The Stagflation vs. Deflation Debate
I've been asked by a lot of people to comment on Mike Shedlock's recent attack on Peter Schiff, and his view that America is facing a deflationary recession rather than stagflation.
There should be little doubt for any regular reader of this blog that I disagree with Shedlock, as I've repeatedly argued for the stagflation scenario. So, why do I disagree with him? Well, to some extent it is a case of our old disagreement about the money supply definition. But I'm going to comment on Shedlock's specific fallacies in the articles.
Shedlock Fallacy #1: "There are constraints on the Fed that he ignores. For example the Fed cannot simultaneously target both money supply and interest rates. Should the Fed pursue a massive printing campaign, interest rates will rise."
No, not true at all. That's the old fallacy that interest rates will necessarily rise in response to higher inflation. But that's only true if the central bank agrees that higher inflation should be met with higher interest rates, which is often not the case, and which is why real interest rates are often negative (like now).
If the Fed decides to buy all government bonds (or corporate bonds or mortgage backed bonds) until the yield fall to whatever level they like, say 0.5% or 1%, there's nothing anyone can do to stop them since the Fed has unlimited power to create money out of thin air. Even if all private investors and foreign governments dump their bonds, the Fed can still simply buy them all with the money they create out of thin air. That implies massive inflation and extremely low interest rates at the same time.
Shedlock Fallacy # 2: "Regardless of what anyone thinks, prices can only rise to the extent that people can afford to pay for goods and services or that banks are willing to extend credit. Without a driver for jobs, and with downward pressure on wages for the jobs we do have, prices will be constrained. If somehow prices rise above people's ability or willingness to pay for them, there will be not be buyers."
No, no, no. If this were really true, we wouldn't have hyperinflation in Zimbabwe where we've seen a severe depression with regard to production and unemployment.
Shedlock is here in essence arguing for a Keynesian "aggregate demand" view of inflation, according to which stagflation is impossible. But as stagflation is a real phenonema (in its most extreme form in Zimbabwe), this argument is simply false.
Shedlock fallacy #3: "That assumption is the US dollar drops....The fundamentals in the UK and EU are as bad as in the US and the property bubbles just as big."
That's actually to some extent true with regard to the U.K.,as I recently explained, and this is why I am bearish about the pound too.
However, the situation is not as bad in the Euro area, which still has a current account surplus.
While Shedlock agrees that the yen will rise, he overlooks the more important yuan, whose continued rise vs. the dollar is a certainty and which will help push up inflation in America, both by making imports from China more expensive and as this increase their demand for commodities given a certain dollar price.
Shedlock fallacy #4: "Take away the US market for goods and China and Japan have massive overcapacity. Without exports to the US and Europe, China would crash. This situation might change 10 or so years down the road, but export economies are not remotely close to being able to ignore the US consumer, at least not now or anytime soon."
Not entirely untrue, but Shedlock overlooks the fact that China has undertaken drastic actions to restrain domestic demand in the form of umpteen increases in interest rates and bank reserve requirements. They thus have a lot of scope to compensate from falling U.S. consumer demand by simply refraining from continuing with these tightening measures or even reversing them.
Shedlock fallacy #5: "Given massive overcapacity in housing, commercial real estate, restaurants, nails salons, etc there is simply no reason for businesses to want to expand business. Nor is there any reason for banks to be willing to extend credit to all but the most credit worthy borrowers. Rising defaults may even impair capacity to the point many banks are unwilling or unable to lend at all. The only reason expansion got as carried away as it did is the psychology at the time suggested residential and commercial property would forever rise.....
....Because the Fed can encourage but not force lending, that shift in the pendulum affects the Fed greatly. The Fed can enhance the current primary trend (as it did in the creation of the housing bubble), but neither the Fed nor anyone else can reverse the primary trend.
Regardless of encouragement, who are banks going to be lending to when asset prices are falling and unemployment is headed higher? And those are conditions that both Schiff and I agree on. With enough defaults, banks will become so capital impaired they could not lend even if they wanted to! We are seeing signs of that in Citigroup already.
