U.S. Sept CPI rose 0.3 pct

Biz.Yahoo/Reuters ^ | October 16, 2003

[Starwind]

U.S. Sept CPI rose 0.3 pct
Thursday October 16, 8:32 am ET

   WASHINGTON, Oct 16 (Reuters) - U.S. Labor Department monthly
Consumer Price Index (CPI-U), 1982-84 equals 100 (except where
noted):
  Percent Changes:           Seasonally Adj.  Unadjusted
.                                 Sept    Aug  Sept03/02
All Items                          0.3    0.3      2.3
 Excluding Food/Energy             0.1    0.1      1.2
Energy                             3.0    2.7     14.7
Food and Beverages                 0.2    0.3      2.5
Food                               0.2    0.3      2.4
CPI-Urban Consumers-X            185.2  184.6      N/A
 X-Data unadjusted. N/A-Not Available.
  Percent Changes:           Seasonally Adj.  Unadjusted
.                                 Sept   Aug  Sept03/02
Housing                            0.1   0.1      2.4
Shelter                            0.1   0.2      2.2
Rent of Primary Residence          0.2   0.2      2.9
Owners' Equivalent Rent-Y          0.1   0.2      2.1
Housing Fuels/Utilities            0.2   0.1      8.4
Household Furnishings/Operations  -0.4  -0.3     -2.3
Y-Dec 1982=100 base.
  Percent Changes:           Seasonally Adj.  Unadjusted
.                                 Sept    Aug  Sept03/02
Apparel                            0.5    0.1     -2.1
Transportation                     0.9    1.1      3.5
New/Used Motor Vehicles-V         -1.0   -0.2     -3.6
New Vehicles                      -0.4    0.5     -1.7
Gasoline                           6.3    6.2     21.0
  Percent Changes:           Seasonally Adj.  Unadjusted
.                                 Sept    Aug  Sept03/02
Medical Care                       0.5    0.2      4.0
Prescription drugs                 0.5    0.5      3.1
Recreation-V                       0.2   UNCH      1.4
Education/Communication-V          0.1    0.5      1.3
Tobacco                           -0.7    0.6     -3.5
Commodities                        0.4    0.5      1.2
Services                           0.2    0.2      3.1
Airline Fares (Unadjusted)        -1.8   -1.6      1.6
CPI-W                              0.3    0.4      2.3
V-Dec 1997=100 base. CPI-W--Index for urban wage earners and
clerical workers.
 FORECAST:
 Reuters survey of economists forecast:
 U.S. Sept CPI +0.2 pct
 U.S. Sept CPI ex-food/energy +0.1 pct

[Starwind]

The full BLS report is at CONSUMER PRICE INDEX: SEPTEMBER 2003

[Starwind]

Fyi...

[The_Victor]

Note the price of energy +3.0 and the price of gasoline +6.3. If not for these the CPI would be down for the month.

[Starwind]

Note the price of energy +3.0 and the price of gasoline +6.3. If not for these the CPI would be down for the month.

Agreed. Yet, workers real earnings were down .3% and they have to pay for energy, regardless of CPI stats.

However, energy is volatile, and excluding it, CPI as a measure of inflation is near flat for the year. Considering how much the money supply has been pumped to avoid deflation and stimulate the economy, the Fed's inflationary policy would seem marginal in any good results, we seem to continue to flirt with deflation, and negative in light of the housing & stock bubbles produced. Thoughts?

[AntiGuv]

... we seem to continue to flirt with deflation, and negative in light of the housing & stock bubbles produced. Thoughts?

Resistance is futile.

[Starwind]

Resistance is futile.

Though you've alluded to us fellow 'doom & gloomers' as ignoring your deflation first scenario :-), I don't believe I've ever seen you post your explanation - which I would like to read. I think the case for deflation is stronger than that for inflation. Might you post your thoughts to this thread (or wherever)?

[AntiGuv]

The very brief answer is that I think that - in the current economic milieau - even a modest rise in the rate of inflation would reduce both consumer demand and corporate activity enough to tip the economy into deflation. I wrote in the matter in more detailed length some two or three months ago, so I'll go track down that thread & repost the comments here when I have a chance later today.

[The_Victor]

However, energy is volatile, and excluding it, CPI as a measure of inflation is near flat for the year. Considering how much the money supply has been pumped to avoid deflation and stimulate the economy, the Fed's inflationary policy would seem marginal in any good results, we seem to continue to flirt with deflation, and negative in light of the housing & stock bubbles produced. Thoughts?

I agree with you. We are walking a very fine line betweeen stimulating the economy and starting a deflationary cycle. The Fed has very little maneuvering roon left with interest rates, so a negative CPI could be a bad sign. A flat CPI is probably the best we could hope for right now, and given news, with the exception of energy/gas proces, this is good news in my mind. Just MHO.

[AntiGuv]

I posted my most extensive commentary regarding deflation in this thread: Escape And Fantasy. Here are the key remarks collected from there:

The Fed can lower interest rates, but it can't force people to borrow.

Nor can it force institutions to lend...

