Ashvin Pandurangi: A Probabilistic Assessment Of Short-Term Inflation, Deflation, Hyperinflation And Serious Deflation

A Probabilistic Assessment Of Short-Term Inflation, Deflation, Hyperinflation And Serious Deflation. Nov 3, 2010. Ashvin Pandurangi.

The blogosphere has been rife with debates over whether the U.S. economy will experience inflation or deflation over the next year or two. Typically, those on either side of the debate believe that, regardless of the specific outcome, it will be severe and destructive, but there are some who believe it will be a milder process. It has also become clear that those on either side of the debate are almost certain that we will experience the outcome they advocate. I am of the view that the best we can do in our complex financial economy (which is highly inter-connected to the global economy) is discuss the broad factors that make one or the other more likely to occur. It appears to me that there are at least three critical questions which should be answered to determine probabilities of outcomes in the controversial inflation/deflation debate:

  1. What do the financial elites want to happen given the current economic circumstances?
  2. Will the Administration (includes Congress for this discussion) and/or Federal Reserve  attempt to pursue policies that accommodate the elites’ preferences?
  3. If the answer is “yes” to #2, can the Administration and/or Fed be successful in achieving these goals.

After considering how much wealth is controlled by the elites (top 1% holds 43% of financial wealth) [1], and therefore how much political influence they exert, we can assume the answer to #2 will almost always be “yes”. This answer is further reinforced by past political experience and a bit of common sense. That leaves us with #1 and #3, which are difficult questions to answer with high levels of certainty. However, many insightful analysts have attempted to answer these questions using facts, data, trends and experience, and have produced very plausible predictions.

Many people may criticize the following analysis for leaving out many different factors that could potentially affect the likelihood of inflationary or deflationary outcomes. However, when too many variables are included, the analysis required to determine chances of specific outcomes grows disproportionately more difficult. This article has attempted to use broad strokes to sketch a general picture of the probabilities involved, sacrificing detailed calculations for targeted clarity. It is somewhat of a perturbation approach, where a few primary factors are used to create a “ballpark estimate”, and then this estimate can be later refined by including smaller, more detailed factors. For example, when physicists attempt to predict the motion of the Earth within the solar system and through the universe, they cannot factor into their calculations every gravitational force that acts on the Earth. Instead, they focus first on the Sun’s gravitational effect, since it is the most influential force by a large factor. After making this relatively simple calculation, they can gradually add in the effects of the next most influential bodies, but they will never arrive at an exact prediction of the Earth’s motion because the calculations eventually become too complex.

Before delving into the discussion, I must note that it will be based on several different assumptions for the sake of simplicity. Instead of mentioning them within the discussion, I will just list them up front and let the readers decide whether they are reasonable or not:

– The financial elites do not want severe deflation or hyperinflation, since these outcomes would wipe out the value of their numerous debt assets or wipe out the value of all their dollar- denominated holdings respectively.

– The Administration/Fed will almost always attempt to pursue the policies that the elites want them to (95% of the time for inflation; 90% for deflation)

– The financial elites cannot unilaterally (without Administration/Fed) make decisions that will affect the probabilities of inflation or deflation (we will assume they will make self-interested lending decisions).

– The Administration/Fed’s attempts to inflate, if they choose that option, will not be significantly counter-acted by currency devaluations of other countries. They may have a temporary effect, but financial/militaristic incentives to work with the American power elites and threats of protectionism will balance this dynamic out.

– Hyperinflation will only occur when financial elites prefer inflation, and severe deflation will only occur when elites prefer deflation.

– Issues associated with peak oil/resources will not be a factor within the next few years.
The following definitions of inflation and deflation, borrowed from The Automatic Earth, will be used [1]:

  • Inflation – Marginal increases in the amount and velocity of credit money relative to goods/services.
  • Deflation – Marginal decreases in the amount and velocity of credit money relative to goods/services.

