One of the most closely and exhaustively reasoned articles I've read on the inflation/deflation debate.

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The authors leave no doubt where they see this financial crisis heading: the greater the deflationary pressure, the more vociferous the inflationary tactics employed to fight it.

The authors do not see much similarity between Japan's predicament and ours. Japan was and is a nation of savers; we are not. We will gladly and willingly debauch the currency, as it helps us both individually and collectively. Japan only tepidly practiced quantitative easing (a euphemism for printing money) in 2001--eleven years after their economy first went sour; Bernanke is already quantitatively easing with relish in the second year of the downturn, not the eleventh year.

As Bernanke's 2002 speech foreshadowed, they are creative, they are determined, they are strongly biased toward inflation, they don't care about rules or convention, and they will continue to find ways to get money into the economy. [My bold].

I have to agree that Bernanke and Paulson have so far gotten Carte Blanche to try any experiment they think might help the economy, and to basically threaten Armageddon if they don't get what they want. They have probably tried a dozen financial experiments so far, with pretty meagre and/or dismal results.This is the central political fact of 2008--as was the non-disengagement from Iraq the central political fact of the aftermath of the 2006 elections in 2007. Elected leaders are non responsive and the unelected bureaucrats run the show--particularly given the fact that so many in Congress are economic illiterates.

So politically Bernanke, Obama, or whoever can and will practice reflationary tactics out the wazoo until they get the desired inflationary outcome with people spending willy nilly, or until our foreign creditors revolt and demand much higher interest rates. At some point the diminishing returns of being a creditor of the US have to weigh, and I think this would be the strongest counter-argument against inflation taking hold. True, creditors have not revolted for decades as the dollar went from 360 (1970) Yen to 90 Yen today, but the US has bought a lot of goods from Japan over the past 38 years.

Anyway, read the article and tell me what you think...

Not that it's not happening. You claim deflation now; and I claim inflation -- already -- the Kosher hot dog ($3.50) never lies.

But the whole thing has LIMITS; otherwise it falls off the tracks.

Despite our economists, nobody talks limits. Our working class won't get jobs in the Global economy if USA produces less and less in Global trade. Production of goods and services is a limiting force. Advantage China and Germany-Japan. Interest rates (Global factors) are a limiting factor.

Bad inflation will make USA a laughingstock with utterly worthless currency and goods, with W becoming a genius.

If no action on VAT and healhcosts and domestic energy-- severe Depression for the lower half no matter how many bridges the Gambinos build or derust.

Greenspan and printing money got USA into the looming Depression. With help from China.

But the country IS dumb and dumbering!

THE solution is always hard work, good products, and solid simple finances.

I do believe I would immediately hop on a plane to Europe, convert the entire $10 million into Euros, and then fly on someplace like Thailand or Costa Rica, buy myself a nice bungalow on the beach, and live out my life there in comfort, shaking my head in wonder at the suffering of ordinary Americans as they try to cope with the inevitable hyper-inflation. And I understand that the dollar would be falling, probably like a rock, even on my plane flight to Europe, so that I would not get the full $10 million. No matter.

This is a good article, Genedio, and I will have more to say about it later, when I have more time. For the moment, let me note that I believe we will have a rather sharp deflation through the first three quarters of 2009 (the deflationary pressures are simply too great, and we are going to see massive job losses these first nine months or so, as retailers and auto dealers and restaurants go bankrupt)....and then we will begin to see the first whiffs of a burgeoning inflation. In other words, I do not question the analysis here so much as I do the time lags involved before hyper-inflationary forces begin to overwhelm the deflationary forces. Jim Jubak has a column where he opines that the real dollar crisis will come in 2010. That sounds about right to me.

Could that be China's game?

I see EU as 80% Socialist, with USA the last real holdout and now USA govt "seizing the steelmills."

Is that IT??

Ronald Reagan. Ronald Reagan. I always said he was a Commie.

Hello Mommy, I'm off to get a commie, so send me a a salami...

Richard Nixon himself said that the failures of capitalism make the people want to try communism. Perhaps the failures of deflation will make Bernanke's inflation palatable? That was always their end game: give the people a real good deflation scare and then sock 'em with inflation in time to debase the unpayable entitlement debt.

Your $10 million would be devalued in like three seconds as the hordes of Europeans would be dumping their dollars to buy Euros, and the hordes of Asians would be dumping dollars to buy anything they could still buy, and the hordes of Americans would be furiously clicking their mice to get out of the all-weakening dollar in their respective trading accounts. Sorry, Leroy. You would have to get the $10 million well enough in advance of other people in order to exchange it.

