Inflation or Deflation? - 2

We have seen on my previous post a couple of days ago, that inflation/deflation should not be confused with their consequences which are the rise/decline of the general price level. I also pointed to this article from Joseph Salermo (An Austrian Taxonomy of Deflation), on the Mises Institute, which contains valuable information and is a must-read. The article was written in 2002, but it's even more relevant today than it was back then.

So first, let us define inflation/deflation using Salermo's words (emphasis mine):

Before World War 2, whenever the terms “inflation” and “deflation” were used in academic discourse or everyday speech, they generally referred to increases or decreases in the stock of money, respectively. A general rise in prices was viewed as one of several consequences of inflation of the money supply; likewise, a decline in overall prices was viewed as one consequence of deflation of the money supply. Under the influence of the Keynesian Revolution of the mid-1930, however, the meaning of these terms began to change radically.

It's hence important to also understand what the money supply is, in terms of the Austrian School of economics, since there's no consensus on this. Let us quote Murray N Rothbard himself to define the money supply in his book The Mystery of Banking (emphasis mine):

The crucial distinction, and the crucial way to decide what is part of the money supply, must focus on whether a certain claim is withdrawable instantly on demand.
[...]
The test, then, should be whether or not a given bank claim is redeemable, genuinely and in fact, on demand at par in cash. If so, it should be included in the money supply.
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But are money market funds money? Those who answer Yes cite the fact that these funds are mainly checkable accounts. But is the existence of checks the only criterion? For money market funds rest on short-term credit instruments and they are not legally redeemable at par. On the other hand, they are economically redeemable at par, much like the savings deposit. The difference seems to be that the public holds the savings deposit to be legally redeemable at par, whereas it realizes that there are inevitable risks attached to the money market fund. Hence, the weight of argument is against including these goods in the supply of money.
[...]
The Fed also publishes an L figure, which is M-3 plus other liquid assets, including savings bonds, short-term Treasury bills, commercial paper, and acceptances. But none of the latter can be considered money. It is a grave error committed by many economists to fuzz the dividing line between money and other liquid assets. Money is the uniquely liquid asset because money is the final payment, the medium of exchange used in virtually all transactions to purchase goods or services. Other nonmonetary assets, no matter how liquid—and they have different degrees of liquidity—are simply goods to be sold for money. Hence, bills of exchange, Treasury bills, commercial paper, and so on, are in no sense money. By the same reasoning, stocks and bonds, which are mainly highly liquid, could also be called money.

This is a very important quote. It debunks all I read in financial papers/blogs about the current confusion of "asset price deflation" and "deflation". It's not because house prices and share/bond prices are collapsing that we will see deflation. Here we see the difference between "could occur" and "will occur".

As I also stated in my previous post, it is not clear we are in deflation, even if the asset prices are collapsing, and it is not even clear the general price level is going to decrease, as a consequence of moneteray deflation or not.

I will quote Joseph Salermo to back my opinion here, in this crucially important quote. This is very counter intuitive and that could explain why so many people do not see it this way (my emphasis):

The fallacious assumption underlying this proposition is that there always exists a positive relationship between movements in raw commodity prices and movements in consumer prices. However, as the Austrian theory of the business cycle teaches, consumer goods’ prices and capital goods’, including raw commodity, prices change relative to one another during the different phases of the cycle and may very well vary in absolutely opposite directions during a recession.
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Meanwhile, because the Fed typically continues to expand bank credit and money during postwar recessions, although at a slower pace, the prices of consumer goods never do stop rising as the persistent injections of new money work their way through the economy from “monetized” government deficits and more slowly growing bank loans and investments to consumers. This vital lesson was illustrated time and again in the series of inflationary recessions or “stagflations” that the U.S. has suffered through since 1969 during which the CPI soared and the value of the dollar plummeted without interruption right through the recession phase of the cycle despite plunging commodity prices.
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Writing in an earlier era of deflation-phobia, the mid-1980, Murray Rothbard gave a definitive response to those, including supply-siders, who claimed then that a fall in a handful of industrial commodity prices presaged a general deflation:

The fact that industrial commodity prices have fallen sharply means precisely nothing for the reality or the prospect of inflation or deflation. Industrial commodity prices always fall in recessions. They fell in the steep 1973-74 recession and they fell very sharply throughout [the recessions of] 1980 and 1981.... What was the impact of commodity prices on inflation or deflation? Precisely zero. The point is that consumer prices kept rising anyway, throughout these recessions and through the generally depressed period from 1980 to 1983....

Most laymen and economists think of industrial commodity or wholesale prices as harbingers of the move of consumer prices, which are supposed to be ‘sticky’ but moving in the same direction. But they are wrong. One of the most important and neglected truths of business cycle analysis is that consumer prices and capital goods or producer prices move in different directions. Specifically, in boom periods capital goods or producer prices rise relative to consumer prices, while in recessions, consumer prices rise relative to producer prices. As a result, the fact that industrial commodity prices have been falling in no sense presages a later fall in consumer prices. Quite the contrary.

So basically, I will stand on my inflation beliefs so far, even though bank credit is contracting, the money creation at the Fed is so enormous, that it has in my opinion by far compensated the credit contraction.

This might also be one of the rare case where Mish's analysis is totally wrong (Helicopter Ben Pulls Out Bazooka here and Huge Demand For Treasuries As Banks Refuse To Lend here) and Peter Schiff might be right contrary to what Mich states several times on his analysis. I also strongly disagree with his opinion about US Gov bonds but that might be discusses in a future post.


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