Malinvestment vs. Overinvestment

Recently we have come across a very interesting article by Lee Adler, which discusses the connection between the Fed's money printing activities and the shale oil boom. In this context the possibility is mentioned that QE may actually contribute to “creating deflation”.

Obviously, we agree with many, in fact with the vast majority of the points made by Lee Adler in his article. Money printing always diverts investment into lines that later on turn out to be unprofitable, precisely because it distorts relative prices in the economy. Lee Adler should also be commended for drawing attention to the fact that the money relation – i.e., the purchasing power of money – depends not only the money side of things, but also on the goods side.

In an unhampered market economy in which a market-chosen money is employed, it would be reasonable to expect that prices will tend to gently decline over time, as productivity increases will as a rule exceed whatever additions to the money supply occur (for instance, if gold were still used as money, its supply would increase by roughly 1.4% per year and it is a very good bet that economic productivity would be rising at a faster pace).

Thus, a mild, persistent decline in the prices of most or all goods and services is a hallmark of a progressing economy. Needless to say, anyone who has observed the computer industry in the wider sense over recent decades – the productivity growth of which has been so large it actually outpaced the effect of money printing on prices – will realize that no business needs rising consumer prices to thrive, and that consumers do not “postpone their purchases” due to falling prices. The entire idea that a “deflationary spiral” could somehow harm the economy is erroneous (however there is a reason why today's policymakers are afraid of falling prices, which we will briefly discuss below).

There is of course already an issue with the definition of the terms “inflation” and “deflation”: in their original usage, these terms were employed to designate changes in the supply of money and were not just describingone of their possible effects (i.e., a rising or falling “general price level”).

For the discussion at hand readers need to be aware that Lee Adler uses the terms inflation and deflation in their current definition, this is to say to designate a decrease or increase in money's purchasing power, not an increase or decrease in its supply. In terms of the original definition of these expressions, there is definitely no deflation in sight anywhere on the planet, least of all in the US:

US money supply inflation has been especially large since 2008, running at about twice the pace of euro area money supply inflation and more than three times that of Japan – click to enlarge.

Oil prices have indeed fallen sharply, and we believe Lee Adler is quite correct in pointing out that the oil sector is one of the sectors of the economy in which massive malinvestment has occurred as a result of the above depicted monetary pumping. As he notes, the recent decline in oil prices (inter alia) reflects the recent cessation of said monetary pumping. The degree to which malinvestment in the sector has taken place is going to be unmasked over coming months, unless the price of oil rises back to its previous levels very fast.

There is one point made in the article though that needs to be critically examined. This is the point that contains the kernel of the “QE creates deflation” idea (in the sense of falling prices of consumer goods):