The only serious argument against deflation...how valid is it?

Inflationists, as well as disinflationists, present many reasons for why deflation won't materialize. As far as I'm concerned, there is only one serious argument against deflation: 'the central banks of this world won't let it happen.' For a serious argument from the inflationist duo at Pacific Capital Associates, Rich Toscano and John Simon, you may want to review the article, The US Government Will Not Choose Deflation, as well as another one, US Not Going Down Japan's Road, on why they don't see USA following the path of Japan.

(Note: When I say inflationist, I am referring to someone who is attempting to profit off inflation. It does not necessarily mean someone that believes inflation is the best thing for society. Conversely, a deflationist is betting on deflation and may or may not believe deflation is benefitial for society.)

There is certainly some irony in free-market supporters who generally do not believe the government is capable, nor efficient at, manipulating the market to suit its needs in the long run, suddenly believing the government can successfully handle a massive deflationary bust. Leading the inflationist parade tend to be goldbugs who often suggest that the market is stronger than any government. Times have certainly changed when there were many of us who believed the market was stronger than any government, in the long run.

In any case, if you lean towards deflation, like I do, the question really comes down to whether the central banks can prevent it. The suggestion by inflationists has been that the central banks can print an infinite amount of money, so they can ward off any decline in prices (whether a physical good or a financial asset.) For those that argue the money multiplier is collapsing, say because the banks are just sitting on their cash hoard, the suggestion by inflationists has been that the central banks would bypass the banks and interact directly with the borrowers. For those that suggest the multiplier will stay low because borrowers don't want to borrow anymore, the suggestion by inflationists has been that the government will drop money out of helicopters (this has already happened to a minor degree with rumours of Chinese banks, which are all majority-owned, and hence controlled, by the government, handing out money to almost anyone that wants it. It wouldn't be a much of a stretch to see a Federal Reserve bank set up shop in your street corner and lending money to anyone.) So, it appears that the government can prevent deflation by printing as much money as possible and/or lending to as many people as possible. But how feasible is this in the real world?

As I remarked in a recent post, I have been reading Robert Prechter's deflation booklet, and have found it very insightful. He follows Austrian Economics so I don't agree with everything, and he bases many of his investment decisions on pure technical analysis, which I do not follow, but I do think he makes some powerful arguments. With regard to the infinite money printing argument, he makes a very persuasive argument, which is similar to my current thinking on the issue.

In essence, Prechter argues that the anti-deflation strategies suggested by many, including prominent economists such as Ben Bernanke, are nothing more than Ivory Tower concoctions. That is to say, the strategies look good on paper but are unfeasible in real life. In particular, the strategies ignore the reactions of market participants, particularly bond investors. Let me quote two full paragraphs of his argument (bolds by me):

(source: THE Guide to Understanding Deflation by Robert Prechter. Elliott Wave International. Quoted text below from section titled The Coming Change at the Fed on pages 29-30. Bolded text are by Sivaram Velauthapillai.)

When credit expands beyond an economy’s ability to pay the interest and principal, the trend toward expansion reverses, and the amount of outstanding credit contracts as debtors pay off their loans or default. The resulting drop in the credit supply is deflation. While it seems sensible to say that all the Fed need do is to create more money, i.e. FRNs, to “combat deflation,” it is sensible only in a world in which a vacuum replaces the actual forces that any such policy would encounter. If investors worldwide were to become informed, or even suspicious, that the Fed would follow the ’copter course, it would divest itself of dollar-denominated debt assets, causing a collapse in the value of dollar-denominated bonds, notes and bills. This collapse would be deflation. It would be a collapse in the dollar value of the outstanding credit supply.

Contrary to popular belief, neither the government nor the Fed would wish such a thing to happen. The U.S. government does not want its bonds to attain (official) junk status, because its borrowing power is one of the only two powers over money that it has, the first being taxation. The Fed would commit suicide by hyper-inflating, because Federal government bonds are the reserves of the Fed. That’s why it is called “the Federal Reserve System.” U.S. bonds are the source of its power. As long as the process of credit expansion is done slowly, as it has been since 1933, people can adjust their thinking to accommodate the expansion without panicking. But by flooding the market with FRNs, the Fed would cause a panic among bond-holders, and their selling would depress the value of the Fed’s own reserves. The ivory-tower theory of unlimited cash creation to combat a credit implosion would meet cold, harsh reality, and reality would win; deflation would win. Von Mises was exactly right: “There is no means of avoiding the final collapse of a boom brought about by credit expansion.” Observe that he said “no means.” He did not say, “No means other than helicopters.”

I'm not an AustEcon follower so I have no idea if Ludwig Von Mises is right in saying that all credit expansions must necessarily collapse. But I do think Prechter is right in observing human behaviour—in this case the behaviour of market participants to money printing.

I just don't see how the US government would pursue some of the extreme anti-deflationary strategies (outside of war or total chaos.) As Prechter points out, if the US government loses the bond market access, it will be floating in the air, only supported by FedRes bond purchases.

If there is mass exit from US$-denominated assets, it would collapse the price of nearly all US$ assets. This should lead to a contraction of credit which is generally defined as deflation.

Now, there is something that needs to be said here. Prechter makes it clear in his guide but it is also something that is debated countless times on message boards, the media, and so forth, and causes a lot of confusion. Prechter, like most AustEcon followers, looks at the entire money supply which includes cash/currency plus credit. Some people out there only look at cash.

In my opinion, one should look cash plus credit (it is too complicated to give my opinion here as to why; maybe in another post.) If the FedRes prints a lot of money, someone looking at cash-only may perceive it as being highly inflationary. After all, the currency in circulation would have gone up. However, if you look at the total including credit, you may actually see deflation. This can occur because credit may decline even if currency is printed.

Going back to the conclusion presented by Prechter, is it actually probable that the FedRes (as well as others facing deflationary busts) can print money at will? I would say no. They would kill the government instantaneously. This is something that the inflationists don't address properly. Can any inflationist out there explain how the US government is going to print huge quantity of money and survive?