Monday, September 28, 2020

Long Term Inflation or How Today’s Governments Will Never Pay Their National Debts Back Honestly

Click here to read the original Cautious Optimism Facebook post with comments 

6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff looks at the very real prospects for higher inflation over the long-term. Anyone interested in understanding more about the national debt may want to read on. 

The Economics Correspondent has written repeatedly he isn’t worried about this year’s Fed Covid QE fueling price hyperinflation. To read his past entries on short and mid-term inflation click the following links:

However long-term inflation is more concerning although again, not because of the Fed’s massive quantitative easing of 2020. Rather, the catalyst is more likely to be the exploding national debt.


Because the federal government has so far borrowed nearly $3 trillion to spend on Covid bailouts, unemployment, assistance to state and local governments, and direct payments to households, the public debt has exploded to $26.8 trillion as of this writing. Meanwhile GDP contracted heavily in the spring although it should bounce back somewhat as economies reopen.

Exploding debt and a shrinking or more slowly growing economy means a skyrocketing debt-to-GDP ratio, the number that really matters to economists and policymakers.

Before the crisis the debt-to-GDP ratio had held fairly steady slightly above 100% from Barack Obama’s departure right up to March of 2020.

However with the Covid crisis the math quickly changed. Now the debt is $26.8 trillion and GDP, while erratic, is down somewhere closer to $20 trillion (it’s hard to say for certain since we’ve only gotten one full quarter’s GDP during the Covid pandemic). In the blink of an eye the debt-to-GDP ratio has risen from 107% to somewhere around 135-140%, eclipsing the all-time record of 120% set at the end of World War II.

As the debt-to-GDP ratio soared through the summer, the Correspondent worried more about inflation in the long term, but not due to some sort of “accident” resulting from a stimulus program like QE. Rather the concern was deliberate Fed policy to dilute the real value of the concerning national debt.

Some readers may already be aware of this longstanding trick by governments and central banks, but for those who aren’t just keep on reading. This might be one of the most informative and depressing things you’ll learn this month about fiscal and monetary policy.


Governments have shown repeatedly over history that they almost never solve their debt problems through honest accounting—ie. raising taxes or preferably cutting spending. Since both of those policies are unpopular with the public and tend to get monarchs deposed or politicians thrown out of office, governments have usually resorted to inflation to lower the real value of the debt.

The trick goes all the way back to Dionysius of Syracuse (ancient Greece: 4th century BC) when he restamped all drachma coins at double their original denomination to solve his own overborrowing problems.

Or to the Roman Emperor Diocletian who helped slowly remove 98% of the silver content from the Denarius coin, using the siphoned silver to create more coins and inflate away the value of the imperial debt.

Even in the 20th century “a little more inflation” is how the U.S. government managed to whittle a debt-to-GDP ratio of 120% after World War II down to 30% by the 1970's. Washington ran deficits in 27 of the 35 years between 1945 and 1980, yet the debt-to-GDP ratio still fell by three-quarters over that time.

How? By both applying economic growth (real GDP growth) and inflating away the dollar's purchasing power from $1 to 24 cents over those 35 years, Congress never had to pay back 1945’s $250 billion nominal public debt honestly.

Back in 1945 a national debt of $250 billion was a staggering, unthinkable number. Almost no one thought such a huge sum could ever be repaid at a time when U.S. GDP was only $228 billon. But by 1980 US GDP had risen twelvefold to $2.85 trillion in nominal terms, so a $250 billion debt didn’t seem so bad by then.

But economic output had not increased twelvefold, only tripled, the result of population growth and higher productivity.

To upsize a tripling economy to twelve times its original size in nominal terms required price inflation which was devotedly provided by our central bank: the Federal Reserve. And hence what was considered an insurmountable national debt in 1945 became quite manageable by 1980.

Fast-forward to today and the debt-to-GDP ratio has grown to record heights once more in 2020. Hence the Correspondent believes the Fed will help out the very Congress that grants its monopoly power over base money by ratcheting up inflation over many years yet again—all to effectively repudiate its debt obligations through sleight of hand.


Well this is all what the Correspondent was thinking this summer. Unfortunately the Fed beat me to writing about it.

Late last month the Federal Reserve made a historic policy change announcing it was abandoning its long held “price stability” target of 2% annual inflation for instead an “average inflation target” of 2%.

Since official inflation has run closer to 1% for the last twelve years, the Fed argued it should run inflation higher than 2% in coming years in order to raise the “average” closer to 2%.

