October 10th, 2006 Price: Subscribe »

ARCHIVED COMMENTARY

Recent give-and-take here on the subject of deflation, including a would-be debate with uber-inflationist Gary North, generated quite a bit of reader mail. To stimulate, provoke and enlighten you, I will be presenting some of the more interesting letters in the coming days and weeks. Readers who wish to add their thoughts should do so via e-mail, citing the author to whom they are responding by name. I will interject my own arguments only when addressing a point that I have not dealt with earlier, either explictly or implictly.

 

Phil Dorsey sees a Jack Benny choice:

 

You may recall that I favor the inflationary scenario but I do not scoff at deflationists.  The massive debt in my view leaves us headed ultimately for an "inflate or die" scenario or maybe an "inflate and then die" scenario.  Sort of like the old Jack Benny radio skit, "Your money or your life."  Responds Jack: "I'm thinking, I'm thinking."

 

I think it is the Fed’s call and it will choose inflation over total collapse into a deflationary depression but I think we do well to be prepared for either fire or ice.

Here's my critique though. I think [your co-deflationist] Jas Jain is confusing depression with deflation.  He cites examples of stagflation to refute the inflationary view, but we must remember that stagflation is inflation and precisely the kind we are most likely to see in the near future if it is fire and not ice that the future holds.

 

My biggest problem, however, is not the deflation argument, but the strong-dollar argument.  Your position has been that massive debt creates the equivalent of a huge short position on the dollar.  I would agree that if dollars were borrowed to buy foreign currencies that would be very much akin to a huge short position on the dollar, but I think what people are borrowing to do is to consume and whether or not they bought those purchased consumable items are from overseas, when people have to pay off the debts they won't liquidate yen or euros but cars and homes and boats, along with mostly American stocks and bonds.  When American stocks and bonds and real estate have fallen into bear markets and credit ratings drop, would you as a foreign investor want to continue holding American denominated investments?  I wouldn't.

 

Here’s Rene Schaub:

 

Thank you for including my email in one of your newsletters on the deflation/inflation topic, along with emails from more eloquent readers. May I make a point regarding the $250 Trillion derivatives figure which you mention frequently. You are the only writer I'm aware of who brings this up in context of inflation/deflation, and it seems to be a main pillar of your deflation argument.

 

As I had really no idea what all these 'derivatives' were about, I did some research, and my current understanding is that the “face value” of $250 Trillion cannot be taken as “credit” or be added to the money supply: derivatives are contracts, specifying certain transfers of assets in the case of an event. So somebody gets richer, somebody gets poorer (its a transfer), but there isn't any new money lost or created. Those derivatives (mostly interest derivatives) can be traded and constitute part of the money supply, but nowhere near the face value of the underlying assets (on average).

 

In a financial crisis, derivatives will be gigantic movers of wealth from one place to another, and since probably the party at the wrong end of the contract won't be able to pay, that means the derivatives/contracts can't be executed, plunging both parties into crisis. Worse, they will probably have to be bailed out to save the system, resulting in more inflation.  But nowhere has there been a 'collapse of $250 Trillion of debt money'.

At least that is my limited understanding.

 

China

 

China, and pretty much everybody else except the British and the Caribbean(…), have been pretty open lately about their intentions of getting rid of the dollar as their main reserve. I would not be surprised if they had a high level meeting with the U.S. a little before the Fed announced ceasing publication of M3. My theory is that China gave the Treasury/Fed a heads-up: "Hey, just to let you know, we will start to get out of the dollar in earnest, so that we can comply with your desire of letting the Renminbi appreciate :). Since we are nice world citizens, we are letting you know five months in advance so you can go figure out whatever you need to do to keep things happy on your side." China has been ramping up its consumer credit infrastructure in recent weeks, which goes hand in hand with their statement that they want to increase domestic spending, and separate statements that China (!) - not the U.S. - will take care of the trade imbalance. Really, if you're producing stuff , why not sell it to your own populace on credit instead of to Americans? I would think the Chinese are more credit-worthy.

