Why I Still Fear Inflation

Paul Krugman wonders why others worry about inflation when he sees no evidence of inflationary trends:

Joe Wiesenthal makes the well-known point that aside from certain euro area countries, yields on sovereign debt have plunged since 2007; investors are rushing to buy sovereign debt, not fleeing it. I was a bit surprised by his description of this insight as being non-”mainstream”; I guess it depends on your definition of mainstream. But surely the notion that what we have is largely a process of private-sector deleveraging, with government deficits the consequence of this process, and interest rates low because we have an excess of desired saving, is pretty widespread (and backed by a lot of empirical evidence).

And there’s also a lot of discussion, which I’m ambivalent about, concerning the supposed shortage of safe assets; this is coming from bank research departments as well as academics, it’s a frequent topic on FT Alphaville, and so on. So Joe didn’t seem to me to be saying anything radical.

But those comments! It’s not just that the commenters disagree; they seem to regard Joe as some kind of space alien (or, for those who had the misfortune to see me on Squawk Box, a unicorn); they consider it just crazy and laughable to suggest that we aren’t facing an immense crisis of public deficits with Zimbabwe-style inflation just around the corner.

Krugman, of course, thinks it crazy and laughable that in the face of years of decreasing interest rates that anyone would believe that inflation could still be a menace. In fact, Krugman has made the point multiple times that more inflation would be a good thing, by decreasing the value of debt and thus allowing the private sector to deleverage a little quicker.

I remain convinced — even having watched Peter Schiff and Gonzalo Lira make incorrect inflationary projections — that there is exists the potential of significant inflationary problems in the medium and long term. Indeed, I believe elevated inflation is one of three roads out of where we are right now — the deleveraging trap.

In my worldview, this depression — although a multi-dimensional thing — has one cause above all others: too much total debt. Debt-as-a-percentage of GDP has grown significantly faster than productivity:

The deleveraging trap begins with the boom years: credit is created above and beyond the economy’s productive capacity. Incomes rise and prices rise above the rate of underlying productivity. And as the total debt level increases, more and more income that was once used for investment and consumption goes toward paying down debt and interest. This means that inflated asset prices become less and less sustainable, making the economy more and more susceptible to a downturn — wherein asset prices deflate, and the value of debt (relative to income) increases further. Under a non-interventionist regime, once the downturn occurs, this would result in credit freeze, mass default and liquidation, as occurred in 1907.

However, under an interventionist regime — like the modern Federal Reserve, or the Bank of Japan — the central bank steps in to lower rates and print money to support asset prices and bail out failed companies. This prevents the credit freeze, mass default, drastic deflation and liquidation. Unfortunately, it also sustains the debt load — following 2008, total debt remains over 350% of GDP. The easy money leads to a short cycle of expansion and growth, but the continued existence of the debt load means that consumers and businesses will still have to set aside a large part of their incomes to pay down debt. This means that any expansion will be short lived, and once the easy money begins to dry up, asset prices will again begin to deflate. The downward pressure on prices, spending and investment from the excessive debt load is huge, and requires sustained and significant central bank intervention to support asset prices and credit availability. The economy is put on life-support. Debt-as-a percentage of GDP may gradually fall (although in the Japanese example, this has not been the case) but progress is slow, and the debt load remains unsustainable.

A fundamental mistake is identifying the problem as one of aggregate demand, and not debt. Lowered aggregate demand is a symptom of the deleveraging trap caused by excessive debt and unsustainable asset prices. The Fed — and advocates of greater Fed interventionism to support aggregate demand, like Krugman — are mostly advocating the treatment of symptoms, not causes. And the treatment in this case may make the underlying causes worse — quantitative easing and low-interest rates are debt-additive policies; while supporting assets prices and GDP, they encourage the addition of debt. 

There are three routes out of the deleveraging trap; liquidation (destroying the debt via mass default), debt forgiveness (destroying the debt via systematically cancelling it), and inflating the debt away. Liquidation in a managed economy with a central bank is politically impossible. Debt forgiveness is politically difficult, although perhaps the most realistic effective bet. And inflating the debt away at a moderate rate of inflation would seem to be a slow and laborious process — the widely-advocated suggestion of a 4% inflation target would only eat slowly (if at all) into the 350%+ total debt-as-a-percentage-of-GDP load.

All three exit routes seem blocked. So the reality that we are staring at — and have been staring at for the last four years — has been remaining in the deleveraging trap.

So why in a deflationary environment like the deleveraging trap would I fear high inflation? Surely this is an absurd and unfounded fear?

Well,  Japan shows that nations can remain stuck in a deleveraging trap for a long, long time — although Japan has had to take to increasingly authoritarian measures such as mandating the purchase of treasury debt to keep rates low and so to keep the debt rolling. But eventually nations stuck in a deleveraging trap will have to take one of the routes out. While central banks refuse to consider the possibility of a debt jubilee, and refuse to consider the possibility of allowing markets to liquidate, the only route out remains inflation. 

