The Inflation / Deflation debate

The U.S. government is planning larger deficits. The Fed has expanded its balance sheet, announced it will spend even more, and is headed by a chairman who is called "helicopter Ben" because of his quip that the Fed can always fight falling prices by dropping cash from helicopters.

Despite all this, "the market" does not expect prices (CPI) to shoot up any time soon (see my earlier post). This appears odd, and begs for an explanation. Consider the main arguments of the inflation and deflation camps:

Inflation arguments: More money "chasing" the same amount of goods, the argument goes, drives up prices for those goods. Printing money does not create more real wealth; but, it raises the nominal value of that wealth. There might be a delay, but eventually prices will rise. (This is the classic "Quantity Theory of Money")

Further, the argument continues, creating fiat money is easy. Look at Zimbabwe today or many other countries across history. Create enough money, and prices can rise over a 1000%.

Deflation arguments: The best people from the deflation camp are not Keynesian. Importantly, they agree with the quantity theory of money in this abstract form: creating more nominal buying power raises the price of things that are bought.

Firstly, the government can expand money-supply if it prints trillions of dollar bills and spends them or even just hands them out. No debate there. However, the deflationists argue, the U.S. is not Zimbawe: so, helicopter Ben will not actually use his helicopter. Instead, the government will try to increase aggregate buying power in more traditional ways (e.g. cutting interest rates, printing some extra money but not a huge amount, buying government securities, etc.).

Secondly, the government is taking many steps that typically do inflate money-supply. However, the deflationists say, many traditional governmental measures work only as long as other things remain equal ("ceteris paribus"). The traditional steps do not work smoothly in a situation like we have just now. Also, it is not simply a matter of waiting a bit longer for them to take effect; it is that more and different things also have to take place. To understand this, one has to consider the process by which nominal buying-power is created in a modern economy.

Modern money-creation: Here's a one-minute tutorial (please comment if any step needs more explanation):

• The government (Fed) starts the money-creation process by in two ways: either by printing actual currency or by boosting bank reserves. A reserve is when the Fed tells a bank: "we've got $100 for you that you can have at any time". Though not physical, reserves are equivalent to printed notes.
  
• Traditionally, the most common way the Fed boosts reserves is by buying things from banks or from the market in general. For instance Fed might buy government bonds that people are holding. It takes the bond and pays for it with new money (increasing book-entries for bank-reserves).
  
• Under a fractional-reserve system, when the total bank-reserves in the economy increase, banks can lend out more money on that basis. For example, suppose banks wish to keep 10% reserves. If the Fed buys $100 worth of government securities, increasing bank-reserves by $100, banks have "excess reserves" (compared to what they consider safe). So, they can lend out an additional $1000. This is the so-called "multiplier effect".
  
• People treat reliable checks like cash. When the Fed prints $100 as notes, if people hold on to that extra cash rather than depositing it in their banks, it creates $100 more of buying power. However, if they deposit the $100 in their bank accounts, boosting bank-reserves, the bank can create $900 new deposit money. The Fed does the same thing in a single step, when it boosts bank-reserves by $100.

An example: Imagine we start with an economy that has $1000 of bank-reserves and bank-deposits of $10,000. Typically, where things are humming along, the Fed creates $100 of new bank-reserves and this might result in $1,000 of bank-deposits. Total bank deposits go from $10,000 to $11,000. Nominal buying power thus rises.

Both sides of the inflation debate agree that the process works roughly as above. However, the deflationist camp argues that banks are not machines. They do not create new buying power mechanically. When banks are in trouble, they want to bolster their reserve-ratios. Consider what happens if banks suddenly want to be moire careful, in the wake of what they think might be a huge economic downturn.

A scardy-cat example: Imagine we start with the same example as above, with $1,000 of bank-reserves underlying $10,000 in bank deposits. However, nervous banks begin to restrict lending. Let's say they decide to raise their reserves from 10% to 11%. They need to cut deposits down to $9,090 [1000/9090=11%], slashing by $909.

Suppose the Fed reacts by increasing bank-reserves by 10%, pumping $100 into the system. Now, the banks have $1,100 in reserves. With their new standard of 11%, that can underlie a deposits of $10,000 [1,1oo/10,000=11%]. In the scardy-cat scenario, after a 10% boost in reserves, we have buying power exactly equal to what it was before. Now, imagine a situation where banks are much more scared -- literally unsure of their survival. It can take a lot of new "base money" just to keep total effective buying power constant.