EconomicReason

Many analysts agree that we are currently in a deflationary period, although they might disagree strongly about the outlook for inflation.

I think we are already inmidst serious inflation. Although consumer prices are falling in many countries, this does not imply we are experiencing deflation. Inflation is not defined as rising consumer prices, inflation is defined as a fall in the value of money because of an excessive increase in the quantity of money. Consumer prices are one (out of several) indicators of inflation. Because consumer prices are sticky, i.e. consumer goods are not traded on liquid markets, consumer prices are a lagging indicator of inflation. Most real-time indicators of inflation point to rather high inflation: growth rates of monetary aggregates around the world are massive, and the purchasing power of the US dollar has been falling on almost every liquid market for several months now (foreign currency, commodities, stocks). Consumer prices will probably follow other prices in due time.

Excellent analysis, by Eric Kraus from Moscow: Green Chutes.

Another excellent analysis by Eric Kraus from Moscow: Happy Families.

“Deflation is set in stone” is what you read sometimes. The argument goes roughly like this: The fiscal and monetary injections amounting to a few trillion are no match for the dozens of trillions of wealth destroyed by the crisis. The underlying logic is that as long as government programs are dwarfed by wealth destruction, only deflation can result.

This sounds logical, but it is not. In particular, some things are badly mixed up. Actually, inflation could probably result with government support being much smaller than wealth losses.

First, real estate, stock, and risky credit were overpriced at the onset of the financial market crisis – their valuations were not backed by an equivalent stream of future production. Note that wealth is nothing else than a claim on future production. Therefore, pre-crisis levels of asset prices did not reflect actual wealth – in fact, there was no chance that these overpriced assets could ever have been converted into future production at prevailing prices. Expectations reflected in asset prices were exaggerated. In order to balance future aggregate demand and supply of goods and services, either consumer prices would have had to rise, or asset prices would have had to fall. The latter happened.

Enter the government. By reinflating prices of worthless assets above their intrinsic value, false wealth is restored. Furthermore, by backing AIG and honouring bets which were not honourable from the beginning, even more false wealth is created. Trying to restore exaggerated expectations is probably a bad idea and could turn out very inflationary.

The second flaw in the introductory reasoning is that apples are compared to oranges. A dollar in wealth (losses) is not the same as a dollar in money supply, which is not the same as a dollar actually spent for goods or services. In particular, wealth and money supply are stock variables, while spending is a flow variable. Simply aggregating the headline amount of government measures and comparing them to estimated wealth losses is therefore useless at best, if not misleading, in order to assess future inflationary tendencies.

Alecto, Tisiphone and Magaera, the three Furies, are the goddesses of vengeance and guardians of law in Roman mythology. They are called Erinyes in Greek mythology. The Furies intervene not only when a crime is committed against the positive law of a given society, but also when it is against the natural law. For example, they would protect beggars, strangers, dogs and young birds. In the Iliad, they are characterized as “those who beneath the earth punish whoever has sworn a false oath”. They are horrible to look at, with snakes as their hair, blood dripping from their eyes, carrying whips made of scorpions, with which they scourge the living and the dead. They are unrelenting in their pursuit of criminals, pitiless, but fair. Often, they are striking the offenders with madness.

It appears that Nemesis, executrix of justice, finally made up her mind that enough is enough. By calling the Furies to appear on Earth and sending them after the perpetrators of the current financial mess, justice should be restored. As an economist, I have no idea how the financial and economic crises are going to play out. However, taking guidance from mythology, the crisis might be far from over. Despite the severity of the crisis, there is still obvious and widespread fraud, corruption, arrogance and ignorance going unpunished, mainly in the financial sector. For divine justice to be be served, the crisis will have to worsen significantly.

Another excellent analysis by Eric Kraus from Moscow: Too Early to Tell.

Last year brought an increase in moral hazard on a grand scale. One year ago, there was still reasonable doubt whether governments would intervene in order to save illiquid, but solvent systemically important banks, and how punitive the terms of a bailout might be for shareholders and management.

Today, there is no doubt any more that governments will intervene in order to save illiquid and insolvent banks, systemically important and unimportant banks, insurance companies, states, countries, industries, home-owners, shareholders, management, and about everyone else who can plausibly argue that he needs a bailout and who can write (because you need to be able to fill out a two-page application form).

Basically, moral hazard makes agents behave more risk-seeking than is optimal for a society as a whole. There are several consequences of the increase in moral hazard. First, by definition, society as a whole will fare less well. Second, as soon as the current deleveraging will be over, risk-love and speculation could return with a vengeance. The next bubble, wherever it will be, will be something to behold. Third, an increase in moral hazard is equivalent to an expansion of monetary policy. This expansion represents a significant (and probably underestimated) boost to the economy and financial markets. Fourth, in the longer run, moral hazard increases systemic risk even further – the next bust might definitely finish off what this bust will have left over.

Moral hazard is the main culprit for the current financial crisis – investors, managers, and basically the whole society behaved recklessly because they were conditioned to be bailed out. The current instance has shown once again that in a democracy with a fiat currency regime, no laws can prevent large-scale bailouts to take place, and that expectations of a bailout are thus justified ex ante. Ultimately, there is probably just one way to credibly prevent governments from bailouts, and thus to eliminate the moral hazard problem – namely to render bailouts financially impossible. The possibility to inflate money supply must be taken away from governments. This could be implemented, for example, by backing money with commodities, possibly gold. The wheel does not have to be reinvented.

Another eloquent and scary analysis by Eric Kraus from Moscow: Things that Fall Apart.

Eric Kraus from Moscow: Havoc/Hope.

Equally also, our thrust has been founded on our unwavering belief that extraordinary circumstances must be confronted through extraordinary interventions…

As Monetary Authorities, we commend those of our peers, the world over, who have now seen the light on the need for the adoption of flexible and practical interventions and support to key sectors of the economy when faced with unusual circumstances.

From the Quarterly Report of the Reserve Bank of Zimbabwe, April 2008 (don’t bother to click on that link, it usually does not work…).

And for those who think this is a joke - here is the full Quarterly Report.