Inflation or Deflation?

With the recent rise in commodity prices throughout the world, much attention has been focused on the threat of inflation to the US economy.  While in 2000 and 2001, when the stock market was imploding, many feared an asset market collapse, in recent years concern has generally shifted to the potential for consumer price increases caused by excessive monetary liquidity in conjunction with an energy crisis.  These fears have been exacerbated by comments made by Ben Bernanke, Chairman of the Federal Reserve, who at one point claimed that deflation could always be avoided by just dropping money from helicopters if need be.  While printing money can always, in theory, defeat deflation in the long term, with the large amount of debt in the US economy, there could very well be a painful period of deflation before the Fed's efforts to debase the currency have any effect.

The Fed's inability to control deflation in the short term is based in the sheer magnitude of the debt overhang in the US.  Total credit market debt is currently over $35 trillion, while the total amount of all currency in circulation is only $750 billion.  Though the Fed can create unlimited amounts of electronic currency in the system, it cannot force banks to lend, or consumers to take out loans.  The only certain course for inflation creation is to print money, yet even with a massive amount of currrency creation, the Federal Reserve and the US Treasury would be ineffective in combating a fall in the money supply caused by declining asset values.  For example, if the total credit market debt in the US were to fall by ten percent, perhaps due to declining real estate values and associated loan losses at banks, the effect on money supply would be a loss of approximately $3.5 trillion.  Even if the monetary authorities succeeded in printing two or three times the amount of all currency in circulation, which would be highly unlikely in the short term, the net effect on the economy would still be deflationary as reduced credit market debt overwhelmed any increase in currency in circulation.  The great run-up in real estate values in recent years, and the correction currently being experienced in this asset class, portend a difficult problem for a Federal Reserve that may not have an appropriate weapon to combat a debt market implosion.

For a real world example of the power of an asset market collapse, one has only to look to Japan.  In 1989 the Japanese stock market peaked, and soon after the real estate markets topped out as well.  More than sixteen years later, wholesale prices in Japan are below their 1989 levels.  In the years after the peak of Japan's credit bubble, the stock market fell by approximately 80%, and residential land prices fell by more than 70% before stabilizing recently.  These declines occurred despite the central bank's efforts to rapidly expand the domestic money supply.

In the long term, it seems that the Fed will surely succeed in printing enough money to alleviate the weight of debt in the economy.  In the short to medium term, however, the debt market appears likely to experience a painful adjustment as asset prices adjust and a period of deflation takes hold.