It's Either Inflation or Deflation - Not Much in Between

For the Fed to play this balancing act, some entities have to fail (and be bought up cheap) so that the capital they hold is transferred to the remaining economic entities. The buyer is bailed out of losses by early failures of the sellers. The game is "last man standing".

Here's why:

If X lends to Y and Y doesn't pay, then if the Fed bails out X, puchasing power is X plus Y. That's inflationary if the credit expansion is big enough (and real estate is a big market). Since a large percentage of the financial entities are likely insolvent, if the Fed doesn't bail some of them out, we could have a deflationary collapse.

But the Fed cannot afford to bail out very many financial entities because that would causes the "X plus Y" purchasing power problem noted above.

The practical effect is the necessity of having a number of failures with a "guarantee" (however accomplished) of the remaining institutions. It is happenening now and likely will continue. The so-called orderly liquidation.

As a result, an investor needs to store savings where it will not lose from these inflation or deflation effects and where the investment provides a hedge against systemic risk (a huge inflationary or deflationary event). In addition, if the Fed is successful, the economy will continue to oscillate between inflation and deflation. Investment policy should take that into account as well.

Why will policy oscillate? Because the Fed cannot afford to have inflation or deflation for too long as it would ruin their power over the currency. However, the Fed cannot (or does not) keep policy level either. When gold was removed as the ultimate form of payment, insiders became able to game the political system or buy it off. That means crises and bailouts.

It also means an investor needs to be prepared to inflation during deflation and vice versa.

If things get out of hand, the system ultimately relies on the solvency of the Federal Government (as opposed to liquidity management by the Federal Reserve) to achieve a sustainable bailout. If a Federal Government bailout isn't successful because the finances of the Federal Government are in question, the choice becomes binary: bite the bullet and go into mega-deflation ... or monetize and suffer unbelievable hyperinflation.

If the market senses inflation, it will begin to shed the currency which brings inflation to the present. That is why the Fed will frequently tighten hard to front-run inflationary expectations when the Federal Government is vulnerable - that is what the Fed is doing now.

However, with 516 trillion in notional value of derivatives, a mere 1% "shock" might be too much, so the Fed is careful to prop up the settlement system. Even so, the correction is probably not over: The magnitude of the losses disclosed so far are too little in comparison to the boom.

I suggest regularly storing a percentage of savings in physical cash (safe deposit box, or other safe storage), gold (include small denomination coins because one ounce is expensive and less liquid), and other storeable assets (in case gold is again outlawed), in conjunction with regular investment goals of buying stocks and bonds in the U.S. and worldwide. The recent (and, in my view, not over) correction in commodities should provide opportunity.

There is an interesting offshoot of the anticipated economic situation. I imagine it could or likely will occur in the next twenty years, perhaps sooner: a world currency with a world bank, a "necessary" result of profligacy of government(s) with the unwillingness of the authorities (or the populations) to answer the binary choice of hyperinflation or deflation. No question the "global bank" solution is even worse, but it likely will be attempted. Preparation for that event might be an interesting speculative play.

The recommendations here are not "prepare for the unlikely worst". In my view, what is happening now is a significant shift in global finance which will continue indefinitely even if it settles down. The U.S. Government may be close enough to a funding crisis that investors should consider the future tipping point, as no one knows how much forewarning will occur.

Raising taxes won't necessarily solve the Federal Government problems as revenues could still shrink. Deficit spending is going to be less possible if financing becomes more difficult. At the same time, expenditures are due to increase dramatically (and there's no stronger, more politically motivated voter than a voter who is retired and living on government payouts).

The genuine solution is to downsize the U.S. government which ensures national solvency. But that is very unlikely to happen with the current presidential candidates and congress in place.

And for those concerned about foreign threats: The only sustainable plan to overcome foreign threats is to stand back and let economic and technological growth keep us strong. No other system can come close to freedom whose practical implementation is private property and private money ....

Right back where we started.

