Deflation versus inflation

After last week's report on CPI-U core inflation from the Bureau of Labor Statistics, which was either -0.1 percent or 0.1 percent depending upon whose mathematics inspires you with more confidence, and the Federal Reserve's decision to raise the discount rate to 0.75 percent from 0.50 percent, the attention of the markets is more closely focused on the question of inflation versus deflation than ever before.

Because the mainstream economic models, both Neo-Keynesian and Monetarist, are constructed around tax rates and government spending on the fiscal policy side and interest rates and money supplies on the monetary policy side, the inflation-deflation debate is almost invariably limited to contemplating interest rates and money supply. However, these analytical approaches also happen to leave out what is easily the most sizable and important factor, which is the amount of debt in the economy and the ability of the various economic actors to service their debts.

Contrary to the assumptions inherent in the series of estimates, guesses and outright fabrications that go into the magic formula that produces the current measure of an economy, Gross Domestic Product, most spending, be it consumer, corporate or government, does not come in the form of money proper. This should be obvious to anyone who has ever used a credit card, signed a mortgage or read a government budget. For example, compare the size of the two primary measures of money supply, M1 and M2, with the total amount of American debt, which represents "All sectors credit market instruments, excluding corporate equities and mutual fund shares liability" as reported by the Federal Reserve in its quarterly Z1 report.

M1: $1.7 trillion (+6.5 percent January 2009 to January 2010)
M2: $8.5 trillion (+1.9 percent January 2009 to January 2010)
Z1: $52.6 trillion (+1.1 percent October 2008 to October 2009)

As you can see, total debt in the American economy absolutely dwarfs both of the money supply measures. It is 30.9 times more than "the total of all bank reserves that are physical currency plus total demand accounts," M1, and 6.2 times more than "M1 plus savings accounts, money market accounts, retail money market mutual funds and small denomination time deposits," M2. This indicates that an increase in either the M1 or M2 money supplies is not going to be inflationary if Z1 is decreasing, because in a debt-based monetary system, total debt is the real money supply.

But the statistics cited above show that Z1 is increasing, correct? That is true, or at least it was true as of the third quarter of last year, but it is necessary to read the report to understand what is actually taking place. What the report shows is that household sector debt contracted -1.8 percent to $13.6 trillion while financial sector debt fell -5.4 percent to $16.1 trillion. That means that $1.1 trillion in debt was either paid off or defaulted while M2 grew $221.3 billion. Clearly, this is not net inflationary. But how did Z1 still manage to grow, however slightly, despite this trillion-dollar credit contraction?

The answer is to be found in the Bush and Obama stimulus plans. Federal debt had to increase by nearly one-third in a single year, to $7.5 trillion, just to keep Z1 barely above zero. And because the fourth quarter Z1 report has not yet been published, the comparisons don't show the full effects of the credit contraction. But these heroic federal efforts are falling short. As one can see from the historical statistics, credit has had to expand around 8.4 percent per year on average to keep GDP and the money supply growing between three and five percent. That suggests that the desperate attempt to substitute federal borrowing for the ongoing decline in private borrowing is falling well short of achieving the required effect.

Moreover, this substitution of public debt for private debt is unsustainable beyond the very short term because the federal government cannot issue an unlimited amount of Treasury securities, which is how it borrows money, and expect to find buyers for them. Nor is the oft-expressed notion that the Federal Reserve can buy an infinite amount of its own loans a reasonable one because the Fed is a private bank, and its owners aren't about to destroy the value of their holdings to bear the full weight of the American economy. While they have clearly been willing to try papering over the recent gap in demand for U.S. debt, there is absolutely no chance they will attempt to fill in a permanent chasm by altruistically falling on an inflationary grenade for the benefit of the American people. As I have written before, the Federal Reserve can print paper, but it cannot print borrowers. There is no question that if the USA was on a true paper system, the politicians would print money until the presses overheated, but that is not an option under the present monetary regime.

Ben Bernanke can make noises about helicopter money, but he will never actually order the whirlybirds aloft because, in marked contrast to the national politicians, the Fed actually cares about making profits, real profits, and not imaginary, inflated ones.

Since Z1 is released on a quarterly basis, it is not possible to make a direct comparison of total credit to the latest money supply measures, but because total bank loans are down -7.05 percent for Q4-Q4, versus -4.57 percent for Q3-Q3, we can be confident that the next report will show that overall debt contraction is not only continuing apace, but is picking up speed. This ongoing credit contraction indicates that debt-deflation and economic contraction will continue in the foreseeable future despite the growth of the money supplies and regardless of what the Bureau of Labor Statistics and Bureau of Economic Analysis happen to report. This is more a failure of theory than of policy, and until mainstream economics begins to properly factor the debt element into its models and equations, there will be a persistent dichotomy between what the government agencies report and what the intelligent observer can see all around him.