The new policy is inconsistent with its previous rationale for targeting 2% year-to-year, and the Fed’s policy statement included quite a bit of mental gymnastics to explain why higher inflation going forward to offset lower inflation more than a decade past is somehow a good thing.

But the real, unspoken reason is clear: The national debt is out of control—at levels that now even the Fed is worried about—and policymakers are finally acting to do something about it.

The solution will be higher inflation.

Just a little math to demonstrate the power of growth and inflation to reduce the federal government’s debt liability is illustrative:

If a $20 trillion economy grows in real terms by 2% a year, in 15 years real output will be $27 trillion (1.02^15 x $20T = $26.9T).

Then if the Fed also creates enough new money to produce 1.5% annual inflation the $27 trillion real economy grows to $34 trillion in nominal terms without a single extra widget being produced. It’s all just higher prices.

Voila, with no reduction in our government’s debt position of $26.8 trillion, the debt-to GDP ratio falls from 134% to 79% in 15 years--all through growth and inflation.

However if the Fed produces higher inflation—say, 3% a year for 15 years—the $27 trillion real economy grows to an even higher $42 trillion in nominal terms. Again, not a single extra widget is produced in the real economy, yet the debt-to-GDP ratio is more than halved from 134% to 64%—1980's levels—without the government paying down a penny of the national debt.

And history shows Congress and future presidents won’t be content to leave it at that. The Economics Correspondent predicts—in fact guarantees—they’ll take the falling debt-to-GDP ratio as license to find new ways to run even higher deficits so that 15 years from now the national debt won’t stabilize at $26.8 trillion but rather rise to $46.1 trillion or higher to reach a “sustainable” debt-to-GDP ratio of 100%.

This free lunch is made possible by the sleight of hand every government in the world uses to finance unlimited deficit spending. Keep borrowing and spending year after year, so long as growth and inflation keep bailing the Treasury out down the road.

Even President Trump was relying on it when he ran $800 billion and $900 billion deficits in the first three years of his administration. His Treasury Secretary Steve Mnuchin said repeatedly that deficits wouldn’t be much concern so long as the economy could achieve 3% annual GDP growth. A $20 trillion economy growing 3% a year in real terms and running 2% inflation can run a $1 trillion deficit with absolutely no change in the debt-to-GDP ratio. And every president before him going back to FDR played the same game.


As Milton Friedman said, there really is no such thing as a free lunch. With a hypothetical future inflation of 3% Americans and foreigners holding dollars will be the ones who pay for this seemingly magical debt payback by losing half the purchasing power of their money every 23 years, but they'll be told by the newspapers and academics that the inflation is good for them and that it “promotes full employment.”

In fact higher inflation is only a good thing for debt addicts and governments who want to spend beyond their means forever without having to pay back their accumulated debts honestly.

And as mentioned before this trick goes back to ancient Greece, but Adam Smith also condemned it famously and eloquently in his famous 1776 book “The Wealth of Nations.”

In Smith’s time most governments didn’t have the luxury of fiat money and monopoly central banks with computers that created bank reserves out of thin air. To expand the money supply and inflate prices they had to reduce the precious metal content in coins or devalue the currency unit’s definition into a lesser weight of metal.

But the fundamental principle is no different in 2020. As Smith noted nearly 250 years ago:

 "When national debts have once been accumulated to a certain degree there is scarce, I believe, a single instance of their having been fairly and completely paid..."

"…The raising of the denomination of the coin has been the most usual expedient by which a real public bankruptcy has been disguised under the appearance of a pretended payment. The honour of a state is surely very poorly provided for, when, in order to cover the disgrace of a real bankruptcy, it has recourse to a juggling trick of this kind, so easily seen through, and at the same time so extremely pernicious."

-The Wealth of Nations (Book V, Chapter III)

Tuesday, September 15, 2020

Q2 Velocity Declines A Record 26.5% and Medium-Term Prospects for Hyperinflation (Wonkish)

Click here to read the original Cautious Optimism Facebook post with comments

4 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff pondered prospects for hyperinflation during the Federal Reserve’s gargantuan spring quantitative easing. Now he follows up with prospects for inflation in the medium term.

Last April the Economics Correspondent wrote a series of articles predicting no hyperinflation despite the Fed’s unprecedented, bigger-than-2008 quantitative easing. Not only did the Fed drive the monetary base straight up this spring, but unlike 2008 its policy also resulted in a huge increase in the broader money supply (measured by aggregates M1 and M2).

