Still Worrying About Deflation, Not Inflation

A lot of people I meet these days ask about the risk of a future surge in inflation, or even a return to “hyperinflation,” as a result of government’s efforts around the world to stimulate spending and demand — in part through large deficits, and in part through very loose and unorthodox monetary policy (including, in some jurisdictions, “quantitative easing”).

I am losing sleep over a lot of things, these days, believe me — but not over the dangers of future inflation.

The Levy Institute has just released an interesting brief which makes this same point more completely, and empirically:

They first document the dramatic rise in the outstanding stock of public sector debt instruments in recent months.  Total federal liabilities have grown by half as a share of GDP in the last year alone.

(By the way, a similar rise is visible in Canada, too. There’s an interesting summary of this in a fascinating recent presentation made by Allan Tomas, Joe Wilkinson, and Eric Boulay at Statistics Canada.  They show that federal gross credit market debt grew by almost $100 billion in the last year, even though the actual government deficit was much smaller — reflecting the energetic interventions in financial markets undertaken by the Bank of Canada and other federal agencies.  These interventions didn’t add to the deficit, but they did add to the total stock of gross debt.  The Bank of Canada’s total liabilities, in particular, exploded by about 60% in the last 2 quarters — from $50 billion to $80 billion.  Thanks to Armine Yalnizyan for passing that presentation along.  I can forward the pdf file to anyone else who wants to see it: contact me at

(Incidentally, this data illustrates that governments can do a lot to stabilize industries — in this case, almighty Bay Street — without at all “dipping into the pockets of taxpayers.”  The government is using its financial power and balance sheet capabilities to help industries that need assistance.  Directly, it doesn’t cost the taxpayers a dime — and it could actually make them money, through the interest spread and other income which government makes as a result of these transactions.  Exactly the same logic applies to the proposed auto assistance package and other forms of pro-active intervention by government, which generally have nothing to do with “throwing around taxpayers’ money.”)

But does this mean that government is firing up the printing presses, and hence that we’ll soon need whellbarrows full of cash to buy our groceries?  Some folks, even on the left, seem to think so.  Their fear reflects a very old-fashioned view of how money and inflation works.

First, there’s no obvious link between the money supply and inflation anyway (as implied by the discredited Quantity Theory, which tried to convert a statistical identity into a causal model). 

More importantly, what we call “money” is not remotely equivalent to the amount of currency in circulation, nor to the amount of public debt.  Over 95% of money is the stuff that’s “printed” by commercial banks and other private financial institutions, in the course of their creation of credit.  Swings in private credit creation (or destruction?) overwhelmingly dominate overall movements in the money supply (which is, in fact, simply a post-hoc measure of how much business and circulation is going on in the overall economy — not a policy instrument that we can somehow control).

Total credit is declining rapidly, not growing, because of the private financial crisis.  Real spending is also falling, largely because of the credit freeze, but now also because of the independent collapse of consumer and business confidence.  That will drive prices lower, not higher, despite the new aggressive interventions of governments and central banks.  The Levy brief makes this point strongly.

The reason we’re in a recession today is because our privatized money-printing machine failed miserably and now is contracting.  Hundreds of billions of dollars of “privately-printed” money are disappearing around us, as a result of “deleveraging” (that is, bankers who go bust, borrowers who go bust, and/or still-living bankers who pull in their loans).  That’s a major factor driving the retrenchment in personal and business spending that is driving us into recession.

In any event, a rebound in inflation (within limits, of course) would be an unambiguously good thing in my books.  It is much easier for industries and companies to restructure in an environment in which their nominal revenues are growing (rather than staying stable or worse yet falling).  The auto industry’s plight is proof positive of that.  It would help companies, consumers, and governments like to work off their debts — especially improtant now given the painful balance-sheet problems that are hammering private sector spending today.

Unfortuantely, it’s going to be a long long while before we get that rebound in inflation that I would welcome.  And just as unfortunately, the long-run mindset of central bankers has not changed much — despite the spectacular collapse of what was pompously called, until just a year or so ago, the “New Consensus in Monetary Economics” (NCM).  They are still of the view that controlling inflation at low and stable levels is the best thing they can do for the world.  And hence as soon as private credit creation starts to rebound, and the real economy starts to grow again, rest assured that the central bankers will be rapidly and firmly tightening their rein on the whole credit machine.


  • The Statistics Canada presentation that Jim mentioned can be downloaded here.

  • “Unfortuantely, it’s going to be a long long while before we get that rebound in inflation that I would welcome. ”

    Let’s be precise about this: (I don’t think you would disagree), I don’t think it’s a rebound in *inflation* we would welcome; rather, we would welcome a rebound in *expected* inflation. That would be one of the main channels through which monetary policy could help us.

    It would be better if everyone had roughly the same expectation of moderate inflation, but given the current uncertainties, that is unlikely. So some people expect deflation, and others expect high inflation.

    In other words, those fears of inflation are exactly what central banks are trying to achieve (or should be). They are signs that monetary policy is working, not failing. Announcement effects, and expectations, matter.