I'm sorry, but the hyperinflation scenario is a mirage. This economy will not hyperinflate. If it were conducive to even modest Seventies-style stagflation, it would already be hyperinflating under present Fed policies. All roads - and I mean all roads - to hyperinflation lead through deflation in the current global economic mileau.

The American consumer will not - no, cannot - increase debt loads to maintain the spending levels requisite for hyperinflation. The American corporation certainly will not do so in a context of excess capacity and contracting aggregate demand. The three pillars of America's market economy - stocks, bonds, and real estate - are so starkly overvalued that they cannot provide conduits for the necessary liquidity.

The American economy will either recover soundly or it will plunge into a deflationary contraction. I would almost bet my life on it. The moment inflation approaches even levels seen in the 70s/80s, the housing sector will grind down, the stock markets will crash, the bond markets will meltdown; there would be a systemic personal credit crunch - a wave of defaults, foreclosures, and bankruptcies.

Consumer spending will seize up, capital investment & labor expenditures will freeze, and prices will drop in an attempt to support corporate earnings. The economy will plunge into the vicious spiral of deflation. As for the Fed, one must account for psychology. At any sign of economic vigor, the Fed will behave as if it's succeeded and tighten monetary policy, which will immediately circumvent the inflationary process.

Even if it does not do so, this economy simply cannot hyperinflate. The malinvestments of the Nineties must be liquidated and the structural imbalances of the post-bubble era must be reordered. Hyperinflation cannot accomplish that task - it will require a deflationary contraction. More exactly, the relatively moderate inflation which must precede hyperinflation will immobilize economic activity before the threshold of hyperinflation is reached.

In keeping with the theme of Russell's commentary, this idea that debasement of the currency may resolve the structural impediments to U.S. economic expansion is another escapist fantasy. The economy will either inexplicably shift into vigorous, sustainable recovery or more likely plunge into a systemic deflationary contraction. The Fed will fail.

---------------------------------------------------------------------------------------------------------------------

A further factor which one must account for is that in the current globalized economy you cannot have hyperinflation within a vacuum. Before you reached such a scenario of uncontrolled inflation, the Japanese economy would simply implode. Their banking sector would collapse, their bond markets crumble, and their export sector go into seizures. They would hyperinflate, and this would drag the rest of East Asia into a devaluation crisis.

In the American and European economies, the price of East Asian imports would dive - thereby acutely magnifying the already marked deflationary pressures of uncompetitive trade disadvantages. American and European corporations would need slash their own prices to compete with those of East Asia - particularly Japan in this instance, which would displace China [or rather reinforce China] as the chief global source of deflationary pressure.

Europe would plunge into crippling deflation almost immediately, and the United States would shortly thereafter sink with the global ship. East Asia will hyperinflate; America and Europe will deflate; this will rebalance the global economy in the worst possible way......

---------------------------------------------------------------------------------------------------------------------

The key caveat in that instance is that the economy would not be in genuine recovery, but rather credit expansion would present the facade of economic growth. While the Fed may very well fail to tighten in any case, it will be incapable of loosening further to maintain such a fictitious growth cycle. America would undergo a process similar to that of Japan following the burst of the 'zaitech' bubble back in 1991. In the course of such a global rebalancement, Japan would hyperinflate, which if nothing else would bring their own deflationary spiral to a quite spectacular close...

---------------------------------------------------------------------------------------------------------------------

Might I add that deflation in America should prove much more crippling than thus far has been deflation in Japan, because key aspects of the Japanese economy were supported by the American consumer bubble. The American economy will not receive any such external support in the event of a slide into deflation. Quite the contrary, the impact would be magnified by East Asian insolvency and European stagnation.

The party's almost over. The American consumer has carried the global economy to the limits of his tolerance, and there's no one around to pick up the tab when he slips into a stupor...

---------------------------------------------------------------------------------------------------------------------

Imagine the assets owned by the Asian and Europeans in the USA in a deflationary spiral. Would they dump them or hold them?

That's actually part of the key nexus I alluded to above in bringing Japan into this global equation. The Japanese export economy simply cannot tolerate American hyperinflation. As their banking sector and bond markets came under pressure, they would need draw on their American assets to maintain their solvency - as would other Asian economies. This would suck liquidity out of the American economy even as the Fed attempts to increase the monetary supply and prevent the onset of deflation induced in part by East Asian devaluation.

The Europeans would seem stuck between a rock and a hard place. Simultaneously service-based and export-dependent by sector. They'd want to pull assets out, but they'd have no obvious havens for their funds since their markets would be under even worse pressure. I'm uncertain what they'll do in the final analysis.

We are in an era of economic M.A.D. - where any given economy might sustain itself over the long-term only at the expense of another.

---------------------------------------------------------------------------------------------------------------------

The difference between Japan and America is that the former has remained export-dependent and the latter has become service-based. While foreign dissolution of dollar denominated assets would place upward pressure on prices, attempts to maintain domestic competitiveness would place downward pressure on prices. My thesis implies that this downward pressure would overwhelm upward pressure.