It's very clear that our fiscal and monetary leaders are willing to do whatever it takes to head off deflation, and that any rule or convention that gets in the way is summarily tossed out the window to the cheers of onlookers.

What's more amazing is that these radical and exceptionally aggressive reflation attempts have taken place in response to a minor decline in consumer prices and no decline at all in the money supply. The graph below shows that the Consumer Price Index (CPI) has indeed fallen, but that it has neither fallen very far nor for very long.

Moreover, the vast majority of the decline to date has taken place as a result of a sharp drop in energy prices...there has not been any notable decline in the CPI net of food and energy prices. We are baffled as to why falling energy prices are considered to be a bad thing for the US economy, but that's a topic for another article. The point here is to illustrate that there is as of yet very little in the way of widespread price deflation.

The price declines so far have been fairly minor and very narrowly based, but they do qualify as price deflation. Monetary deflation, on the other hand, is a no-show. The next charts display the money supply as measured by M2 and MZM, the two broadest measures of money supply provided by the Fed. Both measures show that while money supply growth did flatten out earlier in 2008, it has since picked up again in a robust fashion.

Of course, these are backward-looking indicators, and there are reasons to believe that the economic downturn may exert more price-deflationary pressures in the future. But the violence of the government's reaction to the so-far mild consumer price deflation and a temporary flattening out of monetary growth just goes to show how committed they are to preventing a serious deflation from getting underway.

This article feels late, and not looking at the whole picture. This passage is what alarms me most.

"What's more amazing is that these radical and exceptionally aggressive reflation attempts have taken place in response to a minor decline in consumer prices and no decline at all in the money supply."

They claim the radical reponse is in reaction to a "minor decline". I think they are looking at the wrong chart, and the real reason for the radical response is all about housing prices, not consumer prices. In fact, the whole article doesn't even mention the word "foreclosure" once!

The fed is having much more trouble re-inflating than it hoped. The money is not being channelled correctly, and that increases the risk of overcorrection. They want to do, say, $10 worth of good in the housing sector, but only 20% of the money they spend ends up there, and so they have to spend $50 is reach the goal. Now, just add 11 more zeros, and you have something close to what's happening.

I think they need to move fast to put in controls before the overcorrection becomes too severe. When housing prices do rebound, they may rise 50% in less than five years, which would be very very bad, even starting from now or 20% down from now. We need housing prices that rise only 3% a year, more in line with general consumer inflation.

Mortgage rates dropped like a stone in november and december. This may be great, but may lead to more pain down the road.

The Case-Shiller index is still up an astounding 89% from 10 years ago. Rather than suffering an over-correction, I don't think housing prices have fallen enough. Two years ago, if you'll recall, few experts were expecting much of a correction at all--from astronomical prices. In any event, the Fed shouldn't fix interest rates based mainly on housing prices; they sure didn't when the housing bubble got started. What makes this crisis different is that the banks stupidly and insensibly lent out money to borrowers who were not qualified. That's why the Fed has been helping out the housing sector--because the banks screwed up. Instead of having the banks pay for their mistake, the Fed is making everyone pay.

It's not just prices, it's the foreclosures! The fed needs to cut rates enough to stop the bleeding.

September 18, 2007... I believe I was saying that day I bet Bernanke wouldn't cut rates. (I was, of course wrong)

And that day...

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we crossed the 200k mark on foreclosures for the first time ever. and we didn't just walkover the line, we jumped over it- a 36%+ rise.

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Today, the total properties is 259,085. The fed can afford to put every kind of inflationary pressure to bear on the economy until the rate drops below 200k, and I suspect if they start tightening as soon as the number goes below 200k, they might avoid an overcorrection. But, in the meantime, the price of foreclosures is huge-- it's a nasty misallocation of and manpower in general. We can't expect the economy to grow when the only new jobs are in the field of helping banks kick people out of their homes.

Uh, the target for the Fed funds rate is already at 0.00% to 0.25%.

How much further can they cut?

Should they be paying people to borrow money?

We are caught in a classic Keynesian liquidity trap, the same thing that happened to Japan in the 1990s (and to America in the 1930s). Japan went into an almost two-decade long stagnation. America will not fare so well as that. Japan, at least, is a nation of savers. We are not.

Leroy, the federal funds rate does not control the rate on a 30 year fixed mortage, and that bad boy is the engine of homebuying.