    Underlying all this is the indeterminacy of prices when you conceive of monetary policy in terms of interest rates. If central banks hold the (nominal) rate of interest constant: if people expect inflation, there will be inflation; if people expect deflation, there will be deflation.

    The way out of this indeterminacy is to think again in terms of the “discredited” quantity theory. We don’t need to think of in the way you describe it. But that’s another story.

    So by all means support more aggressive monetary policy (like you, I don’t think it is yet aggressive enough). But the reason we think it is not aggressive enough is that too many people still fear deflation, and not enough fear inflation.

    So when you next meet someone who is very afraid of high inflation, the best thing you can do is not to tell them they’re wrong, but instead to say “Yes, you might be right. Better get rid of that cash and bonds now, and go out and buy….a new car (preferably one made by CAW), because they will be going up in price!”

  • Nick,

    I always thought the point of rational expectations was that the public could not be systematically fooled by economists or governments. Although in light of the experience since 2001 it does seem people are a lot more susceptible to being duped by both.

    That said, I will be holding on to my cash not because I think prices are going down but because I am busy de-leveraging and no amount amount of expected inflation below say 5-8% is going to get me to further leverage. To come to your favourite example, Erin may have to try convince people that Zimbabwe is coming to inflation theatres near them soon. Not very believable even if it can be a rather gullible crowd.

  • Travis:

    I think we’re in a weird sort of situation right now, where more than one different expectation of inflation can be rational.

    I understand why some might need to de-leverage, but even so, you face a choice of how much (or how quickly) you will deleverage. There’s still a trade-off, and expected inflation should affect where on that trade-off you choose to be. You can save more, and de-leverage more quickly, or save less, and de-leverage more slowly.

    In aggregate, we are not in debt. For every dollar borrowed there’s a dollar lent. So not everyone needs to de-leverage. And the paradox of thrift reminds us that if we all try to save less (in current circumstances) we end up saving the same amount, but have higher incomes.

  • A Poem for Jim and the CAW on this day of rationality

    I have never been too much of a fan of text book rational expectations.

    Especially when a lot of what one was taught to believe was rational, essentially turns out to be pretty much exclusively irrational.

    I went to work
    and was told my job was outsourced-
    and that with a glance from a truly legitimatized stare of rational decision making
    based somewhere in the hallways of the company the Decisions tapped their six fingers as agreement was reached many months ago to source this whole series of value adding tasks to a group of workers somewhere else, that for the last 20 or so years, the labour standards for this particular group of other workers within a sea of infinity of labour power- costs were whole bunch less and declining rapdily and they don’t take pee breaks, or learn much about about union drives from the armed guards at the gates of the factory, and the exchange rate of the money this group of worker makes use of in the measurement daily rituals, is a whole lot less when traded at such multinational favoured values than which my group of workers is valued at and use within their daily rituals- eating, drinking, frolicking and debating.

    Rationally this all makes sense, at least contained within these independent microscopies of economic windows onto the globalized markets, where the ships can move masses of discontent without even one yell of protest sealed away in the cargo bay.

    within a regime of far reaching economic forces
    that in the end collapses
    because the rationality was brought to its extreme tensions and burst
    Thrown asunder was buckets and buckets of coloured, irrationality, that was contaminated with highly toxic assets of contradictions.

    Laying face down in the ditch, in my tints of red, green and blue, workers in my group reach for the rationally loaded media and government leaders and harbingers of definition. Relaying the layers of concrete and assurance has begun amidst the micro screams of this uncivilized rationality.

    So I say to myself and my fellow workers, I expect my pay cheque will be gone, but I may have a shot at the local wal-mart where I can distribute value,

    but I expect my pay will be a lot less, and I may have to sell the house.

    But then again maybe I will join the circus and become a clown and stand right next to the dog faced boy and bask within the rationality of it all and dream of the deleveraging and the trillions it will take, and wonder how it will all be rationally explained as we steer right back for those troubled waters of overheated irrationality.

    All along the watch tower, the speakers blared “we cannot have a single restless consumer!”

    And so began the noise of the ratchet as down came the expectations, and up goes the buildings of frugality sharing in the pain, as the new rationality amongst the purveyors of value definition rewrite our future history.

    So I say to my group, “”what are you doing Monday night- we need to meet and have a talk!”


  • Nick,

    I do not doubt the power of effective demand in a demand but not capacity constrained world. My point was rather this: in a deflationary world where prices and sales are falling we can tell people “inflation is coming inflation is coming” but if people actually experience prices falling they will form their expectations accordingly. Think about the potency of screaming “deflation is coming deflation is coming in an inflationary world.”

    However, I actually doubt the strength of the connection between consumers’ expectations about future prices in either direction and decisions to consume. Moreover, I think that the timing of big purchases like houses and cars, which we already spent a good 7 years stocking up on, are more interest rate than inflation rate sensitive. Ultimately at this stage in the game I think things like unemployment and the perceived risk of job loss are more potent forces.

    This is partly why I think ‘monetarism,’ popularly understood, worked (although other methods could have been used): the Volcker shock and tight money (high interest rates and the litany) savaged a whole generations’ expectations about unemployment, job security and income.