And as I have said before, the Fed is a private business. The Fed is not going to give away money any more than Pizza Hut is going to give away free pizzas for a year to all comers." [the last section was from Shedlock's second post]
Here Shedlock makes two fallacies. First, there is no evidence that the banks are refraining from lending, as bank lending has in fact accelerated in recent month during the alleged "credit crunch". In the 20 weeks between August 1 and December 19, commercial bank lending rose 5.85%, which is 16% at an annual rate. Many banks will likely lend on the basis of bailing out their borrowers, knowing that they will fail if they don't.
Secondly, and much more importantly, even if banks get unwilling to lend, they (and the Fed) can then simply start buying securities, and that way expand the money supply, something Murray Rothbard pointed out to the Mike Shedlocks of 1991 in his essay "Lessons of the Recession".
The one thing true Shedlock pointed out was that the stagflation vs. deflation debate mattered because it had investment implications. If we have stagflation, commodities are the place to be, if we have deflationary recession, government bonds are the place to be. To bad for Shedlock then that he and others who invest in government bonds are going to get screwed big time as inflation takes away their value.
Curiously, he argues that gold will do well in deflation (Which we might consider "Shedlock fallacy # 6"). Well, to the extent he invests in that he will be a winner despite his false view of the economy. But, he is simply wrong that gold will do well under deflation. Deflation here refers to the real value of paper dollars, not gold, and if the value of paper dollars were to rise that would imply a falling relative value of gold which unfortunately is not used as money and since 1971 lacks any link to the U.S. dollar.
His argument that gold is not an inflation hedge because it fell between 1980 and 1999 overlooks that the tight monetary policies of Paul Volcker destroyed the demand for gold as an inflation hedge. With real interest rates high, it made more sense to invest in bonds than gold. Also, massive central bank sales and the dollar rally of the late 1990s temporarily depressed gold.
Now, we see gold make a comeback because central bank sales has been limited and many emerging market bank cental bank actually buying, but most importantly because inflation is accelerating and this increases the demand for gold as an inflation hedge.
There should be little doubt for any regular reader of this blog that I disagree with Shedlock, as I've repeatedly argued for the stagflation scenario. So, why do I disagree with him? Well, to some extent it is a case of our old disagreement about the money supply definition. But I'm going to comment on Shedlock's specific fallacies in the articles.
Shedlock Fallacy #1: "There are constraints on the Fed that he ignores. For example the Fed cannot simultaneously target both money supply and interest rates. Should the Fed pursue a massive printing campaign, interest rates will rise."
No, not true at all. That's the old fallacy that interest rates will necessarily rise in response to higher inflation. But that's only true if the central bank agrees that higher inflation should be met with higher interest rates, which is often not the case, and which is why real interest rates are often negative (like now).
If the Fed decides to buy all government bonds (or corporate bonds or mortgage backed bonds) until the yield fall to whatever level they like, say 0.5% or 1%, there's nothing anyone can do to stop them since the Fed has unlimited power to create money out of thin air. Even if all private investors and foreign governments dump their bonds, the Fed can still simply buy them all with the money they create out of thin air. That implies massive inflation and extremely low interest rates at the same time.
Shedlock Fallacy # 2: "Regardless of what anyone thinks, prices can only rise to the extent that people can afford to pay for goods and services or that banks are willing to extend credit. Without a driver for jobs, and with downward pressure on wages for the jobs we do have, prices will be constrained. If somehow prices rise above people's ability or willingness to pay for them, there will be not be buyers."
No, no, no. If this were really true, we wouldn't have hyperinflation in Zimbabwe where we've seen a severe depression with regard to production and unemployment.
Shedlock is here in essence arguing for a Keynesian "aggregate demand" view of inflation, according to which stagflation is impossible. But as stagflation is a real phenonema (in its most extreme form in Zimbabwe), this argument is simply false.
Shedlock fallacy #3: "That assumption is the US dollar drops....The fundamentals in the UK and EU are as bad as in the US and the property bubbles just as big."
That's actually to some extent true with regard to the U.K.,as I recently explained, and this is why I am bearish about the pound too.
