Betting On An Inflationary Outcome -- Kudos to MRED

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Lemonyellowschwin's picture
Lemonyellowschwin
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Betting On An Inflationary Outcome -- Kudos to MRED

There is much coffeetalk about inflation/deflation.  But MRED recently made a great point that merits its own discussion.  If we don't know whether inflation or deflation is more likely:

 "With respect to the small investor, it seems to me that the risks due to an inflationary outcome after betting on deflation are much worse than the risks due to a deflationary outcome after betting on inflation."

To MRED and others, why do you think this?  Is there anyone who disagrees?  Let's have a practical discussion here.  If Joe the Investor can only assign a 50-50 probability to inflation/deflation, should he nevertheless place his bets on one side or the other?

 

 

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Re: Betting On An Inflationary Outcome -- Kudos to MRED
"With respect to the small investor, it seems to me that the risks due to an inflationary outcome after betting on deflation are much worse than the risks due to a deflationary outcome after betting on inflation." 

I would agree with this statement.  I’m not sure about the numbers, but I think I read that there was a 30% deflation during the Great Depression.  That means if you bet everything on inflation you lose 30%.  However, if you bet on deflation and keep all cash, there’s no limit to how much you can lose.  All fiat currencies can and will eventually go to zero.

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switters
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Re: Betting On An Inflationary Outcome -- Kudos to MRED

Let's say you bet on inflation and put all your money into gold and silver.  If deflation occurs, and you own actual physical bullion, it's pretty unlikely that you'd lose everything because gold and silver have never (to my knowledge) completely lost their value.  However, there are over 3,000 examples of paper currencies going to zero.

The other thing to consider is that it seems fairly likely that deflation - for however long it lasts - will be followed by inflation, and quite possibly hyperinflation.  If you're only prepared for deflation and all of your money is in cash, it might be difficult to move into physical metals or other hedges against inflation fast enough.  As Chris said in a recent Martenson report:

I remain convinced that when the “turn” comes for the dollar, your opportunity to protect your wealth in gold will compress and possibly vanish. Better early than late to this game.

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Re: Betting On An Inflationary Outcome -- Kudos to MRED
Thanks Lemonyellowschwin, I was using the term "inflation" loosely, not only to include its usual meaning but also, and mostly, the possible effect of a currency crash. The case I can make more strongly is the deflationary one. But there is a legitimate concern regarding a dollar crash. The deflationary process is protracted; a crash or a run on the dollar would be sudden. This crisis is getting people wiser regarding the confidence game implied in the fiat currency regime, and the more that people look at it, the less trustworthy the regime looks. So, say one buys some asset now. Expanding on what was said by the previous posts: effectively, like in a trade, one just went long on the asset and shorted the currency. If deflation continues, the risk of the trade is, on the downside, the drop in price of the asset, on the upside, there is no limit! Because if the currency crashes, the price of the asset can be anything. Conversely, if one goes long on the currency, the upside is the gain in value of the money with respect to the assets in general, but the downside is 100%. One can be totally wiped out. If one is a worker on a salary and with some savings, then that defines being inherently long on the currency, because that's how one gets paid. So, given the existing risks for this currency, it seems to me that it would be a conservative thing to hedge this position and go long on some assets as well with one's savings. One may consider the downside risk on the asset price as the cost of insurance.

Everything boils down to what are the risks of the currency crashing, and so, what are the warning signs. Chris Martenson posted yesterday his instructive explanation on what would happen in a failed Treasury auction. Well, that would be a very serious thing and something to watch out for. There are other early warning signs. The ones I know involve the precious metals market. I share the view that regardless of what many people say, gold was never fully demonetized. Investors still treat it as a currency, and governments and central banks are aware of this, which explains the apparent (and for many, proved) intervention by these entities to beat down the gold price and maintain the confidence game for the paper for which they hold the issuing monopoly. The condition in which the basis (the difference between the nearest futures price and the spot price) of gold or silver (the historical monetary metals) turns negative (that is, the futures price is lower than the spot price) goes by the horrid name of "backwardation", and is considered an early warning sign for the demise of the fiat currency system. The more knowledgeable people on this say that silver is more critical, because governments/central banks have a smaller chance of manipulating this market due to their smaller silver hoards. Right now we see very strange things in the market for precious metals, like a disconnect between the gold paper price and the street price of physical bullion. So gold and silver prices are battered in the paper markets, but try to go out and get some... it is getting harder and harder, and with higher and higher premia over the paper spot price. So at least with respect to the small physical bullion market, the metals are in backwardation. We also see that prices go up when the Asian markets are open, but then get beaten down when the Western markets open. It is very strange and freaky stuff, and it is not a good omen for the dollar.

