23 May 2010


The wide ranging criticisms of the ECB's performance are bullshit. An inflation target necessarily implies restraining deflation.

There are several independent, but non-mutually exclusive causes of inflationary pressure. Academically, the two classical causes are termed demand-pull and cost-push. Additionally, one must consider the Milton Friedman fallacy that "inflation is always and everywhere a monetary phenomenon."

Demand pull inflation is always and everywhere a monetary phenomena. People can ask for all of the increases in wages they want... But in totality, if the central bank doesn't print enough money to keep up with economic growth, an employer's ability to increase wages will be constrained by their employee's ability to increase his productivity. There will simply not be enough money in the system to stimulate the economic growth needed to encourage an additional consumption of products.

This goes both ways. When Arthur Burns ran the Federal Reserve, he allowed Richard Nixon to bully him into printing money. The continuation of Johnson's "Great Society" push to appease the opposition to Vietnam through increased social spending coupled with the credit creation abetted by the Burns Fed. This double-whammy over-stimulated a strong economy already close to its natural limit of unemployment. The additional money in the system temporarily drove the unemployment rate below 4%. As people were driven off their couches by rising wages, so to were people driven to ask for higher wages to stay at their current jobs. With rising wages came higher expenses, and the demand-pull wage spiral took off.

This is not at all the case today. Europe is on the verge of a terrific period of stagnation and deflation. (inflation=up, deflation=down, dis-inflation=steady) We will see no economic growth, and no additional jobs in the periphery of the Eurozone until the artificially uncompetitive wages of the peripheral economies come back down. America is going to be relatively okay, but with lackadaisical wage growth, stagnant real-estate prices and impressively high unemployment for four years at a minimum.

The price mechanism is a powerful signal. Despite the extremely bearish situation in the world economy, the prices of many key commodities are at extreme levels. This tells us several things: Coffee and cocoa are expensive. Global income/consumption is rising.
Oil is expensive. We are running out of oil.
Coal is somewhat expensive. We will find more coal.
Wheat, soybeans, and corn are cheap. We have had three years of excellent harvests worldwide... we also have powerful subsidies in the U.S. for these crops.
The prices of many rare earth metals have been relatively unaffected by the panic of '08/'09. Global income and the consumption of advanced technological goods is rising and perhaps we are running low on these metals.

Get it? We will find more of the things we are short of globally, except the things we are running out of, namely oil. But on a macro scale, the developed countries are printing more money, and the developing countries are consuming more products. The deflationary impulse of the developed world is being countered by both the printing of money (Friedman inflation), the demand pull of economic growth in the developing world, and the cost push of the world transitioning from an oil based economy. Add in a few years of bad harvests and we will move beyond academic disputes over the nature of the Phillips curve (the reciprocal relationship between rate of inflation and and the rate of unemployment) into a general acceptance of Gregor Macdonald's concept of compartflation...

Basically we are talking really shitty stagflation in the developed world, with the slim possibility of outright deflation if we get a trade war, or a real war, or a European banking collapse, or a revolution in China... etc, etc. In either case, developed world real estate prices will not appreciate in nominal terms for 8 years at least. Stocks and and paper stores of value look terrible.

It is essential to recognize that the dichotomy between deflation and inflation is false. They can easily coexist as a growing differentiation between assets values intensifies along the classic lines of supply and demand. As we enter into a world where the values of the dollar and the euro depreciate together due to both the decreased demand for currency and the increased supply of money, we will see the price of many assets in high supply (real estate, stocks) stay stagnant. Thus the inflation of the money supply will cause a subtle but dramatic deflation in the price of over-abundant assets. However, as we run of of cheap energy the price of oil and coal will continue to inflate with drastic consequences for the world economy.

This will of course work itself out. Indeed, as these events come to pass, market prices are no more than the manifestation of this process of self renewal.

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