U.S. Economy Will Suffer Simultaneous Inflation and Deflation 17 comments
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For the next several years, Americans' net worth will decrease and their food and energy costs will increase as the economy suffers the effects of both inflation and deflation. Keynesianism and Monetarism can not explain this paradox because the money supply can’t simultaneously increase and decrease. However, John Exter’s Inverted Pyramid resolves this economic contradiction.
In 1960, John Exter, then Citibank Vice President, developed what is known as the Inverted Pyramid. The Inverted Pyramid is an upside down pyramid made up of assets backed by debt. The foundation of the Inverted Pyramid is the ultimate form of money, gold, because it is an asset with no liability attached to it. The US Dollar or Federal Reserve Note, which is a debt-backed currency because it is a liability, sits above gold. Higher still is more debt, US Treasury bills, which back the US dollar. As you move up the pyramid, the debt-backed assets get more and more illiquid such as corporate bonds, stocks, real estate etc.
Since the US dollar is a debt-backed currency, increasing debt increases the money supply. Exter argues that as debt and leverage increase in an economy, the money supply inflates and creditors move up the pyramid into increasingly illiquid assets, which cause price increases in those debt-backed assets. The problem, he argues, is that when the economy is saturated with debt, the money supply can no longer be inflated. As the debt becomes difficult to service, bankruptcies and defaults increase, the money supply deflates, and creditors to move down the pyramid into more and more liquid assets; out of real estate and stocks and into US Treasuries, US dollars and ultimately into gold. This flight to quality is deflationary, which results in price decreases in the debt-backed assets. Thus Exter, like many today, predicts the inflationary policies of the past would result in a debt-deflation collapse. However, as Richard Cantillon, a 17th century French economist, showed, inflation does not affect all prices equally or simultaneously; the same holds true for deflation.
The case can be made that the debt-deflation will result in a hyper-inflationary collapse. Since there are two kinds of currency, the US dollar and gold, there are two different pricing systems; one in US dollars and another as a ratio of an ounce of gold. For example, a barrel of oil can be priced in US dollars or as a ratio of an ounce of gold. To calculate the gold/oil ratio, divide the gold price ($1050) by the oil price ($77) to get a gold/oil ratio of 1/14 an ounce. Another way to say the same thing would be to say that 1 ounce of gold will buy 14 barrels of oil. Throughout history US dollar prices always increase but historically gold ratios have remained constant in the long run. For example, the historic gold/oil ratio is 1/15 and the current ratio is 1/14, prices will adjust; the oil price will decrease to $70, the gold price will increase to $1155, or some combination of the two.
Applying Exter’s Inverted Pyramid to the current debt-deflation problem, as the debt-deflation occurs, creditors move down the pyramid into more and more liquid assets; out of real estate, and stocks and into US Treasuries, and US dollars and ultimately into gold. The flight out of illiquid assets decreases their prices and increases the price of gold. When the gold price increases, and the gold ratio to other assets remain constant, the US dollar price of those assets also increases. As more money flows into gold raising the gold price to $2000, the oil price will increase to $133 based on the gold/oil ratio of 1/15. A gold price of $3000 raises oil to $200. A gold price of $6000 raises oil to $400. As the gold price increases all other commodities priced in US dollars also increase because their historic gold ratios remain constant. This flight to quality is inflationary, which results in price increases in gold and assets that haven’t adjusted for past inflation.
The increase in the money supply that hasn’t affected gold and commodity prices is the inflationary policies of the past 30 years. The gold price in 1980 was $850; the price in 2009 is $1050. Gold hasn’t adjusted for 30 years of inflationary policies, which means that commodity prices haven’t adjusted either. When the gold price adjusts for the 328% increase in the M1 money supply since 1980, the gold price will be $2800. On a strict gold standard consistent with the M1 money supply, the gold price will increase to $6300. Therefore, when gold prices adjust for past inflation, commodity prices will increase roughly between 180% and 530%. When this occurs, our commodity-based consumer goods will increase between 180% and 530%. This alarming price increase is for 30 years of past inflation. What is shocking is that these price increases don’t include the current and future increases in the money supply, which are exponentially larger than the past 30 years.