In a deflationary scenario, the American consumer would be reducing aggregate purchases of all products - whether imported or domestic. In the United States, this would manifest as a classic deflationary spiral, but in East Asia, this would manifest as hyperinflation. This because the American consumer market comprises the greater part of demand for both American and East Asian products. Given time, this would inaugurate a competitive rebound of American manufacturing, but this could only follow the initial onset of deflation.

In any inflationary scenario, you simply cannot create the economic circumstances conducive to a revival of American industry & exports. That's another reason why the American economy cannot hyperinflate. No other economy can absorb the global economic shock of American hyperinflation. In the current economic order, all roads to U.S. hyperinflation lead through deflation. You simply can't get there from here any other way, or at least no one has properly explained how....

---------------------------------------------------------------------------------------------------------------------

Yes, that's correct. As inflation rises in the U.S., the dollar would depreciate and consumer demand would decrease. This would maneuver Japan into an untenable situation where they must devalue the yen in order to maintain their export sector. This would compel U.S. corporations to decrease prices in order to compete with East Asian imports, which would induce U.S. domestic deflation. The ECB can only hold the line on the euro for so long; they would also have to attempt devaluation in such a scenario.

I don't see how the Fed can hyperinflate with abandon because people have to be willing and able to actually spend the dollars. The problem with hyperinflation scenarios in this case is that American consumers cannot sustain the credit expansion required to funnel this liquidity into the economy. Moreover, lending institutions would simply refuse to extend credit to overburdened consumers with intolerable debt loads. That's why I alluded to a personal credit crunch in post #81 above; the Fed must have a conduit for monetary expansion.

In other words, a personal credit crunch would deprive the Fed of its means of injecting further liquidity into the economy before the point of hyperinflation could get reached. If and when the economy slides into deflation, then the entire equation shifts and none of the economic precepts we're all accustomed to will matter anymore. There's no meaningful precedent for deflation within the modern fiat system; Japan's experience doesn't qualify because such a great part of its economy is actually here in the U.S.

[Starwind]

I agree with your overall sentiment, though my own position has often been 'intuitive' rather than 'determinative'.

Whatever of your post I don't mention below, implictly means I agree with it as best I understand.

You've laid out several points, on which I would like greater detail, either quantitative (which I doubt you or most anyone could provide) or qualitative (which perhaps is just fleshing-out some of the details in your view). So I've posed some questions on which maybe you could elaborate?

This economy will not hyperinflate.

Is there, or do you have in mind, a definition of hyperinflation?

debt loads to maintain the spending levels requisite for hyperinflation

Any idea how to qualify or quantify what are those debt levels?

More exactly, the relatively moderate inflation which must precede hyperinflation will immobilize economic activity before the threshold of hyperinflation is reached.

Any thoughts on the mechanics or chain of events by which economic activity is immobilized, and perhaps a more precise description of what 'immobilized means'?

A further factor which one must account for is that in the current globalized economy you cannot have hyperinflation within a vacuum.

True. I agree. And you suggest several co-requisites to global hyperinflation:

Before you reached such a scenario of uncontrolled inflation

• the Japanese economy would simply implode [and] hyperinflate
• and this would drag the rest of East Asia into a devaluation crisis.
  [I'm missing the causal connection to the next point]
• American and European economies ... magnify ... deflationary pressures ... corporations would need slash their own prices
• which would ... reinforce China as the chief global source of deflationary pressure.
• Europe would plunge into crippling deflation almost immediately
  [I'm missing the causal connection to the next point]
• East Asia will hyperinflate;
• America and Europe will deflate;

Is the above list your view of the unlikely chain of events leading to global hyperinflation, or the likely chain of events leading to US deflation?.

While the Fed may very well fail to tighten in any case, it will be incapable of loosening further to maintain such a fictitious growth cycle.

But doesn't Soren's point apply here:

However, isn't the ultimate monetary stimulus mechanism having the Federal Govt run huge deficits and have the Fed monetize the debt? (ie. the govt runs a deficit, issues debt, the Fed buys it using newly printed money, and the money enters the economy as the govt spends it) Can't inflation be forced this way?

The Japanese export economy simply cannot tolerate American hyperinflation. As their banking sector and bond markets came under pressure, they would need draw on their American assets to maintain their solvency - as would other Asian economies. This would suck liquidity out of the American economy even as the Fed attempts to increase the monetary supply and prevent the onset of deflation induced in part by East Asian devaluation.

So I'm lost again. Your statement assumes American hyperinflation, not deflation as you expect. So are you syaing why Japan won't have to cope with US hyperinflation, or theortetically what would happen if it did?

While foreign dissolution of dollar denominated assets would place upward pressure on prices,

You're referring to US financial instruments and real property (factories, buildings) being sold right? Why would that create upward pressure on US prices - wouldn't it be downward?

In a deflationary scenario, the American consumer would be reducing aggregate purchases of all products - whether imported or domestic. In the United States, this would manifest as a classic deflationary spiral, but in East Asia, this would manifest as hyperinflation.