 

At this point, unless I'm becoming paranoid, I believe recognizing rampant manipulation of all relevant markets by the government, thanks in part to your introduction to the plunge protection team. Accepting that, I do not believe it is a big stretch for the Fed to start monetizing assets other than government securities (i.e. mortgages, stocks) via the Treasury, and they probably will be doing it covertly, in the belief they are grim heroes acting in the best interest of the U.S. That's an easy way to keep inflating without having to look for borrowers. Of course it will be pretty perverse because at the same time, to keep the dollar from freefall, they will have to keep raising interest rates, which will be in parallel to all those unavoidable government bailouts of banks, agencies and home owners that will act very inflationary. Those two levers are pointing in opposite directions. Guess what might happen: high interest rates acting inflationary! With so many dollars coming in from all directions (don't forget China’s stated goal), interest rates will have to be enormous for the Fed to soak up all that money -- so enormous that they might be creating more money through interest payments, than absorption through reverse repos.

 

Here’s a question from Tony Rodrigues:

 

“With the whole world essentially SHORT dollars and LONG debt (bonds), as deflation unfolds, I am trying to figure out why you would be bullish on bonds?  I agree with you on the dollar.  It seems to me that the force that pushes the dollar up is interest rates as lending dries up to all except to the most creditworthy borrowers. The U.S. government might not in fact get this rating, given their propensity to print their way out. Any thoughts?

 

From Ian Rayner:

 

I spend a large amount of time wrestling with the inflation/deflation issue.  I see a lot of (gold bug) articles arguing that gold must soar because of the massive endless currency debasement.  Evidence of this is usually in the form of money-supply statistics.  Yet, these same authors simultaneously present debt growth stats that dwarf money-supply growth as further evidence of impending doom.

 

If one borrows $50k from a bank and sticks it in a money-market account, it increases M2 and M3 and it increases debt, but it is not inflationary - the loan will eventually be extinguished either through repayment or default. While commentators are justifiably concerned about the credit bubble, it's effect is to cause misallocation of capital (i.e. create asset bubbles) rather than general price inflation; moreover, its effect is reversed when the asset bubble bursts.

 

If inflation were the issue, why has gold performed no better, and in many cases worse than most industrial commodities over the last 10 or 15 years? Gold bugs also tend to predict the collapse of the stock market (phase II of the bear) and the housing market.  If these events occur, how is that going to cause gold to soar?  Most people will be barely making it, capital will be withdrawn from investment markets not put into them -- see how gold did in 2000.

 

The two theses that do make sense for soaring gold prices would be (1) gold becomes the next asset bubble, or (2) there will be a banking system collapse and gold will be the only money remaining.  I suspect water, tinned food, guns and ammo would make a much more cost-effective investment in those circumstances!

 

As far as I can tell, the only thing that matters is the degree to which the Fed permanently monetizes government debt.  Where would one find the evidence of this?  Permanent Open Market Operations?  While the Fed makes things worse (eventually) by putting off the inevitable credit bubble collapse, I just don't see them pulling a Weimar Republic on us - they have too much to lose.  The credit bubble collapse can only be prevented up to the point where interest rates approach zero, beyond that the Fed has no power (currently - see Bank of Japan!).

 

So, my thought is that this is an issue of timing - is there time for one last bubble in commodities, including gold, before deflationary forces overwhelm the world economy or not?  I suspect the collapse of US and European housing will have such a profound effect that gold will be cheaper in a couple of years than today.  I wish I had the answer!!

 

Please keep you thought provoking commentary coming.

 

J. Bentley is as clueless as he is surly:

 

I am not a subscriber, but I have read your commentary periodically for some time. I don't catch every update, so it is entirely possible that I have missed some of the finer points and nuances of your stance on inflation/deflation. However, when reading today's criticisms of North's failure to engage in debate, it occurs to me that he is most likely a busy guy and assumes there's not much point. He'd prefer to channel his efforts towards attempting to influence those who haven't yet shaped an opinion, as opposed to someone like you who is clearly locked on the issue.

