The Unbearable Mightiness of Deflation

A recent article by Gary North, entitled Pushing on a String, has ignited another round in the inflation/deflation debate. My first impression on reading it is that it is distastefully egotistical, dismissive of a position that is obviously not understood, and very likely to cause confusion due to the misuse of terms. Rarely do I find the writing of others grating on a personal level, even if I disagree with their position, but in this instance I would have to describe both the initial article and Mr North’s response to analyst and web writer Mike (Mish) Shedlock’s very valid criticism of it as pompous and ill-informed.

Mr North frames the dichotomy between inflation and deflation in price terms, which does nothing but muddy the waters. Those who argue for deflation (whom North describes rather contemptuously as “a tiny band of intrepid non-economists who have seen their founder’s prediction refuted by the facts in every year since 1973“) do so on the basis of inflation and deflation as the monetary phenomena they are, rather than as price movements.

This is fundamental to the argument, hence attempting to refute that argument by deliberately using the terms to refer to something different is disingenuous. He does use the term ‘price inflation’ but does not make clear the importance of the distinction between price movements and changes in the money supply. Nor does he distinguish between prices in nominal terms versus real terms, which is vital to understanding what is happening to affordability.

Inflation is an increase in the supply of money and credit relative to available goods and services, while deflation is the opposite. Deflation, moreover, is aggravated by a collapse in the velocity of money. Price movements are lagging indicators of monetary changes, but are also subject to a number of other drivers, such as scarcity and substitutability (or lack thereof).

For this reason, price movements alone have no explanatory or predictive value. For instance, we have lived through a highly inflationary credit expansion over the last couple of decades, but prices have not reacted consistently. Some have risen, as one would expect, but others have fallen, due, for instance, to the effects of global wage arbitrage. For prices to fall in nominal terms during inflationary times, they must be going through the floor in real terms.

Deflation would be associated, at least initially, with prices falling across the board, as the collapse of purchasing power would drastically reduce price support for virtually everything. In a deflation, people sell anything they can, in order to pay down debt, to meet margin calls and to cover the cost of living, once access to credit is cut off and earning an income becomes very much more difficult. This is a recipe for prices falling by perhaps 90% in nominal terms, but for goods and services to become simultaneously much less affordable, as purchasing power would be falling even faster. In other words, in real terms, prices rise (i.e. affordability decreases).




As a much larger percentage of a much smaller effective money supply would be chasing essentials, these would receive relative price support, making them even less affordable than everything else. If we later see scarcity of essentials, due to the collapse of global trade and the just-in-time economy, it is possible that prices would begin to rise again in nominal terms despite deflationary deleveraging. For nominal prices to rise during deflation, they would have to be going through the roof in real terms. The interaction of various factors will determine prices, but the deflationary contraction of credit is a given, and deflation can render things unaffordable far more quickly and comprehensively than inflation.

An understanding of the scale of the inflation we have lived through requires far more than looking at CPI or even casting an eye over conventional money supply measures. It is necessary to appreciate the role of credit and the massive scale of a credit expansion that largely took place in the unregulated shadow banking system. Credit is the critical factor, as the ‘moneyness’ of credit in a myriad different manifestations drove the expansion of the effective money supply.

As John Rubino explained in 2007:

”Doug Noland has for years been pointing out that one of the drivers of the credit bubble has been the ever-broadening definition of money. As the global economy expanded without a hic-up, more and more instruments came to be used as a store of value or medium of exchange or even a standard against which to value other things—in other words, as money. Thus mortgage-backed bonds and even more exotic things came to be seen as nearly risk-free and infinitely liquid. In Noland’s terms, credit gained “moneyness,” which sent the effective global money supply through the roof. This in turn allowed the U.S. and its trading partners to keep adding jobs and appearing to grow, despite debt levels that were rising into the stratosphere. For a while there, borrowing actually made the world richer, because both the cash received and the debt created functioned as money.”

Mish agrees in his response to Gary North:

“We have a credit based economy and anyone watching money supply and not watching credit is simply wrong. This is a statement of fact, not idle conjecture.”

Mish is right. However, credit only functions as equivalent to money during the expansionary phase. Once the credit ponzi scheme has reached is maximum extent, the quality of ‘moneyness’ disappears. As the value of credit collapses, so does a money supply of which credit has come to comprise the vast majority. This is deflation, not the fall of prices, and there is precious little central bankers can do about it other than to play a desperate confidence game, hoping that they can obscure reality long enough for confidence to return by itself. It isn’t going to work. Their actions, in combination with natural swings in herding behaviour, can postpone, but not prevent a credit collapse. Mr North says:

“… deflationists argue that the economy is in a deflationary spiral that the FED cannot prevent. They do not know what they are talking about. They never have.”

In reality, it is he who shows no understanding of the importance of credit and the impotence of the FED in combating its collapse. John Rubino again:

”With a few months of hindsight, it’s now clear that debt-as-money was not one of humanity’s better ideas. When the U.S. housing market -the source of all that mortgage-backed pseudo money- began to tank, hedge funds found out that an asset-backed bond wasn’t exactly the same thing as a stack of hundred dollar bills. The global economy then started taking inventory of what it was using as money. And it began crossing things off the list. Subprime ABS? Nope, that’s not money. BBB corporate bonds? Nope. High-grade corporates? Alas, no. Credit default swaps? Are you kidding me? No longer able to function as money, these instruments are being “repriced” (a slick little euphemism for “dumped for whatever anyone will pay”), which is causing a cascade failure of the many business models that depend on infinite liquidity. The effective global money supply is contracting at a double-digit rate, reversing out much of the past decade’s growth.”

