It's Time to Revisit the Inflation/Deflation Debate

It was the summer of 2008, oil prices were through the roof, the government was creating money like it was candy, gold was ‘going to $2000’, and the dollar was ‘on its way out’. Ahhh yes… I remember it…… as if it were only a year ago…

At that time you could find articles about inflation everywhere (especially in the mainstream media) and almost no one was talking about deflation. For me, something didn’t click, and I decided it was worth serious investigation. I wanted to understand what was going on, I realized the importance of such an understanding, and I wanted to share my finding on here when I was done.

Early in the fall of 2008 I created a post each on inflation and on deflation. In the search for the truth I remember at that time typing in ‘deflation’ into you tube and finding that only a few videos came up. One of them showed some maniacal guy talking about deflation and the book Conquer the Crash. I don’t know who he is but he certainly offered a fresh perspective at the time, and I couldn't get him out of my mind (I dare anyone to try). He also, by the way, lead me (indirectly) to Elliott Wave Principle and the great work of Leonardo Fibonacci... (As a side note, for those interested in math/science/nature or even history, he is one of the most interesting figures you will ever come across. In addition to discovering mathematical ratios that underpin everything from the spirals of the galaxy to the human figure to the stock market, he also brought the Arabic numeral system the Western World. If you ever thought algebra, calculus, or economics was boring/confusing, imagine what it would be like if you had to learn them by using Roman numerals!)

Anyway, the question at the time was... are we going to face inflation or deflation in this economic crisis? On the one hand, if the dollar was a measure of the strength of the country, certainly as compared to creditor countries such as China and Japan, then certainly it looked like inflation would rule the roost. This looked to be especially true with the way the 'Fed' was printing money, via 'quantitative easing.' Yet, on the other hand, it seemed to make sense that the implosion of housing bubbles and credit bubbles should lead to deflation, not inflation, as money would be less available (less credit) and prices would have to fall to accommodate this...

Ultimately my conclusion was that there was a tug of war between the deflationary credit collapse (reminiscent of the 1930s style depression) and the Fed's inflationary plan to continue creating money, despite the poor balance sheets of the government and many of its citizens. Given the size of the credit collapse, it seemed apparent that we would get significant deflation first, especially as the global economy contracted, followed a number of years later by some serious inflation. I offered these conclusions to a former professor of mine at UCLA... the one, by the way, who first really turned my attention to the stock market with the company Cameco (CCJ).

For over a year I have held that this conclusion was the most likely to transpire. The dollar is the current global reserve currency. Hence, the contraction of the credit expansion would be expected to cause deleveraging and the need to raise dollars. Additionally, strapped US consumers would have less access to dollars, and the combined effect would strengthen the dollar until the credit implosion started to ease, causing prices to decline in dollars. The contraction of the global economy would further fuel deflation, as Europe and emerging markets would not have as much money to buy products either. All good,(well in terms of a cogent argument at least), so far.

However, there was always one factor that could potentially change things: an accelerated collapse in the dollar from international policy. I am writing this post now because recent news offers a warning in this regard. What if, for some crazy reason (well maybe not so crazy), China decided to stop buying treasuries or to stop taking dollars? What if the middle east stopped accepting dollars for oil? What if these countries decided that, even with the immediate term strengthening of the dollar, the long-term picture looked so bleak for the dollar that it was not worth the risk of taking on more now? What if the deflationary process caused a return to a different currency than the dollar? What would that do?

I am not in any way certain of the outcome, but the logical conclusion is that such an event would accelerate the inflationary process for those holding dollars. That is to say, the inflationary process would kick in sooner. I would expect, further, that we might see continued deflation in US domestic services and products, such as US housing prices, commercial real estate, haircuts, house cleaning, etc., but less deflation and even inflation (perhaps significant) in items that are purchased globally, such as oil and other commodities. In fact, I would not be at all surprised if the recent moves up in gold and foreign currency, against the dollar, were due to speculation of a news release regarding this matter.

The Wall Street Journal recently published an article titled "Dollar Sinks to Low for the Year... Investors Switch to Riskier Foreign Assets in Gamble on Global Economic Recovery. " The article primarily focused on the reason for the dollars' decline on a 'carry trade' where investors could borrow dollars cheaply and get higher interest rates in other currencies, albeit at a higher risk. On the other hand the article only gave lip service to their findings that the UN had announced that the dollar should be replaced as the primary reserve currency and that 'China would be the first investor in a new IMF series of notes'.

What I saw, in between the lines, was that the exact opposite focus should have been given. The creation of a new global currency, or basket of currencies, could drive a stake through the heart of the dollar. I mean... $5 a gallon gasoline may look like child's play in comparison to what could occur should the dollar no longer be favored or even accepted throughout the world. In my opinion, this labor day article should have made headlines throughout the world, rather than being casually mentioned on a one page news blip on Bloomberg dot com.

All of this being said, in the short-term to medium-term, dollar and commodities (and stocks too for that matter) tend to be largely influenced by trading phenomenon. That is to say, by the time the newspapers are headlining stories on dollar lows it probably (hopefully?) means we are getting near the short-term bottom. What these stories do mean, in my opinion, is that the dollar's short to intermediate -term revival could be muted (well... likely not completely but certainly mitigated) and its ultimate weakness exacerbated by the implementation of this policy. Perhaps dollar strength in the future should be looked upon as an opportunity to exchange at least some of your greenbacks for something more substantive, including but not limited to other paper currencies, such as the Swiss Franc. Consider it, at the very least, and insurance policy.


I want to close this discussion with a very interesting essay, Gold and Economic Freedom, which was written by Alan Greenspan in 1966. In it, he argues that to maintain economic freedom you must have currency backed by gold, or at least by some other hard asset. The idea is that free market economics work just fine, and markets regulate themselves beautifully, provided, that is, that the lenders have real money (gold, silver, etc.) at stake when they lend and, essentially, are fully accountable for their actions. It's something to ponder, especially in the the light of who wrote this article and when it was written.


As Linda Richman (Mike Meyers) used to say on Saturday Night Live's Coffee Talk, "Rhode Island is neither a road nor an island... Discuss."






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