[An audio version of this article, read by Ron Jennings, is available as a free MP3 download.]
A debate has been raging for some time among those in the finance industry about whether the United States is currently experiencing inflation, deflation, stagflation, reflation, hyperinflation, or maybe even some other sort of "-flation" that only Dr. Seuss could imagine.
Unfortunately, much of this debate is unproductive because the participants use varying definitions of these terms, and even when they use the same ones, deciding on one simple label might not be sufficient to describe the deeper economic forces at work and what their effects are likely to be. Given the confusion, this article will add some color to the debate by offering usable definitions of the terms inflation and deflation and then attempt to show what is occurring in today's economy.
What Is Inflation?
The most commonly used definition of inflation — a general increase in the prices of goods and services — is probably the least descriptive, and it is certainly the most misleading. By no coincidence, this is the definition used by politicians, major financial newspaper columnists, and CNBC pundits; and it is the one taught in public high schools and colleges. The reason that this definition is misleading is because, as described in a recent article, it detaches the cause of the phenomenon (an increase in the money supply) from its eventual effects (an increase in the prices of goods and services).
Furthermore, use of this definition also leads to such ridiculous terms as "food inflation" to describe price increases in a few specific agricultural commodities. The absurdity of this notion can be seen when one realizes that nobody ever complains of "stock inflation" or "housing inflation" and that no economics textbook contains a case study that explains how monetary policy caused "Beanie Baby inflation" from 1995 to 1999.
If we agree with Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon," then we should adopt a definition that explicitly acknowledges this point. Prominent Austrian economists such as Ludwig von Mises, Henry Hazlitt, and Murray Rothbard have presented definitions that vary slightly from one another, but one aspect common to all of them is an increase in the money supply.[1] Accordingly, I will adopt that simple definition. Deflation will be defined conversely as a decrease in the money supply. In order for these definitions to be meaningful, however, one must also have a precise definition of money.
What Is Money?
Money, as Frank Shostak succinctly explains, is "that for which all other goods and services are traded." In practice, money is typically a homogenous and durable good that is universally recognized as something of value and which people are willing to accept in exchange for goods and services. It might be gold or pieces of paper physically exchanged in transactions, or it might be such items stored in institutions like banks and drawn upon by checks, debit cards, or other means.
Complications arise in applying this definition, however, due to practices such as fractional-reserve banking. When a depositor places a sum of money in a checking account at a fractional-reserve bank, the bank may loan out 90% of his deposit to another person with the assumption that the depositor will not withdraw all of his funds. When the bank extends such a loan, the depositor has effectively loaned his money to the borrower, but without his knowledge. In fact, both the depositor and the lender will have legal title to the same sum of money at the same time. Insofar as the depositor believes he can withdraw his money from the bank at any time, he perceives that he still possesses 100% of his deposit. As a result, the money supply has effectively become 190% of what it was originally. But this is just the first step. As the new money is deposited in turn, it generates yet more new money, which can also be deposited, on and on through the banking system until the money supply grows to as much as 1,000% of what it was originally.
While loans like the one above, which Ludwig von Mises referred to as "circulation credit," have the effect of increasing the money supply, they lie in stark contrast to loans in which the lender temporarily gives up the right to his money, as happens when a depositor purchases a certificate of deposit from a bank. During the term of the CD, the depositor presumably understands that he cannot withdraw his money, and he adjusts his behavior and use of money based on that understanding.
To underscore the point, a loan that involves a temporary transfer of money from one party to another does not increase the money supply. A loan in which the lender somehow retains full title and use of the lent funds does increase the money supply.
Inflation or Deflation?
In order to determine whether inflation or deflation is occurring, it then becomes a simple matter of measuring the money supply. Conveniently, the Ludwig von Mises Institute recently began publishing True Money Supply (TMS) data. Unlike the various "M" monetary aggregates published by the Federal Reserve, the TMS properly includes those accounts that are money and excludes forms of credit that resemble money but are not (e.g., money market mutual funds). A graph of the TMS for the past five years is shown below:
While there are slight downward movements in the TMS from time to time, it has generally been increasing, and has continued to do so through its most recent measurement in April 2008. Accordingly, using my definition, we are experiencing inflation. While that much is perfectly clear, one must be careful not to draw certain conclusions based on that observation.