What do Power Elites Prefer – Policies Supporting Mild Inflation or Mild Deflation?
            Mild Inflation (25%)

The argument for power elites preferring mild inflation is perhaps the most intuitive. Inflation of the money (credit) supply to devalue the currency should lead to rising asset prices, as more money is chasing the same supply of assets. Financial elites have large investments in real estate, stocks, bonds and commodities and should therefore benefit from higher prices and interest rates. If consumer prices are also supported, then there could be a resumption of hiring by various businesses, which would certainly help restore some confidence in the economic structures of the status quo elite. In a more general sense, inflation manufactured via another credit bubble would return the economy to a state of consistent growth, allowing power elites to continue playing their cruel games. However, this argument contains the following assumption, which may simply be incorrect: that creating a modest amount of growth in the money supply, by getting debt-money to investors and consumers, will actually lead to higher prices.

The prominent blogger Charles Hugh Smith (“CHS”) has provided a very insightful argument for why the elites would not prefer mild inflation [2]. To understanding a key part of this argument, it’s important to note that the economic situation now is unlike it has ever been in the last 60-70 years and also that the elites are aware of this fact. There has been an enormous, decades-long credit bubble in the private sector (~300% Debt/GDP in 2008), and now the consumers, who make up 70% of GDP, are buried beneath a mountain of debt. Despite the Administration and Fed’s programs to inject trillions into the economy via stimulus and quantitative easing, the velocity of money has remained stagnant as investors, small businesses and consumers hesitate to lend, invest or borrow. It is very plausible that a modest increase in money supply will simply lead businesses and consumers to pay down some debt and hoard any remaining cash in the face of future uncertainty. We certainly see a version of this dynamic in the stock market, where institutional investors continue pulling money out of equities despite the recent rallies [3].

For the above reasons, the economy will most likely be in a prolonged period of low growth and subdued asset price inflation despite modest amounts of further stimulus or monetary easing. Even some of the major investment banks (financial elites), such as Goldman Sachs, have predicted a negative GDP print in Q4 2010. [4]. The current dynamic for elites is much different than the one existing after the Great Depression, where losses on cash holdings from consistent devaluation of the dollar via inflation were more than offset by returns on asset investments. CHS points out that the dollar has lost more than 95% of its value since 1913, but the Dow Jones Industrial Average has actually risen at about seven times the rate of dollar depreciation over the same time period. It would be prudent to assume that the elites have learned their lesson from 1966-1981, when a period of “stagflation” (low growth coupled with high price inflation) wiped out much of the value in their stock and bond holdings. [5]. The last thing the elites would want is a period of inflation in consumer prices, which eats up the value of their debt assets, but doesn’t contribute to high returns on financial investments.

Elites prefer Mild Deflation (75%)

CHS explains that mild deflation, on the other hand, would increase the purchasing power of elites holding cash, money market instruments and short-term treasuries, while also increasing their returns on debt assets. When inflation is negative, the real interest rate paid on debt (= nominal IR – rate of inflation) is higher than the nominal rate. As long as the deflation doesn’t become too severe and wipe out heavily indebted consumers, businesses and governments, the financial elites can continue making decent returns while setting themselves up to buy various assets for pennies on the dollar in the future. [6]. By maintaining their wealth and political control, the elites can also ensure that any new regulations or fiscal/monetary policies continue to be in their favor (backstops of the housing market, monetization of treasury debt, higher taxes on the middle class to pay interest on public debt, welfare benefits to quell social unrest, watered down “reform”, etc.). Therefore, on whole, it seems significantly more likely that power elites would prefer a path of mild deflation above all else, but the question of whether it is even possible to maintain this Japan-style malaise still remains.

What can the Administration and/or Fed Accomplish?

