Can price inflation occur in the midst of debt deflation?

February 26th, 2009

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Right now, major economies like the US and UK are undergoing debt deflation. Large swathes of Europe is also going through this malaise. According to Professor Steve Keen, Australia, with its debt levels in the 3rd position behind US and UK, will suffer the same fate soon. Indeed, in the month of December 2008, Australia’s credit growth turned negative. Year-on-year credit growth in the second half of 2008 was decelerating. This is a worrying sign for Australia because as we explained before in Will Australia?s own pump-priming work?,

According to Professor Steve Keen, Australians? increased debt last year added $250 billion in spending into the economy. Currently, Australia?s credit growth is decelerating very rapidly. Should credit growth stagnate (or worse still, contract), this $250 billion (or more) in spending will go up in smoke.

So, there is plenty of scope for de-leveraging in the Australian economy, which will lead to debt deflation. Under such a scenario, asset prices will fall. As the theory goes, consumer prices should follow as well.

But is it possible for price inflation to rise in the midst of debt deflation? We were thinking of that possibility in What will happen if RBA cuts to zero?. The most likely culprit to blame for such a disturbing scenario will be the trashing of the Australian dollar. Debt deflation theory says that such a scenario is impossible. But there is a real-life example that shows that this can happen- Iceland. Today, Iceland is suffering sky-rocketing unemployment as well as price inflation. From the Icelandic central bank’s web site, you can see their price inflation rate has gone to the moon at 18.6% in January 2009.

How can both debt deflation and price inflation be possible? As someone in Professor Steve Keen’s blog site asked,

I?m wondering about what?s happening to Iceland now and going forward. When no one has a job, no one has savings and no one can sell a single thing. Everyone has no money. If no one has money, no one can buy things. If no one can buy things the shops must drop price further and further. This is monetary deflation and price deflation. More businesses fail and unemployment continues to rise. Where does the future inflation come from?

So, how can we explain Iceland?

Well, under the conventional demand-supply equilibrium model, prices should come down. But in this case, the system is out of equilibrium and cannot return to equilibrium. If there?s no money to buy imported things, it does not mean that the prices must come down. What will happen is (1) demand destruction and/or (2) the seller goes out of business (and contributes to higher unemployment). The remaining few sellers that survive will most likely sell to the richer Icelanders who can cough out the higher prices.

Furthermore, as we explained with an example in What will happen if RBA cuts to zero?, even locally produced goods can rise in price too.

Can this happen to Australia? Fingers crossed. The inflation part depends on the Aussie dollar.

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  • Temjin

    Hi Ed,

    It’s been a while since I made a comment here. Nice to be back again. 🙂

    Yes, how can we explain Iceland? I still don’t understand your explanation, so it would be great if you could further elaborate on it.

    On Steve Keen’s blog and my readings on Mish’s Global Economic Trend Analysis blog, I came across this blog post made by Mike.

    I will leave everyone to read it without having me to summarise it. But his conclusion is that the model of looking at inflation/hyperinflation (probably related to expansion of money supply through printing, Austrian economics theory), is wrong and that as the market value of credit start expanding again, it would be weaker in scope than most think.

    Note both Steve and Mike do not think gold/silver will rise at all during the next few years of massive deflation. And Mike made the claim that the US Fed will need to boost up their “stimulus” package by 25 times over pre-bailout levels. I guess it’s up to the will of the politicians if they would do such things.

    The things I agree with Mike is attitudes to spending and credit will change completely after this global financial crisis.

    Cheers!

    Temjin

  • Temjin

    Hi Ed,

    It’s been a while since I made a comment here. Nice to be back again. 🙂

    Yes, how can we explain Iceland? I still don’t understand your explanation, so it would be great if you could further elaborate on it.

    On Steve Keen’s blog and my readings on Mish’s Global Economic Trend Analysis blog, I came across this blog post made by Mike.

    I will leave everyone to read it without having me to summarise it. But his conclusion is that the model of looking at inflation/hyperinflation (probably related to expansion of money supply through printing, Austrian economics theory), is wrong and that as the market value of credit start expanding again, it would be weaker in scope than most think.

    Note both Steve and Mike do not think gold/silver will rise at all during the next few years of massive deflation. And Mike made the claim that the US Fed will need to boost up their “stimulus” package by 25 times over pre-bailout levels. I guess it’s up to the will of the politicians if they would do such things.

    The things I agree with Mike is attitudes to spending and credit will change completely after this global financial crisis.

    Cheers!

    Temjin

  • Hi Temjin!

    I will leave everyone to read it without having me to summarise it. But his conclusion is that the model of looking at inflation/hyperinflation (probably related to expansion of money supply through printing, Austrian economics theory), is wrong and that as the market value of credit start expanding again, it would be weaker in scope than most think.

    Their explanation is not ‘wrong’ in the sense that in the context of debt deflation, printing of money will not have an immediate impact on price inflation. A quick explanation of why can be found in Demand for money, inflation/deflation & its implication.

    But in the long run, when debt deflation runs its course, it’s only a matter of time that massive printing money of money will result in hyperinflation. Other contrarians like Marc Faber are already looking a decade ahead and contemplating the possibility of hyperinflation. A good read will be Recipe for hyperinflation.

    Even Steve Keen acknowledge (in one of his comments) that it is possible (though he reckon not likely) that over-the-top fight against debt deflation can trigger a hyperinflation. He mentioned that even he finds it depressing that he’s considering buying gold as a hedge. Therefore, hyperinflation is not an immediate threat yet and is something that is more of a judgement call then economic model/theory call.

