The Deflation Scare

I have several times in this blog questioned why it is that deflation might be a bad thing, including in my discussion of a new form of money. Having presented my arguments, I thought it might be useful to find out exactly why economists insist that deflation is something to be feared. Having read through some academic literature, I found an excellent paper which clearly shows that the deflation scare is exactly that - a scare.

There is absolutely no evidence that deflation will cause depression. I have therefore written a summary of the paper in question below, which is by Gregor Smith (reference at end). It might be noted that his paper is written in the polite tones of academic discussion, but the message is clear. He divides up his paper into some basic arguments and I will follow the format.

1. Deflation is associated with depression

Smith reviews the study of Atkeson and Kehoe (2004) who considered the empirical evidence for a link between the deflation and depression. He summarises their work by concluding that only ‘for 1929-34 is there a positive relationship between the inflation rate and the output growth rate’ and that ‘excluding 1929-34, there is virtually no link [between deflation and depression], even though there were other periods of deflation, especially under the gold standard’ (p1046).

My comment: The important point here is that there have been many, many deflations in which there has been a growth in output.

2. Unexpected deflations are associated with depression

In a contrast to the work of Atkeson and Kehoe, Smith reviews the work of other researchers have utilised different analytical models which have found a relationship between depression and deflation, for example in Canada 1870-96. However, when models take into account other shocks in the economy, the correlations found appear to be coincidental rather than causal, and such shocks also serve to explain the only correlation found by Atkeson and Kehoe.

My Comment: Again, it appears that that there is no evidence that deflation and depression are connected and as Atkeson and Kehoe identify, there are many examples that directly contradict the idea that deflation and depression are linked.

3. Sticky nominal wages

In his review of the literature, Smith finds some problematic findings on the relationship between wages and deflation, such that each of the studies fails to fully explain the relationship between wages and deflation. For example, he reviews the work of Bordo, Erceg and Evans (2000) which explains wage stickiness for the period of the early 1930s, but fails to explain wages in the slow recovery for the period of monetary growth after 1933. His conclusion is that there is a need for further research if there is to be a meaningful debate on how wages might be determined in deflations. In summary, there is a general lack of research that might present any firm conclusions on the relationship between deflation and wages.

My Comment: It is worth noting that, if wages were to remain static in monetary unit terms during a period of steady deflation, the recipient of the wages would find the purchasing power of their wage increasing. As such, the person would, in real terms, see an increase in their wealth. Even if the person’s wage were to decrease in a period of deflation provided that the decrease is less than the rate of deflation, they would still be seeing an increase in their wealth. Why such outcome might be viewed as problematic is entirely unclear. Actual wages in monetary unit terms are irrelevant without relating them to what they might purchase in terms of goods and services.

4. Debt deflation

Smith identifies Fisher (1933) work as being the key work on debt deflation, whose theory Smith summarises as ‘depressions begin with debt liquidation, leading to deflation and then to bankruptcies, and to a fall in output and employment’ and that there is an association between these events and ‘a nominal fall in interest rates and a rise in real interest rates’ (p1050). Smith then identifies that Fisher is rarely cited in empirical studies, that the majority of studies cover the period of the Great Depression, and that the studies that cite Fisher provide ‘little empirical evidence on the mechanisms Fisher outlined’ (p1051). From this starting point, Smith reviews many studies, and concludes that ‘the historical research does not seem to me to provide much evidence on the debt deflation mechanism in the 1930s’, and that no recent studies are identifying debt deflation in a deflationary environment that might support a ‘spectre’ of deflation hypothesis.

5. Deferred Spending

The idea that deferred spending is a result of deflation is described by Smith as the worst argument made against deflation, noting that the saving from deferred spending will lower the rate of interest and increase investment. Smith is quite right to question the principles of deferred spending, but his questioning might be taken further.

Smith later looks at some modern deflations, such as Hong Kong coming out of the Asian crisis, and finds that there is a correlation in these cases with unemployment. However, in some of the cases that he examines, the deflation appears to be resultant from shocks (i.e. the shock of the Asian crisis itself for Hong Kong and the collapse of property prices, the property and equity melt down in Japan). In two cases, Britain and Canada in the 1920s and 30s, the explanations are less clear, though some of the deflationary episodes followed episodes of high inflation, and other parts of his analysis again cover the Great Depression. Without more detail on the episodes in these countries, with which I am not familiar, I am unable to comment on these.

It should be noted here that he is presenting a very limited number of examples in which there is a correlation between unemployment and deflation, and his conclusion is that, whilst he has found a link between deflation and depression (in the form of unemployment), he can not square this with the other studies. Most importantly, he points out that there are 'different kinds of deflations', meaning that there is no reason to link deflation to depression. His own examples, are therefore not indicative of the idea that deflation will cause a depression, or that deflation must be accompanied by depression. Even Smith, despite a genuine intention to examine deflation from a firmly empirical point of view, appears to have a basic confusion in the cases that he studies. The confusion arises from trying to impose economic theory on to the evidence.

The source of the unemployment in Japan and Kong Kong was, in both cases, the result of unwinding bubbles in which resources were allocated in unsustainable ways. The bubbles in the economies led to the destruction and misallocation of capital, and labour being directed into unsustainable businesses. Unemployment is inevitable. It will take a considerable amount of time for the bubble based businessed to unwind, and further time for retraining and redeployment/retraining of workers who are laid off as a result. It is a simple and logical explanation. Why on earth would deflation result in unemployment? As Smith himself identifies, there is a lack of evidence for this mechanism.

The interesting thing about Smith's work is that it is a review from academia (interestingly including work of Ben Bernanke). As was mentioned at the start, he uses polite academic language, which is the language of polite questioning and requests for further study. Nevertheless, he presents a compelling demolition of the idea that there is any evidence that deflation will lead to depression, or that depression accompanies deflation.

The most important point in the paper by Smith is that it shows that deflation can take place during periods of growth in output, that the deflations associated with depressions are mostly the result of shocks and were not causal. At the moment the world economy is undergoing a shock. That this shock might cause deflation does not make deflation a 'bad thing'. It would simply means that it is associated with a 'bad thing'. However, the scare of deflation has been used to justify the printing of money, low interest rates and the fiscal stimuli.

As I argued in an earlier post, it is not deflation that is a problem, but the move from inflation to deflation, or even high inflation to low inflation. What we are seeing in the stimuli and money printing is an attempt to prevent such an occurance. For any borrowing undertaken at a fixed interest rate before the change, these result in real increases in the burden of debt for the period of the fix. Preventing this problem might be seen as a justification for the policy, but the broader cost of these policies is a risk of hyper-inflation. The scale of the potential problem of the increase in the debt burden has never been spelt out, but it is the only legitimate reason that might be used to justify the deflation scare. More to the point, the transition from high inflation to low inflation has an identical effect upon debt burdens (see notes for further explanation), but we have never heard arguments against moving from high to low inflation. Why is that?

At the moment, the depression is already taking place. That depression might create deflation is not to say that the deflation is itself problematic. When looking at the deflation scare, it is a genuine puzzle that the scare has been allowed to gain so much traction. There is simply no evidence that a deflation would take the economy deeper into depression. Despite this, all over the OECD there is a huge experiment in monetary exansion, and an explosion of debt, with the fight against deflation as one of the explanations for this policy.

It just does not add up.

References:

Atkeson, A. and P. J. Kehoe (2004), "Deflation and depression: is there an empirical link?," American Economic Review, 99-103.

Bordo, M. D., C. J. Erceg, and C. L. Evans (2000), "Money, sticky wages, and the Great Depression," American Economic Review, 1447-63.

Fisher, I. (1933), "The debt-deflation theory of great depressions," Econometrica: Journal of the Econometric Society, 337-57.

Notes

Note1: I have included a previous discussion of deflation from a previous post in the notes below, and have added an additional example that shows that consumers do not defer spending:

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In the following examples, it will be shown that the reality is that people do not delay purchases in the expectation of lower prices.

Example 1 – Fast Moving Consumer Goods

If a shampoo manufacturers were to improve their output by 5% through a manufacturing innovation each year, their output of shampoo would increase, and this would reflect in a decrease in the price of shampoo. In other words, there will be a steady and continued deflation in the price of shampoo. According to the idea that consumers will delay purchases in an environment of deflation, in such a situation, consumers would choose to walk around with greasy hair, never buying shampoo in the expectation of further price decreases. Such a proposition is fatuous.

