Inflation: As Inevitable as Death and Taxes

We've been arguing for some time that the Federal Reserve and others who influence the economy must choose between two great evils – inflation and deflation. No middle ground remains open.

What's more, inflation remains the more palatable of the two. A nation can endure high inflation for a time without destroying its long-term economic prospects. For example, after World War II, Japan experienced inflation on the order of 40% annually for several years. Yet it segued from that ordeal to become an economic juggernaut for much of the seceding decades.

Similarly, high inflation plagued Brazil during the early 1990s. Yet today Brazil is one of the strongest emerging economies. The U.S. can only envy its growth rate. Warren Buffett, moreover, has singled out Brazil's currency as one he would like to invest in.

On the other hand, economic depressions have far more severe aftereffects and require more drastic measures to solve. It took over ten years for the U.S. economy to recover from the Great Depression that began in the early 1930s – and even then it was only the massive spending and industrialization necessary to fight WW2 that caused growth to reach 15% that pulled us out of our slump.

Similarly, many people don't realize that the hyperinflation which plagued Germany in the 1920s was a short-lived phenomenon. While the suffering it caused may have contributed to the rise of Hitler, it was really the hardship of the 1930s depression that gave the biggest boost to the Nazis' careers.

People can adjust to and even weather high inflation – even double-digit inflation, because high inflation does not necessarily destroy the social structure. As long as the social structure remains intact, measures can be taken to improve the economy, reduce future inflation, and set the stage for a healthier economy. Depression, however, can destroy the social structure, making it difficult to invest in solutions.

In our situation today, high inflation would clearly be the lesser of the two evils. It might chasten us to aggressively develop alternative energies. More plentiful energy would then free us from future inflation caused by dwindling oil supplies.

As you probably know, we expect high inflation will be the path our economy takes. However, depression remains a possibility. In fact, today we seem to be at a crossroads. For instance...

FRAGILE GREEN SHOOTS

The close correlation between commodity prices and the stock market today suggests that further gains in stock prices, further “green shoots,” will be accompanied by rising inflation. As long as the economy remains sluggish, inflation becomes a kind of tax, a suppressor of consumer spending and investment.

Therefore, if commodity and stock prices keep rising, the Fed must be willing to loosen credit or risk a deflationary event such as we had last year. You recall that the Fed failed to see higher oil prices as an economic suppressant in 2008. Keeping monetary policy too tight resulted in October's nasty stock market crash.

On the other hand, if the stock market rally soon reverses (and we think it will), that will be the end of the only green shoot. All the other economic stats are anything but green – home prices, unemployment, mortgage applications, interest rates up, etc.

In the event of a stock market correction, the Fed will have no choice but to add considerably to its balance sheet, even though the balance sheet is already a quantum leap above anything we've ever seen in history. Aggressive money creation and liquidity would be the only option. The Fed will feel that the stock market, as the only green shoot, must be nurtured.

On top of that, with 2010 being an election year, the government cannot allow a worse economic disaster to unfold. No incumbent politician wants to campaign during a period of misery.

So no matter what happens, we feel the Fed will maintain its loose monetary policy. If the stock market rises, so will commodity prices and inflation, and the Fed will need to loosen credit so the economy doesn't become choked. If the market falls, the Fed will need to loosen credit to stop the fall and stimulate growth.

With no choice but to keep easy money flowing, keep the balance sheet rising, the Fed's actions will make higher inflation inevitable. Record levels of money creation can only result in a less valuable dollar and higher prices. Looming resource shortages ready to emerge on any hint of an economic recovery will create inflation by other means. Our only questions regarding inflation are “when” and “how much.” We have no doubts about “if.”

Making money under such conditions may be challenging, but the methods are clear...

THE TWO BEST INVESTMENT AREAS

To beat inflation over the coming months, you need to own growing companies with footholds in not just Chindia but also the BRAC nations – Brazil, Russia, Australia, and Canada. These resource-rich nations will resist inflation better than any.

Fears about the world economy may push commodity prices lower for a short time, but any hint of a recovery will benefit resource-based investments.

Meanwhile, we want to emphasize gold over all other investments. Though gold has had a tough couple of weeks, and is off to a bad start today, it is only a matter of time before its value as an inflation hedge causes it to outperform substantially most other assets. Meanwhile, gold also offers protection against deflation and recession, which will send investors fleeing for the safety of hard assets.

Comments

[capitalisth...:]

I agree that inflation is inevitable but I disagree that deflation is the worse of 2 evils. Deflation is what is supposed to happen in a free market competitive economy. As economies of scale and technological innovation occur, cost of production decreases, profit margins increase, and prices decline. Deflation increases the purchasing power of my dollar and makes my real hourly wage rise. Deflation is a good thing.

