Inflation vs. Deflation

The current situation in the financial markets is not just scary but also confusing.  It doesn’t help that people are talking and writing in ways that further confuse the matter.  First, I will try to provide clarity around some terms that people have been abusing.  Growth and recession are “real” concepts, which means they can best be thought of as quantities. In a recession the economy is producing less stuff.  Inflation and deflation on the other hand are “nominal” concepts, which means they can best be thought of as price per quantity.  In a deflation, stuff costs less.  These two pairs of concepts are neatly orthogonal by construction and provide us with a 2x2 matrix in which you can have growth + inflation, growth + deflation, recesssion + inflation and recession + deflation.  Historically we have observed growth + inflation and recession + deflation a lot more than the other two combinations but they are certainly possible.

Second,  I have read comments in several places saying “the government just printed a bunch more money."  That is not the case.  Instead, the government is planning to incur additional debt.  Printig money and incurring debt are not the same.  In the printing money case there is a fairly clear and immediate link to inflation.  If the economy churns out the same amount of stuff but there is more money, stuff will simply wind up costing proportionally more.  On the other hand if the government borrows, the total amount of money in the economy (including the government) stays the same.  The reason is that the government borrows the money from someone (citizens, foreign central banks, etc) who already have the money!

Additional borrowing by the government could be inflationary, but it could also be deflationary.  How’s that?  The answer is sadly classic economist talk: It depends.  On the one hand it could be inflationary if people are concerned that the only way the government will repay its debts is to eventually start printing more money.  The anticipation of more money in the future could drive up prices today.  On the other hand it could be deflationary.  Imagine that the money was previously used to buy stuff but the government after borrowing the money decides to literally burn it.  Voila less money in the economy which would be deflationary.  These are super simplistic scenarios which one could easily shoot holes into, but the point I am trying to make is that it is neither obvious nor inevitable that additional government borrowing will lead to inflation or that it will lead to deflation.  Incidentally, this kind of reasoning once prompted President (Truman?) to exclaim "Please send me a one-handed economist!”

Among many investors the current consensus view appears to be that we are headed for deflation.  The reasoning goes something as follows.  There is a lot of demand for US government bonds due to a “flight to quality."  The current compression in yields on Treasuries is cited as evidence of that demand.  At the same time there is a big credit contraction (e.g., no more "home equity” loans) so that there is effectively less money in the economy.  Even though the economy will shrink due to a recession (i.e. less stuff), if that shrinkage is slower than the contraction in the available money you wind up with deflation.  The proponents of this view point to Japan’s post real-estate bubble experience as supporting this view.

There is a minority view that we are headed for inflation.  In this view, the government’s willingness to pay “cash for trash” will worry folks about the government ultimately having to print money as the assets it has bought turn out to be worthless.  This will lead to inflation via anticipation and also via lowering the value of the US dollar.  As this happens the government will need to raise interest rates to be able to continue to sell debt, potentially setting off a debt spiral.  Shrinking of the economy due to a recession in this scenario actually exacerbates the inflation problem.

My initial reaction to the bailout was the inflationary view, but the more people I talk to, the less convinced I am, at least for the near term.  It seems that enough people are so scared that they will sell even slightly risky assets at virtually any price to snap up Treasuries, whereas very few people seem to be thinking far enough ahead about what the government will ultimately do to repay its obligations.

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