Inflation vs Deflation

Oh yeah............This is probably the most hotly contested topic 'round these parts. Just peruse the boards and you'll see some brilliant arguements for both sides; and some not so brilliant ones too.

I have a feeling that now that you've lit the fuse it's time to sit back and watch the fireworks!!

Inflation v. Deflation

The general belief at the moment seems to be that hyperinflation will happen because the Federal Reserve has been printing money to support its quantitative easing program and that this must continue because they have no choice. Either that or the financial system will collapse along with the US dollar. The remedy to protect oneself is to buy gold or other precious metals. I find this puzzling to say the least for two obvious reasons:

1.      

The dollar has been rising since May or more than 15% from bottom to top 2 weeks ago.

2.      

Gold topped in September and fell 20% to a low in the final days of 2011.

A less obvious reason is that gold languished for two decades from 1980 during a period of intense inflation of the money supply. However, it rose strongly during the last decade when money supply rose at an even faster rate until it eventually dipped for the first time in 70 years. I believe that period is over and the trend will now be down again. In fact Gold and the Dow30 have tracked each other pretty well over the last decade. I fully expect both to end up much lower over the next 5 years.

Time will tell whether these movements are new trends or just corrections. I favour the former  for the very simple reason that  40 years of  absolutely unbridled  credit creation (since the un-harnessing of the dollar from the gold wagon in 1971) have led to a series of bursting bubbles over the last decade. It seems to be common sense to me to consider that the game is up. We have been borrowing from the future at a rate that we have become used to and expect as normal but which is not sustainable. If it was, then the economy would be employing more people and expanding faster but it is not doing this.

The future has to be paid back and the only way to do that is by shining the clear light of reality upon the massively overvalued debt assets lurking on the balance sheets of the major banks and financial institutions around the world. That will, of course, result in bankruptcies and huge write downs in values and will be the final catastrophic stage of the deflation.  It will be the way that wealth relativities between the 1% and the 99% (or whatever the figure really is) will be restored. Unfortunately, it will not redistribute wealth  but it will allow businesses and economies to start growing again and put people back into work. Nominal values will be lower all round – house and land prices, financial assets and labour costs because the driving force that kept all those prices high will have disappeared. That driving force is “imaginary money” or credit without backing and which, therefore, has no hope of being paid back. The fantasy is still intact – just – but the signs are all around that the gig is over.

Annual growth has been slowing since 1979 just as it did all the way through the 1920s into the Depressionary bottom of 1934. Manufacturing jobs have halved since 1979 and housing starts are back to the level of the early 1920s despite the population of the US tripling since then. The Case-Shiller Composite Home Price Index fell from over 200 in 2006 to less than 140 in 2009 and is still barely above that level.  This happened mainly because of government intervention over many years at the instigation of bankers - in particular, the creation of  the Federal Deposit Insurance Corporation (FDIC 1933),Fannie Mae (1938,) Ginnie Mae (1968) and Freddie Mac (1970). The FDIC is funded to an extent by the banks  - a cheap cost for them to maintain the illusion that the public’s deposits are safe.  Of course, nothing could be further from the truth because already billions have been paid out of the public purse to prevent the banks from falling over. Eventually the deposits of those using the banks will be gobbled up as well. The huge debt burden of mortgages is keeping house prices down and that debt burden is mostly underwritten by Fannie/Ginnie/Freddie which is the government. It is hard to see how home building can take off while prices remain depressed. The US government has been inflating since 1913 when the Federal Reserve was created and the Government began taxing people’s income. How do you think the US was able to afford defence spending that equals the next 8 countries combined defence budgets? Federal outlays (as a percent of GDP) peaked during the Second World War but this did not create inflation because there was so much destruction caused by that war. The same thing has already been happening – the destruction of manufacturing in the US and Europe and its substitution with service industries. Most of these service industries produce nothing but cost – huge burdens from welfare, health, safety and legal costs both in the private and public sectors. The only manufacturing sector that is more or less intact is the military industrial sector which is also a huge cost on the taxpayer for a very dubious benefit.

There is no doubt that the Fed and Treasury have been trying to inflate via quantitative easing but when set against the worldwide debt levels and the inflation that has taken place over almost a century, the present effort is not much more than a fart in a hurricane. Interest rates are at near zero because there is very little private demand  for borrowing and debt investors are clearly happy with the rate offered. If they were not, would it not make more sense to amass cash in the form of greenback notes or gold. Or buy real assets  such as commodities like copper or farmland.  This is not happening because, in aggregate, commodities have been falling (the CRB Index topped in 2008) which again suggests that there is not much demand. The only real evidence of an inflationary breakout is in US equity markets but they are very nervous and seem to me to be driven mainly by trading rather than investment plus a need to find a bit of yield. The market turned up in March 2009 because the mood changed, not because of quantitative easing which had failed to stem the fall all the way through 2008. The KBW Bank Index shows a very modest recovery – far less than the Dow 30 or the S&P 500 - despite the more upbeat mood and the Bernanke/Geithner interventions, which you would have thought could have propelled the banks forward to new highs.

The banks are in trouble and are signaling the next phase of the deflation. Many commentators are arguing that hyperinflation will come after the deflation. That is not a level of pessimism that I am willing to embrace! The deflation will be bad enough – encompassing wealth destruction on such a scale that stock , futures and option markets will take a number of years to regain the trust of investors. Think Japan. So much of the money (credit creation) that has been “printed” (really a computer record entry) by the Federal Reserve to buy debt assets from the Treasury via the banks will simply disappear as the toxic “assets” on bank’s books are written off. What are the “assets” on the Fed’s balance sheet and what is their  marked down value? They certainly are not the same quality assets as they once were. Even if they were all Treasuries, which they are not, the US credit rating has been downgraded which means the quality of the debt has been downgraded. Despite this the yields are still extraordinarily low. Not exactly a sign of inflationary fears. Gold is sending out the same message that fear of inflation is actually quite low. I take a contrarian view to the common view that gold must be held to protect wealth.  I am believe it will deflate too because it will be sold off to cover losses in other markets and to pay off debt. However, relative to other assets it may well remain quite strong – which will only go to show how bad the destruction will be in these other asset sectors.