Inflationists vs. Deflationists: Who's Right?

Those of us in the very small group that has correctly anticipated that past excesses would eventually come home to roost generally fall into two camps: the deflationists, who believe that another Great Depression is on the cards, at least initially, and the inflationists, who argue that hyperinflation - where prices spiral rapidly higher - is the most likely near-term outcome.

While there are more than a few reasons for the contrasting perspectives, in my view it largely comes down to a difference of opinion about how the U.S. reached the "tipping point" to begin with. That is, was it "printing presses" that fueled the housing and other bubbles, the malinvestment and imbalances, and the widespread belief in "something for nothing," or was it excessive credit creation?

If the answer is the former, then the dollars that were and continue to be created remain in circulation, stoking inflationary expectations and exerting a relentless upward push on prices. As economists put it, there is too much money chasing too few goods.

If the answer is the latter - which is what I believe has been and is the case - then logic and history suggest that when the jig is finally up, it leads to relentless, liquidation-driven downward pressure on asset and other prices. As opposed to paper currency (or even digitally-created "money" that did not come about as a result of central bank buying and selling of government and other securities), much of the credit-money that was created out of thin air ends up "disappearing" (e.g., through default), diminishing overall demand.

In "Worried about Inflation? Just Wait," Reuters columnist James Saft lends further weight to the deflationist perspective, and puts paid to growing worries over rising commodity and consumer prices.

Never mind inflation, the powerful and long-lasting effects of the credit crisis will rein it in soon enough.

With oil, gold and other commodities at very high levels and U.S. producer prices up 6.3 percent last year -- the most since 1981 -- fears have risen that an aggressive round of rate cuts by the Federal Reserve will embed inflation.

Consumer price inflation for December was up 0.3 percent and has risen 4.1 percent since a year earlier.

But these are likely to prove lagging indicators, even if demand from emerging markets remains strong for raw materials.

If credit is being strictly rationed and asset prices falling -- as they are in housing and in stocks -- investment, consumption and just about anything else that can be put off will be put off.

"The strong probability is that we will get at least disinflation in 2008," said George Magnus, senior economic advisor to UBS.

"I'm not aware of any banking crisis in history, almost without exception, that was not accompanied by falling inflation.

"When balance sheets are shrinking and credit restriction is being applied, the whole effect is to cause people either to not be able to make spending decisions or to defer them. It puts a downer on aggregate demand," Magnus said.

A round of poor data, notably unexpectedly weak retail sales, prompted rumors of a highly unusual inter-meeting rate cut by the Federal Reserve, whose next scheduled meeting is January 29-30.

The Fed declined to comment. Traders were roughly evenly split on Wednesday in betting on a 50 basis point or a 75 basis point cut this month in the Fed benchmark, currently 4.25 percent.

But even aggressive cuts in interest rates will have a limited and painfully slow impact on demand under these circumstances, according to Magnus. He contrasts the current crisis, which is fundamentally about the solvency of borrowers and the banks that lent to them, with other crises, such as 9/11 or the stock market crash of 1987.

"When solvency is involved and asset prices are declining, monetary policy can help but can't solve the problem."

Yen carry trade and credit cards next?

Ominously for the economy, the Baltic Dry Index BADI of shipping capacity suffered its biggest one day drop since records began on Wednesday, down 5.74 percent and following similar heavy falls on Friday and Tuesday. The index is down almost 20 percent since January 1.

Because trade travels on ships, the Baltic index is often a good indicator of forward demand, both for natural resources and finished goods. Interestingly, the Baltic index continued to climb as the credit crisis unfolded through the summer, supported by strong economic growth in emerging markets.

Tim Lee of pi Economics in Greenwich, Connecticut, thinks prices of many assets and commodities will fall strongly in what he calls an "incipient deflation".

"Ignore gold, ignore oil: they are lagging indicators of the excessively loose central bank policies we had in the past," Lee said.

"The leading edge that is really telling us what is going on is the government bond market and property prices."

Yields on 10-year U.S. treasuries have fallen as low at 3.69 percent, down almost a half a percent since late December.

The credit crunch is breeding new areas of concern, such as credit cards and commercial loans. Another round of losses in a new area would further dampen credit.

Citibank has more than doubled its loan loss reserve ratio on U.S. consumer debt since the end of the second quarter, with the sharpest move in the past three months.