Why hyperinflation in East Asia? Why not deflation there as well as their unsold goods pile up? Won't they lower prices, reduce production, reduce utilization,...etc. Won't they have a deflationary spiral too?

That's another reason why the American economy cannot hyperinflate. No other economy can absorb the global economic shock of American hyperinflation.

Are not the world economies absorbing American inflation now? Or would you argue that in fact they are absorbing nothing, as Amercia has been undergoing actual dis-inflation for sometime? What prevents them from making the transition to absorbing 'hyperinflation' (however that gets defined).

I don't see how the Fed can hyperinflate with abandon because people have to be willing and able to actually spend the dollars.

Soren's point again about the Fed monetizing debt.

I appreciate any elaboration you can bring. Understanding the mechanics of how deflation comes about is very interesting to me.

[AntiGuv]

OK, how about I just begin working through these various issues and pick up with whatever I don't get to as I have the chance.

Is there, or do you have in mind, a definition of hyperinflation?

Before that, it's worth noting that the thread in which these remarks appeared was specific to hyperinflation, and so my comments are geared toward that. In other words, my intent had been more to establish that - within the current economic milieau - deflationary pressures appear a much greater threat than does any inflationary scenario. I was not directly attempting to outline a deflation forecast, per se, except as a tangent to dismissing the hyperinflation outlook.

With that out of the way, the most concise working definition of hyperinflation I've seen is that provided by Phillip Cagan in The Monetary Dynamics of Hyperinflation: price increases exceeding 50% a month. In general, hyperinflation results from a disorderly and abrupt expansion of the money supply whenever government expenditures spiral out of control under a fiat currency regime. When a government must resort to financing these expenditures by printing money, a self-perpetuating hyperinflation cycle initiates until the stock of money ceases to grow - by whatever mechanism.

Any idea how to qualify or quantify what are those debt levels [requisite for hyperinflation]?

Not really. What I am alluding to here is that we live in a profoundly credit-based economy quite unlike those which have featured hyperinflation in the past. In order for an economy to hyperinflate, consumers must be willing and able to spend the debased currency almost as swiftly as the government is willing to print it. Whenever the money supply is expanded within the American economy, this is generally accomplished by funnelling this via at least one of several credit conduits. In a hyperinflationary context, creditors would either instantly lose the incentive to lend as any fixed-rate contracts become worthless or debtors would rapidly lose the ability to borrow as they slide into default.

In my view, we simply do not have a monetary regime even designed for the genuine possibility of hyperinflation, short of scenarios so catastrophic that they are beyond meaningful analysis. Put differently, our economic order is designed in such a manner that the path to hyperinflation would 'short-circuit' before the cycle would manifest in the first place. Whatever the case, debt levels are so high and the savings rate so low that hyperinflation would almost certainly require a sudden, wrenching transition to a much more broadly cash-based economy.

Any thoughts on the mechanics or chain of events by which economic activity is immobilized, and perhaps a more precise description of what 'immobilized' means?

I am just using 'immobilized' as a more dramatic way of saying economic expansion would cease.. ;^) To be sure, all I'm saying is that the economy would slide into a contraction. As such, the sequence is fairly routine: rising inflation would lead to a decline in consumer spending, which would lead to a slide in corporate earnings, which would lead to an acceleration of unemployment, which [combined with other factors] would lead to a drop in aggregate incomes, which would lead to a further decline in consumer spending, and so on.

My most basic premise is that another economic recession in the near-term would likely degenerate into a full-blown deflationary contraction.

Is the above list your view of the unlikely chain of events leading to global hyperinflation, or the likely chain of events leading to US deflation?

That chain of events was intended to convey the consequences of a significant increase of U.S. inflation short of hyperinflation - say to Carter-era low double digits. In other words, it's intended as a corrolary argument to the above suppositions on why the American economy cannot hyperinflate (or, more precisely, why it would deflate before it could hyperinflate).

The "likely chain of events leading to US deflation" is merely the inevitably, eventual reversal of monetary expansion for whatever reason. In my view, expansion of the money supply is the singular factor preventing deflation, and I see nothing that would alter this dynamic before the credit expansion must halt. This hypothetical sequence of events is designed to outline what would happen if a substantial rise in the rate of U.S. inflation were to occur.

In order for the American economy to inflate, the price of American-produced must fall in the course of a dollar depreciation. The Japanese export-based economy cannot absorb the impact of this and their economic system would soon become unable to service their enormous debt loads. The Japanese bond and stock markets would crumble (all over again) and their economy would hyperinflate. To be sure, the economic collapse of Japan - one of the three pillars of the global economy - would induce a worldwide fiscal cataclysm of its own accord. Whatever the case, I am basically saying here that Japan cannot [to say the least] absorb the consequences of the sort of U.S. inflation which must precede the onset of hyperinflation.

