Good question…and one that’s been bandied about furiously over the past year or two. I’ve personally been persuaded by the likes of Peter Schiff that the US is headed for a hyper-inflationary depression, but that belief doesn’t dismiss the rather significant deflationary forces at work.
One reasonably consistent proponent of the deflation argument has been Bob Prechter, the Elliot Wave guy. In a recent series of three interviews, Prechter is now calling a “right shoulder” formation, ending the bear market rally. In effect, he believes that the deflationary forces are simply too large for Bernanke to stop.
My thought: However true that might be, Bernanke and company can still do significant damage to the dollar in the process of trying to stave off deflation.
In response to a couple of Prechter’s best points:
1. The Fed has begun and will continue to resist the sort of monetization that’s probably required to re-flate.
Leveraged assets can (and will) crumble. Wages and income can (and will) decline. Some, maybe a lot, of bond holders will be left holding the default bag. Government spending can (and will) be increasingly constrained. We might expect adjustments to the retirement age, means testing for benefits, and higher taxes. Households will be poorer and will spend less. All deflationary, all probably unavoidable. That would seem to put me in Prechter’s camp, right? Maybe, maybe not.
First, the accepted Keynesian view is that you must re-flate to avoid a deflationary depression. At the moment, very few seem to understand just how big the deflationary problem really is (or will get) and just how much the dollar can and will be (and already has been) devalued in the effort to stave off deflation. Even when that process fails and/or is curtailed, the dollar is still devastated in the process.
Where it get’s really sticky, I think, is that this is a global contagion problem. Unfortunately, the world is now divided between those with massive debt and those without, those who are dependant on the US market, those who aren’t, those with hard assets to sell and those with consumer-driven industries. Most of the so-called “advanced” economies are now well in the process of “racing to the bottom”, as the debt-laden fiat currency countries do their Keynesian best to avoid a deflationary train wreck.
Notwithstanding the knee-jerk market response to flee toward dollars as one nation after another is abruptly confronted with the limits of both their borrowing, monetizing, or fiscal discipline, the United States is in exactly the same boat as they are. Depending on how you slice and dice the deficit and debt data, it may be worse than most. In the end, it’s hard to imagine that the dollar will be excused from the very same market forces. Notably, interest rates will rise.
Unfortunately, the dollar has an additional problem, being the world’s reserve currency. It is the “gold standard” of our day. Thus, I believe that fleeing from the dollar can and will prove to be (perceived at least) as necessary as fleeing the gold standard in the early 1930’s. So what happens when the world abandons the dollar? I imagine that part of the answer to that question will depend on what replaces it. I don’t necessarily believe that the world will go back to gold or silver, although I suppose that could happen. A petro-currency is also a very real possibility, if for no other reason that the first to abandon the dollar might well be petroleum producing countries.
Regardless, the dollar is likely to get very cheap and imports are likely to get very expensive for the US. And that, I believe, is exactly how our country can experience hyper-inflation in the midst of a massive depression. As even Peter Schiff would concede, however, it does matter what policies we implement going forward. However inevitable deflation might be, it is still an open question just how much we debase the dollar in the process of trying to avoid those consequences.