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Deflation In A Fiat Regime?


The Fed can postpone, but it can't prevent.


I was asked by some to reply to a post by Doug Noland called Setting the Backdrop for Stage Two. Before reviewing Noland's post, I would first like to comment on this statement made by Professor Lewis: "I have never been one to believe you can have true deflation with a fiat currency."

Before we can begin any discussion, it's imperative to agree on the meaning of terms. I happen to believe in Austrian economics and the definition I use when I speak of inflation is a net increase in money supply and credit. Deflation is the opposite, a net decrease in money supply and credit. For more on those definitions as well as rationale for discarding seven other definitions, please see Inflation: What the heck is it?

Deflation In Japan

Assuming that there is agreement as to what inflation and deflation are, it's quite easy to refute the idea that deflation cannot occur in a fiat regime. Japan was in deflation for a decade.

However, some still argue that Japan never went through deflation. One basis for that argument is that "money supply" as measured by M1 or base money supply never contracted over a sustained period. The other argument is that prices as measured by the CPI never fell much. Those are flawed arguments (at least from an Austrian economist point of view), given the focus on consumer prices and money supply alone as opposed to money supply and credit.

Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to five consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. Those are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark.

Yes, there was deflation in Japan. Furthermore, if deflation can happen in Japan, then there is no reason why it can't happen in the U.S. as well.

Economist Paul Kasriel Weighs In

I discussed how a Japanese style deflation might occur in the U.S. in an interview with Paul Kasriel.

Mish: Would you say that consumer debt in the U.S. as opposed to the lack of consumer debt in Japan increases the deflationary pressures on the U.S. economy?

Kasriel: Yes, absolutely. The latest figures that I have show that banks' exposure to the mortgage market is at 62% of their total earnings assets, an all time high. If a prolonged housing bust ensues, banks could be in big trouble.

Deflation Is Here Now

The interview with Kasriel was in December of 2006. On March 17, 2008 in Now Presenting: Deflation! I stated "Deflation's here and it's now." A followup post was called Why Do Oil Prices Keep Rising? The key idea from the latter article is as follows:

A weak dollar Is masking deflation! Right now what we have is deflation with a weak dollar. That weak dollar, in conjunction with peak oil, has caught nearly everyone off guard to the point they are screaming about oil prices and bond bubbles, while missing the far more important deflationary forces of foreclosures, bankruptcies, and massive writedowns in credit.

Setting the Backdrop for Stage Two

Week in and week out Noland writes a great column. Stage Two made "Best of the Web" on Dollar Collapse. I happen to agree with that "best of" designation because Noland took a viewpoint and argued it well. However, let's take a look on a point by point basis (Noland's original post is in italics):

I hear pundits still referring to a "deflationary Credit collapse." Well, the U.S. Credit system implosion was largely stopped in its tracks last month. The Federal Reserve bailed out Bear Stearns (BSC); opened wide its discount window to Wall Street; and implemented unprecedented liquidity facilities for the benefit of the marketplace overall. Central banks around the globe executed unparalleled concerted market liquidity operations.

Technically the Fed bailed out JP Morgan (JPM) not Bear Stearns. The Fed was very afraid of a derivatives cascade, and the Fed made JP Morgan whole on swaps it was holding on Bear Stearns.

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