Why I Was Wrong About Inflation


Back in 2007, I was much more interested in finance and trading than I was in macroeconomics. When the crisis — and the government’s macroeconomic response to the crisis — began in 2008 what was really needed to get a strong grasp of the situation was an understanding of macroeconomics, which I did not have as it was a topic I only really began studying in depth at that time. This led to some misconceptions, particularly about inflation. I mistakenly assumed — as did many at the time, and as do many today — that the huge expansion of the monetary base would lead to stronger inflation than the timid and low inflation we have seen in years since the programs began. While I strongly doubted the claims of individuals like Peter Schiff that hyperinflation might be nigh — as I understood that most historical hyperinflations occurred due to a collapse in production, not solely due to money printing — I thought a strong inflationary snapback was likely, Why? A mixture of real effects and expectations. If central banks are printing money at a higher rate, people will fear that money is becoming less scarce. If having more money in circulation does not begin to bid prices upward, producers will soon begin to raise prices to anticipate any such rise. Simply, I thought that central banks couldn’t print their way out of disaster without some iatrogenic side-effects. I assumed the oncoming pain was unavoidable, and that the onset of inflation was the price that would be paid. As Ludwig von Mises put it: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

So why did that not occur? After all, plenty of internet goldbugs — and very serious people following the advice of people like John Taylor, Eugene Fama, and Niall Ferguson — were talking about the potential for a strong inflationary shock. The gold price was soaring — hitting a peak above $1900 an ounce in September 2011 — as people anticipating inflation sought to buy insurance against it. Well, for a start it seems like the public did not really buy into the notion of an oncoming inflationary shock. Expected inflation as measured by the University of Michigan has remained very close to the post-1980 norm since the crisis:


But above and beyond this, the real monetary effects were not the ones I first assumed them to be. The total money supply — most of which is generated not by the Fed but in the private sector through lending — has been stagnant, even while the Federal Reserve is expanding the monetary base. So while the financial sector is flush with cash and has bid the stock market up above its pre-recession nominal peak, other goods in other sectors just have not had enough of a bid behind them to send inflation strongly upward because other areas of the economy (for instance housing, consumer electronics and real wages) have continued to deflate in the context of continued deleveraging, accelerating offshoring driving down wages and the receding effects of the 2008 oil shock.

Yet even more importantly the supply of goods in the West — flowing as it does from East to West, from the factories of the Orient to the consumers of the West — has remained strong and stable. There has been no destabilising, chaotic Chinese crash or revolution, even though many wished there would be in the wake of the Arab spring. And for all the talk by the Chinese and Russians of bond vigilantism, starting a new global reserve currency and dumping the dollar, that has not happened either. And why would it? Certainly, the Asian bond-buyers might have suffered a few years of negative real interest rates. This might have pissed them off. But undermining the Western recoveries further (which have been quite pathetic thus far) when such a high proportion of their assets — dollars and treasuries and increasingly real assets like land and industrials — are related to the economic performance of the West would be to cut off their nose to spite their face, while simultaneously risking conflict with the American military, whose capabilities remain unmatched. The Chinese and Russian talk of de-Americanisation and a post-American world is all bluff and bluster, all sound and fury signifying very little. In the long run, America will have to accept a world where it is no longer the sole global superpower, but there is no incentive for America’s competitors to hasten that way with the kind of aggressive economic warfare that might cause an economic shock.

On the other hand, it is certainly true that much of the new money entering the system is sitting as excess reserves. Is that a symptom of the inflation simply being delayed? Until the middle of last year I thought so. Now I very strongly doubt it. The existence of excess reserves in the system is not a symptom of stored-up future inflation, but a symptom of the weakness of the transmission mechanism for quantitative easing. Simply, the system is in a depression. The banking system is infected with a deep paranoia, and would prefer to sit on risk-free cash instead of lending money to businesses. If the money was lent out, there would be an increased level of economic and business activity. Therefore there is no guarantee of any additional inflation as the money is loaned out.

