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Let’s Welcome The Deflation That Is Coming – It Helps Everyone Except Government And Its Cronies.

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The greatest hoax perpetrated by the governing class on the rest of us is the Federal Reserve’s 2% inflation target. They are telling us that the dollar in our pocket will buy 2% less every year, or about 20% less in 10 years and 33% less in 20 years. And they are telling us this is a good thing. In fact, since the first year of the Federal Reserve in 2013, the average annual rate of decline of the spending power of the US dollar has been over 3%, so the Fed is beating its target. Your dollar has lost more than 95% of the purchasing power it represented in 1913.

We tolerate this because we have been taught (in the government’s own schools) since kindergarten that inflation is a good thing, and its opposite, deflation, is a bad thing. If there were to be deflation, then the purchasing power of the dollar in your pocket would be increasing not decreasing. So why would that be a bad thing?

Well, the Fed has a lot of myths they’s like you to buy into to support the idea of deflation as a bad thing. They include:

  • The economy can’t grow when prices are falling. Wrong. Empirically, economic growth is not negatively correlated with falling prices. As one example, the US economy in the last third of the 19th Century grew strongly while overall prices were declining, so that real per capita income growth accelerated. And that’s the point: it is real income growth that people seek, not inflation-boosted nominal incomes measured in dollars that buy less and less every year.
  • Companies can’t make a profit when prices are declining. Wrong. Profits are the difference between selling prices and costs. When both are declining, there is no reason why profit margins can not be maintained. Companies have become very smart at anticipating future prices and future costs during the unstable inflationary conditions induced by the Federal Reserve and other central banks, and they will be able to utilize the same forecasting skills when prices are falling.
  • Deflation creates unemployment. Wrong. The economy can grow and therefore employment can grow amidst declining prices. Real wages can also grow in deflation. The only possible cause of unemployment in deflationary times would be the maintenance by government regulators of a mandatory minimum wage that was higher than the free market price that labor could command. The government would quickly find that such regulation would be unsustainable.

There are several more “deflation is bad” myths, but none are persuasive. So why are our governing class masters so adamant that inflation must be maintained? Because it is good (indeed vital) for government, and for its cronies in banking and the financial industry. Inflation is the fuel for never-ending government growth. When the Federal Reserve prints money (“expands the money supply”), which is the action that creates inflation, it goes straight to government spending. Government can issue unlimited amounts of debt for the Federal Reserve to buy (or “monetize”), in the confidence that (a) government can pay it off in future years with lower-value dollars, and (b) government will always have access to new Federal Reserve-created dollars in the future so it never needs tp stop or reduce spending. This inflation machine is the main engine of continued welfare state and warfare state expansion. Government just keeps getting bigger and bigger under conditions of inflation.

Similarly, the government’s closest cronies, the banks, are the next recipients of Federal Reserve-created money, which they can lend out at high interest rates to businesses and individuals, making profits on the spread. Banks lend every dollar they receive from the Fed nine times, multiplying the inflationary effect of newly printed money. In inflationary conditions, firms are happy to incur debt that they can repay in the future with lower value dollars. Business becomes more speculative as a result. In deflation, businesses are more likely to finance themselves with equity than debt, so that business becomes more soberly managed, more reliable and more likely to generate high quality growth. Both businesses and households become more likely to save now for investment later, taking economic and social power away from the Federal Reserve and the banks and putting it back in the hands of private citizens.

If government has such a vested interest in continued inflation, what are the signs that they might not be able to maintain their 100+ year record? There are three.

  • Central Banks are beginning to realize that never-ending inflation is beginning to turn destructive to society. We reported here that the research arm of the Bank For International Settlements, the nation state central bankers’ own global central banker, has declared that the financial crashes and crises knowingly caused by unrestricted money printing should be brought to an end. At the same time, nation-state Central Banks like that of Japan are beginning to recognize that, in the anemic economic conditions they have brought about with their unrestrained money-printing, there comes a point where the citizens give up and cease to be economically productive.
  • Technology-induced price deflation is becoming more and more pervasive. In the case of the declining prices / growing economy story of the US in the last third of the 19th Century, technology – in the form of railways, manufacturing machinery, electric lighting and telephones – played a large role. Today, we are undergoing a technology shift of comparable influence, with global trading platforms, declining transaction costs, and galloping automation, both software-based and hardware-based. Technology’s typical effect on prices is to reduce them not increase them.
  • Today’s demographics are deflationary. As the baby boomer generation is retiring, they are starting to withdraw money from their retirement accounts to live on. Whatever they spend, they do so very carefully. Many countries, including Japan and China, are aging faster than they are adding to their affluence.  Insofar as consumer spending influences price inflation, these conditions are anti-inflationary.

