Inflation Vs Deflation: Between A Rock And A Hard Place

There was something about the article I wrote last week that touched on a nerve with a lot of people.  There wasn’t a lot of middle-ground; readers loved it, hated it, or were annoyed with me for complaining without proposing a solution.  I’m glad I was able to stir the pot and get something controversial enough on paper to bring out the passion on both sides of the argument.  This article isn’t written to further my points and persuade those who disagree with me.  Instead I want to purpose what I see to be the best potential solution to a very difficult problem.  I agree with the readers who took issue with my empty complaints.   Today’s article is written for those who see the problems, but wonder what choices or alternatives we have to current policy.

Given all of that, there’s no easy solution to our current mess.  I wish there was a simple solution, but there isn’t.  We have cornered ourselves through decades of loose monetary and fiscal policy with those practices being taken to a recent extreme.  Essentially we have left ourselves with two potential roads that probably lead to the same location.  The two roads are inflation or deflation.  I’ll elaborate…

As mentioned, we have gone through decades of loose monetary and fiscal policies.  What I mean is that during economic downturns, monetary and fiscal tools have been used to artificially stimulate growth.  In recent times, they have been used in extremes.  The Clinton administration should be known for nothing other than the inventions of sub-prime lending, 40x leverage, and credit derivatives (I’m sure a certain intern will be remembered as well - haha).

Anyway,  this created a massive artificial pile of liquidity that the domestic economy grew to service.  The growth, not the means of the growth, is what people remember from Clinton.  What should be remembered is an economy whose growth is based upon changes in money supply and outstanding credit.  This growth cannot be maintained.  Bush inherited this mess, but his policies only made the situation more desperate.  In attempting to keep the economy running at its artificial level - he cut taxes, increased government spending, and grew the money supply.  All are economic stimulants in their own right, and when combined they create a very powerful force.  Like the Clinton era, these artificial stimulus worked for a while, but the new economy ran at artificially higher levels of liquidity than its predecessor.

Inflate or Die

All in all, what I’m trying to say is that an economy whose growth is based on liquidity expansions cannot last.  It’s just like Adam Smith’s invisible hand.  Our economy is not running at its equilibrium point and the further we get from that equilibrium, and the longer we stay there just means the invisible hand starts to push harder and harder.  Natural forces are trying to push our current economy back to equilibrium.  The excessive growth was the result of an expansion of liquidity (inflation), and in order to get back to equilibrium, liquidity must do the exact opposite and contract (deflation).  So the question of do we inflate or deflate becomes a question of if we can’t inflate we deflate.  The question of policy is do policy makers try and inflate or let it deflate?  Let’s look at what happens in each scenario.

The x-factor of each “flation” has to do with outstanding debt.  The U.S. government and its citizens are staring at a lot of debt.  If inflation is increasing at a faster pace than interest rates represent (negative real interest rates), than the real value of debt decreases.  This is in the best interest of the borrower, which is the credit card/mortgage strapped consumer and the debt laden U.S. government.  Unfortunately this makes our debt look unattractive to buyers.  The problem is that both parties greatly need credit lines to be open in order to keep the artificial level of liquidity up.  If we choose to inflate, buyers of U.S. debt will either stop buying or demand higher interest rates.  This would simply be unacceptable at a time when the U.S. and its citizens need to finance exponentially more debt than it ever has.  The path of inflation leads to monetizing debt as foreign demand for Treasuries and asset backed paper denominated in dollars dries up.  If we are forced to monetize our debt, the U.S. dollar will collapse and inflation will turn to hyperinflation.  This is as certain as the sun rising tomorrow.

The deflation path isn’t much prettier.  Just as inflation decreases the real value of debt, deflation increases it.  If we deflate, the value of all the outstanding debt faced by consumers and the U.S. government will begin to increase, and increase substantially.  You have to look at how far above market equilibrium we are.  A rough nominal judge of that is housing prices.  Housing prices increased for multiple years at double digit rates when historically housing prices increase a point or two above inflation.  That created a massive pile of excess liquidity which resulted in all sorts of new demand for goods and services.  Now consider the expansion of the industrial and commercial sectors that grew to service this new pile of liquidity.

