The Case Against Inflation

Many pundits suggest--with varying degrees of conviction--that we're headed for a bout of inflation. They do have a point. Prices are obviously going up--the May CPI print was up 5.2%. But this is often seen as a one-shot response to the end of the pandemic, as supply chains readjust and changed consumer preferences are accommodated. Inflation, properly understood, is more than a once-off jump in prices--the Fed terms this as transitory--but instead a continuous escalation over an extended period of time.

The case for genuine inflation beyond the transitory rests on the "printing money" argument. Peter Schiff is the loudest exemplar of this school, where he basically channels his inner Milton Friedman: 

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.

The Treasury is issuing too many bonds, and the Fed is printing too much money to buy them, effectively monetizing the Federal debt. Interest rates are being kept arbitrarily low, and the result has to be sustained inflation.

A more subtle and sophisticated version of this analysis comes from two leading economists: John Cochrane and Arnold Kling. I very much enjoyed a lecture by Mr. Cochrane, and I learned much from a subsequent explication by Mr. Kling. Together they have dented my faith in the long-term secular trend toward deflation. They both make compelling arguments which I feel unqualified to summarize--so I encourage you to attend to those original sources.

Still--I'm gonna argue for deflation, or at least disinflation. Let me count three reasons.

1. Fundamentals: These include demographics (declining and aging populations), technology (automation), and globalization (more efficient supply chains). I believe this is deflationary--but of course I'm ignoring Mr. Friedman's dictum. If inflation really is only about money, then the fundamentals don't matter.

2. History: Large deficits have not yet resulted in inflation. Japan has been running huge deficits for decades, and they're in a seemingly permanent deflation cycle. The (then) huge deficits the US incurred in 2008-9 did not lead to inflation--again quite the contrary. Europe has experienced the same phenomenon. Perhaps you'd have to go back to the end of WWII to find a counter-example.

At very least, the empirical result is that government deficits don't inevitably lead to inflation. In fact, they seem deflationary. One can always argue that "this time it's different," and maybe it is. But don't count on it.

I have no obvious explanation for these empirical facts, but somehow Mr. Friedman is wrong.

3. Supply and demand: There is clearly a market for money--a subject which I now realize I know nearly nothing about. (I have pre-ordered Scott Sumner's book The Money Illusion. I'm hoping that provides me with an introduction. Mr. Sumner is a good writer.) Obviously the money market depends on total output and interest rates. It must also depend on how one defines money. Misters Cochrane and Kling define it very broadly.

But there is a money market, which has to be approximately the same thing as a liquidity market, which depends on a bunch of things that I don't understand very well. So I can't give you a coherent, analytical explanation, but I can tell you a story. It's cartoonish, it's fiction, and it takes place in the near future, perhaps a year or two from now. I hope it captures some basic ideas.

I'm a really lucky guy. No, I didn't win the lottery, but it's almost as good. Between the CARES act, the first stimmy check, my proceeds from the Human Infrastructure Bill, the second and third stimmy checks, the very generous Fund to Stimulate Retired College Professors Act, along with the fourth stimmy--with all that I managed to put together a million dollar stake. I went condo shopping in Miami Beach.

I paid for it in "cash"--actually a certified check for a million bucks. The seller turned out to be an old lady named Louise. She was too frail to be living alone and planned to move in with her daughter's family in Ft. Lauderdale. Louise didn't trust the stock market, and she'd never heard of bitcoin, so she took her check and marched down to the local bank and deposited it. The teller did her job--the check was endorsed, scanned and put in a bin with the five other paper checks that had come in that day.

But the bank manager--Elmer--was royally pissed. A $1MM deposit shows up as a liability on his books, and unless he could turn that into a moneymaking asset it would impair his bank's profitability. It might even hurt him with regulators, who may insist that he raise additional capital.

There were other issues besides. Some other customers (people less fortunate than me) were using their stimmy checks to pay off their credit cards and to pay down mortgages. There was so much money floating around that nobody wanted to borrow anymore. Last month Elmer only got one application for a new credit card--it came from Tom, who had a FICO score of 350. Not worth more than a $1,000 credit line, but better than nothing.

Elmer needed that million bucks like he needed a hole in the head.

A short term solution was the reverse repo window at the Fed. There Elmer could buy a T-bill in exchange for cash, on which he would collect some tiny rate of interest. It got rid of the cash--but only overnight. The next morning he'd have to return the T-bill and take the cash back (now with interest). Yeah, he could repeat this night after night, but that gets old real quick.

Then he could try to buy mortgages from other banks. This is a version of the "hot potato" problem, where banks try to cajole/fool/cheat their competitors into taking cash off their hands. The problem is there weren't very many mortgages for sale (folks like me were paying cash for houses), and no bank wanted to sell them because, like Elmer, the last thing they wanted was cash.

If something doesn't happen quick, then disaster will strike. Eventually the checks will clear, the funds will settle, and Wall Street will grind its way to the inevitable conclusion. Disaster will arrive at Elmer's bank in the form of a Brinks Armored Truck loaded with 10,000 fresh, clean, sequentially-numbered, just-printed $100 bills--straight from the Fed.

If Elmer couldn't even dispose of a million bucks in electronic format, just what was he gonna do with the actual, physical bills? They'd just sit in his vault, pose a serious security risk, and gradually decay from the elements (even in a climate-controlled safe). His Board of Trustees would never forgive him.

Fortunately, at the last minute the Fed came to Elmer's rescue. They offered to pay interest on excess reserves. OK--it was only 0.000001%--but that's infinitely better than the disaster scenario. So that's where the money went--back from whence it came--the Fed's vaults.

And there it will sit, indefinitely--or at least until the computer bugs eat all the hard drives and everything is forgotten in the mists of time.

Please tell me where you find inflation in this picture?

Further Reading:

• Peak Bitcoin?
• Book Review: The Future of Higher Education
• Louis Proyect and the More-Poverty Solution