Nevertheless, the Correspondent predicted plummeting monetary velocity would offset money creation resulting in very little inflation and certainly not hyperinflation.

From his April 26, 2020 post:

“During the financial crisis single-year period 2Q2008 to 2Q2009 monetary velocity fell by 17%... …the Economics Correspondent believes the Fed anticipates an even larger drop in velocity than 17% for 2020 and that the decline will easily outpace GDP’s”

Well the Q2 velocity numbers are out and they’re impressive. M1 velocity plummeted by 26.5% in a single quarter. 

Not 17% in a year. 26.5% in a quarter.

Federal Reserve official velocity records only go back to 1959, and no quarterly decline in monetary velocity for the last 60 years has even come close.

NBER velocity estimates that go back to 1869 show the same: The second quarter's collapse has set a record that goes back at least 140 years, and probably for all of American history.

And that’s why the record amounts of money created in Q2 produced not only no hyperinflation, but even a slight deflation for the quarter (CPI changes in April, May, and June were -0.8%, -0.1%, and +0.6%).

Incidentally it’s worth noting that by making this one correct prediction the Economics Correspondent now has more to his name than New York Times columnist Paul Krugman.

So now that the large spring economic contraction is behind us, what are the prospects for hyperinflation going forward?

Eventually the Correspondent’s crystal ball will cloud up and his luck will run out, but he can confidently say even in the absolute worst case there is still virtually no threat of hyperinflation. Slightly higher inflation perhaps, but not hyperinflation.

Let’s explain why.

Since the Fed launched its unprecedented easing campaigns in mid-March the money supply as measured by M1 and M2 has risen 31% and 17% respectively with those increases leveling off the last few months.

And as previously stated, falling velocity offset all of that new money.

However velocity’s rapid decline will certainly level off too if for no other reason than 26.5% quarterly declines are simply unsustainable. Another plausible reason is that the economy has been reopened, millions of workers have been rehired, and consumers and businesses are spending more money than during the spring lockdown. Under those conditions velocity simply can’t fall 26.5% again.

So will a recovery in velocity be the catalyst to finally fuel hyperinflation? Once again, probably not.

Let’s take the absolute worst and highly unlikely case. What if velocity were to instantly jump back to its pre-pandemic levels right now?

Well, if we ignore GDP for the moment M1 and M2 being 31% and 17% higher would translate into a price level 17%-31% higher than in March.

Now that would be a major inflationary event and quite harmful, but it still wouldn’t be hyperinflation. And absent another giant Fed QE it would also be a “one-and-done” event.

By comparison let’s look at real hyperinflation. When people mention Venezuela and Zimbabwe hyperinflation—which many did when the Fed began its massive QE in March—they’re referring to 1 million and 11 million percent price increases—year after year after year—not a onetime hike of 17% or 31%.

So yes, if—and it’s a gigantic if—velocity returned to normal overnight the USA would experience a single major, harmful inflationary event, but it still wouldn’t be hyperinflation.

Now let's include GDP in the mix.

If velocity really did return to February 2020 levels so quickly, it wouldn’t happen in a vacuum. Such a massive spike in velocity would be accompanied by a consummate rebound in real GDP. Since according to the Equation of Exchange (mv = py) rising output reduces prices, a huge velocity rebound would be at least partially offset by increased economic activity. 

So instead of 17% or 31%, inflation would be more subdued—maybe mid or high single digits, and again just a onetime event.

And all of these scenarios assume the Fed would not react by adjusting the remaining component of the Equation of Exchange it has a greater degree of control over: the money supply.

This is where things get a bit tricky, because if velocity really did take off and rising output was not enough to offset it, the Fed would be forced to pull back some of the new money it has created. 

To do so it could sell off securities in open market operations to withdraw reserves from the banking system, or raise the IOER (Interest on Excess Reserves) rate it pays banks on the trillions of dollars in excess reserves they hold at the Fed instead of lending them out. It could also raise the traditional Fed Funds policy rate.

So a theoretical 20% increase in velocity offset by a 10% recovery in output could be addressed with a 5% decline in the money supply resulting in only a 2.6% increase in prices ($1.00 x 1.2 x 0.9 x 0.95 = $1.026).

What's the tricky part? As George Mason economist Lawrence White has stated, the Fed would have to “thread a small needle” to pull off such a feat without causing another recession.

But there’s a good chance (not 100%, but good nevertheless) that the Fed won’t even have to resort to pulling back on the money supply, as velocity will rise at a slower pace than “back to normal overnight” and to the extent it accelerates it will be accompanied by an increase in economic output which acts to restrain prices.

