Modern monetary systems operate on the ability to turn debt into money. Mises' business cycle theory showed that this process results in unsustainable distortions in the productive structure of capital and of relative prices between different capital goods. Mises also showed that, and left to market forces, the credit expansion would unwind in a credit contraction as relative prices corrected. However, central banks have for the most part been unwilling to let the system correct. Instead, they respond with a further round of inflation, trying to solve problems inherent in the relative structure of prices by increasing aggregate demand.

A debate has been going on recently on several web sites among those who accept the preceding premises but disagree whether the inflation process can be pursued to its ultimate conclusion -- hyperinflation -- or whether market forces will at some point prevent further inflation and cause a credit collapse -- deflation.

The deflation scenario consists of a cascading chain of defaults wiping out the leverage in the system and leaving physical currency as the only safe store of value. Because the dollar is, as Charles Holt Carroll said, “debt, organized into currency”, debt default destroys money. When the quantity of money decreases, prices tend to fall. This increases the real value of remaining debt and therefore the difficulty of repaying it, leading to more defaults. Because the debt consists of an asset on the balance sheet of banks, at some point the banks would become insolvent. If people became nervous and withdrew their cash from banks that would decrease bank reserves even more and accelerate the process.

Advocates of the inflation view starts by accepting the premises of the deflation outcome, but believe that the Fed would intervene and try to generate inflation rather than standing aside and watching the system implode.

I previously contributed to this debate with an editorial on the so-called Dollar Short Squeeze theory. In the current piece, I will take on what I consider a few of the more errors and questionable arguments that have been appearing from the deflation side.

The most obvious error in many deflationist writings is to point to the large amount of debt as a case for deflation and then to stop there. All of us agree that the debt levels are unsustainable. But there are two ways of getting rid of debt that cannot be repaid: default or inflation. Debt can be inflated away. Historically there have been far more hyperinflations than deflations.

Deflationists have claimed that debt cannot be inflated away as long as people are not willing to borrow, and that once debt reaches a certain level, the ability to borrow goes away. Whether this is true or not, the Fed has made it clear in a series of speeches that they are ready to monetize anything and everything by turning on the printing press and buying assets, gold mines, or whatever else it takes to prevent nominal prices from falling.

The reader of the Fed’s papers and speeches will find a series of progressively more effective techniques for destroying what purchasing power remains in our money. From beginning to end these methods span the range from the unsound to the bizarre and terrifying. With the likely appointment of Dr. Ben Bernanke to the chairmanship following Greenspan, this outcome becomes more probable. Bernanke has provided intellectual leadership for the “helicopter money” ideology. While volumes have been written on this topic, I will include a few short quotes here from Fed officials.

One tool commonly attributed to the Federal Reserve, at least in theory if not by the Federal Reserve Act, is that of conducting "money rains."

Money rains are a clean way to study theoretically the effects of increases in the supply of money. In practice, it seems a bit difficult to envision how the Federal Reserve could literally implement a money rain - that is give money away either through directly disbursing currency to the public or by disbursing it through the banking system. The political difficulties that are likely to arise from the Federal Reserve determining the distribution of this new wealth would be daunting.

In other papers on their site, there is extensive discussion of the purchase of private sector securities, such as stocks and bonds. The Financial Times reported in 2002 that the Fed Considered Emergency Measures To Save Economy:[1]

Minutes which summarised the meeting were released last week. A full transcript will not be available for five years but a senior Fed official who attended the meeting said the reference to "unconventional means" was "commonly understood by academics".

The official, who asked not to be named, would not elaborate but mentioned "buying US equities" as an example of such possible measures, and later said the Fed "could theoretically buy anything to pump money into the system" including "state and local debt, real estate and gold mines - any asset."

If the Fed is willing to purchase financial assets (other than Treasuries), then they could in essence provide a nominal floor under securities prices as long as they were willing to hold them in their portfolio. Because most US home mortgages are securitized and resold on secondary markets, they could prevent widespread mortgage defaults in nominal terms through the purchase of mortgage-backed securities (MBS). The resulting price inflation would mean that home owners were defaulting in real terms on their mortgages. But if Fed were to acquire the mortgages, then they would be that lender.

Should all else fail, the final stage of Bernankeism is the direct monetization of economic goods.

Why not have the Fed just conduct an open market purchase of real goods and services? Even more so than exchange rate intervention, this strategy would represent a direct stimulus to aggregate demand. … By coordinating with fiscal policy, the Fed could even implement what is essentially the classic textbook policy of dropping freshly printed money from a helicopter. In this case, the Fed would monetize government debt that had been issued to finance a tax cut.

