Inflation, Deflation and Recession

Discussing recent talk of deflation with a friend, I offered these thoughts. He asked, "My understanding is that the Fed controls the money supply, which is what inflation really measures, and that they maintain a low but steady level of inflation. How could it be that we could end up with deflation?"

Ironically, the people worried about deflation now are the ones disputing the "slow but steady level of inflation" in recent years, because they define "inflation" in terms of the money supply (or the volume of credit extended) rather than a current rise in consumer prices.

The recent rise in house prices wasn't slow. Share prices also rose rapidly in recent decades. Share prices fell after 9/11 but recovered rapidly in a very low interest rate environment. Consumer prices and wages haven't risen extremely rapidly yet, but the CPI has been over 5% recently, and that level seems worrisome.

I understand the inflation/deflation issue this way, from the Austrian perspective. Malinvestment occurs when credit is very easy, because easy credit enables people to reorganize means of production. You're a builder. I borrow to buy a building from you. The building will house a widget factory. I hope to earn enough producing and selling the widgets to repay the loan. The lower the interest rate, the more I'll pay for the building (and other resources). That's part of the inflation issue.

A lower interest rate also lowers my risk aversion, because my expected yield on the widget factory involves uncertain assumptions, like how many widgets I can turn out and what price they will fetch. My expected price is a product of prices I predict and the likelihood that my predictions are correct. A lower cost of producing the widgets tempts me to accept a lower likelihood of earning a given price for a particular volume of my produce.

In the Austrian view, when credit is too easy, we invest too much, i.e. we shift too much expenditure away from current consumption and toward organizing means for future consumption. Eventually, consumers effectively can't absorb all of the produce, so prices fall, businesses fail to profit, and we have a recession. The price of productive means previously inflated by the cheap credit then also falls as investors divest. The longer investors use cheap credit to organize means to satisfy demand also created by cheap consumer credit, the deeper we sink into unsustainable debt, and the longer the deflationary recession lasts.

This Austrian view involves an imbalance between production for current consumption and production for future consumption, an imbalance between the production of final goods and the production of intermediate goods that are means of producing other goods; however, predicting a fall in the price of common goods involves a questionable assumption.

Entrepreneurship is experimental. An entrepreneurial investment is an experiment in the organization of productive means to produce something that consumers might or might not want. Producing too much of a desirable good is only one reason that ventures fail to profit. Entrepreneurs may produce goods that no one ever much wanted. When we have "the right amount of credit", new experiments replace these failed experiments continuously, and the supply of desirable goods grows just fast enough to meet growing demand, so prices are stable.

When excessive credit simulates excessive experimental entrepreneurship, malinvestment occurs, but the supply of goods that people actually want need not increase. The supply of desired goods can even decrease as resources producing desirable goods are drawn into entrepreneurial experiments destined to fail. In this scenario, consumer prices rise until investors acknowledge the failures and reorganize resources to produce more desirable goods. This recession can be inflationary rather then deflationary.

Some Austrians argue that malinvestment is simply a matter of central bankers commanding the extension of too much credit, but I take a different view. Excessive credit can occur without central authorities. For example, baby boomers want to retire for a given period, so they save a lot, i.e. they defer current consumption to purchase means of future production. This expansion of credit is not a matter of central authorities simply printing money. It reflects real desires by current consumers to defer current consumption for future consumption.

But simply deferring consumption to purchase means of production or extend credit does not guarantee future production. We must purchase sufficient means of the right sort to satisfy the future demands. Investors don't really behave this way. Investors purchase means to satisfy current demands, not future demands. Even if savers really defer consumption to invest in future production, they can, over a long period of time, fail to purchase enough of the real means of producing in the future to replace the consumption they currently defer.

The most significant example of this malinvestment in recent decades is inadequate investment in labor, i.e. we probably didn't produce enough labor (children) to produce the goods that retirees expect to consume in the future. Even if these retirees defer as much current consumption, purchasing capital instead, as they expect to consume in retirement, they don't necessarily purchase enough of the required capital.

For example, would be retirees can build factories that later do not produce the expected goods for want of adequate labor, because the would be retirees produce the factories but not the labor. Simply "saving" is not enough. We must invest in the right mix of capital, and I doubt that we have. Our housing crisis may be an example of building too many "factories" for too few laborers.

So I don't expect a deflationary recession, except in particular goods like housing and "intermediate goods", goods enabling laborers to produce other goods. I expect an inflationary recession, or I expect stagflation with output growing more slowly as many prices rise, simply because the labor force grows more slowly while many consumers try to retire.

Between 1970 and 2000, the U.S. labor force (people between 20 and 64) grew three times faster than it will grow between 2000 and 2030, but the number of U.S. retirees (people 65 and over) will double over the later period, growing even faster than it grew in the earlier period.

U.S. population (thousands)
	1970	2000	2030
Children (0-19)	77,170	83,236	95,104
Workers (20-64)	106,706	166,515	197,027
Retirees (65+)	20,106	35,061	71,453
Retirees/worker	19%	21%	36%
Children/worker	72%	50%	48%

Change in U.S. population
	1970-2000	2000-2030
Children (0-19)	+8%	+14%
Workers (20-64)	+56%	+18%
Retirees (65+)	+74%	+104%
Retirees/worker	+12%	+71%
Children/worker	-31%	-3.4%

The figures are from the U.S. Census Bureau. Projected figures for 2000-2030 are reasonably reliable for Workers and Retirees, since the projection largely ages people already born using existing actuarial statistics. A projection of U.S. population must assume considerable immigration. The projected number of children assumes a substantial increase in fertility, but this increase cannot affect the projected Retirees/Worker ratio.