U.S. Economy Will Suffer Simultaneous Inflation and Deflation

by: Joseph Brom

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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