However, the situation is not as bad in the Euro area, which still has a current account surplus.
While Shedlock agrees that the yen will rise, he overlooks the more important yuan, whose continued rise vs. the dollar is a certainty and which will help push up inflation in America, both by making imports from China more expensive and as this increase their demand for commodities given a certain dollar price.
Shedlock fallacy #4: "Take away the US market for goods and China and Japan have massive overcapacity. Without exports to the US and Europe, China would crash. This situation might change 10 or so years down the road, but export economies are not remotely close to being able to ignore the US consumer, at least not now or anytime soon."
Not entirely untrue, but Shedlock overlooks the fact that China has undertaken drastic actions to restrain domestic demand in the form of umpteen increases in interest rates and bank reserve requirements. They thus have a lot of scope to compensate from falling U.S. consumer demand by simply refraining from continuing with these tightening measures or even reversing them.
Shedlock fallacy #5: "Given massive overcapacity in housing, commercial real estate, restaurants, nails salons, etc there is simply no reason for businesses to want to expand business. Nor is there any reason for banks to be willing to extend credit to all but the most credit worthy borrowers. Rising defaults may even impair capacity to the point many banks are unwilling or unable to lend at all. The only reason expansion got as carried away as it did is the psychology at the time suggested residential and commercial property would forever rise.....
....Because the Fed can encourage but not force lending, that shift in the pendulum affects the Fed greatly. The Fed can enhance the current primary trend (as it did in the creation of the housing bubble), but neither the Fed nor anyone else can reverse the primary trend.
Regardless of encouragement, who are banks going to be lending to when asset prices are falling and unemployment is headed higher? And those are conditions that both Schiff and I agree on. With enough defaults, banks will become so capital impaired they could not lend even if they wanted to! We are seeing signs of that in Citigroup already.
And as I have said before, the Fed is a private business. The Fed is not going to give away money any more than Pizza Hut is going to give away free pizzas for a year to all comers." [the last section was from Shedlock's second post]
Here Shedlock makes two fallacies. First, there is no evidence that the banks are refraining from lending, as bank lending has in fact accelerated in recent month during the alleged "credit crunch". In the 20 weeks between August 1 and December 19, commercial bank lending rose 5.85%, which is 16% at an annual rate. Many banks will likely lend on the basis of bailing out their borrowers, knowing that they will fail if they don't.
Secondly, and much more importantly, even if banks get unwilling to lend, they (and the Fed) can then simply start buying securities, and that way expand the money supply, something Murray Rothbard pointed out to the Mike Shedlocks of 1991 in his essay "Lessons of the Recession".
The one thing true Shedlock pointed out was that the stagflation vs. deflation debate mattered because it had investment implications. If we have stagflation, commodities are the place to be, if we have deflationary recession, government bonds are the place to be. To bad for Shedlock then that he and others who invest in government bonds are going to get screwed big time as inflation takes away their value.
Curiously, he argues that gold will do well in deflation (Which we might consider "Shedlock fallacy # 6"). Well, to the extent he invests in that he will be a winner despite his false view of the economy. But, he is simply wrong that gold will do well under deflation. Deflation here refers to the real value of paper dollars, not gold, and if the value of paper dollars were to rise that would imply a falling relative value of gold which unfortunately is not used as money and since 1971 lacks any link to the U.S. dollar.
His argument that gold is not an inflation hedge because it fell between 1980 and 1999 overlooks that the tight monetary policies of Paul Volcker destroyed the demand for gold as an inflation hedge. With real interest rates high, it made more sense to invest in bonds than gold. Also, massive central bank sales and the dollar rally of the late 1990s temporarily depressed gold.
Now, we see gold make a comeback because central bank sales has been limited and many emerging market bank cental bank actually buying, but most importantly because inflation is accelerating and this increases the demand for gold as an inflation hedge.
posted by stefankarlsson at 2:42 PM
14 Comments:
This is becoming a really interesting debate. Both you and Mike Shedlock make your cases so well that I'll have to reread both your and Mish's arguments. As you say it has a profound effect on how one should invest one's "safe" money. Government bonds (Riksgäldskonto in my case) or gold.