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The feds actions(rate cuts, and all the other stuff they've been doing) may lead the 30-year fixed rate to dip below 5%. And when that happens, it will be a refinance-orama. I'm tempted to refi, but I may have to move in 2 years, and I've already got a sweet 5.375% rate... hard to believe it could pay off to refi, but for people not about to move, it's more likely a good time to refi.

Meanwhile, Leroy, the US is far better off than Japan in this regard. Why?

1. We are heartless. We will bankrupt your businesses and foreclose on your homes rather than let the zombie loan fester on the books.

2. We are net importers. If japan suffers job losses, no amount of "buy japanese" nationalistic sentiment can get the back on track. The US can indulge in populist protectionism during periods of job loss and slow down the bleeding.

3. We welcome immigrants. Consider: most immigrants enter the US an join the bottom quintile. 2nd generation immigrants may claw their way out of poverty and join the middle class, meanwhile, more immigrants flood in to fill in the bottom. the results? a.) prices for unskilled labor is held low. b.) prices for land and housing are driven up c.) quality of life for middle class rises with housing values and cheaper services. Japan is relatively unwelcome to outsiders, and the population remains 98.5% japanese.

Madai: Leroy, the federal funds rate does not control the rate on a 30 year fixed mortage, and that bad boy is the engine of homebuying.

LeRoy: I hope you are aware that the Fed has no direct control over, or statutory authority over, the 30-year fixed mortgage rates, or the 15-year fixed mortgage rates, or, indeed, any long-run interest rate. What is true is that Fed, in its current desperate situation, is pulling out all the stops, and using all the unorthodox tools of monetary policy that Ben Bernanke can dream up, to try to pull down those long-run rates, which are ordinary under the 'control' of the enormous bond market. And so far, those unorthodox tools are working, to a point. But there will be potentially quite severe long-run trade-offs to these highly unorthodox monetary policies by the Fed.

Madai: Meanwhile, Leroy, the US is far better off than Japan in this regard. Why?

1. We are heartless. We will bankrupt your businesses and foreclose on your homes rather than let the zombie loan fester on the books.

LeRoy: Yes and no. We are, of course, bailing out our businesses that are 'too big to fail', including many of our largest banks and insurance firms and quite possibly our automobile companies. Those big banks still have untold gazillions of bad debts on their books, and the suddenly increased nervousness about the health of our big banks was cited as a reason for the drop in the stock market yesterday. It is not at all clear to me that we are going to proceed in a manner much different than Japan did insofar as bad banking debts being allowed to 'fester' [a good word, that]. Meanwhile, we are going to have innumerable small and medium-sized businesses go bankrupt, to a much greater extent than Japan saw in the 1990s, with all of the implications for American employment. It is just beginning to happen: restaurants, auto dealerships, furniture stores, and the biggest jewelry store chain in the Rocky Mountain region just yesterday.

Madai: 2. We are net importers. If japan suffers job losses, no amount of "buy japanese" nationalistic sentiment can get the back on track. The US can indulge in populist protectionism during periods of job loss and slow down the bleeding.

LeRoy: Yikes. Populist protectionism is what we should be fearing the most. Other nations are also concerned about their people and their jobs, you know. [Or maybe you don't know.] This would trigger nothing less than another trade war, similar to what we unfortunately saw in the 1930s. You really want to go through that again?!? Meanwhile, the Japanese people certainly could have increased their consumption of Japanese-made goods, as the Japanese had and continue to have a whole range of world-class manufacturing companies. Indeed, the Japanese government tried (at various times) to encourage just that, but the Japanese consumers have been resistant, due to a culture that emphasizes saving and due to latent fears about the future of the Japanese economy. But, in general, it is easier for a net exporter (like Japan) to increase domestic consumption and reduce exports than it is for a net importer (like America) to increase domestic production and reduce imports. In our case, it would probably be MUCH harder.

3. We welcome immigrants. Consider: most immigrants enter the US an join the bottom quintile. 2nd generation immigrants may claw their way out of poverty and join the middle class, meanwhile, more immigrants flood in to fill in the bottom. the results? a.) prices for unskilled labor is held low. b.) prices for land and housing are driven up c.) quality of life for middle class rises with housing values and cheaper services. Japan is relatively unwelcome to outsiders, and the population remains 98.5% japanese.