So I was wrong to worry that inflation could become an imminent problem. But I was wronger than this. The entire paradigm that I was basing these fears upon was flawed. Simply, I was ignoring real and present economic problems to worry about something that could theoretically become a problem in the future. Specifically, I was ignoring the real and present problem of involuntary unemployment to worry about non-existent inflation and non-existent Asian bond vigilantes. The involuntariness of unemployment is a very simple fact — there are not enough jobs for the number of jobseekers that exist, and there hasn’t been enough jobs since the crisis began. Currently there are just over three job seekers for every job. So unemployment and underemployment are not simply things that can be dismissed as a matter of workers becoming lazy, or preferring leisure to work. Mass unemployment has insidious and damaging social effects for individuals and communities — people who are out of work for a long time lose skills. For communities, crime rises, and health problems emerge. And there are 25 million Americans today who are either unemployed or underemployed as a practical matter it is not simply a case of sitting back and allowing the structure of production to adjust to the new economy. And worse, with unemployment high, spending and confidence remain depressed as the effects of high unemployment create a social malaise. This is a mass sickness — and in the past it has led to the rise of warmongering political figures like Hitler. So while it may be preferable for the private sector to be the leading job creator under ordinary conditions, while the private sector is engaging in heavy deleveraging this is impractical. Under such an eventuality the state is the only institution that can break the depressionary trend by creating paying jobs and fighting back against the depressionary tendency toward mass unemployment. Certainly, centralised bureaucracy can be a troublesome and distortionary thing. But there are many things — like mass unemployment and underemployment, and the social problems that that can bring — worse than centralised bureaucracy. And no — this kind of Keynesianism was not the problem in the 1970s.

By worrying over the potential for future inflation or future bond vigilantism due to monetary and fiscal stimulus, I was contributing to the problem of mass unemployment, first of all by not acknowledging the problem, and second by encouraging governments and individuals to worry about potential future problems instead of real-world problems today. As it happened, a tidal wave of evidence has washed these worries away. It is clear from the economic data that inflation is not a concern in a depressionary economy, just as Keynesian-Hicksians heuristics like IS/LM suggested.

Of course, if the depression ends of its own accord then inflation could become a problem again.  If the United States were to experience a strong unexpected spurt of growth sustained over a year or so, pushing unemployment significantly down and growth significantly up, inflation could rise appreciably. The Federal Reserve would have to quickly taper both its unconventional policies and probably begin to raise rates. Of course, that is rather unlikely in the present depressionary environment. But certainly, it is a small possibility. That would be the time for the Federal Reserve to start to worry about inflation. A strong negative energy shock — like the one experienced by the UK in 2010 and 2011 — could push inflation higher too, yet that would be a transitory factor in the context of the wider depressionary environment, and would most likely fall back of its own accord.

If the Fed was engaging in actual helicopter drops — the most direct transmission mechanism possible — there would likely be a stronger inflationary response than that which we have seen thus far. Yet ultimately, this might prove desirable. After all, if the private sectors of the entire Western world have a very large nominal debt load which they are struggling to deleverage, some stronger inflation would certainly begin to minimise that. Yes, that is redistribution from lender to borrower. No, creditors will not be happy about this. But in the end, creditors may find it easier to take an inflationary haircut than face twenty years of depressionary deleveraging as Japan has done. Although the West certainly does not have the same demographic troubles as Japan, such an outcome is possible unless people — governments, entrepreneurs, individuals, society — decide that unemployment and a lack of demand in the economy must be tackled, and do something about it. Then can we confidently expect to climb out of the lip of the deleveraging trap.

23 thoughts on “Why I Was Wrong About Inflation

  1. Inflation as defined as an increase in the money stock is there and continues to be there. The pressure valve is the stock market which will continue to absorb the inflation until rates start rising in earnest. As the stock market rises the acceptance will kick in and the money velocity will increase, causing price inflation. You do make a good point about unemployment as a mechanism that decreases spending, ie. money velocity. I have to wonder if terrible programs like Obamacare, which will cause much more unemployment is another factor that will decrease money velocity even more. However, with Janet Yellen at the helm and even more dovish than Bernake, I tend to think she will do whatever it takes to get the unemployment rate “turned around” and finally decreasing. Price inflation is coming, just a matter of time before the lag kicks in.

      • LOL ! Maybe you just don’t understand my statements. What exactly does your comment add to the “conversation” other than ignorance? Derp, Derp. What a child…

        • Sorry A.C. Jitsu, by your definition of inflation there was more inflation (i.e. increase of the money stock) before 2008 than since.

