Friday, August 1, 2008

The Inflation Versus Deflation Argument - Part 2

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Inflation can only get out of control if the monetary authorities act irresponsibly by failing to stop rising prices and respond with denial and duplicity instead. In general, the worse the denial the greater the final inflation rate. In no case was this more clearly demonstrated than during the German hyperinflation when prices rose a 100 trillion percent between 1914 and 1923. Toward the end, consumer prices more than doubled every two days.

Eminent financiers, economists, politicians and Wiemar government officials all denied that inflation even existed in Germany, at least right up to the time of its final hyper phase and some of them continued with their denials even in the midst of those explosive price increases. Minister of Finance, Helfferich, assured the public that there was no inflation in Germany because the 'value' of currency in circulation was covered by a greater amount of gold reserves than it had been before prices began rising. Eminent professors, Elser and Wolf, echoed his argument. President of the Reichsbank, Havenstein, categorically denied that the German central bank was creating inflation and was convinced he was following a restrictive monetary policy. The Statistical Bureau of the German Government concluded in a study that there was a shortage of currency in Germany, but a great deal of inflation abroad!

How did these government officials and eminent economic authorities justify their continued assertions that there was no inflation despite rapidly rising consumer prices? They used one of the oldest tricks in the book, simply redefining inflation to be something else. By saying X really isn't X, but X is really Y and Y has certain attributes so X must have those attributes, you could of course prove almost anything. And the Wiemar German experts did just that by defining inflation as an in increase in the real value of currency in circulation (instead of the nominal value, which would essentially be the current definition of money supply) plus credit . While the total face value of currency in Germany was increasing dramatically, the total actual value was declining and this was interpreted as 'proof' that deflation was taking place. The accurate interpretation would have been extreme consumer price increases can take place when real money supply and credit are decreasing.

If instead of defining inflation as a function of real money supply and credit, Wiemar economists had defined it as the change in the value of a nations currency, they would have arrived at the correct conclusions about consumer price inflation. The exchange rate of the German mark essentially went to zero as price increases in Germany approached infinity. Since that time, globalization has only made the importance of currency as the key determinant of inflation even more important.

While the mistakes of the Wiemar German officials and financial experts seem laughable today, almost the exact same arguments about inflation began circulating in the U.S. in 2008. If such absurdities only surface prior to a massive outbreak of inflation, serious trouble was obviously ahead for the U.S. financial system.

NEXT: The Inflation Versus Deflation Argument - Part 3

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:

Daryl Montgomery
Organizer, New York Investing meetup

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