Which Will Cause the Coming Depression? Inflation or Deflation? (+3K Views)

So asks Monty Pelerin (www.economicnoise.com) in edited excerpts from his original article*.

Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!) has edited the article below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.

Pelerin goes on to say, in part:

In our highly regulated and manipulated economy, economics is important but generally takes a back seat to political considerations.

The Fed has backed off temporarily on further monetary stimulus, or at least that is what they would have you believe, but there is no assurance that the Fed will continue to abstain. Without further Fed easing, a deflationary collapse will occur. A resurgence of Fed activism does not ensure hyperinflation, although it points in that direction. The amount of inflation depends on Fed aggressiveness (the supply of money) and public reaction (the demand for money).

The Inevitability Of A Depression

Debt levels in the private and public sectors are unmanageable. Prior governmental stimulus, beginning several decades ago, is responsible for the current condition. Capital and labor are mis-allocated. Relative prices are distorted. The economy, in short, is broken and unable to function properly.

A correction must occur for the economy to return to reasonable productivity and growth. The government myth that it can manage the economy and avoid slowdowns has nearly run its course. For the last fifty years this myth has resulted in nearly continuous economic interventions. The intent of each intervention was to prevent the natural, self-correcting processes of the economy from occurring. These corrections require the recognition of wasted and mis-allocated capital, producing a temporary slowdown in economic activity. Every government intervention is an attempt to prevent these corrections.

We are now at a breaking point where additional intervention no longer works. The distortions built up over a half century are so great that it is impossible to continue to cover them up. The amount of misplaced and misused resources is now so great that the economy no longer functions properly. That is why five years and trillions of dollars have not produced a recovery. Until the economy is purged of these imbalances, no intervention can help.

Economic actors are saturated with debt. These include both the private and public sectors of the economy. Zero interest rates will not stimulate borrowing or economic activity. Federal, state and local governments have overextended themselves and are close to sovereign defaults. Debt, across the board, is too high and must be liquidated in order to regain economic vitality.

Liquidation of Debt

The perceived necessity of additional Fed intervention relates to anemic economic growth. However, the problem is too much debt. More of the poison that caused the illness is not a cure. In order for the economy to regain resiliency and growth, a large portion of debt will have to be extinguished.

There are only three ways debt can be extinguished:

1. Pay it down in accordance with the debt contract
2. Default on it
3. Inflate it away

1. Pay down the debt: Mathematically, much of the debt cannot be serviced out of cash flows, i.e., paid down according to the contractual agreement.

That leaves either a default or inflationary alternative as the means for reducing the debt.

2. Default on the debt: Some debt defaults have already occurred as a result of the economic crisis but nowhere near what is ultimately coming. Debt defaults are deflationary, shrinking the money supply. Deflation makes other nominal obligations harder to honor, creating even more defaults. This spiral leads to Depressionary conditions as experienced in the 1930s. It is the reason why so many economists fear deflation.

3.a) Inflate the debt away: The other alternative is “surreptitious” default. Inflation depreciates the value of the dollar, reducing the real burden of existing debt. Debt is paid back in dollars which buy less. This process represents an economic default. Lenders are cheated out of some portion of their contract as a result of cheaper dollars. Borrowers win at the expense of lenders. Society as a whole loses as such a process tends to initiate another false boom and additional mis-allocation of resources. It does not solve the underlying economic problems, but may defer the ultimate resolution which will be more painful as a result.

There are limits to which inflation can be carried. At some point, economic actors anticipate the inflation and price it into loan agreements (higher interest rates), purchasing contracts (higher prices), etc. At that point, inflation ceases to “fool” people and the inflationary policy is ineffective unless the rate of inflation is rising faster than expectations. In extreme cases, people recognize the fraud and protect themselves against anticipated future inflation by spending dollars faster. If goods are perceived to be more expensive tomorrow, then buying them today is equivalent to obtaining a “discount.”

3.b) Hyperinflate the debt away: Once inflationary expectations reach or exceed the rate of inflation, whatever were assumed to be the positive effects of inflation are gone. It is at this point where the government and the Fed lose control. The purchasing power of money is a function of both supply and demand. Within limits, the Fed controls supply. Individuals determine demand. Once continued inflation is perceived, then demand for money declines. At this point, the velocity of money begins to rise, meaning the Fed has lost control of the value of money. In extreme conditions, money is shunned in favor of barter.

Barter may be a partial protection against inflation, but it is an inefficient means of trade. Modern economies collapse when dependent on barter. Thus, high inflation also leads to Depression.

Will It Be Inflation or Deflation Preceding The Depression?

The question might seem appropriate for an economist to answer, however it is really a political question. The political class controls the money supply via the Federal Reserve. Economics only can answer what happens given various monetary actions/policies. Inflation is always a political event. Economics can only explain the mechanics of money and its influence on prices. Politicians ultimately decide on the money supply.

What precedes our entry into a Depression is debatable. A strong case can be made for either deflation or inflation being the catalyst that triggers the economic collapse but I am of the opinion that extreme inflation will precede extreme deflation, purely based on political motives. I do not see why politicians would allow deflation to occur, if in fact they will try to remedy it once it has begun. All actions up to this point show that they are willing to print money (almost a quadrupling of the monetary base in the U.S.) to avoid a collapse. Why will they not continue to take whatever actions are necessary to extend their pretense of an economic recovery?

Arguments for Inflation

There are two reasons for politicians to continue to print money in whatever quantities are required:

1. To allow government to have the liquidity to pay its bills (defense, social security, welfare, etc.). Arms-length credit markets no longer consider the U.S. a reasonable credit risk which explains why 61% of treasury debt issued last year was purchased by the Federal Reserve (money creation). If government is unable to pay its legal obligations, its credit ratings plummet. If it is unable to pay its social promises, rioting in the streets begins.
2. The continued printing of money allows financial markets and the economy to levitate beyond where they would be without this stimulus. That is, it masks the true and potentially miserable conditions of the economy, at least for a while longer. The importance of that to incumbents in an election year should not be underestimated.

Conclusion

The critical issue is political. Will government allow deflation to occur or social security checks to not go out? I think not, although government regularly misjudges matters and is clumsy in its execution. If we have deflation, it will be political ineptness rather than intent that causes it. Regardless, prepare for an inevitable Depression.

*http://s.tt/1j2CP

Editor’s Note: The above may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The views and conclusions expressed are unaltered and no personal comments have been included to maintain the integrity of the original article.

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