The financial landscape shifted at breakneck speed during 2008. But so did expectations for the global economy, which are supposed to move at a more considered pace. One of the fastest changes of view was on inflation. In the first half, rising prices were the concern following years of appreciating asset prices, in particular for commodities and food.

Now deflation is the buzzword. Headline measures are falling rapidly around the world as energy prices collapse. Many economists warn that a prolonged period of Japanese-style deflation is possible. Core inflation is ticking lower too. But the deflation doomsayers are not having the argument all their own way. Others warn of a return to rampant high inflation, or even hyper-inflation. How to reconcile such diametrically opposed views?

At root is a disagreement about what money is. For the deflationists, the current malaise is all about credit. Even cash is seen as an IOU of the Federal Reserve backed by debt. Private sector credit is already contracting and, at some point, they argue, confidence will even be lost in the government’s ability to create credit (money). This will keep a downward pressure on prices.

Rubbish, say those in the inflation camp, such as Casey Research. New money is not necessarily backed by debt (the Fed could just as easily buy stocks instead of bonds) and the government has unlimited power to create money. Whatever the rate of deflation, the central bank’s printing presses can out-run it. That is why it is possible to have increasing money supply while credit is contracting.

Much then, rests on the actions of government. History shows, however, that the temptation to swap pain today for inflation tomorrow always proves too hard to resist. With politicians falling over themselves to “do something”, there is no reason to think this episode will end differently.

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