Why we might soon see big-time deflation

I'm skeptical of all of the soft sciences.  I'm especially down on economists, be they Keynesian or Austrian.  If they were merely stupid, they would get maybe half of their predictions right, but these fellows manage to get nothing right.  When the NYT started touting inflation, I braced for deflation.

The solons tell us the increased money supply from the stimulus packages will chase fewer goods and so increase prices.  So how can the increase of money lead to deflation?  Turns out that the explanation is pretty straightforward.  In short, the new money is invested in a lot of worthless stuff, and that worthless stuff is not worth any money.  The "fiat" money (quoting Austrians) as conjured into existence by our Fed disappears as easily as it appears.

Let me explain.  New money is created when the Fed buys bonds and other investment instruments from banks and other large investment companies, paying with dollars that the Fed has just created.  The "Q.E.s" merely accelerate and magnify the process.  The banks and other financial institutions invest this money by lending for mortgages or building projects or by buying assets like stocks, real estate, and other bonds.

The result is that all sorts of assets including stocks (equity investments in American companies don't produce much anymore), bonds, bitcoins, gold and other commodities, real estate, and the art markets have all been bid up to dizzying levels.  This fiat money is seen as wealth by the investors.  More importantly, there is a "wealth effect," which means that people feel they can spend money as their investments increase in price. 

As you might expect, only a small amount of this new money is distributed to the nobodies.  They might get wages as construction workers or, as we have recently seen, COVID-19 stimulus checks.  (Thomas Lifson of AT has detailed that a lot of this money is invested in the stock market.)  In the last year, their productivity and wages have been low.  Despite government checks, their income really has not changed much.  The net result is that there is not much increase in the money circulating on consumer markets, where people buy the needs for their daily living.  The CPI has been flat.

Inflation has happened only in the investment markets.  This new money is in part from the creation of the Fed and in large part due to the price amplification resulting from the frenzy as individuals and institutions invest their money and bid investments up to dizzying levels.  Everybody feels richer and is spending more money. 

I called this bid ask money.  It is priced at the most recent market clearing transaction by two anonymous individuals who exist somewhere on the planet.  The thousands or sometimes millions of current owners of these assets have no say in the price that shows up on their screens.  None.  Their wealth is determined only by that latest bid and ask. 

The bid ask money of the nobodies is invested in IRAs, pension plans, insurance, stocks, and housing.  They feel rich right now, and many continue to spend.

But what happens when markets collapse?  People will realize that these are bubbles and head for the exits.  Tax increases or minimum wage increases could cause even more unemployment and business closures.  What happens if China, Japan, and the Gulf Arabs lose confidence in U.S. treasury bonds driving up interest rates, smothering commerce and new projects? 

The mega-banks, investment firms and insurance companies might well collapse.  (I never understood why their failure should cause me problems.  I sat on the board of our credit union in Grand Rapids for most of the '90s.  In principle, we were just like Goldman Sachs, but in addition, our board got a really nice dinner once a year.)  As Big Finance implodes, our government economists will chase along, always worsening the problem with even more insertions into the capital markets, always with borrowed "money."  My little co-op credit union with its $150 million of saved money will have to step into the breach.  Projects funded will not be grand, but they will be well chosen.  In the background, bid ask money shrinks to nothing.

But what happens to the nobodies?

How rich or willing to spend is the man who bought the Dow Jones Industrials at 33000 when it falls to one thousand, where it was forty years ago?  When there are no jobs?  Or when he foresees that a house will lose half its price in the next year?

Less money in the hands of the nobodies sounds like deflation.  The official recognition of deflation occurs when buyers have less money to pay for as stuff and force merchants and other suppliers to lower their prices.  Debtors will not be able to service their loans, and bankruptcies will accelerate.  New investments will shrivel, and only those likely to succeed will be made.  Jobs will be harder to find. 

That being said, a deflationary spiral is not necessarily bad.  Japan had its investment bubble burst nearly 30 years ago and has muddled on in deflation since.  The USA had periodic deflationary periods during the nineteenth century, when it had its greatest period of growth.  Some of the most durable businesses in the twentieth century were started during the Great Depression, also a time of deflation. 

The good news is that economists will be disgraced but, unfortunately, not jobless.  These racketeers will conjure yet more self-serving fiction to explain their failures.

Erwin Haas, M.D., MBA writes in West Michigan.  He was a flight surgeon in Vietnam and served as a city commissioner in Kentwood, Michigan.

Image: PublicDomainPictures via Pixabay, Pixabay License.