03/10/2008: On the road to inflation or deflation?

Government debt is soaring as the US and Europe scramble to rescue distressed financial institutions. Central banks worldwide are pumping liquidity into markets and lowering their interest rates. Classical economic theory argues that these actions should pave the way for a surge in inflation pressures ahead. But is it really so?

Economic textbooks generally take the view that two government actions can be counted on to fan the flames of inflation––printing more money or increasing government debt. While few economists would dispute this thesis, there can be exceptional circumstances that defy it, and this is what we now are seeing.

Money is created from two sources: a central bank, like the US Fed, and financial institutions, like commercial banks. When the central bank wants to create money, it simply prints it and then buys something with it, such as government debt. The “new” money goes to the seller of the government debt, who in turn buys something or saves it.

At some point, this freshly created money lands in a bank’s accounts. The bank will lend most of this money to someone, who will buy something with it; at some point the money will land in another bank account; that bank will lend most of the money to someone else; and the cycle continues.

In a smoothly functioning financial system, one unit of central bank money, or base money, thus creates multiple units of money in the real economy. How much it creates depends on the reserve requirements of banks that stipulate the proportion of deposits that must keep at the central bank rather than lent. It also depends on interest rate levels and on the willingness of banks to lend.

In today’s dysfunctional financial markets, the willingness to lend has abruptly vanished, especially in the US. This means that the Fed can print money, but these funds will not find their way to the public via loans and will therefore have no affect on demand, prices, and inflation.

After the Japanese real estate and stock markets collapsed in 1990, the Bank of Japan and the Japanese government confronted a situation similar to what the US and to a lesser extent Europe now face. Despite years of central bank interest rates at zero percent and government debt that ballooned to more than 150% of GDP, Japan actually experienced more than ten years of deflation, that is, declining prices, because banks drastically reduced lending and deleveraged, that is, they removed debt from their balance sheets.

Both inflation and deflation hurt equities, but inflation is obviously the lesser of the two evils as the Great Depression of the 1930s and Japan in the 1990s both confirm. Bonds, especially the safest ones, tend to perform well in a deflationary environment; so does currency, even if its returns are low. Commodities, on the other hand, do well in times of rising inflation and less well when deflation prevails.

Thus, the view that money creation automatically feeds inflation does not neatly apply in the current situation. The environment is more complex this time around, which means that making the right investment decisions will be absolutely crucial to your portfolio once the worst of the current crisis is behind us.