Monday, August 18, 2008


The inflation-deflation question is to me the trickiest macro-economic call at the moment, probably due to the fact that it is really a political question at bottom. If we still used gold as money, the limited supply would mean that when the music stopped after the exuberant debt creation party, the room still had the same number of chairs. The fact that we print money calls this into question, though it does not assure it, as you still have to get that money into people's hands so that they spend it and it flows through the system. Interfliudity makes an interesting comment on this point, which speaks directly to the two great examples of modern deflation:
Japan's experience in the 1990s and the US' in the 1930s are often cited to suggest the inevitability of deflation, despite monetary policy heroics. But in both cases, the deflating country had a large, positive international asset position. To the degree money was owed by foreigners in domestic or pegged currency, the "national interest", looking past winners and losers, was to tolerate deflation.
This actually has a compelling ring to it -- to inflate or deflate is a political question that depends on whether you are a debtor or a creditor. If you are a net creditor nation, even though deflation is painful in domestic economic terms, it's even worse to let your debtors off the hook. As a net debtor, there's no reason to accept the pain of deflation, and the political calculation will always be to inflate.

The question in the current case of the US is to wonder aloud whether the US can engineer a quiet bailout where we exchange China and the gulf's ongoing support of the dollar for an agreement to actually pay these bills (i.e. not inflate). This would allow us to avoid the nastiness of a default, including a major currency collapse and a severe recession, and gradually bring our balance of payments in line via years of subpar growth and reduced standards of living. Theoretically you could engineer a kind of cancelling of the inflationary and deflationary forces -- debt restructuring as opposed to simple default. I'm not sure that's a geopolitically viable course of action unfortunately.

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