Three Notes on the Inflation vs. Deflation Debate

There is an interesting ongoing debate on inflation versus deflation at financialsense.com. This week was a debate between Mish and Daniel Amerman. Mish has been one of the most vocal deflationist before the stock market collapse, and he has nailed it correctly. Getting the big picture correct on inflation/deflation is probably the single most important thing for your financial portfolio (and I just cannot emphasize that enough).

So do yourself a favor, and listen thru the 1+ hour of online radio. I was expecting simultaneous asset deflation and commodity deflation back in early 2008. That seems to be what Amerman is saying during his debate. However, with Mish, he is more of a total deflationist, although he also agrees with the fact that there is no way for the US to pay out all the entitlement/welfare programs at the current US dollar value. What Mish adds into the debate is the timing of the next inflation, and that he doesn’t believe in a general commodity inflation in a consumer retrenchment. I must say that I personally side with Mish more than Amerman. Here are a couple of noted points from the debate:

1. Amerman is taking a long term view that the US may follow in the footsteps of the Roman/Argentine style of hyper-inflation or high inflation. Even if inflation is not that serious, it’s very true that back in 1970, the US went through a period of high inflation, where real estate gained in nominal value, and many homeowners benefited from the reduction in the real inflation-adjusted value of mortgage debt. There is no doubt, in my opinion, that the Federal Reserve would like this ideal high-inflationary scenario to unfold, without getting into a hyper-inflationary scenario, where the economy and banking industry simply gets trashed. That was my primary reason for forecasting high inflation coming due to an impending collapse in the real estate market back in 2006. Under a well-controlled but high inflation scenario, the Fed can reflate the housing market, and therefore make the banking/mortgage industry be whole again. However ideal (for the Fed) this is, there is a very big problem. A reflation in the housing market can only happen along with a wage inflation. And that is just NOT happening, due to global wage arbitrage from globalization, and a high (and lasting) domestic unemployment rate. In fact, because of that, I think the likelihood for the US to follow Japanese-style deflation is probably higher than most people realize.

2. Amerman keeps saying that for the average Joe, monetary inflation/deflation is much more important than asset deflation. I definitely agree with that. Mish tries to argue that there is also a price deflation besides asset deflation, while Amerman doesn’t believe in that. With certainty, commodity prices have gone through some deflation. The notable example is crude oil prices falling from $150 down to $40, and now back at $70. That is a lot of deflation in a short time. From my own day-to-day observations, it appears that most companies are holding the price levels as much as possible. However, actual deflation creeps in through various means of promotions:

• In grocery, I’m seeing triple coupon values now. And there are constant ad wars going on for promotional items.
• In restaurants, I’m seeing more heavy distribution of coupons, and the serving size of dishes are really getting bigger (at a minority of restaurants). I have been surprised that ordering the same number of dishes now is leaving my family with more leftovers to take home.
• For “monopoly” businesses, such as Disneyland tickets or Lego, prices are not falling at all. They have been rising. But promotions do seem to go on slightly more frequently than before. However, without promotions, I’m definitely paying 3% to 15% more on every Lego box that I’m buying for my children.
• In government, taxes and fines are going up. And I don’t see any possibility that this trend will reverse itself.

From the above personal observations, I must conclude that most business are handling the deflationary pressure (due to less demand) via more promotions. They obviously wouldn’t back-roll the prices if they didn’t need to. I don’t know if we will actually see more pronounced deflated prices at the stores. But certainly, I think the majority of savings from commodity suppliers has not passed down to consumers yet. With this economic background, I think there will be some significant differences to your wallet whether you shop with coupons or not.
Furthermore, due to more business close-outs and bankruptcy and lack of credit for new business to come in, there is less competition for the existing survivors. Less competition will simply mean higher prices going forward. These are the economic cycles at work.

3. One of the most important things to recognize in this debate is Mish’s point in including credit for arguing a deflation. This is actually quite crucial. The destruction of credit has been much more relentless, relative to money printing at the Fed. The money printing for stuffing the banks with good tier-1 reserve money truly came after mortgage credit creation, not before. There is no way for banks to lend out this newly minted money, since they know very well that their mortgage assets are still deteriorating at an alarming pace. This is the point that I was missing when I forecast high inflation in 2006 (#1 above). Certainly, for the much longer term, it still doesn’t change the fact that either the US dollar or US liability needs to get trashed. But the timing of such an event is likely to get postponed due to the current unfolding of deflation.

Overall I tend to agree with Mish who is blasting every hyper-inflationist out there. I don’t know whether the debate really puts an end to hyper-inflation, but I do think that Japanese-style deflation may be with us for at least a couple of years. However, Mish's view obviously doesn’t jibe with the current optimism on Wall Street and global stock markets. Just be careful holding equities. When the game is up, no one is going to ring a bell to remind you that the top is behind you.

Comments

[LKofEnglish:]

oil, oil, oil, oil, oil.

Sep 22 08:43 AM

[chap08:]

It's a mistake to characterize this as deflation v. "high-inflation" or "hyper-inflation". What happened to plain old inflation? That's where the Fed want to get to, and that, to me, is the most likely destination (with a few swerves and a lot of instability along the way).

