Inflation or Deflation: Which Will Win?

The most important thing to remember about the inflation vs. deflation debate is that this financial crisis is about the expansion and contraction of credit.

As we all know, "we've a debt laden economy," and when people are on the verge of defaulting on their loans, they will sell everything to stay afloat and maintain their standard of living. If they don't, then their creditors will.

But during deflation practically no one buys so debtors remain on the margin of survival or default.

To add insult to injury, due to the contraction of credit, these debtors cannot get any more credit and the vicious cycle continues. So as of late, it is not just debtors that are on the edge. Creditors are on the edge because the debtors cannot pay their debts; corporations are on the edge because their sales have collapsed and they cannot pay their debts nor get lines of credit extended; and now governments are on the edge because this is a SYSTEM-WIDE collapse and there is nothing they can do about it.

So what we have had and are going through at the moment is a contraction of credit, which is an effect of deflation.

Headlines and economist are saying that we've hit bottom and the worst is over. Contrarians say 'don't believe it.'

Inflation or Deflation? Which will win?

From an Elliott Wave Principle perspective, deflation will win and the worst is not over yet. The U.S. economy is starting on its second dive into a deflationary spiral, towards what could be labeled as a new great (global) depression.

When we imagine the cycle of credit contraction just described continuing at an accelerated rate, on a wider scale, and penetrating deeper into our daily lives, at work and home, then it is easy to see Robert Prechter's forecasts, in his October 2003 Elliott Wave Theorist newsletter, coming true:

• The total amount of credit outstanding worldwide will decline substantially.
• Consumer confidence will fall to record low levels.
• The trend toward economic contraction that began in 2001 will continue to develop into a depression.
• Real estate values will fall more than they did in the 1930s and 1940s.
• More banks will fail than failed in the 1930s.
• The unemployment rate in the U.S. and in most countries around the world will rise and eventually exceed 25 percent.
• Affordable housing will become difficult to come by. Family members will move in with each other. Homelessness will increase.
• Stock markets around the world will continue to fall. Ultimately, the averages will drop more than 90 percent.
• Debt packages made of mortgage-backed bonds, auto loans and credit card debt will become viewed as unworthy investments.
• Many, if not most, pension plans will fall in value and be unable to provide the promised benefits. Anger over this development will result in demonstrations, violence and tardy and ineffective political reform.
• The Federal Reserve System will be discredited and then abolished.

Understanding is your first step. If you haven't yet given Prechter's deflation argument your full attention, you should know now that yesterday was the best time to do so. Steadfastly throughout the years, financial analyst Robert Prechter issued warning after warning about the coming deflation. The experts said he was wrong. The markets proved otherwise.

Comments

[Michael Clark:]

Deflation will win until about 2019. That's when the New Expansion will begin again.

History is a mysterious process. When the Spirit inflates, the Material World inflates, and reason dominates. When the Spirit deflates (becomes depressed), the material world deflates -- and there is no force on earth that can make it inflate again before it's appointed time. During the deflation, reason no longer dominates. The world becomes dreamlike, with nightmares being a part of this scenario: wars, depressions, tragedies on large scales. Last Night Cycles: 1929-1947; 1965-1983; 2001-2019. Everything is getting dark again.

Every religious system in the world talks about God breathing Life into man. When God breathes life into man, the Spirit expands through man, and the material world also expands (credit expands). When God withdraws life from man, from the world, the Spirit deflates, and the material world begins to collapse, contract back toward the origin, back toward the seed. Winter is at hand.

Oct 08 10:27 AM

[TxTim:]

Chap08 is spot on again. Re-flation will happen because it has to, it's the best way out now. The problem is that the gov't gets to spend the freshly printed money first. Hell, at this point we should monetize a Trillion dollar tax credit and make it very generous on the lower end of income earners and cut right to the chase. The money is ours (we the people) and it would be a bailout for the people/ consumer. Businesses and banks would benefit because people could repay debt and begin consuming again (hopefully at a rational level, but doubtful.)


On Oct 08 08:00 AM chap08 wrote:

> "now governments are on the edge because this is a SYSTEM-WIDE collapse
> and there is nothing they can do about it."
>
> I'm afraid this is completely wrong. If they want to, governments
> and central banks can monetize spending, tax reductions, unemployment
> benefits etc. This boosts spending and nominal GDP with no concomitant
> increase in credit. Deflation would be stopped in its tracks.

Oct 08 11:22 AM

[Craig Hemke:]

Hyperinflation is coming because it is a CURRENCY event not an economic event.

Oct 08 11:31 AM

[D. McHattie:]

Everyday money in the form of credit is destroyed as loans default or are paid off.

Everyday new money is created via Quantitative Easing and low interest rates, given to banks.

