Monday, February 8, 2010

The Case for Deflation: Discussion 2, the Case for Inflation!

Curious George has provided another informative post for inquiring minds...

“In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.” From Wikipedia

In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money – allowing one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation decreases, but still remains positive). As inflation reduces the real value of money over time, conversely, deflation increases the real value of money – the functional currency (and monetary unit of account) in a national or regional economy. From Wikipedia

The Inflation Case Outlined
Where does inflation come from? Very simply deflationists will tell you inflation comes from increases in the money supply which is lent into circulation by the banks. As the velocity of this money increases, wages and prices increase due to the supply of money increasing faster than the production of goods and services. Deflationists continue by explaining that today the money supply is not expanding even close to a rate that would cause inflation and in fact may even be shrinking. Furthermore, the banks are absorbing all the newly created money and buying Treasuries instead of lending that money into broad circulation. The new money effectively goes into a “black hole” (stays in the banking system) and does not see circulation or create velocity. At worst it goes into treasuries and the government spends it on bailouts and other items that may not help the economy. Deflationists will go on to claim that the current trend of private sector delevering reinforces the deflation, that unemployment and the weak economy (weak GDP) underscores the deflation trend and that this trend has many years to go. Falling home prices, falling stock prices, and falling commodity prices are all deflationary. Massive fiscal and monetary activities will not lead to price inflation due to private sector delevering. The money just never makes it into circulation or it only replaces the credit the private sector delevering removed from the economy. There is no inflation and there will be no inflation for years. This is the deflationary argument.

Since there is no inflation, interest rates can remain low. We will be able to afford to finance our government debt. Since there is demand for Treasuries, and inflation is low, Treasuries are a good investment. Since inflation will be low and our debt service affordable, the dollar will be strong. In fact, “the best credits in the world” according to Shilling. Since many currencies are in much worse shape, the dollar will be strong. And so the reasoning goes. Except, for a few teensy little problems.

1. The debasing of the dollar. Deflationists will not discuss the details of the dollar’s problems. Somebody else is always dumber and uglier, therefore the dollar looks good on a relative basis. Not so fast. You just might have a point if you debate the dollar vs. the pound or the dollar vs. the yen or the dollar vs. the euro but this relative judgment is missing the point. The point is, we are debasing our currency and the world investment community cares and they are doing something about it. They are quietly preparing alternatives. Russia and the gulf states are planning a currency. China is negotiating trade deals in their own currency and planning beyond the dollar. The world community is buying less and less of our debt. Guess what? Much of the consumer goods we buy in the stores is not produced in the USA . A substantial drop in the value of the dollar will translate into much higher prices in the stores. The dollar, pound, yen and euro may compete in a currency demolition derby where we win, but China will only ship the goods in exchange for fair value. OPEC will only ship the oil in exchange for fair value. As China , Russia , India and others buy gold to bolster their currency and give it credibility, we debase ours. We monetize, hold interest rates at zero, and book massive fiscal deficits. Come on deflationists. Obama said he plans $trillion deficits for 10 years. The Fed is stuck on low interest rates and is stuck buying our own Treasuries. Even if the dollar appreciates against other uglier currencies, gold, oil etc will appreciate against the dollar due to dollar debasing activities. Producers will want value in return for their goods. The dollar will not retain its purchasing power. “Buy Treasuries”? I say buy stuff.

Scarcity. Some items are becoming more scarce. Crude oil is becoming more expensive to produce. As demand falls in the developed world, it is increasing in the developing world. Meanwhile crude oil production is falling. Eventually prices rise and the crude will go to the highest bidder using the strongest currency. Factors pushing crude oil prices higher are rising demand, falling supply, rising cost of production, and geopolitical risks. Gold production is trending down. Silver production is trending down. Rare earth elements production is down. The fact is the fundamentals for many commodities are very good. If the dollar is debased and there is a shortage of basic items, that is a recipe for much higher prices.

Food production. Rising population combined with falling arable land acreage means higher food prices. Grain stocks are very low. Three months for some grains and only three weeks for soybean oil. With inventories this low, a weather blip anywhere in the food production world could cause prices to jump significantly. A price increase due to increased population – decreased arable land would be permanent. thinks the situation is so serious that future food shortages could become so acute that some countries would sell their dollar investments to raise capital to buy food.

Finally, the investment prescription dispensed by deflationists is to buy Treasuries. Really? A flight to quality? With federal debt exploding, state and local governments teetering on bankruptcy, the banks not lending to promote growth, a mountain of adjustable rate mortgage resets dead ahead, threatened tax increases and tax revenues falling, where is the compelling reason to buy treasuries? A more reasonable position is the one calling US Treasuries a giant Ponzi scheme. See James West,,, ,, , and Bill Bonner on 2/21/09.

The voices and evidence against treasuries are piling up and the international investment community agrees and that is why the Fed resorts to monetization. Foreign buyers are avoiding the dollar. Most of the deflation argument is believable. Their position on the US Dollar and Treasury bonds is weak. The purchasing power of the dollar is at risk. This is the issue at the heart of all portfolio decisions.