We Don’t Know If the COVID-19 Shock Will Be Inflationary or Deflationary

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by Michael Hoffman via Mises

I recently wrote about the economic implications of COVID-19 and what effects it will have on the economy. There is much debate on whether this supply shock will inevitably result in inflation or will induce a fall in aggregate demand and thus cause deflation. My opinion is that neither will occur in the conventional sense, but the focus here will not be on predicting the final outcome, only on illustrating the complexity of money and its effects on prices. This “corona shock” is reminiscent of what I have dubbed monetary kaleidics.1

The term is derived from a metaphor used by Austrian economist Ludwig Lachmann in which he compared the ever changing patterns of economic activity to the seemingly random and unpredictable patterns we see in a kaleidoscope. His view was that it was a mistake to assume that the economy is always tending towards equilibrium, and that countervailing forces are always at play. It is true that there are many variables at play in a complex economy, and one of the most elusive of these is money and its effect on the price structure. Below are some countervailing economic forces from the COVID-19 shock:

Contributing to Price Inflation:

  • Domestic and global supply chain reductions, causing a fall in production and output
  • The Federal Reserve’s $6 trillion stimulus
  • Inflation expectations
  • Reduction in oil production

Contributing to Price Deflation:

  • Unemployment and falling incomes
  • Money velocity falling due to pessimism and uncertainty
  • Global demand for the dollar and US Treasurys
  • Stimulus used to pay down debt

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As we can see, there are numerous factors at play. It cannot be denied that a significant rise in unemployment, which is currently happening, as 16 million workers have lost their jobs in the last several weeks, reduces real demand and thus spending. In fact, this can lead the unemployed to increase their savings even further as they anticipate a prolonged period of being out of work. This creates a tendency toward deflation. In addition, COVID-19 is a threat to many major world economies, not just the US. Investors, corporations, and even governments will likely find the US dollar to be a safe haven for investment in such uncertain times. This will also lead to the demand for dollars to rise, causing a commensurate tendency for its purchasing power to rise as well. In fact, this is just what we are seeing at present. US prices seem to be falling in the graph posted by Reuters below.

On the other hand, there are serious inflationary pressures bubbling that have yet to surface. We’ve already seen disruptions to our supply chains, as the empty shelves at our local supermarkets like Walmart shows. This alone, however, has not been significant enough to increase the general level, or trend, of prices in the economy because of the counteracting forces mentioned above. Yet, this week checks have begun posting to US bank accounts and will continue to do so for months. This could quite possibly offset the fall in money velocity we’ve seen by unemployed consumers thus far.

There are complications involved, of course. Part of the Federal reserve’s stimulus package is not “money printing” per sebut repos (repurchase agreements). In essence, $1.5 trillion of the Fed’s efforts haven’t necessarily permanently increased the money supply, but have provided temporary liquidity through short-term loans (some of them overnight) that will be paid back. This means that although over $2 trillion of the total stimulus is inflationary, it is uncertain how much of the remainder will be as well. If the loans that the central bank has made to banks cannot be paid back, then it will perhaps be forced to monetize them, likely resulting in both price inflation and money supply inflation. The Federal Reserve’s balance sheet now exceeds $6 trillion, and it is likely to climb higher as the potential for debt monetization rises, putting upward pressure on asset and consumer prices.

In addition, the Federal reserve has also promised to provide loans to small businesses through the Small Business Administration’s Paycheck Protection Program, to provide liquidity to money market mutual funds, and to prop up the municipal bond market with liquidity. This has inflationary potential as well, though nothing is certain. One possibility is that, far from satisfying the demand for liquidity in such a crisis, an increase in the supply of credit or money might actually increase the demand for it. As Amasa Walker states,”the supply does not satisfy the demand: it excites it. Like an unnatural stimulus taken into the human system, it creates an increasing desire for more; and the more it is gratified, the more insatiable are its cravings.”

Inflationary expectations are another consideration as well. Should consumers expect stores to raise the prices of the goods they need the most, such as food and toiletries, they’ll increase current spending, creating a self-fulfilling prophesy (unless price controls are used, which economist Paul Krugman recently advocated for).

Some have claimed that the desire to pay down debt will outweigh the desire to spend on either consumption or investment. This may be true, but we have to remember what happens to such expenditures. If creditors decide not to reloan or hoard the money, and instead spend it, this excess supply of money created by the stimulus will create added demand for consumer goods or capital goods despite the initial receivers of the funds using it to reduce their debt burdens. This will, in turn, create inflation. They key to everything is the subjectivism behind the demand for money, which was emphasized in Lachmann’s writings.

The usual tools of analysis by economists won’t work in such a kaleidic situation. The government lockdown of “nonessential” businesses has both a deflationary and inflationary effect on the monetary and financial system. We are seeing a significant rise in unemployment which will continue so long as the shutdown lasts. In fact, it could continue into the indefinite future as “regime uncertainty” takes hold, creating a lack of interest in hiring and increasing output in the near future among businesses. Also, further monetary stimulus proposed by the Trump administration could result in a combination of significantly high inflation and high unemployment, also known as stagflation.

Stagflation is the worst of both worlds, and will take hold if either the money supply or money velocity rises as businesses are prevented from resuming commerce and workers are prevented from producing. The result will be an “excess” supply of money in the system alongside a reduction in the supply of goods and services. The most difficult part is extracting all of the variables at play and weighing them against each other. This would take an admirable effort, but would also be mistaken. We cannot know what will happen to people’s subjective demands for money or their demand for specific products. Such a signal extraction issue is why money is as misunderstood as it is pervasive. The corona shock is a real-world example of monetary kaleidics, and the patterns we are seeing emerge from it are as unpredictable and turbulent as the weather often is. Time will tell how the economy will react, but, much like a kaleidoscope, radical changes are likely.

1.Michael J. Hoffman, Monetary Kaleidics: Reflections on Money Illusion and the War on Cash (self-pub., 2019):
The monetary kaleidics of the economy today indicate an ever-changing order of financial interactions that must be accompanied by a progressive theory of money, which maintains a foundation that allows for the evolution of economic exchange.


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