Making the case for deflation
In our prior post (Inflation vs. Deflation Part I) we discussed some driving factors of inflation and evidence that inflation hawks were using to formulate their opinions. Certainly, few theories in macroeconomics and monetary policy are without controversy. Even with simple equations, a nearly infinite amount of questions are asked as the layers of evidence are peeled back. That simple equation is but a synthesis of other equations, just as an atom was thought to the most finite particle, science soon revealed neutrons, protons and electrons. Later, quarks and tau neutrinos were later discovered. Quantum mechanics later brought forth even more questions, making Newtonian physics seem so basic.
In similar respects, financial markets are just as awkwardly tricky and exciting. Often, with the same figures, multiple conclusions are drawn. Or, further evidence is discovered which totally changes opinions. When we add a few more levels of complexity to the inflation problem, some individuals derive the opposite result. In this case, that we should fear deflation, rather than inflation. This was presumably one of the reasons for QE2. Freidman and others have focused on the behavior of the Central Bank in the depression and found that they let the money supply contract too much, inserting us into an inflationary spiral. Bernanke, a student of the depression, very likely had this in mind.
So, what evidence is there of deflation today? One likely piece of intelligence is the velocity of money, which measures the speed money travels through the economy. Currently it is at historically low levels. Although some may contend something else, I think the velocity of money may be an indicator of demand for money. Instead, banks have piled money into excess reserves (although for some not enough). This is one reason why inflation may not necessarily be a concern.
Additionally, leverage was one of the main ingredients in the recipe of destruction that we have experience in moving to boom, then bust. The natural antidote is deleveraging. One way this is occurring is by consumers and businesses defaulting on loans. In other cases, people are paying down debts and now have an aversion to credit altogether. In addition, falling real estate prices and stagnant wages are considered to be symptoms of inflation but it is really the role of credit that is most often ignored.
Mish (Mike) Shedlock of Mish’s Global Economic Trend Analysis correctly identifies credit as the often ignored component, much like subatomic particles. Mr. Shedlock gives a full list of deflationary concerns. http://globaleconomicanalysis.blogspot.com/2011/08/yes-virginia-us-back-in-deflation.html
We also find that credit is an ignored component. This particular ingredient is a main contradiction to the inflation argument.
Next time, I will attempt to tie more factors together.