Friday, August 01, 2008

What is inflation?

Paul Krugman seems to think that inflation is a change in general price levels. I believed the same thing, but I've found that it's an unhelpful way to think about inflation. Changes in general price levels are, in fact, a composite of two factors: 1) dilution (or concentration) of the money supply, and 2) other factors, such as supply and demand, that genuinely change prices. When Milton Friedman said that "inflation is always a monetary phenomenon" he was talking about 1.

The US is currently experience a dramatic reduction in money supply, as credit and investments made in the past 8 years have been revealed to be worthless. The US has too many strip malls, office buildings, and houses. The prices for houses remain far in excess of their worth from a DCF perspective, and the non-residential real estate crash is just beginning. These were loser projects, and their existence is the same as a pile of dollar bills being set on fire. Money supply is shrinking.

On the other hand, the Fed is printing money like there is no tomorrow, and for the fiat dollar, there may not be. Taking on the huge liabilities of Fannie Mae and Freddie Mac, taking on investment banking toxic waste, running large deficits, essentially all increase the money supply and give that new money to investment banks and the housing Agencies. This money is being taken from the 3 or 4 American chumps who actually save money, and the Chinese.

So, is the net effect of this an increase or decrease in the money supply? Is there inflation or deflation? And how does this impact the latest bubble we see in commodity prices?

Suppose, just suppose, that there is someone out there who is not a currency speculator, and just wants a safe place to store value. I know, it's a crazy idea, but work with me here. Suppose that person decides that the US financial system, where the Fed prints dollars and gives it to banks who get rich wasting it, no longer represent a good store of value. Where do you go next? Do oil or gold sound like better bets?

Paul Krugman thinks that the commodity bubbles are unrelated to dollar dilution, and so the Fed should continue printing like there is no tomorrow. I think Paul is wrong -- the commodity bubbles are directly related to dollar dilution, and continuing to print money will just make things worse. I don't think wages in the US will rise, I think they will continue to fall in relative terms, and the US will be locked into a long term deflation trap, like Japan.

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