“In his influential 1998 book Inflation Targeting, Ben Bernanke and his co-authors advised policymakers to announce a target inflation rate because it “communicates the central bank’s intentions,” which would “reduce uncertainty.” The announced rate should be substantially positive, they wrote, because if officials tried to get it close to zero, any mistake could result in deflation, which “might endanger the financial system and precipitate an economic contraction.” As Federal Reserve Chair from 2006 to 2014, Bernanke formally introduced inflation targeting in the United States in 2012, setting the annual rate at 2%, where it has remained ever since.”
Whew. Boiled down to its essence, this is a remarkable theory about the cause of deflation from an economist who would become Chairman of the Federal Reserve. Shiller is rightly skeptical. According to Bernanke, deflation is caused by inflation getting too close to zero.
This is shockingly fatuous for someone with a PhD in economics. After all this sophisticated advanced education, the best he could come up with was a slippery slope theory of deflation. Just get too close and you risk falling over the edge.
This begs for a deeper analysis. And not just because the biggest deflationary crash since the 1930s occurred on his watch as head of our monetary system, when he was better placed than any human being alive to put his theory to the test.
First let’s look at how inflation is produced in our current monetary system. It all starts with supply and demand. If at a given value of the dollar the supply of dollars exceeds the demand for dollars, the value of the dollar will decline until supply and demand are matched. Nothing controversial here, and certainly nothing that requires a PhD to understand. It’s Econ 101.
So in order to decrease the value of the dollar, the Fed need only produce more. All else being equal, the increased supply will result in a reduced value of the dollar. Because it now takes more of those dollars to buy the same stuff, prices rise.
How does the Fed produce more dollars? It lends them into existence via the banking system. Normally we think of money borrowed by one party as being lent by another, but in our banking system some of this borrowed money didn’t exist prior to the loan being made. It was conjured up from nothing within the banking system. If the amount of borrowing and lending are in equilibrium at a given rate of interest, the Fed can induce net borrowing by lowering the rate of interest. This results in more dollars being created.
The crucial point to note here is that these dollars have a temporary existence. The banking system doesn’t just give money away, it lends it out and expects it to be paid back. When more dollars are repaid than borrowed the supply of dollars decreases. What’s more, the need to acquire dollars to repay the dollars borrowed represents dollar demand. This dollar demand is what balances dollar supply and is what prevents the value of the dollar from going straight to zero.
We’re now in a position to understand where deflation comes from. If at a given value of the dollar the demand for dollars exceeds supply of dollars, the value of the dollar will increase until supply and demand are matched.
Since the ultimate source of demand for dollars is debt, debt is the ultimate source of deflation.
But wait … dollars are lent into existence in the first place … the creation of debt is how the Fed produces inflation. This means that the cause of deflation is inflation. Let’s let that sink in a moment:
The cause of deflation is inflation.
This makes sense on the intuitive level. Only that which has first been inflated can deflate. So not only is Bernanke wrong in saying inflation is necessary to avoid deflation, he’s 180 degrees wrong. The way to avoid deflation is to avoid inflation.
This poses a bit of a problem, no? The same tool that the Fed uses to reap inflation sows the seeds of deflation. So long as the creation of money relies on the creation of debt, permanent inflation is not possible. Ben Bernanke’s steady inflation is a fantasy. The deflation of 2008-2009 was a direct consequence of the inflation of 2002-2008.
Let’s look at this a bit more granularly. In 2002-2008 the Fed used the housing market as a reservoir for the debt creation it needed to spike inflation. When the debt became too great for borrowers to bear, that failed, leading to a deflationary crash. That crash was arrested by turning to the US government as the next borrower. Unfortunately even after the system had recovered the zero interest rate policy continued, entraining corporate America and much of the rest of the world in a new excess of debt. So if this view is correct we should expect another round of deflation as this new debt bubble deflates. It will first appear in real time markets such as stocks and commodities. Come to think of it, we’ve been in such a phase for most of this year.
Can Bernanke’s dream of steady, positive inflation ever be realized? It doesn’t seem likely. Markets just don’t work that way. If people become convinced that a security is assured to decline in value, they can take a short position in the security and be guaranteed a profit. Whether that security is issued by a central bank and called a currency is immaterial. And shorting a currency is as easy as taking out a loan, whether it’s used to buy a home, a car, stocks, or anything else. When just about everybody shorts the currency against just about every imaginable asset, a short squeeze is on the way, and the only way to prevent that is for interest rates to be higher than the rate at which the currency depreciates. If they are held below that rate for a sustained period of time, as they were for most of the last ten years – ironically in pursuit of a steady positive rate of inflation – deflation is inevitable.
Not only that, but if Dr Bernanke succeeded in permanently and steadily depreciating the dollar, the economy would collapse too. Everybody could make money just by shorting dollars. Just borrow money and buy stuff. No one would need to work, so there would be no food, medicine, power, trash service …
Making financial and economic predictions is an inherently hazardous enterprise. But logic dictates that certain things are inevitable. The current debt based monetary system will end. A steady positive rate of dollar depreciation will end. The sooner the realization sets in the sooner the damage caused by trying to make them keep going will end.