Inflation Vs Deflation

I don’t think we have a definitive thread on the inflation/deflation debate (mods, if we do please delete this), so I thought I may as well start one. Thought it might be useful to group the current and forthcoming articles on the debate.

First off …

Personally, Im a firm believer that inflation will come back with avengence once confidence returns and people start spending again (whenever that is). Quite simply, far too much cash and credit has been thrown at the problem not to have an inflationary impact.

Layman’s view:

Seems to me that everything is so fundamentally overpriced that I just don’t know how prices can rise.

I suspect the infaltionists response to that is that inflation is about money supply and not rising prices per se, but to the layman it is very hard to disassociate inflation from rising prices. And as a non-economist all I can say is I do not know how houses, rents, cars, insurance, banking, utilities, consumer durables etc can go back up in price in the next 10 years (absent another artificial, unsustainable bubble, of course).

Another layman view, I think the money creation that’s happening now is to deal with money that’s already been spent. So many institutions and countries are leveraged to the hilt we have to create a whole buncha moneys just to get back to “normal”.

**The Myth Of The Hawkish ECB **
Thursday, April 02, 2009 … h-ecb.html

Dying of Money: Lessons of the Great German and American Inflations
by Jens O. Parsson

I reckon the Irish government policies are reinforcing deflation in this country, by creating zombie banks just like Japan did, they are allowing the fiction of high valuations on property to continue, as a result the Irish banks lending is curtailed by the overvalued assets and they have less to lend. The sensible policy would be to guarantee savings and throw the banks to the markets who would buy them up cheap, be able to write down the loans and eventually begin the reflation policy again with foreign capital. Of course it would mean that existing bank shareholders, boards of directors, managers and pension funds, bond and securities holders get wiped out, but, on the flipside Irish taxpayers and their children do not get burdened with toxic debt for a generation, and the government can divert scarce resources such as capital to something productive, the administration also don’t have to cut into the public sector as deeply as they will eventually be forced to do if they follow current policies.

The second aspect of government policy is current spending is not being balanced, there is no reserve fund for social welfare and pensions (The banks are getting it), so the shortfall is made up by increased taxation and borrowing, this might work in the very short term, but it reinforces the next slide down as people get sick of paying high taxation and those that can leave do, when the other countries economies pick up.

Continuing rising taxation also makes economic calculation impossible for entrepreneurs, and marginal businesses do not invest any further as the rewards are removed. The higher taxation also drives the black economy and it becomes profitable to trade in cash only or barter, further forcing the government to raise taxation and borrowing which now has greater interest rates due to larger payments and market pricing of higher risk of default.

Since we are in the ECB the government can’t impose movement of capital controls easily like they did in the 70s nor can they print punts, they are then faced with the problem that people move their money where they reckon it will get the highest reward, so if say Dutch banks offer a better rate of return, people will move their money there and out of the Irish economy.

Would we in the circumstances be better following the trail led by New Zealand as a way forward?

Economy of New Zealand

At the moment an idea that appeals to me (gleaned from one of the many links posted by GB where some American economist sounded like he knew what he was talking about) is that no matter how much money is printed now, it will not feed into the real world economy as inflation until the rest of our problems are sorted out.

Essentially the stages are:

  1. deflate to reduce costs and encourage jobs
  2. once the economy turns the corner people start to borrow the money that has been printed and pumped into the economy
  3. we then see the inflationary effects as the money flow returns.

A few points of note (flaws in the theory as much as aspects of it, and I’d welcome corrections):

A) When quantitative easing policies are adopted, they usually take the form of the government either spending directly (such as infrastructure projects and increased public sector pay) or more often, they buy assets from the banks and private investors and sit on them so that the money can be distributed to places of maximum return (as can only be achieved through private hands). Thus, governments find it hard to find a suitable method of injecting the new money into the system. This is exacerbated in that the ECB controls our currency but has no control over allocations to governments (AFAIK), so the only way that there can be euro QE is by buying up bank assets etc.

B) Given the mess our banks are in and the unwillingness to deal with them on the part of the government, we could be stuck at stage 1) for a long time.

C) There is no real way of knowing how much to inject, because the timing of the future inflation is unknown and based on several contingent factors coming into effect and also because the scale of the deflationary period will lead to a false assumption about the amount of money required to restore the economy (i.e. the more deflation the greater the inflation will be).

D) If this theory proves to be correct, then it is not the quantitative easing that ends the recession; the recession ends itself and the QE just causes inflation afterwards.