All of it must contract, and it is my belief that if allowed to deflate, we would see deflation that would dwarf the deflation seen in the Great Depression.  It’s rather frightening to compare the liquidity growths prior to the 1930s and prior to our current economic crisis.  This extreme deflation would result in a massive growth in the real value of outstanding debt denominated in dollars.  As a result, there would be enormous amounts of personal, corporate, and municipal bankruptcies.  There would also be a high probability of the U.S. government defaulting on its debt.

As you can see, each situation is a mess.  Obviously current policy is to inflate at all costs, but I don’t think this is the best choice.  It happens to be the most politically viable choice, but that’s a discussion for another day.  You don’t necessarily have to agree with the motives, but you don’t need to look very hard to see which path the U.S. and rest of the G-7 economies have chosen.  Their quantitative easing has not been subtle.

Deflation with the Edge

So why do I pick the deflation route as the most desirable route?  Well, I have 1 ½ reasons.  Both inflation and deflation would probably result with the dollar no longer being the reserve currency of the world.  Inflation will force the U.S. to monetize the debt as demand dries up.  Attempting to monetize even a portion of the U.S.’ massive debt load will absolutely and completely destroy the dollar.  And deflation will ALMOST surely result in a U.S. default on debt.  Considering the massive amount of outstanding debt, if the U.S. defaults on its debt the dollar will be worth the paper it’s printed on.  I just have to say here that this will by far be the most painful part of this economic crisis.  Think you’ve seen chaos in financial markets lately? Just wait until when U.S. dollars begin to flood global forex markets - it will be like screaming fire in a crowded movie theater.  A global panic among the largest holders of U.S. dollars will ensue, and for starters, resulting in a 20-30% overnight devaluation of the greenback.

So why deflation?  Because it’s quicker - plain and simple.  Think of it like taking a band aid off.  Inflation is taking the band aid off slow, while deflation is just ripping it off.  Financially, deflation will give something closer to a v-shaped recovery as opposed to an extended u-shaped recovery.

My proposition is to IMMEDIATELY stop the monetary and fiscal irresponsibility.  Stop growing the money supply and defend the dollar.  Raise interest rates, re-value the dollar against gold, and implement a new gold standard.  Pass legislation that only allows for balanced budgets.  If there’s a deficit planned, cut spending.  If there’s a surplus, cut taxes.  It’s simple, yet probably perceived as barbaric and inflexible.  I do not want to understate the pains this will cause in the short run, but the alternative is to postpone the inevitable.

The sooner we hit bottom the sooner we can begin the recovery process.  This is when we can start an economy based on real growth; an economy whose economic activity is not based on a liquidity see-saw.  We will have the potential to make an economic machine that doesn’t grow because of debt creation.  This would be an economy with sustainable growth and less volatility.  Notice that I used a key word there: potential.

Will we learn from our lessons?  I doubt it.  There may be a couple decades of prosperity, but I imagine we will eventually go through another one of these Keynesian cycles.  It’s human nature, and for whatever reason, it seems to be the most flawed, such as Maxine Waters, that sets policies.  I’m not here to make the world a better place.  I care about my family and my friends.  I use what I’ve learned to make money and inform those who care to listen.

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Comment by Nik T

2009-06-23 21:59:56

Nicholas,

Great article, apology for the delayed response. It’s evident that buying (physical) Gold and Silver is the way to go in preparation for the inevitable. However, what most people fail to understand are 2 key points.

1) 70% of the world economy is backed by the USD. So the damage is tremendously huge- beyong belief..

2) 90% of Americans still believe the USD is still backed by Gold- even though it stopped in 1971.

Today, (24 June 09) i looked at the US debt clock and it is standing over $11.4 Trillion Dollars and is changing at over $3.5 Billion dollars a day.
I personally think the world is heading into hyperinflation and we are currently in the eye of the storm.

NT
(Australia)- its not much better over here =)

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