Financial Profit Inflation from Price Deflation By Henry C.K. Liu This article appeared in AToL on May 27, 2008 as Liquidity drowns meaning of 'inflation'. An edicted excerpt of this article appeared in New Deal 2.0, a project of the Franklin and Eleanor Roosevelt Institute. The conventional terms - inflation, deflation - are no longer adequate for describing the overall monetary effect of excess liquidity recently released by the Federal Reserve, the nation's central bank, to deal with the year-long credit crunch. This is because the approach adopted by the Treasury and the Fed to deal with a financial crisis of unsustainable debt created by excess liguidity is to inject more liquidity in the form of both new public debt and newly created money into the economy and to channel it to debt-laden institutions to reflate a burst debt-driven asset price bubble. The Treasury does not have any power to create new money. It has to borrow from the credit market, thus shifting private debt into public debt. The Fed has the authority to create new money. Unfortunately, the Fed's new money has not been going to consumers in the form of full employment with rising wages to restore fallen demand, but instead going only to debt-infested distressed institutions to allow them to deleverage from toxic debt. Thus deflation in the equity market (falling share prices) has been cushioned by newly issued money, while aggregate wage income continues to fall to further reduce aggregate demand. Falling demand deflates commodity prices, but not enough to restore demand because aggregate wages are falling faster. When financial institutions deleverage with free money from the central bank, the creditors receive the money while the Fed assumes the toxic liability by expanding its balance sheet. Deleverage reduces financial costs while increases cash flow to allow zombie financial institutions to return to nominal profitability with unearned income while laying off workers to cut operational cost. Thus we have financial profit inflation with price deflation in a shrinking economy. What we will have going forward is not Weimar Republic type price hyperinflation, but a financial profit inflation in which zombie financial institutions turning nominally profitable in a collapsing economy. The danger is that this unearned nominal financial profit is mistaken as a sign of economic recovery, inducing the public to invest what remaining wealth they still hold only to lose more of it at the next market melt down which will come when the profit bubble bursts. Hyperinflation is fatal because hedging against it causes market failures to destroy wealth. Normally, when markets are functioning, unhedged inflation favors debtors by reducing the value of liabilities they owe to creditors. Instead of destroying wealth, unhedged inflation merely transfers wealth from creditors to debtors. But with government intervention in the financial market, both debtors and creditors are the taxpayers. In such circumstances even moderate inflation destroys wealth because there are no winning parties. Debt denominated in fiat currency is borrowed wealth to be repaid later with wealth stored in money protected by monetary policy. Bank deleveraging with Fed new money cancels private debt at full face value with money that has not been earned by anyone, i.e. with no stored wealth. That kind of money is toxic in that the more valuable it is (with increased purchasing power to buy more as prices deflate),  the more it degrades wealth because no wealth has been put into the money to be stored, thus negating  the fundamental prerequisite of money as a storer of value. This is not demand destruction because decline in demand is tmeproarily slowed down by the new money. Rather, it is money destruction as a restorer of value while it produces a misleading and confusing effect on aggregate demand. Thinking about the value of any real asset (gold, oil, etc.) in money (dollars) terms is misleading. The correct way is to think about the value of the money (dollars) in asset (gold. oil, etc.) terms, because asset (gold, oil,etc.) is wealth. The Fed can create money but it cannot create wealth. Central bankers are savvy enough to know that while they can create money, they cannot create wealth. To bind money to wealth, central bankers must fight inflation as if it were a financial plague. But the first law of growth economics states that to create wealth through growth, some inflation needs to be tolerated. The solution then is to make the working poor pay for the pain of inflation by giving the rich a bigger share of the monetized wealth created via inflation, so that the loss of purchasing power from inflation is mostly borne by the low-wage working poor, and not by the owners of capital, the monetary value of which is protected from inflation through low wages. Thus the working poor loses in both boom times and bust times.   Inflation is deemed benign by monetarism as long as wages rise at a slower pace than asset prices. The monetarist iron law of wages worked in the industrial age, with the resultant excess capacity absorbed by conspicuous consumption of the moneyed class, although it eventually heralded in the age of revolutions. But the iron law of wages no longer works in the post-industrial age in which growth can only come from mass demand management because overcapacity has grown beyond the ability of conspicuous consumption of a few to absorb in an economic democracy.    That has been the basic problem of the global economy for the past three decades. Low wages even in boom times have landed the world in its current sorry state of overcapacity masked by unsustainable demand created by a debt bubble that finally imploded in July 2007. The whole world is now producing goods and services made by low-wage workers who cannot afford to buy what they make except by taking on debt on which they eventually will default because their low income cannot service it. All the stimulus spending by all governments perpetuates this dysfunctionality. There will be no recovery from this dysfunctional financial system. Only reform toward full empolyment with rising wages will save this severely impaired economy. How can that be done? Simple: Make the cost of wage increases deductible from corporate income tax and make the savings from layoffs taxable as corporate income. May 25. 2009