Hyper-inflation and deflation are two sides of the same coin

There is a raging debate among economists.  The divisions run deep and the rhetoric is heating up.  The debate pertains to our economic future and, unlike some of the inconsequential intellectual feuds that take place in remote ivory towers, the stakes are sky high.

On one side are the deflationists who argue that we are about to experience a major global price deflation in which asset and goods prices will fall.  On the other side are those who believe the exact opposite, that the greatest risk we face in the future is very high, or even hyper-, inflation.

As they say, get four economists in a room and you’ll get five opinions.

The deflation camp comprises a number of competing schools of economic thought and their theoretical champions, who have a wide array of reasons for believing why we’re headed for deflation, and vastly disparate views on what the economic consequences will be.

This range of views is probably as varied in its disparities as the number of economists in the deflation camp itself, but essentially we can distil it into two broad sub-camps.

1. The first group we will call the “Liquidity Trappers“.  These folk could also be called the “pro-stimulus camp”, or, more broadly “neo-Keynesians” because of their absolute fear of deflation and their desire to see the fiscal and monetary authorities enact as large stimulatory policies as possible to avoid falling prices “at all cost”.  By and large this group believes that current fiscal and monetary stimulus is too small to work and needs to be ramped up considerably.  To pin this group to an intellectual champion, they might also be called “Krugmanites”.
2. The second group we’ll call the “Liquidationists“.  These folk may also go by the name of “Austrian Business Cycle theorists (ABCTs)” or the “pro-deleveraging camp” because of their belief that only a deflationary recession can restore economic balance and provide the necessary price adjustments to restore real incomes and allow society to once again create sustainable growth.  By and large this group believes that fiscal and monetary stimulus will be unable to stem the tide for wholesale deflation in the years ahead.

Paul Krugman

The Liquidity Trappers worry that the private sector, due to fear, lack of confidence, and falling employment, cannot provide the ‘aggregate demand’ required to keep businesses profitable, and that until such private sector demand is restored, the government and central bank must make up the deficiency in demand through deficit spending and ultra-loose monetary policies.

Some of the more ardent members of this group advocate not only zero% interest rates when ‘required’ to boost growth and employment, but sometimes argue for negative interest rates (as Nobel Laureate Paul Krugman has done) and considerable new money creation by the central bank with which it should buy government bonds and other assets, thereby pumping more money into the economic system.  Because savings rates rise during a recessionary period and people tend to pay down debt, the Liquidity Trappers worry that the lack of demand will force companies to shed staff in order to remain profitable due to falling sales.  Those newly unemployed people lose purchasing power, creating a downward spiral of job losses and diminishing aggregate demand that leads to utter economic ruin.

Furthermore, this group, like the Liquidationists, acknowledges that as people pay down their debts so bank ‘credit money’ is destroyed, and that this ’shortage of money’ is a crisis impacting aggregate demand at current prices, necessitating falling prices (hence the need for money pumping by the central bank).  The Liquidity Trappers argue that as prices fall so people come to expect falling prices, and a ‘deflationary psychology’ can set in.  Once this happens, people desist from borrowing (as falling prices are bad for borrowers trying to pay back debt) and they reduce spending as they hold off purchases in anticipation of lower prices in the future.  This means that no matter how low interest rates become and no matter how much money is pumped into the system, borrowing and spending cannot be stimulated and monetary and fiscal policy becomes ineffective.  This is called a Liquidity Trap.

In sum, the Liquidity Trappers believe that a financial crisis caused by a preceding period of irrational exuberance can lead to financial turmoil.  Banks tighten up on credit standards and business activity slows down.  A weak job market and future economic uncertainty causes people to save more and pay down debt.  This ‘paradox of thrift’ means lower aggregate demand and the threat of falling prices.  Left unchecked, this situation will lead to a downward economic spiral and prolonged depression and misery.  The appropriate policy response is to run large fiscal deficits and ultra-loose monetary policy.