OK, so what about the long term, into 2021 or even several years out? The Correspondent will address the more distant horizon in the next article.

To read the Correspondent’s April 26 post predicting no hyperinflation, go to:

Friday, September 4, 2020

August Unemployment Down 6.3 Points in Four Months: Comparing the 2020 Jobs Recovery to the 2008 Recession

Click here to read the original Cautious Optimism Facebook post with comments

Unemployment rate: 2008-2020

4 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff analyzes the stark contrast between the 2020 jobs recovery and that of the Obama years… even if the media won’t.

Today the Bureau of Labor Services announced that 1.4 million jobs were created in August.

But more importantly, the August unemployment rate fell to 8.4%, far below the consensus forecast of 9.8%.

Four months ago, the unemployment rate peaked at 14.7%, accompanied by endless media headlines comparing the Coronavirus recession to the Great Depression.

The Economics Correspondent, himself author of twenty CO articles on the Great Depression, thought from the beginning that such comparisons were uninformed and ridiculous.

During the Great Depression, unemployment not only peaked at 25.9% (1933) but it remained over 10% for more than a decade (October 1930 - February 1941 to be exact).

In 2020 unemployment hovered in the double-digits just four months before making its exit.

That’s 124 months versus four. “Not comparable” would be an understatement.

But what’s even more striking about the August unemployment rate is that it’s already down 6.3 percentage points from the peak in just four months.

Let’s contrast this to the jobless picture after the 2008 financial crisis.

Under Barack Obama the unemployment rate peaked in October of 2009 at 10.2% and reached full employment, loosely defined as 5% joblessness, in September of 2015 nearly six years later.

Even as Obama was on his way out in January of 2017 unemployment was at 4.8% or down 5.4 percentage points, and it took a Trump administration to get the rate down to 3.8% (finally down 6.3 points) in May of 2018 or 8 years and 8 months later.

See chart for a dramatic visual representation:

Granted, once you’re down to full employment it’s more difficult to reduce the jobless rate as quickly, but the comparison is still worth repeating: In 2020 it’s taken four months for unemployment to fall 6.3 points from the peak. In 2009 it took 104 months. So the job recovery in the Trump era is so far moving 26 times faster than that of the Obama era.

The press was rapid-fire, trigger-happy quick to compare joblessness under Trump to the Great Depression just a few months ago, but today it’s dead silent when it comes to comparing job recoveries under Trump and Obama... or the Great Depression, or any other recovery for that matter.

So why was unemployment so much slower to fall during the Obama years? The Economics Correspondent sees two primary reasons: one beyond Obama’s control, and the other quite Obama-specific.

First, what Obama had little control over was the nature of the recession he was handed. After the 2008 financial crisis the economy was highly imbalanced and had to undergo fundamental readjustments. There was a huge bad mortgage overhang, many banks were reeling from massive deterioration in their assets and loan portfolios, and an oversized portion of the economy that had been misallocated to real estate and finance had to be diverted away to more rational lines of business.

Those kinds of adjustments take time. Not necessarily six years but they don’t fix themselves overnight either.

By contrast the economy was doing extremely well in early 2020 when it was suddenly hit by an exogenous shock. The introduction and spread of Covid-19 into the USA disrupted the behavior of consumers and businesses—even on a voluntary basis. People stopped flying and avoided restaurants, bars, movie theaters, concerts, cruise ships, public transportation, and countless other venues. Spectator sports closed their doors to fans. Many businesses told workers not to come to the office and laid off those who couldn’t work remotely.

This isolation problem was further compounded by government lockdowns that prohibited even those consumers, businesses, and workers who wanted to participate in the economy from doing so.

But there was no major fundamental problem with the economy itself.

As soon as lockdowns were loosened across the country, economic activity partially resumed and moved closer to its pre-pandemic levels. Thus unemployment has fallen rapidly from the April peak. However it will likely take a full resolution of the virus problem before full employment is possible again, and monthly job gains will probably slow from the torrent pace of the summer.

One could argue the economy was already in great shape because of Trumponomics policies and there would be some truth to that. But even a President Hillary Clinton would likely be looking at a healthier economy in early 2020 than Barack Obama was faced with in early 2009.

Second, the policy responses by the Trump and Obama administrations couldn’t be more different.