Example 2 – Hedonic Goods

Over the last few years countries such as the UK have seen the emergence of many discount airlines, such as Easyjet. The emergence of these kinds of airlines, and the increase in competition within the sector, has seen the price of air travel deflating. Much of the utilisation of these airlines has been by consumers using the discount airlines to have cheap foreign holidays, and this can be described as a hedonic good. It is an entirely discretionary expenditure as there is no necessity to go on holiday to another country. Despite the continual deflation, there have been many years of continual expansion in the discount air travel market. The deflation has not prevented consumers from taking flights to go on holiday, but rather has had the opposite effect.

Example 3 – Computers

Personal computers (PCs) are an interesting case, as they have year on year improved performance and year on year seen deflation of actual prices. It is also an example that includes both business purchases and consumer purchases. Despite the ongoing deflation in the prices, the market for PCs has had a long period of explosive growth throughout this deflationary period. It seems that the steady deflation in prices has had no impact through the postponement of purchases.

Example 4 – Special Cases

Remaining with the example of PCs, it is possible to construct a hypothetical example of how consumers might indeed delay their purchase in expectation of deflation. If one of the large computer manufacturers were to announce that they would be introducing a new type of computer in the coming year, and that the computer was to offer twice the performance at half the cost, it is quite likely, assuming their claim were credible, that consumers might delay their purchase of computers in expectation of this future deflation.

Example 5 – Purchasing on Credit

The example of purchases on credit with interest of goods and services suggests that there is a fundamental flaw in the deferred purchase argument; that theorists have misunderstood the psychology of consumers. Purchasing a product on credit at interest is a real increase in the cost that will be paid for the good, whilst saving the money with interest paid is a real decrease in the cost paid for the good. Despite this, many consumers do not defer the purchase, but instead choose to purchase the good at greater cost now, than the cost in the future. Furthermore, in sectors such as computers, the deflation of the good does not prevent purchases utilising credit.

If the thinking of those who argue against deflation is considered, such a deflation is a ‘bad thing’ as consumers withhold their money in expectation of lower prices. If this logic is followed, then the new and more effective design of computer is not a good thing for the economy, as it has created a deflation in the price of computers, and has caused a delay in the purchasing of computers. However, once the computer is introduced, it will make more computing power available to more people. How this might be a ‘bad thing’ is not entirely clear. Everyone who purchases a computer sees their wealth increase, as they are able to enjoy relatively more computing power in relation to their income. They are quite literally wealthier.

Debt and Deflation

There is an argument that suggests that deflation causes problems with the servicing of debt, as the value of the debt sees relative increases through the deflation. This is a scenario that appears to be very plausible, and can be backed by some solid calculations and formulae. However, what is missed in such arguments is that it is not deflation that is problematic, but the move from inflation to deflation. It is not the change in the value of money that is problematic, but the change in inflation/deflation from the original inflation/deflation position from the time of the issuance of the loan.

A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.

If we think of this example and think of a change in the rate of inflation from 5% to 2%, and compare this with a change from 2% inflation to deflation of 1%, we can see that there is the same process taking place. In both cases we are seeing the relative burden of debt in relation to income moving in exactly the same way. In the inflation and deflation environment, interest rates will move to reflect the underlying changes in the value of money, and debt burdens will be locked into repayments that are based upon an out of date criterion.

In other words, it is not inflation or deflation that is problematic, but rather it is the change in inflation/deflation that alters the burden of the debt. As such, any monetary system should aim to achieve either stable inflation or stable deflation.

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Note 2: I am currently trying to convert my concept of a fixed fiat currency system into an academic paper. In doing so, I have given it much more thought, and have challenged many of my own ideas. The result is considerable refinement of the idea, and it appears to be an even stronger system than I first thought. I also worked out that the idea was probably inspired by my study of PWR nuclear reactors many years ago. For those that are interested, the money is represented by the neutrons, and the primary and secondary loops are the economy. The moderating effect is similar, and the control rod position might be the point at which the money supply is fixed. There are, of course, points which do not translate from one system to another, but I hope you can see the similarities.

Inflation, Deflation and Money

The post that follows is a slight change of direction. I started one post (see below) and found the question of money was nagging at me. In particular, there were some interesting comments on the subject of money after my last post.

The first point I would like to consider is output and money. The measure of output is a bit of a tricky problem when looking at an economy. In particular, if the measure is made in currency x then, if there is inflation of currency x, it appears that output is actually increasing by this measure.

If we imagine that factory x produces 100 units a day, and there is £100 available to purchase these units, we have 1 unit = £1. If we increase the supply of money without increasing output, then we will have more money chasing the output but still no more output. This is inflation. If we then record output in £, we will measure an increase in output. However, this is not the whole story....

MattinShanghai, a regular commentator, has raised the issue of inflation and money supply as follows:

You've talked a lot about the dangers of hyperinflation resulting from the uncontrolled printing of money by central governments. I have to admit that I'm quite confused about the whole subject, and reading numerous opinions published both by "experts" and amateurs, does not help. On the one hand, there are voices saying that we are on the road to Wiemar-style hyper inflation. Others say that the destruction of paper wealth in real estate and the stock markets, collapse of the markets for securities which underwrote many of issued loans, bankruptcy of financial institutions etc. have "shrunk" the money supply so much, that no amount of central bank money printing can fill the "black hole" and avert deflation.

I suppose that my natural reaction in the face of this is simply to suspend judgment and adopt a "wait and see" position. But I also do seem to have some fundamental problems with supposedly "uncontroversial" aspects (at least in mainstream economics) of money theory. I wonder if you or any of your readers can enlighten me on the subject and point out where I'm wrong.

Matt goes on to offer a critique of mainstream economic formulae, and highlights the absurdity of the fudge factors in the formulae. I find myself in agreement with his critiques.

I have previously discussed at some length the nature of money. In particular, I have argued that money is what 'we' collectively believe it to be. Although Matt has suggested that he disagrees with me on what money might be, I find that he hits the nail on the head in the following point:

But it gets worse. Take the money supply 'M'. What is it? Is it just the sum of notes and coins in circulation? What about money stored in jars buried in gardens? Does this count? How about credit card limits? Savings accounts? Private debts? Cheques "in the post"? Questions and more questions...

What I have argued is that money is 'money' when we believe it to be money. When a shop accepts a credit card, and a person generates a debt on the card, the shop is accepting the payment as real money. They believe that the credit card will provide them with x number of electronic currency units that they will be able to exchange for goods and services in the future.

If I am a worker, and I am short of cash, I might exchange my labour to mow your lawn at some future point in time in exchange for your buying me a beer. I might write an IOU note, promising that I will, within a week, spend an hour mowing your lawn. In turn, you might transfer that IOU to another person in exchange for some cakes that they have baked, and I will have to mow that person's lawn for one hour instead.

The critical part of these two very different transactions is that they must be based upon a belief that the currency in question will be repaid in goods or services in the future. If I am actually lazy and unreliable, and therefore unlikely to meet my promise of lawn mowing, then it is unlikely that my IOU would get very far as a currency for exchange. Quite simply, people will not believe that they will be paid.

I have previously given another example; the famine currency. If we are in a situation of famine, and there is a limited supply of food still available, then the idea of what money is will shift. If I offer my services to you in return for payment, and I am on the point of starvation, I will want to be paid in food. You might offer me piles of gold bullion but, if that gold bullion can not be exchanged for food, then I will reject that as a currency, and only accept the food. Gold can not buy what I need, and therefore ceases to have meaning as a currency. The same might be said of any medium of exchange that might be offered to me, if it ceases to allow me to buy food.

Money is therefore a matter of perception. In a previous example, I have pointed to the lines outside of Northern Rock. The people in those lines wanted bits of paper with the head of the queen printed on them, not IOUs provided by Northern Rock. Northern Rock held large numbers of IOUs, but individuals refused to believe in them. They no longer believed that the IOUs would do the equivalent of purchasing one hour of lawn mowing.

It is when we see money in these simple terms that the arguments about deflation make sense, but it is also possible to see how they do not finally add up.

Banks have been passing on the savings of people (value of their labour) to provide credit in return for IOUs. Those people who have provided the IOUs have promised to apportion part of their future labour in return for the money. The trouble is that there was so much money pouring into countries like the UK from overseas, that prices of assets such as houses rose. As such, there was a boom in the issuance of IOUs which started to exceed the ability to repay the IOUs, or at least impossible without a significant fall in consumption of those issuing the IOUs.