Some deflationists have questioned the willingness of the Fed to act. But in the “welfare state of credit” to use Jim Grant’s phrase, debtors far outnumber creditors. In a crisis, there is always an intense demand for the government to “do something”. The something that looks most appealing at the time usually means some action that has the superficial appearance of addressing the immediate problem, while creating far worse problems slightly out of sight and some time in the future. It is difficult to conceive of a political climate in which the inflation option would not be taken.

Another deflationist argument is that wage competition from China is deflationary, and that inflation cannot occur in the US as long as there is wage competition. This argument confuses two entirely different economic phenomena.

There are two factors that influence money prices: changes from the money side and changes from the goods side. The inflation/deflation question concerns changes from the money side. An increase in the supply of computers, for example, causing a fall in the price of computers, is not deflation, or at least it is not credit deflation. Salerno calls this "growth deflation"; in any case the fall of prices due to the increase in supply has nothing to do with bank credit contraction. One does not lead to the other, nor does growth deflation prevent inflationary bank credit expansion. As the French economist J. B. Say wrote,

The success of one branch of commerce supplies more ample means of purchase, and consequently opens a market for the products of all the other branches; on the other hand, the stagnation of one channel of manufacture, or of commerce, is felt in all the rest.

What has become known as “Say’s Law” is the observation that the ability to demand comes from the power to supply. Absent monetary inflation, all demand in the economy is generated supply of some kind. An increase in the production of some goods, according to Say, results in more purchasing power for all other suppliers of non-competing goods because the total supply of goods has expanded. The increased purchasing power for producers of goods and providers of services is a natural outcome of savings and investment in a market economy, and has nothing to do with bank credit deflation.

Some deflationists have said that inflation cannot occur while workers are facing competition from Asia depressing wage rates. In the same way, wage competition due to an increase in the supply of skilled labor in other countries might result in a fall in the wages of competing labor in the United States, and it might be considered growth deflation, but it is not credit deflation and does not lead to credit deflation or prevent bank credit expansion.

Inflationists are not saying that real wages cannot decrease. On the contrary, real wages and real income tends to decrease for most people during high inflation and hyperinflation. The reasons for that are wages tend not to keep up with goods prices; tax brackets for business and wage earners generally are not indexed to the actual rate of prices increases, causing taxflation; it becomes more difficult for business to produce and invest during an inflation so the supply of goods decreases; and inflation causes a wasteful boom and bust cycle in which productive resources are misused and become idle.

There is no logical contradiction between decreasing real wages and simultaneously increasing nominal wages. If the Fed inflates the at a 15% rate, then real wages would remain constant if nominal wages rose at 15%, and real wages would fall if nominal wages inflated at a lower rate than 15%. Nominal wages could increase in the US and/or in China due to monetary inflation, while real wages either decreased and while the relative wage ratio between US and Chinese workers either increased, decreased, or remained the same.

China has adopted a fixed-exchange rate against the US$. Chinese central planners have as their motive for adopting the peg the belief that they can develop their economy by building up their export sector. An economists would point out that what they are really doing is subsidizing their export sector at the expense of their domestic consumers.

If the Chinese policy makers wanted to continue this during a period of increasing US inflation, they would have to increase their rate of purchases of US dollars and accumulate more foreign exchange reserves. Roubini and Duncan have both argued that China is near the breaking point in their ability to absorb more dollar reserves, so this is unlikely. What is more likely is that they would at some point allow the dollar to devalue against the RMB, which would mean higher US$ prices for Chinese imported goods.

Another similar argument is that price increases cannot occur in the US for goods manufactured in China, and that will thwart any efforts at inflating, China will always offer these goods at lower prices than they can be produced in the US, thus causing "deflation". This is also wrong for the same reasons cited above concerning nominal and real wages.

Another relevant factor, brilliantly expounded by Antony Müller in a recent daily article, is that the type of currency fixed rate that we have with China can only work for a limited period of time. Because the US cannot entirely offset purchases of Chinese goods with the sale of US-made goods to China, there is a reverse capital account flow to make up the difference. The Chinese, in effect, loan the US money through their purchases of US bonds (mostly government and Fannie/Freddie mortgage bonds). As China accumulate more dollar-denominated debt, the US must pay an ever-increasing amount of interest.

Over time, an increasing proportion of the reverse capital accounts flow goes toward interest payments to service the debt. This portion of the consisting of US$ interest payments can only increase at the expense of that portion used to purchase Chinese goods. The change in relative proportions must end at the point where 100% of the outflow was going to service previous debt and 0% to purchase. Most probably well before the 100% limit, the currency peg would longer be effective as a policy mechanism to subsidize Chinese exports.

Another reason for the unsustainability of the peg is that the US consumers are increasingly purchasing things that they cannot afford to pay for in terms of the value of goods that they are able to produce. That is not a sustainable state of affairs. China, then, is in the process of increasing their manufacturing base to produce goods for people who cannot afford them, instead of allowing the market to direct investment toward Chinese consumers who need lower cost manufactured products. These capital investments must be regarded as mal-investments in the Misesean sense of the term. They are unsustainable.

