The Case Against Inflation
By David Russell | July 06, 2009 | 1:09 PM | 4 Comments
Many observers worry the government's massive spending programs and fiscal deficits will produce runaway inflation. I understand this point of view because I used to share it. But after studying trends in the credit market and economy, I see little basis for this concern, which is based upon thinking from another century. The more likely outcome of the policies of the federal government and central bank is a prolonged deflationary process.
Most inflation hawks, including greenfaucet's own Michael Pento, point to the rapid growth of the M1 monetary base, which expanded before previous bouts of inflation in 1966-68, 1973-75 and 1978-80. However, the cause-and-effect relationship between monetary expansion and rising prices has been waning for more than two decades and is now weaker than ever:
I believe that when correlations start breaking down, people should stop using them. Another correlation that's much more relevant today is the relationship between home prices and lending.
Thanks to securitization and the shadow financial system, when home prices went up, banks could extend more credit. That in turn drove home prices even higher and generated more lending. Just as M1 was once the basis credit growth, in the last 20 years real estate became the basis of credit growth. That explains why home prices and mortgage origination reached insane levels between 2004 and 2007 period as the monetary base stagnated. M1 simply didn't matter anymore because a new money standard based upon real estate had taken over.
Instead of treating inflation as a direct result of changes in the monetary base, it's better to view it as a broad secular trend. Like most such trends, changes in CPI follow the principles of Elliott Wave analysis:
A more recent look at the CPI chart shows no emergent trend higher:
One way to understand a trend is as an animal that flourishes or starves depending on the availability of food. The 1960s and 1970s provided growing amounts of nourishment for the inflationary beasts as millions of people adopted a consuming suburban life style. The government was spending billions on the Vietnam War, and companies enjoyed strong pricing power thanks to their factories running at close to 90 percent capacity. By the later 1970s, military spending subsided as an inflationary force, but was replaced by higher oil prices and a weaker dollar after Nixon closed the gold window. Throughout the entire period, the lending system remained stable and provided credit for the growing consumer class.
Paul Volcker's tight-money policy in the early 1980s was the first major famine to strike the inflationary animal. The creature was further starved by rising imports from Asia, which drove down the price of apparel and consumer durables. A simultaneous movement toward labor-market flexibility and outsourcing broke the power of most private-sector unions and reversed the existing cycle of rising incomes:
In fact, we're currently facing a major secular decline in employment in general, as I discuss in this article. Also, even with unions apparently regaining some sway, I seriously doubt their ability to affect wage gains in this environment. It's more likely that employers will respond to their new power by simply moving more jobs outside the U.S.
Additionally, despite all the talk about America being on a consumption binge during the last 10 years, the pace of spending gains has actually been trending lower for three decades, which is another deflationary pressure:
What about all this deficit spending by the government? Surely that's inflationary? Looking at Latin America's experience with inflation over the last few decades shows why this isn't the case for us now. Latin American grew in the 1970s thanks to foreign lending to governments, which drove their economies with Keynesian-style public spending. When the foreign loans stopped, the governments continued spending -- only now with deeply devalued currencies. The primary food for inflation, government spending, never went away. In fact, it was further augmented by huge spikes in import prices resulting from the collapse of Latin currencies.
In the U.S. today, we face an utterly different situation. Instead of being dependent on government expenditures, the economy relied on household spending. That means the inflationary animal needs to adapt to a new food, government money, while the consumer is literally starving it to death. Furthermore, this year's "stimulus" package was so intertwined with special interests and political considerations that it will never accomplish its "reflationary objectives." Consider a recent quote from Argus Research Chief Economist Richard Yamarone, who's been speaking to business leaders throughout the country:
"They're all telling me there's no stimulus. There's not reason to hire, let alone increase capital spending... They're not worried about hiring workers. They're worried about staying in business." -- CNBC, 7/2/2009
Another doubt I have about government spending is that a large proportion of it will probably be siphoned out of the economy and into foreign bank accounts, which is exactly what happened in Latin America years ago. Even if you're not worried about massive embezzlement, it's a huge assumption to expect government spending -- no matter how vast -- to offset the collapse of the American consumer.
Other government actions will have a deflationary impact. First, the Bush tax cuts are expiring, and rates are likely to increase into the foreseeable future. Second, the financial "reform" measures proposed so far -- especially the idea of forcing banks to retain a 5 percent stake in securitized assets -- will almost certainly reduce lending for years to come. And finally, the "cap and trade" plan that emerged from the House threatens to double energy prices in 2012. While that might sound inflationary, unless it's massively changed by the Senate it will drive even more investment outside the country and deter recovery in the private-sector job market long before the price increases take effect.
I'd also like to look at the Fed and its control over interest rates. Most people ignore the true nature of our central bank and give it far too much credence as a force in the economy. The Federal Reserve is a private banking syndicate that was created after the Panic of 1907 to provide emergency liquidity and prevent bank runs. Over time it morphed into an agent of economic policy based on its ability to manipulate the money supply and bank lending. While it has at times succeeded in that role, I believe it has largely lost that power thanks to the rise of securitization, which transferred credit creation from bank balance sheets to international capital markets. In fact, I suspect the Fed's tools now largely accomplish the opposite of their intended effects, as I argue in this column.
I also suspect the common thinking about interest rates is wrong. The textbook says that low rates drive investment and spending, but the real cause is the movement of borrowing costs lower, not simply low rates per se. For instance, most people wouldn't want to buy a house now as a speculative investment knowing that mortgage rates have nowhere to go but up. Low rates discourage investment because people know conditions will only get worse going forward as they rise. This is why the Japanese have responded to their own low rates by pouring money into places like Australia and the U.S. over the last few years. It doesn't take a genius to figure out that low rates cause capital flight, and capital flight causes deflation (barring places like Latin America and Iceland, which had a huge currency devaluation and reliance on imports.) The inflation hawks also give far too much credence to government programs, which usually produce the opposite of their intended effects. Half jokingly I say that if politicians want to cause inflation, that's a good reason to bet it won't happen.
Of course, we've already seen massive capital flight, as anyone who follows the government's TIC data knows. This brings me to the final consideration: The role of the dollar in the world. On one hand, the almost inevitable decline of the dollar will drive prices higher. But it will require several years and won't really take hold until the middle classes of India and China replace the U.S. consumer. In the more immediate horizon, as some lenders diversify away from dollar assets, it will reduce demand for our bonds and thus deprive the economy of credit. After all, the credit bubble resulted directly from foreigners recycling dollars back into our economy. Now that our trade deficit is plunging, it means less credit everywhere.
Over the much longer term, I do agree the dollar has nowhere to go but down, and that it will lose purchasing power in general. But this decline will negatively impact lending on a global scale for years to come, likely producing much stronger deflationary forces. When it will shift towards inflation is anybody's guess.
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