What Is Inflation and How Does One Measure It?

In recent years, more and more economists have begun to include time deposits in banks in their definition of the money supply. For a time deposit is also convertible into money at par on demand, and is therefore worthy of the status of money. Opponents argue (1) that a bank may legally require a thirty-day wait before redeeming the deposit in cash, and therefore the deposit is not strictly convertible on demand, and (2) that a time deposit is not a true means of payment, because it is not easily transferred: a check cannot be written on it, and the owner must present his passbook to make a withdrawal.

Yet, these are unimportant considerations. For, in reality, the thirty-day notice is a dead letter; it is practically never imposed, and, if it were, there would undoubtedly be a prompt and devastating run on the bank.[2]

Everyone acts as if his time deposits were redeemable on demand, and the banks pay out their deposits in the same way they redeem demand deposits.

The necessity for personal withdrawal is merely a technicality; it may take a little longer to go down to the bank and withdraw the cash than to pay by check, but the essence of the process is the same. In both cases, a deposit at the bank is the source of monetary payment.

In a fiat world, money is printed into existence by the central bank - in the United States the Fed. Given there is nothing backing up this money, it is inherently worthless. However, one can think of as real. It was printed (even if only electronically), therefore it exists.

In addition to the previously mentioned money supply, fractional reserve lending allows credit to be extended by banks and financial institutions on top of that inherently worthless money. Indeed, banks and financial institutions have leveraged credit to base money at ratios of 30-1, 50-1 or even higher.

It's pretty amazing if you think about it: Credit is extended with 30-50 times leverage on inherently worthless paper.

Ponzi Financing

Borrowers have to pay interest on the amount borrowed. However, the interest and the debt cannot possibly be paid back except by an ever expanding Ponzi scheme of lending. That scheme can last only as long as everyone believes the debt can be paid back and the market value of that debt keeps rising.

It's a faith based system in which banks extend loans and hold the credit on the books (or in many cases off the books in various structured instruments). The banks are thought of as being well capitalized as long as the value of credit on the books in relation to their reserves meets some ridiculously low minimum set by the Fed.

This is how the system works, using the term "works" loosely.

Day of Reckoning

The day of reckoning comes when asset prices start falling, defaults soar, and the value of credit on the books starts plunging. That day of reckoning has arrived.

And if leverage is high enough, as it was with Bear Stearns and Lehman, the institutions are wiped out overnight. Citigroup (C), Bank of America (BAC), Fannie Mae (FNM), Freddie Mac (FRE) and AIG are essentially in the same position of Lehman except the taxpayers via the Treasury are funding the bailouts.

Will this printing create [price] inflation? This is dependent very much on what money will do next. If banks will not lend and banks sit on that cash forever and ever like the great depression because the risk is too high and the banks do not know if the lending will end up in good assets or bad assets, and because banks are in so many bad assets now they probably will not lend at all.

That is the observation that Murray Rothbard made, that during the Great Depression that banks have chosen not to lend because the risk of accumulating bad assets was far to high. So they were sitting on massive reserves. That is what is developing right now.

A good example is what happened in Japan in 2001-2002 where the Bank of Japan pumped 300% at one stage and lending continued to collapse. I expect similar things to happen here. If lending will not increase we can conclude this will not be inflationary.

Kass: The bond market is in a bubble that is reminiscent of (and quite possibly as extreme as) other bubbles during previous eras. From my perch, the only issue is the timing of this trade.

Mish: Timing is indeed everything and perhaps there is a temporary selloff. But the primary trend is for lower yields. Perhaps much lower yields. There is no bubble in bonds. Not yet.

Those who want to see how low treasury yields can get and stay there, need to look at Japan. Yields in the US are going to go far lower and stay lower longer than nearly everyone thinks.

Those focused on the CPI failed to see any chance of the Fed Fund's Rate at 2.00 again. On the other hand, those focused on the destruction of credit from an Austrian economic perspective got this correct. That is just one reason why it makes more sense to watch the credit markets than the CPI. The second is the CPI is so distorted it is useless.

In my opinion, it is very likely new all time lows in the 10-year treasury yield and 30-year long bond are coming up.

It is quite possible the lows in treasury yields are in. Unlike 2008 where I was constantly beating the drums for lower yields, 2009 could be different.

Practical Definitions Of Inflation And Deflation

Most know my definitions by now but here they are again for convenience.

• Inflation is a net increase in money supply and credit.
• Deflation is a net decrease in money supply and credit.

In both cases credit must be marked to market to make any practical sense out of what is happening. Those who focus solely on money supply cannot easily explain stock markets that have fallen in half (this does not happen in disinflation), TIPs yields, a global race to ZIRP, or many other events that are happening.

Humpty Dumpty Defines Inflation

Unfortunately there are many definitions of inflation and deflation strewn about. Some play the role of Humpty Dumpty changing meanings at whim, switching from commodity prices, to consumer prices, to expansion of base money or M3 or whatever measure of money seems to be expanding at the fastest rate.

Some do the inflationista two-step to avoid admitting that we are indeed in deflation, choosing instead to call it "disinflation"


In short: "We are going to have a period of deflation that we will instead call disinflation."

'When I use a word,' Humpty Dumpty said, in a rather scornful tone,' it means just what I choose it to mean, neither more nor less.'

'The question is,' said Alice, 'whether you can make words mean so many different things.'

'The question is,' said Humpty Dumpty, 'which is to be master - that's all.'

Credit (and credit problems) dwarf monetary concerns at the present.

Until something happens to disrupt that model (far more likely from Congress than the Fed at this point) I see little reason to change my model. In fact, it will likely not be the model that changes, but rather changing conditions will give the model a different forecast.

Right now, I still expect the US to slip in and out of deflation and recession for years to come just as happened in Japan. I also expect we will suffer through a Decade of Lost Jobs.

Those focused on money supply alone, the CPI, the stock market, so-called leading indicators, or any other factors are likely to miss the boat unless their forecast just happens to be in alignment with credit conditions.

Unfortunately, I cannot state a precise measurement of inflation or deflation given the shell games at the banks and the Fed regarding mark-to-market accounting.

However, the hard data shows banks aren't lending, consumer credit is contracting, credit writeoffs are likely to exceed monetary printing, and symptoms like treasury yields are in generally in agreement. That to me is good enough.

Given that credit conditions and bank lending have not changed and treasury yields are still near historic lows, fears over run away prices and soaring interest rates are misplaced. You can choose to call this environment "inflation" or "stagflation" if you want. No one can stop you. However, practically speaking, there is far more "stag" than "flation" and the proper prefix is still "de". The stage is set for another market crash.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Mike "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.
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