    The things I agree with Mike is attitudes to spending and credit will change completely after this global financial crisis.

    Precisely. It is this change in attitude that will put a spanner in the works of Mish’s strident adherence to his deflation theory.

  • Hi Temjin!

    I will leave everyone to read it without having me to summarise it. But his conclusion is that the model of looking at inflation/hyperinflation (probably related to expansion of money supply through printing, Austrian economics theory), is wrong and that as the market value of credit start expanding again, it would be weaker in scope than most think.

    Their explanation is not ‘wrong’ in the sense that in the context of debt deflation, printing of money will not have an immediate impact on price inflation. A quick explanation of why can be found in Demand for money, inflation/deflation & its implication.

    But in the long run, when debt deflation runs its course, it’s only a matter of time that massive printing money of money will result in hyperinflation. Other contrarians like Marc Faber are already looking a decade ahead and contemplating the possibility of hyperinflation. A good read will be Recipe for hyperinflation.

    Even Steve Keen acknowledge (in one of his comments) that it is possible (though he reckon not likely) that over-the-top fight against debt deflation can trigger a hyperinflation. He mentioned that even he finds it depressing that he’s considering buying gold as a hedge. Therefore, hyperinflation is not an immediate threat yet and is something that is more of a judgement call then economic model/theory call.

    The things I agree with Mike is attitudes to spending and credit will change completely after this global financial crisis.

    Precisely. It is this change in attitude that will put a spanner in the works of Mish’s strident adherence to his deflation theory.

  • Steve Netwriter

    Hi,
    I do wish there was a better expression than “price inflation”. I used to use it myself, but now I dislike using the word “inflation” when talking about prices, which obviously do not inflate, they just go up and down.
    IMO it would be good if we could stick to using “inflation” for things that can inflate/deflate, like the amount of currency, and use another term for prices going up/down.

    I wonder whether prices in Iceland have simply risen because their currency has fallen, and so imports are more expensive. That is a one-off event, which is very different to inflation (in the true sense), isn’t it ?

    If true, then the question is how far will the purchasing power of the currency fall.
    Steve

  • Steve Netwriter

    Hi,
    I do wish there was a better expression than “price inflation”. I used to use it myself, but now I dislike using the word “inflation” when talking about prices, which obviously do not inflate, they just go up and down.
    IMO it would be good if we could stick to using “inflation” for things that can inflate/deflate, like the amount of currency, and use another term for prices going up/down.

    I wonder whether prices in Iceland have simply risen because their currency has fallen, and so imports are more expensive. That is a one-off event, which is very different to inflation (in the true sense), isn’t it ?

    If true, then the question is how far will the purchasing power of the currency fall.
    Steve

  • David

    Hi CIJ,
    I’ve been thinking about this question a lot (what the answer is will have hugh consequences in our lives). The problem we face seems to be the shadow banking system has collapsed (the unregulated and unknown derivatives market) and the size of that system is somewhere between 60 and 600 Trillion US Dollars. Some part of that market had the quality of moneyness without technically being money (how much is also a question). So when we all looked at M1 or M2 in the past we really weren’t measuring all the things that had moneyness and it seems that the deflation that is happening now is also not being represented by M1 or M2 and the big spike there does not represent an increase in all the things that had the quality of moneyness, but just money, and now the deflation is happening in the money-like stuff and it is effecting asset prices to the same degree as it did when the money-like stuff was being created, just in the opposite direction now. Also it seems like, among other things, the system is dealing with the shock of all these things that were money-like all of sudden not being money-like anymore (or even having a value that can be figured out). I don’t think that much of the money-like stuff is coming back and the economy needs to be reset to a place with less money-like stuff and less debt (it seems the debt was real and is still here). Money and debt go hand in hand and we either need to print real money to make up for the missing money-like stuff or we need to write off the debt (through bankruptcy or its equivalents). Anyway, I think this lens may help explain how we can have what seems like deflation (even while M1 or M2 is up) and price increases, especially in non-asset classes of products. It be great to hear your thoughts on this idea. Thanks for the great article.

  • David

    Hi CIJ,
    I’ve been thinking about this question a lot (what the answer is will have hugh consequences in our lives). The problem we face seems to be the shadow banking system has collapsed (the unregulated and unknown derivatives market) and the size of that system is somewhere between 60 and 600 Trillion US Dollars. Some part of that market had the quality of moneyness without technically being money (how much is also a question). So when we all looked at M1 or M2 in the past we really weren’t measuring all the things that had moneyness and it seems that the deflation that is happening now is also not being represented by M1 or M2 and the big spike there does not represent an increase in all the things that had the quality of moneyness, but just money, and now the deflation is happening in the money-like stuff and it is effecting asset prices to the same degree as it did when the money-like stuff was being created, just in the opposite direction now. Also it seems like, among other things, the system is dealing with the shock of all these things that were money-like all of sudden not being money-like anymore (or even having a value that can be figured out). I don’t think that much of the money-like stuff is coming back and the economy needs to be reset to a place with less money-like stuff and less debt (it seems the debt was real and is still here). Money and debt go hand in hand and we either need to print real money to make up for the missing money-like stuff or we need to write off the debt (through bankruptcy or its equivalents). Anyway, I think this lens may help explain how we can have what seems like deflation (even while M1 or M2 is up) and price increases, especially in non-asset classes of products. It be great to hear your thoughts on this idea. Thanks for the great article.

  • We will explain more on Iceland in the next article.

  • We will explain more on Iceland in the next article.