Will We Have Inflation, Deflation, or Hyperinflation? Part 4 (Final)

Will Inflation Be the Effect of the Fed’s Action?

In either alternative or a combination of the two, we would have inflation because money supply would increase. How much inflation depends on how much cash is injected into the system. Such inflation would eventually cause another artificial business cycle that would further damage the economy by destroying more capital as the new money is misdirected into businesses that would not be otherwise viable but for the effects of inflation. This is called “malinvestment.” We are presently suffering the results of malinvestment in real estate assets.

This new cycle will be less of a boom and more of a bomb. This is what happened in the 1970s when the CPI went sky high yet economic activity stagnated. Stagflation was the term devised to describe it.

The problem is this: how many times can you destroy capital before you have jeopardized the ability of investors and entrepreneurs to create new profitable businesses?

Real wealth as I discussed before, is not a piece of paper. It is goods produced that are not consumed. (See my article, “Money: A semi Fictional Fable.”) Money is just a way of holding wealth until you wish to consume something. If I am a factory owner producing silicon chips for Apple, and I save some of my profits rather than spend all of it, those savings are real capital.

It is difficult in our complex economy to measure “real capital.”

Some Austrians believe a decline economic activity indicates a decline of real capital. I would agree that is probably the case, and, I would agree the last two cycles have been destructive of real capital. I do know that more pieces of green paper will only result in malinvestment (the destruction of more real capital) and rising prices.

When will we see inflation?

This is where I believe the deflationist argument fails. The deflationists believe we will have years of deflation because of the credit freeze. Banks are still loaded with bad debt and viable borrowers are difficult to find. While I understand the similarities with the Japanese experience (massive fiscal stimulus, zero interest rate policy, low inflation, and stagnation) I believe the situation will be different here.

That difference is that we are cleaning up our mess whereas the Japanese, perhaps because of cultural reasons, let bankrupt (zombie) companies and banks stay alive. This tied up capital in unprofitable businesses (malinvestment), and new capital was not able to be directed to entrepreneurs and profitable companies.

While we may be going at it slowly, America has a rich tradition of failure, foreclosure, and bankruptcies which acts as a cleansing mechanism to rid the economy of malinvestment. This is what Joseph Schumpeter referred to as “creative destruction,” or the process by which capitalism corrects its mistakes. This process is occurring here, but the problem is that the process is being slowed down by government policies that prevent bankruptcies (mark-to-make believe, extend and pretend, delay and pray, and TARP, TALF, Cash for Clunkers, and housing subsidies).

I don’t agree with the deflationists that deflation is a decline in real estate asset values. I believe the deflationists conflate deflation and deleveraging. I agree with the deflationists that deleveraging and the decline in real estate values has and will limit economic activity because it has suppressed bank credit, but it isn’t deflation.

Further, as pointed out by Austrian economist Bob Murphy, we haven’t seen deflation yet, or at least it has not been reflected in the CPI. In fact, he says, we haven’t had deflation since the Great Depression.

At some point the Fed’s efforts to increase money supply will be effective. It is difficult to predict when that will be.

I think we are seeing current declines in money supply growth as a response to the Fed’s cessation of MBS purchases. It is possible that we may go into negative territory which would be deflation, but, with evidence of a double-dip economic decline, the Fed will do everything it can to re-inflate and I think they will succeed.

This time the result will be stagnation and inflation.