Depressions are Highly Inflationary: Evidence from the Federal Reserve



For the third time since 2008, financial markets are pricing in a deflationary rather than inflationary future. The reasons for this are understandable. There is now strong evidence that global economic activity is slowing. The euro-area banking and sovereign debt crisis is worsening. The US is heading towards a so-called ‘fiscal cliff’ in 2013, implying a recession. And all this is occurring without global GDP having surpassed its pre-2008 peak. Notwithstanding multiple rounds of massive, Keynesian-inspired, theoretically inflationary stimulus, deflationary pressures are building anew. Does this imply that we face a deflationary future? To answer that question, we must study carefully what happened in 2008-09. When the deflationary push came, policymakers responded with an even larger unconventional inflationary shove. Deflationists beware: There is clear evidence that, under an elastic, fiat currency regime, the deflation endgame is, paradoxically, inflationary.

DEFINING TERMS Economists have a word for recessions that occur prior to a previous GDP peak: A depression. Yes, when the normal economic growth and business cycle course of events fails to materialise, with each peak in activity surpassing the former, you are no longer in recession, however severe. You are in a depression. Well, now that leading economic indicators the world over point to a severe slowdown ahead, to paraphrase US Treasury Secretary Tim Geithner: “Welcome to the Depression”.1

It has been some time since the world experienced a depression. The US and much of Europe experienced one in the 1930s. Great Britain led the way already in the 1920s. Prior to that, to find a depression not confined to one country but that spanned much of the globe, you need to go well back into the 19th century.

Economists have a habit of associating depressions with deflation, monetary and price. Let’s quickly define these terms too: Monetary deflation is a general contraction in money and credit, not merely a slowing of money and credit growth. Price deflation is a general decline in the price level for consumption goods, not merely a slowing of price increases.

It may seem obvious that an economic depression should be associated with both monetary and price deflation. After all, a prolonged period of weak economic growth implies weak demand and, hence, falling prices. But what about the monetary unit, the numerator of all prices? Recall that, during

For those who don’t recall, Secretary Geithner penned an op-ed in the Wall Street Journal back in August 2010, titled Welcome to the Recovery. I was not alone at the time in thinking this was either demonstrable ignorance or a sick joke. With Geither now expressing his desire to leave the administration, I lean toward the former view. This link to the article is here.

the 1930s, the US was still on the gold standard that had been abandoned by just about everyone else already in the 1920s. (Great Britain devalued and left the gold standard in 1931. The US would eventually devalue in 1934, although remain on the gold standard.) Through most of the 19th century, with the exception of the Civil War, ‘greenback’ period, the US was on the gold standard too, as was Europe.

What this implied was that the money supply was inelastic, that is, while economic policymakers might try to stimuluate demand in various ways to buffer a downturn, lowering interest rates and/or expanding the supply of money was not one of them. Indeed, under a gold standard, in the event that demand falls and an economy enters a recession, it is essentially automatic that the supply of money stays more or less constant and that the general price level falls. (The supply of credit, however, is likely to contract as unserviceable debts are restructured or defaulted on.) Once the price level falls sufficiently and bad debts are written off, economic growth then resumes. As the world is no longer on a gold standard, we take it for granted today that policymakers will normally lower interest rates and expand the money supply in a recession and will do so rather more aggressively or even unconventionally in a severe recession or depression. But then why on earth do we still assume that depressions are deflationary? Indeed, based on available evidence, it would be more accurate to conclude that, if not on a gold standard, depressions are highly inflationary!

Don’t believe me? Well, let’s look at some charts of the US money supply, narrow and broad:


Depressions are Highly Inflationary: Evidence from the Federal Reserve


Now, the same cannot be said for bank credit, which contracted somewhat in 2009-10 before recovering in 2011, as we see in the chart below.



So, to be fair, we did observe credit deflation in 2009-10. But we did not observe monetary deflation, rather the opposite. Beginning in 2011, following on successive rounds of US monetary and fiscal stimulus, a general money and credit inflation has been observed and continues right up to the present.

It should perhaps therefore be no surprise that, as we turn our discussion to price inflation and deflation, we have seen more of the former than the latter. In the next chart, we see what has been happening with both producer (commodity) and consumer prices.


Now if a Martian were to come round to earth to observe the economy and these various statistics, do you think they would conclude that depressions are inflationary or deflationary? The answer is obvious.

This is not to say that there is not deflationary pressure out there. By all means there is. The financial crisis of 2008-09 was a classic deflationary rush to the exit that, had it been left to unfold without policymaker intervention, would have collapsed a substantial portion of the global financial system. But for all those ‘deflationists’ out there who believe that, under elastic, fiat currency regimes, deflationary pressures result in either monetary or price deflation, please reconsider. The evidence points to exactly the opposite: UNDER AN ELASTIC CURRENCY REGIME, DEPRESSIONS LEAD TO MONETARY AND PRICE INFLATION, NOT DEFLATION!

I know I’m not going to make many ‘deflationist’ friends with that comment. And there are some clever ‘deflationists’ who predicted the 2008-09 crisis. But it resulted in inflation. If we are going to approach investment strategy in the right way and reach the right conclusions, the facts are a good place to start.

Let’s consider now how the natural deflationary pressure associated with the 2008-09 crisis resulted in monetary and price inflation instead. As seen in the charts, as the crisis unfolded, the Fed expanded the monetary base. Economists, in particular Keynesians, often point out that

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