What tou write largely makes sense, but is it not true that a high inflation rate will make money lenders ask for higher interest rates? Who is willing to lend money for 1% of inflation is sky-high? Might be that what you say aplies to bonds already issued, but hardly to bonds issued during a massive inflation.
Anyway, the US dollar and US monetary policy is horribly mismanaged and if they continue this nonsense gold will continue to climb.
Yes, high inflation will of course make lenders ask for higher interest rates. And make borrowers more willing to tolerate higher interest rates, I might add.
But the point was that the Fed could if it wanted to replace the lenders by buying as many bonds as they need to in order to push down interest rates. As the Fed has the capacity to create an unlimited amount of money out of thin air, there is nothing to stop them (except for the fear of hyper inflation) from buying enough bonds to push down, even if genuine savers refuse to buy bonds.
In fact, Peter Schiff also argues that gold will do well under deflation, and that paper money will not: "During deflation, money gains value, so prices naturally fall as fewer monetary units are required to buy a given quantity of goods. In the coming deflation, real money (gold) will gain considerable value, so prices will therefore fall sharply in gold terms. Paper dollars however, which have no intrinsic value at all, will lose value, not only as the Fed increases their supply, but as global demand for the currency implodes." http://www.europac.net/newspop.asp?id=11164
I don't buy the "gold is money" argument at all. Btw it is not an argument, rather some mantra. And that paper money would lose value during deflation is a mystery.
Johan, that Peter Schiff quote is taken out of context. What he meant was that *if* we measure prices in terms of gold, we will see deflation in the prices of both consumer goods and assets. And if you define deflation as a rising price of gold compared to other prices, then of course gold will rise (that's basically a tautology).
That tautology is something very different from Shedlock's claim that if we see a deflation in terms of paper dollars, gold will rise in value.
That was a *very* creative interpretation. An investor talking to his customers about hypothetical situations, like "If prices were measured in gold in the coming deflation" or "If Peter Sellers was alive" and presenting tautologies. In fact he spells out explicitly that the deflation he talks about is the coming one in paper dollars.
Here's the full paragraph with my highlights:
"To fully understand the way inflation and deflation affect prices, we need to differentiate between assets, such as stocks and real estate, and consumer goods, such as shoes and potato chips. If we measure prices in gold, as we did during the 1930’s, both asset and consumer goods prices will fall, with the former falling faster than the latter. So in that sense the deflationist are correct. However, in terms of today’s paper dollars, this outcome is completely impossible. During deflation, money gains value, so prices naturally fall as fewer monetary units are required to buy a given quantity of goods. In the coming deflation, real money (gold) will gain considerable value, so prices will therefore fall sharply in gold terms. Paper dollars however, which have no intrinsic value at all, will lose value, not only as the Fed increases their supply, but as global demand for the currency implodes."
Mish's comment to this paragraph was also interesting:
"My Comment: While it makes sense that the demand for currencies other than gold fall, it is important to understand that it is not just the US dollar we are talking about. There is no major country on the gold standard so it is relative demand between other competing currencies that will determine how fast they fall in relation to gold."
http://globaleconomicanalysis.blogspot.com/2007/12/not-your-fathers-deflation-rebuttal.html
They seem to agree on this subject. Mish talks about gold as a currency and Peter calls it real money. Rather than having your investment strategy based on a mantra, I would like to see an explanation at micro level why anyone should go and buy gold when the paper money stock is collapsing. Of course, if enough people believe in the mantra, it could happen.
I think it is obvious that secure paper money depress demand for gold and that unsound paper money fuels the demand for gold.
Given the highly unsound monetary policy of the federal reserve bank it seems likely that the demand for a "safe haven" will make the purchasing power of gold increase. This is especially true due to the fact that nearly all paper currencies are unsound ant that it is likely that Japan - whose currency is fairly sound - has an interest in preventing a higher exchange rate.