President Obama took a fragile economy barely starting to recover and hindered it further with thousands of new regulations, raised taxes (in 2012), and launched a nonstop rhetorical war on the employers who he also expected to reduce unemployment. 

Obamacare itself was a huge job killer, as businesses 50 fulltime employees or over were required to provide health insurance and thus small businesses refused to grow to over 50 workers or even laid off enough to get below 50. And large corporations cut hours to convert millions of workers from full to part time.

It’s no coincidence that the job recovery to full employment—when measured from the date of a banking crisis to when 5% unemployment was reached—was the second longest in American history at exactly seven years, only after the Great Depression itself.

Now *there* was a valid Great Depression comparison, but the press was silent on that one too.

President Trump’s response to his recession has been fairly hands off and if anything gone in the opposite direction. There have been tax refunds instead of tax hikes, and he has signed emergency deregulation instead of adding regulations, although most of the rules suspensions have been designed to speed up and facilitate fighting the virus.

Both Presidents signed stimulus legislation. While the Economics Correspondent is not generally a fan of stimulus spending, there have been key differences there as well.

The Obama stimulus focused heavily on channeling government deficit spending towards green energy companies—nearly all of which failed—and overpriced/wasteful public works programs, many of them politically motivated. 

The Trump stimulus has been focused more on government deficit financing of "bridge support" to a post-Covid recovery for existing businesses and industries, not ones he’d like to create himself.

Both stimulus plans expanded unemployment benefits. While the Correspondent doesn’t think it was a good idea to offer low-skilled workers additional payments that were more lucrative than working, the Obama stimulus extended unemployment checks for up to 99 weeks which incentivized millions to put off looking for work longer. And of course the current recession only began about 20 weeks ago so there hasn’t even been a reason to offer 99 weeks of benefits.

So the current job recovery is to date the fastest in American history, the press has suddenly gone silent with amnesia, and the contrast between 2020’s job market and that of 2009-2018 couldn’t be greater. The fast-track to reemployment under Trump is due in part to the unique and shorter-term nature of the recession, but it’s also an indictment of the job-killing policies of the Obama administration and the generally job-friendly policies under Donald Trump.

And don’t expect to hear that from the press, especially two months before the election.

Tuesday, September 1, 2020

Inflation and Deflation Fallacies Part 2: "Deflation Plunges Economies Into Depression"

Click here to read the original Cautious Optimism Facebook post with comments

Apoplithorismosphobia: (n.) The fear of monetary and economic deflation.

5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues with the his series on inflation and deflation fallacies

The view that falling prices invariably produce rapid and painful recessions and depressions is accepted almost as religious dogma among central bankers, government policymakers, the press, and many academics. 

The hypothesis, which has clearly not been closely examined historically or theoretically, is that if consumers and businesses see prices falling they will put off purchases and the loss of demand will plunge the economy into a “deflationary spiral” from which it will need decades to recover.

And according to many deflationphobists, prices don’t even have to fall. In the minds and writings of mainstream economists like Paul Krugman, Ben Bernanke, and Larry Summers no inflation or even too little inflation—say, prices rising only 0.5% or 1% per year—is enough to produce a recession or stymie a recovery


To quote British Keynesian economist Duncan Wheldon:

"Falling prices might sound like a good thing, and in individual cases they often are, but a falling general price level is usually associated with severe economic strains. Why buy anything today if it will be cheaper next week? The end result tends to be falling output, rising unemployment, falling wages and a large increase in the real burden of debt."

What could be wrong with that reasoning? Surely if prices fall, or even stay flat, no one will buy anything and we will experience another Great Depression, right?

Actually there are plenty of glitches in this reasoning. 

First, consumer and business time preferences have to be factored in. All things being equal, consumers and especially businesses tend to prefer consumption in the present over consumption in the future. 

In fact at the extreme no one really stops buying completely. Imagine if everyone stopped buying food because they felt food prices will be cheaper in a year. All of humanity would starve to death. 

The same is true for not paying rent or the mortgage or the power and gas bill. In most places we’d die from exposure to the elements. Clothes, medicine, and many other consumables are absolute necessities and no one is going to stop buying them just because they might be 1% cheaper in a year.

But what about discretionary goods? Surely if discretionary consumables fall in price then purchases will grind to a halt, right?

No. Consumer time preferences play a strong role even with nonessential purchases. 

Let’s take Starbucks coffee with 0.5% annual deflation for example. To paraphrase Austrian economic historian Thomas Woods, does anyone really believe Starbucks customers are thinking “I’m not going to have that cup of coffee this morning, because next year it will be two cents cheaper?” 