Then there is the risk that cuts in U.S. interest rates will unravel what is perhaps the world's biggest leveraged bet, the use of carry trades, according to Lee of pi Economics.

Estimated at as much as $1 trillion, carry trades involve borrowing cheaply in yen or other currencies such as Swiss franc that have low interest rates in order to invest in higher yielding currencies, or indeed in anything else the borrower hopes will go up.

Both the yen and the Swiss franc have rallied sharply against the dollar in recent days driven by expectations of much lower rates in the U.S.

If funding currencies like the yen and franc continue to rise, borrowers could sustain big losses. For example, many Hungarians have taken out mortgages in Swiss francs and many Korean corporations have funded in yen. Strong moves upward in the currency they borrowed may leave them unable to carry the debt.

"As the carry trade unwinds, liquidations and asset sales will push prices (down) further," Lee said.

It seems clear that, as with the credit-fuelled boom that preceded it, the bust has taken on a life of its own.

Comments

[NutritionFacts]

"Those of us in the very small group that has correctly anticipated that past excesses would eventually come home to roost".

Give yourself a pat on the back, why don't you. And for how long have you been 'anticipating' this event, may I ask?

[Sr. Pessimist]

Money is worth nothing. Inflation, then deflation, then crash/poof. In the Great Depression there was hyperinflation, then there was stagflation, then there was deflation. Better quality US Dollars- the ones with no expiration date, which non-workers get- are deflating. Crappy quality US Dollars- the ones with an expiration date, which workers get and are robbed of either in the excessive costs of living or by fault of a corrupt system- are inflating.

Riots on the streets this year I think. Maybe next year. This year is a 70-30 chance. By some time next year is a 90-10 chance. About, and if you ask me.

[Johnny Bitchdog]

What a phony ! Here's a guy with a constantly dour forecast for years and years accross good times and bad claiming to some kind of Nostradamus. Ridiculous.

You get credit when you have timing correct, not some constant prediction of doom accross multiple cycles. Ridiculous.

And small group......give me a break dude.....you may fancy yourself part of a small elite group of gloomcasters, but this country has been full of folks saying the same types of things for years......

Man are you delusional.

jbd.

[Easy E]

What happens when when foreigners shun dollars? Won't those dollars come home to roost? And hasn't the Fed made it it's mission to not allow deflation.

Defaults don't cause the evaporation of money, just debt. That money was paid to someone, most likely the previous home owner. The effect is banks becoming insolvent with depositors being paid from FDIC insurance. So deposited money won't disappear and neither will the borrowed money. The end result is that borrowed money being monetized into the private sector just like our government is doing publicly. I don't believe deflation is possible under these circumstances, hyper-inflation is my bet.

The only way I see deflation happening would be for borrowers to pay off loans, that's the only way money will disappear. And we all know the US Government won't be participating in that.

[Georealist]

Aside from the overbearing pretentiousness..you seem to have a stunted vision of how inflation and deflation come about. Almost every dollar...M1 for instance...is created thru credit. The printing presses only roll to either replace worn out currency or translate those credit creations into cash...real folding money. How in the world would the Fed inject enormous piles of cash into a financial system except thru credit creation???
Inflation and deflation aren't mutually exclusive entities..they are different sides of the same coin and that coin is constantly revolving...there is a huge struggle going on now between the two..and that's what leads to the incredible market volatility today.
Not a single, specific investible idea in your overly long and simple minded article.

[Sage]

Great article, but the one thing over looked during this economic crisis is all of the outstanding dollars that are overseas in China and Saudi Arabia just to name two countries.

Here is the question what will happen when we have deflation and these dollars are losing value. Is it possible that they will run to buy assets and other things of value in the the US? I think we will have deflation with a drop in the value of the currency then a run up in inflation as dollars rush back to the US.