Yet the big inflation that would be required to eject the United States from the deleveraging trap makes creditors — the sovereign states from which the US imports huge quantities of resources, energy, components, and finished goods — increasingly jittery.

According to Xinhua:

The U.S. has long been facing the same problem: living beyond its means. At present, the country has debts as high as 55 trillion U.S. dollars, including more than 14 trillion U.S. dollars of treasury bonds.

And last October:

Economists agree that as the United States’ largest foreign creditor, China should contemplate ways to pull itself out of the “dollar trap,” as the U.S. economy is faltering with its debt piling up and its currency on the brink to depreciate.

China must make fuller use of the non-financial assets in its foreign reserves, as well as speed up the diversification of investing channels to resist a possible long-term weakening of the dollar, said Xia Bing, director of the Finance Research Institutes of the Development Research Center under the State Council.

Zheng Xinli, permanent vice chairman of China Center for International Economic Exchanges, has suggested that Chinese companies boost overseas investment as a way to absorb trade surpluses and fend off the dollar risk.

And it’s not like America’s Eurasian creditors are doing nothing about this. As I wrote earlier this month:

If the exporter nations feel as if they are getting screwed, they are only more likely to escalate via the only real means they have — trade war. And having a monopoly on various resources including rare earth minerals (as well as various components and types of finished goods) gives them considerable leverage.

More and more Asian nations — led by China and Russia — have ditched the dollar for bilateral trade (out of fear of dollar instability). Tension rises between the United States and Asia over Syria and Iran. The Asian nations throw more and more abrasive rhetoric around — including war rhetoric.

And on the other hand, both Obama and Romney — as well as Hillary Clinton — seem dead-set on ramping up the tense rhetoric. Romney seems extremely keen to brand China a currency manipulator.

The Fed is caught between a rock and a hard place. If they inflate, they risk the danger of initiating a damaging and deleterious trade war with creditors who do not want to take an inflationary haircut. If they don’t inflate, they remain stuck in a deleveraging trap resulting in weak fundamentals, and large increases in government debt, also rattling creditors. 

The likeliest route from here remains that the Fed will continue to baffle the Krugmanites by pursuing relatively restrained inflationism (i.e. Operation Twist, restrained QE, no NGDP targeting, no debt jubilee, etc) to keep the economy ticking along while minimising creditor irritation. The problem with this is that the economy remains caught in the deleveraging trap. And while the economy is depressed tax revenues remain depressed, meaning that deficits will grow, further irritating creditors (who unlike bond-flipping hedge funds must eat the very low yields instead of passing off treasuries to a greater fool for a profit) who may pursue trade war and currency war strategies and gradually (or suddenly) desert US treasuries and dollars.

Geopolitical tension would spike commodity prices. And as more dollars end up back in the United States (there are currently $5+ trillion floating around Asia), there will be more inflation still. The reduced global demand for dollar-denominated assets would put pressure on the Fed to print to buy more treasuries.

Amusingly, this kind of scenario was predicted in 2003 by Krugman himself!:

The crisis won’t come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.

But at a certain point we’ll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government’s access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

This is not a Zimbabwe-style scenario, but it is a potentially unpleasant one involving a sharp depreciation of the dollar, and a significant change in the shape of the American economy (and geopolitical reality). It includes the risk of costly geopolitical escalation, including proxy war or war.

However, American primary and secondary industries would look significantly more competitive, and significant inflation — while penalising savers — would cut down the debt. Such a crisis would be painful and scary, but — so long as there is no escalation — largely beneficial.

42 thoughts on “Why I Still Fear Inflation

  1. Please correct this if wrong, but while there is disagreement as to both causes and possible cures, there is little or no disagreement that NO solution is likely, or even possible, given politics, geo-politics, old grudges, national interests, etc.

    If so, what can the individual/family do to survive?

    • Having your own energy, food and water supply, and a good portion of your wealth in tangibles instead of abstract financial instruments sounds sensible.

    • DG, you already know what you must do to survive. Don’t worry about things like, “assets,” as these will disappear as quickly as they appeared.

      The “good” in a crisis is that it allows people to re-orient themselves to those things that are truly important…other people.

        • At the risk of hogging too much of everyone’s time and posting-space: one needs more specific advice.

          As it happens, my extended family does have the rare potential to implement AZIZ’s and Impermanence’s guidance — food, water, energy and family/friends/neighbors — farm land, perhaps plus guns and ammunition. But what if we didn’t? What can big-city dwellers do?

          I’m reminded of the nuclear era cold war Civil Defense planning. Nations — US, USSR, Switzerland, etc.– would survive nuclear exchange. But people in target cities would not.