The deflation arguments that depend on the low real prices of Chinese goods are either misunderstand the difference between real and nominal prices, or assume that the process of China providing vendor financing for the over-spending US consumer can go on forever.

Inflationists have pointed out the vulnerability of the US$ to a sharp depreciation. This case is best made in Richard Duncan’s book The Dollar Crisis and in the research paper of Nouriel Roubini and Brad Setser on the unraveling of the “New Bretton Woods Monetary System”. They point out that the accumulation of dollar reserves by the rest of the world is running up against economic limits.

Some deflationists have argued that there could not be a crash in the dollar because, there is not a sufficient volume of alternative currencies for people to buy, or even that the deflation crisis will be accompanied by a strengthening dollar exchange rate. The quantity of other currencies does not in itself constitute a reason that the dollar could not crash. For any good on sale, any volume of supply and demand can be balanced through price changes. At some exchange rate any supply of dollars could be sold for anything else. If the rate were 1 trillion dollar per Yen, then the entire US federal deficit could be paid off with 11 Yen.

In reality, the purchasing power of a currency never gets infinitesimally small. In the real world, we would not ever see a trillion-to-one exchange rate. Some time before any currency reaches a vanishingly miniscule value, enough people see that it is going to zero. Then, there is an abrupt run out of the currency.

Mises observed:

…a money that is continually depreciating becomes useless even for cash transactions. Everybody attempts to minimize his cash reserves, which are a source of continual loss. Incoming money is spent as quickly as possible, and in the purchases that are made in order to obtain goods with a stable value in place of the depreciating money even higher prices will be agreed to than would otherwise be in accordance with market conditions at the time.

This is the final stage of hyperinflation in which the currency is destroyed. People frantically exchange out of the currency for anything – either concrete goods or alternative currencies. If the other major central banks in the world wanted to stave off a dollar exchange rate crisis or did not want their currency to appreciate against the dollar, then they could continue, as they have been, to purchase ever-greater amounts of dollars and invest them in dollar assets. This is exactly what has been happening for some time, and has been a crucial mechanism in diverting the effects of US monetary growth away from US consumer prices.

By some estimates, the US trade and government deficits are equal in quantity to around 100% of the total world's total savings. But that does not mean that the US is borrowing all of the savings in the world. Instead, central banks are printing a portion of the money that they use to purchase US debt. The Fed is in effect able to export of US$ inflation because other central banks are willing to do the job of monetizing debt.

Could this prevent a dollar exchange rate crisis? Yes, with all the major central banks inflating, they could possibly stave off a dollar crash in terms of the exchange rate but then we would experience world-wide hyperinflation: a crash of all currencies against goods.

A similar argument to the preceding one is that there are no other currencies that are sufficiently attractive. The dollar will always be the "belle of the ball". Marc Faber, in this stimulating piece, has some interesting things to say about that:

Also, since most of the crises experienced over the last 15 years, beginning with the Persian Gulf crisis of 1990, were related to problems outside the United States, there was a flight of safety into U. S. Treasury bonds not only by domestic investors, but also by international ones. This, in turn, tended to strengthen the U. S. dollar in times of crisis. But, what if the Fed were to embark on a massive money printing operation because of a really nasty economic surprise or financial accident in the United States? Would foreign investors still consider the U. S. dollar and U. S. bonds to be safe? I doubt it.

Under such circumstances a far more likely outcome would be a tsunami of dollar selling and, along with it, selling of U. S. dollar bonds. In the wake of massive selling of dollars and dollar bonds by foreign investors, interest rates would likely rise. In turn, this would force the Fed to monetize even more. A further loss of confidence in the dollar would follow.

The question here is, what would the dollar sell off against, and what would investors perceive as a safe haven in such a situation? The Euro? Not very likely! Asian currencies? Possibly, but if China were to weaken simultaneously with the U. S. economy it's unlikely that Asian currencies would be viewed as a safe haven. I suppose that in a crisis of confidence arising from an economic or financial problem in the United States of a scale that would lead the Fed to print money in massive quantities, only gold, silver, and platinum would be regarded as truly safe currencies notwithstanding their current weakness.

Could “it” happen here, asks Bernanke? One cannot entirely rule out the possibility of deflation. It is hard to see just how it could happen. Inflation is always the easy way out. In the age of activist governments, it is difficult to imagine the Fed standing aside and watched the banking system become insolvent. It’s far morel likely that one day we will tune into CNBC and hear “Don’t worry about that black helicopter hovering over your home. It is not here to enforce the Patriot Act IV, but to drop bales of freshly printed bills onto your front lawn.”

[1] The Financial Times, March 25 2002. Available to paid subscribers of the FT on the internet through archival search. There is no URL.

© 2005 Robert Blumen
Editorial Archive