LeRoy: Holding the price of unskilled labor at low levels harms our own native low-skill workers, keeping them in poverty and indeed making it very difficult for them to augment their human capital. This is NOT how America became rich in the first place. We became rich by being a labor-scarce country with high real wages, high interest rates, high profits, and rapid growth. Driving prices for land and housing up (basically what we have been doing for most of this decade) simply makes homes unaffordable to the average middle-class American, and is exactly what led to all the ridiculous exotic mortgages that triggered the housing bubble, which has now definitively burst, leaving us in the present economic calamity. Having a large supply of unskilled labor reduces the incentive to develop labor-saving machinery, which is the REAL path that America took to becoming rich: We mechanized and automated, and thereby became the technological leader of the world.

"I hope you are aware that the Fed has no direct control over, or statutory authority over, the 30-year fixed mortgage rates, or the 15-year fixed mortgage rates, or, indeed, any long-run interest rate."

Didn't I pretty much say this? It is true. However, either the fed's actions will influence the 30-year rate, or the economic downturn will. The rate fell in nov and december, and might continue falling until the refinance-o-rama begins.

"We are, of course, bailing out our businesses that are 'too big to fail', including many of our largest banks and insurance firms and quite possibly our automobile companies."

Uh.... Bear Stearns, CFC, WaMu, IndyMac and Lehman Brothers. All being dismantled. It cant happen overnight of course, but all 5 had some good loans on the books that have to keep being tracked. But none of these five have a future. And the companies that survived are shedding jobs left and right-- something that would not happen in Japan.

"This would trigger nothing less than another trade war, similar to what we unfortunately saw in the 1930s. "

If we passed a LAW, yes, that would trigger protectionist retaliation. But I was referred to grassroots protectionism.

"But, in general, it is easier for a net exporter (like Japan) to increase domestic consumption and reduce exports than it is for a net importer (like America) to increase domestic production and reduce imports."

That's an interesting assertion, one not backed by Japan's longterm deflation crisis. In recent history, America's unemployment is so low (below 5%) that that we can't add the jobs to meet domestic demand. Hence imports and outsourcings. Now that America's unemployment is well above 5%, it should be easier for us to claw back some domestic production and create some jobs. Of course, this is only true when the global economy is faltering. When the global economy is good, it is as you say: japan consumption can go up, and us production gets hard.

"Holding the price of unskilled labor at low levels harms our own native low-skill workers"

Holding the price of unskilled labor is a signal to the "natives" that they better get some skills fast. Meanwhile, should a mexican remain in absolute poverty in mexico so that some deadbeat born in the USA can have a marginally better life? The immigrant's life, by moving, may improve by 400%, while mr. USA deadbeat's life declines in quality by 20%. Even if USA deadbeat does not get his act in gear, the utilitarian in me says a net good has occurred.

That said, we do need immigration reform. We need to fine those who arrive here illegally(and those who hire them) so much money that they can help fund legal, orderly migration of law-abiding immigrants and guest workers.

"This is NOT how America became rich in the first place."

A bold assertion about a nation that was one of the last western nations to ban slavery.

"We became rich by being a labor-scarce country with high real wages, high interest rates, high profits, and rapid growth."

Labor scarce?? Hey, if we were content to labor in the original 13 colonies, I'm sure enough workers could have been found. Instead, we somehow found enough of that "scarce" labor to employ armies to push Indians on to reservations, annex a chunk of mexico, and generally shoot enough people to achieve that "rapid growth". And, you are missing the fact we leveraged pre-educated immigrants and abundant natural resources. If you ever read your Ida Tarbell, you would know that oil used to be much much easier to find. And, some people rushed out west due to large gold discoveries.

"Driving prices for land and housing up (basically what we have been doing for most of this decade) simply makes homes unaffordable "

Leroy, that's a nonsense assertion. You can't drive the price of something up unless you buy it, and if something is being bought, it must be affordable.

"the REAL path that America took to becoming rich: We mechanized and automated, and thereby became the technological leader of the world. "

I interpret history differently. we mechanized and automated, alright! We mechanized and automated until our factories made more shit that our consumers could buy! Our consumers borrowed instead, they borrowed to buy cars, stocks, and housing, until they could borrow no more. And then we got dumb and passed a law which reduced trade- the Smoot Hawley tariff. and that caused the great depression. We didn't mechanize our way out of the depression. If anything, the mechanization ensured the depression stayed bad. The thing that got us out of the depression was of course a war, and the fact that during the war, employment was high and goods were scarce. People had little to buy with their money besides war bonds, which were a form of savings. And then, we had a GI bill where we educated up a bunch a soldiers.

Savings, Education, and the fact any international competition was BOMBED TO SHIT is what made the US rich. Mechanization does not so much have the good track record.