The Weekly Blather July 13, 1930

July 13, 1930 was a Sunday with no Journal, so again a little editorial commentary.

Inflation vs. Deflation II - This Time It's Personal

One of the more interesting current economic debates concerns whether the future holds inflation or deflation. On the inflation side we have a vast array of Orthodox Economists; arguing for deflation we have a few Lone Crackpots blogging feverishly from their wood-paneled basements. (Note: I'm exaggerating for comic effect here - quite a few O.E.'s now say deflation is a concern, although a couple of years ago the last statement would have been pretty accurate). Normally, I'd just set the odds at about 60-40 in favor of the L.C.'s and move on, but there are a couple of complicating factors. One one hand, we have the inconvenient truth that for the past couple of years the Lone Crackpots have been absolutely nailing things, whereas the Orthodox Economists have been lost at sea even more than usual. On the other, we have no less a personage than Buffett coming firmly down on the inflation side:

Well, I don't worry about deflation at all. We won't see deflation in any significant amount in your lifetime, which is more relevant than my lifetime.

So, I was driven to think about this issue using my own brain, and summarize some of the issues based on my extremely rudimentary understanding of economics. To begin with, we clearly have a number of conflicting events of titanic scale going on at the same time.

On the deflationary side:

Reverse Wealth Effect: Equity and real estate markets have taken drastic haircuts, on the order of 40%-50% off the peak in many places. This represents a huge amount of wealth that many people thought they had a couple of years ago and is now gone. This must affect future spending by those people.

Demographics: A big bulge of the population is approaching retirement years; this should increase effect of the above, since many have fallen below what they calculated as a requirement for retirement, so will be saving to catch up.

Un- and under-employment and fears of same: This likely will reduce ability and readiness to spend.

Credit Crunch: Availability of credit to entities not backed by governments remains tight; this reverses the previous pattern of borrowing for consumption; both credit card and home equity availability has been cut back.

Reduction of the Bezzle: A smaller effect, but worth mentioning - times like these tend to expose financial scams (Madoff, Stanford); as Keynes observed, embezzlement is inflationary until discovered because both the criminal and victim think they have the money. Discovery of the crime is therefore deflationary.

And on the inflationary side:

Massive rescues and backstops of financial institutions: In some quarters this may be thought of as the biggest inflationary factor because of the eye-popping number of trillions involved. I'm more with the L.C. crowd in thinking this will have little inflationary effect - given the huge amounts of rotting assets still owned by the banks, and the public crucifixion they know they're in for if they return for more money, the most likely fate of those trillions is to wind up in virtual Scrooge McDuck-sized piles in the banks' electronic vaults.

Other deficit spending: This should have some effect on demand, but not as large as generally thought. Infrastructure spending takes time to happen, while tax cuts will probably mostly be saved for the reasons above.

Demand by countries moving up the living-standard ladder: I think this is the most significant current inflationary effect, though not as much discussed. Unlike in 1930, we currently have a big population in countries that have built up large reserves and savings (ex. the BRIC countries - Brazil, Russia, India, China). This population would probably be desirous of moving up the living-standard ladder, and their governments would have the means to kickstart this if they choose to. I believe this is the largest current source of potential demand.

Sadly, my conclusion from looking at all this is that given the large element of chaos in the economic system, there is simply no possible way to know which of these massive effects will dominate. So, I wouldn't be shocked if we got deflation, high inflation, or one followed by the other. While this may be disappointingly indecisive, it does lead to a practical conclusion - that I shouldn't be investing in things that get killed either under high inflation (ex. the long bond), or under deflation (ex. the typical leveraged commodity producer). (Your mileage may vary and do your own due diligence, of course).

Why, then, does the consensus seem to be for inflation? I think people may be affected by two biases:

Recent experience bias: Recent, meaning “last 60-70 years” - for that period, the thing to worry about almost universally has been inflation, which seemingly could be ignited with the greatest of ease. The disturbing recent counterexample of Japan, which has been unsuccessful in igniting inflation in spite of trying for the past 20 years, doesn't yet seem to have affected this bias.

Convincing thought experiment bias: It can easily be seen that a really determined government can ignite inflation at will; for example, Congress could pass a law making Publisher's Clearinghouse sweepstakes checks into legal tender. So, it's easy to conclude that the government will simply do whatever it takes to avoid deflation.

However, isn't there a practical problem here? The Publisher's Clearinghouse Act would certainly create high inflation, the only problem being the currency would shortly afterward turn into confetti. What if it turns out that a really massive stimulus beyond that already enacted is necessary to counter the huge deflationary factors above? Wouldn't even the serious contemplation of such an action cause a firestorm both politically and in the bond market, due to fears of the currency becoming worthless, with really painful immediate consequences?

I think the idea of the US igniting inflation in this way might turn out to be analogous to gradually amputating your own finger with a cheese grater - it's certainly possible in theory, but the immediate agony resulting from starting the operation would as a practical matter prevent its completion. Or, as Yogi Berra profoundly put it, “in theory, theory and practice are the same, but in practice they're different.”