Johan, the whole point of his column was that there won't be any deflation as measured in paper dollars, and that is what he says in the quoted paragraph too. He says explicitly that paper dollars will lose value. Paper dollars losing value is by definition inflation, not deflation. The deflation he refers is in terms of real money (gold), not paper money (paper dollars). So what he is saying that in the coming period of deflation in terms of gold and inflation in terms of paper dollars, gold will rise in value.
That is a different view from Mike Shedlock, who believe that paper dollars will rise in value. Schiff repeatedly argued that paper dollars will lose in value.
That particular paragraph from Schiff may have been formulated in a unfortunate way, but the point is not that we will see deflation as measured in paper dollars, but that we will see inflation in paper dollars. Deflation will only occur relative gold. And that means by definition that gold will rise in value relative to goods, services and assets.
Could be. If so, that's the most muddled analysis I've read for a while. He shouldn't be talking about "coming deflation" because relative to gold almost every asset has declined in value over the last years. The world has experienced deflation since 2000. He also mentions stagflation and hyperinflation later in the article. Apparently, not in gold terms. Great communication, Peter!
given the fed is always behind the curve is lowering rates when the economic cycle turns (ie the ffr and discount rate have followed the t-bill rate, not led it), is it not possible that shedlock's scenario at least partially plays out? that is, a massive collapse in equity and property prices takes the markets by surprise (obviously), and the fed then fights a rearguard hyperinflationary battle to restore nominal values. setting all the commodity markets on fire in the process. i find it hard to imagine that asset markets (ex-commodities) can be somehow be isolated from downside even be a pro-active fed. the fact that this has occured in the past only makes this higher-stakes poker.
ps: one aspect in the mike shedlock article i don't think you rebutted was the japan recession episode. that is where the money supply aggregates were flat, not turning negative, but where the value of loans collapse under write-offs.
i'd like to hear you take on that, as it seems that even with the fed's 15% ms growth pa, nobody really has a firm idea about how big a disaster the derivatives/credit bubble may turn out.
after all, the jap banks teetered for a long time, before being able to float away their bad debts riding the yield curve.
one final point that shedlock made - zimbabwe monetary system is essentially a cash-based one (so printing has an almost immediate effect), not the "modern" american credit-based system, so the transmission of prices is likely to be more opaque and indirect.
Newson: The reason why the Japanese central bank failed to achieve significant expansion of the broad money supply measures ( they rose, but only slowly) was that the Bank of Japan governors were unwilling to undertake unorthodox measures to inflate. Paul Krugman and several other Western inflationists urged the Bank of Japan to fully monetize the Japanese budget deficit by buying all newly issued government bonds. The Bank of Japan refused to do so.
Ben Bernanke by contrast has made clear that he will use whatever unorthodox action that is needed to create inflation if interest rate cuts fail-including the infamous money helicopters. And certainly he wouldn't hesitate to monetize the U.S. federal government debt to whatever extent is necessary to restore inflation(A debt that will BTW likely soar in value as the government deficit usually soars during recessions).
And it is really irrelevant for this discussion if the money supply consists of cash or deposit money. Both will have a price increasing effect, and stagflation have occurred in countries with significant degree of deposit money. United States today is in fact a perfect example of this, with inflation over 4% and employment and production contracting.
As for your comment about asset prices falling, I do in fact expect
stock and housing prices (but not bond prices) to fall. But the Fed will certainly limit the decline in nominal terms as it is now agressively cutting rates even though stocks are down just 10% from their all time high and even though house prices have fallen just a few per cent. And Fed policy will at the same time keep consumer price inflation at a high level.
Stefan,
Now, I've reread both what Mike Shedlock says and what you say. In addition I reread Peter Schiff's article. So here are a few comments:
- I think you are actually all right in some way. There are many possible scenarios, both inflationary and deflationary. To make predictions which will play out is hard, since it depends on so many factors. They might actually all play out one after the other.
- You have convinced me that the inflationary scenario is indeed possible, though I doubt that it is probable. Yes, as you say the Fed *can* decide to start buying up all government bonds (and lots of corporate or mortgage backed bonds), but *will they* do that? What would be the other side effects of such a situation. In the extreme case, the Fed would end up as owner of most US government and a large part of the private debt (if they buy up bonds and the banks fail to buy them back later). How would they handle a situation like that? They’re not prepared for it, I suspect, so the whole thing would be a great big mess with an unpredictable outcome. So I still lean towards a "Shedlock" scenario being probable, though I wouldn’t bet on it.