          Maybe we will see a return to slightly stronger inflation in the future, but it will only occur in a sustained fashion in the context of successful private deleveraging and much lower unemployment. And what would those two things also imply? Recovery. I look forward to seeing the Fed raise rates in the context of a recovery.

  2. Economists have got to stop denying that technology is an economic game changer and as a result that mere employment is an equal to or even more important human endeavor than is purpose. This denial and human mis-characterization is at the heart of why economics in general and finance in particular must descend from their current outsized positions of power and assumed importance. Those positions belong in fact to Human Wisdom and not to either religion or Science, but to both, whose mindsets are indeed essential for the complete understanding of Humanity and the full blooming of Wisdom itself whose interdisciplinary character and unitary effects reflect the ultimate goal of economics which is equilibrium, the nature of our monetary system which is digital (+,-) and what must become the true goal of Finance which is intermediary BETWEEN Wisdom and its economic and monetary policy expression in the temporal universe….not the usurper of value and power and/or a pretender to Wisdom itself.

  3. I appreciate what you are getting at. According to Stephen Innes, early seventeenth-century English economic theorists defined a healthy economy by the level of employment, not the level of productivity. The American colonies were formed in large part as a means to “vent” the unemployed masses in England. This is one reason colonization found government support. Land in England had become monopolized by the wealthy few in England, thus the “New World” provided a business opportunity for the man of small means. Business opportunity has again become monopolized in our day. It has been accomplished by corporations via corporate law—a government creation. Seeing there are no more new worlds, government must abandon its legal support of large scale business which it accomplishes largely via Limited Liability law. It must instead promote small-scale business and a return to individual responsibility. If it takes 1000 individuals to produce what one automated factory can do…so be it. As you pointed out, better to have a society’s members productively employed, rather than productively rioting.

  4. “It is clear from the economic data that inflation is not a concern in a depressionary economy…” The only thing that has yet to inflate is the cost of money. This, in part, is due to the concerted effort to continually redfine inflation. We are doing it again with the idea of “Chained CPI”. Homes are cheap to finance… but they are very expensive when you consider wages haven’t moved for 20 years.

    I can’t imagine the Fed is that clueless. I think that when the doors are closed and the meetings are held, there is a plan and it’s well thought out. They had their chance to rid the economy of the chaff… but they chose otherwise (yes… we are Japan). So… instead… we recapitalize the banks… slowly, deliberately, and rather than pay the savers and actually give them money by which they can consume…. we steal from them and only allow them to borrow more money as a transmission mechanism. Yet…. if I were a banker… why would I lend? Interest rates are too low to outrun inflation…and they certainly can’t make enough to offset the credit risk… so… lets buy stocks! So… to me it makes perfect sense. It may take 10-20 years…maybe more… but as long as they can control interest rates and the definitions of inflation, and as long as we see banking requirements (think Basel III) increase capital requirements, they can continue the charade for a very long time.

  5. John, thanks for your frank assessment on the way things are. Takes balls to publicly admit your mistakes. How many pundits out there refuse to adjust their thinking in the face of strong evidence? Anyway, thanks again. On a separate note, solar companies are rallying hard, suggesting that the sector is coming into good times.

  6. Aziz,

    If you were american I would say that you might be to young to remember a large blatant devaluation of the currency. You are still young. But, I don’t know much about England’s currencies changes in purchasing power.

    You might not even be old enough to see your significant monetary savings value halved over the years.

    Perhaps one should talk to older people who have seen such things, read history, talk to people from other countries currently with the problem, or better yet visit such a country.

    If you visit such a country you will get very good deals, and later better deal, and an education. Of course every one will want your stronger money so they can preserve their purchasing power. You might even see zeros added to the bills. Strange stuff. Of course you must look at it from their point of view too. Talk with people in those countries. Hah! Ask them what they think of their economists!

    I have seen silver dollars, half dollars, quarters, and dime coins leave circulation. But, that was just a small part of the problems.

    @physinomics: Hey man, I was offered .005% interest with a strait face at a bank in a grocery store with prices going up.

    I just read Shiller saying that we should have talked to grandpa {instead of listening to economists}.

