Tuesday, November 04, 2008

In Praise of Savings and Deflation

Dean Baker, whom I like, has a post where he gets very confused about deflation. This is understandable -- the thinking around deflation is very confusing. After all, if iPhones go from being $500 to $200 we are all happier (and richer) but this contributes to deflation. If flying from San Francisco to New York goes from costing $20,000 to $200 (someone invented Southwest) again, this would contribute to deflation, but we would all be happier (and richer). How can something that makes us all happier (and richer) be bad? How can something that impoverishes us all (inflation) be good in small doses, but bad in large doses. If this strikes you as a kind of economic homeopathy then you are not alone.

But first, to Dean:
There is no need to look to credit crunches or deflation. The problem is quite simply a massive lost of housing wealth, compounded by the recent loss of stock wealth. The only cure will be finding alternative sources of demand. In the short-term, government will have to fill the gap. In the longer term, it will be necessary to get the dollar down so that the country's trade is closer to balance.
Housing is a levered instrument, which means that prices are a function of financing. For a long time I believed that financing should have no impact on prices but I was wrong -- for goods purchased primarily with debt, price is directly driven by the cost of that financing. Houses would cost much more if you needed to pay in one lump sum. Since credit is money, a collapse in the price of housing is a reduction in the amount of money in the world. When the amount of money in the world goes down, the value of the remaining money goes up -- the money has been concentrated. The $20K you have in the bank is looking much better now that houses cost $100K instead of $300K.

Alternatively, when money (credit) expands, the value of the money that was there to begin with goes down (the old money is getting diluted). Houses now cost $300K again, and your $20K savings account is too puny again. D'oh!

This expansion/dilution of the money supply can be hidden by changes in demand or technology. Money supply may increase (dilution, causes prices to go higher) but some engineering mastermind figures out how to make an iPhone for 50% less. Prices stay the same, the CPI shows no change, but savers have still been robbed because instead of having access to a $100 iPhone they still have to pay $200 for it. D'oh indeed.

When Greenspan, the great Monetarist, talks about whether or not to factor bubbles into interest rate decisions, I shake my head in disbelief. Credit bubbles are, by definition, an uncontrolled increase in money supply. For a Monetarist, who (correctly) believes that inflation is always and everywhere a monetary phenomenon, ignoring credit growth is like an oncologist ignoring a group of uncontrollably dividing cells. There are clear grounds for a malpractice suit. Also note that there is more to credit than interest rates -- there are down-payments, prepayment penalties, rate resets, subsidies, etc. etc etc. A central banker who thinks he can control money supply (credit) just by controlling interest rates is wrong, he's wrong when the economy is in a liquidity trap, and he's wrong when the economy is in a credit bubble.

Let's take a moment to consider just how much of the economy a central bank needs to control given our current credit infrastructure.


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