Now, in the event of this scenario (an East Asian devaluation crisis) prices of East Asian goods would dive in America and Europe. This would amplify deflationary pressures in both the US and the EU as domestic corporations would need slash prices to compete. The alternative would be the erection of trade barriers which would present a whole alternate array of economic dislocations. I haven't bothered to discuss this latter possibility since I cannot foresee that any meaningful protectionist measures would be enacted in the short time-frame contemplated here. Such action would represent a stark departure from the present norm and I just don't see the political establishment of either continent moving with any expedience or consistency in such a direction.

Perhaps my hypothesis would seem clearer if I cited the 1997 Asian currency crisis. As those several currencies were devalued, domestic inflation spiked in the affected nations even as their products became cheaper elsewhere. The resulting deflation in their prices on the world market did not have a substantial global impact because Korea, Thailand, Indonesia and the rest don't provide a very great share of world supplies. In my scenario, the devaluation consumes the yen and the yuan (in fact, it's initiated by the yen) and so the global deflationary impact of their devaluation is much more profound. Such a difference in degree from the 1997 episode as to create a difference in kind from a global perspective.

China, in particular, with its archaic, obsolete banking system; its vast, insolvent state conglomerates; and its massive level of socialized expenditures necessary to maintain social order could quite easily degenerate into a textbook hyperinflation. This would unleash a flood of dirt-cheap exports onto the global market which would exercise a deflationary impact in America and Europe, even as the domestic Chinese economy hyperinflated. Does the scenario make sense now?

While I presented this as a consequence of double-digit U.S. inflation, I should also add that this could very well unfold as a consequence of a U.S. deflationary contraction. What I am basically saying is that any major slowdown in the American economy - whether due to inflation or due to deflation - would have these consequences on the East Asian economy. If it were due to inflation, then an East Asian devaluation crisis would contribute toward turning the consequent recession into a deflationary contraction; if it were due to deflation to begin with, then an East Asian devaluation crisis would amplify the already manifest deflation in America and Europe.

I'll stop here for now. Hopefully this clarifies more than it confuses. I'll try to cover the remaining points tomorrow and feel free to ask if the above still doesn't adequately address what you've asked!

[Starwind]

Is there a typo in here?

In order for the American economy to inflate, the price of American-produced [what?] must fall in the course of a dollar depreciation. The Japanese export-based economy cannot absorb the impact of this and their economic system would soon become unable to service their enormous debt loads.

[AntiGuv]

Yes. That would read more clearly:

In order for the domestic American economy to inflate, the overseas price of American-produced goods must fall in the course of a dollar depreciation.

In short, I'm saying that the U.S. economy cannot appreciably inflate without a substantial (further) dollar devaluation, and that Japan cannot sustain the impact of such a devaluation.

[AntiGuv]

OK, picking up where I left off, this should address the remaining questions you've raised post #10 about my comments in post #9. I'm also pinging a few of the usual suspects who may find this discussion of interest. Moving right along:

But doesn't Soren's point apply here:

However, isn't the ultimate monetary stimulus mechanism having the Federal Govt run huge deficits and have the Fed monetize the debt? (ie. the govt runs a deficit, issues debt, the Fed buys it using newly printed money, and the money enters the economy as the govt spends it) Can't inflation be forced this way?

Well, I've essentially addressed this point above, in explaining that a 'credit crunch' would prevent the onset of hyperinflation. To suggest that the Federal Government would finance exorbitant debt creation via the printing presses is simply to state that the American economy would hyperinflate. As briefly described in post #11, this is indeed the classic, textbook definition of hyperinflation. Two points are worth noting:

1) As alluded to in this Michael Belkin thread:

Belkin abandoned his Nasdaq 2280 target because he noticed that money-supply growth had begun to contract as credit markets froze up -- an event that, in his words, has "drained the economy of bubble fuel."

As stated in several ways previously, the Federal Reserve cannot compel inflation so long as the available credit conduits are unable to funnel the added liquidity into the economy. If lenders are unwilling (or unable) to lend or if borrowers are unwilling (or unable) to borrow or if both factors are the case, the Fed has no sustainable means of inflating the economy within our system. In the 2000-2003 cycle, the Fed has managed to accomplish the task via the refi cycle and Asian purchases of U.S. Treasuries. The first of these has a clear limitation and is now drawing to a close while the latter is contingent on efforts to maintain the competitive valuation of Asian currencies.

It's an interesting confluence of Catch-22s in fact. The Fed knows that it cannot expand the supply of money indefinitely, but it cannot voluntarily abandon credit expansion because the economy will slide into deflation. The economy cannot inflate so long as China & Japan refuse to appreciate their currencies, but if they permit their currencies to rise they would need cease purchasing U.S. securities thus contracting the U.S. money supply. In short, there is no apparent combination of factors which permits the U.S. money supply to expand much further (and I haven't even addressed the political limits to runaway federal debt formation).

So I'm lost again. Your statement assumes American hyperinflation, not deflation as you expect. So are you saying why Japan won't have to cope with US hyperinflation, or theortetically what would happen if it did?

As explained, my statement was responding to a U.S. hyperinflation scenario and so I was presenting a hypothetical description of what would happen to Japan in that eventuality. What I ultimately expect is deflation and the inability of East Asia [or Europe] to absorb the impact of a substantial rise in the rate of American inflation is one of several factors toward my expectations.

