The Deflation Debate: Why This Time Is Different

I originally wrote this article in 2005, but the same argument pertains today:

It's fascinating to study and observe the distribution of wealth. History has shown great nations and companies that rose to the top from nothing and subsequently fell to nothing.

During the last phase of a boom, few save while most spend on credit. All the money spent flows to a few strong hands. Eventually banks (then private) stop lending, the public is bankrupt, and price deflation follows as people liquidate (so called K-winter). The few strong hands with money have no effect on prices since

1. They are very few in number, thus their consumption doesn't affect prices.
2. They believe their money is worth something, therefore they are in no hurry to spend until deflation is over and inflation picks up again.

This is what happened in the 1930s deflation/depression. Why were those strong hands (JPMorgan's, Rockefeller's etc) so few in number? First, there simply aren't many smart ones with the sole desire to make money; secondly, the contrarian group by definition is small in number. When everyone is bathed in good times, few can detect the winter is coming.

Those insiders reaped the benefits of deflation and came out even further ahead with their increased purchasing power. Such a theory is supported somewhat in reality as the world's wealth is concentrated in a few dozen hands. Over time, though, few rich manage to keep the wealth. When you have massive wealth (as a country, individual, or company), you attract the unscrupulous, and one careless mistake sinks your entire boat. There is the old Chinese saying-Wealth doesn't pass on 3 generations. Therefore, a fair amount of the concentrated wealth gets redistributed back to the ordinary people.

This is my view on how the world managed to get along reasonably well. 1930s is also what the K-winter / deflationists predict will happen again, as the USA seemingly approaches the end of its boom.

This time, however, I believe we won't have K-winter. Refer to points 1. and 2. above and we see that

1. This time the strong hands aren't few in number. The strong hands with trillions of dollars are in Asia-Just India and China constitute 40% of world population. You see, the Chinese and Indians didn't live under the same roof as the dollar-printing Americans. The general public this time aren't monogamous in spending attitudes and debt level. Asian debt levels aren't even close to their American counterpart. Asia's share of population consumption will have a big impact on prices. We never had such polarized, contrasting general public (one part broke, while the other part rich). Since the strong hands are larger in population size (2 billion vs 600 million in Europe and USA), I'd say inflationary forces are stronger than deflationary. Again, for price deflation to happen, most of the public must be broke, this just isn't the case today.
2. This time, the strong hands know their dollars are worth nothing. Because they didn't bathe in the golden times and debt bubble, they get to see things clearly. The US government never had such a strong hold in influencing money, banks, and with such corrupt morals-the US gov't doesn't care for the dollar's survival. Such arrogant and ignorant attitudes are demonstrated repeatedly with explicit action (deficits and market manipulation in unprecedented proportions) and statements (printing electronic dollars, helicopter money)

The take away is: K-winter proponents didn't take into account of:

1. The makeup of strong hands. The strong hands this time are large in population, whereas before the strong hands were the elite few.
2. A US government that has lost its time and place. Banks are no longer private, markets are no longer functioning, and few in power care to salvage what's left of the dollar, because they have other ways out (I mean with airplanes and internet access, there are plenty of nicer places to live around the world than a bunker hole in Wyoming should things go wrong, right?)

Comments

[CLH:]

An interesting article but probably not true. The number of people in India and China are not important. Its money thats important. The US still is far ahead of the East (except for Japan). The dollar is strenthening not dying.

2008 Nov 07 07:30 AM

[tomatden:]

I'd say it probably is true. How much longer can the dollar continue to strengthen? The longer-term supply/demand fundamentals are not good. Once the current dollar trend reverses in earnest, a wave of dollars will return to the US, chasing a shrinking amount of goods and services being produced by the shrinking US economy. Commodities could start to soar and gold could dramatically increase it's role as "real money" and also soar. Great article!

2008 Nov 07 08:33 AM

[investor88:]

China and India are small boys economically compared to ailing G3 uncle Sam, Europe and Japan. If there is a deep recession, deflation follows period, never mind the existence of "peripheral" players like China and India.