In contrast, inflation erodes purchasing powers, decimates your saving and your wages.

Also, I completely disagree with your comment that gold "offers protection against deflation." Cash is the best hedge against deflation! Deflation will decimate the price of gold.

Jun 23 05:07 AM

[Dave Wrixon:]

Inflation favors the HaveNots against the Haves. It is a great leveler. Basically most existing wealth is destroyed and all that is left is peoples ability to generate income from their wits and their labor. It is devastating if you are retired on a fixed pension, but often much better if you have debts.

Deflation favors the Haves against the HaveNots. It make the Rich richer (relatively) and the makes the Poor Poorer (absolutely). That is why the social repercussions are so much more severe. If you are going to have revolution, it is the disenfranchised youth rather than bitter octogenarians which pose the greatest threat.

Jun 23 06:04 AM

[Dave Wrixon:]

Deflation through productivity gains is a good thing. Deflation due to collapse of demand due mass unemployment and loss of capital is not.

But you are correct about Gold. It would fall in a deflationary environment. Gold produces no income. It can only ever be worthwhile as an investment if it is appreciating against cash. As the value of cash drops the value of gold soars, but only ephemerally. But in this day and age other commodities such as oil could do equally well. Much of the mystique around Gold has disappeared.


On Jun 23 05:07 AM capitalisthero.com wrote:

> I agree that inflation is inevitable but I disagree that deflation
> is the worse of 2 evils. Deflation is what is supposed to happen
> in a free market competitive economy. As economies of scale and
> technological innovation occur, cost of production decreases, profit
> margins increase, and prices decline. Deflation increases the purchasing
> power of my dollar and makes my real hourly wage rise. Deflation
> is a good thing.
>
> In contrast, inflation erodes purchasing powers, decimates your saving
> and your wages.
>
> Also, I completely disagree with your comment that gold "offers protection
> against deflation." Cash is the best hedge against deflation! Deflation
> will decimate the price of gold.

Jun 23 06:09 AM

[DONE_SONZ:]

Agreed.Alot of havenots,just look at unemployment.


On Jun 23 06:04 AM Dave Wrixon wrote:

> Inflation favors the HaveNots against the Haves. It is a great leveler.
> Basically most existing wealth is destroyed and all that is left
> is peoples ability to generate income from their wits and their labor.
> It is devastating if you are retired on a fixed pension, but often
> much better if you have debts.
>
> Deflation favors the Haves against the HaveNots. It make the Rich
> richer (relatively) and the makes the Poor Poorer (absolutely). That
> is why the social repercussions are so much more severe. If you are
> going to have revolution, it is the disenfranchised youth rather
> than bitter octogenarians which pose the greatest threat.

Jun 23 06:25 AM

[D. McHattie:]

I think it really depends on the kind of inflation we get. And this is where the discussion really must be enlightened by acknowledging that inflation does not effect all prices equally.

If we get inflation along with high unemployment then it hard to see how that benefits the havenots. Wage inflation will be 0, as it has been throughout this decade as long as unemployment rates remain high.

If the money supply is increased by creating money through people that are already rich, oh, say, through laundering $10B to Goldman Sachs via AIG producing record Goldman bonuses, then this money will be used to buy assets. The result is asset inflation and a cheapened dollar making it that much harder for the havenots, who live on their wages and not their assets, to obtain the necessities and luxuries of life.


On Jun 23 06:04 AM Dave Wrixon wrote:

> Inflation favors the HaveNots against the Haves. It is a great leveler.
> Basically most existing wealth is destroyed and all that is left
> is peoples ability to generate income from their wits and their labor.
> It is devastating if you are retired on a fixed pension, but often
> much better if you have debts.
>
> Deflation favors the Haves against the HaveNots. It make the Rich
> richer (relatively) and the makes the Poor Poorer (absolutely). That
> is why the social repercussions are so much more severe. If you are
> going to have revolution, it is the disenfranchised youth rather
> than bitter octogenarians which pose the greatest threat.

Jun 23 07:29 AM

[prairiedog555:]

Inflation is inevitable, yeah, but when? That is the question. I am beginning to believe more in the Japanese model, long drawn out malaise.
What to do in the short run, 1-2 years out.
What does good in these conditions?
foreign bonds
Muni's
high yield corporates
dividend stocks

Jun 23 08:15 AM

[Roger Knights:]

All the logical reasons against gold will vanish if China decides to stockpile it. China is running out of alternatives to stockpile.