You're referring to US financial instruments and real property (factories, buildings) being sold right? Why would that create upward pressure on US prices - wouldn't it be downward?

Yes, the net effect would be downward pressure on US prices, but you cannot take that fragment in isolation as you have done. The full statement was:

While foreign dissolution of dollar denominated assets would place upward pressure on prices, attempts to maintain domestic competitiveness would place downward pressure on prices. My thesis implies that this downward pressure would overwhelm upward pressure.

At any given time, any given economy involves both upward and downward pressures on aggregate price levels. While foreign dissolution of dollar denominated assets would indeed place upward pressure on prices due to a sharp depreciation in the value of the dollar, the combined effects of other economic developments - particularly the consequent stock/bond crash and corporate efforts to contain the trade disadvantage - would place a greater downward pressure on prices.

What I was basically saying here is that America cannot escape the deflationary scenario via currency devaluation, which is the mechanism implicitly advocated by many commentators. This actually raises the conundrum I've wrestled with for several years now, which is how the US economy may deflate despite currency devaluation (because I think both are 'necessary' to rebalance the global economic order). What I have indirectly outlined is the circumstances under which both can take place, as was the case in the 1930s where deflationary pressures in a number of economies overwhelmed devaluation tactics to counter them.

The key element to my analysis is the money supply. My basic premise here is that the US money supply would eventually contract regardless of dollar devaluation. As stated above, expansion of the money supply is the singular factor preventing deflation, and I see nothing that would alter this dynamic before its inevitable reversal.

Why hyperinflation in East Asia? Why not deflation there as well as their unsold goods pile up? Won't they lower prices, reduce production, reduce utilization,...etc. Won't they have a deflationary spiral too?

Well, I've already addressed this aspect of my outlook in greater detail within post #11, so I'll just reword that in a manner more relevant to this objection. Hyperinflation is the consequence of money issuance to finance government debt. Currently, East Asia is financing its government expenditures by importing American funds in exchange for its consumer goods. In the absence of that source of income, East Asian governments would need finance their expenditures by debasing their currency. Ergo, they would hyperinflate, even as America and Europe deflate.

Now, keep in mind this scenario does not posit perpetual hyperinflation for East Asia, but rather a hyperinflationary phase toward whatever would follow. It's difficult to speculate precisely what would follow (which may well prove to be a deflationary spiral for them as well) because it's quite unclear by what mechanism they would seek to halt the growth in their money supply. What I would suggest one keep in mind is that economies have a historical tendency to overcorrect in whatever direction.

Are not the world economies absorbing American inflation now? Or would you argue that in fact they are absorbing nothing, as Amercia has been undergoing actual dis-inflation for sometime? What prevents them from making the transition to absorbing 'hyperinflation' (however that gets defined).

Yes, I would argue that the American economy has been undergoing fundamental dis-inflation for quite some while, as may be seen by considering the following graph:

Figure 2 shows the trend in stimulation in terms of the sum of government debt and money supply as a percentage of real GDP [1]. Along with this measure of stimulation (bold black) is plotted the price index (blue), both on a logarithmic scale. Note that the shape of both lines is similar and that the trend towards higher prices mirrors the trend towards higher debt + money. An empirical model for prices was constructed using linear regression [2]. This model gives what the price "should be" if fiscal/monetary stimulation were the only factor that affected prices. The actual price is usually different from the predicted value. The ratio of the actual price to the predicted price is plotted in Figure 2 as the reduced price (red line). The reduced price tracks the changes in price level after the complicating effect of fiscal/monetary stimulus has been removed.

In essence, the American consumer is 'absorbing inflation' via ever escalating levels of private, corporate, and government debt alongside a declining rate of savings. Indeed, the American consumer is also absorbing East Asian inflation via an overvalued dollar. Whenever this process of debt formation (a historical 'price revolution' might I add) reaches its eventual limits, prices should fall accordingly as they would have done absent this artificial inflation.

I appreciate any elaboration you can bring. Understanding the mechanics of how deflation comes about is very interesting to me.

There's a very intriguing analysis of deflation which I have bookmarked somewhere, the link to which I'll try to track down and post when I have the chance. If recollection serves, it's by Paul Krugman (I may be wrong on that) so if one might overlook that aspect, it may help provide additional insight.

Otherwise, I think I've adequately addressed the final two points regarding impediments to Asian absorbance of US hyperinflation as well as impediments to the Fed monetizing debt indefinitely. Let me know if I should elaborate further on any aspect of the above remarks wherever they may fall short.

Disclaimer: This should all be regarded as JMO until evidence appears to the contrary!!

[AntiGuv]

Hmmm, I didn't make clear that the second point in the first response above was that East Asian economies cannot finance US inflation because in order to do so they would need stop purchasing US securities (which would have a deflationary impact by contracting the US money supply). That is the counterpart to my numbered point 1 that an eventual 'credit crunch' would place an involuntary upper limit on the Fed's ability to monetize debt (an upper limit which we're already pushing against).

