Deflation is coming!

Discussion in 'Economics' started by Locutus, Feb 5, 2011.

  1. Locutus


    I thought I'd present a somewhat alternative argument to what is currently capturing headlines, the "hyperinflationary" scenario. In my humble perception, you must be nuts to believe we can have hyperinflation in the current environment.

    First off I'll start with a few points from inflationists because I don't want them below as counter-arguments (because they don't count and are irrelevant). Firstly food inflation: CPI is not perfect but it is definitely better than looking at agricultural commodities and/or gold as an inflation proxy. Inflation is ultimately decided by "stuff/money". Because of technological advances that enhance efficiency in all sorts of processes "stuff" increases. Thus I agree, in this instance, with his royal chairness that food inflation is mostly driven by supply constraints (caused by climate shifts*) and growing demand from EM's. Secondly.... wait... there is no secondly, the only argument pro-inflation is the food prices! haha!

    So, on to the arguments that matter. Inflation is caused either by a contraction of "stuff" or an expansion of money. A contraction of stuff is not really an option because we are nowhere near (for the next decade(s)) depleting natural resources and technological advances are still being made. Hence an expansion of "stuff" is much more likely than a contraction. A contraction from the demand-side is possible, however this will pair with a relatively larger contraction of money as I will explain.

    The main ways to massively increase money supply have generally been the issuance of debt by banks and other lending institutions (i.e. leveraging) to consumers, corporations and the government and lately has also been massive monetization of public debt.

    Let's go over the three groups: consumers are obviously still relatively leveraged and have been releveraging in recent months. This is very bad for the inflationist arguments because it is the nature of the credit markets that once in a while it must mean revert (this is also just plain old common sense, since leverage is not free and as consumers use leverage to consume and not to produce eventually the burden must be reduced)

    Businesses overall have a very strong cash position and as interest rates rise they will cease to refinance and as the economy is still quite weak and no major projects are launched by big biz during that phase of the cycle, I expect business lending to not be helpful.

    The government is obviously the big spender, but as noted earlier the government faces huge deficits. Not only is it common sense, even casino operator BennieB has commented that current debt and deficit levels are unsustainable and must be reduced, i.e. the debt levels must be returned to sustainable levels. Again, deleveraging is deflationary. Of course, I have no faith in the US administration and I consider a default event a real risk. I have no idea what exactly would happen in the financial markets in case of a default, but at least the equity market would fall sharply, the USD index probably won't respond much as any panic outflows will probably be offset by higher treasury yields and inflation-driven commodities such as gold would most likely also plummet against the USD.

    The only remaining argument for inflation to take hold is to expect QE ad-infinitum and at a much higher pace than at this time (as QE is barely keeping up with the deflationary torrent...without QE2 we'd probably have seen the CPI nosedive into deep negative territory). As with leverage, the monetization of public debt can only go so far before certain vigilantes will step in (i.e. foreign holders). The FOMC carries a few more hawks this time around and a continuance of QE is not only politically unfeasible, it presents stagflationary risks which is a lot worse (and would end up completely destroying the US economy) than a deflationary spiral which lasts only a few years at most.

    Wrap up:
    -Commodity prices are mostly supply/demand driven, not money supply driven
    -Lending from business and consumer to remain subdued in the forseeable future
    -Lending from government is unsustainable, if they reduce lending/retire debt it will create deflationary pressure
    -QE cannot continue forever, comments from FED officials state caution. May continue to QE3-4 but even if that happens it won't be enough to create hyperinflation

    * I've also had it with the fuckers who keep distracting the public with "global warming" and whatever kind of crackpot theories. There is no "global warming", however we have a lot of weather anomalies which are very unlikely to happen naturally. Pollution of oceans, exhaustion of farmlands, landslides wreaking havoc, weather destruction of crops and a bunch of other effects are and will continue to affect the supply-side of agricultural commodities while EM may (though not necessarily will) continue to grow. Hence food prices may continue to rise, but it has nothing to do with QE.
  2. A lot of people have been saying that here. In any event it won't be good.
  3. Locutus


    It will be good if they can continue QE, the deleveraging continues gently and real growth remains strong. This is a remote possibility, in which case we will see reasonably flat markets for a while.
  4. So you are saying even if rates would be at 10%, banks would have been allowed to fail and QE2 let alone QE1 would have never happened oil would still be at 100$ a barrel today?
  5. Ed Breen

    Ed Breen

    Many of you have suffered my commentary before, so I apolgize for repetition...but this seems like a new post on the old subject....maybe there will be a new response....

