INFLATION or DEFLATION?

August 11, 2005
Inflationists Risk Missing the "Big Picture"by Chuck DiFalco

The inflation versus deflation debate is the most interesting, as well as the most hotly debated, macroeconomic issue concerning the current secular bear market in global equities. The current cyclical bull market ('02-'05) notwithstanding, the "Great Recession" is still with us. The five years that have passed since the stock market peak in 2000 most likely contain the easy part of the 10 to 20 year economic bust. A critical aspect for a person's desire for capital preservation is to know whether the rest of the bust will be characterized by inflation or not. Ignoring the other side of the (for now) academic debate, as part of an "I'm right" zeal, can doom an investor to years of losses or sub par returns. Indeed, the world economy might deal a pernicious dose of both inflation and deflation to everyone's dismay. While I cannot expose all my ideas on this issue in one short article, I first focus on one critical aspect, that bigger power brokers can trump big ones.

"Give someone a hammer, and everything looks like a nail." Those inflationists with economics or mathematics backgrounds, with their data plots representing equations laden with logarithms, derivatives and exponentials (I took one, maybe two dozen college math courses), often fall into this logical trap. There is no room in their plots for outside-the-chart thinking that could result in discontinuities in the otherwise smooth lines or clean waves. Current trends NEVER continue! Many inflationists dismiss phenomena such as politics, mass psychology, and event risk.

These messy and unquantifiable "what ifs", however, still exist, and serious investors must literally take them into account. The focus on the realm of numbers, intensified by looking backwards in time, sits at the heart of why many inflationists miss the big picture.

Inflation versus deflation articles repeatedly delve into definitions. While I have my own extensive views about the meaning of up and down, I will (perhaps mercifully) postpone such irreverent discussion to a future article. At the risk of oversimplification, I will restrict inflation, with a few strokes of the keyboard, to the increase in price level of a basket of goods and services in the USA. Note that the popularized measures of this narrowly defined inflation, such as CPI, core rates, deflators, etc., don't even do a good job of this task. Their resultant effect on asset prices is what concerns investors struggling to profit in an overpriced world.

Now, back to the future. There are basically two camps on how the sharp end of the Great Recession will play out over the next ten or so years. The inflationists argue for a surge in inflation. Like that 1970's show, irresponsible government and quasi-government institutions will print vast quantities of valueless fiat currency in the vain attempt to anesthetize the voting populace from any and all economic pain. On the other hand, the deflationists contend that the next decade will feel more like the desperate 1930's. A few well-placed mortals cannot overcome the Kondratieff cycle of market economies, they say. The inevitable aftermath of the feel-good 1982-2000 "autumn" can only be a dark, deflationary winter.

Gross domestic product, trade deficits, trillions in debt, central banks, international asset, labor, and goods markets--what can be bigger than the global economy? Here the inflationists miss the boat on one important point. The crux of their argument stems in their contention that central banks, most notably the US Federal Reserve Bank, one of the most powerful quasi-government institutions in the world, will never let deflation occur. Everybody knows that deflation renders central banks powerless. Their most potent weapon, the level of short-term interest rates, then become ineffective because zero is as low as they can go.

When prices are falling, and people cannot earn money in a bank account, they will just withdraw it and stuff it in their safe deposit boxes. Thus, the "fed" will just create money out of thin air in their own bank account. Computers are much faster than printing presses to this end.

The implied omnipotence of central banks is an incorrect characterization. Central banks, including the USA's and China's, do not hold the commanding heights over their own economies, let alone over the global economy. There are other, bigger players, ready to overrule the central bank. Most correctly take it for granted that the Communist Party has this power in China. To forget or dismiss that the same power exists in the USA is a serious mistake. Right now, the USA is the world's only superpower, and its money is the world's reserve currency. A volatile dollar, suffering from chronic trade deficits, and stoking fears of (but not quite the quantity of) 1970's style inflation, would jeopardize the dollar's reserve status, and thus undermine political and military global primacy.

You cannot be a world power if your highly visible currency loses value and drags down your economy with it. Germany, with its hyperinflation in the early 1920's, is an extreme example. Also, recall the American "malaise" versus Soviet-style totalitarianism in the stagflationary 1970's.

If there were a currency crisis in the next decade, which could involve the mere threat of sudden devaluation, let alone an actual one like Argentina had just a few years ago, do you think the US government would stand idly by and let the dollar crash in the currency markets? Elected government officials like and will continue to jealously guard their positions of power in Washington, DC. As they feel that power dropping with the dollar's value, are they going to delegate economy fixing authority to a recessionphobic federal reserve? Not a chance. The US federal reserve does not operate in a political vacuum.

