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The "Flation" Debate

A common misconception propagated by many sources is that US Federal Reserve has been printing tons of dollars to get us out of economic worries and start smiling again. Some even alluded that they put these dollars into small packets with "don't worry, be happy" notes on the top and have been dropping them around our houses in the middle of the night from black, quiet helicopters. After my wife knew about it, I got into big trouble. She made me go and check around our house at wee hours, to find out whether my suspicious-looking neighbor was taking all my packages away. Needless to say, I had little luck catching him.

Now I have come up with this elaborate excuse to explain her that there was really no packet. If you are in the same boat as me and had to conduct unusual nocturnal activities for last one year, please feel free to use this excuse to avoid further trouble.

Let me get into my usual Aesop mode and use a small story to tell you what is really happening. Imagine you are a university student in desperate need of a car. Of course you do not have much money to buy one. Someone told you about a car auction where you could buy good cars at reasonable prices. You went there taking all the money you saved from your job at the university library. That was 2000 dollars of student money.

The auction was big and several cars caught your attention. However, you found out that the rules of payment were very strict. If you won a car, you had to pay for it in full cash right away. The bids were low because most people did not bring much cash. You saw this beautiful Audi going away for just 6000 dollars and you could do nothing. You did not carry enough cash.

The auction companies get commission as a percentage of the closing price. If closing price is low, they have less to take home as well. The manager noticed that the bids were too low and decided to change the rules of payment. He announced that the winner could bring the cash by next day. There would be a small fee for those who used that option but still it was really a small price for the convenience.

This change in payment option started to raise the bids. Poor you still figured that the Audi was out of your reach because you did not have the money in bank either. What if the auction manager changed the rule to allow you to pay within next five years? You knew that the job market is good and you were graduating in six months anyway. You could pay for that car comfortably. Would the manager believe your word that you could land a job so easily? Let us assume he did. Hence you chose to bite. The same was true for many others and you ended up in a bidding war. Finally you left with the Audi paying 8500 dollars for it, a price four times you could afford.

Notice here that the auction manager did not put small packets of money in your pocket to help you bid higher. All he did was just change the rules for payment. Rest was your conscious decision to borrow from your own future. Two conditions had to be satisfied for you to agree to borrow:

(i) Manager's willingness to change the rules,

(ii) Your gut feeling that the future job prospects were going to be bright and the manager's faith in it.

US economy is an auction at a grander scale. The managers at the Fed change the rules of the game and induce you to borrow from your future to pay for current pleasures. They do not need to drop money from helicopters to help you buy wine instead of diet Coke. Also when the rules are relaxed, prices go up. This increase in price comes from your decision to do spend both your 2004's and 2005's Christmas money to do this year's shopping. That is the key to understanding why the housing prices have been going up at double-digit rates and where all the money is coming from. It is coming from our ability to get mortgage much easier than before, with questionable job prospects and our willingness to borrow more percentage of our current income. This is credit expansion, not printed money in our pocket.

That brings us to the core of the inflation/deflation debate. What is the future path for this kind of credit expansion? Going back to the car auction, can the manager continue relaxing the rules and thus keep getting higher bids? There is a point when he may have gone too far. At that point, many who bought cars with borrowed money will not be able to pay. Then he has to tighten the rules to take care of two things: (i) avoid additional losses, (ii) compensate for money he already lost.

In the broader economic perspective, there are additional effects to consider. As more people decided to borrow to buy car or house or wine, more auto factory workers, house-builders and wine-makers were hired. Since this money is borrowed or rather taken from the future, these jobs are also taken from the future. As you decide to spend your 2030's income on that SUV now, jobs from 2030 also get completed now. Once the system goes too far to one extreme so that there is much speculative borrowing, defaults will rise and lenders will start to tighten rules due to higher defaults. This will cause more people to lose their ability to spend future money, more job losses and more defaults. This vicious cycle is likely to continue to the other extreme, if history is of any guidance.

All I explained so far is Fisher's debt-deflation theory. Can today's Fed do something new to make it stop happening? The short answer is no. There are two reasons. Firstly, Fed is prisoner of market forces. In the collective memory of market participants 70's inflation ring more alarming bell than 30's deflation. If there is any hint of inflation, there will be collective clamor from the market for the Fed to take action as there currently are. Response to deflation, on the other hand, will be less muted. Even if the Fed manages to fool the market, they do not lend money to people by themselves. Their role is in changing the rules so that other banks can lend easily. These are private banks conducting business. Why will these banks lend money and why will you want to borrow money, if you know that you have to continue as student for next five years and there is no certainty about job after that?

The only thing I can expect looking forward is deflation. People borrowed from their future, believing that the future will be good. Once this assumption turns false, there will be more and more unwillingness to borrow, as well as more destruction of previous debts through defaults and bankruptcies. Credit-based economies show inflation during the credit expansion phase (such as now), but once the credit expansion phase comes to an end, there is deflation on the other side of the slippery slope.

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