Bad Inflation, Not-Bad Inflation
One reason that Austrian economists place so much emphasis on the phenomenon of inflation is that it often causes boom-bust cycles. It is a specific type of inflation, however, that causes unsustainable booms, which I term "bad inflation." This is the type of inflation that occurs in fractional-reserve banking, where money that is intended to be used for current consumption is loaned out to businesses, sending false signals about people's preferences for current vs. future consumption, which makes it impossible for businesses to properly allocate resources. To the extent that market participants are not aware of the money creation or are not able to determine its rate or otherwise adjust for it, they will undertake business ventures and adopt consumption patterns that are unsustainable. In precisely the same way that Ponzi schemes can operate seemingly healthily for years or more before collapsing, the unsustainable booms caused by "bad inflation" might persist for a while, but will eventually go bust when reality surfaces, prices adjust, and previously profitable enterprises go out of business.
The other type of inflation that can occur I term "not-bad inflation." This type of inflation does not lead to harmful booms and busts, but it's not necessarily "good" in any sense either. Rather, it is a natural occurrence in a truly free market. An example of this type of inflation would be found in a society where gold is used as money. In such a society, it would be expected that some amount of gold would be mined from the earth and added to the money supply each year. As long as the rate of this dilutive increase in the money supply was acceptable to the populace (if it were not, a different commodity would be selected to function as money), entrepreneurs would adjust their calculations and business plans based on this dilution. If the growth in production of goods and services was faster than the growth in the money supply, the economy would experience gradually falling prices. Goods and services would go down in price vis-à-vis gold, and everyone would adjust his or her expectations to these falling prices and behave accordingly, exactly as people in modern society must adjust their behavior to rising prices.
To provide further illustration of why "bad inflation" leads to errors in decision making, consider the example of a valet parking service in an office building. Every morning when you arrive at work, you leave your car with the valet. In the evening, you retrieve your car and leave. Now assume that the valet has surreptitiously opened a side business where he loans your car to a taxi driver for a few hours during the day (much like a fractional-reserve bank). As long as you never leave during the day, no problems will occur. However, if you make the assumption that you can retrieve your car any time you want, and you attempt to do so one day based on that assumption, you will discover that your car is missing and you will not be able to honor the lunch commitment you made earlier in the day.[2]
Now consider the above scenario with one small change: the valet has disclosed his side business to you. Assuming that you consent to it (perhaps he reduces your parking fee), you will not assume that your car is available to you during the business day. You will therefore plan accordingly and avoid the errors that would be inevitable in the first scenario.
Unsustainable Booms
As noted above, the United States is undergoing inflation, and under the Federal Reserve System (FRS), inflation is primarily driven by the extension of circulation credit by private banks that are members of the FRS. As such, it is "bad inflation." Those familiar with the Austrian theory of the business cycle might therefore hastily conclude that the United States will continue to experience an unsustainable boom and that prices of commodities will continue to rise, just as they have been for the past few months. However, drawing such a conclusion would be premature. Widespread business failures and cutbacks in consumption are threatening the solvency of the banks that are responsible for creating money. As these banks discontinue loans to capitalize their losses, the amount of money in circulation will tend to decrease. This pressure could eventually overwhelm whatever new money the FRS is creating elsewhere and lead to deflation.
Those who insist that Federal Reserve policymakers have the ability to simply print up as much money as they want are completely right in one sense, but they perhaps fail to realize that the bulk of the money supply is in the form of circulation credit, which banks, rather than the Fed, produce. The Fed directly controls only the monetary base, which is basically comprised of physical currency and bank reserves. When the Fed purchases securities through its open-market operations, the monetary base increases by a corresponding amount, but it is ultimately the banks and their customers who determine the amount of circulation credit built on top of the monetary base. This is where the idea of the Fed "pushing on a string" takes its meaning. The Fed can let out slack to the banks by buying securities from them to increase their reserves, but it cannot force them to take up that slack by loaning those reserves to businesses. To see the size of the monetary base relative to the overall money supply, consider the graph below:
As the graph shows, the monetary base is roughly $850 billion, compared to the TMS, which is about $5.4 trillion. The Fed therefore directly controls only about 15% of the money supply. It should be noted that despite many people's claims that the Fed has been inflating tremendously in the last year, the monetary base remains relatively flat. Therefore, the Fed is not "printing," but is instead relying on banks to expand the remainder of the money supply. And as long as they continue to experience losses (perhaps due to holdings of subprime securities or other impaired investments), their ability to extend new loans will be reduced, and there will be downward pressure on the money supply and potentially deflation.
