Sunday, June 21, 2009

The Distinction Between Deflationary and Hyperinflationary Policy

I've been reading When Money Dies: the Nightmare of the Weimar Collapse by Adam Fergusson. The book is so rare it costs several hundred dollars on Amazon, but fortunately it is free online. I'm still near the beginning but it is a thought provoking read.

What interests me in it is the distinction between deflationary and hyperinflationary outcomes of economic contractions. The more I read, the more I conclude the differences are disturbingly narrow, and if monetary policity shifts from one direction to the other it could easily go without notice to the public for awhile.

I hope both inflationists and deflationists can agree that either outcome will be a determination made by the regulators of fiscal policy—in the U.S. it would be the Fed and the Treasury Department. There is nothing inherent in economics that will naturally go in one direction or the other. Hyperinflation or deflation is a choice consciously made and acted upon by financial authorities.

In the event of recessions, governments try to stimulate the economy with loose monetary policy. In our case now, this has been going on without stop since the end of the internet bubble. It is still going on, first with a real estate bubble, then a second stock market and commodities bubble, and now with quantitative easing. Efforts at money creation have been taking place non-stop for a decade.

But all the money created by the government, so far, is in the form of credit, which is expected to be paid back. The act of paying back credit at the end of a bubble is deflationary. First, there will be less credit available in the coming years, and second what disposable income people now have will be mainly used to pay off debt. The overall result is money contraction and price deflation.

What happens in hyperinflation is that money is created and distributed without any need to pay it back. It is handed out as payment for government services or entitlements without any expectation it will be returned.

This difference turns out to be subtle. So far, all reported stimulus money is a government loan underwitten by the tax base. This fundamentally does not expand money supply. Any expansion is only temporary, so the ultimate outcome is deflation. Were such loans NOT to be underwritten by the tax base and could be defaulted on freely, hyperinflationary risks come into play.

When it comes to tight wages, unemployment, reduction of government services, widespread defaulting on credit, and tight lending standards—deflation is what we are seeing. Prices of everyday goods remain about the same but most investment classes remain down from 2008. All deflationary unwinds have exhibited rebounds like the one we are seeing now and if deflationary patterns hold then corrections to fundamentals will resume any day now.

My money remains in dollars, but at this point diversifying into gold and some competitively priced stocks would be a more sensible strategy than when this blog first began. Were I a more savy investor I would have jumped from dollars into stocks in March, but had I done that now I would be going back to cash.

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