- I agree with Newson that the stagflation example of Zimbabwe is dubious when comparing to the US. First of all, the Zimbabwe central bank has rather different motivations for its actions than the Fed. Secondly, Zimbabwe’s economy is fundamentally different in many ways from that of the USA or Europe. I’m not saying that stagflation is impossible in western economies, I’m just saying that taking Zimbabwe as an example of how it could happen is not that relevant. Maybe Argentina would be a better example, thought there are other differences there, e.g. the US has the "advantage" that their foreign debt is denominated in their own currency.
- The example of Japan, that somebody else mentioned here, might give some clues to the future of the US economy, but we must note that there are big differences. E.g. the immense foreign account and budget deficits of the US. This adds to the as I see it unpredictable outcome.
- As for China, you say:
"[…] China has undertaken drastic actions to restrain domestic demand in the form of umpteen increases in interest rates and bank reserve requirements. They thus have a lot of scope to compensate from falling U.S. consumer demand by simply refraining from continuing with these tightening measures or even reversing them."
True, but how do you expect the Chinese economy to survive falling demand from US (and probably soon European) consumers without crashing? Their economy is just not organised to cater for domestic demand for goods instead of foreign demand. First of a lot of the stuff they produce is probably not the stuff demanded by Mr. & Mrs. Chang, so they would have to switch a lot of their production, with all the problems that come with that – layoffs, etc. And how are Mr. & Mrs. Chang going to afford buying that stuff? With borrowed money? Who’s going to lend them that money?
After the scenario plays out, of course some economist (out of all the predictors around the world) will have predicted more or less what would happen and will say ”I told you so”, but it might just as well have been someone else who was right.
/Henrik "Flute"
"Yes, as you say the Fed *can* decide to start buying up all government bonds (and lots of corporate or mortgage backed bonds), but *will they* do that? What would be the other side effects of such a situation. In the extreme case, the Fed would end up as owner of most US government and a large part of the private debt (if they buy up bonds and the banks fail to buy them back later). How would they handle a situation like that? They’re not prepared for it, I suspect, so the whole thing would be a great big mess with an unpredictable outcome."
I completely disagree with that. Bernanke and others at the Fed, as I pointed out previously said, have made it very clear that they will take whatever action that is needed to prevent deflation. And considering that deflation is generally regarded as "the end of the world" there is no reason that Bernanke would hesitate to do so.
" I’m not saying that stagflation is impossible in western economies, I’m just saying that taking Zimbabwe as an example of how it could happen is not that relevant."
I don't know what your problem here is. Deposit money can create price inflation just as much as cash can, so what is the point really, especially since you yourself admit that stagflation is possible in America too.
The point here wasn't about the money supply process but about the fact that high inflation can be combined with falling production and rising unemployment. There are endless examples of this in addition to Zimbabwe. Indeed, today's America is an example of this.
"After the scenario plays out, of course some economist (out of all the predictors around the world) will have predicted more or less what would happen and will say ”I told you so”, but it might just as well have been someone else who was right."
Well, we'll see about that. Obviously that can't be settled now. But with production and employment starting to fall and inflation over 4%, my stagflation scenario have proven correct so far.
"True, but how do you expect the Chinese economy to survive falling demand from US (and probably soon European) consumers without crashing? Their economy is just not organised to cater for domestic demand for goods instead of foreign demand. First of a lot of the stuff they produce is probably not the stuff demanded by Mr. & Mrs. Chang, so they would have to switch a lot of their production, with all the problems that come with that And how are Mr. & Mrs. Chang going to afford buying that stuff? With borrowed money? Who’s going to lend them that money?"
They've got a lot of savings. China has a 50% savings rate.
While there be some adjustment problems, China's high investment rate will ensure it happens quickly. Already there is a significant level of malinvestment, but China still manages to grow over 10% because the overall level of investment is so high.
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