Saturday, September 25, 2010

THE GREAT DEBATE

It is our conjecture that inflation is always a monetary phenomenon and willing policymakers have the ability to create inflation. Now, before we delve any further, we want to make it clear that inflation is an increase in the supply of money and debt. Conversely, deflation is a decrease in the supply of money and debt. Furthermore, it is critical to understand that an increase in the general price level is a consequence of inflation and a decrease in the general price level is a consequence of deflation. Most importantly, despite what you may hear elsewhere, you should keep in mind that a booming economy (operating at maximum capacity) is not a pre-requisite for inflation.



Now, if you reside in the deflation camp and believe that inflation cannot occur in a weak economic environment, you need to visit Zimbabwe and meet Mr. Mugabe who will explain how you can create hyper-inflation at a time when a nation is facing an economic depression! Whether you like it or not, Zimbabwe’s hyper-inflationary saga clearly shows that despite a huge output gap, surging unemployment and a bankrupt economy, reckless policymakers can succeed in creating massive inflation.



Look. We do acknowledge the fact that the economies of the developed world are struggling and they will probably remain weak for several years. We also accept the fact that the aggregate demand in these troubled economies will stay well below the available capacity (output gap). However, contrary to the deflation camp, we totally respect the money-creation abilities of the central banks. Accordingly, we firmly believe that in order to avoid sovereign defaults in the near-term, the Federal Reserve and the European Central Bank will create unprecedented inflation.



Already, short-term interest-rates in the US and in Europe are at extremely low levels and real short-term interest-rates are negative. If such a loose monetary policy fails to create inflation, you can bet your bottom dollar that these central-banks will unleash even more rounds of ‘Quantitative Easing’. Needless to say, such reckless monetary-inflation will dilute the existing money-stock even further and reduce the purchasing power of money. Okay, enough about the inflationary bias of the public-sector, let us now move on to the private-sector.



As far as the private-sector is concerned, you may recall that after the credit-bubble burst two years ago, commercial-bank credit in the US started to contract. After all, this debt repayment by the private-sector was a logical response to the crisis and for 17 months, commercial-bank credit declined by roughly US$700 billion. In fact, it was this private-sector debt contraction which prompted many economists and investor to enter the deflation camp.



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