The Liquidationists on the other hand regard the saving and deleveraging processes so feared by the Liquidity Trappers as necessary to restore economic balance and create the conditions for sustainable economic growth.  They differ from the other Liquidationists who actually fear inflation (more on them later) in that they see no alternative, regardless of policy, to falling prices and the painful but necessary asset price deflation that follows a massive asset liquidation.

This group sees deflation as unavoidable and recognises the painful consequences it can have, but argue that it is the inevitable pain to take.  They believe the destruction of bank credit money, due to households and companies paying down debt, is only just beginning, and that it will usher in a huge deflationary episode, something akin to the extent that prices plummeted during the Great Depression.

The Liquidationist folk are regarded by many as somewhat sadistically in favour of economic turmoil, but the Liquidationists argue that taking the pain is a) unavoidable and b) a better option than taking it later when the consequences will be far worse. They are not suckers for punishment but genuinely regard the liquidation path as the lesser of two evils.

The inflation camp meanwhile is also made up of strange bed-fellows and, like the deflation camp, have different reasons for believing why there will be inflation and different interpretations of its implications.

Once again though, these views can basically be distilled into 2 distinct corners:

1. The first group we will call the “Reflationists“.  These folk are not too different from the Liquidity Trappers, except that they have a far more upbeat view of the US and global economy, and believe the policy authorities will comfortably be able to cause prices to keep rising in the future.  This group may currently be the most mainstream group in the debate, and this position tends to be held by most mainstream business owners and stock market investors, as well as policy makers.
2. The second inflation sub-group we’ll call the “Mainstream Austrians“.  This group may also be called the “Sceptic Liquidationists” or “Crack-up Boomists”.  Again, this group is not too different from the Liquidationists in its belief of the need for a wholesale liquidation of unproductive capital and asset price deflation to restore economic balance, but instead of seeing such an outcome, this group is sceptical of policy makers’ willingness to allow such a liquidation to happen and believe that the current policy course may even lead to hyper-inflation.  This view currently seems to be the mainstream view of the Austrian School, as opposed to the views of the Liquidationists who are probably a minority within the broader Austrian/free market tradition.  Absent any political will to allow a broad-based market-driven debt deflation, Austrian economist Ludwig von Mises predicted that repreated attempts to restore bubble price conditions would result in ever more misallocated capital, wealth destruction, and higher inflation, and ultimately result in a Weimar style “Crack-up Boom”, or hyper-inflation.

The Reflationists acknowledge that the stimulatory policies of central banks can create inflation problems, but they view this as a far lesser evil than deflation, and regard some inflation as actually conferring great benefit on society.  This group would argue that the Liquidity Trappers are too worried about a liquidity trap and deflation spiral developing, but would join them in their disdain for the Liquidationists and would wholeheartedly reject the notion of the need for a cathartic liquidation and deflation period.

This group regards the US economy has having gone into a temporary funk that government economic policy can fix, and that while the recession is deep and long, it is not likely to see rising deflation risks as the response in terms of fiscal and monetary policy has been appropriate.

The Mainstream Austrians agree with the Liquidationists that, if left alone, the US economy would fall into deflation.  They further agree that this is desirable.  However, this group believes that the money pumping from the Fed and large federal deficits will eventually create strong enough money supply growth to outweigh the bank credit money destruction from household and corporate deleveraging.

The Mises Institute (Austrian School)

This they say starts to become uncontrollable, and that hyper-inflation can set in when society starts to expect ever-increasing amounts of monetary debasement by the authorities.  As people expect more monetary debasement, so their demand for holding cash balances starts to wane and ever rising inflation rates can set in, precipitating a spiralling collapse of confidence in the currency.

The Mainstream Austrians therefore believe that in the early part of the reflation cycle, money supply can grow far faster than prices rise, but that in the latter stages of the reflation, when confidence in the currency begins to get damaged, prices can rise much faster than money supply grows.

So, who’s right?

As can be seen above, the distinction between the deflation camp and the inflation camp could just as easily be delineated as a distinction between those who desire inflation (Liquidity Trappers and Reflationists) and those who desire deflation (Liquidationists and Mainstream Austrians).