Therefore, the US economy is suffering an economy-wide price adjustment caused by inflation and deflation. The deleveraging and decrease in credit is deflating the present money supply, which will cause the prices of stocks and real estate to decrease. The past inflation in the money supply will cause the prices of gold and commodities to increase as they adjust for the past 30 years of inflationary policies. So, for the next several years, Americans will watch their net worth decrease and their food and energy costs increase.
Disclosure: Long Commodities and Precious Metals. No Stock Positions.
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This article has 17 comments:
Right. So you just picked 1980 by chance did you? Here are some facts to help you on your way:
1. Gold was in a bubble in 1980. The size of this bubble can be judged by the fact that after this price spike, it fell by 47% in 3 months and 65% in 2 years.
2. Gold, on average, maintains its purchasing power over time. In your words "historically gold ratios have remained constant in the long run". That means that multiplying by M1 does not give you any meaningful prediction. So don't do it. Try building the growth of goods and services in the economy, and the increase in gold supply, in to your next prediction.
3. The evidence shows that Exter's pyramid is false. The deflation "scare" of last year did not cause a flight to gold. In fact the reverse occurred. It caused a flight to the dollar and away from gold, which fell by 30%.
1. 1980 was chosen because in 1980 the M1 money supply divided by the 262.5 million ounces of gold the US claims to have equaled $850, so the market put the dollar on a gold standard. The subsequent fall in the gold price is explained by the fact that the Gold/Dow ratio was 1, which means gold was overvalued compared to the Dow so money moved out of gold and up into stocks according to Exter’s pyramid.
2. I’m not sure what you mean by multiplying M1 with the Gold/Oil ratio. If we divide the current M1 money supply by 262.5 million ounces, the US claims to have then we arrive at the gold price under a gold standard. The Gold/Oil ratio fluctuates, historically between 1/5 and 1/40 but always seems to revert back to its long run average which is 1/15.
3. Correct, money did go into the dollar and also Treasuries, but gold only fell 30% and is breaking new highs today, rather than the Dow or the S&P, which are still well below their highs. This suggests that money is in fact flowing out of the dollar and into gold as predicted by Exter's pyramid.
On Oct 16 10:34 AM chap08 wrote:
> " When the gold price adjusts for the 328% increase in the M1 money
> supply since 1980, the gold price will be $2800. "
>
> Right. So you just picked 1980 by chance did you? Here are some facts
> to help you on your way:
>
> 1. Gold was in a bubble in 1980. The size of this bubble can be judged
> by the fact that after this price spike, it fell by 47% in 3 months
> and 65% in 2 years.
> 2. Gold, on average, maintains its purchasing power over time. In
> your words "historically gold ratios have remained constant in the
> long run". That means that multiplying by M1 does not give you any
> meaningful prediction. So don't do it. Try building the growth of
> goods and services in the economy, and the increase in gold supply,
> in to your next prediction.
> 3. The evidence shows that Exter's pyramid is false. The deflation
> "scare" of last year did not cause a flight to gold. In fact the
> reverse occurred. It caused a flight to the dollar and away from
> gold, which fell by 30%.
Another factor predicting decline in US living standards is democrat plans to enact a VAT (valud-added-tax) to pay for the deficit. Pelosi publicly stated we need VAT to level playing field with Europe, as in reduce American standard of living and increase taxes to equate with Europe.
We will be living with permanently higher unemployment and slower growth combined with increased taxes and reduced living standards.
I'm not sure what "rigid formulas" you are referring to. The Gold/Oil ratio is simply a way of pricing oil in terms of ounces of gold. If you examine the Gold/Oil ratio since the mid 1960s, prior to 1971, the ratio was a very steady 1/12-1/13. After 1971, the ratio fluctuates between 1/5 and 1/40, but always reverts back to the long run average of 1/15. This isn't a "rigid formula," it is just what the historical data tells us. Actually based on this information, someone may be able to make some money by buying oil when the ratio is closer to 1/40 and selling when the ratio is 1/5.
