The answer to the above question is no, meaning that “Austrian Economics” makes no prediction about whether the future will be inflationary or deflationary. That’s why some adherents to “Austrian” economic theory predict inflation while others predict deflation. A good economic theory can give you insights into the likely short-term, long-term, direct and indirect effects of policy choices, but it doesn’t tell you what will happen regardless of future choices and events. I’ll try to explain using two well-known quotes from Ludwig von Mises, the most important economist of the “Austrian” school.

Here’s the first quote:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

The first sentence of this quote is sometimes taken out of context as part of an argument in favour of deflation. It could be construed, if considered in isolation, as a statement that a period of deflation MUST follow a credit-fueled boom. However, no good economist, let alone the greatest economist of the past century, would ever claim that price deflation was inevitable regardless of what was happening to the money supply. To do so would be to claim that the law of supply and demand did not apply to money. In the real world there will always be a link between money supply and money purchasing power. The link is complex, but it will always be possible to reduce the purchasing power of money by increasing its supply.

The second sentence provides the necessary clarification. In essence, it says that a boom fueled by a great credit expansion can collapse in one of two ways. The first is by voluntarily ending the credit expansion. This would generally involve doing nothing or very little while a corrective process ran its course. The other is by relentlessly persisting with credit expansion in an effort to avoid a crisis. This would lead to a total catastrophe of the currency system, meaning it would lead to the currency becoming completely worthless.

The first of the two alternatives is the deflation path. The second is the inflation path (endless rapid monetary inflation leading to hyperinflation and, eventually, to the currency becoming so devalued it no longer functions as money). Note that money can only collapse due to inflation. Deflation makes money more valuable.

The Fed is presently heading down the inflation path, but it doesn’t have to stay on this path. A change of direction is still possible.

Now for the other Mises quote mentioned in the opening paragraph:

“This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.”

The gist is that if the inflation policy continues for long enough then a psychological tipping point will eventually be reached. At this tipping point the value of money will collapse as people rush to exchange whatever money they have for ‘real’ goods. Mises refers to this monetary collapse as the “crack-up boom”. Prior to this point being reached it will not be too late to abandon the inflation policy.

Today, the US is still immersed in the first stage of the inflationary process. If it continues along its current path then a “crack-up boom” will eventually occur, but there is no way of knowing — and “Austrian” economic theory makes no attempt to predict — when such an event will occur. If the current policy course is maintained then the breakdown could occur within 2-5 years (it almost certainly won’t happen within the next 2 years), but it could also be decades away. Importantly, there is still hope that policy-makers will wake up and change course before the masses wake up and trash the currency.

In conclusion, “Austrian” economic theory helps us understand the damage that is caused by monetary inflation and where the relentless implementation of inflation policy will eventually lead. That is, it helps us understand the direct and indirect effects of monetary-policy choices. It doesn’t, however, make specific predictions about whether the next few years will be characterised by inflation or deflation, because whether there is more inflation or a shift into deflation will depend on the future actions of governments and central banks. It will also depend on the performances of financial markets, because, for example, a large stock-market decline could prompt a sufficient increase in the demand for cash to temporarily offset the effects of a higher money supply on the purchasing power of money.

The upshot is that regardless of how the terms are defined, at this stage neither inflation nor deflation is inevitable.

In reaction to the ECB cutting off financial support to Greece’s banks and the resulting closure of all banks in Greece, the Global X Greece ETF (GREK) plunged 19% on Monday 29th June to a new bear-market low.

However, apart from the assets most directly affected by the goings-on in Greece there are currently no real signs of fear in the financial markets. For example:

The Dollar Index initially rallied on Monday and broke above short-term resistance at 95.5-96.5. This was a predictable response to the burgeoning crisis in the euro-zone, but the gains were quickly given back and the Dollar Index ended the day with a loss. This price action reflects a general lack of concern.

The S&P500 Index (SPX) finally broke below the bottom of its recent narrow trading range, but while this is a preliminary sign of weakness it is far from a sign of panic.

The EURO STOXX 50 Index (STOX5E), the European equivalent of the Dow Industrials Index, fell 4% on Monday. This is a sizable decline for a single day, but it wasn’t even enough to push the index to a new multi-week low.

TLT, an ETF proxy for long-dated US Treasuries, bounced on Monday, but the bounce came from a 6-month low and wasn’t even sufficient to take the price to the declining 50-day MA.

The HYG/IEF ratio, a credit-spread indicator that rises when credit spreads contract and falls when credit spreads widen, has been working its way higher since mid-January. This upward trend implies increasing complacency and/or rising economic concidence. It pulled back on Monday in reaction to the Greek news, but the size of Monday’s move was not out of the ordinary.

I would have expected a bigger financial-market reaction to the ramping-up of the “Grexit” risk. However, with none of the other major financial markets showing much fear on Monday, I’m not surprised that there was only a small move in the gold price.

There could be a much bigger reaction over the days ahead as the situation in Greece continues to evolve, but right now the financial world is taking the Greece news in stride. The thinking seems to be: this is a major problem for Greece, but a minor issue elsewhere.