Mild Inflation (10%)

It would appear that the Administration and Fed have been completely geared towards creating inflation up to this point in time. The former attempted to re-capitalize major banks with TARP and mark-to-fantasy accounting, promote consumer spending with stimulus and stabilize housing prices through Fannie, Freddie and the Federal Housing Administration. It has also provided billions in jobless benefits and other aid to struggling citizens. The Fed has attempted to stabilize the housing market and banks’ balance sheets through asset purchases of mortgage-backed securities and zero-interest rate policy. The latter, along with the direct monetization of treasury bonds by the Fed, also serve to finance the Administration’s deficits at low interest rates (banks borrow at 0% and lend to the government at 1-4%).

Despite all of these measures, consumer price inflation remains close to 0% (excluding energy/food) [7], unemployment remains close to 22% [8] and consumer credit continues to contract [9]. Of course, the stock and bond markets have benefited greatly from these policies since the beginning of 2009. The former, however, has become increasingly unstable this year as retail investors continue to opt out in large numbers and robots with synchronized time horizons are left to buy and sell to each other. [10], [11]. The bond market, however, is much bigger than the stock market and its stability is significantly more crucial for the power elites and politicians. It appears at this time that, although it is in a huge bubble, the bond market will remain relatively stable due to investors’ preferences for “safe havens”, the desire of external creditors’ to support our consumer economy, and, of course, the permanent open market operations (“POMO”) of the Fed.

            Hyperinflation (30%)

Many commentators involved in the inflation/deflation debate believe that, in pursuit of inflation, the Administration/Fed will inadvertently jump start a process of hyperinflation. This argument typically follows the following logic: every time the economy renews its deflationary pressure, the politicians and central bankers will keep spending/printing money to fight it off, and eventually we will reach a tipping point of confidence in the U.S. economy and its currency as a reliable means of exchange. History certainly seems to suggest the first part of this argument is accurate, but the sociopolitical dynamics involved have significantly changed in the last few years. Both the public and politicians who pander to them have expressed much disdain for further spending or printing, and on top of that, its unclear how many trillions would even be necessary to combat the deflationary pressure. As mentioned above, the elites must maintain relative stability in the bond market to protect their holdings and the current power structure, and another $5-10 trillion in printed money would be counter-productive to this goal. For these reasons, it seems unlikely that the government will print enough money to spark hyperinflation, but that certainly does not mean we can rule it out.

A blogger named Gonzalo Lira has produced a series of articles presenting a unique perspective on how hyperinflation could occur. [12]. To summarize, he believes that a temporary spike in commodity prices (such as oil) will lead to institutional asset managers selling a portion of their large treasury holdings (paying artificially low yields) to buy into the ramp. This small sell-off will occur before a somewhat large treasury auction, and so the Fed will step in and buy to stabilize yields. Similar to what we currently see during the POMO operations, asset managers and primary dealers (“PDs”) will start unloading larger amounts of treasuries onto the Fed to turn a quick profit and reinvest proceeds into the commodity space. Asset managers will then begin to dump huge portions of their holdings, since they see the PDs selling and the Fed buying a large volume of treasuries at a time when they are already on edge about the precarious nature of the economy and bond markets. This cycle represents a classic positive feedback, where asset managers dump treasuries for liquidity, causing the Fed’s buying to stabilize yields, causing even more managers to dump while there is still a willing buyer with unlimited cash. All of this action will occur within a few hours at most, and the managers will turn to commodities as a relatively safe and perhaps quite profitable place to invest their cash.

Mr. Lira believes that physical commodities will be perceived as the only sure store of value, and will therefore shoot up between 150-250% by the end of this panicked week. Once this spike translates into significantly higher gas prices at the pump, average consumers will begin selling all of their paper assets and buying hard commodities out of fear of prices continuing to rise in the future. [13]. It is easy to see how this process will eventually translate into a self-reinforcing spiral, where almost all discretionary assets will be swapped for energy, food and other essentials, eventually leading to skyrocketing prices and hyperinflation. What’s even more frightening is that the Administration and Fed will be practically helpless to do anything about it at this point, since their limited tools will be woefully inadequate once the consumer has lost complete confidence in the currency.

