The inflation/deflation debate is now the 'topic du jour' and although I have discussed this issue many times in the past, I think that it is time to re-examine the conundrum. Today, many prominent economists (Nouriel Roubini, David Rosenberg and Paul Krugman) and fund managers (Bill Gross and Jeremy Grantham) are forecasting deflation and according to these folks, a deflationary contraction is now 'baked in the cake'. In fact, these deflationists are extremely worried about the ongoing private sector debt deleveraging in the developed world and they are also concerned about the lack of aggregate demand. Bear in mind that these factions are Keynesians and thus believe that deflation is now almost guaranteed and inflation is out of the question.
On the other end of the spectrum, and in stark contrast to the deflationist camp, are many prominent market participants (Paul Tudor Jones, John Paulson, Jim Rogers, Marc Faber and Peter Schiff) including me, who are now warning about high inflation or even hyperinflation. According to these people, the large fiscal deficits and massive debt overhang almost guarantee runaway inflation.
It goes without saying that such conflicting views are extremely strange when you consider that all these highly experienced and successful people are reviewing the same economic data! Well, everyone is entitled to their opinion, but as far as I am concerned, deflation is an urban myth and the global economy will have to contend with very high inflation. More importantly, when you are in doubt as to who to listen to check their individual track records. If they did not foresee the problems that we are now in, what makes you think they suddenly found G-D and discovered the solutions? I always believed that doing more of the same as what got us into trouble is the first place while expecting a different outcome this time around is the definition of Stupidity. The first thing I do when I get a headache from banging my head against the wall is I stop banging it.
It has always been my contention that inflation is a monetary phenomenon and short sighted policymakers always have the ability to create inflation. Now, before I go any further, I want to make it clear that inflation is an increase in the supply of money and credit (debt). Conversely, deflation is a decrease in the supply of money and (credit) debt. Furthermore, it is critical to understand that an increase in the general price level is a consequence of rapidly increasing money-stock and credit and a decrease in the general price level is a consequence of a falling money supply and credit. Most importantly, despite what you may hear elsewhere, you should keep in mind that a booming economy (operating at near full capacity) is not a pre-requisite for or a cause of inflation.
If you reside in the deflation camp and believe that inflation cannot occur in a weak economic environment, you need to visit Zimbabwe and meet Mr. Mugabe who will explain how you can create hyperinflation at a time when a nation is in an economic depression! Whether you like it or not, Zimbabwe's hyperinflation clearly shows that despite a huge drop in GDP, surging unemployment and a bankrupt economy, reckless policymakers can succeed in creating hyperinflation.
So, while the economies of the developed world are struggling and will be operating below trend for several years and aggregate demand will stay well below their available capacity, contrary to the deflation camp, the money creation abilities of the central banks will be operating FULL BLAST. In order to avoid sovereign defaults in the near-term, the Federal Reserve and the European Central Bank will create unprecedented amounts of new “out of thin air” money.
Short-term interest rates in both the US and Europe are at extremely low levels and real short-term interest rates are negative. If such a loose monetary policy fails to create inflation, you can bet your bottom dollar that these central banks will unleash even more rounds of 'Quantitative Easing'. Needless to say, such reckless monetary inflation will dilute the existing money-stock even further and reduce the purchasing power of money.
As far as the private sector is concerned, the credit bubble burst two years ago. Commercial bank credit in the US started to contract and debt repayment by the private sector was a logical response to the crisis and for 17 months, commercial bank credit declined by roughly US $700 billion. In fact, it was this private sector debt contraction that prompted many economists and investor to enter the deflation camp.
While it is true that the private sector in the US did experience deflation (contraction in debt) for a brief period of time, it is notable that this 'austerity' did not last very long! US commercial bank credit bottomed out earlier this year and since then, it has risen by roughly US $400 billion. So, it should be clear to all observers that the private sector in the US is no longer de- leveraging and this is inflationary. It also seems that a “Take Over” craze is also beginning.
Furthermore, I would like to point out that even though commercial bank credit in the US contracted between October 2008 and March 2010, during that period, America's federal debt went through the roof! Ironically, during the time frame when American households and corporations were tightening their belts, the US Treasury borrowed US $2 trillion thereby stopping deflation in its tracks. The truth is that at no point during the Recession did total debt (private sector plus Federal) in the US contract, so deflation did not occur. Now, it is conceivable that the private sector in the US may abruptly start repaying its debt again. However, if such a debt contraction occurs, Mr. Bernanke will create money like there was no tomorrow.
Today, America's total liabilities (including Social Security, Medicare and Medicaid) are around 800% of GDP and federal debt has climbed above 90% of GDP. Given the fact that deflation will increase the real value of this debt, you do not have to be a genius to figure out that before the US Government declares bankruptcy, it will desperately try and inflate its way out of trouble by unleashing another 'stimulus'. The current administration will try and maintain nominal GDP growth, so that nominal incomes and tax receipts are sufficient to service the outstanding debt.
QE2 should begin any day now in a last ditch effort by the government to save the election for the party in power.
It is interesting to observe that in order to fund its spending binge, so far the US Administration has succeeded in borrowing huge amounts of money at low or zero interest rates. It is notable that up until now demand for US Treasuries has been strong and the US Administration has not had much trouble raising money. Perversely, in today's volatile economic environment, US Government debt is still viewed as a safe haven. However, all good things must come to an end and investors' perception could and will change virtually over night. When that happens and the bond market starts to focus on America's ballooning deficits, demand for government debt will dive. At that point, the Federal Reserve will have no option but to create new money so that it can lend it to the US Treasury. In fact, the Federal Reserve has already announced that it will use the proceeds from the sale of its mortgage-backed securities to buy US Treasuries. It’s my view, that this is only the beginning of outright debt-monetization which will intensify over the coming years.
Throughout history, periods of massive money creation have always been inflationary and this time should be no different. Over the following months, if the economies of the developed world take a turn for the worse, you can be sure that the respective policymakers will respond by creating copious amounts of paper money. That is their only option OR so they think.
Given the inflationary environment we find ourselves in, I do not like cash or fixed-income securities. In my view, both cash and bonds will lose considerable real value and the ongoing strength in the government bond market (the world’s BIGGEST Ponzi scheme) will also turn out to be the history’s BIGGEST BEAR MARKET. Conversely, I maintain that precious metals will provide stellar returns in this inflationary environment. I am not so sure about energy and the stock markets of the fast growing developing markets. They may initially crash as well, but then present stellar buying opportunities.