        • City people need to build community and trust. I think that’s the paramount thing to have in an era of high economic upheaval.

    • To survive, I believe is is important to buy silver and gold bullion. With mounting problems throughout the world, it just makes sense to own bullion. That is what the central banks are doing throughout the world, especially China. I buy my bullion at http://www.cherishedgold.com . This site caters to the small investor. You will not be disappointed with their service. Thank you for an informative article. If other readers have recommendations, I would appreciate their comments.

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  5. John, great article as usual. I do have a couple of questions regarding your endgame predictions. It seems that as an alternate of sorts to your three routes out of the deleveraging trap (debt liquidation, debt forgiveness, inflation) is for the US to go the Japan route (moderate, persistent inflation which drags on for years, but will not cause creditors to panic). This is where I get a bit confused. If we do go the Japan route, (correct me if I’m wrong here) you foresee a potential trade war sparking rising commodity prices in the US at some future date. Why would this cause a massive dollar inflow from Asia?

    Moving to your last two paragraphs, would high interest rates be present in this dollar depreciation/high inflation scenario? I’m not sure how this last scenario would be beneficial, as a high interest rate environment would push both the private and public sector into insolvency and potentially forced debt restructuring.

  6. Consider that dollars “held” by China are mostly in the U.S.; they circulate back when the Bank of China buys U.S. Treasuries. “Dumping” dollars in another form would require the Chinese to buy U.S. goods, which means that they’re abandoning their export imbalance policy.

    Also, a Fed-induced inflation has two main roads: (i) through increasing the monetary base and (ii) monetizing government debt. In the “deleveraging trap” you describe, (i) is difficult because banks aren’t in a position to seriously expand the volume of outstanding loans — it requires endogenous money creation. The only option, therefore, is (ii), and I don’t think this is a serious alternative in a country where the central bank is independent of U.S. fiscal policy. I mean, it is happening at a relatively small scale, but in order to induce the needed amount of inflation the Fed would essentially have to print money to pay for all new spending.

    • Agreed, printing is the only viable option which means hold hard assets like gold / silver as they will adjust in price and preserve purchasing power

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  8. I think Krugman misses the point, as you say QE was asset friendly but it was also inflationary in the things people *need* through its shifting of portfolio preferences and resulting commodities inflation. This type of inflation is both regressive and in a world of cheap labour unlikely to lead to needed wage inflation to deal with debt, more likely margin compression and job losses.

  9. Treasuries, dollars, no real difference. When a treasury is no longer a dollar then that is the end of the current global financial system.

    I don’t think China cares about the falling value of their reserves. Global money printing ultimately ends up in the Chinese because of the peg. So more printing by another country means benefits of its own money printing are less. Of course they will still print. All just a matter of time.

    • China will keep investing in dollar denominated assets like treasuries, else they have to convert all the usd to yuan hence putting pressure on the peg, for now they are okay but then for how long? And eventually they too will have no option but to print

  10. They keep treasuries because its how the system works. There simply isn’t enough dollars in the global financial system. What has taken its place is the us government bond, which is backed by the government that backs the us dollar. There is no way in the world they can keep several trillions in US dollars, so its converted into treasuries which is accepted worldwide like dollars. Treasuries is the collateral that backs the global financial system. Not necessarily “dollars.” Treasuries and dollars are identical for all intents and purposes, but they are not technically the same.

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  12. Great piece, John.

    What the fed’s been trying to do is selectively inflate (or more correctly) re-flate certain “asset” prices, while actively trying to depress others, so it looks like inflation isn’t a threat. In 2008 for example, we found out that there was in fact no such thing as $700 gold (when it dropped below $700, Paulson himself stopped US mint sales).

    What happens when there’s no such thing as an $8 bushel of corn? With this drought we may see that later this year. Paper traders may be able to try to dictate prices, but they can’t shit corn (not much, anyway).

    Suddenly people will realize what they thought were “prices” were actually “price controls” (one of the hallmarks of failed regimes on the brink of collapse). When that illusion cracks, things will get very real, very fast. And no one will trade you a share Apple stock for an apple.

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  14. One problem with trying to inflate your way out of this problem is the way the bond program is set up in the US. Most of the bonds in the system are of short duration which would cause the debt to increase faster once inflation takes hold. Could be one of the reasons for Twist. For inflation to work bond duration should be greater than 5 years.