The Fed's Response
Most people are led to believe that deflation is a bad thing, but it is not. In fact, it is precisely what the economy requires to eliminate the malinvestment created by the Fed's inflationary policies. Unfortunately, deflation tends to be politically unpalatable because it causes, among other things, a temporary increase in unemployment as capital resources are reallocated to more productive sectors. Accordingly, it can be expected that the Fed will do anything it can to avoid deflation, not to mention the fact that its chairman, Ben Bernanke, has gone on record discussing the importance of preventing "deflation" (he uses a definition of falling prices).
Given the goal of avoiding deflation (using my definition), the Fed can go one of two routes. It can "print" large amounts of money and inject it into the economy by various means, but this runs the risk of leading to hyperinflation[3] due to the "multiplier effect": if reserve requirements for banks remain constant, any addition to the monetary base could result in an increase of up to 10 times that amount in the overall money supply. So if the Fed increases the monetary base too quickly, the very potential for further explosive growth in the money supply could lead to an utter loss of faith in the dollar and its abandonment by foreign central banks and other large holders of dollars. And for the government, to destroy a fiat currency system such as the dollar is to kill the goose that laid the golden egg. Despite any disagreements one may have with Ben Bernanke on economic theory, he is no fool. So far he has been supportive of mild forms of Keynesian deficit spending, but he has not yet resorted to printing. I find it doubtful that he will pursue any policy in earnest that he believes will cause hyperinflation.
Instead of printing, the Fed's second option is to try somehow to convince banks to extend more loans, businesses to borrow and expand, and consumers to continue to consume. This is quite a challenge indeed, given the general negative sentiment in the business world. The housing bust has led to the laying off of many workers and the realization by homeowners that they aren't as wealthy as they thought they were. Automakers and other retailers are struggling, and other problems continue to plague nearly all areas of the economy. The Fed's challenge is compounded by the fact that its lowering of interest rates has led to the dollar's weakening significantly against foreign currencies, which has had the effect of increasing the prices of imports, leading to further cutbacks in consumption and investment.
In order to combat the deflationary forces affecting banks, we see the Fed doing everything in its power short of printing money to prevent them from experiencing losses. This is why we have seen the Fed take actions that, as former Fed chairman Paul Volcker has said, "extend to the very edge of its lawful and implied powers." When the Fed provided $30 billion in financing for J.P. Morgan to acquire Bear Stearns, it bailed out not Bear but Bear's credit counterparties. If it had allowed Bear to go bankrupt, the banks that had loaned Bear money would have had to take losses, thereby reducing their reserves and their ability to extend credit elsewhere. It is even possible that Bear's bankruptcy would have caused other large firms to become insolvent and declare bankruptcy as well.
In other attempts to encourage banks to create money, we have also seen the Fed create three new lending facilities (the TAF, the TSLF, and the PDCF) — in succession, in the hope that the additional liquidity they provide would induce banks to extend more credit. While each of them might have achieved limited success in doing so, there is no telling what other sorts of imaginative creations the Fed will reveal next if banks continue to experience losses and reduce the amount of circulation credit.
Conclusion
Ultimately, the debate over whether we are experiencing inflation or deflation is a simple one if it is only a matter of observing the change in the money supply. The debate becomes far more complex, however, if its purpose is to predict what will happen in the future. While measures of the money supply might provide some indication of where things are headed, one must also have a thorough understanding of the workings of the banking system and the role of businesses and consumers in the creation and destruction of money. The Fed has already taken several drastic actions in an attempt to prevent deflation, but it remains to be seen whether it is even possible for it to achieve such a goal without destroying the dollar and the entire financial system.
Notes
[1] Mises and Rothbard offer definitions similar to what I term "bad inflation" later in the article. Hazlitt offers the somewhat vague definition of an "increase in the supply of money and credit."
[2] Such a scenario would also lead to economic miscalculations elsewhere. Although the "car supply" would appear to be two, there would in fact be only one car. This would send a faulty signal to the taxi driver about the number of cars truly available for his business to use. If the scenario were switched so that you retrieved your car before the taxi driver arrived to borrow it, he would experience a "credit crunch" and be left with no car to borrow. In a very basic sense, this is the same concept that underlies the Austrian theory of the business cycle — that when money enters the supply of loanable funds when it should not, it sends a faulty signal to producers about consumers' preferences for current vs. future consumption.
[3] By hyperinflation, I mean a scenario where money loses its value so rapidly that consumers spend it as quickly as possible in order to avoid holding it.
