The Inflation-Deflation Shell Game

One of the economic forebodings that are beginning to gain some momentum is the notion of deflation. The exact definition of ‘inflation’ or ‘deflation’ can be subjective in nature, but they are generally understood to be an over-arching increase or decrease in prices across a specified period. Traditional economic theory holds that when a government increases the amount of money in circulation relative to real output, it creates inflation. Irving Fisher articulated this thought in the following mathematical identity:

MV = PT

In this simple equation, “M” represents the amount of money (or currency) in circulation, “V” equals the velocity of circulation for that money, “P” is the nominal price level, and “T” represents the level of real output. A simple analysis of this identity reveals that the most important part of the equation is real output or T. The reason for this is that real output frequently grows at a rate between 2% and 3% per year for mature industrialized countries.

P = MV/T

Another way of viewing this identity is to isolate the “Price” variable so that the price level is equal to the quantity of money times the velocity of circulation, both divided by the level of real output. In practically terms, the level of real output is relatively static over the short-term, since both the supply of money and velocity of circulation can be extremely volatile. Thus, the two key variables that affect the market price level are the amount of money in the marketplace and the velocity of circulation.

This can create a bit of a ‘feast or famine’ effect, since periods of economic expansion typically increase the velocity of circulation as people spend and invest more quickly. Similarly, periods of contraction decrease the volume of circulation, as people are more wary of spending or investing. The political response to this trend is an attempt by the Federal Reserve to ‘fine tune’ the price level by increasing or decreasing the amount of money in circulation.

After the 2008 financial crisis, there was a tremendous bout of deflation pressure that stemmed from a collapse of transaction velocity. This contraction in velocity was most heavily concentrated in high priced capital assets like homes that depend on credit financing, since the reduction in credit availability suddenly removed many potential buyers from the marketplace. This phenomenon is the core argument for deflation in the near future by people who believe that a ‘double dip’ recession will result in another contraction that deflates prices by clamping down on the transaction velocity. In response to this slowdown of currency velocity, the Federal Reserve injected a tremendous amount of new money into the banking system. When this happened, many people became very concerned that the increase in money would create inflation when transaction velocity regressed back to equilibrium. The root of this fear comes from the fractional reserve banking system where a deposit in one financial institution is used to create loans. (The US ‘required reserve’ ratio for banks is 10%, meaning that banks must hold 10% of all deposits in reserves) These new loans are subsequently deposited into another financial institution, which results in more loans until the ‘money multiplier’ rate of expansion has been achieved. When people refer to the ‘money multiplier’, it refers to the re-loaning of funds out so that the total money creates equals the initial deposit divided by the required reserve ratio. In the United States, a fully multiplied deposit will create 10 times the amount of money that was initially deposited.

By now, I am sure that you have become highly concerned over the potential for fractional reserve banking to take monetary expansion by the Federal Reserve and turn it into hyperinflation. The way that the Federal Reserve has chosen to ‘contain’ this risk of inflation is through a ‘shell game’ of manipulated incentives to hold down prices and prevent monetary expansion from causing widespread inflation.

The Inflation Control Shell Game

The way that this ‘shell game’ works is by masking money printing through an artificially low Fed Funds rate those banks can use to borrow money from the Federal Reserve. When banks can borrow an extremely large amount of money for near-zero interest, it becomes immediately obvious why the banks are not making loans. The reason that banks are not lending is that they can make more money buying treasuries with a higher yield than the Fed Funds rate and capturing the interest spread as an arbitrage profit.

The secondary effect of this scheme is that the bank arbitrage of artificially low interest rates by the Federal Reserve holds down treasury rates. The reason for this is that banks have an incentive to purchase large quantities of treasuries with money that they have freshly borrowed at near-zero interest rates. Thus, the banks realize enormously large profits, inflation stays modest, and treasury rates stay low. This nifty trick allows the government to use freshly printed money to hold down the cost of borrowing.

This is the step where deflation may temporarily emerge. If the Federal Reserve is overly successful in suppressing private lending with distorted incentives to banks, it could result in an incremental credit contraction that further slows the velocity of money through the economy. This is especially likely if the economy slips back into recession as losses in the commercial real estate sector and persistent unemployment create more drag than the fictional government stimulus can overcome. There is a distinct likelihood that a limited duration of asset deflation from reduced currency velocity may unfold.

However, just like the Pied Piper of Hamlet, all debts must eventually be paid. In this case, the debt to be paid is our continually increasing national debt. The inflation control shell game of the Federal Reserve is being used to mask the impact of burgeoning government deficits by artificially suppressing interest rates. As the debt continues to grow out of control, the ability of the Federal Reserve to manipulate rates will diminish as foreign governments and domestic investors refuse to accept low interest rates for debt from a government with no semblance of
fiscal responsibility.

As the government finds itself unable to sell treasuries at low rates and roll-over its debt burden, yields will necessarily rise. As these yields rise, the amount of government spending required for debt service will also rise. This will increase government deficits until they reach a point where so much of the government budget is dedicated to debt that a ‘sovereign debt crisis’ is declared and either spending cuts or currency devaluation is triggered to keep the national budget from collapse. Since spending cuts of the magnitude necessary to get the government back on strong financial footing are unlikely, the most probable option for the government to bail itself out is monetary inflation. By this point, the inflation will necessarily roll through the economy since treasury arbitrage by banks relies on an artificially low Fed Funds rate. By this point, the debt will have grown to such a point that it cannot be contained with bond arbitrage by banks. At this point, attention will need to be focused on solving the fiscal calamity caused by nearly a century of irresponsible spending.

At some point, the eventual result will most likely be currency devaluation by the government that is wrapped in the form of monetary expansion pushing up prices. The monetary expansion will occur as the government prints new money to pay for its entitlement obligations and the inflation will occur when this flood of money washes out into the economy. In the end, large amounts of inflation are an almost complete certainty. There is a distinct possibility of temporary deflation from distorted market incentives in the near-term, but long-term actions cannot possibly lead anywhere but inflation unless our government adopts austerity measures that are greater than three times the restraints recently imposed on Greece. Since governments are naturally irresponsible until forced into responsibility, the reality of inflation in the future is a matter of almost complete certainty.

Action Item: Take advantage of government interest rate manipulation by locking-down fixed rate financing on income properties immediately. The shell game being used by the government to control inflation and interest rates cannot continue indefinitely. When it breaks, there will be a torrent of inflation that most people have never imagined before. By taking action now, you and your family will be prepared so that the irresponsibility and corruption of government bureaucrats will not destroy your financial well-being. (Top image: Flickr | woodleywonderworks)

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