2008 Nov 07 09:22 AM

[socrateazz:]

I thinkl the problem we see today is too much wealth in the hands of the few. The middle class is the key to spreading and spending wealth Reagan was very right about the fix of too much wealth in the hands of those who purchase causing inflation. Today too much wealth is in the hands of those who do not spend. Another problem is the foriegn deficit...as long as foriegners think the dollar is safe all will be well....I think we are in the last year of that situation. Once the belief shifts adequately watch the dollar follow the course of the stock market more or less

2008 Nov 07 10:14 AM

[peterthepai...:]

very interesting but not correct...nice try though...

2008 Nov 07 11:10 AM

[DVW:]

The problem with using China's population is MOST people there dont have any money. More now than there used to be, yes, but you can't say that the entire population is strong hands.

They do hold an awful lot of dollars that they need to get rid of. Expect them to come shopping here like the Japanese did a few decades back.

However, I do agree that the next seed of economic power might sprout in Asia. Give it a few to 10 years.

2008 Nov 07 11:38 AM

[kebu77:]

Does all the money held by the top dogs in the oil-producing countries change any of the views expressed above?

What happens when the Treasury (soon) goes into the bond market in a big way, if there are shortage of buyers?

If rates on long issues then rise substantially to attract the extra cash needed? If the dollar then drops fast and oil and other commodities rise fast... just after OPEC has (on or before their Dec meeting) cut quotas again, triggering an unintended second oil price spike?

2008 Nov 07 12:58 PM

[Mr. B:]

He may be right for the wrong reasons. The massive explosion of money created by the Fed will likely stop a deflationary spiral in the long-term.

Inflation subsides in any recession and the question here is how long and deep will this recession be.

China does have about 300 million people with discretionary income. Granted it is a fraction of the total population of 1.1 billion people, but it is still a large number. Everyone should hope they keep spending.

What he does point out is that the US Government is pursuing the economic policies of a banana republic. We have just witnessed the discipline of the market when too much debt relative to income/cash flow occurs.

Ultimately, the hazards of excessive government spending, inflationary monetary policy and the trade deficit will be harshly judged by the global market place. (We will see if the new Obama adminsitration is as naive as I think when it comes to even larger government programs and larger deficits.)

The rally in the dollar is temporary and the trend of US dollar weakness will resume as the current crisis fades. The US Government is debasing the dollar by defict spending to support current consumption (and a new government healthcare program will just compound this massive problem). A huge percentage of the $3.1 TRILLION federal budget is consumption spending.

The only way for the US to recover is to stop asking the government to do everything and insist that government spending (both real and as a percentage of GDP).

The US used to be the world's largest creditor nation. All of that has changed beginning with Johnson's Great Society spending. All that has done is transfer more power and influence to the federal government and it has done nary a thing for the poor it was supposed to help.

Even an economy with an inefficient, corrupt central government like China's can prosper as a creditor nation.

2008 Nov 07 02:17 PM

[X-15:]

China and India are just a large part of the picture, the other players to become important are adjunct to China and India growth story, Smaller in population but RESOURCE rich with good budget and strong currency futures, Canada, Australia, New Zealand ,and Brasil are in great position to have strong future. We in the USA are dead in the water for at least 3 years maybe more..... This, sadly is the beginning of a protracted dollar decline thanks to bad Fed policy and Government miss-allocation of resources.

Study Real Estate trends from 2002- 2007 the real estate bubble is our cement overcoat -no part of the country was/is unaffected by its' massive inflated rise- Rural Montana, Idaho, to Rural Vermont, and Nowhereville upstate New York, Texas and Nevada wasteland to the swamps of Florida the speculators are being crushed. Add this to the Wall Street 'Black Hole' of 30 to 1 leverage -trouble in River City.

2008 Nov 07 11:54 PM

[This is naive:]

This post is, in my opinion, extremely naive view of the world economy for many reasons. In short:

*Both China and India have huge reliance on demand from developed countries. Domestic consumption and capital allocation efficiencies (very important) are still well below that of the developed world. There are many reasons for this but is largely to do with the structural differences in their political and/or social and/or economic systems.

*The "strong hand" is really the one WITHOUT the money. Let me put this simple. We all know that the US owes a whole lot of debt to the hardworking populations of the world, BUT, we love them and we need them to continue to do so because we're so used the way it works and pain will not be felt alone should they DEFAULT. It's that simple! We need to keep the US spending until they can find enough resources to pay down debt from the moon (not counted in the current financial system, if you REALLY understand what I'm saying).

DEBT owns the world, not equity. Wake up people! Get it right!

2008 Nov 20 05:48 AM