 

Personally, I have no idea which way we're headed, and neither your nor his arguments have convinced me that one or the other outcome is a sure thing. It does, however, occur to me that timing must be part of a prediction. Eventually being "right" doesn't validate all the interim time that you (or he) has been wrong. Whether inflation has been "well contained" or not, for a good while now, I know that I am paying more for just about everything-- health insurance, gas, heating, food, you name it-- and the real-life consumer inflation arrived after you began predicting deflation.

 

If, a year from now, deflation begins to take hold, you will no doubt claim that you were right all along. The problem is, that's akin to a manic CNBC stock picker calling to the masses to load up the truck on a hot stock right before it drops 50%, but two years later when it's at new highs patting himself on the back for the call. If you debate the issues long enough, eventually you'll most likely be both right and wrong, so that you can spin the cycle to fit your agenda. Whatever.

 

What About China? asks Peter Rhalter:

 

I haven't made up my mind about whether the world will end in fire or ice, but I do have a simple question about what may happen to the dollar. The Chinese, for example, hold 800 billion bucks (or, at least, credits for them) in their reserves. Just for arguments sake, what happens if they decide to send those dollars/credits back home to America? Wouldn't that bulge in the domestic money supply devalue the dollar and create inflation? Thanks for your consideration.

 

John Buttery sees a stronger dollar:

 

It is clear to be that the dollar will be worth more. It is likely that the popping of the housing bubble will result in massive wealth destruction that the fed will be unable to refloat ( as they can with the stock and bond market) At the same time that the dollar grows stronger (which will be worth more than any other currency) the cost of energy will go through the roof ( yes in deflationary times) Anything manufactured will be in a depressed stated due to over built production facilities. Commodities won't soar because a whole lot of American consumers won't be buying due to the costs of transporting goods. China , FedEx , UPS and Wal-Mart will not be  selling much because of the cost of transportation.  The important question isn't deflation or inflation: It is will we have slow leak or a burst bubble

 

Gary North’s Heart in Right Place, says Allen Thompson:

 

Have read you for a few months now and really appreciate your thoughts on deflation. I agree with you but I think there will be inflation between 10-15% on an annual basics before deflation sets in. Please don't reach the point of disliking Gary North, he has had some great and some not so good calls over the last thirty years but he is a great American and you can tell he loves Christ with all his heart. As you know all of you speakers of economics are wrong at times.

 

I probable missed one of your articles on what core deflation hedges to hold. I'm not asking for your picks, just in general, as in cash, bonds etc. I know in the 1929 depression, gold stocks did very well until the President mandated the exchange of gold coins for paper. Silver, I think would follow gold to a point because when gold moves too high in price, the average person will want gold but can't afford gold and therefore purchase silver. This is what happened as you well know in 79-80 along with the Hunts part in trying to corner the market.

 

Or am I completely wrong and when deflation sets in, I should sell gold and silver and turn to just cash and bonds? Its so confusing, I know how busy you are but hope to hear from you with in a couple weeks or so.

 

Two question from Nathan Irhcke:

 

1.  What if the Amazons, EBay’s, Toyotas etc start accepting E-gold for payment along with paper currencies... and what if something similar begins happening in the commodity markets?  The Masses Vote for their currency ...

 

2.  What if this Pivot Point in Monetary history is unique... "different" this time, insofar as we are facing a Major Structural change in civilization itself?

 

We are very early in the transition from Fossil Fuel based industrial age into what will probably become - by default - the Electronic Age (or, perhaps a short period of Dark Ages)? Peak Energy (Fossil Fuels) might make this Episode in Monetary Madness end a little differently than past episodes.  Attached is the syllabus for a class I teach on the End of the Fossil Fuel Age.