I was recently sent an article containing the claim that during the next financial crisis and/or stock-market crash there will be a panic ‘into’ the US dollar, but that unlike previous crises, when panicking investors obtained their US$ exposure via the purchase of T-Bonds, the next time around they will buy dollars directly. This is wrong, because large investors cannot simply buy dollars. As I’ll now explain, they must buy something denominated in dollars.

If you have $50K of investments in corporate bonds and stocks, then you can sell these investments and deposit the proceeds in a bank account. You can also withdraw the $50K in physical notes and put the money in a home safe. In the first case you are effectively lending the money to a bank and therefore taking-on credit risk, but the deposit will be fully insured so the credit risk will be close to zero. In the second case you have no credit risk, but there will be the risk of theft. The point is that it is feasible for an investor with US$50K to go directly into US$ cash.

This is not true, however, for an investor with hundreds of millions or billions of dollars.

If you have $1B of investments and you want to ‘go to cash’ you can, of course, sell your investments and deposit the proceeds in a bank account. The bank will certainly be glad to receive the money, but less than 1% of the deposit will be covered by insurance. This means that more than 99% of the deposit will be subject to credit risk (the risk that the bank will fail), which can be uncomfortably high during a financial crisis. In effect, depositing the money at a bank will be risking a loss of almost 100%. Not exactly the safety you were looking for when you shifted to cash!

Also, if you have a huge sum of money then removing the money from the banking system will not be an option. First, you probably won’t be permitted to convert such a sum to physical notes, but even in the unlikely event that you are permitted you will have the cost of transporting, storing, insuring and securing the cash. This cost will be large enough to preclude the exercise. Furthermore, accumulating a physical cash position of that magnitude will have the undesirable side effect of drawing greater government scrutiny to your business dealings.

Therefore, if it’s US$ exposure that you want and you are looking for a place to safely park a large quantity of dollars for a short period, you really have no choice other than to lend the money to the US government via the purchase of Treasury notes or bonds. That’s why a panic ‘into’ the US dollar will always be associated with a panic ‘into’ the Treasury market.

Keith Weiner often posts thought-provoking stuff at his Monetary Metals blog. A recent post entitled “Interest – Inflation = #REF” is certainly thought-provoking, although it is also mostly wrong. It is mostly wrong because it is based on a fundamental misunderstanding about saving.

Before I get to the main point, I’ll take issue with the following paragraph from Keith’s post:

“Normally, you don’t spend your savings, only the income on it. In ancient times, people had to hoard a commodity like salt when they worked. In retirement, they sold it to buy food. Modern economies evolved beyond that, with the development of interest. Retirees should not have to liquidate their life savings.”

Who says you shouldn’t have to spend your savings? One of the main reasons to save today is so that you can spend more in the future. Also, interest isn’t a modern development, it has been inherent in economic activity since the dawn of economic activity.

Now, the main point: When people save money, it’s not actually money that they want to save. Money is just a medium of exchange. What they want to save is purchasing power (PP). For example, if I have a million dollars of savings to live on over the next 20 years, what matters to me is what the money buys now and what it will probably buy in the future. If a million dollars is currently enough to buy a mansion in the best part of town and if a dollar is likely to maintain its PP over the next 20 years, then I’ll probably be able to live quite comfortably on my savings. However, if a million dollars only buys me a loaf of bread, then I have a problem.

A consequence is that, contrary to the assertion in Keith’s post, the real interest rate is very important to the average retiree. The easiest way to further explain why is via a hypothetical example.

Fred, our hypothetical retiree, has $1M of savings at Year 0. At the dollar’s current purchasing power his cost of living is $20K per year. Also, the interest rate that he receives on his savings is ZERO, but the dollar is gaining PP at the rate of 5% per year.

At Year 1, Fred’s monetary savings will have declined to $980K, because he spent $20K and received no interest. However, $980K now has the same PP that $1029K had a year earlier. That is, over the course of the year Fred’s PP increased by 29K Year 0 dollars. Furthermore, his annual living expense will have declined to $19K.

At Year 2, Fred’s monetary savings will have declined to $961K, because he spent $19K and received no interest. However, $961K now has the same PP that $1059K had at Year 0.

That is, after 2 years of receiving no nominal interest on his savings, our hypothetical retiree is in a significantly stronger financial position. Thanks to the receipt of a positive real interest rate he now has more purchasing power than he started with. The fact that he has less currency units is irrelevant.

I could provide a second hypothetical example of a retiree who, despite earning a superficially-healthy positive nominal interest rate and ending each year with the same or more currency units, has a worsening financial position over time thanks to a negative real interest rate. I could, but I won’t.

The upshot is that the real interest rate is not only important, for savers and investors it is of greater importance than the nominal interest rate. The problem, today, is not only that central banks have pushed the nominal short-term interest rate down to near zero, it’s also that they have done this while reducing the PP of money. The great sucking sound is wealth being siphoned from savers via negative real interest rates.