The Great Debate: Inflation vs. Deflation
There is no shortage of debate these days regarding the future purchasing power of the dollar—and understandably so. Not since the early 1980s have we had such strong arguments for either outcome at the same time. A number of powerful forces will play out in the years to come. I will discuss some of the main arguments for each, my own conclusion, and what investors (and savers) can do to protect themselves.
With the recent explosion of the Federal Reserve’s balance sheet, it is easy to understand why many are terrified of the possibility of the kind of rampant inflation often found in banana republics. After all, prices are more or less a product of the money supply and its velocity. While the Fed has more than doubled the monetary base since September 2008, we have not yet seen high inflation because the velocity, or multiplier, of money has gone down by roughly half over the same period. However, the potential for high inflation is there. And this is what folks are rightfully worried about.
To make matters worse, the U.S. was already heading down a dangerous path in regards to budget deficits and an unmanageable mountain of unfunded Social Security, Medicare, and Medicaid liabilities. The stimulus response to the financial crisis only added fuel to an already blazing fiscal fire.
The strongest risk of inflation comes from rapidly increasing government debt that currently carries a low average interest rate and low average maturity. This is the economic equivalent of an adjustable rate loan because we don’t have the resources to repay principal. Recent data from the U.S. Treasury show an average maturity of about 4.5 years at an average interest rate of 2.5%. This equates to about $165 billion in annual debt service (interest only), which is about 7% of total estimated 2010 receipts of $2.381 trillion. There are three specific factors that could exacerbate this problem and push interest rates higher: 1) Investor fear of dollar devaluation; 2) Rising fear of technical default; and 3) Simple supply and demand forces from ever-increasing debt issuance due to the $1 trillion annual budget deficit that is estimated to persist for at least the next decade. And the government is notorious for making overly optimistic budget predictions.
The Great Depression Part Deux
On the other end of the spectrum, we find another large camp of people who believe that massive deleveraging will lead to a second Great Depression. This makes sense because we have a debt-based monetary system in which money is born into existence from debt. And, of course, all debt needs not only to be repaid, but repaid with interest. As debt is destroyed through repayments and defaults, the money supply is also destroyed. Lower money supply leads to more defaults and more debt destruction, and the vicious cycle continues. This was at the heart of the Great Depression. It is easy to understand why Ben Bernanke, a student of the Great Depression, made the decision to flood the market with liquidity in response to the financial crisis.
Other strong arguments for deflation are the rising unemployment rate and potentially higher tax rates to pay down ballooning debts at federal, state and local levels. Both of these would have the effect of lower total discretionary income, which would decrease demand for goods and services.
So Which Will It Be?
In a world of self-proclaimed experts, almost everyone with an opinion is firmly in one camp or the other. In fear of appearing indecisive or incompetent, many overlook the most rational answer: I don’t know. Since when did it become so shameful to admit that we don’t know what the future holds? There are very compelling arguments for both inflation and deflation. The answer will eventually depend on decisions made in Washington and how people react to those decisions. For now, let’s stop fooling ourselves and admit that we don’t know. It is a problem that has to be dealt with and there is no easy medicine. Either path will be painful, but that’s what we get for our two and a half decade debt binge.
How Can We Protect Ourselves?
Once we admit that we don’t know what the end result will be, we can focus on how to protect ourselves based on a range of different outcomes. Investors and savers should focus on the likelihood that different outcomes will materialize and also look at the resulting consequences if they don’t. And the more uncertainty there is, the more they should diversify.
Because there are such strong arguments on both sides, it may be wise to diversify your risks and build a portfolio with exposure to both outcomes. One word of caution here: Even if we did know the end result, the ability to profit from it is diminished because we don’t know the timing of the end result. If we are, indeed, heading down the path of a banana republic, it may not come to fruition for another decade or longer. Conversely, the deflation scenario may be long and drawn out, much like in Japan.
If you are concerned more about inflation, you may want to favor things such as commodities and other hard assets, real estate, foreign denominated assets, businesses that are paid in foreign currencies, and floating rate debt. If you are concerned about hyperinflation, you may even consider gold and silver coins. The problem with these and other commodities is that they produce no cash flows and so value investors cannot estimate their intrinsic value. The return is completely dependent upon the resale price. In other words, this would be a form of speculation. It is a speculation on a bad outcome and a further speculation that these assets will protect you from the bad outcome.
If, however, you find yourself more concerned about deflation, then the choice is easy. You will want to hold a lot of cash and invest in U.S. denominated assets.
Although there is such a high probability of extreme outcomes, I will continue to do what I have always done. There is no better way to protect against both inflation and deflation than to be a value investor. Buying cheap assets and cheap cash flows can build and protect wealth in any environment. A large margin of safety protects on the downside and amplifies the upside. And when no opportunities exist with a sufficient margin of safety, value investors are content to hold cash—and perhaps a little hard cash (gold and silver) as speculative insurance against the unknown.For additional insight, visit IgnoreTheMarket.com.
Disclosure: No Positions