In real terms, a Japanese worker has provided a car to a UK consumer. The UK consumer has promised to repay the labour of the Japanese labour with an equivalent value of labour. For the moment we will leave aside the difficult question of how labour might be valued. In our lawn mowing example it was a beer for an hour of lawn mowing, but it might equally have been an hour of building a shed. The important part is that there is an expectation that the returned labour will have a value that is worthwhile to the recipient.

The problem that has arisen is that the Japanese labour has been exchanging their labour for IOUs, but the labour in receipt of the IOUs is unwilling to return an equivalent value of goods or services. The credit crisis is simply a recognition of this fact.

In other words, huge amount of the IOUs are no longer recognised as money, or at best are seen as debased money.

At first blush, this appears to support the deflationary argument. It appears that the money supply in the countries that were recipients of the labour of countries like Japan, now have less money. After all, individual IOUs have ceased to be an accepted unit of money. There is a lack of belief that the individuals can repay in an appropriate value of goods or services.

However, instead of issuing credit to individuals, the new method is to extend ever more credit to governments. As such, instead of lots of individual IOUs being generated, there is a single huge IOU being developed as a replacement. Just as with the individual IOUs, there is an implicit promise to return the value of the labour at some future date. In other words, even as one form of money is being destroyed, more money is being created as a replacement. Of even greater concern is that the previous money that was supposed to have been destroyed, has not in fact been destroyed. It is being converted into the new form of money - government IOUs (of course, government debt was expanding even before the credit crisis, but I hope that you understand the point).

Now, if we return to the beer and lawn mowing example, one of the key features of the transaction is that I have consumed the beer. Now if we imagine that I am not just issuing the IOU to you, but making similar deals all around the town, I am getting extremely drunk, and having a very good time this week. However, all the time I am drinking, I am in a situation where I am promising greater and greater amounts of labour to people all over the town. In fact, I am promising that next week I will undertake 100 hours of lawn mowing. In other words, for the consumption of this moment in time, I am going to have to have a very tough week next week. In addition, even if I do all 100 hours of mowing, I will have to use all of that labour for repayment, and will not be able to exchange my labour for beer during that week.

I wake up on Monday morning with an almighty hangover, and can not face the job of the mowing. As you would expect, the creditors of my beer drinking binge are none too happy when I fail to show up for work. The problem they face is that the beer has now been consumed, and there is no way to get it back.

Unlike in the analogy that I have provided, there is another important consideration. In the real world, governments are now borrowing more, and promising to repay the debts that were accumulated during the binge. As a result of this, the creditors are willing to continue to extend credit. The important point about government is that they can, through the taxation system, enforce less consumption upon people, and indirectly force them to work more. In other words, they are in a position where they can allow me to drink more beer now, but make me work the necessary 100 hours next week. It is on this basis that creditors continue to lend.

As such, as the situation exists, there is more money flooding into the economy, and ever more IOUs being issued in return. In other words, the money supply continues to increase, and the form of money is IOUs.

Now if we were just to imagine that Japan was the only creditor, then we can see that we have a growing debt of labour to Japan. That debt translates into a future commitment to provide goods and services of 'x' value to Japan. If we then think of this in practical terms, each gilt (for example) that is issued is a call on the output of the UK economy. If we then see no increase in the output of the economy, we can see a greater amount of labour owed per unit of labour. If each unit of labour is producing one unit, but we keep issuing ever more IOUs against that one unit, then it becomes less and less possible for that labour to service the debt. What you have is more and more IOUs making demands on the one unit of output. That is inflation.

In addition to this, we have the confounding factor of what I would call 'traditional' money. This is the units of £GB, and I call this traditional on the basis that this is what the people who lined up at Northern Rock believed to be money.

As regular readers will be aware, the Bank of England is creating more of this traditional money, but is doing so without any commensurate increase in output from the economy. This means that, in addition to more IOU money being issued, there is more traditional money being issued. This is, in effect, a double whammy. Both the issuance of traditional money and the issuance of IOUs represent a commitment of future labour in return for the credit now. They are both being expanded at a time when the output from labour is not expanding.

The one factor I have not included in the example of the real world is time. In the case of the lawn mowing, I specified 'next week'. As many are aware, government debt is issued over a range of time periods, such that in different periods, different quantities of debt are due for repayment. I have not included time, as there is currently no proposed time frame for government to start repaying the overall burden of debt. Rolling over existing debt, whilst accumulating more debt, means that the time frames are moot points.

The only solution to these problems are as follows:

1. There is a massive reduction in consumption, and an expansion in working hours. This would allow an increase in output available for repayment of debt. This is deemed as politically unacceptable.
   
2. The government takes the credit offered, and later repays it with less value than was implicit in the original bargain. This is the process of inflation, in which the government allows ever more issue of money whilst not demanding that labour reduces consumption and increases hours to the necessary level for repayment. Under these circumstances, more money will be chasing the existing output, such that the value of all UK money is debased. Inflation.
3. The government, by magic, engineers a productivity miracle such that output exceeds the increase in the amount of money.

The current policy is item number two, but with number 3 as the excuse for greater borrowing.

If we think of money in the terms that I have discussed, it becomes apparent that the reality of money is contingent on the belief that it will have a future value in goods or services. In issuing IOUs, governments are increasing the money supply, as they are increasing the promise of future goods and services. The problem that arises is that they are being dishonest, as there is no way that they intend to repay the IOUs in full.

They are like me drinking too much beer, refusing to work the 100 hours I have promised, and only accepting that I will do 39 hours of lawn mowing. Not only do I refuse to do the 100 hours, I also insist that many of the 39 hours I undertake is used to purchase more beer. In other words, I am cheating my creditors. My currency of IOUs is debased, and is inflated.

When I have discussed money on previous occasions it has always been highly contentious. I fully expect that there will be further debate on this post, and will try to find time to address any of the points. In the meantime, I would like to just highlight the key points of the arguments.

1. Money is a belief in anything that is seen as a medium of exchange for the future value of labour (i.e. goods and services). Money is only money so long as people believe that it might be exchanged for goods and services that they need/want.
   
2. The value of money is determined by the total supply of money, measured as a division of labour output divided by the units of money in supply, over time in which the money might be utilised. e.g. the timescale of IOUs is a factor in the value of money, as in the case of the lawn mowing. Time and value is contingent on the amount of money calling upon labour output in a given period.
   

The last point is complex, and I hope it makes sense (I had to re-read it myself and I'm still not certain). However, the principles I am outlining are my best explanation of money, and why there must be inflation.

This leaves the timing of inflation in relation to the two points above. The money supply, according to my understanding of money, is increasing. The question that remains is how that increase might eventually translate into demand for the value of labour, at what time. This is a question that is, quite frankly, beyond me. However, I hope that, from this explanation, it is apparent why inflation might be delayed for some time. My suspicion is that inflation will be prompted through a collapse in belief in UK issued money, rather than a progressive increase in inflation as debt falls due.

Of one thing I am certain. More money is being issued than can be supported by output. Short of a miracle in productivity, I see no prospects for anything other than hyper-inflation.

Below is the original article that I was going to write. Somehow, thinking about the points below led me into the discussion of money. The post below may make more sense in light of the discussion of money.

More Green Shoots.....

There has been yet more talk recently of economic recovery in the UK, and the £GB has strengthened as a result. This is a perfect illustration of the point that I made in my recent TFR article - that any good or bad news will see wild swings in markets.

In this case, the good news has been provided by an economic think tank, the National Institute of Economic and Social Research (NIESR). The Telegraph reports their findings:

The NIESR figures were the latest sign that parts of the economy have been staging a modest recovery, and coincided with data from the Office for National Statistics, which showed that UK manufacturing output increased by 0.2pc in March.

It was slightly better than economists expected and represented the second monthly rise in a row after the ONS revised up March's figure from a fall of 0.1pc to an increase of 0.2pc.

There has long been talk of a restocking of inventory, and it is likely that this is the process in action (assuming the figures are accurate). However, there is something faintly absurd in such figures, and this is illustrated in the following quote:

Meanwhile, governments across the world have seen their budget deficits explode as they seek to cushion their economies from the crisis. In the US and the UK, the fiscal deterioration is especially severe - with deficits this year around 12pc of GDP each and no credible medium term plans for balancing their budgets.

What we have here are two figures that simply do not add up to anything. On the one hand we have an explosion of fiscal deficits to around 12pc of GDP, and on the other hand we have a minuscule uptick in a couple of indices. In other words, the situation is so dire that the monstrous pouring of money by the government is still leaving the economy in a situation where it is barely into positive territory on a couple of indicators. The real question here is to ask what this indicators would be showing if the debt spigot were to shut down.