Finally, one thing to remember is oil. If you believe, like I do, that we are at peak production and that the output of the most important fields is going down, then, when a modestly declining demand meets a more respectably declining supply, the price will shoot up. This has consequences in many aspects of the economy, because oil is the basis for much of transportation, agricultural inputs, industrial production, etc. So there are conditions in which prices will increase even if from the monetary perspective we are in deflation. Not that precious metals would help you here either. But living in a world of diminishing resources will have unpredictable consequences. These are interesting times...
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Lemonyellowschwin
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Re: Betting On An Inflationary Outcome -- Kudos to MRED

Mred,

Thanks for this excellent response as well as your earlier post.  I think you and others are correct.  Planning for inflation and being wrong is not as bad as planning for deflation and being wrong.

Here is the way I see it, and I'd be interested to know if others have the same idea:

Deflation risk:  There is one avenue here and it is a pretty simple one:  As deleveraging and demand destruction continue, assets continue to fall in price.  There is little question that this is what we are seeing now.  If you though it was going to continue you would want to hold cash.

Inflation risk:  There are two avenues here.  The first is what I would call "traditional monetary inflation."  If the increase in the monetary base finds its way through the credit system and has its designed effect, you would see an increase in money supply, a decrease in the value of money, and an increase in prices.  The second avenue is what I would call "sudden dollar destruction."  (Maybe someone can think of a better term).  In that event, the phenomenon would be as Chris described in his earlier post -- essentially a destruction in the value of the dollar due to the decision(s) of foreigners to no longer buy our debt and a decision by the Fed to monetize our debt.  If that happens you get a sudden decrease in the value of the dollar and a rapid increases in in the price of commodities and things imported.  If either of these two scenarios unfold, holders of gold and silver would stand to benefit, so by planning for inflation you actually hedge against both these possibilities even though they come about in very different ways.

I am begining to think that the conditions for hyperinflation (through sudden dollar destruction) must first be preceded by deflation.  This is because, for hyperinflation, you first need a horrible economy that prevents a government from being able to raise sufficient revenue through taxation.  You also need (1) a great deal of existing government debt; (2) a government with large future financing needs; (3) no more lenders; and (4) a government without the political will to stop spending.  So, perhaps the idea of deflation is not at all inconsistent with the idea of dollar destruction.  To get the second you need the first.  They are two sides to the same coin.

Comments?

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mred
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Re: Betting On An Inflationary Outcome -- Kudos to MRED
In purely monetary terms, creation of money equals inflation, destruction of money deflation. Despite the obvious moonshot that the balance sheet of the Fed has taken, it is not clear to me that this huge amount of high-powered money will be multiplied by commercial banks and thus fed into the streets. At least not now. I do not have data on this. It would be interesting to see charts of the monetary supply measures, like MZM or the Austrian AMS. A drop in that is pure monetary deflation. The banks may increase their reserves, but as long as they are unwilling to lend or people and corporations are unwilling to borrow, monetary expansion may not happen. This is the possibility that you described. The point is how much money is being created vs how much money is being destroyed.

I see another avenue to deflation, one more insidious. In this I assign credibility to the Austrian explanation. The cause of deflation is not so much a crash in demand, but a crash in production. How come? Because it is the decapitalization of businesses that makes them fail, that feeds the joblessness and causes the drop in consumer demand. Pretty much what we are seeing now. I like the explanation that Antal Fekete gives in this topic (http://www.professorfekete.com/articles.asp), check it out, start with his articles on the Great Depression at the bottom of the page. I think that we are seeing today the mechanisms that he describes. So the chances for a depression are quite high. In contrast with the 30's though, the USA is not the biggest creditor country, but the biggest debtor. So it is not clear to me how the US will continue the game of musical chairs in the bond market, effectively extracting tribute from the rest of the world. But we may be surprised. China will be a willing participant as long as its export market justifies it, and the impoverished Americans actually need the dirt-cheap Chinese imports, which aggravates the trade deficit problem of course. Here is where the threat that didn't exist in the 30's exists now: the run on the dollar. However, the effects of this are so drastic, that even the rest of the world may want to keep the game going. For an example of the wild things that are floated out there, listen to this: http://www.kereport.com/DailyRadio/Daily100608-2.mp3

I say it is wild because there is no backing of the assertions, and because if true it would be Armageddon. The USA has openly declared that it will use its military force to access markets and resources if it is denied access. So other countries may not be able to do what they want simply because of the gravity of the consequences. Remember that one of the last things Hussein did was to denominate Iraq's oil in euros. So the economic/financial reasons are not the only things out there. Well, how else would the world not shake off a continually depreciating reserve currency after the dollar default in 1971? The US can exert a lot of arm-twisting, starting with the commercial type. The current fiat currency regime is being sustained by various central banks like a collection of spinning discs on long sticks, like in a circus. These kinds of things increase the uncertainties.

Having said this, I agree with your observations. If there is to be a dollar debacle it will be preceded by the current deflationary phase, which could throw us into a depression in not too much time. That is how I'm seeing things, at least for the moment.

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