How would the US government fight a dollar crisis? Like backward looking generals, it would fight the last war. There was a dollar crisis in the 1970s, with the US going off the gold standard, oil embargos, soaring inflation, mobbed gasoline stations, recessions, stagflation, exponential precious metals prices, and WIN (Whip Inflation Now) buttons.

Eventually the elected politicians in the US were forced to act strongly. Along came Paul Volcker, appointed to chairmanship of the federal reserve, armed with a single mindedness to destroy inflation, and determined to increase interest rates regardless of the economic cost. He provided a spectacular economic discontinuity in 1979-80. The resulting high real interest rates created benign disinflation from the mid 1980s to the late 1990s. A 2010 (to guess on a year) administration would see that paradigm, and think that we could do it again. The heat would be turned on the federal reserve to increase short term interest rates to save the dollar. While an outright seizure of the federal reserve might not be politically feasible, more subtle pressures might be applied. Executive and legislative big shots could "make happen" forced resignations and appointments of more aggressive federal reserve board members. What could do the trick is a simple "nudge nudge, wink wink, if you don't go along with us or resign, we've heard of many hellacious IRS audits recently." Regardless of the actual power mechanism, the US federal reserve board members ultimately serve elected politicians.

The result might not be the same next time, since all other things will not be equal to the 1970s USA. A scenario of downsized wages and benefits, unsustainably high consumer, corporate, and government debt loads, and the subsequent cascade of bankruptcies and credit destruction could mean that inflation drops below zero for an extended period of timeeven ten months, let alone 10 years, would feel like a long timebut that's another article. Even now, the more I hear protests that the US is not like the deflationary Japan of the 1990s, the more we're turning Japanese. I have read that elected politicians would have no stomach to risk serious recession(s) by creating an environment in which real interest rates surge. I'm not confident that the logic would match political reality. Interest rate hawks might have a strong political ally. I see the huge baby boomer segment of the population increasingly demand investment income, as opposed to capital appreciation. To those millions of registered voters with nonzero portfolios, increasing real interest rates would be a GOOD thing. The inflation busters could also be cheered by an impatient citizenry wanting the government to do something NOW about an inflation scare (but not reality) highlighted by volatile gasoline prices.

The inflationists counter that the US government would not want to raise taxes, and instead inflate away, its debt. Oh, really? Rather than risk superpower status, why not raise taxes in a politically palatable way? You think politicians are not clever enough to pull it off? "It's all China's fault that we're in such a mess! And India! And everyone else! Let's do right for homegrown American products. An across the board tariff on all imported goods and services! Let's help American workers! Let's get America back on its feet again." This is one scenario out of many that I can envision in which an inflation and deflation combine to devastate the standard of living in the US, thus confounding both the inflationists and deflationists. Markets enjoy maximizing investor frustration.

Can the inflationists be correct? There is a possibility that shocking price increases, even hyperinflation, will negate the current deflationary pressures of globalization and irredeemable debt accumulation. If people like "Helicopter" Bernanke get their way without veto from the three branches of the federal government, an extra zero or two might magically be appended to everyone's bank balance. Seriously, the way to push on a string might be to dangle an enticing carrot in front of the hungry person holding the other end, and to hold on for dear life. The carrot could take the form of millions of fat US Treasury checks in the mail, wrapped in some catchy advertising like "Citizenship Dividend".

The money behind the check would quietly be created from nothing, or noisily obscured in an Enron-style "off budget" accounting scam. The US government would in either case have no intention of financial discipline or honesty. Consumers would rush to spend their money before the government could debase it further. Dollar devaluation would shift into high gear. Perhaps there is a cycle bigger than the "K-wave" that totally trumps deflation.

While this "ugly" scenario might not be quite what most inflationists have in mind, the general idea of creating monopoly money from nothing is common. They remain convinced that the federal reserve bank's supposedly unlimited power to create money will inevitably overpower deflation. Inflationists focus on chartable measures of money supplies, at the risk of ignoring innumerable factors that are integral parts of the economic big picture. Both they and their deflationist colleagues risk much more than they realize with their one-way bets.

Krassimir Petrov proposes that China, with its huge surpluses, will do anything to prevent Stephen Roach's "global imbalances" from crashing down before the 2008 Beijing Olympics. Thus, we just might have some time to theorize, strategize, invest, and hedge before the Great Recession decides the inflation question for us.
Chuck DiFalco