On Oct 17 12:12 PM IGDICK wrote:
> ALL ATTEMPTS AT RIGID FORMULAS ARE A CHIMERA. IF IT ALL COULD BE
> REDUCED TO FORMULA, WHO WOULD EVER LOSE MONEY IN THE MARKETS? OBVIOUSLY,
> THERE IS ALWAYS THE BLACK SWAN, AND NO ONE KNOWS WHERE, WHY, OR WHEN
> IT WILL REAR ITS UGLY HEAD!!!
The observation that food and energy prices are increasing while stocks and housing are decreasing is noted by most people but the inflationists or deflationists. The main problem with the inflationists and deflationists arguments is that they don't take this simple observed fact into consideration in their arguments. Part of the confusion is assuming that the money supply is one thing which either increases or decreases rather than examining it in parts such as M0, M1, M2 and M3. When the parts are examined and the Cantillon effects are considered, you can see that you can have inflation and deflation simultaneously.
On Oct 17 12:13 PM Jimbo wrote:
> I have been seeing stagflation, an ugly reminder of the 1970s, for
> some time. Things which people have to buy frequently, such as energy,food,
> and other consumables, are rising in price. States and municipalities
> are raising "fees" instead of taxes. But home prices, hard goods,
> and other things seldom purchased are declining. Meanwhile, the availability
> of jobs and salary increases decline dramatically. This is a formula
> for much pain and social unrest. By the way, ten quarts of powdered
> skim milk have gone from $5.99 to $7.99 in Florida, yet dairy farmers
> in the northeast are selling off their herds because they can't pay
> their overhead. Strange times.
We shall have both the inflation and deflation by whatever name one chooses or creates, but only the general trend points the way, but not with any specificity.
Our government has really done it this time, I think the 1970's will soon be upon us.
One tip: Stocks are NOT "illiquid" assets, you CLOWN.
Feel free to lash out at me in response. There is NO danger of my bothering to return here to rebut it.
Your ad hominem attack is testament to the strength of the argument.
On Oct 19 11:36 AM Fanatical Yankee wrote:
> Your horrific ignorance of the most FUNDAMENTAL aspects of Economics
> is matched only by the childishly presumptuous conclusions you draw.
>
>
> One tip: Stocks are NOT "illiquid" assets, you CLOWN.
>
> Feel free to lash out at me in response. There is NO danger of my
> bothering to return here to rebut it.
The author, Jospeh, and Exter classify something as liquid, does not simply based on the ability to sell it, but based on the ability to sell something fast and at a stable price.
Anything can be sold, but it is a matter of price. If the price is not relatively stable, it is not liquid. Gold has been relatively stable in price for a few thousand years, and it has only have a high fluctuation since the beginning of the US$ being a fiat currency.
Gold have always been able to purchase lets say silver or oil at a certain ratio, but shares of Goldman Sachs, or Yahoo or Lehman Brothers certainly do not have a stable conversion ratio.
Pls do not call someone a clown when the fundamental basis of your argument is flawed.
I run a hedge fund, and I can tell you that stocks under cetain sceanarios and market conditions are certainly not liquid.
Sure if you only sell US$10000 worth of Yahoo in the market it is relatively liquid at a fluctuating price. Try selling US$1bn worth of Yahoo or even US$300m and see how liquid it is and most important of all, at what price.
money supply without diluting the currency. The dollar is going to get a lot weaker before it recovers. And that translates to even higher gold prices.
Ben Bernanke is well aware of the monetary policy mistakes (credit tightening) which derailed recovery efforts during the Great Depression, so he is loath to commit the same error; Interests rates will remain at historic lows for the foreseeable future. Add to the equation persistently high unemployment, low consumer confidence, and a slew of new bank failures and you've got a perfect storm of factors elevating gold prices in the
months ahead.
Expect to see gold at $1350 - $1400 by the end of January. The catalyst for such a short-term upward price move: A lackluster retail holiday season in the U. S. which leaves businesses no choice but to layoff more workers.