Some assets/goods/services will get deflation and some will get inflation, depending on what is purchased with the new money and what assets were purchased with the money from loans that are defaulting and being paid off.

Oct 08 11:33 AM

[mbkelly75:]

Robert Prector is always worth listening to - even if you do not agree with him. Options Trader A.J. Brown has another useful outlook here that applys equally well to the stock market:
www.tradingtrainerblog.../

Oct 08 12:45 PM

[bbro:]

You neglect that there is plenty of cash flow and demand still exists
(just at smaller nominal rate)

Oct 08 12:52 PM

[Kevin_T:]

I am certainly not an expert on this but it seems to me inflation is most likely to be the ultimate end game. The reasons as follows:

It is very politically popular to "fight" deflation. It involves running large deficits, borrowing and printing money and handing it out in large quantities. Everyone from individuals and corporations to government entities are in favor of receiving money. Politicians like handing out money because it helps them get re-elected. Big corporations like easy money to expand, buy back stock, buy their competitors,etc. Banks like cheap money because they make more loans and can get a higher spread. Politicians can hand out money in "stimulus" programs, this is popular with everyone that can tap into this money. The Treasury and Federal Reserve have the capacity to print and borrow as much money as needed to prevent deflation. And since it is popular there is no reason they will not be successful.

Fighting inflation, on the other hand, is very unpopular. It often means recession. It means making money hard to get. That means unemployment rises and people get upset. Mortgage and loan rates go up, it is difficult and expensive to get credit. State and local government tax receipts dry up at the same time funding their projects get more expensive. Politicians lose elections. The Fed comes under intense political and media pressure to keep money cheap even in the face of inflation. That is why the bubbles of the past decade were allowed to inflate to the bursting point.

Therefore inflation seems by far the most likely outcome. Unless some event occurs that limits the printing or borrowing of money.

Oct 08 01:03 PM

[Tack:]

The only way that enduring deflation can even be considered is if we have some massive, catastrophic collapse of the economy, and everybody decides not to work or spend any money for any reason. This is so highly unlikely as to make it barely reasonable to consider.

What is much more reasonable is that the normal laws of economics, i.e., supply and demand, get applied to currency, as they immutably must be. If world fiat currencies multiply at vastly faster rates than goods and services, as they have been doing in this recession, then, there is simply no alternative to inflation, as the relative value of currencies will fall versus the goods and services for which they are exchanged. There's nothing complicated or mystical about this; it's just simple, unavoidable economics.

The only way that such an outcome could be prevented would be if world governments, all acting with exquisite timing, withdrew excess capital from the system, precisely inversely to the increase in velocity of currency through the economy. The problem is that governments are run by politicians, who even in their best intentions, err to the side of "giving" rather than "taking," so they will be cautious and reluctant to administer tightening --both in money supply and in fiscal spending-- so inflationary effects are all but assured.

Oct 08 02:04 PM

[Tack:]

Kein T:

Brilliantly stated.


On Oct 08 01:03 PM Kevin_T wrote:

> I am certainly not an expert on this but it seems to me inflation
> is most likely to be the ultimate end game. The reasons as follows:
>
>
> It is very politically popular to "fight" deflation. It involves
> running large deficits, borrowing and printing money and handing
> it out in large quantities. Everyone from individuals and corporations
> to government entities are in favor of receiving money. Politicians
> like handing out money because it helps them get re-elected. Big
> corporations like easy money to expand, buy back stock, buy their
> competitors,etc. Banks like cheap money because they make more loans
> and can get a higher spread. Politicians can hand out money in "stimulus"
> programs, this is popular with everyone that can tap into this money.
> The Treasury and Federal Reserve have the capacity to print and borrow
> as much money as needed to prevent deflation. And since it is popular
> there is no reason they will not be successful.
>
> Fighting inflation, on the other hand, is very unpopular. It often
> means recession. It means making money hard to get. That means unemployment
> rises and people get upset. Mortgage and loan rates go up, it is
> difficult and expensive to get credit. State and local government
> tax receipts dry up at the same time funding their projects get more
> expensive. Politicians lose elections. The Fed comes under intense
> political and media pressure to keep money cheap even in the face
> of inflation. That is why the bubbles of the past decade were allowed
> to inflate to the bursting point.
>
> Therefore inflation seems by far the most likely outcome. Unless
> some event occurs that limits the printing or borrowing of money.

Oct 08 02:16 PM

[ETFdesk.com:]

Since June 10, the yield on the U.S. 10-year T-note has plunged 80 basis points and at the same time the S&P 500 has rallied 14%. The bond market is telling us that we still live in a deflationary world, yet the equity market, at this juncture, is pricing in over $80 of operating earnings, which would be a double from the current four-quarter pace.

Bond camp was right in the summer '07, I'd go with them again...