It's also a mistake to say that we can't have inflation without the banks going on another lending orgy. Firstly, you can import a lot of inflation through a devalued dollar (I think that's what the comment above about oil relates to). Secondly, if the mild deflation that we have experienced looks likely to deepen, then the Fed and government will take action. If need be, this action will include monetized spending. That way you can inject money directly in to the economy without the banks having to be involved.

Between the government and the Fed, they have the tools to stop any level of deflation. It's just a question of the whether they have the will to implement these tools - and the level and timing of how they do it. When I look at their words and actions to date, there is only one conclusion - inflation will return.

Sep 22 09:21 AM

[W.E. Heasley:]

Its very possible, in the short run, that certain sectors of the economy may experience inflation while other sectors experience flat pricing. The same may very well hold true for assets.

The high and persistent unemployment (a real rate north of 16%) is an unemployed group that will not be stoking the furnace of inflation. The remaining 84 +/- employed are to a large extent deleveraging. Hence this group is not causing inflationary pressure.

However, skip by the term "hyper inflation" and replace it with "hyper debt". Simultaneously deploying QE and Keynesian Government Deficit Spending in an environment of Government Hyper-Debt is clearly inflation oriented.

Devaluation of currency and Monetizing Debt are clearly inflationary as well.

Of course if you Socialize 16% of the economy (Health Care), add in Cap and Trade, then top it off with increasing Federal, State and Local tax increases, consumption get slashed and inflation gets no nudge forward.

Its more like Dr. Doolittle's Push-Me-Pull-You character.

In the end, cost push inflation will be short term and demand pull inflation with be the longer term theme.

Sep 22 10:58 AM

[Johnny Oxygen:]

What I can't see is the government playing both sides of the deflation/inflation game. It will come down to precious metals. When our fiat currency becomes worthless no one will want it and that includes the US government. I have believed for a long time that Executive Order 6102 (making it illegal to own gold in any reasonable quantity) will be reinstated in some form and that's what concerns me about owning gold (I think silver is the better bet). While you may still be able to stash is some place out of the governments reach you won't be able to trade with it easily if its made illegal. I emailed Egon von Greyerz at Matterhorn Asset Management AG about this very issue and his response in part was this:

"If gold becomes illegal in the US, this is why you should store it outside the country and with a company that has no activity or assets in the US. This is what we do."

The problem I see here is that you still don't have the gold in hand and trading across the ocean would certainly attract unwanted attention. Egon suggested moving over seas with your gold for a time being. For me that is simple not economically feasible.

Back on point. When the US government abandons the dollar and reaches for our gold that will cause hyperinflation prices. So I still see hyperinflation as being the most likely outcome.

Sep 22 11:16 AM

[Johnny Oxygen:]

This is a myth:
"Under a well-controlled but high inflation scenario, the Fed can reflate the housing market, and therefore make the banking/mortgage industry be whole again."
Policy cannot force people to buy. Its not just wages. The consumers are up to their eyeballs in debt.

"In restaurants, I’m seeing more heavy distribution of coupons, and the serving size of dishes are really getting bigger (at a minority of restaurants). I have been surprised that ordering the same number of dishes now is leaving my family with more leftovers to take home."
What you are seeing is a reduction in quality and an increase in the less expensive 'fillers'.

"In grocery, I’m seeing triple coupon values now. And there are constant ad wars going on for promotional items."
A year and a half ago a gallon of milk was $1.80 now its $4.00. The triple coupons are for products that are being phased out because they are not selling. If you look at the staples like bread, milk, cheese, eggs, etc. You will see the prices have skyrocketed.

"From the above personal observations, I must conclude that most business are handling the deflationary pressure (due to less demand) via more promotions. They obviously wouldn’t back-roll the prices if they didn’t need to. "
I see this a lot from people who argue the deflation scenario. To really see deflation or inflation you must look at the economy as a whole. Deflationist tend to focus on the lack of demand and say this will cause deflation, ignoring the fact that the government is printing 15 to 30 billion dollars every month. When people chose to not buy a specific item like a car or a house or gourmet chips it doesn't mean the entire economy is deflating. It just means people are being more cautious with their choices. This doesn't stop the government from destroying the dollar and that is what it is all really about the macro view not the micro view. In order for there to be true deflation we have to see much more than 15 to 30 billion leaving the economy each month and that isn't going to happen while the printing presses are running.

Sep 22 11:51 AM

[Carlos Lam:]

I listened to the debate. Here's the key: Mish was unable to give one example of a time and place where a fiat currency's purchasing power rose overall. Not even Japan (where, while real estate prices fell, prices for food, gasoline, and other day-to-day essentials either didn't fall much or actually went up).

As Ammerman said, if we had a commodity-backed currency, Mish would be exactly correct. Since we have a fiat currency, and no fiat currency has stood the test of time, Mish will be proven wrong.

Sep 23 07:25 AM

[Tony Daltorio:]

Mish is in a dream world concocted by Wall Street snake oil salesmen -- "We will have terrible deflation...Step right up and buy your Treasuries...buy them while they're hot at 0%..."

There has NEVER been a fiat currency whose purchasing power has increased. The US dollar will be no exception.

Sep 23 03:02 PM