Although it presents a very interesting hyperinflation scenario, the problem I see with Mr. Lira’s argument is two-fold:

(1) A large, temporary spike in oil prices is unlikely to occur or lead to a treasury-dumping spiral – The spark for a short-term spike in oil prices would have to be a major disruption of Middle East supply through a military conflict or a voluntary embargo by exporting nations. In contrast to 1973, when OPEC nations decided to place an embargo on oil exports due to Western support of Israel in the Yom Kippur War [14], the U.S. now has strategic military bases throughout the Middle East and would not allow such an embargo to even take place. [15]. Any further military conflicts that take place in this region will have the U.S. military directly involved, and it will certainly do everything it can to make sure America’s share of oil supply is not disrupted. In fact, a prerequisite for any military action would be to have a solid plan for securing production facilities in the region.

If the supply of oil to America is disrupted by military action in the Middle East, then the Administration will most likely institute price controls on gas at the pump. Mr. Lira states that these controls would simply create a black market for goods and do nothing to reverse the underlying hyperinflation, but he is assuming these controls would only occur after there is a run on treasuries and hyperinflationary concerns reach the average consumer. It is more likely that the government will immediately cap the price of oil, perhaps through an executive order in the name of “national security”, which will destroy the incentivize for asset managers to dump large amounts of treasuries for commodities in the first place. When the potential upside gains of commodity plays can be artificially limited, it would be very risky for investors to bet against the federal government.

(2) The outstanding debt obligations of consumers/businesses are still excessive – The major reason why the U.S. economy naturally faces a deflationary depression is because there is too much private debt outstanding, and the need to destroy this debt suppresses aggregate demand for consumer goods or financial assets. Currently, when the price of oil gets significantly above $85/bbl, consumers are priced out of the market and demand destruction ensues, since demand is still relatively elastic to price changes. A temporary spike in oil prices would most likely lead asset managers to sell off stocks and commodities as well, since they are worried that consumers will heavily cut back on spending and pay off debts. This process is what the U.S. experienced in 2008 after oil hit $140+/bbl, and although the circumstances have changed since then, the underlying realities of excessive debt and artificially high consumer demand are still present. From this perspective, a temporary spike in oil prices would actually trigger a deflationary collapse rather than hyperinflation.

Mild Deflation (30%)

According to analysts such as Dr. Steve Keen, “Mish” Shedlock and Nicole Foss, the Fed is simply “pushing on a string” when it sets to generating inflation in the economy. [16], [17], [18]. Without any desire of consumers to borrow or creditors to lend at affordable rates, the trillions printed by the Fed will simply lay dormant as excess reserves or, at best, help keep the financial markets relatively stable. As for the Administration, it would have to give away a whole lot more “free money” before consumers and businesses begin spending/investing again in any meaningful manner. The best the government can do at this point is pump liquidity into asset markets and continue handing out benefits to the unemployed and poor among us. As CHS explains, the main goal here is to keep consumers paying off credit cards and mortgages, tax revenues flowing, financial markets somewhat stable and the general population placated, while economic actors continue to deleverage. [].

If the goal of power elites and the government is to manage this process of mild deflation, then perhaps the Fed is not pushing on a string at all. CHS has produced another piece which clearly shows that the government’s policies since 2008 have merely served to keep the system alive by transferring wealth from taxpayers to the top 10% of the population. Specifically, the Fed has blown more speculative bubbles in stocks, real estate and commodities, which mostly benefits the owners of financial wealth and also reduces the purchasing power of the bottom 90% through artificially high energy/food prices. Much of the toxic mortgage debt has been removed from the elites’ balance sheets and handed to the taxpayer through various government programs. [19]. This path has not been one to sustainable inflation, but rather one that keeps the power elites in business while cash flows in the general economy slowly dry up and investment capital relocates to emerging markets.