I think one of the interesting things about the inflation/deflation debate is that no one seems to have any firm ideas on what will happen. It’s not as easy to predict as unemployment trends, GDP trends etc, but it is perhaps the most important thing of all to anyone who has savings or debts (i.e. most people). It also affects what you do. If you told me that there would be 1000% inflation over the next 5 years, I would be mad not to buy a 1 bed apartment for €300k, because even if it is only worth €60k now, it will be worth €600k in 5 years time. Of course, in such a situation, gold would be a better bet, but the point is that most people’s behaviour would be altered if they knew as a relative certainty whether there would be inflation or deflation.

We really need to avoid a deflationary downward spiral. If that were to actually develop, I don’t even want to think of the consequences. Mr. Anderson and JohnnyS, great posts!
If the Brits latest printing press response does not achieve intended results, the consequences not only for the UK but also Ireland are truly terrifying. It will Kill what little consumer spending exists right now aswell as a few other ‘minor’ issues.

Deflation all the way, baby.

And about time too.

Why would deflation be so bad? From a punters perspective (as sharper already mentioned) deflation just equates to cheaper prices although I understand it comes with reduced spending power (reduced wages, higher taxes, etc).

I agree with GB (great post btw) - it looks like the government tactics will result in deflation - I guess this will be good for anyone with a secure job, good savings and no debt. Maybe I just answered my own question… :angry:

The central bank policy response is now clear:
use QE to buy long term bonds (treasuries) to push down long term interest rates.

This is, in theory, a win-win for govts. You get lower interest rates at the same time
as you reflate the money supply. It seems to currently be working in the US, so I
expect everyone will try it, and eventually its success will cause it to fail. We will
probably have inflation in 3-5 years.

Another laymans view.

I think that we in Ireland are in a very complex situation as regards inflation or deflation. We need and will have pretty serious localised deflation as all costs are scaled backed from the bubble heights especially anything property driven. We may see this deflation continue longer than in the main eurozone countries which are of more immediate consequence to us than the US or UK as this is where our inflation rates and monetary policy are set. It is my belief that the in the core eurozone countries we will see an end to deflation in 18 months to 2 years followed by accelerating inflation which will have to be curbed by interest rate hikes past the point where they will cause further deflation and damage to the fragile Irish economy. I think that it would be entirely possible to see a situation where the Irish economy remains in deflation for up to 2 + years longer than most of Europe with the situation being worsened by the counter inflationary measures being taken by both the ECB and the big players of Germany and France.

I would not be surprised to see inflation reappear in less than 18 months in the US as they were the first to start pumping money but this will take time to trickle to the rest of the world especially those countries which suffered the most from the bubbles like Ireland & Spain.

I think the main point in my first article is that, with all this talk of deflation, some of the largest investment companies in the world are positioning themselves to take advantage of what they see as unavoidable inflation.

Its a classic case of the big boys being one step ahead of the little ones.
However, it is not a conspiracy.
They just take an unemotional look at the market and adjust their investment strategy based upon that.*

There was a thread posted here over the last few days where a fixed interest mortgage holder wanted to break out of it and into a variable one. This stood out to me as a classic emotional and short-term response to our current circumstances and the type of thinking that leads to disaster.

  • Im fully aware they are not always correct.

I agree.
The USA, UK and EURO countries will all experience different forms of deflation/inflation as determined by their different central bank strategies.
The ECB is the most anti-inflation out of the three and perhaps this will lead to them suffering the longest from deflation, but then the least from inflation.
Ireland, again, is in a somewhat different situation as it allowed its cost base to explode over the past 10 years or so.
Consequently we have far more scope for deflation than most other EURO countries.
Still doesn’t mean we wont be hit with inflation when it rears its ugly head once more, its just our timescales may be somewhat unique.

For Ireland it’s deflation in terms of assets (read property) and exports.
Inflation in terms of imports.

An articel in todays eurointelligence: … 3ec.0.html

Keynes’ savings paradox, Fisher’s debt deflation and the banking crisis

What about other EU banks coming to Ireland to do business? Ireland is small part of eurozone, if banks would be not performing well, foreign ones could enter and take all profitable markets.

If a bank came in and offered 20 year fixed rates they could probably clean up.

It’s a good point, I had not considered due to the current size of the foreign competition currently operating here.
ACCbank (Rabo) and National Irish (Danske) are both aggressively writing down their loans and pulling the developers and builders through court to recover funds. IIB now KBC and also in balance sheet recovery mode.
First Active are being rolled up into Ulster bank, however their parent UK RBS is impaired.
Halifax, Bank of Scotland parent UK HBOS/Lloyds is also impaired for now.
If the foreign banks can recover first then AIB BoI PTSB et all will still be impaired.

Back to the Inflation-Deflation Debate … ty-of.html

I found this article hugely enlightening on the whole inflation / deflation thing. I’ve scanned it in for anyone interested. … MmY5&hl=en

Good article, roc. Very relevant.