THE INFLATION DEFLATION DEBATE WAGES ON
by Ghassan Abdallah, Ph.D.
July 2, 2009

The pendulum swings, day to day from fear of deflation and the collapse of asset prices to fear of inflation, hyperinflation, and the collapse of the U.S. Dollar. What is it deflation or inflation? The question is complicated and cannot be answered with an either or. The first thing to do when discussing such a complex issue is to define inflation and deflation. Most, including some renowned economists, mistakenly define inflation as rising prices and deflation as falling prices. The most accurate description I have seen of inflation and deflation comes from Robert Prechter.

When the volume of money and credit rises relative to goods available, the relative value of each unit of money falls, making prices for goods generally rise. When the volume of money and credit falls relative to the volume of goods available, the relative value of each unit of money rises, making the prices of goods generally fall. Though many people find it difficult to do, the proper way to conceive of these changes is that the value of units of money are rising and falling, not the value of goods.
Prechter, Robert (2003, p. 88) Conquer The Crash.

Using the above definition and given the increase in money supply, quantitative easing, and trillions worth of dollars in governmental induced liquidity, not just in the United States but around the world, one would have to conclude that we are in an inflationary environment. Yet Robert Prechter himself is a deflationist and does not expect inflation before we see an even further decline in the value of assets across the board relative to paper money. I have not had the privilege of meeting Mr. Prechter to ask him how he maintains a deflationist stance in the midst of a period that can be appropriately described as one of the greatest increases in the volume of money periods in human history. However, based on his writings, I can make a fairly accurate assessment of what Prechter would say regarding this matter. Prechter would, most certainly, maintain that even though the money supply from the government is at an all time high the velocity of money is not, and credit or the availability of credit is actually contracting and not expanding. In the aftermath of the burst of the greatest asset bubble of our time the psychology has shifted from one of risk taking and endless optimism to one of fear and extreme pessimism. And if one looks at the behavior of financial institutions today it is very easy to find corroborating evidence supporting this point of view. Banks have closed and slashed hundreds of billions of dollars worth of credit lines in the past year even to individuals and businesses with an exceptional credit history. The banks, which in many cases have liabilities exceeding their assets, are not eager to lend, and the consumers who lack job and income security are not eager to borrow and spend. Hence, we are trapped in a spiral of fear with fear begetting more fear until further notice.

Noble prize winner economist Paul Krugman is also in the deflationist camp. In a recent NY Times article, titled “The Big Inflation Scare” (May 28, 2009), Krugman dismissed the rising fears of inflation, maintaining that consumer prices remain low and wages stagnant. To Krugman quantitative easing by the Federal Reserve and deficit spending by Congress will not necessarily lead to inflation. Those same practices were applied in Japan, yet deflation in that country continued for over a decade. Krugman compares the discussion regarding inflation today to the one during the 1930’s. At the time many influential analysts warned of inflation as the United States went through a great deflationary depression.

Bill Fleckenstein of Fleckenstein Capital holds a divergent view. Readers who read his daily column cannot miss his main motto which appears at the top of his home page and reads: “In a social democracy with a fiat currency, all roads lead to inflation.” Fleckenstein maintains that falling equity and real estate markets are not necessarily evidence of deflation and that deflation cannot come about until what he refers to as the money printing machine is taken away from the Federal Reserve. In Fleckenstein’s own words: “only when money-printing leads to a collapse in the dollar or in the U.S. treasury market will there be any possibility of the asset market declines we face actually turning into the deflation that so many people still seem to expect” (Daily Rap, May 8, 2008). Fleckenstein has plenty of company in the inflationist camp. Peter Schiff, Mark Faber, and Jim Grant have for years warned about the dangers of easy money policies by various central banks in order to keep asset prices at highly inflated levels. Marc Faber has been quoted by various media outlets as saying that he was “100 percent sure” that the U.S. will face hyperinflation in the coming years. He even went as far as comparing the U.S. to Zimbabwe where inflation was recorded at 231 million percent last year. However, there is no statistical evidence of inflation or hyperinflation, at least not yet. If you believe U.S. Government statistics, consumer prices in May recorded the steepest decline in 59 years. Data from the European Union Statistics Office in Luxembourg also indicates no evidence of inflation. Inflation in the European Union dropped to zero in May, the lowest level since records of inflation began to be recorded in 1996. This debate is not likely to end any time soon.

© 2009 Ghassan Abdallah, PhD
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Ghassan Abdallah, Ph.D | Adjunct Professor, Univ. of Houston | Email