    • People who are sitting on “significant monetary savings” might want to consider putting their capital into more productive activities if they want to preserve or increase their purchasing power. Money in a bank has not been a good preserver of purchasing power. Nor should it be.

  7. Data shows the gold in dollar terms can go down when prices are rising. That happened for 20 years from 1980-2000 in the united states. Well, well.

    Plot it logarithmic.

  8. Fiat money is a confidence trick, at which the snake-oil salesmen in and around the Fed and the BoE are increasingly, incredibly able. Reality must break through nonetheless. When it does, the way the huge increase in the money supply has been concealed – in government bonds bought with money created and loaned by those self-same governments – facilitates divergent inflation.

  9. Aziz,

    Why worry about being wrong on inflation? Fame, fortune and promotion in academia comes from churning out large volumes of rubbish. It doesn’t come from producing original ideas that can be spelled out in a few hundred words. Nor does it come from being right. Look at the rubbish we’ve had to put up with from Niall Ferguson, Rogoff and Reinhart.

    For details on the rubbish that appears in academic journals, see:


  10. How can prices inflate, if people don’t have the income to spend?

    It was said about inflation in the Weimar Republic, that people would bring a wheelbarrow full of cash just to buy a loaf of bread. The people evidently had a wheelbarrow full of cash to spend. I don’t see how we could ever see much more price inflation (we are at the top end of a generational inflation), without a corresponding increase in jobs and wages.

    • The so-called rich are experiencing incredible inflation. Look at the things they buy… real estate, art, jewelry, collectibles, equities…. prices are absurdly high.

  11. There are two economies, the regular one that the vast majority partake in, and the credit economy, available to the .1%. The inflation is in credit, so this is where it shows up, in the prices of commodities purchased with credit [or money stolen from credit sources, i.e., banking/financial services].

    The regular economy has been in depression [interspersed with inflationary periods] since 1971. Real incomes [in the West] have been going down for most people since the sixties.

    All things knowable are defined by its duality, so within depression there is inflation. The inflation is in credit-based commodities, housing, automobiles, higher education, etc., and/or in extortion/cartel based business/government enterprise, military, heath care, administration, etc.

    The bottom-line is that nobody knows how this thing is going to end, and it matters not whether the deflationary depression runs its course, or, if politically, it is determined that a rapid inflation is the best way to de-leverage.

    At the moment, the headwinds against inflation in the regular economy are very strong, with demographics, unemployment, and the over-production of every damn thing over the past decades providing zero stimulus to raise prices.

    The Elite continue to do what they can to protect their wealth. Their minions in the professional class seems quite willing to continue to do their bidding for the scraps they receive. So, its business as usual on the surface, with the foundations slowly but surely rotting underneath.

    So, kick-back, crack open a cold one, and enjoy the show!

    • “There are two economies, the regular one that the vast majority partake in, and the credit economy, available to the .1%. The inflation is in credit, so this is where it shows up, in the prices of commodities purchased with credit [or money stolen from credit sources, i.e., banking/financial services].”

      Impermanence: Very good point! It seems most overlook this “duality”. The argument is usually poised as either inflation or deflation. As we see today, it can be both. So when we ask the question “Inflation or deflation?”, we must also ask “For which segment of the economy?”

  12. If you read the actual interview with Fama, he doesn’t actually make an unconditional prediction of inflation. He says that paying interest on reserves severs the normal relationship between the monetary base and inflation, and that without it the huge increase in the base would be very inflationary. He’s also responding to a suggestion that the government could “inflate away” the national debt. It would be surprising if the man most closely associated with the EMH was proclaiming that the TIPS spread was greatly underestimating inflation.

  13. Aziz. Respect for the flexibility of mind & control of ego needed to admit the above. If you still think reserves are waiting to be loaned out, come a recovery, then you still have a major conceptual error in your mental model. Reserves cannot be loaned. There is no money multiplier. The reason that reserves are sitting within the system is because when you understand what banking reserves are, then you understand that there is absolutely no possible alternative. If you want, S&P (of all people) has a reasonably helpful paper titled ‘Repeat After Me: banks cannot and do not loan out reserves,” available freely on google. I think this is the primary misunderstanding of QE that people still have. I enjoy your blog mate.

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