Sunday, November 30, 2008

Why 'Expected Deflation' Can Be a Good Thing

I am a bit more optimistic about the economy these days (up to a 3 on a 10 point scale, up from a 1 a few weeks back). Why? Well, before I go into my theory lets rewind and review some theory by some actual economists.

John Maynard Keynes, whose work is becoming mainstream once more, suggested that a developing recession can be cured through an expansionary monetary policy (i.e. increasing the money supply) when the desire of individuals to increase savings leads to an environment in which the demand of individuals is less than that required to employ all the economy’s resources.

On the other hand, Milton Friedman believed that a spike in the money supply wasn't the answer. The reason is that Friedman believed when the money supply increases, it will increase both productivity and inflation; the more expected / transparent this increase, the more likely it will only be reflected in a new inflated price level, as prices for goods and services are quickly increased ahead of the money supply. Friedman famously quoted Abraham Lincoln in explaining why this type of move had worked in the past, but would not work going forward:

"You can fool all of the people some of the time, and some of the people all of the time. But you can't fool all of the people all of the time."
Expected Deflation + Increased Money Supply = Good
So, where does this leave us? We are without question increasing the money supply by an amount without compare in our nation's history. However, expectations for inflation are not only low, but as can be seen below negative (as of Friday's close, you can purchase inflation swaps based on CPI that price in deflation at 2% annualized over the next two years!).



I believe this is a good thing (not deflation, but expected deflation in the wake of expansionary money supply). If this money gets into the proper channels (i.e. mechanisms / individuals that will "recirculate it"... this helps), while both corporations / households expect deflation so keep prices / wage demands low or negative, then the "real" price of goods and services could become strikingly cheap, thus increasing productivity.

For any of this theory to work in the short-run, inflation needs to come in above the "expected" level. Thus, it now becomes a race between the deflationary pressures associated with the natural course of deleveraging and the inflationary pressures associated with quantitative easing (great post here at Credit Writedowns about the latter). While I am not yet outright optimistic, I am MORE optimistic that new policy will be ahead of the curve and inflationary pressures will win out.

If this happens, then our economy should be saved from a depression.