The ugly sisters: inflation and deflation. Part 1


by David Malone

Having an ugly sister isn’t great.  Having two is awful.  Having them both visit at the same time is a disaster.  That’s where we are. Inflation and her ugly mirror-twin, deflation, have both arrived.

A lot of people argue about whether we will have inflation, hyperinflation or deflation. In Currency Wars and in Inflation/Deflation, back in August of last year, I argued that we already had and would continue to have both.  I argued that we have two different dynamics at work, one based on and in the sovereign currencies, the other on and in debt backed paper.  It seems to me that we have had inflation in those things which are bought with and depend on cash, but deflation in those ‘assets’ held in and traded in debt, such as mortgages and debt backed bonds.

Even if you were to allow that we do have different parts of the economy based on different kinds of assets, valued and traded in different kinds of ‘money’, you might still expect that eventually the two opposite forces would either cancel each other out or one would triumph over the other.

But think of two vortices spinning side by side.  The way they can co-exist and lie side by side, is if they flow in opposite directions, one clockwise, one counter.  Exactly as cogs in a machine spin against each other in opposite directions.  Exactly as real vortices do spin off on either side of a flow and do co-exist by spinning in opposite directions.

And where vortices do spin side by side, they actually re-enforce each other.  This is what I think is happening now in the global economy and within economies as well.  I believe, though seemingly opposed to each other, inflation and deflation are coexisting and amplifying each other.  Deflation in one part of the economic system is now feeding and amplifying inflation in the other and that inflation is in turn feeding back to fuel further deflation.  We have, I now think, a positive, amplifying feedback between the two.  And that strikes me as dangerous and unstable.

I may think this, the question is can I make it stand up for you?

Debt backed currency

First can I convince you of the idea of a debt backed currency?  I have written about this many times but it won’t hurt to summarize.  All money is a promissory note.  The note in your wallet says somewhere on it, “I promise to pay the bearer.”  What makes money ‘work’ is that it is a promise that is universally accepted, so that no one worries they are going to be stuck with a piece of paper that someone else won’t accept as payment.  Now a mortgage or any other debt agreement, also says on it “I promise to pay.”  And that promise is the basis of all the securities and paper which are in turn, based on the underlying mortgage or debt agreement.  Securitization turned these agreements in to a currency by slicing, dicing and standardizing all the mortgages and debt agreements into promissory notes which people could buy, sell and exchange.  They could be transferred between people as payment.  In all these respects debt backed paper became a currency which the banks controlled and printed.  But because the banks controlled it they could also debase it.  And so they did.  They gradually replaced the truly gold AAA rated mortgages with rubbish, tin mortgages but wrapped them in a think veneer of gold foil called insurance.  On the outside they looked AAA gold but inside they were sub-prime tin.

Such fraud makes you rich in the short term and allows an ailing empire to totter on past the time when it was solvent but in the end, as every greedy idiot in history can attest, it always crashes in on itself.  And so it did in 07-08.  When it did, we got massive deflation.  Paper once accepted as worth what was printed on it, was suddenly called into question and no longer accepted at face value.  The bank’s currency failed, what it was based on devalued and huge, titanic amounts of wealth were destroyed.  It simply evaporated.  The bubble of debt backed and debt based wealth defaulted and so did the circulation of that currency.

What made this bust different from previous ones was that normally the people holding the worthless and devaluing paper are you and me.  This time the banks found they were holding more of it than we were.  So if it had been allowed to be written off it would have been them more than us who would have suffered impoverishment.  And that would not do at all.

Inflation and Deflation

So now for the sake of clarity let’s define inflation and deflation.  Inflation is when more and more money chases the same amount of stuff, which tends to drive prices up.  Deflation is when less and less money chases the stuff and so prices tend to fall.  To become a problem both trends need a mechanism to amplify the trend.

In inflation, the classic mechanism for increasing money in the system, is wage increases.  Prices go up.  To compensate people agitate for higher wages.  Higher wages puts more money into the system to chase the same goods and the price responds by going up again.  You can describe the result as goods becoming more expensive or money becoming worth less.  It amounts to the same predicament for buyers and sellers alike.

The classic mechanism for deflation, taking money out of the system, is for people to earn less and then buy less, which in turn classically comes from unemployment or the fear of it.  This drives prices down.  As prices go down, manufacturers find they are making less, and lay people off.  Unemployment and the fear of it goes up and people are less able or inclined to spend.  Prices fall as a result.

I am not saying this is how inflation and deflation always work.  I offer these just as simple starting places.

Clearly inflation and deflation are diametrically opposed. One is driven by more money, the other by less.  But, I think they have become mutually self re-enforcing because of the way finance and our economies have evolved.  So now let’s go back and look at how we got here.

How we got here

In the run up to our present mess we had a vast and sustained increase in money, credit, debt and asset value/wealth.  In short we had inflation.  Now you might object that you didn’t see prices in the shops going up, so what am I talking about?  But the vector of inflation doesn’t have to be consumer goods.  In the last few decades inflation has been in house prices.  The huge increase of house prices above any increase in your money’s buying power caused and carried huge inflation.  To buy a house took much, much more of your money and labour.  So property was the vector, the carrier, of inflation.  But what was driving it?