[logical]

From the comments here, I'd say you're still in a very small group -- but I believe you're also still correctly anticipating what will come of our past excesses.
Every consumer loan that defaults destroys a family's wealth as well as capital on the books of a bank somewhere. It then reduces the investment of whoever bought that loan bundled into an asset-baked security. Digits on a computer get erased and the bottom line is lower. Money that was created gets destroyed. Defaults are deflationary, especially if they are on depreciated assets or are unsecured, such as credit cards.
Regarding inflation: in a way, it needs a counter-party. There is no such thing as a high price without someone having to pay it. That is the problem with a hyper-inflationary scenario -- average folks are losing money. They aren't able to pay. That's why they're defaulting.
I think when we look back a few years from now we'll see that these past years have been the inflationary stage. The housing bubble has been the economic growth we've been experiencing and has disguised the economy's real weakness following the tech bust. We never actually recovered, we just bubbled it over.
Now we are entering stagflation as the reality sets in. Next up; deflation.

[Jose Goldburger]

Massive inflation has already happened. The recent real estate bubble *is* inflation. The bubble before the last one was inflation, too. Gas prices up 300%+ in 10 years is inflation as well. Same goes for food, medical insurance, etc.

Many sub-prime loans went to low income people/areas that need to be redeveloped. The banks will take a short term hit so they can bubble these areas in the near future with higher priced homes and offices. The overall hit of the loan defaults is minor compared to the gains that will be made on lending out much bigger dollars on the redeveloped properties.

Fiat money and deflation is a combination that doesn't even make sense. What the author might have meant is 'disinflation', i.e. price drops. The existing central banking system only works if there is continual inflation (i.e. the 'new' money has to be realized somewhere in the system). Short bouts of disinflation are fine because that is just hiccups between inflation bubbles.

We are seeing a real estate hiccup right now, but it is all according to plan. The only real issue in the economy is jobs. The rather large job of reworking the existing economic system to be based on 'services' instead of 'manufacturing' is just nowhere near done. So many jobs are being lost to globalization. Without a reworked system, the middle class will continue to erode, their jobs either being sent overseas or replaced by illegal immigrants.

The prestige, the magic, will be coming up with some good stories (or just filling the time with more wars) while the economic system is reworked so that the middle class is done away with and replaced with an upper lower class that will be called the new middle class. Because of constant inflation, the dollars will look the same so most of the sheeple won't be able to figure it out.

Hey, the story goes on. But there is no point in sharing the rest of it here. Vaya con dios, amigos.

[WDZ]

I am one who believes in full blown deflation. There is one thing that I have never heard an inflationist mention while carrying on a conversation about this subject, and that is the Federal Reserve is a PRIVATE corporation. Most of their assets are locked up in U.S. Government Bonds or cash, and though they have really opened up the floodgates of liquidity the last few years, they will most certainly retrench when the reality finally surfaces that if they continue to inflate, they will destroy the value of their own holdings. At that point, they will simply sit back on bonds and cash in a mode similar to one putting money under their mattress during the Great Depression, watch it gain real value by leaps and bounds due to deflation, and satiate their politician allies by conveniently blaming free enterprise and Gold Bugs for causing the biggest economic debacle in the last 75 years.

[Notehound]

We are definitely heading into a severe deflationary period worldwide. The loose credit of 2002-2006 are just part of a perfect storm. However, the credit problems alone would not have been sufficient to create the crisis. It took accountants to set it up.

Inappropriate Mark-to-Market accounting for bank assets has made the situation infinitely worse. If you read the Center for Financial Studies Working Paper 2006/17 by Dr. Franklin Allen and Carletti, you will see that the FASB and IASB are responsible. Changes that the IASB and FASB forced on the banks in 1999-2000 (diverging from almost a thousand years of bank accounting tradition), involving FAS 133, 154, et al., have caused our banks and insurance companies to be come insolvent, even if the mortgage assets they hold are generating positive cashflow.

Accounting rules that manufacture insolvency out of thin air are bound to lead to devaluation, panic and, ultimately, to a run on the banks.

I am firmly in the "deflationary&quo... camp. However, I blame the IASB and FASB for causing the credit crisis to become a worldwide financial meltdown. Look at the Asian markets today and you'll see what I mean.

[jackc]

With government being to large and the fact that there will be 2 types of welfare, welfare people with money (baby boomers) and welfare people without money, I highly doubt the printing presses are going to stop any time soon. So, my bet is that high inflation is going to continue. Futhermore the inflation numbers currently are a lot higher than they say, Housing and Autos should not be taken out of the equation because they were the economy over the last five years.

[jurp]

Ford Focus and Ranger trucks are advertised for about 10-11k in todays's paper! Almost the same price as 15 years ago.