It is at that point that we would start to see the underlying output of wealth creation, in contrast to debt fuelled activity.

It is a long time since I discussed the essential reality of government borrowing, and borrowing in general. For every £1 of borrowing now for consumption there will be £1 less to be spent on consumption in the future. If I have a credit card and I spend £25 on a meal today, next month I will have £25 less (+ interest) to spend on a meal next month. The only way that this may not be the case is if my earnings in the future outstrip the debt, in which case I might still have £25 to spend on a meal, instead of £25 + my increased earnings. Even in this case, my consumption now is restricting my future consumption.

In the case of government, if they borrow to spend money on a nurse this year, there will in the future be the same amount unavailable for spending in the future. In other words, one nurse now, costs one nurse (+interest) in the future. Again, the same provisos apply as with the credit card debt.

The question that then arises is to ask how earnings might increase such that they outstrip borrowing. The only way that this can happen is if there is significant investment in the productive parts of the economy, such that productivity rises. This applies to directly to the example of personal debt, and indirectly to government debt. As a worker, I need to achieve greater increases in my income if I am to be able to continue to spend at the same level as I am now, and these increases can only be sustained through greater output in my area of work. If not, at some point in the future, my spending must decline. In the case of government, it is possible to continue with the same spending only if I tax more from the economy, but this is replacement of private spending with government spending. This is neutral for the economy overall in terms of total consumption.

This discussion does not consider an ongoing increase in borrowing, which appears to be the current solution. In this case, all that is happening is that there is the build-up of a larger future contraction in consumption.

Within this scenario is a deep problem. If the government and individuals continue to borrow for consumption now, then there is less money available for investment into productive output. If the government borrows £40,000 today to pay for a nurse (figure guessed at for illustration), then there is exactly £40,000 less for investment into future increases in output of new wealth (i.e. there is less money available for investment into business). The situation is, of course, complicated by the problem that finance is global, such that an individual economy might have finance for both consumption and investment, but the problem in aggregate remains accross the world economy. Bearing in mind the explosion in government borrowing accross the OECD this presents a problem.

What we are looking at is a situation in which there must be a significant future increase in output per person, a massive growth in productivity, if there is not to be a future contraction. However, there is no prospect or indication of such a productivity miracle on the horizon. Whilst it is impossible to deny that such a miracle is possible, it currently looks improbable. In the meantime, governments are competing for finite capital that might make such a growth in productivity possible, thereby making it less probable.

Returning to the slight uptick in output reported in the Telegraph, what we are seeing is the fruits of debt fuelled consumption, not increases in output that might be sustained in the medium term. This is a best case scenario, but it is just as likely that there will be a tail off in the output once inventories are rebuilt.

At this point I was going to discuss inflation, and at this point I moved to the other article. The point I was trying to explain is that it is quite possible that inflation will offer the illusion of increased output. I suspect that, it is quite possible we will start to see inflationary effects appearing in the economy, and that these might be mistaken for recovery.

As such, I am increasingly concerned that there will be a relaxation of governments as a result of thinking that they have solved the crisis. The problem is that, instead of solving the crisis, they are simply deepening the crisis.



Note 1: The discussion of the Austrian school proved to be very interesting. I am happy to see that I could find some common ground with Lord Keynes on the point that commodity currencies are as subject to debasement by government as fiat currencies.

One of the interesting points in the discussion was the role of ideology in forming views on economics. Regular readers may have noted that I pick 'n mix from various sources, wherever I see a point of interest. As such, I value the Austrian school's critique of Keynesian solutions, but disagree with their approach on many points. I am endlessly impressed with Adam Smith, but still believe that trade can be a zero sum game and so forth. In other words, I do not subscribe to a particular ideology, and am not bound by any particular school of thought.

Whilst having a libertarian streak, in that I mistrust government, I still see a role for government in many areas, such as healthcare, or ensuring legal frameworks operate fairly. I simply believe that power should, as far as possible, not be concentrated. As such, wherever possible government should be minimised and powers dispersed.

However, I would hope that the balance of my personal approach is best expressed in the articles on reform. I am not sure that the ideas would fit neatly into any ideology.

Note 2: A long post, but I hope that it proves to be interesting.

Inflation, Deflation And Printing Money in the UK

Many of the readers from the UK may have been seeing news of the 'deflation' in the UK economy. A typical piece can be found in the Times as follows:

Deflation tightened its grip on the economy last month after a record fall in retail prices.

The retail prices index (RPI), the benchmark for pay deals, fell to -1.2 per cent, the lowest since records began in 1948, dragged down by a decline in energy and mortgage costs.

Economists expect that prices may fall farther as the recession takes its toll and unemployment rises. Some believe that the rate could fall to about -2.7 per cent, raising fears of prolonged deflation as consumers delay purchases and businesses withhold investment.

It becomes increasingly difficult to view such articles without a measure of irritation developing. In particular, the media seem to be subject to some confusion. As such, a quick introduction is given below to the two main measures of inflation, taken from National Statistics (emphasis added):

Consumer Prices Index (CPI)

The Consumer Prices Index (CPI) has been designed as a macro-economic measure of consumer price inflation and forms the basis for the Government's inflation target that the Bank of England's Monetary Policy Committee is required to achieve. It has been developed according to internationally agreed rules and internationally is known as the HICP. The HICP is the preferred measure for international comparisons of inflation.

Like the RPI, the CPI measures the average change from month to month in the prices of consumer goods and services. However it differs in the particular households it represents, the range of goods and services included, and the way the index is constructed.

Retail Prices Index (RPI)

The Retail Prices Index is the most familiar general purpose domestic measure of inflation in the United Kingdom and is continuously available from June 1947. It measures the average change from month to month in the prices of goods and services purchased by most households in the United Kingdom. The RPI or its derivatives are used by the Government for the uprating of pensions and benefits and index-linked gilts.

The important point to note here is the key difference between the two measures, which is in the cost of housing, as follows:

For example, the RPI basket includes a number of items chosen to represent owner-occupier housing costs, including mortgage interest payments and depreciation costs, all of which are excluded from the CPI. These differences are described in greater detail in Roe, D. and Fenwick, D. (2004), ‘The New Inflation target: the Statistical Perspective’. Beyond these specific areas, the contents of the CPI and RPI baskets are very similar, although the precise weights attached to the individual items in each index differ [the Roe and Fenwick article can be found here]

It is very easy to get these measures confused, but the important point to take forward is this:

The government and Bank of England use the CPI for inflation targets, and the CPI does not include housing costs.

By contrast, the RPI includes housing costs as follows, taken from the ONS guide here:

Rent
Private furnished rent Private unfurnished rent
Local authority rent Registered Social Landlord (RSL) rent
Mortgage interest payments
Average interest payments on a typical repayment mortgage (estimated/modelled)

Back in December, I wrote a post on what I thought the prospects were for deflation, and pointed out that currency weaknesses and therefore higher import prices would likely offset the deflationary factors within the UK economy. At the time of writing, food prices were already starting to climb. As it is, much as predicted, the CPI has continued to be inflationary. The chart below shows the different measures of inflation.
















[Chart from the ONS here]

Having introduced these measures, the astute reader will immediately see that there is a circularity to the measures. Mortgage interest payments are linked to the interest rate, and the interest rate is determined in part by the interest rate targeted by the central bank. As such, during the boom years, the RPI would have been held down due to the low level of measured inflation of the CPI. In other words, even though there was rampant inflation in the economy (in house prices), it was hidden in part by the way in which the statistics were used and measured.

It is here that we come to the source of irritation. At present, the Bank of England have reduced interest rates to record lows. As such, the cost of servicing mortgages and indirectly rental costs are falling. Furthermore, as house prices fall, there will be a combination of lower interest rates on smaller mortgages. In this scenario, the problem is that what we are seeing is a case of deflation being measured as a result of an asset price bubble popping, and central bank intervention.

It is hard to imagine that the asset price bubble bursting should be seen as a bad thing, as it is an inevitable correction in the market. As for the other element, the central bank intervention, this is where the circularity starts to kick in - sort of.....If we remember, the bank targets CPI, not RPI. However, in the Bank of England inflation report from February, it might be noted that the RPI is discussed in the report, even though the CPI is the target for inflation. You will note how the measures are blurred in this passage.

