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The Third Way In The Inflation/Deflation Debate

 April 17, 2009 05:41 PM

The inflation vs. deflation call may well be the call of the decade for investment policy. On one side are the inflationists, who argue that all this fiscal and monetary stimulus is bound to create inflationary pressures once the world economy begins to recover. On the other side are the deflationists, who argue that the de-leveraging process has unleashed powerful deflationary forces.

There may be a Third Way out of this debate – and that Third Way is even more scary than either of the scenarios contemplated by the two factions.

Do you believe Warren Buffett?
The conventional economic view is exemplified by the likes Warren Buffett. In his latest letter to Berkshire shareholders, he wrote (emphasis mine):

This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone "all in." Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation.

The Federal Reserve is well aware of these concerns. In a speech on April 14, 2009, Ben Bernanke stated that:

I can assure you that monetary policy makers are fully committed to acting as needed to withdraw on a timely basis the extraordinary support now being provided to the economy, and we are confident in our ability to do so.

Avner Mandelman of Giraffe Capital suggested that the Obama Administration is positioning Paul Volcker in the wings for a liquidity mop-up once the financial crisis is over. It is unclear, however, how much political will there is to take the pain once it is clear that an economic recovery has begun.

Deflationists: Proof by counterexpample
When I went to school back in the Dark Ages, math classes had a technique of "proof by counterexample". Conventional wisdom holds that all this stimulus is going to result in inflation some time down the road.

Japan is the proof by counterexample. During the Lost Decade, the Japanese government spent like crazy and the BoJ adopted a policy of quantitative easing. Debt to GDP ballooned. The government built roads to nowhere. Yet the economy didn't recover.

One of the leaders of this deflationist movement is Richard Koo, whose webcast is long but well worth watching. He argues that as long as government spending displaces consumer spending (because consumers are saving and not spending), there will be no inflation. The appropriate policy in this case, according to Koo, is for government to spend until it hurts and spend some more.

The Third Way: Down the hyperinflation road?
Simon Johnson, formerly of the IMF, wrote a disturbing article about the current financial crisis that compares past emerging market crises to the current one (emphasis mine):

(T)o IMF officials, all of these crises looked depressingly similar.

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