    'Hyperinflation' is a deflationary event. It occurs when sovereign credit deteriorates and the sovereign cannot sell its debt. If the sovereign, without being able to sell its securities continues to print expand currency the currency will fail. 'Hyperinflation' is the repudiation of sovereign debt, including its non interest bearing debt, its currency. When that happens the price of all fixed domestic assets of the sovereign both financial and tangible (priced in foreign money and money substitutes, not failed domestic currency) falls dramatically. Inflation in contrast requires a functioning currency, available foreign credit and expanding private debt applied to tangible assets which increase in value due to the expanding leverage. Inflation can lead to a deflationary 'hyperinflation' if the sovereign becomes insolvent through its inflationary policies....excess borrowing to fund consumption.
  6. There is one name missing from this site when you search for it. The author Bernard Lietaer hasn't ever been mentioned once on this site. He offers an alternative model of the inflation / deflation dichotomy. Many of the problems originating in the inflation scenario or deflationary scenario and especially the hyperinflation scenario are really issues about dysfunctional monetary systems.

    He offers unique alternatives. Its obvious when you read him, or people like Charles Hugh Smith, that the problem is much more fundamental than whether its an inflationary or deflationary scenario playing out.

    Not even mentioning what these 2 authors bring to the table, try to think about it of the more critical things is that depending on who you are as a demographic today, some people face 15 yrs of deflation, while others face 15 yrs inflation. The scariest of demographics faces both.... I don't think anyone has made that clear, because its an important starting point towards moving on from the idea of the country facing only inflation or deflation. By sheding light on that, you immediately see that the FED cannot win either scenario with the tools it currently has.
  7. Ed Breen

    Ed Breen

    Interesting post Psy, I'll check out your authors. I am not familar with them...too bad they are not writing on this site. I don't really understand you mean with your reference to demographics. Can you elaborate on that a little with some specific examples to explain your meaning?

    The reason I think it is useful to distinguish inflation, deflation and hyperinflation is that the policy responses are different. With hyperinflaton you have a currency solvency problem. With inflation you have a capital flow dynamic that bids up the price of tangible assets though increasing leverage...and when combined with progressive taxation, destroys real earnings. With deflation you have a capital flow out of tangible and financial assets, destroying savings, and into money and money substitutes with reduced leverage and lowered investment in production.

    I agree that monetary responses are not effective in the current situation and fiscal incentives are required (not consumption spending). In all situations monetary responses need to be supplemental to fiscal drivers and it is the fiscal drivers that are determinative in all cases.
  8. Eight


    If the long cycle plays out properly we will have inflation about 46-60 years after the last time, the Jimmy Carter years of the late '70's.. that would be ~2022-2034. I've had adjustable rate mortgages since 1980's, saved tons of money with those over the years...
  9. The demographics issue is something I've thought quite a bit about in recent years. In many regards, I view the monetary response as a generational type of bailout..i.e. those who have accumulated assets, those who purchased homes in the pre-asset inflationary cycle are basically complicit in supporting these policies.

    For instance, a recent college grad or someone in their late 20's, early 30's not only has an enormous debt burden from inflated tuition costs, but also has a very high cost to entry into the housing market (which is still grossly overvalued), their cost of living is much higher as well thanks to these generational bailout tactics.

    You also bring up a good point that the Fed cannot win both battles, so they are going to disenfranchise one group...but more than likely both as they have been unsuccessful in creating the "right inflation" more times than not. For the vast majority of the population, food and energy inflation is not going to sit well as their houses deflate, their costs of living shoots skyward, etc, etc...