Tuesday, April 28, 2009

Inflation or Deflation? Money Supply, Credit Supply

Measure Money and Credit
NOT Prices, Wealth, Assets, Velocity, Transparency

People debating inflation/deflation often take the Austrian economics' definition:

Inflation = Increased supply of money and credit (combined)

Deflation = Decreased supply of money and credit (combined)

Therefore, the following are NOT inflation/deflation:

  • Prices: Many deflationists rightly state that price increases are not inflation (such as when gas prices were rising during the current recession). As Milton Friedman and Anna Schwartz wrote, "Inflation is always and everywhere a monetary phenomenon." In contrast, prices can be a lagging-indicator effect of inflation/deflation (monetary phenomenon) or an effect of supply and demand (production phenomenon). The Federal Reserve confuses people by using prices (CPI, PCEPI) as an inflation measure. Actually, prices can rise even during deflation if supply (relative to demand) drops faster than money/credit supply drops (a common definition of "real" (relative) "inflation" (actually, general prices increases) as "too much money chasing too few goods" explains prices by combining the monetary effect with the production effect, money relative to production, but we will stick with inflation/deflation as absolute money/credit supply for clarity). If rising gas prices are not inflation, falling gas prices are not deflation. We saw years of inflation with falling prices in electronics. Beware when people cite falling prices such as gas, wages, and assets (not money/credit supply).
  • "Wealth Destruction" ("Asset Deflation"): These terms often misleadingly refer not to actual wealth destruction (your quart of milk spoils), nor to money destruction (burn a dollar bill), nor to credit destruction (pay off your credit card), but to price declines, which we already know are not deflation (see the previous paragraph). First, asset destruction (house burns down) is different from asset price declines (house assessed value declines but is still the same house providing the same housing shelter). Price decline from peak is different from price decline from purchase price (house or 401k goes up 2 pennies and then down 1 penny--despite the "asset deflation," you did not lose a penny, you gained a penny). Prices can decline without practical wealth destruction when dealing with unreal, unrealized "paper" profits/losses. Second, money does not equal asset value even in "normal" markets when house prices do not decline. Someone with a 5% 30-year fixed-rate mortgage (FRM) will pay almost $600k for a $300k house after interest ($280k interest). Third, asset prices can plummet without decreasing the money/credit supply by a single penny. If someone buys a house for $300k, sells it to you for $600k, and then overnight the value drops back to $300k, the $600k is still in the economy (you gave the $600k to the seller, plus you still have $1.16 Million debt payments to give to the bank ($600k + $560k interest @ 5% 30yr FRM) if you used a no-money-down mortgage). That case is wealth transfer, not wealth destruction. Asset price fell (50%), Loan To Value (LTV) ratio rose (from 100% to 200%), and money/credit supply remained unchanged. Assets are not money. Assets are not credit. If you prefer, not all assets are money/credit. Beware when people cite falling asset values (not money/credit supply).
  • Velocity: Velocity, the turnover rate or frequency at which people exchange money, is an effect of economic activity, not the cause of it as central planners like to say (people need a productive reason to exchange money and increased velocity is a consequence--but politicians prefer higher velocity even for unproductive make-work because they profit from churning even wealth-destroying transactions). Do not confuse the number (supply) of an item with the number of people using that item. If your street of 10 people shares 1 lawnmower, together you have 1 lawnmower, not 10 lawnmowers (1 "high-velocity" lawnmower that travels a lot, instead of 10 low-velocity lawnmowers that each stay in 1 yard). Velocity is the speed of the money/credit supply. Velocity is not the money/credit supply. Velocity is not money. Velocity is not credit. Beware when people cite the speed of money (not the supply of money). Beware when people cite the number of dollar transactions (not the number of dollars). Beware when people cite decreased velocity (not money/credit supply).
  • Hypothetical Transparency (Mark-to-Market Price Discovery): "If credit were marked to market (write-down bad loans), we would have deflation" is not a factual statement, it is a conditional statement (what if). "If pigs had wings, they could fly. Therefore, pigs can fly." That conclusion is wrong because the prerequisite condition does not exist. Pigs do not have wings. Credit is not marked to market. The whole point of government interventions to date has been to prevent accurate mark-to-market of credit and assets (prevent price discovery and transparency). Beware when people cite what-ifs (not actual money/credit supply).
Prices, wealth, velocity, and transparency are important economic factors but they are NOT the money/credit supply.

You can see that these variables are distinct in the modified Quantity Theory of Money formula:


Y=Income (Keynesians replaced T=Transactions with Y)

If you want to know the money/credit supply, measure the money/credit supply.

Measure actual money/credit supply and the jury is still out on the inflation/deflation debate:
Deflation would be the natural consequence and beneficial solution to the economic bubble, which is why the government is fighting to prevent the solution--and the charred battleground is your wallet.