How It Fits Together——QE, Deflation And Malinvestment


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 describing one 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:


TMS-2-annUS 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):


“The central banks have been frustrated in their insane and misguided aim to increase inflation because QE and ZIRP actually foster the opposite of what central bankers expect. Central bankers and conomists think that to get inflation they only need to print more money, not recognizing that the inflation that does result from money printing, asset inflation, leads eventually to consumer goods deflation. ZIRP and QE cause malinvestment and overinvestment that leads to excess productive capacity. That leads to overproduction and oversupply. Oversupply puts downward pressure on prices. That spurs a vicious cycle where the central banks print more money to try to create inflation. That puts more cash into the accounts of the leveraged speculating community and off we go again.”


(emphasis added)

The problem with the above is the term “overinvestment”. What the manipulation of the money supply and interest rates does is to create malinvestment alone. In short, it diverts scarce resources into what later turns out to have been the wrong lines. There can be no “overinvestment”, unless we use to term to point to the amount of investment in specific sectors in the economy that have been the chief beneficiaries of monetary pumping.

This is so because no additional real capital or real resources can be created by money printing. New money does however enter the economy at discrete points, which means that some prices will always rise before others. Often the sectors that eventually attract the bulk of capital malinvestment initially appear to offer sensible investment propositions. However, since the amount of capital in the economy is not magically increased by pumping up the money supply, this investment activity can only take place at the expense of other economic activities. If a massive amount of resources is drawn into the oil drilling business, then these resources cannot be employed for alternative uses. These “alternative uses” are what is not seen, because they simply don’t exist as a result of this diversion of capital.

Ludwig von Mises explained the problem with the aid of an excellent anecdote:


“The erroneous belief that the essential feature of the boom is overinvestment and not malinvestment is due to the habit of judging conditions merely according to what is perceptible and tangible. The observer notices only the malinvestments which are visible and fails to recognize that these establishments are malinvestments only because of the fact that other plants-those required for the production of the complementary factors of production and those required for the production of consumer goods more urgently demanded by the public are lacking.

Technological conditions make it necessary to start an expansion of production by expanding first the size of the plants producing the goods of those orders which are farthest removed from the finished consumers’ goods. In order to expand the production of shoes, clothes, motorcars, furniture, houses, one must begin with increasing the production of iron, steel, copper, and other such goods. In employing the supply of r + p1 + p2 which would suffice for the production of a + g1+ g2 as if it were r + p1 + p2 + p3 + p4 and would suffice for the production of a + g1 + g2 + g3 + g4, one must first engage in increasing the output of those products and structures which for physical reasons are first required.

The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal.


(emphasis added)

In short, the “master builders” have been led astray, as monetary pumping has distorted prices and thereby falsified economic calculation. As a result we do however not have “general overproduction”: instead, we have too much production of something that is not as urgently needed as was previously believed, while either too little or nothing at all is produced of other things that may have been produced instead and may be needed more urgently.


The Nature of Malinvestment

In Mises’ explanation excerpted from Human Action above, it is also mentioned that what tends to attract the most investment as a result of a boom created by monetary pumping are sectors in the higher stages of the production structure – largely to the detriment of consumer goods production. The reason for this is that capital goods are as a rule the greatest beneficiaries of a boom in its early to middle stages.

Their prices will increase more than those of goods that are situated closer to the consumer stage of the production structure, because they are affected to a much greater extent by the time discount. Declining interest rates will therefore tend to attract investment to these earlier stages. We can show this effect with the help of the production indexes calculated by the Fed. As can be seen, capital goods production tends to expand far more during boom times than consumer goods production, and also tends to collapse more strongly during busts, during which time malinvestments are unmasked and many of them have to be liquidated.


Capital and consumer goods production-annThe production of capital goods vs. the production of consumer goods and non-durable consumer goods – click to enlarge.


One of the things we can conclude from the above is that at some point in the future, the distortion of prices could well be subject to a renewed shift: there may come a time when the prices of many capital goods decline, but the prices of consumer goods begin to rise because their production has been neglected.


Deflation Paranoia

It is of course true that the money supply is mainly expanded by a method that involves the creation of additional debt – which results in the bulk of the money supply consisting of uncovered money substitutes or fiduciary media (it is slightly different with “QE”, as the Fed creates both bank reserves and new deposit money when it buys securities from non-banks, so most of the money created in this fashion is in a sense “standard money”, i.e., it consists of covered money substitutes that can at any time be transformed into currency).

Such uncovered money substitutes are inherently susceptible to deflation when a boom turns to bust. In fact, the Federal Reserve and the FDIC were created for the express purpose to help avoid bank runs that would result in a contraction of the money supply. Let us briefly consider how the money supply can contract:

In times of the gold standard, busts would tend to destroy many of the extant fiduciary media (both uncovered bank notes and uncovered deposit money), with the money supply shrinking back close to its original specie backing when banks that had overextended themselves went bust. Once a bank went bust, all the uncovered money it had issued went to money heaven. Busts were more frequent at the time, but they also tended to clear out economic imbalances swiftly, and the knowledge that this would happen put a brake on the expansion of fiduciary media by private banks. Bank runs were a healthy way of clearing the dead wood from the economy.

In modern times, this no longer happens, although recent changes in EU legislation (which other countries are said to be eager to adopt as well) suggest it might once again happen in the future (in fact, it has already happened in Cyprus). One reason why it cannot be allowed to happen though is the modern welfare/warfare State. It is precisely the fiat money system that makes it possible for governments to incur vast debts that will never be paid back. As the euro area debt crisis showed, if the ability to print their own money is taken away from individual countries, this vast debt can become a problem. It took a pledge by the ECB council that it would print however much was required to calm the markets down again.

“Inflating away” the real value of government debt by means of financial repression is an essential feature of the modern monetary system. Moreover, since the great bulk of the outstanding money supply still consists of fiduciary media, a true deflation (i.e., a contraction of the money supply) would bring the government, the banking system, the shadow banking system and every large debtor into dire straits. The real value of their debts would rise instead of declining. It would be advantageous only for the prudent who have not incurred more debt that than they can shoulder, but even they would have to fear for their claims held in the form of deposit money. Therefore, in spite of legislation that will supposedly allow deposit money to disappear back into the thin air whence it came again, we can rest reasonably assured that bail-outs will once again occur if push truly comes to shove.

In such a system, how can the money supply possibly decline? There is only one way: if/when more debt is paid back than is created. This is in a nutshell at the root of the deflation angst of modern-day policymakers. They would rather expropriate savers than see the ability of governments to amass even more debt diminished. In addition, there is a widely held and erroneous belief that “economic growth” requires a steady increase in both the supply of credit and money.



One cannot make generalizations about the purchasing power of money in terms of consumer goods from the fact that malinvestments in highers stages of the capital structure are unmasked. In fact, since the production of consumer goods is neglected in favor of capital goods production during a monetary boom, there could well be a strong rise in consumer prices at some point in the future. The time lags involved can be quite considerable, as post war history has already shown. What happens in detail depends moreover on contingent circumstances, which have become more complex with the huge expansion in international trade. Therefore, it is also not certain whether, or when, consumer prices will increase. What is certain is only that some prices in the economy will always increase when the money supply is expanded. We will discuss the above mentioned “contingent circumstances” in greater detail in a future post.


Charts by: Saint Louis Federal Reserve Research