## Tuesday, April 14, 2009

### The Financial Crisis for Dummies: Inflation and Deflation, monetary policy

This is the second post in the "Crisis for Dummies" series. One of the difficulties in giving a comprehensive narrative is that the nature of the beast is to have many variables that play together. It is easy to describe each connection and relation, the logic is not that complicated (housing prices go down, people sell) but it is the number of such agents and relationship that can boggle the human brain. I am working with a professor in Sydney on a mathematical model and will share it soon.

Meanwhile the human narrative must put the spotlight on a aspect of the crisis and unravel the relationships, the best I can do in "for dummies" is to use examples that everyone can grasp instead of throwing out 3 letter acronyms that scare little girls away. But do not lose sight of the fact that it is only when all these variables are at play at the same time, that the real story unfolds.

There are however variables and agents that play more important roles than others, they are central to the drama. Today I focus on "money", or rather credit money, monetary levels and their impact on price levels. Inflation and Deflation.

It came as a surprise to me when I was 38 years old and my brother told me "you realize credit money is money and increases the monetary mass". Assume there is a house on the market the ask is 500k. Assume there are 2 buyers you and them, A and B. Assume now that the amount of CASH that you hold doubles both for A and B. That Cash is CREDIT and you have access to it. If you start with 50K and can borrow up to 700k what is the price going to be? 750k. Because credit created CASH IN THE SYSTEM, the price level goes up. This is MONETARY ASSET INFLATION.

Assume the reverse for credit. Credit is tight. You have 50K cash assets and you can borrow only 300k. The price of the house will be 350k. THIS IS MONETARY ASSET DEFLATION.

The amount of CREDIT-MONEY in the system (monetary levels) directly affects price level. This is one of the tenets of modern economics:
Inflation and Deflation are always and everywhere monetary phenomenons

You may ask "but wait, the government CPI index has shown very benign inflation for the past 20 years, while the credit has expanded, what gives?"
Be careful that CPI, the index of consumption prices that governments use does not take into account asset prices. Housing and stocks for example may inflate in a monetary bubble, it will not be captured as "inflation" by the CPI index but rather be touted as "growth". It is mostly monetary growth. So while official statistics were showing low CPI due to the Chinese influence, a more comprehensive CPI measure would include the cost of housing in full, the cost of stock assets, and would have shown a HUGE BUBBLE. ASSET PRICES are subject to monetary inflation and deflation.

Inflation in bad, Deflation is worse
Inflation is bad, at least a lot of it is bad. We all know that from recent memory and history. But Deflation is worse, why? because if nominal prices are going down then you are better off holding onto cash and spending later. That house you want to buy will be cheaper in a year, so wait! The problem with this is that economic activity slows down dramatically and the "velocity of money" goes down. Worse still the burden of debt increases. See it this way: you took a loan on that 750k house. Your income may go down or disappear. The net worth of your assets may go down (your house is now worth 350k in the market), but the nominal value of you debt is still 750k. In a deflationary environment your cash inflow follows deflation but your cash out-flow is set.

Ponzi type II bubbles
Monetary bubbles kick off ponzi type II mechanisms. Expand credit, you will expand prices, so you will expand returns, so you will expand demand for credit to invest in those very assets and you will further expand prices and return and so on and so forth. Keep this in mind, the original inflationary euphoria in monetary led bubbles is really hard to resist. It talks and walks and looks like growth! The problem with this dynamic is that is kicks IN REVERSE when the prices go down. This is the "negative feedback loops" everyone talks about.

Price Stability: the FED charter, shock and awe
Central banks have as a stated goal to insure "price stability". This has resulted in practice in "a little inflation is optimal, too much is bad and deflation is worse". One can understand the current FED shock and awe program (QE and MTM suspension) as a desperate effort to derail the negative feedback loops. It is done by artificially raising monetary levels (printing presses are on: Quantitative Easing (QE)) and suspending mark to market so that at least on paper earnings stop going down with the market. Do not be fooled.

Juha Lindfors said...

So there's one part to this that does not compute (well, for me anyway) in the current environment.

That's the discussion wrt central bank's goal of price stability.

The shock and awe of quantitative easing and removing mark-to-market rules can be seen as working towards price stability under the threat of deflation. However, these are actions that are taken based on asset price stability (not a criticism, it makes sense to do so). But when we were going through the good times, the goal of price stability (inflation control) is based on the consumer price inflation index, deliberately leaving out asset or commodity inflation.

So this leaves us with a wonderfully biased mode of operation... although maybe not surprisingly, Greenspan was famous for not wanting to prick the bubbles on the upside (which would have worked towards ensuring price stability, unless you conveniently leave those asset prices out).

And the argument goes that the central bank shouldn't (or can't) control the bubbles so better let them grow and burst and so we have this boom-bust cycle. But is it really necessary?

The whole thing seems logically flawed unless you take into account the human factors of greed and political wrangling that comes out of it. "Look at that wonderful growth and don't you dare to touch it, it's doing great things to our country (oh and filling my own pockets on the way)". Even while a lot of the "growth" is actually an illusion.

And it does bring to question the real utility of CPI. I'm sure there's a long list of arguments why CPI still makes sense, although I can't personally recall any good ones.

Planning to cover any of that?

Marcf said...

Juha,

I do discuss that the point you make about "greed and political wrangling" is right on. I have discussed this briefly here (no one can handle the money stuff) and here (blame it on reagan: touches upon the political difficulty of dealing with inflationary monetary policy). It is not "logically flawed" it is in fact the path of least resistance, imho.

I completely agree with you that CPI is a flawed measure of inflation since in fact it capture only "consumption" and in practice monetary inflation looks like "growth" when it fact it is just a inflation of assets for those that "have assets". In other words this type of inflation may be the most unfair socially since it artificially increases the difference between rich and poor. I vividly remember being a young developer in Silicon Valley and not being able to afford a starter house. You are right that I could dedicate a full entry to the topic as these points bear repeating and in fact the socially unjust monetary divide is blatant in this case.

I haven't really read anything on the feasibility to track inflation over asset prices. I should investigate.