Comments

[flow5]

Assets don't have a "monetary store of purchasing power" quality unless there can be a net conversion of that asset into money, eteris peribus. In other words, it must be possible to effect this conversion without necessitating that any persent money holder reduce his holdings. Any other interpretation becomes mired in a futile discussion of relative degrees of confidence and liquidity. Much more than monetary liquidity for the individual holder is necessary if an asset can be said to have the "store of purchasing power" quality; it must be simultaneously monetarily liquid for society as a whole.

Definitions of the money supply are not timeless. The extension of the scope and practices of the Federal Housing's Administration's Authority accompanied by Federal Government guarantees - assures a secondary market for housing - the "store of purchasing power" attribute of money. I.e, there are various types of "tertiary money". These assets possess general liquidity. They do not, (like money creating depository institutions), bear a direct, unit for unit, unvarying relationship, to the primary, means-of-payment, money supply. Any legislation which is passed to support the mortgage market, as a result of the housing crisis, would have inflationary ramifications because of the Government's guarantees.

[BlueSky&Sunshine]

Mr. Bradley: Very well written and illuminating article. In particular: "The U.S. Government may be close enough to a funding crisis that investors should consider the future tipping point" is not exactly new information, but explained in a way that brings the issue much closer to the top of the list of concerns. Is it safe to say that the effect on the economy of a US Gov't funding crisis would be equivalent to extreme high interest rates? Would this be severely deflationary, both in the US and worldwide? If 'yes' then how can investors protect themselves (stashing cash in a safe box has its limits)? This sounds like a prescription for capital flight out of the US - well BEFORE trouble strikes!

[User 167683]

"safe deposit box, or other safe storage"

Having done some judicious asking around among acquaintances engaged in the banking industry after reading (briefly) published news stories which made the rounds many months ago, the term "safe deposit box" -- in a time of extreme financial stress -- seems likely to prove an extreme oxymoron.

Owning your own physically-controlled commercial safe may be less vulnerable to confiscation by loyal agents of the US Treasury acting under secret bank regulations and "emergency executive orders" previously made popular by our previous Beloved Leader, FDR. US banks are no more than agents of the government, standing only a heartbeat away from being formally nationalized, thus tearing away the thin. fascist veil of pretense that they operate as "private" institutions of any kind recognizable in a free country.

[Lucia]

Again this one is great! It is the best "guess" one can have on this confused ecnomical mass. I just wondering what you think about bank JPM.

Thanks

[JIMB]

BlueSky&Sunshine - In my view the inflation / deflation debate is too aggregative, but it does help to present the basic issues.

If you work in a "long maturity" industry (takes a long time to come to market with a viable product, especially one which is financed on credit) you will likely be hit hard, while consumption goods will zoom upward. Even if there's no net inflation, imagine losing everything being in the wrong industry, while your expenses still rise!

What matters is which prices do what.

User 167683 - You're right. It sure makes sense, if possible, to have assets in a variety of places, even out of the country (like quite a few congresspeople do).

[JIMB]

Lucia - For most financial institutions, it would not take much (as a percentage of assets) to wipe out the equity. Unfortunately, for a number of financial firms, the quality of the assets is not transparent, meaning there is unknown, but potentially fatal, risk.

[User 167683]

"User 167683 - You're right. It sure makes sense, if possible, to have assets in a variety of places, even out of the country (like quite a few congresspeople do)."

Regrettably (though entirely predictably) the feds have been racing to "tighten up" regulatory fences to discourage sheep from thus bolting from the herd.

It is fair to assume, of course, that honorable congresscritters will continue to award themselves uniquely generous benefits in exchange for their exemplary service to the nation -- and since the majority are lawyers, you are probably correct in assuming the most cunning among this crew of heroes have already made a dash for the lifeboats in anticipation the ship may spring a fatal leak.

No doubt we should be grateful to these careerists for their enduring, selfless courage in the face of clear and present danger. Never mind they are mainly responsible for having allowed generations of chief executives to dare the gods by repeatedly aiming our "unsinkable" ship of state toward financial icebergs.