Deflation is sometimes used to describe any fall in the general level of prices (as measured in the United Kingdom by the CPI, RPI or the GDP deflator), however short-lived. A more economically significant phenomenon, however, would be a sustained period of negative inflation.

The RPI is likely to fall temporarily over the coming months (Section 4.1). This period of negative retail price inflation would be unusual (Chart A) and predominantly reflects the much lower contribution from mortgage interest payments, following the recent large falls in Bank Rate. The MPC’s central projection is for its target measure, annual CPI inflation, to remain above zero throughout the forecast horizon. (p33)

Whilst there is no direct statement of targeting of RPI, the way in which the whole passage is put is somewhat grey. The same section of the report then goes on to warn of the dangers of deflation......it appears that the Bank of England is subtly conflating the two measures, and they even use a chart which is designated as the 'ONS composite index'. (p33) One of the interesting points is that an argument for printing money directly follows this discussion of RPI and deflation:

Periods of low inflation, associated with weak demand, may limit a central bank’s ability to use conventional monetary policy to stabilise the economy. But if reductions in official interest rates do not prove sufficient to meet the inflation target, policymakers still have other options available to them to stimulate the economy, if necessary (see the box on pages 44–45 in this Report). (p33)

Page 44-45 are discussions of unconventional monetary tools, otherwise known as quantitative easing (QE- or printing money). The problem that we are now seeing is best expressed by Liam Halligan from the Telegraph:

Over the last few months, we've printed money on an unprecedented scale and run up enormous extra liabilities. When sensible people have protested, pointing out the clear dangers, we've been told such "bold" measures were necessary for the UK to avoid getting sucked into a deflationary spiral.

But now, just three months later, this looming threat has apparently passed. It warrants not a mention in the Bank's Inflation Report. Has deflation really gone away? Or did we never actually face such dangers? Was the spectre of deflation conjured up, instead, for other reasons – as an excuse for this ghastly Government to yank monetary policy back off the Bank and nail interest rates to the floor, while junking fiscal caution and borrowing in a fashion more akin to a banana republic?

Liam Halligan is quite correct that the latest report passes by the deflationary scare stories, and rightly identifies that there was no real prospect of CPI deflation. As can be seen from the chart earlier in the post, it is still relatively high. However, he misses the way in which the RPI was introduced as a means of pulling deflation into the picture in the February report. As you will see from the above text, it is done in a very subtle way, and this has been broadly absorbed by most of the media. The elements of the report that considered CPI were very nuanced, and were not firmly deflationary.

The February report was actually a very subtle and nuanced document overall. The spectre of deflation was primarily raised against the RPI, but the way that the report reads does not reflect this. Crucially, acceptance of the deflation argument was the reason for why quantitative easing (QE - printing money) was accepted in the media. Now that the controversy over QE has died down, the RPI issue is now quietly dropped, along with the talk of deflation.

Here is the central problem for the Bank of England. The only way to justify QE is through the fear of deflation, but the only measure that is showing deflation is the RPI. The bank's remit does not extend to RPI so that it can not use the RPI as an excuse to print money. As such, they subtly conflated the measures, planted the idea of deflation in the mind of the media, and 'lo and behold', deflation has appeared. It now looks like, post hoc, that the Bank of England can justify the deflationary scare. Through smoke and mirrors, the media have accepted the deflationary argument and continue to accept QE.

However, if the media were paying attention, they would note that the deflation is on RPI and, in part, due to the very policies that the Bank of England is actually pursuing. In particular, the Bank of England is fighting to reduce interest rates on consumer debt and mortgages through QE and historically low interest rate policies. Furthermore, the deflation of the housing bubble, in which asset prices are returning to sustainable levels, would be an extremely difficult reason to use to justify the policy of QE - if not impossible. Such an argument would be that the policy is aimed at reflating house prices, and I am not sure that anyone in their right mind might accept such a policy.

The fundamental problem in this whole picture is that the Bank of England has a problem with justifying QE if deflation is identified in the RPI. Over and above the problem that the remit is to target the CPI, the problem arises that targeting of the RPI would be to reverse a bubble deflating and would also preclude any further monetary easing. In particular, the monetary easing would serve to reduce interest rates, and thereby be deflationary through reduced costs in housing.....

I am hoping that, at this stage, it is apparent that there is a significant problem with the policy of QE. The remit of the bank is to target the CPI, the justification for QE is deflation, the index showing deflation is the RPI, and the bank is actually contributing to deflation in the RPI.

In other words, even if the principle of QE is accepted (which is not the case for this blog), there is currently no justification for the policy which can withstand scrutiny. Under such circumstances, it is only possible to return to the long standing argument/theory of the blog, and conclude that QE is simply a way of printing money to buy bonds and support the bond market. The policy is therefore really about printing money to support profligate government spending through printing money.

The trouble is that, excepting a few commentators like Liam Halligan, the media are still buying the lie that QE is to fight deflation.....

Note 1:

I did not want to make the main article too long, so I have not discussed the problems with deflation theory. I discussed this in a very long post previously, and have quoted from the post below [the most relevant bit]:

[Quote starts.....]

Economists say that deflation is a terrible thing. They say that it wrecks economies. If you have deflation, then people stop consuming, and stop investing.....

Let's start with the case of consumers stopping consuming. In this case, we have a good example of deflation to illustrate that deflation does not stop people buying things that they want. The example is computers which, as every year has gone by, have become ever cheaper in relation to their performance and sophistication. We all know that if we wait until next year, we will get a much better computer for our money. This is real deflation, but during a period of real deflation, the sales of computers has expanded, and expanded, and expanded.

If we think of a more mundane example, we might come up with something like a bottle of shampoo. Let's imagine that every year there are ongoing productivity gains in manufacturing shampoo such that the price falls by 3% per year. Does this mean that we will defer our buying of shampoo? Does that mean that, in order to benefit from the price reduction of shampoo, we will walk around with greasy hair.

Alternatively, we can take the case of a discretionary spend on something like a holiday. As some people will be aware, the low cost airlines have seen huge reductions in the cost of overseas travel, and the costs continued to go down over a period of years. Did this mean that people stopped overseas travel while they waited for the flight prices to drop even lower? What we actually saw in places like the UK was a massive expansion in overseas travel, as it became ever more affordable. However, this occurred despite deflating prices. This is like the example of the wine glasses....

The idea that people will not spend money during deflation is simply not true. However, if we knew that there was an unusual deflation about to take place, such that we expected the price of something to drop dramatically at some future point, we might defer our spending. For example, if the newspapers were to announce that in April of this year that there will be a new type of computer which will cost half the price of a computer today, then we would likely wait until April before buying a new computer. Moreover, when the new computers were released in April, then the sales of computers would increase as more people could afford them, and we would all potentially be richer by a factor of half a computer (if that makes sense).

However, such events would always be exceptions, and we readily buy computers despite the steady price deflation.

In short, steady deflation does not stop people from consuming.

[Quote ends]

I have since seen a book review, on the Mises institute website, that uses similar arguments and examples. I was hoping to link to it, but could not find the article (apologies).

The other nasty element proposed for deflation is discussed in the Economist:

Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.

However, this does not account for the savers. People who save see the value of their money grow, and this means that they have greater spending power. The problem is, of course, that there are too many debtors rather than savers....but this is perverse way of looking at the problem. A more balanced economy would not see such a situation, and it is lax monetary policy that caused the problem in the first place.

However, I do not want to go into the full argument here. I detail far more in the original post, and (bear with it) this can be found here. The issue of inflation versus deflation is very complex, and I am not sure that even my long article does the subject full justice.

Note 2:

I have long been grumbling about the use of inflation statistics. It has been a regular feature of the blog. Two quotes are given below, but these are only a limited selection.

This is from a post I wrote in January.

Now the expression measured is very important, because asset price inflation did not count in official inflation. In particular, as fast as new money was produced, asset prices such as houses inflated. Greenspan, in his wisdom, allowed one bubble after another to soak up the expansion in money. However, we have now gone one bubble too far, and there is no new bubble on the horizon to soak up the money being dropped into the market (which would in any case just be a delay, not something that would be a 'good' thing). As such, one of the sources of money absorption has been bubbles in assets, which stopped the prices of other goods going up. Mainstream economists seem to think inflation was conquered, but it was just displaced into something that was not measured.

