When ‘cash’ becomes confetti, inflation/deflation becomes irrelevant

September 23rd, 2008

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The financial and economic events of this month is amazing and history will one day judge September 2008 as one of the major turning points.
Today, if you follow the inflation/deflation debate on the Internet forums, blogsphere, etc, you will find this issue to be a highly divisive, polarising and at times, rather emotional debate. No wonder it is a highly confusing time for investors and traders.

For investors, it will be a big mistake to take sides in this debate. You may have certain inclination towards one or the other side of the fence, but do not dig in and get permanently committed to an opinion/idea. From our observations, some people have become too religious and emotionally involved to one side of the debate. They have become so religious that whoever belongs to the other side is regarded as an infidel. Such loss of objectivity will cloud your judgement.

First, for our newer readers, please take a read at What is inflation and deflation? for our definitions of inflation or deflation. They are not the mainstream idea of price rise/falls.

So, will hyper-inflation or severe deflation be the endgame of this financial crisis?

We don’t know which one will be. But our guess is that it is probably the former. But that does not mean we are loyally committed to that position and bet our entire life and wealth on that. After all, life is more subtle than that either black or white. Because we cannot know with certainty what the future will hold until time has passed, it becomes a game of probability for the present.

Now, take a read at Understanding the big picture in the inflation-deflation debate,

So, the world?s fiat money system works under the ?mechanism? of credit. Because money has to be returned, it acts, in theory, as a check against abuse and rampant monetary inflation.

The fact that the global financial system is facing acute deflation threat shows that this credit-system ?mechanism? is working to protect the integrity of fiat money!

At the root of the deflation argument is the fact that we live in a credit-based economy. As long as this credit-based system is in place, any inflationary bubble will be ultimately deflationary. Please note that the word “ultimately” in the previous sentence is bold. The word, “ultimately,” is a very important qualifier. This implies that before the ‘ultimate’ deflation, we can have inflation in the interim.

So, to illustrate the point of this qualifier, let us conduct a thought experiment. For the purpose of argument, let’s assume that the credit mechanism is firmly in place.

Say, the US nationalisation of its financial sector transfers most of these toxic private sector debt into the public debt. Given that the US government already has a huge amount of debt, this means they have to raise even more debt. The only way for the US government to issue more debt is to issue government bonds, which is still borrowed money that has to be returned. We can see why this is still ultimately deflationary because no matter how much the US government borrows, it has to return them eventually (e.g. by raising taxes).

Now, let?s take a step further and say that the US government monetises its debt by selling the newly issued government bonds to the Federal Reserve. That?s in effect printing of money. Even then, some will argue it is still ultimately deflationary because it is still credit i.e. the government has to eventually buy back the bond from Federal Reserve.

Let?s take a step even further. Let?s say the government pays off that expired monetised debt by monetising even more debt. That?s like an individual borrowing from one credit card to pay off another credit card. Imagine what will happen if the government do that! Its debt will grow exponentially, which is hyper-inflationary. Still, it can be argued that it is still ultimately deflationary because all these government debt has to be returned.

At this point, let’s pause and think.

In such hyper-inflationary environment, it’s doubtful whether people will see government legal tender ‘cash’ as money any more. In Zimbabwe, during an auction of a car, ‘cash’ no longer function as money. Instead, petrol vouchers (denominated in litres of petrol) were used as a unit of account for the bids. In Vietnam, the recent high inflation of the Vietnamese currency leads to some instances whereby people no longer uses legal tender ‘cash’ as money in buying/selling land.

The point we are trying to make is that by the time the situation becomes that bad, all talks about inflation or deflation is irrelevant because, ‘cash’ no longer function as money for practical purposes. They become as good as confetti. Who cares about the inflation or deflation in the supply of confetti?

Please note that the purpose of this article is not to make an inflation/deflation forecasts in the prediction sense. Its purpose is to show you how dragging an idea to the extreme can lead to erroneous thinking. In this example, while it is true that deflation will ultimately happen theoretically in the context of a credit-based system, it is pragmatically irrelevant.

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