Monday, May 28, 2012

Inflation or Deflation - Between the devil and the deep blue sea - Part 1

So let's continue with our analysis of the current monetary system. In the last 2 articles we discussed the following:

- In a fiat monetary system it's the credit that leads to savings and not vice versa
- This system is one big Ponzi scheme as it can only continue if people take in more debt or new people come in debt
- The system by its very design (not intentionally ofcourse) leads to a transfer of wealth in the following order:

  • People working on fixed wages are the biggest losers as they have all downside risk & no upside reward
  • The entrepreneurs have both downside risk  and upside reward though their upside reward is a little skewed
  • The biggest beneficiaries are the banks as they have no downside risk (as they print money out of thin air; not a laborious task i guess :) ) and all upside

Please note again, the intention is not to blame any specific group or industry, just stating as things are under the current system.

In this article we are going to discuss a very important debate that has engulfed the investment community of what end the world would see "Inflation" or "Deflation". I would discuss this topic in two parts.

First let me put forth the correct definition of inflation/deflation, it's not the increase in CPI, that is only one of the symptoms of inflation. Inflation is increase in money supply (base money + credit) and deflation is decrease in this money supply. This money supply can go into wages, commodities, stocks so CPI is just one of the symptoms of inflation. With a quantitative easing/LTRO episode happening once every 6 months it is now almost a common understanding that with such a massive money printing effort going on the world would up in some hyperinflation debacle and buying into stocks or commodities are the way to go.

Well all I would say is that this is another one of those theories that has sprang along like the investment theme that fueled the Nasdaq rally (remember: increase in productivity) or the 2003-07 rally (this time it's different theme as real business are showing growth). While I believe hyperinflation is a possibility but in my opinion the way to hyperinflation is laden through a hyper-deflation as a lot of things would have to happen should the world monetary system witness a hyperinflation collapse.

So let's discuss first why I believe the threat of deflation is more pronounced. During the peak of the credit cycle in 2007, US saw a 4.5 trillion dollar credit creation now as we have discussed in the modern monetary system the savings = credit + government deficit so this net amount of savings is what goes into stocks/ commodity investment, real estate, bonds and finally saving accounts.

What has happened post the end of this credit cycle is that US and most of the western world has reached the saturation point of credit creation simply because of demographics and their people are already under huge debt.So as you can guess that with a lesser credit growth the savings would come down which would lead to a collapse of stock prices etc. Earlier whenever credit growth used to slow down the Central Banks used to cut the interest rates and thus boosting the credit growth, however now with the interest rates near the zero threshold this is no longer an option. Now to avoid such a scenario two things are happening, the US government is running more than  a trillion dollar deficit (this adds to the savings) and the Federal reserve and now the ECB is buying this debt thus making the extra savings created because of government deficit to go into stocks, commodities, real estate, corporate bonds etc. However in spite of all these efforts the global credit growth is far below the average credit growth seen during 2003-07 and we are almost 4 year into the recovery, the very nature of monetary system ensures that we enter into a recession every 6-7 years. Why?

Let me explain: Let us say a company takes a 5 year loan and starts producing things, looking at the business potential more companies take such a loan and enter into the business, because of this other business also start to grow. However the profile of the loans taken by the company is for a 5 year term and after 5-6 years  when the companies start to repay the loan there is suddenly a deflationary environment created leading to a recession. This is what we call a business cycle from the monetary perspective or in other words a credit cycle.

So inspite of such a loose monetary policy the world is unable to generate sufficient credit growth, what would happen when we hit the peak of one of these business cycle which is no doubt coming, the credit growth can again slip down and chances are that it can go into the negative. Global credit growth has gone into the negative only once (in a year) in the past 40 years and that was in 2008 and we know what happened then... So I would submit again that irrespective of what we hear in the financial media which is again one of those old stories recycled to sell the gullible investors with crap stocks; the threat of deflation is more pronounced. Ofcourse since I believe this monetary system is unsustainable this is not an unexpected or undesired outcome but simply an inevitable outcome.

We would continue with this discussion in our next article wherein we would also see what changes would have to happen for the world to finally see a hyperinflationary outcome, till next time............

Addendum from previous article:

This is from the previous article wherein I would explain how things behave differently when we have savings driving credit growth and not vice versa.

For this let me clarify that any depositor depositing his money in the bank is lending to the bank and like any business of lending there are risks involved contrary to the perception of risk free lending that has been created, thanks to the modern monetary system.

So let's say a farmer produces 100 kgs of copper and intends to consume 80 kgs and save 20 kgs of wheat in a bank. The bank issues that 20 kg of wheat to the entrepreneur with which he pays off the salaries of his two employees which they again deposit in the bank. Again for some reason the project doesn't materialises. However unlike last time in this case the two employees would get their payment irrespective and the loss would be borne by the depositor which is fair as he was involved in the business of lending and should take the hit if the project doesn't go well.The fundamental reason why this happens when savings lead to credit is because here the risk is rightly transferred to a third depositor whose deposits made the project possible unlike in the previous scenario where the employees of the company were themselves the only depositors as credit lead to creation of savings............


Tripati said...

Himanshu, equating money supply to inflation presumes a one-to-one correspondence with inflation. However, in short-run, money has a real effect on output (post- and new- keynesian would argue), wherein the credit money for a given fiat money, may surge courtesy banking system accommodating the demand for money through financial instruments. Thus, it may have a benign effect on interest rate. In this sense, post- and structuralist- would, nowadays, have thrown away the traditional LM curve (which assumes money demand stability) and replace with CC - commodity-credit curve. Here money demand is governed by income (GDP) change than vice versa.

Stochastic Process said...

Hi Sir, I absolutely agree that in the near term money supply has effect on real output and in the fiat monetary system as you have pointed out the money supply surges courtesy of the bank credit the demand for which depends upon the interest rate, existing indebtedness, demographics and opportunities in the economy , when i say that inflation is increase in money supply I am defining inflation as the Austrians do i.e. not just the CPI/WPI which is merely one of the places where this increase money supply may land up but it can land up in stocks, real estate, bullion etc.

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