These are the two Catch-22s.

[arete]

Good work! Be sure to keep us all updated on any changes you is coming down the tracks.

Richard W.

[sourcery]

East Asian economies cannot finance US inflation because in order to do so they would need stop purchasing US securities

Let's see if I am correctly understanding your point here.

When foreigners purchase US securities, they exchange dollars in their possession for bonds and stocks. The effect is to inflate the prices of US securities. Such "inflation" does not, however, show up in the CPI numbers.

In order for foreigners to contribute to price inflation as measured by the CPI, they'd have to start purchasing more US raw materials, capital goods and consumer products. The only source for the capital for such purchases would be the funds that are currently being used to purchase US securities.

Is that what you mean? If so, I have a problem with the analysis: the dollars with which foreigners purchase US securities end up in the hands of those who sell those securities. Can not those who sell US securities to foreigners finance US inflation? The issue would seem to rest on how those who end up with the cash decide to use it. What forces are oprating to discourage the use of liquidity to buy real things, as opposed to buying financial instruments or holding cash? That would seem to be the fundamental deciding factor in the argument for or against deflation.

Deflation is simply a bull market in cash. It comes about due to fear, risk aversion, disinclination to borrow and to lend. This sort of fear-driven deflation causes the money supply to collapse as the "multiplier effect" works in reverse. That's why it's called a deflationary debt collapse.

[David]

This is responsive to AntiGuv's well written and well thought out #'s 9, 11 and 14. I have a couple of additional thoughts.

First thing, as to TheVictor and Starwind in #'s 3 and 4, the point about energy prices driving the CPI up, use by BLS of the basket of goods method for measuring inflation is defective. Inflation and deflation are monetary phenomenon--that is creatures of the money supply and its velocity. Thus you might have a buyers and sellers market price adjustment having nothing to do with the inflation/deflation issue. We have that in energy at this time--and in the near future, a more extreme version with natural gas. Weather might affect aggricultural prices in the same fashion. The CPI number is not very meaningful for serious analysis of the monetary issues.

I don't see Soren's point in a post on this thread--however one of the issues we have discussed is the possibility that Fiscal Policy (Federal Government operating deficits) might result in creation of sufficient additional money to cause inflation.

I have generally thought it would be difficult in the modern economy to have that result because although the deficit seems large, in the context of the international money system and supply of money, it is a small number.

But I have recognized the possibility that might be the hole in the definitional deflation analysis--maybe it could happen. I think AntiGuv's proposition in response to this point, is that people will stop buying T-Bonds if the fiscal deficits get out of control to the extent they would affect the monetary base.

In order to analyze that issue, at some point, you will be forced to think about the distinction between newly issued T Debt and the secondary bond market. Fed has to print money to pay current deficits; they might do that but they are not likely to print to support outstanding bonds for the reason advanced by AntiGuv. And I think AntiGuv's answer to that is the same as mine--there is a point (a magnitude of deficit) at which the result of that kind of money creation could be inflation; and it is unlikely you would reach that result without the dollar ending its utility as a medium of exchange (hyperinflation).

" This should all be regarded as JMO until evidence appears to the contrary!!" Well with all due respect, your numbers 9, 11, and 14 are a fine scholarly description of how the monetary system works in an economy where debt service requirements have outrun available current liquidity. End result, by definition, is going to be deflation.

In reading your material, I think you should clarify--when you talk about devaluation, what I think you mean is that the current fed policy of so called reflation or disinflation avoidence is exactly that; an effort to avoid deflation by devaluation--perhaps, at least threatened, by trying to cause inflation through the printing press. It is that effort to which your analysis is addressed: It can't be done by any means short of induced hyperinflation which will cause the dollar to disappear, as well as significant other dislocation in the international economy, particularly in Southeast Asia.

Several follow on issues flow from this analysis. What do you do about it? And why, if the end game is relatively clear from a technical point of view, is gold in a bull market (because if we are in a deflation, by definition, the dollar goes up against all goods and services including gold)?

If the legal and monetary system survive the shock intact, owning Treasury Bills should protect investor capital. I tend to think the system will not survive.

Maybe that is also the answer to question number two. Those investors who do not expect the monetary system to survive buy gold and gold stocks? An alternative explanation is that the gold market does not understand the mechanical answer at this point and when it does, the gold bull market is over--I discount this explanation.

[Soren]

Let me see if I understand your view on fiscal policy. My take is that you are saying that in order to implement monetary policy via fiscal policy (i.e. to run deficits, and have the Fed print money to finance them, for the purpose of expanding the money supply to the extent that it offsets deflationary forces) the federal deficits would have to be enormous due to the small size of the budget relative to the overall money supply. Further, deficits of this size would undermine faith in the solvency of the US government and people would avoid holding US debt. Lower demand for govt bonds would create rising interest rates. Now here I get a bit fuzzy: The Fed is forced to step in and monetize the tidal wave of bond sales, which expands the money supply to such an extent that the dollar collapses?