This is from a post in February:

It should be recognised that arguments against including house prices might be put forward, such as the idea that the cost of owning a house is in part dependent on the interest rates charged on mortgages, and that is a valid measure. However, this becomes a circular argument as, if house prices are inflating and are not measured in inflation, interest rates will remain low despite the actual inflation, thereby keeping the cost of the mortgage repayments relatively low whilst the asset price inflates. However you look at it, having to borrow £200,000 this year to by a house, and having to borrow £300,000 next year is inflation. The day to day cost of servicing the loan may change, but the cost of the good has still inflated.

You will find the UK Office of National Statistics personal inflation calculator here. You will note that they do not calculate the rate of inflation by the interest rate paid on borrowing when buying, for example, household goods. They measure it against the price of the good itself. It seems that they have not noticed that a house is a 'good', or more likely they have decided that the inflation of house prices is something they would rather not measure.

Note 3:

For US readers, you may be interested in an article here. It details how the inflation statistics have been manipulated in the US. It is not happy reading. I have yet to find a similar discussion of UK statistics, and would ideally like to look into this. I did consider it, but will admit to being 'outfaced' by the scale of the problem of digging through the various papers, and studying the methodology in enough depth. Any links to such articles would be appreciated.....

Note 4:

I hope the above article makes sense still. I had to chop it around to shorten it, and hope that this has not led to any errors. Comment if you spot any, and any other readers can then see any errors.

Note 5:

Sorry to not respond to any of the comments, but this post was rather demanding of time. The final article does not reflect all of the articles I have recently read on the subject...as there are just too many out there....

Note 6:

I have long been (against the grain of the same conventional economists that failed to predict the recession) arguing that regulation of the banking system was a major part of the crisis. I have been heartened to see a very similar argument from Niall Ferguson, which can be found in the New York Times here....

Note 7:

Regular readers will know that I have long been discussing the idea that China has been positioning the RMB as the new reserve currency. Arguably, progress in that direction can be seen in Brazil, and more and more people are picking up on it:

Brazilian President Lula is the latest world leader (after Wen Jiabao and Vladimir Putin) to call for moving away from the US dollar in trade and and for a new monetary and financial order. On the eve of his trip to China this week, Lula suggested in an interview with Caijing (and other news sources) that the two countries should conduct more of their trade in their own currencies rather than the US dollar.

“Between Brazil and China, we need to establish a trade that is paid for in our own currencies. We don't need dollars. Why do two important countries like China and Brazil have to use the dollar as a reference, instead of our own currencies? We've already started doing this with Argentina. Our trade is taking place in our own currencies. Otherwise, we'll be in an absurd situation, where the country that caused this crisis will be the country that gets the most dollars. It's crazy that the dollar is the reference, and that you give a single country the power to print that currency. We need to give greater value to the Chinese and Brazilian currencies.”

Early this year, China supplanted the U.S. to become Brazil’s largest trading partner, as its commodity demands resumed and Brazil’s trade with the U.S. slumped. At the moment, Brazil is one of the few countries with which China runs a significant deficit which rose to $11 billion for all of 2008. Chinese imports are almost all raw materials.

Greater use of the RMB in trade with Brazil would be yet another step China has recently taken to increase the use of the RMB outside of China. China has been signing 3-yr RMB/local currency swaps with a range of emerging and frontier markets including Argentina, Brazil’s neighbor. As Nouriel Roubini notes in a recent oped, these swaps are small steps towards a possible greater international role of the RMB – pilot projects to use RMB as a settlement currency in Hong Kong Macau and Asean are other such steps. These deals are also another way to provide a bit of trade finance to key trading partners. The swap with Argentina might help finance China’s extensive trade with the country. As a result, even if US dollars are not used, it could well be the RMB and not the BRL that is used, especially if China wanted to avoid bearing the exchange rate risk.

In addition to the Petrobras-CDB deal the Brazilian development bank BNDES is reportedly seeking a credit line from China. BNDES, like other trade credit providers globally, has taken on a higher profile in the face of the withdrawal of private trade finance. Such a loan could be conducted in RMB/BRL. While that would be major, there are significant preconditions before the RMB internationalization progresses further. In particular, the more the RMB is used outside of China’s border the less control the central bank has. In this way China’s shorter-term goals of economic stabilization and longer term goal of more sustainable consumption driven growth may conflict.

The really interesting step will be any move towards pricing oil in RMB. My guess is that we are on the cusp of such a move, though initially it will be small scale (i.e. not the Gulf states). However, it is possible to see the progression forwards of the RMb with each passing week.....

Dinner Table Economics and Deflation

I recently mentioned that I would post an article on deflation, as I have become concerned by the way that this is being used as an excuse to engage in printing money. The idea that deflation is bad seems to be widespread amongst economists, but I am not at all convinced of this. In order to understand why, I will need to take a slightly circuitous route, which is to discuss what wealth is and how it is created. After all, economics should be primarily about how we create (and distribute) wealth.

Happily for the purpose of writing this post, I had a couple of friends come to dinner recently, and our discussion turned to economics and wealth creation. I say 'happily', as one of the friends is very knowledgeable about economics, meaning that he knows the arguments of many mainstream economists. As we conducted our discussion, it struck me that there is a fundamental problem in such arguments. It is not something that they ever say directly, but an assumption that sits underneath many of their theories and thinking. They actually think that wealth has arisen as a result of macroeconomic tinkering by governments.

As such, I thought I would start this post with a key part of understanding deflation, which is to consider what wealth actually is and how it is created. I will use some rather odd illustrations that I used during the dinner so that, as I explain, at several points it might be useful to imagine you are at the dining table with us.

One of the points which was central to the discussion, is so obvious that it should not need to be said. However, it is a point which is often lost in all of the complexity of economic discussion. The point was this:

If an economy has a total output of 100 units, it does not matter what the number of money units there are in circulation, as this will have absolutely no bearing on the level of wealth in that economy. The economy could have one hundred units of money in circulation, a thousand units, or a million units. It will make not one jot of difference to the wealth of that economy. The output will still be 100, and that output represents wealth.

To explain the point I was making, I took two wine glasses on the table and said that yesterday I, as a unit of labour, produced two such wine glasses every day. These two glasses of output were sufficient for me to live a day to day subsistence lifestyle. I then added a wine glass, and explained that due to various improvements in my ability to make glasses, I was today making three glasses instead of the two yesterday. As such, I have an additional glass which means that I have increased my wealth creation such that I can use that one glass of output for discretionary spending.

Having added the additional wine glass to my output, I suddenly have some choices. I looked around the dinner table, and decided that I would utilise that additional wine glass as a means of exchange for one portion of dessert. I designated one of my friends at the table as a dessert manufacturer. I moved my additional wine glass over the table, and exchanged it for a portion of dessert. I am now one portion of dessert richer, and the dessert manufacturer has one wine glass.

The interesting part of our transaction, however, is not immediately visible in this example. When we increase the output of a good, more of that good is available in the market. Assuming that demand is not increasing through factors such as significant population growth, then the additional supply of glasses has some interesting effects.

Before my output of wine glasses increased, the cost of wine glasses was higher reflecting the greater input of my labour in each wine glass, and the dessert maker would therefore have to pay me one and a half portions of dessert in exchange for a wine glass. Under these circumstances, the dessert maker could not afford to buy the wine glass, and was forced to use a cheap pottery mug to drink his wine. As it is now, the number of wine glasses has increased in relation to demand, my input of labour per glass is lower, such that I am now willing to exchange my additional wine glass for just one portion of dessert. The result of this change in my wine glass output is therefore as follows:

I am one portion of dessert wealthier, and the person who makes the dessert is wealthier because he can now keep a half portion of dessert that he would previously need to have given me. We have both become wealthier. Even as the exchange value of the glasses has decreased, we have both become wealthier.

The curious point in this is that, if the wine glass production had not increased, then the dessert manufacturer would not have wanted to make the exchange at all. He felt that one and a half portions of dessert was too much of a price to pay for a wine glass. My increase in output not only allowed me to increase my wealth by one dessert, but also expanded the market for my output. This is why everyone is wealthier...

If we return to the earlier point about an economy having 100 units of output, in this case I have just increased the output by one. We have 101 units of output. The economy is more wealthy, and it has nothing to do with the number of units of currency in circulation.

Returning to my increase in output of glasses, there is no necessity for me to use this addition of one glass of output to consume a portion of dessert. I can use it for many purposes. Let's imagine that I am supporting a family, and I have ambitions for my children. I want them to go to university. In order for my children to go to university, I will need to save some money to pay for the fees. As such, I forgo the portion of dessert, and decide I will save the additional daily output of wineglasses. According to many economists today, this foregoing of consumption of dessert is a bad thing....the more we consume, the wealthier everyone becomes.