Inflation is classically seen as driven by wage increases.  They are what put money in to the system, driving the inflation in prices.  But it’s not that simple.  Inflation is a creature of ‘the good times’.  And the good times are not driven solely, or even primarily, by wage increases.  If mere wage increases were really all that powered inflation and the ‘good’ times that precede every bust, then we would all be safe.  The ups and downs would all be minor and correcting the down-swing would be simple.  But the ups are not fueled by wage increases alone.  They are mostly fueled by debt/credit increases, which pile on top of and hugely amplify wage increases.  People don’t generally spend the money they have. The banks get in on the act and say, ‘but you can have more’.  And so people spend money they don’t have, by borrowing it.  What inflates the good times is not earnings but debt.  And the great thing about debt is that it can go up much faster than earnings.  Earnings are in there somewhere, near the bottom, but earnings are always dwarfed by the debts on top of them.  And this is where it gets complicated, divisive and hugely more painful.

The banks fuel ‘good times’ by lending.  Not a bad idea.  It’s how we buy houses.  But it must be policed because avarice and stupidity are always ready to run riot if allowed.  Not content with lending the banks, left to their own devices, will always super lend.  Like supersize but corporate.  They get obese on debts and so do we.  The banks not only lend us money, they borrow it themselves, in order to lend us more.  Just like us, they don’t spend/lend the money they have but they too spend/lend the money they don’t have.  To lend more they borrow and lend that.  Which is what Leverage is.

The is a difference between our borrowing and theirs, however.  No matter how insane our borrowing becomes there is still sometimes a limit when a bank manager says ‘no’.  The banks don’t have a bank manager around to say they can’t have any more.  They are the bank managers and they are not sensible.  They are greedy and reckless and in some cases profoundly morally retarded.  In dire need of very special help.

So while, in the ‘good’ boom times, we borrow at multiples of 6 times earnings and now ruefully admit this was insane, the banks borrow at 30-80 times their earnings.  Leverage is roughly the bank’s equivalent to our multiples of earnings.  So you can see that the scale of our stupidity is dwarfed by theirs.  And they are supposed to be the experts!

So how we got here is the banks had an orgy with each other, of epic proportions, of lending and borrowing, till none of them could see straight.  The result of this unfortunate state of affairs was that when the bust came, when the bubble of confidence, in that night of debauchery that was never going to end, burst, it was not just us who found we had loans we couldn’t pay.  The banks found they had massive loans they could not pay.

So property was the carrier or vector of inflation, while debt is what drove it.  In the end inflated wealth was held by us in our properties and by the banks largely in the form of debt – both ours and their own.

Then the property and debt bubble burst and the securitizing machine stopped and we had sudden, massive deflation.

What happened then?

The banks were in massive debt.  None of them could afford to buy anything.  There were no buyers and since the money to buy securities came largely from selling securities the entire market seize up.  With no buyers, the value of the securities and more exotic financial products based on them, all collapsed.  So it was not just a collapse in the price of houses.  That happened obviously.  But over and above that there was a collapse in the market for the securities, and the debt backed currency which the banks had created, and debased.

We had deflation at both the ‘ordinary’ level of you and me but also at the level of banks and what they buy and sell: loans, securities, debts and bonds.  The markets for these dried up and prices went down.  Or would have, but they weren’t allowed to.  And this is where it all started to pull away from democratic control and fairness, to become a policy of vast subsidy for the super rich at the expense of everyone else.

Several things were done to prevent deflation from utterly eviscerating the banks and their rotten assets.


Mark to market was suspended.  Which meant losses at the banks were not recognized and could therefore be denied and hidden.  Of course the loans were bad and the assets were, and still are, rotten.  Which meant that no matter what public denials and what false accounting, behind the facade the banks weren’t getting the cash flow coming in from their loans/assets.  Which is where the bail outs came in.  Without cash flow the banks would go under.  Our bail outs replaced their cash flow with ours.  Our cash flowed to them so they could pay it on to those to whom they owed money.  Net result, the banks stay in business, our money is gone.  Their loans are satisfied on a day to day basis, ours grow till the point that we now have debt problems and difficulty raising funding.  Which of course the banks insist we solve by cutting public spending on everything but them.

But being kept alive was only the first part of what the banks needed.  They also needed and wanted to make profits.  Partly to pay us back but mostly so they could draw huge bonuses and strut about as the lords they they feel themselves to be.  For that they need more money.  Hence QE2 and the on-going money pumping exercises of buying bonds and assets with newly printed cash.

All this borrowing and printing has flushed a few trillion into the global financial system.  And in each country has inflated the money supply leading many to warn of and expect rampant inflation.  Which we have not yet had.  Why?  Because all the new money has been printed into a vortex of deflation.  The central banks felt, correctly, that they would get away with all this printing because it was largely off-setting a storm of deflation.

And here, I think, we come to one of the first lies told about this crisis and can perhaps shine a little light upon the policies followed.  From the beginning of this debacle our governments and central banks have talked about trying to ‘stimulate’ the economy and have said how they urged the banks to ‘lend to the real economy’.  What used to rile me was the blatant stupidity of saying you wanted to stimulate the real economy but then pumping the bail out money in to the banks who were never going to lend cash to anyone and didn’t.   Yet the ‘stimulus’ nearly all went through them.  Why?  And of course the clear answer is that it was a lie, a convenient, public pacifying lie to say the bail outs were stimulus.  They were not.  The fact that they were all passed to the banks makes it clear that the main intent was to provide cash flow to the banks and so keep them alive.  The sop to the conscience of the liars is that they could say to themselves, that once the banks were saved, they would lend and thus stimulate the economy.  Only they didn’t lend in to the real economy.  At least not ours.

The bail outs were to keep the bank breathing.  Full stop.  The rest was lies.

So this doesn’t get so long thast people start losing the will to live and so I can go to bed I’ll break it here.

Part two to follow


David Malone is the author of the book Debt Generation. You can read and listen to excerpts from his book here: