What’s ahead? Inflation or Deflation?

October 5, 2011 § Leave a comment

Interesting and critical debate between the authors of Automatic Earth and a critic. The debate concerns whether or not we are in for inflation or deflation. And the answer depends on whether you explain inflation by means of a real relationship between money supply and prices, or demand psychology and markets.

The distinction echoes the current split between those who believe in a fiscal or bank intervention to resolve the Eurozone crisis, and those who believe the current crisis is one of trust and confidence. Is credit tightening due to a lack of trust in the system itself (trust in the solvency of institutions/nations/banks)? Or is credit tightening due to fundamental fiscal issues (debts, interest on payments, economic austerity)?

In other words, does one continue to keep the machine running as is — adjusting for current fears by adding on greater debt? Or is the situation exacerbated by psychology of fear and mistrust to such a degree that any additional fiscal measures, or even leveraging of ECB funds, only pours “good” money on bad?

That is how speculative periods always resolve themselves. We argue, however, that this does not mean commodities will be cheap, even at much lower prices than today, given that the implosion of the wider credit bubble will cause purchasing power to fall faster than price. This means affordability worsening even as prices fall.

To be clear, at TAE we define inflation and deflation as monetary phenomena – respectively an increase or a decrease in the supply of money plus credit relative to available goods and services. Mr Martenson begins his piece with:

Their argument is pretty clear cut: Because inflation is a function of available money plus credit (their definition), and because credit has fallen, deflation is what comes next.

We would point out that, according to our definition, credit contraction does not lead to deflation, it IS deflation by definition. What it leads to is falling prices, virtually across the board.

Mr Martenson points to three conditions which he argues would have to be met for commodity prices to fall, arguing that these are “all just versions of the old supply/demand argument for commodity prices, except that our consideration also includes the important element of the Austrian economic view of demand for money”.

In this view, three things have to be true:
Demand for commodities has to fall below supply. After all, as long as demand exceeds supply, prices will typically rise.
Money, including credit that would normally be used to buy commodities, has to shrink. That’s the definition of deflation that we’re analyzing here.
People’s preference for money has to be greater than their preference for ‘things,’ with commodities being very obvious ‘things.’ That is, faith in money has to be there or people will prefer to store their wealth elsewhere.

Regarding the first condition, Mr Martenson has this to say:

A key component of the deflation argument is that with credit shrinking, demand will drop, leaving excess market supply that resolves with lower commodity prices.”

This does not represent our position, which is based on the powerful impact of bubble psychology, rather than on supply and demand. In contrast, we would argue that for commodity price to fall a long way, and very quickly too, it is not necessary for supply to exceed demand, especially by any significant margin.

Changes in supply and demand do not typically occur rapidly, but changes in perception certainly do, and it is perception that drives markets. If the fundamentals of supply and demand were responsible for setting prices, we would not see price collapses over a matter of months, yet this is exactly what we saw in 2008.

Source: Commodities and Deflation

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