In our previous article, “Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model”, we promised to explain Marc Faber’s view on why inflation (rather than deflation) will be outcome in the years to come. As he wrote in his most recent Gloom, Boom, Doom market commentary,
Now, from the numerous emails I get I have the impression that most investors are leaning toward the view that ?deflation? will be the problem in the future and not ?inflation.? An ?expert? [Editor’s note: For the sake of peace, let us all assume he was not referring to Professor Steve Keen] even opined that whereas it was possible under a pure paper money system (large quantity of banknotes in circulation) to create high inflation rates, this was not possible under an electronic banking system.
First, let’s take a look at Professor Steve Keen’s view that the destruction of credit (IOUs) will overwhelm any money printing by the government. As Steve Keen said in “The Roving Cavaliers of Credit”,
To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels.
Our view is that while massive deflation of credit will occur, it will not happen overnight. Instead, while the deflationary pressures will continue, it can be slowed down via unconventional monetary policies (see “Bernankeism and hyper-inflation”), gigantic fiscal policies, bailouts and even government fraud. The result will be a long drawn out affair, akin to a grinding trench warfare and a war of attrition on the real economy as credit contraction (IOU destruction) collide head on with money printing, massive government spending, stimulus and bailouts. In fact, this is what is happening right now in the US as optimism for “green shoots” of economic recovery fuels a rally from the depths of the panic of 2008. To make this saga even more confusing, despite the credit destruction in the second half of 2008, prices on the street have yet to make a meaningful decline. Simply speaking, money ‘printing’ will be spread out over a number of years until deflationary pressure subsides. Thus, Bernanke is not going to increase M0 by 25 times in a flash- he is going to do so over an extended period of time until it is no longer deemed necessary.
Next, credit contraction will not go on forever. As Professor Steve Keen commented before, he expects deflation to end eventually and inflation to return after say, a few (or several or dozen or whatever) years.
Now, we will talk about Marc Faber’s argument. Consider what’s happening as the Global Financial Crisis (GFC) unfolds:
- Economy contracts
- Interest rates are cut
- Fiscal policy is stepped up to assist failed monetary policy (see “What makes monetary policy ?loose? or ?tight??”). Then as Marc Faber said,
But for the fiscal stimulus to even have a small chance of succeeding at reviving economic activity it has to be larger than the private sector credit contraction.
With that, he had a chart to show that “US Private Sector Credit Contraction Is Offset by Public Sector Credit Expansion!”
- Government spending going up when tax receipts declines.
- Upward pressure on interest rates (see “How are governments driving up fixed mortgage rates?”)
- Governments forced to monetise debt (i.e. print money, which is already happening in the US, UK and Japan) in an attempt to force long-term interest rates down. See “Why are nothing-yielding US Treasuries so popular?”.
That’s where the crux of Marc Faber’s argument,
And here lies the crux of the problem most deflationists do not understand. By keeping short term rates artificially low and by monetizing the growing fiscal deficits a central bank digs its own grave in terms of its ability to pursue tight monetary policies when such policies become necessary.
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If the US Fed failed to tighten monetary policies after the US economy began to recover in November 2001, what are the chances of tight monetary policies in the future (which would significantly increase in the short run the cost of servicing the government?s debt) when both the US government and the Fed will be loaded with toxic assets and burdened by all kinds of other liabilities? The chances of the US government implementing tight monetary policies in the next few years are exactly zero.
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But my point is simply this: Once a government embarks on highly expansionary fiscal policies which entail government expenditures vastly exceeding revenues (leading to enormous budget deficits and soaring government debt) and simultaneous monetization (?printing money?), the reversal of these inflationary policies becomes for all practical purposes impossible. Inflation and higher interest rates follow. At this point the reader should clearly understand that any upward pressure on interest rates brought about by the market participants will actually force a central bank that embarked on monetization to monetize even more [Editor’s note: This is the time when money supply will increase exponentially!]. The other point to remember is that the longer an economy does not respond to such ?inflationary? fiscal and monetary policies, the larger the ?doses? will become.
So, by implication, any global recovery from the Global Financial Crisis (deflation) will bring forth another crisis (inflation)!
Tags: deflation, inflation, Marc Faber, monetisation, Steve Keen
