Does Recession Invite Inflation or Deflation?

Depends on measures taken to combat recession......

A common misconception related to inflation and deflation is that one is a result of an increase in price level while the other one is a result of a decrease in price level, respectively. These are however the symptoms of inflation and deflation, and not the underlying reasons.

The real reason why inflation occurs is because of increase of money supply in the economy; i.e, government prints more money, banks lend to the public at a greater propensity, credit cards and debit cards proliferate in the economy and so forth. As the amount of money circulating in the economy increases, prices of commodities across all sectors go up to match up with the increasing affordability. Similarly, deflation is a result of contraction of money supply in the economy; i.e, government stops printing money, banks lend at smaller scales (credit freeze), and consumers stop relying on credit cards as a mode of purchase, and start spending much less, exactly what is happening today in the recession affected countries.

Therefore, some amount of deflation is inevitable in countries affected the most by the current financial crisis.

Let us take US as an example.The recently published data indicates that the number of people unemployed will reach 10 percent of the working population. That is about 15 million more unemployed people compared to when the economy was doing well (unemployment rate was around 5 percent then). The purchasing power of these additional 15 million unemployed would be drastically reduced, resulting in a drastic reduction of the amount of money circulating in the economy, thus reducing the demand for consumer goods, and thus providing a downward pressure on price levels. In a recent McKinsey & Company survey, 90 percent of US respondents said that their households had reduced spending as a result of the recession—one third of them “significantly.” More than half said they expect to keep their expenditures down after the recession. As consumers return to more traditional spending patterns, companies will have little choice but to reduce prices in order to maintain competitiveness and retain market share. This is more so true for products that have positive elasticity with the income level of consumers.

In the great depression of the 1930s, the money supply in the US fell 25 percent from 1929 to 1933, and co-incidentally, so did the price levels by the exact same amount. This fact places primary blame for the depression on the US federal reserve for allowing the money supply to fall by such a large amount. Economists such as Milton Friedman have argued that contractions in the money supply have caused most economic downturns and that the great depression is a particularly vivid example.

The US federal reserve has been careful not to repeat the same mistake again and has been busy expanding the monetary base by injecting huge amounts of capital in the economy. However, these relief efforts have not led to desired results: consumer confidence has not increased and banks are still keeping credit frozen. This has created a surplus of Bank Reserves to fight the financial crisis.Banks have plenty of cash on hand at an affordable lending rate (Today, the Federal Funds Rate is at 0% - virtually free capital) but they are not putting it into circulation. Strangely, having a large cash balance sheet is typically a negative factor for banks. For their stock to perform, they need to turn those reserves into interest bering loans that yield them profit - expanding the credit and money supply. This has not transpired. We are also seeing deflation in the Consumer Price Index. The value correction in the US housing market by up to 30 percent in some markets has also contributed to deflationary pressures. In parlance, the cost of living has gone down. If the measures to combat the recession continue to include huge amount of capital injection in the economy by the fed, deflation today, combined with a mounting Federal Deficit will invariably lead to inflation tomorrow.

This argument--that the financial crisis will eventually lead to inflation--is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system, and that this sharp growth in the monetary base will eventually cause high inflation. The massive injection of liquidity in the financial system will be inflationary, as it accommodates the demand for liquidity that the current financial crisis and investors' panic have triggered. Once this excess demand for liquidity shrinks, the supply will remain in excess and thus giving rise to inflationary pressures. In other words, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized, as opposed to financed with a larger stock of public debt. However, as long as such deficits are financed with debt or higher taxes--rather than by the printing presses--such fiscal costs will not be inflationary, as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.

It can be beleived that central banks will be tempted to monetize these fiscal costs--rather than allow a mushrooming of public debt--and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers. What exactly happens remains to be seen.

SP