However, (wisely) ignoring these economists, I go ahead and decide that I will save the one wine glass of additional output to pay for my children to go to university. I look around, and conveniently decide that the other person at the dinner table happens to be a bank. I cancelled my deal with the dessert maker, returned his portion of dessert, and passed the wine glass to my friend who is now acting as a bank. Instead of the dessert manufacturer holding the glass, the bank now holds the glass.

Why did I not just keep hold of the additional glass? After all, over the years, I could store up lots of glasses and give them to the children when they reach university age, and they can then use those glasses to exchange for all the things they need. Why did I give it to the bank?

I gave it to the bank because the bank will invest it. In this case, the bank uses the value of the glass as a means to give another producer the ability to do something new, such as increase the sales of wine. At the time I am giving the glass to the bank, one glass of wine can be exchanged for one wine glass (obviously that is the quantity of wine - as you do not keep the wine glass). In order for me to give the glass to the wine seller (a wine bar owner), I ask that the wine seller gives me a tenth of a glass of wine every day for every glass that I provide. The wine seller gets more glasses in which to serve the wine, and I get wine in return. Meanwhile, as a price for putting me and the wine seller together, the bank charges a fee of one twentieth of a glass of wine per day, per wine glass invested. We all get wealthier.

In the case of the wine seller, with more wine glasses available, he can now serve more units of wine to more people and increase output, I am wealthier as I am getting lots of wine, and the banker is wealthier because they used their knowledge to put me and the wine seller together, and they get some wine too. Just as before, the economy has become wealthier. It has nothing to do with the number of units of currency. It has to do with my increased output of wine glasses.

Now at one point, my economically knowledgeable friend suggested that we needed inflation to make people invest money, and that it was necessary to increase the money supply as the economy grows. That was why I gave the example of why I would (without any inflation) still invest my money in the bank. I also explained inflation this way:

I went back to my original choice of using my original wine glass as an exchange for a dessert; exchanging a portion of dessert in exchange for a wine glass. Instead of consuming the dessert myself, however, imagine that I am going to give it as a birthday present. The birthday is not for 6 months, so I take the dessert home and put it in my freezer. Having put it in the freezer, I am rather surprised to find that, every day, a stranger comes into my house, opens the freezer, and takes a small piece of the dessert away with them. As such, every day the dessert gets a little smaller. This is inflation. The stored value of my labour, represented by the dessert, is reducing every day that goes by.

This is one of the keys to understanding the supply of money. Every time there is an increase in the money supply, it is the equivalent of taking a little part of the value of everything from people. Where does that value go. Who is the person who is coming in and taking away a small piece of my dessert every day?

In the case of money, this is the person who makes more units of the money. Whenever they do this, they take a little part of the value of money from the existing money. In the case of the dessert, it represents the stored value of my additional wine glass of production, which is equivalent to saving x units of money. I made an exchange for one unit of dessert, and wanted to give the person having the birthday the equivalent of one wine glass of my labour. However, in a situation of inflation, the same thing happens to money as happens to my portion of dessert. Someone comes and takes a bit of it away every day. Whilst we would not accept a person coming in to our house and taking a piece of our stored value from the dessert, we readily accept them doing the same thing with our money in the bank, or money in our wallets.

In this example there is an illustration of something about wealth and money. Wealth is based upon output, and the structure of the money supply has nothing to do with making wealth, but has something to do with the distribution of wealth. Inflation distributes wealth away from you to the printer of the money. The only way to become wealthier is to produce more 'stuff' and this can be achieved without any manipulation of the money supply. This then raises the question of why there is so much manipulation of the supply of money. Macroeconomics is full of lots of complex models of the supply of money.

For the answer to this, we will leave the dinner table economics behind and turn to Adam Smith, who (as ever) got the picture absolutely right. This is what he has to say about money:

'For in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal [gold or silver], which had been originally contained in their coins [...] By means of those operations the princes and sovereign states which performed them were enabled, in appearance, to pay their debts and fulfil their engagements with a smaller quantity of silver than would otherwise been requisite.'

The cost of this he illustrates with an examination of landed estates, some of which which were awarded rent in money, and some which were awarded rents in corn. The estates with rent fixed in units of corn continued to be wealthy, but the estates with rent fixed in money became poor.

What Smith is explaining is that debasement of money serves only to help the state. Inflation of the money supply today is exactly the same in principle to what Smith was describing, and the same as someone coming in an taking a piece of my dessert.

In modern macroeconomics it appears that many economists are entirely confused about money. They seem to think that money has some mysterious purpose. If we go back to the dinner table economics, we did not need money to get wealthier, we just needed me to increase my daily output. Money has absolutely nothing to do with wealth. Money is, or should be, a unit of exchange that makes transactions more simple, and an abstraction of stored value that everybody accepts. It is the equivalent of the portion of dessert, or the wine glass - it is representation of these objects and the input of labour that created them.

The velocity of money, the number of units in circulation has nothing do with output whatsoever, it has to do with the way the wealth of output is distributed. I can not put this any more clearly than this:

Wealth is created by units of labour A, B and C producing and output of X, Y and Z.

The only difference that money makes in this equation is whether the money system offers incentives or disincentives to those units of labour to produce more or less output, and how the wealth is distributed. That is largely a factor of how much and in what way the value of their labour is expropriated through the scheming of 'princes and sovereign states'.

My knowledgeable friend was suggesting, and has argued that it is that monetary system that has allowed the growth in wealth in the Western world. My point is very clear; it is the increase in total output of labour that is the sole reason for the increase in wealth. All of the fiat money systems, and all of the rest of the apparatus of modern macroeconomics has done is play a part in how that wealth is distributed. From the dinner table economics, we can see that there is no need to create any incentives for people to get on with the useful business of increasing output and investing their increasing wealth to create even more output. The logic of these actions determines that this is what would, in any case, be what would happen.

Now if we return to the economy that has an output of 100 units, and imagine that today we have 100 units of money for that output, we can see where inflation fits in. If we then increase the money supply to 110 units, then we have inflation. The increase in the money supply has no bearing on the output, but simply means that there are more units of money relative to the output. The ten new units of money have been produced, and the value of the new units means that the producer of the new units of money have taken a portion of the value in exchange of the existing money. If you hold one of those units of money, you have just given something to the producer of the new money.

Lets imagine that the units of output also increases to 110, at the same time as the money supply increases to 110 units. Surely this is okay, as we can still buy the same number of units of output with our 1 unit of currency? This might seem reasonable, right up to the point where we start to think about where the increase in output has come from. If we think of the dinner table, it is me that has increased my output of wine glasses, so I have created the wealth. The printer of the new money has not increased output of anything, but they still have ten units more of money. This still means that my unit of money is worth less than it should be. If the additional units of money had not been created I would have been wealthier, but that additional wealth has been transferred to the producer of the new money.

But the producer of the new money has created no output....I have, and it is me that increased the output....but I see no benefits from it.

As an alternative, we can take another scenario, which is that output increases from 100 units to 11o units, but the units of money remain at 100. In this case, as my output increases, I become wealthier. My increase in output directly benefits me. I gain the full benefit of my output (the reality is however, that this is collective, not individual - everyone benefits). This is what many economists fear - deflation.

Economists say that deflation is a terrible thing. They say that it wrecks economies. If you have deflation, then people stop consuming, and stop investing.....

Let's start with the case of consumers stopping consuming. In this case, we have a good example of deflation to illustrate that deflation does not stop people buying things that they want. The example is computers which, as every year has gone by, have become ever cheaper in relation to their performance and sophistication. We all know that if we wait until next year, we will get a much better computer for our money. This is real deflation, but during a period of real deflation, the sales of computers has expanded, and expanded, and expanded.

If we think of a more mundane example, we might come up with something like a bottle of shampoo. Let's imagine that every year there are ongoing productivity gains in manufacturing shampoo such that the price falls by 3% per year. Does this mean that we will defer our buying of shampoo? Does that mean that, in order to benefit from the price reduction of shampoo, we will walk around with greasy hair.

Alternatively, we can take the case of a discretionary spend on something like a holiday. As some people will be aware, the low cost airlines have seen huge reductions in the cost of overseas travel, and the costs continued to go down over a period of years. Did this mean that people stopped overseas travel while they waited for the flight prices to drop even lower? What we actually saw in places like the UK was a massive expansion in overseas travel, as it became ever more affordable. However, this occurred despite deflating prices. This is like the example of the wine glasses....

