Financial Crisis Has Inflationary And Deflationary Potential

With legendary investor Jim Rogers warning that repeated liquidity injections are setting the stage for a "massive inflation holocaust", it’s worth asking if deflation may also be something to worry about amid the global financial crisis.

After all, as the credit crunch thwarts borrowing and lending, a logical economic consequence is a decline in demand and consumption, which would depress prices.

The good news for price stability fans is that neither is likely to be a problem for the global economy.

“It's always tough to disentangle a garden variety recession and financial market chaos,” says Josh Bivens of the Economic Policy Institute. “My first thought is that wondering about inflation right now is so far down the list of things to worry about.”

(Watch the accompanying video for the full interview with Jim Rogers...)

That thinking was echoed by other economists, who wouldn’t rule out a inflationary problem but said it was a remote and distant possibility that a dangerous price ascent would occur.

“It’s way ahead of the game," said Bank of Tokyo-Mitsubishi economist Chris Rupkey, who also cited the “long lead time” involved in that scenario.

Economists ticked off several reasons why inflation isn’t likely to be a problem in the short term or otherwise.

In general, economists say the liquidity moves are providing much-need cash, with the intention of reflating the global economy through an expansion of money supply such that normal lending resumes.

“Those hoarding cash are highly unlikely to go out and buy something,” says David Resler, chief economist at Nomura International. “We now have massive asset price deflation," from securities to real estate to commodities.

Rupkey says more money is certainly not “showing up in bank deposits.” 

Bivens says the liquidity is pumping potential purchasing power into the system, not actual power.

Disinflation, not inflation, is now the operative condition largely because of the bursting of the commodities bubble. Prices continue to increase but at a lesser pace.

Economist Ram Bhagavatula, managing director at the hedge fund Combinatorics Capital, says the “recession will be pretty serious” and thus depress production and demand, which relieve wage and price pressures.

A conventional recession and the credit crunch, however, also have the potential for creating deflation, or falling prices.

“A credit crunch means consumers and businesses are not able to spend the money they would spend,” says Bivens. “We use debt for a lot of consumption.”

The classic deflationary spiral involves declining demand as consumers await lower prices. That in turn results in a decline in production and payrolls, which depresses demand even further, requiring yet more price cuts.

“The downward pressure on prices will be limited,” says Resler, who adds that if goods and services become cheaper, it’s likely to “encourage buying.” 

© 2009 CNBC.com