The signs are promising that we might be entering a period of price deflation, or at least price stability. If the rate of money printing by Central Banks continues to slow, and the downward influence of technology and demography on prices strengthens, then it could happen. Citizens will rejoice, and governments and banks will cringe, which is as it should be.

This Central Banker Is Certain That All Other Central Bankers Are Deluded, Dangerous, And Wrong.

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Central Bankers know less than they think they do, and their ignorance imposes huge costs on the rest of us. Their economic theories offer little meaningful guidance for how to sustain growth and they actively undermine financial stability.

Says who? Claudio Borio, who heads the economic-research department at the Bank for International Settlements. The BIS is an informational clearinghouse for the world’s central banks, in possession of more data and more analytics than any other single Central Bank. Since Mr. Borio is not tied to any nation, political viewpoint or policy dogma, he can be a producer of objective and practical insights – giving him a distinct advantage over all the academic economists who work, directly or indirectly, for nation-based Central Banks.

What does he think of the standard of knowledge at all the Central Banks, universities and think tanks. They are, he says, “all struggling!” In other words, they don’t know much.

Here’s what mainstream monetary economists think they know: Inflation, employment and economic growth change in relation to each other in predictable ways. As unemployment falls, inflation rises. Deflation – which the Central Bankers have defined as a “bad thing”, since they seek 2% inflation every year – is a result of economic slack.

Central Banks can’t tolerate deflation because, in their minds, it signifies slower-than-natural growth in which too few people have jobs. When it occurs Central Banks have only one simple tool at their disposal: to provide limited jolts by tweaking short-term interest rates. Mr. Borio describe this thinking as “very, very simple”.

Economists need to go back to the drawing board, says Mr. Borio. The financial system is much more complicated than Central Bankers can appreciate, and much less amenable than they think when using their simplistic models and tools. “One needs to examine how resources are allocated across different sectors in ways that may not be optimal.” It’s very different from the simple-minded orthodox view that a rising tide of new money lifts all boats.

First, they need to realize that deflation is a good thing- it typically brings lower prices to both consumers and producers, and it is associated with economic growth.

“The main drivers of deflation at the moment are good forces,” Mr. Borio says. “They improve the capacity of the economy to produce and boost growth. Think of it as a benign increase in supply.”

In a 2015 paper Mr. Borio and colleagues examined 140 years of data from 38 countries and concluded that consumer-price deflation frequently coincides with healthy economic growth. If he’s right, central banks have spent years fighting disinflation or deflation when they shouldn’t have, and in the process they’ve endangered the economy more than they realize.

“By keeping interest rates very, very, very low,” he warns, “you are contributing to the buildup of risks in the financial system through excessive credit growth, through excessive increases in asset prices, that at some point have to correct themselves. So what you have is a financial boom that necessarily at some point will turn into a bust because things have to adjust.”

By slashing rates in pursuit of that hard-to-attain inflation target, Central Bankers create imbalances in the financial system that lead to crises like the one in 2008. They actually know this, but they’re just strangely unconcerned about it. They believe that Central Banks must set ultralow short-term rates to support economic growth—and if that destabilizes the financial system, it’s the will of the economic gods. In this way, they unleash financial crises deliberately. (Emphasis added.)

Central Bankers were able to observe the effects of their delusion in the global crash of 2008. Central Bankers, says Mr. Borio, actively create macroeconomic instability and financial market instability inevitably follows.

Mr. Borio, in contrast, can explain exactly where dangerous financial imbalances come from: the incentives policy makers  create for bad decisions on Main Street about borrowing and investment. The misallocation of resources during the booms requires a prolonged and miserable process of reallocation during and after a recession.

“You know, in many of these models, how do they explain the Great Financial Crisis? They explain it as a meteorite coming from nowhere—it’s an exogenous shock, it’s productivity that all of a sudden for some unexplained reason collapsed, or people all of a sudden decided to save more, but without an explanation. I say ‘shocks’ are a measure of our ignorance, not a measure of our knowledge.”

“95% of the time Central Bankers carry out their policy as if these factors didn’t matter, and then when they see that the economy is running red hot and they see obvious signs of financial imbalances, they start moving.”

Mr. Borio’s work amounts to an argument that Central Bankers and monetary economists need to acknowledge how little they know about the economies they seek to manage, and how weak their models are. They need to become more modest, and appreciate the limitations of the current simplistic theories and the need to rethink them.

Based on The Weekend Interview that appeared in the November 17, 2018, print edition of the Wall Street Journal. Illustration by Ken Fallin.

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