Severe Deflation (60%)

As mentioned before, however, the political capital for further deficit spending and monetary easing is drying up quickly as well. The Republicans have taken back the House of Representatives, picked up a few seats in the Senate and will certainly oppose further stimulus by the Administration. John Taylor has suggested that the Fed will also be on a much tighter leash when Congressman Ron Paul becomes head of the sub-committee overseeing its operations. [20]. Although the Fed will most likely shovel out another $500B-$2T in treasury purchases via “QE2” (waiting for the announcement as I write this), it is becoming clear that there are diminishing returns to its efforts. A QE2 package that is smaller than the initial QE program, and only targets treasury bonds, will only serve to keep interest rates low and perhaps give a small, temporary boost to equity markets. It will certainly fail to stave off further deleveraging in an economy worth ~$14 trillion that also has trillions more in unserviceable debt.

So the question becomes whether the Fed’s incremental liquidity programs can at least maintain modest deflation. The best answer to this question seems to be “not too likely”. The Fed actually has little ability to counter-act the debt deflation in the consumer economy, since it cannot print money and give it directly to small businesses and consumers, and Congress will also have its hands tied after the elections. What the fiscal conservatives fail to realize is how fast the economy will unravel once government subsidies are drawn down. Dr. Keen points out that the trillions spent and printed by the government after 2008 helped to decelerate the rate of credit contraction in the private sector, and this deceleration actually reduced unemployment and projected the illusion of an economic recovery. For this deceleration to continue, the private debt to GDP ratio would soon have to begin increasing again, and this is extremely unlikely to occur in an economy with ridiculously high levels of debt. [21]. If and when housing prices begin falling again, pushed along in no small part by the “fraudclosure” crisis, we can be certain that the acceleration of debt destruction will turn positive. The excessive debt, inventory and over-capacity of American consumers, businesses and markets will reveal itself in full force, and the economy will be caught in a deflationary spiral once again.

The Guesstimated Probabilities of Each Outcome

In the perturbation sense, the strongest influences governing inflation or deflation are the natural state of the economy, the preferences of American power elites and the policy tools of the Administration and Fed. We can express the results of the simplistic inflation/deflation analysis by translating the qualitative discussion above into percentage probabilities, based on general conclusions regarding the likelihood of each outcome. To summarize, power elites would prefer mild deflation over mild inflation at a ratio of about 3 to 1, when considering the current economic circumstances. Similarly, the Administration/Fed will be able to achieve mild deflation over mild inflation at a ratio of about 3 to 1. Hyperinflation will occur three times as often as mild inflation when power elites prefer inflation (mainly due to Mr. Lira’s scenario), and severe deflation will occur twice as often as mild deflation when elites prefer deflation. The following table lists these percentage probabilities along with the chance that the government will agree to pursue the power elites’ preferred policy, and multiplies down each column to acquire a resulting probability of each outcome.


Mild Inflation Hyperinflation Mild Deflation Severe Deflation
Preferences of PE 25% 25% 75% 75%
Government Ability 10% 30% 30% 60%
Chance of Agreement 95% n/a 90% n/a
Resulting Probability 3% 8% 21% 45%

**probabilities are rounded to nearest whole number

The resulting probabilities above add up to 77%, which leaves another 23% for outcome combinations and also further refining of the stated outcomes’ probabilities. Perhaps the initial assumptions could be modified to make the analysis more realistic. Some readers may feel that I have derived faulty probabilities from the discussion, or even that the discussion itself contains flawed logic. I encourage readers to take the framework and general discussion points that are presented in this article and generate their own probabilities for specific outcomes. The analysis could also be refined by including the next most influential factors that have been left out for purposes of simplified calculation (i.e. European sovereign debt crisis, global currency devaluations, coordination by international elites, geopolitical factors, etc.). Personally, I believe that the probabilities listed above are at least a ballpark estimate of potential outcomes over the next year or two. Of course, without extensive data-mining and the use of computer-simulated dynamic models, we may have to simply rely on time to eventually tell the tale.

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