Even as it seeks greater and greater powers, the FED is not omnipotent. Its reach is limited, particularly in relation to the shadow banking system, as Henry Liu pointed out in 2007:

As an economist, Ben Bernanke, the new Chairman of the US Federal Reserve, no doubt understands that the credit market through debt securitization has in recent years escaped from the funding monopoly of the banking system into the non-bank financial system. As Fed Chairman, however, he must also be aware that the monetary tools at his disposal limit his ability to deal with the fast emerging market-wide credit crisis in the non-bank financial system. The Fed can only intervene in the money market through the shrinking intermediary role of the banking system which has been left merely as a market participant in the overblown credit market. Thus the Fed is forced to fight a raging forest fire with a garden hose.

Here’s Mish again, from 2008, making clear the limitations of money printing in an attempt to prevent deflation in a fiat regime:

”Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. These are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark. Yes, there was deflation in Japan. Furthermore, if deflation can happen in Japan, then there is no reason why it cannot happen in the US as well.”

We are on the verge of a deflationary debt default tsunami. More and more individuals, companies and governments at all levels are approaching the point where servicing their debts will no longer be possible. Quantitative easing will eventually greatly exacerbate the difficulty this poses by risking a seizure in the bond market that would send interest rates into the double digits. For the time being though, we have very low nominal interest rates. Mr North argues that this should spur lending, as money is essentially free:

“At some low price – such as “free” – people will take the money. That’s why price inflation is in our future. Price deflation isn’t, short of a banking gridlock, which is quite possible, but an unpredictable event”.

It is, however, real interest rates that matter, not nominal rates. Money offered at zero percent interest in nominal terms is not free if the effective money supply is contracting, as the real rate of interest is the nominal rate minus negative inflation. The Fed is pushing on a string as even zero is not low enough. And banking gridlock is not an unpredictable event under the circumstances we are facing. On the contrary, it is to be expected.


Money is actually free when real interest rates are zero, or even negative, as they were in the years following the tech-wreck. Low nominal interest rates against a backdrop of a rapidly expanding credit pyramid was an invitation to take on unsustainable levels of debt if ever there was one, and both borrowers and lenders took full advantage of the opportunity. Borrowers thought only of their low monthly payments and lenders thought only of the fees they were earning by setting up loans and selling them to Wall Street in the form of securities. Lending standards hit a new low as credit-worthiness was forgotten.

Both parties are now living to regret their previous excesses, but the damage is done. Now that credit is contracting, that ‘free money’ has turned into unpayable debts and illiquid asset markets, which will eventually have to be marked-to-market. Now balance sheets must be rebuilt and neither borrower nor lender is willing to dig themselves into an even deeper hole. The velocity of money will inevitably fall dramatically as risk aversion rises, reserves are held again looming defaults and cash is hoarded. The scale of the bad debt in our global economy is gargantuan. The Fed cannot midwife credit creation under those circumstances, and things will get much worse before they get better.

Mish, in response to Gary North:

“Of course those “excess reserves” are a mirage; they don’t really exist. Banks need those reserves because of the massive wave of credit card defaults and foreclosures yet to hit the books. Every uptick in unemployment exacerbates credit card losses, foreclosures, losses on home equity loans, etc, something that Gary North ignores.”

Mr North dismisses the role of credit and the impact of its contraction summarily, stating:

”Those forecasters who are predicting price deflation argue that monetary inflation will not be powerful enough to overcome price deflation. Nobody is predicting an actual decrease in the money supply, short of some sort of banking gridlock and a complete breakdown of monetary transactions, which no conventional analyst even considers, since it is just too pessimistic to consider seriously, like nuclear war.”

Commentators are predicting an actual decrease in the effective money supply. If conventional analysts are not, then they need to broaden their understanding of what constitutes the money supply in practice. Saying that something cannot happen because the impact would be severe is a non-argument. Serious negative events do occur, and the circumstances leading to this one are obvious. We are headed for banking gridlock and a breakdown of monetary transactions, as we did in the 1930s, only this time it will be worse, as the excesses leading up to this crisis have been worse in every way than they were in the Roaring Twenties.

Finally, Mr North has a distressing tendency to personalize his criticism of his intellectual opponents in a particularly patronizing manner. His leading criticism of Mish for instance, is that, as a photographer, Mish could not possibly have the time to be a credible economic commentator:

“It takes years to build this sort of portfolio. You must eat, drink, and sleep photography. You must master the tools of the trade. You also need creativity. This is not a part-time occupation. It is not a hobby. It is a career. I know what it takes. I used to be an amateur photographer. I gave it up in 1960. I knew I did not have the time to become really good and also pursue my work in economics, history, and markets. I had to choose.

Not everyone is forced to choose one field to the exclusion of all else in order to understand the fundamentals of that field. In fact, building an appreciation of the bigger picture requires a broad view. In order to understand the scope of our predicament, it is necessary to understand finance, but also energy (net energy, EROEI, receding horizons etc), ecological carrying capacity and population, collective psychology and herding behaviour (see Prechter), diminishing marginal returns to socio-economic complexity (see Tainter), catabolic collapse (see Greer), positive feedback loops, adaptive ecological cycles (see Holling), pollution and pathogens, game theory, real politik, risk dynamics, reality versus perception as socioeconomic drivers etc, etc. Breadth and depth are not mutually exclusive, and the narrowly focused approach will only take one so far. I think Gary North has some serious reading to do.

Note: I have not answered Mr North’s 10 questions for deflationists, as he frames the debate in terms that serve to obscure rather than illuminate the important factors. The fundamental criticism of Mr North’s position is that he fails to recognise the role of credit and the nature of deflation.

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