  15. good discussion. you may want to check out itulip.com. i don’t see it in your blog roll, but – led by eric janszen – we’ve been discussing these scenarios in some detail for years now. as i believe you correctly conclude, the choices seem to be a japanese scenario versus an argentine scenario. in particular, a chart shown in several itulip pieces of argentine inflation, interest rates and currency shows a slow deflationary process leading to a sudden inflationary burst accompanying a currency plunge. something like that lies in our future if we are to avoid a deflationary collapse.

    u.s. dollars held abroad, mostly frozen as treasuries, seek to convert to real assets – note chinese global asset acquisitions. but the u.s. is ultimately the only place in which dollars MUST be accepted in exchange for assets, so if you want to spend the old-maid dollars, you eventually spend them in the u.s. if you are a sovereign or its entity, your ability to spend your dollars in the u.s. may be thwarted, witness china’s failed attempt to acquire u.s. energy assets several years ago. some discussions at itulip have focused on war [hopefully for the most part a “cold” one] as part of the “solution” of a burst of high inflation. we’ll see.

    besides the growing burden of debt service that you point to, the other issue is the role of the dollar as global reserve currency in light of triffin’s dilemma. i don’t think the dollar will go away, nor will it cease to have some role in international trade, but it’s hard for me to imagine how a multi-currency reserve system will function. part of the “solution” to that problem appears to be remonetization of gold. central banks switched to net accumulators instead of net sellers some years ago, though the particular banks doing the accumulating are a different population than those which were doing the selling. nonetheless, there’s a reason that cb’s still hold the barbaric relic.

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  17. Hyperinflation will hit the USA in 2013. The Dollar will tank in December 2012 when the Chinese issue SINO BONDS at a higher rate of interest than US Treasuries.

    The catalyst is after the US election results are announced. This gives clarity to 2 pre planned scenarios.

  18. F***. They’re gonna come up with a huge war. I bet that’s what’s being discussed at Bohemian Grove right now. It’s the only way out to “stimulate” U.S. economy. It’s what happened in the 30’s. And by doing it in 2012, they can play up the whole Mayan thing to confuse everyone. F***!

    Oh, and can you address Peak Oil sometime? I have a feeling this is an issue hardly ever discussed thoroughly.

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  21. One of the best discussions I have seen as to what to do to get out of this Debt Collapse. Like Richard Russell, I think it will be some version of “INFLATE OR DIE” where the Fed and Treasury clandestinely prints money Wiemar style until the populace rises up and puts a legal governor on these academics when bread costs $10 per loaf. There is no political appetite for debt forgiveness in the country, rightfully so for all of the financial adults out there, at least on a scale that would solve this Tens of Trillions of Dollars problem. Out right default Iceland style would be equally opposed by vested interests in the financial community, not to mention all of the municipalities that are holding sovereign or bank debt that will evaporate. DEVALUATION ARGENTINE STYLE HERE WE COME until the masses storm the gates with torches and pitchforks. “This is a fine mess you have gotten us into, Stanley!” Sage of Wexford

    • Inflation arguments are going to be muddy at best. Our government inflation estimates
      say there has been little to no inflation over the last 5 years, while our shopping costs
      for food have nearly doubled. Tinkering has our devaluing sovereign currency paying
      less for government pensions, which are wasting down and away, conveniently. Even
      Russian Gazprom is issuing U.S. dollar denominated bonds, likely because they believe
      that they will have to pay less back to redeem them, as the U.S. is close to 100% Debt to
      GDP, while Russia has virtually no long debt, nor short debt to brag about, since they
      restructured their currency fall. A little inflation may be useful to restructure our U,S.A.
      debt long term, but our government is not willing to offer us honest accounting numbers,
      with our permanently unemployed even cut out of our unemployment figures. When
      we lose our sovereign currency status, in great part to the Chinese, who have little to
      no government debt of their own, it will be a Supply Side Moment!!!

  22. A good cause for the Tea Party might be to get enacted a law that would make all forms of monetary inflation TAX DEDUCTIBLE. It’s too late to save us from the profligacy up to this point, but might assist future generations in the new monetary order that seems certain to follow.

  23. Remember, Rome was not destroyed in a day.

    The essential problem with the “there is no inflation worry” crowd is their extreme short-termism. By looking at the meaningless CPI measure they manage to convince themselves that the currency is only being devalued at trifling percentages a year. But you need to look at the long-term trend, and of course that shows that the dollar is being decimated in terms of real purchasing power. You needed $38 to buy an ounce of gold in 1971, but need about $1600 today. Everything just keeps getting more expensive in the dollar, while getting largely cheaper in gold.

    This is currency collapse; but currency collapse does not just happen when people one day wake up and decide to play Weimar Republic. It is a long drawn-out process of the currency going from reliability to worthlessness, especially long and drawn-out for large economic powers and empires. It took centuries for Rome’s inflationary policies to fully destroy the Roman Empire, so Krugmanites shouldn’t feel too relaxed over last quarter’s seasonally-adjusted core CPI numbers.

    Austrians like Schiff and Lira, on the other hand, need to chill-out on the ‘Apocalypse Tomorrow’ predictions. They are essentially correct in their views, but they need to recognize there is no way to predict when the final stage of this currency destruction occurs.

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