EconomicReason

“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.