    So to my mind what people need to believe now is that unemployment will decrease, and that their job security and purchasing power will increase. Not mention reassuring workers there pensions are not up for grabs in bankruptcy proceedings.

    Those things point in the direction of significant fiscal stimulus and broad extension of EI coverage and benefit rates not in the direction of trying to convince that small cadre of individuals who have bullet proof job security and lots of liquidity to consume now because inflation is coming.

    On a positive, note the last retail figures show pills and booze are doing exceptionally well

    Food is too, but this almost all because of inflation in food prices. I would go buy a years worth of vegetables but they perish in storage:).

  • someday I will finish that poem. It has some potential/

    Bottom line is, I am not a fan of rational expectations- could you tell. And Travis, my poem said exactly what you did. Or at least that was what I was trying for.

    GM is now going to be owned by the the US govt and the Labour unions, so I may need to change a few lines in that poem someday to reflect the changes, at least I hope so.

  • Paul,

    I was thinking about my choice to become a prof and how irrational that choice was. Lawyers hours for a professors salary and six extra years of forgone income and extra debt. I guess if I gave multiple choice and no essays as the criteria for evaluating my undergrad I could get down to some more reasonable hours. I guess I just have a preference for average rather than marginal quality.

  • A Poem for Jim and the CAW on this day of rationality

    I have never been too much of a fan of text book rational expectations.

    Especially when a lot of what one was taught to believe was rational, essentially turns out to be pretty much exclusively irrational.

    Version 2

    I went to work
    and was told my job was outsourced-
    that with a glance from a
    Legitimatized stare of rational decision making.
    Perched up within the den of short run profit maximization
    Decisions tapped their six fingers as
    Agreement was reached many months ago
    to source this locality of work
    to workers somewhere else.

    Whose lax labour standards made them more rational?
    Amidst a global sea of a seemingly infinite labour power-
    Where being and lifetimes are now quantified with minimization

    It now is a race for a whole bunch less for the human-
    and declining rapidly.
    The boss said to me, “those people don’t take 15 minute pee breaks,”
    And “they don’t learn much about union drives”-
    From the armed guards at the factory gates.
    Exchange rates are quite efficient rationalizors of irrationality.

    Shrinking payrolls do have costs but don;t expect your account to know how much

    What is the price of value and what is a skill?

    Central banks have been serving up such good flavours
    Of money at their delicatessens for the MNCs.

    Daily rituals being valued with such oddity
    As we spin around this planet so handsomely with pride.

    eating, drinking, frolicking and colouring our nakedness with cultures and social fabric.

    That bold Rationality that comes streaming though our economic windows.
    Globalized markets, where the ships move masses of discontent,
    without one yell of protest heard,
    as they are so neatly sealed away in the cargo bay.


    within a regime of far reaching economic forces

    that collapses cyclically every few months for the last 250 years.

    Rationality has brought itself to the extremes of tension and burst- wars, famine, disease are economic.

    Thrown asunder are buckets and buckets of coloured, irrationality, that is contaminated with the highly toxic assets of contradictions.

    Yet even as I Lay face down in the ditch, in my tints of red, green, and blue,

    My co-workers still insist on reaching for the irrationally loaded media and deaf government leaders.

    After all this present and history, why are these old ideas still the harbingers of definition.

    laying this concrete for a new assurance,

    That “things are just fine or will be soon”

    Amidst the beaten workers and their screams of discontent from this chaos of uncivilized rationality,

    I say to myself and my fellow workers, “I expect my pay cheque will be gone, but I may have a shot at the local wal-mart”, where I can distribute value.
    “But I expect that new paycheque will be a lot less, and I may have to sell the house.”

    But then again maybe I will join the circus
    and become a clown, they are so highly paid these days,

    and stand right next to the dog faced boy and bask within the rationality
    of it all and dream of the deleveraging and the trillions it will take,

    and wonder if it will be enough to buy that rationally needed to explain this mess.

    All along the watch towers, the speakers are blaring “we cannot have a single restless consumer!”

    And so begins the noise of the ratchet as down come the expectations,
    and up goes the buildings of frugality
    which legitimize the asymmetrical sharing of the pain,
    or so goes the new rationality.

    So I stand up with one leg on my TV set and the other on my home computer desk and say to my group, “what are you doing Monday night- can we all meet and have a talk!”

    PT May ‘09

  • Seems like the banks are on a profit binge. I cannot believe they raised rates today. Was I just having a nightmare, or did I really read they raised rates by .2%.

    What the hell is going on in this country. It’s not enough the banks received bailouts, they now need to pad their profit margins.

    I say, these are dangerous times to be pulling such pillaging and raping of the peasants. We had a bad harvest and now they are taking even more than the King has suggested. I guess if we had a Red king instead of a Blue king, then the suggestion would have been more of an instruction.

    Flaherty and has got to be replaced!!!!!!!

    Such venom must only be answered with similar moves. Get rid of these tories now, call the election in the summer and be done with it.

    If we get more rate hikes you could see a braking action on the economy that will break the back of a recession and turn it further into some deep dark corner of the country where we start discover the undiscovered country and it won’t be a joyous ride.

    Playing with fire here.

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