A couple questions. First, isn't there a continuum of US deficits? Why do we jump from negligible impact on the money supply to destruction of the dollar? Isn't there a theoretical balancing point? (not that I think it could ever be achieved in practice).

Second, what are the actual numbers? Isn't M3 somewhere around 9-10T? What kind of annual percentage decreases are we talking about in a deflationary crunch? By way of reference, 5% would be less than the projected federal deficit for next year (not that there are plans to monetize the entire deficit).

Finally, the gold bull. I think your comments about how prices are affected by supply and demand, as well as monetary phenomenon apply. Over the past few years, CB sales and producer hedging have created excess supply that has resulted in lower prices. This is drawing to a close. This is compounded by the fact that as a result of low prices, exploration budgets were slashed, and supply is projected to fall. Mining is not a industry that can turn on a dime with respect to supply. On the demand side, there appears to be increased demand in Asia, particulary China, as well as CB's beginning to increase their gold reserves (Russia for example). In the West, there may be increased demand due to fear. Just look at this thread: destruction of the current economic system as a plausible scenario! Lower supply + increased demand = bull market.

[David]

Responsive to Soren's #19: First, as to the issue of impact of deficits on the monetary environment. Current fiscal year spending in excess of tax receipts (cash deficit), while it seems to be a large number to this poor simple taxpayer, is a small number in the aggregate credit market--investors will loan the Treasury the money as they do all other borrowers, and at a cheap price because of the Treasury's preference on the rate curve. The inflation issue would become relevent in one of two ways: Congress decides to have new bills printed up and thrown out the window of a helicopter flying down fifth Avenue at lunchtime--borrow the liquidity? Well we doubt that would happen because the end consequences are so clear, the dollar would cease to be an acceptable medium of exchange. The other way this issue could become relevant is as an unintended consequence of routine fiscal policy. The deficits are going to be larger than budgeted because tax revenues will be lower, and then much lower. I have thought this is unlikely to cause an inflationary impact on the dollar for the reason that the deficits still don't get to be large enough in the aggregate credit market to be a problem before Congress wakes up to the proposition that there is a problem.

That does leave open the possibility of an accident however--the individuals who make up these decision making bodies have no remote idea of how the economy or the monetary system works. Like the California legislative body last year arguing the state should continue to borrow, there will be individual members of Congress advocating continued spending long after it becomes unsustainable.

Your point about the deficit being a continuum--it's not. Because of the way our money system is structured, the impact of financed deficits is the impact. This stuff about the debt being a payment burden to our children and grandchildren is nonesense--it is never going to be paid by anyone, children, grandchildren, or anyone else. The only impact is the current account (obviously including interest which is in fact a significant budgetary number).

We need to look at the two elements separately to see how this would work. The T bond market is different from the current financing requirement.

About four months ago, Richard Russell had an article about how inflation is guaranteed because the fed will be required to print to keep the bond market afloat--and that is what Bernanke and Greenspan were threatening specifically at one point. They (Bernanke and Greenspan) backed off publically, and that caused rates to go up for a short time.

The bond market is a problem--and it is already a problem. Because international institutional investors other than Bank of China and Bank of Japan are beginning to lighten up on bonds and they are having trouble finding a new home in the market at current interest rates. This is in Belkin's numbers.

But reason Bernanke and Greenspan backed off is because the fed can't step in a monetize a tidal wave of bond sales.

Distinction between the bond market and the current deficit is that the fed is obligated to buy the debt for the current deficit even if it must print the money to do so.

As to gold, well what you are doing here of course is just handing me back things I have said elsewhere. No doubt the buyers and sellers conditions you describe are clearly impacting the price of the metal.

But with the exception of the jewlery trade, much of which is also motivated by monetary considerations, this entire market is a "money" market. And we know that when this deflationary condition becomes impacted which we can pretty clearly see is about to happen, the paper money goes up in value against everything, presumably including gold.

It goes up against buyers and sellers markets just like everything else--but for deflation, Natural Gas would have gone up more (hypothetically in the developed future deflationary environment).

Gold is just another form of money. You don't, and in the future won't be able (in the lease market), to earn any interest or other return on holding it. So why would anyone want to own the stuff? The only possible motivation is that it will be a more reliable store of value to spend in future periods than the paper dollars on which you will continue to get some small return in the form of interest. Under circumstances where you are losing ground (foregone interest; maybe dividends on common stocks when the Dow is at 800), why would anyone want this metal?

Gold is even worse. At some point, it will be recognized that the Paul Volker method in fact offers the prospect of getting out of this mess--if implemented while the system will still withstand the pain, you raise fed fends to 8%; and make a serious attack on the deficits (including the liability to pay Social Security to people who don't need it to buy groceries, pay rent, and buy energy). The free enterprise system would in fact solve the problem. So to hold gold, you will be required to forego 8% interest.

But the only role I see for gold is if you also converted to a gold money system and I don't think that is in the cards either. Gold is just plain worthless in any of these sceaneros. All these investors who are bidding the price of gold up just don't understand how the monetary system works at all. Right?