Sunday, September 25, 2011

Qualitatively Defining Deflation and Inflation

Simply put, deflation is persistent economic contraction caused by the withdrawal of credit generally.  An economy in persistent contraction cannot continue to service existing debt that in all cases assumes economic expansion.  Institutions charge interest at a rate greater than the expected rate of inflation.  That is how they make money.

On the other hand, inflation is persistent economic expansion caused by leveraged financial speculation.

Others who I respect continue to insist on describing inflation/deflation as monetary phenomenon (aka Milton Friedman's Big Lie), but I think they've modified the description enough to make it workable and consistent with my view.  See Stoneleigh here:

As we have consistently explained here at The Automatic Earth, inflation is an increase in the supply of money and credit relative to available goods and services, while deflation is the opposite. Deflation, moreover, is aggravated by a collapse in the velocity of money. Price movements are lagging indicators of monetary changes, but are also subject to a number of other drivers, such as scarcity and substitutability (or lack thereof).
I was poking around over at the Automatic Earth this morning, and I strongly recommend reading this "primer" and following the links contained therein.  I particularly liked Stoneleigh's take "On the Nature of Political Crisis," which includes the following choice paragraphs:

As expansion morphs into contraction, in accordance with the very exact same Ponzi logic that underlies our present financial crisis, institutions may collapse along with other higher order structures. While they are eventually to be replaced by something much simpler from the grass roots, to serve their essential functions, this does not happen overnight.

The psychology of contraction may well inhibit the formation of effective new institutions, even much simpler ones, for a long period of time. The psychology of contraction is not constructive, and leads in the direction of division and exclusion as trust evaporates. Unfortunately, trust – the glue of a functional society - takes a long time to build, but relatively little time to destroy.

Elites (top predators) will have a smaller peripheral pool from which to extract the tithes they have come to expect. No longer able to pick the pockets of the whole world, they will very likely squeeze domestic populations much harder in a vain attempt to maintain the resources of the centre at their previous level. This will be very painful for those at the bottom of the pyramid, who will be asked, told and eventually forced to increase their contributions, at the very moment their ability to do so declines sharply.

Whether the left or the right presides over contraction, we are most likely to see a much more pathological face emerge, and this will aggravate political crisis considerably. On the right this could be xenophobia, strict enforcement of tight and arbitrary norms dictated by the few, loss of civil rights, extreme poverty for most while a few live like kings, and fascism, perhaps grounded in theocracy.

On the left it could be forced collectivization, the elimination of property rights, confiscations, and a desire to punish anyone who appears to be doing relatively well, whether or not they achieved this legitimately through foresight, hard work and fiscal responsibility. In either case, liberty is likely to be an early casualty, and intolerance of differences is virtually guaranteed to increase.
As long as we insist on the false left/right dichotomy, Stoneleigh's prediction will come true.
I also found this post quite insightful:

As collective human endeavours, markets follow rules of collective, or herding, behaviour that are hardwired in us as they are in other mammals. As humans, we respond subconsciously to the emotional signals of others, validating our own opinions by their conformity to received wisdom. We are genetically programmed to feel reassured by conformity to consensus, whether accurate or not, and to feel acute discomfort if everyone else around us thinks we are crazy. As trend-following is a recipe for social inclusion, consensus is a powerful force. Most market participants have no real information upon which to act. All they have to go on is what they see others doing, and the perceived comfort level of others in taking those actions. Unfortunately, the received wisdom they rely on is a lagging indicator of relatively persistent trends. By the time the advantages of a particular course of action have become common knowledge, it is almost always too late to act on them advantageously, as the gains will have gone to the early movers.

* * *

Markets are at heart a predatory wealth concentration mechanism for separating the herd from its money. They allow insiders to feed off the greed and fear of a momentum-chasing majority that is always fully invested at tops and fully liquid at bottoms. While the majority always hangs on for too long, giving back their erstwhile gains and more, insiders take a contrarian stance and reap the rewards. While some call this immoral, it is better described a amoral, and is no more unnatural than any of the many predator/prey relationships that exist within and between other species. While we generally prefer not to think of human societies in such terms, we delude ourselves to think that survival of the fittest does not apply to us. As individuals, we must be proactive rather than reactive, and we must not be complacent as the complacent become prey.

* * *

However, society's collective mood swings from optimism to pessimism are about far more than making, or more often losing, money in the market. Social mood tells you a lot about what people will collectively do, and as such acts as a leading indicator for a large constellation of effects. Prechter refers to this as socionomics and has written many books on the topic (some of which we recommend below). When the majority is in an optimistic mood, trust and confidence increase. People are prepared to take risks because they see a good chance of success, and their confidence becomes a self-fulfilling prophecy. They start companies, and invest for the long term because their 'discount rates' fall as their tolerance for risk increases. In other words, they value the future more than usual (although humans are collectively so biased towards short-termism that this increased valuation of the future is sadly never enough to actually preserve a future for the next generation). Mainstream environmental movements are always formed near highs in social mood for instance (but they disappear very rapidly when hard time short people's horizons drastically). Optimistic populations also increase the social inclusiveness of their political culture over time, weakening the 'us versus them' dichotomy to everyone's benefit.

* * *

If you read the mood of the crowd and watch consensus develop, it is possible to predict where events are headed, since mood is a leading indicator. Mood drives liquidity and financial decisions, which are followed in turn by economic effects and then by political fallout from those economic effects. We are currently witnessing the development of a large scale shift towards a pessimistic mood in the wake of the greatest optimistic bubble in history. As trust and confidence are progressively lost, I am expecting (in roughly this order due to differing time lags) ever-increasing increasing risk aversion, progressively less liquidity, enormous financial losses, angry recrimination leading to witch hunts of those who have been particularly successful at the expense of others, xenophobic persecution and demonization of other cultures, the election of populists prepared to play the blame-game at great cost to everyone, and finally war.

By understanding the nature and direction of social mood, it is possible to resist becoming part of a highly unconstructive consensus, although there may be a social price to pay for doing so. Retaining trust in one's fellow man will become harder and harder, especially at a societal level. This is why we recommend establishing and cementing relationships of trust at the local level as soon as possible, as such relationships are the most valuable thing you can have in times of great upheaval.
For the last couple of years, I've been standing on the sidelines observing the social mood and how it changes over time.  The latest trend, and I've seen it with people like Jesse, CHS and Yves, is to stop questioning and start concluding.  A sense of urgency is developing, and it is forcing certainty because uncertainty paralyzes the human animal.  Many rationalists were able to embrace uncertainty for quite awhile, but doing so can be quite depressing.  Yves, for example, has embraced MMT and is busy trying to drive what will prove to be "a highly unconstructive consensus."