It can also be said that all four groups highlighted above would basically agree that, absent some degree of government and central bank policy intervention, there would be deflation.  So in essence the delineation of those who desire inflation vs. those who desire deflation is really better stated as a delineation between those who desire government policy intervention and those who desire that the governing authorities refrain from such intervention.

Yip, that’s right, the great debate of the day boils down to a good ol’ State vs. Market slug-fest.

We now therefore have arrived at the clash of positive and normative economics and descriptive and proscriptive economic analysis.

Pro-State
The Liquidity Trappers describe/predict deflation, but proscribe inflation.
The Reflationists describe/predict inflation, and proscribe it.
Pro-Market
The Liquidationists describe/predict deflation, and proscribe it.
The Mainstream Austrians describe/predict inflation, but proscribe deflation.

These complex theoretical and descriptive strands all hold varying degrees of truth, and it is our attempt here to draw out those commonalities to see if perhaps they help us get closer to the truth.  So what do these hold in common?

1. Left alone the market would probably dictate a major debt deflation.  The pro-state camp sees this in a negative light, the pro-market camp in a positive light.
2. A major debt deflation would be a huge negative risk to indebted households, businesses and countries, potentially precipitating a financial/banking crisis.  Again, the pro-state camp sees this as very negative to be avoided at all costs while the pro-market camp sees this as painful but the lesser of two evils.
3. Allowing a painful debt deflation would be political suicide for any ambitious politician and will be avoided at all costs.  Both camps agree on this although the pro-market camp would obviously like to see less populist politicians that allow market forces to unfold.
4. Only government stimulus policies can avoid such a deflation.  The Reflationists would argue not much stimulus is needed, while the Liquidity Trappers see the need for huge intervention.  The Mainstream Austrians also believe that huge stimulus is required to reflate, but that it ultimately is folly, while the Liquidationists believe we are beyond the point of no return already where no amount of stimulus can avoid a debt deflation.  The bottom line though is that most by and large agree that only large fiscal and monetary stimulus can avoid a painful debt deflation (for now at least), and that policy makers are fully politically incentivised to do so.
5. Between the Liquidity Trappers, the Reflationists (to a lesser extent), and the Mainstream Austrians, most therefore believe that more fiscal and monetary stimulus will be forthcoming in the months/years ahead.  This means more government debt accumulation, and more money printing.

So, the overarching view is that the economic imperative is for deflation, while the political/policy imperative is for inflation.  This leaves a tug-of-war between deflation and inflation.  Deflation is certainly the more immediate risk, but inflation is the potentially longer term threat as policy responds to the underlying economics.  But none of the four main schools of thought outlined above can truly predict how strong the inflationary push-back against deflation will be, meaning that none truly knows the potential extent of the longer term inflationary consequences of policy action.

The Liquidity Trappers and Reflationists don’t care too much about this, arguing that inflation problems are better than deflation problems anyway, and that central banks have adequate ‘tools’ to deal with inflation as and when it arises.  The Liquidationists don’t really see hyper-inflation as a credible scenario, such is their strong view of unstoppable debt deleveraging.

It is only the Mainstream Austrians, who comprise the mainstream Austro-Libertarian view, who have major concerns about future inflation and hyper-inflation.  They are worried about the supply AND demand for money.  They are therefore concerned about hyper-inflation from two angles: the first is the excessive rise in supply of money due to central bank stimulatory policies, and the second is the diminishing demand for holding cash money due to a loss of confidence in the currency.  The former can easily give rise to normal or reasonably high levels of inflation, but the latter is the catalyst for hyper-inflation.

In essence therefore, the hyper-inflation risk boils down to the extent to which people expect society at large to lose faith in and reject the US dollar as the US and global reserve currency.

At this stage this is not a mainstream view at all, but there are some signs that a loss of confidence in the dollar is perhaps not that far off.  Firstly, gold is rallying, and confidence in gold tends to be a verdict of diminishing confidence in the US dollar and other paper currencies.  Secondly, the velocity of circulation of money in the US is very low and falling, suggesting a significant debt deflation risk as people pay down debts, save money, reduce transaction frequency, and hoard cash balances.  This does not directly signal a loss of confidence in the dollar, as people are clearly still willing to hold dollar cash balances en mass, but it does signal a loss of economic confidence.  If this is indeed what the falling velocity figures indicate (and we have every reason to believe this from historical low-velocity episodes), society can quickly proceed to a loss of political confidence and then a loss of confidence in the currency, reversing quickly the demand for cash balances and driving price inflation and velocity of money circulation higher.

All major losses of political and monetary confidence (ie hyper-inflations) were preceded by major losses in economic confidence followed by poor policy responses (government credibility is key as the state ultimately backs the value of fiat currencies).  The more government enacts irresponsible monetary and fiscal policies to solve economic problems, the greater the chance of a loss of political and monetary confidence.  As was seen in Weimar Germany or Mugabe Zimbabwe, damaged economic confidence can lead governments to run large fiscal deficits and unlimited money printing, which damages political confidence and then monetary confidence, leading to a hyper-inflation.  The key here is confidence in government policies.  Initially, people tend to trust their government, but if the policies are not seen to work appropriately or as expected, political and monetary confidence can start to wane and then deteriorate quite quickly.

This is why most hyper-inflations tend to come as a surprise to many, and tend to pounce quite suddenly and unexpectedly, even after years of policy profligacy where confidence seemingly remained intact.

The US and Western economies therefore need to be careful.  Clearly, in fighting the market force for deflation, the government and central bank must enact monetary policies that can potentially cause a loss of political and monetary confidence.  Some would argue that the US is already starting to experience this, with Barack Obama losing popular support in polls, and many people sceptical as to whether the large fiscal and monetary policies will actually work or simply saddle the nation with higher debts, higher prices and sagging economic growth and employment.

Paul Krugman wants policy makers to deal with this loss in economic and political confidence by ramping up stimulus policies even more to dwarf what has already been done.  This is clearly a huge gamble.  If Krugman is correct then at best we return to a normal economy (we do not share Krugman’s view on this however), but if Krugman is incorrect, the chance of an even greater loss in economic and political confidence can precipitate a dangerous loss of monetary confidence, and therefore the threat of hyper-inflation.

The larger the deflation risk therefore, the larger the risk of financial crisis, and therefore the larger the required fiscal and monetary stimulus.  The larger the stimulus, the more vulnerable the currency to deteriorating monetary confidence, and therefore the greater the hyper-inflation risk.

In other words, the larger the deflation risk, the larger the hyper-inflation risk!

It can be seen from this that, indeed, hyper-inflation and deflation are two sides of the same coin and that, going forward, BOTH are possible.  The medium- to longer-term inflation risk rises in proportion to the shorter- to medium-term deflation risk.

Therefore we do not believe it is a case of deflation vs. inflation, or even a case of desired deflation vs desired inflation, but a case of deflation first, followed by inflation, followed potentially by hyper-inflation.

Future inflation/hyper-inflation risks must therefore be analysed in the light of the current deflation risks and the policy response to such risks, and economists should be intently focused on just how large these deflation risks are in order to understand the magnitude of policy response that will be forthcoming and the future inflation risks such policy holds.

Note here that we do not need to see the deflation actually manifest in prices, only that the monetary destruction resulting from debt deleveraging creates the threat of actual price deflation, forcing a huge reflationary policy response.  This is an important point because many are being blinded to the deflation threat by the fact that prices are not actually falling.  This is misleading because the central banks are already countering the destruction in bank credit money due to private deleveraging with the creation of new money due to public leveraging and debt monetisation.  In other words, the tug-o-war process described above is already well under way.

With total US debt (public and private, household and business) at around $54 trillion and over 100% larger in real terms than the long term historical average, and the scope for anywhere between $5-20 trillion of private deleveraging in the US alone, we suspect the deflation risks are high, that the fiscal and monetary policy response will increase rapidly, and therefore that the risk of dollar hyper-inflation is substantial.