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The inflation/deflation debate explores arguments promoting both U.S. deflation and U.S. inflation. It concludes with the resolution that rates may fall in the near term, to the benefit of U.S. Treasuries, and rise in the long term, to the benefit of gold.

The Deflation Argument: The deflation argument originates with the idea that the U.S. experienced an abnormal credit boom from 1980-2008. This was an abnormal event in the course of U.S. history whereby U.S. consumers were able to lever their personal balance sheets, primarily though popularization of home equity loans.

Furthermore, this boom took place within a fractional reserve system and fiat currency that originated in 1971. Within the fractional reserve system, the Federal Reserve prints money and pushes it to the banks, who in turn lend it to consumers. Yet, with consumers having loaded and overloaded on debt, present creditworthiness is dismal. Hence, banks are unwilling to lend to consumers. Moreover, consumers are unwilling to accept additional debt, at market rates and terms, and are repaying previous loans.

Here, assumptions include that an economy with high interest rates encourages savings. The higher the interest rate, the more incentivized participants are to save rather than spend their money. Savings, in turn, is redeployed as investment. Higher interest rates, however, would decimate short-term consumption, and possibly send an economy into a recession of unknown duration. Meanwhile, banks still carry a sizeable amount of bad assets, and a rate increase would further reveal their insolvency. This could necessitate another round of bailouts. This seems unlikely because bailouts, in the U.S., force taxpayers to support bondholders, who continually seem to be a protected class (note that all 24 Bear Stearns bonds still trade above par). Clearly, the Fed’s actions are directly tied to politics.

The result from this situation is a multiyear malaise consisting of widespread pessimism and deflation that resemblances Japan’s economy of the past twenty years. This situation will persist as long as the bad debts persist. Investment action is to sell stocks and buy the U.S. 30 yr Treasury. Rates can go lower; therefore the investor wants to be in Treasuries.

The Inflation Argument: The inflation argument originates from the simple fact that the U.S. is over-indebted, and no one should lend to it. Funding to the U.S. persists because China is buying U.S. Treasuries for political reasons. China may wish to avoid selling at a loss, or it is using its U.S. Treasury holdings to manage its own currency. Meanwhile, as the Fed becomes the dominant and only buyer, the U.S. dollar loses value as fewer countries demand it. As these dollars become less valued, the marketplace perceives inflation, and the Fed, to salvage any remaining credibility, would have to raise interest rates. From a political perspective, inflating out of a problem (which is a stealth tax to all and further impoverishes the poor) is the best alternative to unpopular austerity measures.

The main domino in this argument is the perception of the U.S. dollar. To many, it is a risk-free asset and a safe haven during tumultuous times. However, in 2011, Treasury Secretary Geithner proclaimed that if the U.S. did not raise the debt ceiling, the country would have defaulted. His argument implies that the U.S. would only repay interest and principal if other countries continued to lend it funds; this is a Ponzi scheme.

The result from this situation is that interest rates will be forced to rise, and consequently, the U.S. dollar loses its status as the world’s reserve currency. Investment action would be to short treasuries, long real assets such as commodities, and long foreign stocks on foreign exchanges (see Real Returns).

Possible actions: If deflation of economic stagnation plays out, then owning U.S. Treasuries will be profitable. Likewise if a chaotic default in Europe occurs, U.S. Treasuries will do; gold could also be okay here. Finally, if U.S. inflates away its debt, real assets (gold, timber, and other commodities) will be a good investment; cash could also be okay here as it would reinvest at a higher rate every 30 days.

Conclusion: Both the deflation and inflation arguments have elements of credence to them. The inflation argument seems to lack a catalyst. The Fed has boldly proclaimed low rates through mid 2013, and this assertion seems credible. Meanwhile, China seems content to sit on its U.S. Treasury holdings. Thus, the deflation argument will likely be correct until the foreign exchange markets drive down the value of the U.S. dollar.

We must also consider the effects of real interest rates movements. If rates go lower, then U.S. Treasuries are clearly the way to go. If real interest rates are negative, as they were in the mid 1970s, then gold wins. Additionally, both U.S. Treasuries and gold can perform simultaneously. For rates to rise, the U.S. dollar would likely need to lose a significant value relative to other currencies. At the very least, shorting Treasuries seems imprudent in the short run.

I believe that the only way that gold loses in the long run is a substantial change in U.S. fiscal policy OR investors find an alternate safe haven, both of which seem unlikely. Some wildcards, such as a crack in China or a shatter in Europe, could still alter the structural landscape of both of these arguments. Overall, the best outlook seems to be long U.S. Treasuries for short term deflation and long gold for long inflation.

Source: The Inflation/Deflation Debate