Oct 08 02:56 PM

[Carlos Lam:]

Price declines will occur in some areas, especially those asset classes that are traditionally tied to debt (i.e. real estate). Price increases will occur in other areas, particularly those items that must be paid for in a depreciating currency for which we compete with other nations' consumers (i.e. petroleum, gold, food). The big financial institutions are deathly afraid of the former because it means that the collateral securing the loans they have made has declined in value. The rest of us fear the latter because it affects our everyday lives.

Robert Prechter, Mike Shedlock, and others who take the deflationist side have some very good arguments. At the heart of their claims, though, is the contention that in our current system credit is just as much a part of the money supply as currency. They claim that the destruction in credit will overwhelm any attempts of the government and central bank to inflate.

Personally, I respectfully disagree with the deflationists. While it is true that credit is essential for debt-tied assets, such as real estate, this is not the case for all assets. One need not usually borrow to buy food or gasoline. Moreover, the central bank is not constrained in any way in providing liquidity. Finally--and Mish was unable to answer this question during his debate with an inflationist on Jim Puplava's podcast--there is no known example in history of when a fiat currency was inflated and yet overall prices declined.

Oct 08 03:04 PM

[Tack:]

And, what is gold telling us?


On Oct 08 02:56 PM ETFdesk.com wrote:

> Since June 10, the yield on the U.S. 10-year T-note has plunged 80
> basis points and at the same time the S&P 500 has rallied 14%.
> The bond market is telling us that we still live in a deflationary
> world, yet the equity market, at this juncture, is pricing in over
> $80 of operating earnings, which would be a double from the current
> four-quarter pace.
>
> Bond camp was right in the summer '07, I'd go with them again...

Oct 08 04:48 PM

[User 362998:]

Gold is, I believe, telling us a few things...that Iran is going to go Nuclear, and/or that the dollar's reserve currency status is being eaten away, and that, in the medium term, if equities dive, the dollar's weakness makes it unlikely that it will be seen as the no-risk trade.

Oct 08 05:08 PM

[MGA_1:]

Well first off, inflation is an expansion in money and credit. Deflation is a contraction in money and credit. During heavy inflationary times people can lose faith in the currency, raid their bank accounts and greatly increase the money in circulation thereby increasing consumer prices.

There are only two ways of clearing out excess debt/credit - deflation or inflation. We were on a deflationary path until the govt/fed stepped in. I pick significant inflation until the govt gives up and we have heavy deflation.

Oct 08 07:25 PM

[Poor Texan:]

On Oct 08 10:27 AM Michael Clark wrote:

"When the Spirit inflates, the Material World inflates, and reason dominates. When the Spirit deflates (becomes depressed), the material world deflates -- and there is no force on earth that can make it inflate again before it's appointed time."

Thanks for reminding us that humans are more than automatons and that their feelings will determine their actions.

Oct 08 09:20 PM

[Dan Perkins:]

My dog has fleas!

Oct 08 11:16 PM

[MarvinMBA:]

Basic economic sense tells you that % inflation equals excess % money created beyond the real GNP times the velocity and the velocity is practically zero....banks not lending...but when the velocity starts increasing watch out because were going into a super inflation cycle even with the high unemployment. This was a monetary problem and were solving it in a monetary way. Also with the buck down the tubes start looking for all the dollar holders around the world to come to the USA to buy everything...its going to happen...MarvinMBA PS I like the international corporations plus SLV as a portfolio..try to keep one years income in PM's...

Oct 09 12:11 AM

[Denis Gould:]

The inflation / deflation question is actually a false dichotomy.

It is quite easy to reject persistent deflation - as many commentators have eloquently done above . It is equally easy to reject hyper-inflation because it there are so many tightening avenues available to combat it. Isn't the most natural conclusion therefore that we will have some form of price stability / modest inflation?

Oct 09 04:24 AM

[Wizler:]

inflation/deflation is not an either or scenario. we are on the path to have both. longer term housing prices are attached to personal incomes.

right now the liquidity has stopped the hemorrhaging but not created sustainable incomes, in fact with the dropping dollar and a net import country there will be inflation on consumers goods, further reducing incomes.

if the gov put money into programs that created long term income streams, like R&D and health services, rather than pumping liquidity, housing would rebound sooner.

the growth in assets over the last ten years was pure financial engineering and needs to correct however painful if we want to get on a sustainable growth path (not to say the gov can not facilitate a softer landing)

shifting the debt burden from the people who over stretched their credit to all taxpayers is going to be an expensive way to deter the inevitableright now we are on a path to falling assets and inflation

Oct 09 08:35 AM

[Christopher B:]

For those of you wanting to find out more about the inflation/deflation debate, go to this URL www.financialsense.com...
for a series of recent interviews of Bob Prechter, Peter Schiff, Harry Dent, and Marc Faber. You decide who is right.

Oct 09 08:46 AM