Lost and Found

Music can be such a revelation
Dancing around you feel the sweet sensation
--Madonna

Milton Friedman once claimed that inflation is always and everywhere a monetary phenomenon. The implication is that it's an issue of supply, which of course in modern day economies is controlled by central banks.

But modern money is not primarily denominated in paper bills. Instead, it's in the form of credit. And no matter how much supply central banks offer (and their general tendency is to offer a ton of it), credit needs demand (i.e., borrowers) in order to come to life.

As such, I think deflation and inflation are not monetary phenomena at all. They are social phenomena related to collective views on risk.

A deflationary situation is grounded in collective risk aversion. Folks shed risky assets, pay down debt, and shun loans because they have little appetite for potential loss.

Inflation is characterized by the opposite. Folks buy stocks, houses, and junk bonds, and lever up because their appetite for risk is high.

Perhaps the key question to be asking right now is, "Which direction is the collective appetite for risk heading?"

Bulls are pointing to higher stock market prices and collapsing credit spreads as indicators that risk appetites are returning to markets.

Bears point to slow real estate markets and low levels of bank loans as indicators of persistent risk aversion.

I must admit that, after thinking that we've entered into a secular period of risk aversion, I'm flinching on that thesis a bit. Stocks jam higher, and those credit spreads, which have been very effective forecasters of risk appetite in the intermediate term, suggest folks want more risk.

We may be at an inflection point here. Will collective risk appetites resume their 20+ yr groove after a brief sabbatical?