Jun 23 09:30 AM

[Craig W:]

The Have-nots benefit through inflation . . . except for the have-nots that are unemployed. Those Have-nots will become destitute.

The inconsistency in your argument is that the Have-nots you are referring to are the same people who obviously lack the ability to generate sufficient income to save and become Haves. That’s why they are the Have-nots in the first place. The Haves will remain Haves because they have earning power . . . that’s why they’re the Haves. But high inflation won’t just destroy the poor . . . it will also hammer the senior citizens as the value of their fixed incomes erode. They will be forced to turn to their kids for support adding an additional financial burden on the middle-class . . . a burden on top of their higher taxes, lower real incomes, and reduced wealth.

With high inflation, the rich will stay rich, the middle class will become poor, and the poor will become destitute.


On Jun 23 06:04 AM Dave Wrixon wrote:

> Inflation favors the HaveNots against the Haves. It is a great leveler.
> Basically most existing wealth is destroyed and all that is left
> is peoples ability to generate income from their wits and their labor.
> It is devastating if you are retired on a fixed pension, but often
> much better if you have debts.
>
> Deflation favors the Haves against the HaveNots. It make the Rich
> richer (relatively) and the makes the Poor Poorer (absolutely). That
> is why the social repercussions are so much more severe. If you are
> going to have revolution, it is the disenfranchised youth rather
> than bitter octogenarians which pose the greatest threat.

Jun 23 11:23 AM

[morph366:]

I concur with D McHattie that we need to be more precise in how these terms are used. It seems that most debate about economic matters uses too simplistic polarities - either/or, black/white, inflation/deflation etc. - when we really should be talking about are shades of grey.
Inflation in asset prices benefits the haves if it is not accompanied by a general increase in incomes.
Statistical measures of inflation - CPI, PPI place too little emphasis on asset prices and index linked incomes are perpetuating the growing divide between asset rich and asset poor.

Jun 23 12:11 PM

[johnm:]

There are winners and loosers in an inflationary environment
but I do not think it is as simple as you put it.

Some loosers I see are:
- wage earners that are in no position to negotiate
salary increases
- people on fixed incomes (retired people mostly)
- investors in long term fixed income instruments
- in general conservative people with savings

Some winners I see:
- owners of businesses that make usefull stuff and
can pass on price incresses to their customers
- leveraged investors in equities, fixed assets (real estate, land etc),
commodities
- in general the people that can borrow money at low rates
as soon as it leaves the feds printing press and invest it
wisely (as an example, not everyones wealth evaporated
during the Weimar Republic, a small group of investors with
access to loans levered up, bought businesses and made
a ton, of course we know what followed)


On Jun 23 06:04 AM Dave Wrixon wrote:

> Inflation favors the HaveNots against the Haves. It is a great leveler.
> Basically most existing wealth is destroyed and all that is left
> is peoples ability to generate income from their wits and their labor.
> It is devastating if you are retired on a fixed pension, but often
> much better if you have debts.
>
> Deflation favors the Haves against the HaveNots. It make the Rich
> richer (relatively) and the makes the Poor Poorer (absolutely). That
> is why the social repercussions are so much more severe. If you are
> going to have revolution, it is the disenfranchised youth rather
> than bitter octogenarians which pose the greatest threat.

Jun 23 01:18 PM

[iggyDalrymple:]

> Inflation favors the HaveNots against the Haves. It is a great leveler.

Explain that to the Zimbabweans.

Jun 23 07:26 PM

[Luis de Agu...:]

Falling prices aren't by themselves evidence of deflation anymore than rising prices necessarily signal inflation. Both are always monetary concepts that result from a rise or decline in the value of the unit of account.

Basic supply and demand when it comes to goods prices is not inflationary or deflationary. Change in the value of the currency is. Objectively against gold, the dollar is weak since 2001.

We’ve been inflating a long time. This correlates with economic weakness. When currency loses value, capital flows into hard, less productive assets, and away from creative and growth economy.

Luis de Agustin

Jun 24 06:05 PM

[the.bighouse:]

Mild inflation and even a bit of stagflation have worked for most of us us early baby boomers over-time. My dad never got over the depression and was always waiting for "the balloon to bust again"
Given my experience, I'll gladly take the inflation scenario.

Jun 26 08:04 AM

[Think-About-It:]

If you desire a rising standard of living for as many people as possible then deflation through the free market process (not money/credit manipulation/contraction) is what you want. If you desire a rising standard of living for a few select groups then inflation via money/credit expansion is what you should wish for.

Jul 02 03:33 PM