A year later are consumers thinking “Those Starbucks people must think I’m some kind of a sucker, it’s going to be another two cents cheaper next year?”

Of course not. Starbucks customers, even armed with an expectation that prices may fall 0.5% a year, are still going to buy their coffee today—because of time preferences.

But Starbucks coffee is a relatively cheap item. The savings are much larger on big ticket items so consumers will certainly hold off on those purchases, right?

Well let’s look at one of the biggest ticket consumer goods there is: cars. 

With 0.5% deflation a consumer who really wants a new car for $25,000 might be able to get it for $125 less if they wait a year ($24,875).

If they put 5% down and take out a car loan, as most consumers do, for 60 months at 4% interest their monthly payment will fall from $437.39 to $435.21: a savings of $2.18. How many people would really postpone buying a car they want or need for one year because they anticipate they might save $2.18 a month?

According to Woods, in the deflationphobists' view of the world “None of us are going to buy anything until we’re on our deathbed and then we’ll finally reach out and grab an iPhone just as we’re expiring.”

The same time preference paradigm is even truer for businesses. 

Companies that need to make their capital purchases and investments now in order to secure greater revenues and a return on investment tomorrow aren’t going to defer their plans by a year hoping to save 0.5%. In the year they wait their operations will be so disrupted (not to mention the loss of their higher revenue streams) that the costs would be far greater.

OK, well what if prices fall faster, like 1% or even 2%? 

Well no need for theory. Let’s just look at actual evidence in possibly the most deflationary sector of the economy: consumer electronics. Everyone knows if they buy a phone or a TV or a computer today, a better version will come out in six months for less money, often at a discount greater than 1% or 2%. It’s been that way for decades.

Are the phone, TV, or computer industries in Great Depression as a result? Has there been a 30 or 40 or 50 year slump in consumer electronics because no one is buying? Of course not. It’s been possibly the hottest growth industry all that time. Because there are some things that human beings just want now and they’re not going to put their entire lives on hold for a year or two just to save 0.5%... or 1%... or 2%.


And to the extent that consumers might really curb their purchases slightly the necessary result would be greater savings (ie. deferral of consumption), an indispensable key to economic growth. 

Real savings were a critical component fueling the explosive growth of the American economy in the late 19th century, or Great Britain during the Industrial Revolution, or Japan after World War II, or China in the last 30 years, as opposed to the sluggish growth plaguing most of the overconsumption world in the 2000’s. 

Because the actual physical tools and machines that make workers more productive and new technologies available don’t exist if consumers spend all their income on immediate gratification now instead of preserving some share of the productive economy to produce the advanced tools and machines that will fuel a larger, more prosperous economy tomorrow.

Deflationphobic economists assume that spending and consumption are the key to economic growth, neglecting the critical precondition of saving. Someone must forgo consumption in the present, but many mainstream economists—particularly Keynesians—believe central banks printing more money and transferring it to banks in exchange for bonds (their idea of saving) is a credible substitute for tangible capital resources. It’s not.

(Note: this is the larger concept of capital theory which the Correspondent will write about in greater detail later).


OK so the theory all sounds good, but surely empirical evidence supports the deflationphobia view, doesn’t it?

Well it just so happens we have historical evidence in the United States and plenty of it: over 100 years in fact.

From 1800 to the establishment of the Federal Reserve in 1914, prices nationwide fell about 42%. That’s slightly faster than a compounded average of 0.5% deflation per year. 

Granted there were some ups and downs in that century-plus, namely inflations during wars such as the War of 1812 and the Civil War, and an experiment with artificial bimetallic inflation in the early 1890’s, accompanied by slightly more rapid deflations between inflationary periods.

But for the vast majority of those 114 years prices fell in the United States.

Was the result a 114 year Great Depression that dwarfed the 1929-1946 Great Depression? No, the United States grew into the world’s largest economy in what’s considered an economic miracle of that period by all but the most hardcore Marxist economists and economic historians. 

This presents quite a quandry for the deflationphobists who warn 0.5% deflation or even zero inflation will lead to disaster.

The same story holds true in Great Britain, Canada, Germany and the industrialized European nations of the 19th century. Prices gently fell and far from tanking, their economies boomed. So both the empirical evidence, as well as the more closely examined theory, contradict the mainstream view that insufficient inflation or even benign deflation will plunge economies into deep depression.

We’ll examine the economics profession’s deflation blind spot in more detail in Part 3.