Pumpin’ It Up #1: Inflation or Deflation?

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. 

First, I don’t think anybody has a clear idea just how far down the monetization path we’ve already traveled.  Prechter sort of makes that point, suggesting that “despite such efforts, we’re still deflating”.  That’s a really good point, which, by the way, is generally consistent with an early guess that Bernanke and company might see the need  to monetize to levels approaching $30 trillion or so….roughly equivalent to the amount of “excess money & credit” created over the past 10-12 years. According to Bloomberg, total bailout costs (and pledges) are currently near $12.5 trillion or so.  (Although, not that all that much has actually been spent as yet, except for mortgage backed securities and bank recapitalization, etc.) 
 
Still, for all we know, the real “re-flation dose” that Keynesian’s might require could easily be closer to $60 or $70 trillion, which is just a rough guess as to the overall leveraged impact on total market asset valuation that’s accrued over the same 10-12 year period.  In any regard, Prechter is right about one thing:  the Fed is balking.  Despite “Helicopter Ben’s” famous promises to re-flate at all costs, he understands that you can quickly topple the apple cart when you burn through “the full faith and credit” imputed to the dollar.  As a result, the Fed is surely making the right kind of noise about an appropriate exit strategy….no more MBS purchases and the like. 
 
Despite this stance, we can only guess how they’ll deal with another round of bank failures, a significant jump in market-driven interest rates, or an utter lack of political will to constrain spending to the degree required…..which, as it happens, leads to point #2.
 
2.  Socio-Economic forces will force government to reign in spending.
 
Well, sure, at the moment, there appears to be quite a lot of momentum behind the “tea-party” movement and, coincident with Obama’s apparent deafness, could well lead to a “sea-change” in Congress this year.  Of course, we’ve not yet dealt with an impossible to hide 12%+ unemployment, the unchecked growth of households without aid of unemployment benefits, a second (perhaps larger) wave of home foreclosures,  30+ states (and XX% of municipalities) in default, a run on government debt, 10%+ rates on even shorter-term treasuries, ballooning interest payments as a share of the budget, increasing revenue shortfalls, pension failures, widespread union strikes as we’re now seeing in Europe, or the sort of response we’d see to the real level of cuts required for medicare and social security.  
 
On the surface, Prechter is right about growing resistance to the re-flationary policies (from both the Fed and the fiscally conservative public).  Personally, I just don’t believe that anyone is truly prepared to accept the degree of pain that has to come from the measures required to reverse course.  Either way, we’re talking about really massive deflation vs. really massive inflation.  So, in effect, I agree with him (by and large) about the size of the problem; just not how it will play out politically and, more importantly, on the global stage.  
 
My Best Guess
 
As stated above, I tend to agree with Schiff’s (and others) expectation that you can have both inflationary and deflationary forces at work simultaneously.  This, in effect (and in this context) is merely “Stagflation on Steroids”.  

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.

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3 responses to “Pumpin’ It Up #1: Inflation or Deflation?

  1. A good time to invest in local currencies – like pies.

    M. Ragazzo

  2. Thanks for the article, the last two years have indeed been a mixture of inflation and deflation, but i think inflation has edged it.

    I think that the Euro is more of a gold standard the the dollar, although the dollar is more of a safe haven at the moment. The problems with Greece shows that the a Euro members cannot print its way out of trouble, Ireland has made big cuts, if Greece, Spain and portugal get their deficits back to 5%, then i think the Euro will be shown to be a valued currency. Which diverges them from the dollar, pound and yen

    • Samba:

      Agreed. I tend to believe that, while the Eurozone has a number of member states that need house-cleaning, it is fundamentally more difficult to debase the Euro than it is for the dollar.

      As to inflation, we should note that we are experiencing pricing increases despite weakening demand. Total gasoline sales revenues are up, we note, but on falling volume. There are other sectors with a similar pattern.

      While some might argue that this is merely demand weakening in the face of rising prices, we ought to know better. Prices are rising in the face of weakening demand.

      Curious economists should want to know why. Can we say, “weaker dollar”? Can we say “marginal pricing” constraints for all those producers getting squeezed? Hmmm. I thought that we could.

      Thanks again for your input.

      Harry Tuttle

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