Of couse, Ford hopes to trade you up to 4 wheel drive, auto, AC and garner another 7k; but the net is deflation if you buy the simple car.
or worse;

Because people won't/can't buy new at any price when they are worried.

[Expat]

The US consumer is broke and has been for years, but with easy and excessive credit there was no need to admit it. The US boom stoked "growth" worldwide. The mountains of money also stoked inflation. The result: lots of plastic junk and "obselete" electronics as well as one of the largest bubbles in history (world real estate).

It's all over now (at least for now). There will be massive deflation in housing , but this is not counted in government statistics so it won't affect inflation. Cars may drop in price, but car prices are not highly elastic; at some point, it makes no sense to sell a car. Other things will continue to rise, such as food, healthcare, and taxes. Overall, the affect will likely be inflationary, though there should be some disflation.

(By the way, I love this term "disflation"... I understand it to mean that inflation will slow, so, for example, instead of prices rising at 5% per year, they will rise at only 4%. Disflation is the third derivative of price. Deflation would imply that prices are actually going down in nominal terms.)

Oil and other commodities are dropping recently, but they are well above last years averages. Consequently the inflationary affects leaking into CPI and PPI will continue with a lag effect.

Frankly, we are headed to stagflation. Overall demand for many basic things will continue, including food. While food is not counted by the government in inflation, try convincing yourself that it doesn't matter next time you buy groceries. The thirld world is unlikely or incapable of shifting back to traditional foodstuffs and will probably not die off massively in the next year just to help the US consumer (despite what Cheney might wish for). While all this goes no, recession and massive hangover from the credit bubble will wreak havoc in the economy.

The US no longer has a real economy to drive a recovery. Everything is either finance or consumption. Even the much-touted stimulus package is aimed entirely at getting some fat slob to buy more lattes and an iphone. It's just another quick fix for the junkie.

The US is no longer a rich country. It is a country with lots of toys. A few of us have lots of dollars, but we have seen just how valuable those things are. When Helicopter Ben slashes the interest rate and Bush further damages our solvency with more tax cuts, the dollar will continue its slide. We are owned by those we hold our debts, mainly the Asians and Arabs. But they won't be able to help us much more as the global contagion guts their bubble economies as well.

It is going to be ugly. It won't be Armaggedon, but I don't think a depression is out of the question.

[Toto-13]

This is irrelevant here. Watch the most promising stocks and bet when the time is right.
Rob,
Www.WallastonInvestmen...

[Expat]

Gee, Thanks Rob. Great advice. Can I borrow your magical watch?

[Congressman]

I can't get past your hair. Do you dye it that white, because it doesn't look natural at all!!

[BillyWade]

All good points with the exception of Congressman. In theory the worst case could happen, but I do not feel panic is the answer. More importantly, how do you invest in these two scenarios?

Thinking that we will get some more "doomsday" economic forecasts but I see this as nothing more than a much needed correction in the world economy. The market goes up too fast to reflect reality and then it corrects.

If you are an investor, then it is an opportunity to buy assests at lower prices. Your horizon should be far enough out there to weather any storms. Or you can fall in with the crowd and panic...this is not 1929. Its just another bubble popping...Happens over and over again but it seems we do not learn from the past.

[marinaray]

I'll put in my 2 cents worth, which I think will be worth 1 cent next year. But invested correctly by the guy with the magic watch, it should be worth at least 3 cents.
Great article, first one to tell me what the carry trade was in a sentence.
However, analyzing interest rate and asset values and so on is like studying why leaves fall in autumn and why it gets hot in summer. We just know they do, like governments setting interest rates at the wrong time and politicians dislocating a natural market in an attempt to protect those that financed their ascendancy to power.

I'll always remember an article I read in a Brisbane newspaper that described the Economic Clock. High noon was equities, then real estate at 3:00 PM, commodities, infrastructure, then back to equities.

I didn't believe real estate could go up after a market crash like the tech bubble, but after a short and severe drop (Hong Kong being a good example) off it went.
Why? There are lots of interesting theories, but don't waste your time. Just pick stocks or assets with the help of the magic watch, which is displaying about 5:00 PM, give or take.
I've been an expat most of my working life, so I know what it feels to have jetlag.