no money has been destroyed. The $10 is sitting there in the till at Starbucks, soon to make its way elsewhere throughout the economy.

The deflationary effect of debt defaults is that they inhibit future lending. While in the example above there has been no change to the amount of money in the economy, lender Alice in specific is now out $10. She has $10 less to lend to future borrowers. Given that credit is a velocity accelerant, as described above, this decrease in lending could have price-deflationary effects.

Defaults could also affect future money supply growth. Banks, as stated earlier, can lend money into existence. So a bank that slows its lending due to having been burned by defaulting borrowers will effectively be creating less money than it would have otherwise.

The results end up as described in the two prior sections. The reduced lending resulting from debt defaults could slow velocity or cause the money supply to increase more slowly. But it is not the case that debt defaults cause the money supply to shrink, and it is especially not the case that a default on a certain amount of debt causes an equivalent decline in the money supply.


Many people think that inflation cannot take hold in a recessionary environment in which demand is being destroyed. But this view doesn't take currency debasement into account. Real demand for goods and services can drop even as currency debasement causes nominal prices to increase.

To provide an overly simplified illustration, if real demand were to drop 10% but the government was able to engineer a 12% loss in purchasing power of the currency, then nominal prices should increase 2%.

There are numerous examples of countries undergoing economic contractions alongside substantial monetary and price inflation. A mild version of this phenomenon, dubbed "stagflation," took place right here in the United States in the 1970s. Some notable examples of more severe contractions accompanying more dramatic inflations include present-day Zimbabwe and Argentina earlier this decade. In these cases, people lost confidence in the currency as a store of value. When people lose confidence in a currency (almost always as a result of excessive monetary inflation), demand for the currency will drop, velocity will increase, and price inflation will follow regardless of the economic climate.

But an Argentina-like loss of monetary confidence is certainly not required to cause inflation in a recessionary environment. The "Pushing on a String" section above describes numerous ways in which the government could stoke monetary and price inflation even in an environment of declining private sector demand.

Foreigners Won't Let Us Inflate

One argument maintains that our foreign creditors will not sit idly by as we debase our currency. But this is precisely what they've done for years, and their ongoing support of our increasing indebtedness (evidenced by enormous foreign Treasury purchases) shows that they continue to do so. They are driven by their own short-sighted, mercantilist policies; the potential for long-term purchasing power loss on their dollar-denominated holdings clearly hasn't been a concern for quite some time. And it apparently continues not to be a concern. We are vigilant for signs that this may change someday, but so far no such signs are forthcoming.

The dollar recycling must end eventually. But when it does, that will be an inflationary event, not a deflationary one. Foreigners would most likely express their disapproval by buying fewer dollar-denominated assets, resulting in a drop in the dollar's foreign exchange value. This would exert upward, not downward, pressure on prices in the US. The decrease in foreign Treasury purchases would also lead to higher rates and a potential situation in which the government couldn't borrow the money it needs for all its stimulative deficit spending. In this case, there's a good chance that the Fed would inflate the money supply to fill the funding gap and buy down rates rather than take the economic pain that would accompany higher long-term interest rates and a sharp cutback in government spending.

The winding down of the dollar recycling game will almost certainly lead to inflationary problems, when it eventually happens -- but in the meantime, the US can continue its reflationary policies for as long as it has the support of its foreign creditors.

The Fed Doesn't Want Inflation or a Dollar Crisis

Another argument goes that the government will not choose to invoke a serious inflationary crisis or cause a serious dollar decline. We agree that this is clearly not an outcome that the government desires. But these are the same people who denied the stock bubble in 2000, then denied the housing bubble in 2005, then denied that the "subprime crisis" would have any negative impact on the overall economy in 2007. The people manning the bureaucratic institutions of our government rarely spot a problem until it's already become a problem. And to the extent they spot a potential problem, they do not act to head it off if doing so would inflict the type of short-term economic pain that they try so desperately to avoid.

We are fairly confident that our leaders feel that they are in control and that they are risking neither serious inflation nor a dollar dislocation as a result of their unprecedented debt accrual and monetization. We imagine that the recent rise in the dollar and the drop in commodity prices emboldens them in this opinion. (That we don't share their confidence is irrelevant here). Moreover, they've repeatedly come out and said that they are more worried about deflation than inflation, and as monetary authorities of an over-indebted society they have reason to be.

The government prefers inflation and feels confident in its ability to manage that inflation. They have already shown that they will not let fears of inflation or dollar problems scare them into sitting back and letting deflation -- the worst of all outcomes, to them -- run its course unhindered.

The Fed Will Reverse Course

This is more of an argument as to why inflation won't be a problem, as opposed to why deflation will. But we'll throw it in for good measure anyway: some people acknowledge that current policy is highly inflationary, but suggest that Fed will be able to quickly reverse course before inflation becomes a problem.

Even if they wanted to do so, the Fed could have trouble quickly reducing its balance sheet considering that they have loaded themselves up with illiquid assets that were largely rejected by the private sector. But the bigger problem with this argument is that it assumes that the Fed would actually reverse course early enough to prevent the inflationary effects of their policies from coming to the fore.

The Fed, along with the government in general, is panicked. They have an extreme preventative bias against deflation, and they are taking extraordinary measures to fight the current deflationary pressures. But these policies work with a lag, and if the government has to choose, they will for reasons noted throughout this article always pick inflation over deflation. So we submit that the government will not even slow its reflationary efforts until the inflation has already gained a significant and noticeable amount of traction. By that time it will be difficult to reverse the inflationary effects of their previously expansive policy.

The venerable James Grant put it nicely in a recent WSJ Op-Ed:

Yes, today's policy makers allow, there are risks to "creating" a trillion or so of new currency every few months, but that is tomorrow's worry. On today's agenda is a deflationary abyss. Frostbite victims tend not to dwell on the summertime perils of heatstroke.

But the seasons of finance are unpredictable. Prescience is rare enough in the private sector. It is almost unheard of in Washington. The credit troubles took the Fed unawares. So, likely, will the outbreak of the next inflation. Already the stars are aligned for a doozy.


We in the United States have been dumping our dollars into the world for years and we continue to do so. We owe a staggering amount of foreign debt denominated in dollars and we are gearing up to borrow even more. Our legislators and the stewards of our currency are rabidly hostile to deflation -- they are hostile, in other words, to the idea of the dollar gaining purchasing power. They have shown via word and deed that they will do whatever it takes to prevent deflation from taking hold. When deflation is viewed as even a remote possibility, there are effectively no limits to the amount of money the government can create nor to what they can do with that newly minted money.

Under these circumstances, we just don't believe that the dollar is going to gain purchasing power in any sustainable way. The current deflationary storm could continue for a while yet, but the longer it goes on, the more violent and severe its reversal is likely to be.

Deflation is a choice within the current monetary regime. It is a choice that our government has shown it will not make. There are serious long-term risks inherent in our dysfunctional monetary system, to be sure -- but deflation isn't one of them.



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