Originally published at http://eleconomistaprudente.com/ on December 2011
Paul Krugman wrote an article in the New York Times dennouncing Peter Schiff’s predictions about inflation in 2009. I normally disagree on Paul Krugman’s views 90% of the time. But in this case, I regret to say that his complains are justified.
First of all, Schiff amazingly disregards the possibility of deflation, which is one of the most possible outcomes of any credit bubble.
Second, Schiff assumes that the Fed is issuing money, but this is not true, they are issuing credit that we use as currency. This differentiation between money and credit is extremely important, since money (understood as a present good) remains forever in the system, while credit is always temporary. Credit monetization is inflationary in a very first stage, but it is deflationary the rest of that credit’s existence as it is paid down, or even worse as it is defaulted.
Third, since our currencies are liabilities (credit), this credit bubble is a perfect sinonymous of a massive short sell against the currency. Schiff doesn’t realize that central planners are being the last agents to board in the credit bubble. They are just the sucker in the poker game, and the main reason for their attitude is that is not their money what they lose, it is the taxpayer’s money. When Central Banks and Government are entering the credit bubble at this late stages, they are just shorting the currency when everybody else (the market) has realized that is time to do the complete opposite covering their short positions in currency and therefore reducing their balance sheets. The Fed and the Government were the very last agents to follow the market in 2008 / 2009 with their “all-in” bet by dramatically expanding their balance sheets. The Central Planners will follow again the market and eventually will begin to let their balance sheets contract, or at the “best” case, maintaining its size. Operation Twist is the first proof of this attitude so far.
Fourth, Schiff awards an amazing power to central planning institutions, given for granted that they are able to solve any problem they face, no matter if the problem is reversing the credit contraction caused by the greatest credit bubble in humankind’s history.
Fifth, Schiff is predicting high inflation, but this is what already has happend during the last 40 years, as the credit bubble grew!!!. The Fed’s problem is that the bubble is not growing anymore.
Now, regarding Krugman’s proposal to avoid his “liquidity trap”, he could not have thinked of a more self-defeating strategy. While it is true that monetizing debt might offset deflation at a first stage, this debt will feed a greater deflationary potential for the future. Besides, it is not possible to create infinite debt, no agent’s balance sheet can be expanded ad infinitum. If the government keeps expanding its balance sheet by issuing additional debt, the bond market will collapse just the same way it collapsed in Iceland or Greece. The Federal Reserve cannot impersonate the full bond market as a creditor, it is just such a inmensely big task for the Fed. And if the Fed is still buying bonds, is because the market still considers that the US is creditworthy. Once the bond market begins to collapse it will be an extremely thorny business for the Fed to monetize those bonds, specially taking in account the current situation of the Fed’s balance sheet.
When a credit bubble gets to the size of the current credit bubble, credit contraction is unavoidable. The later we face it, the greater the credit contraction will be. The “natural” outcome of a credit contraction is Deflation, which theoretically could be turned into hyperinflation by the Central Bank. I can’t see the Fed delibilerately sacrificing the dollar and therefore destroying its own business, but that depends on their political will, so I must admit that both Deflation and High Inflation are possible outcomes. Anyway, I don’t think that economists should disregard the possibility of deflation, they should advise to face smaller credit contraction as soon as possible, instead of foolishly feeding future greater credit contraction by throwing in more debt into the monetary system.