The idea that people will not spend money during deflation is simply not true. However, if we knew that there was an unusual deflation about to take place, such that we expected the price of something to drop dramatically at some future point, we might defer our spending. For example, if the newspapers were to announce that in April of this year that there will be a new type of computer which will cost half the price of a computer today, then we would likely wait until April before buying a new computer. Moreover, when the new computers were released in April, then the sales of computers would increase as more people could afford them, and we would all potentially be richer by a factor of half a computer (if that makes sense).

However, such events would always be exceptions, and we readily buy computers despite the steady price deflation.

In short, steady deflation does not stop people from consuming.

This still leaves investment. In the case of investment, an argument might be put forward that, in the event of deflation, you could keep money under your mattress and still see it increase in value. As such, you have a disincentive to invest.

However, if we imagine that we have a situation of deflation, what has changed compared with inflation. In a period of inflation we have to invest our money just to stand still. However, we have many choices. We can put our money into a building society account and get a steady interest rate which will see a small return on our investment. Alternatively, we can put our money in a higher risk investment but risk our investment overall. In all cases we measure our return bearing in mind the rate of inflation. If we see inflation is at 3%, then we will want at least a 3% return, but most of us will want a return greater than inflation.

If we then imagine a deflation rate of 3%, that means that we will gain a 3% return on our money under the mattress. However, if someone offers us an additional 2% return over and above that 3%, we are very likely to be tempted into this. Just as in the case of the investment of the wine glass in the dinner table example, we will see that this can be a very smart thing to do with our savings. The only difference here is that it is not necessary to invest in order to keep your money, and this therefore becomes an issue of morality.

This is the morality argument; if we return to the dinner table economy, I have through my own ingenuity and efforts, ensured that I have achieved enough output to have an additional wine glass every day. This is the value of my own labour, not the labour of anyone else. The question here is, do I own the value of my own labour? What I do with the value of my labour should, as far as possible, be my own. If I choose to risk that value of labour by investing it should be my own decision. Whilst there are good arguments in favour of me making that investment, does that mean I should be compelled to invest it in order to preserve its value? If we think of the person coming into my house and taking away a piece of my dessert every day, such that I will not want to store the value of my labour in such a way, is that morally justified?

I will let you decide on the morality argument. However, what is certain is that there is no reason why deflation should lead to people not wanting to invest their money.

The final argument is that it makes the burden of debt greater. This one is a real puzzle to me. If you have a situation of inflation of 2 % and you want a 5% return, you will charge 7% to achieve this return. If you have deflation of 2%, then you will charge interest of 3%. In both cases the cost to the borrower remains the same. If you move from inflation into deflation, as would be the case now, then you have a problem in that the debt burden would increase. However, if you went from an inflation rate of 10% down to an inflation rate of 2% then the debt burden would also increase. In other words, the burden of debt is nothing to do with inflation of deflation, except for when there is a change.

What if there were a rate of deflation of 10%? The cost of borrowing would then have to go up dramatically for our example, with a 15% rate! However, if we had no increase in the money supply and the output of wealth from the economy was increasing by 10% causing 10% price deflation, I think that nobody would be complaining....everyone would be much, much wealthier...the deflation would later ease back as the supply of credit would reduce, reducing investments which might increase output...the system would balance back towards steady deflation. In other words, deflationary growth in wealth is self-regulatory and will provide a more steady model of growth in wealth.

Quite simply, I just do not believe that ongoing and steady deflation is a bad thing. If anything it is far better than ongoing inflation. Regular readers will know that I have advocated a system of money based upon a fixed specie of commodity (such as a gold standard). However, the more I have thought about this, the less I like the idea as the supply of gold also increases, such that the supply of money increases.

There is a better way, which is to absolutely fix the supply of money, such that it can never be expanded. Instead of inflating the money supply, as an economy expands, the units of currency at the start simply increase in value.

This does pose some practical difficulties, such as a unit of currency increasing in value so much that it becomes difficult to exchange for anything but ever larger items. To illustrate with an extreme example, if there were one thousand units of currency in the year 1066, then each unit of currency today hold nearly enough value to buy a city. The way around this is not to increase the units of currency, but to sub-divide the currency into smaller units. Just as today there are pounds and pence, as the value of a currency increases, it would need to be divided into pounds, pence and 'x'. At no time are any more pounds created, such that the pound is never watered down. Dividing a pound into pence does not devalue the pound, it is the increase in supply of pounds that devalues the pound.

There are many more points that could be made for such a fixed supply of currency (such as international implications), but this post has already gone way beyond my original intent. As such, I will leave it there, and leave you pondering on dinner table economics.


Note 1:

I am still getting more comments on my posts on fractional reserve banking. A brief answer to some of the comments. Yes, I agree that £1 GB is actually an IOU, and that banks also are creating IOUs. As such they are comparable. As you may have noted - throughout the blog I am casting doubts on whether the IOU that underpins the £GB and $US have any greater value as money than the IOUs of banks. In this sense, they are even more comparable than is widely believed.

However, my point about what is money always rests on a single principle, and I have explained this in several examples. Money is what people collectively believe it to be. I think I gave an example that illustrates this. A person who is starving to death will see a bowl of rice as more valuable than an ingot of gold, if he can not exchange the gold for rice. In a situation of starvation (where no food can be purchased from outside with the gold) rice would become a currency. People would exchange houses, land, or anything for the rice. It would become the currency that everybody believed in.

In the example in this post, even the value of the currency that I am proposing would be superseded by a food currency in the starvation situation.

When people were waiting in long lines outside of Northern Rock, they wanted to have their money denominated in £GB, not in bank IOUs. When they did this, they were clearly expressing their view of what money was, and that was not a bank IOU. It was a government IOU. Sadly, their belief in the government IOU is probably about to be tested as well....

The point in all of this is that when policy makers make policy, it seems a wise idea that, when they model the economic world, they have an understanding of money that conforms to the idea of money held by all of the economic actors - a reality which is expressed in the people waiting in line outside Northern Rock.

Note 2: At the dinner (on Saturday), I was explaining to a Chinese friend that her country was now the most powerful in the world, that power had shifted entirely towards China. As if on cue, Hilary Clinton is seen with the begging bowl out in China. Regular readers will know that I have been pointing to the reliance of the US on China for a long time.....

Note 3: Regular readers will also know that I have long been suggesting that the economic crisis has the potential to see the end of the Euro, and this is now the subject of speculation in the press..

Note 4:

A regular commentator 'Lord Sidcup' points out that mainstream commentators are starting to arrive at the same conclusions as my own (a couple of examples above). He asks where I can take the blog as they finally catch up.

It is a good point. I am wondering this myself, as my purpose was always to try to get a message 'out there' to as many people as possible. The blog has moved to the point where many readers (measured in many 1000s) now read each of my posts. As such I have a sense of obligation to offer something useful and that will only be the case if I can offer what I believe to be a better description of 'reality' than others. My philosophical foundation is critical scientific realism, which has helped me in this task so far.

However, if others offer the same analysis as the blog, then it might be time to call it a day. As such, I suspect that this blog may not have much life left in it. In particular, the scene is now set, and I very much doubt that anything will turn back the inevitable course of events. Whilst the exact timing of the denouement is still a matter of some uncertainty, the contradictions I have been discussing for so long must be resolved. A commentary on the detail of events will not offer anything that I have not already covered. Wealth will be still be wealth, and ongoing economic delusions that are the subject of this blog will remain delusions.

The populists, the something must be done politicians, will flail around for solutions, all the while doing more harm. The general populace will still think that everything might be 'fixed', without accepting the reality of what is actually broken. The fundamental problem is that the reality of the underlying problem is something that is hard to accept. This is the idea that we are no longer wealthy enough to live as we have before....unless we accept reform, and very tough reform.

At this stage, I am less and less sure of what I can add, and have had this thought occur to me several times recently. I will give this subject some thought. Comments welcomed.

P.S. Lord Sidcup, I am glad to hear that you read Marx and Adam Smith. Smith, is quite astonishing, and I have long suspected that one of the problems with economics is that all economists are comparing themselves to his ghost.

Note 5: I had a considerable amount of traffic on my posts on QE, and hope that many letters were sent to MPs. My thanks to those who took the trouble. I find it very disturbing that a significant (historic proportions?l) policy might take place under such conditions of opacity. Let's hope somebody pays attention.....