The Great Inflation/Deflation Debate

Reinhard Seiser
October 14th, 2009

Recently, Jim Puplava (Financial Sense) hosted an excellent debate between proponents of inflation and those of deflation. With excitement I listened to the interviews hoping to learn of any arguments that I had not heard of and to find clues as to what is in store for the near future.

I was surprised to find that the advocates of both sides are actually quite in agreement on the general subject, and their opinions only vary on some of the details as to what time frame or what definitions/investing-aspects to look at. Let me summarize in the following paragraph.

Almost all interviewees agree that in the long-run the supply of money and credit will grow and this will lead to a lower value of the currency (the dollar), and hence higher aggregate prices. This has happened to all fiat currencies in history, has happened to the dollar since 1913, and the incentives exist for government to continue on this path. Major reasons are the debt to the foreigners and the entitlements promised to U.S. citizens. Most participants of the debate also agree that the current huge credit overhang has the potential to deflate and in the near term to act as a buffer to absorb any monetary inflation. So the main difference in opinion is how strongly this buffer can subdue inflation, or even push it into the deflation side, and how long this phase can last, e.g. a few months or a few years. It is generally difficult to answer this question, because it will depend on human actions: the actions of participants in the market and the actions of the government/Federal Reserve. It is not clear at what speed individuals will curb their borrowing and lending, the former due to fear of not investing the borrowed money wisely and the latter due to fear of not getting paid back. And it is also not clear if politicians and Federal Reserve officials will be hampered by public sentiment or their own long-term agenda to only expand the money supply when there is a crisis and when credit has substantially contracted, but not before.

The best "not-in-a-vacuum" argument was made by Robert Prechter (actually in his previous interview). He claims the market is so aware, that for every dollar that is created by government/Fed, the credit market will shrink by much more than a dollar and hence cause net deflation. This is hard to prove or disprove, but it is clearly in the realms of possibilities. Especially starting with high debt levels (Total-debt/GDP exceeding 3.0) it is possible that when government tries to push $5 trillion out the door, total credit contracts by more than $5 trillion, e.g. $10 trillion during a market crash. Once private-sector-debt/GDP is at a smaller, more manageable level, it is probably easier for the government/Fed at that point to win over deflation if it wants to. And according to Marc Faber and Peter Schiff, this is clearly how they would respond to such a deflationary wave. (And at that point the final verdict for run-away inflation can be cast if the debt buffer doesn't exist anymore.)

Now, the most important step is the one formulating an investment thesis what actually to do or what to buy in anticipation of a certain event. It does not do one good to claim that money and credit are pointing to inflation and then buy an asset class that falls in price. So we need to talk about prices, since that is what we ultimately want to predict. Theory or not, it is more or less accepted that an increase in the amount of money and credit (everything else being equal) leads soon or later to a rise in aggregate prices. "Everything-not-equal" would also consider a changing velocity of money and the quantity of products and services to arrive at prices. If people decide to get rid of their dollars since they don’t like pieces of paper, or if we destroy all goods and assets (such as in a war, or to some extent if we all sit idle due to unemployment), prices will go up despite no increase in the monetary aggregates.

A very simplistic model of forecasting aggregate prices would be to mathematically add up money and credit, and look at this total to see if it expands or shrinks. (For definition, "money" is something that ends up in a demand deposit, including bank loans that create simultaneous demand deposits using the fractional reserve banking. This could for example be measured by the True Money Supply. "Credit" is defined as when a creditor purchases a future good in exchange for a present good, and here money is just transferred from one person to another, and the creditor gets a piece of paper, but not a deposit in his checking account. This could for example include the whole bond market.) Since money in a checking account is not the same as a bond certificate in one’s brokerage account, it is not correct to lump money and credit together as if they were equal. But in a credit boom as the one we just had, one can argue that lenders have totally lost regard for risk and didn’t change their bidding behavior one bit in either case, while borrowers went out and spent the money on corporate purchases or houses as if the money was free, and thus drove up prices. This theory of "composite money and credit" also becomes very compelling if credit is so much larger than money, in which case it is really the change in credit that drives aggregate prices for the time being.

Fig. 1: Theory of Composite Money and Credit.

Since we look at money AND credit here, which includes all purchasing power, we also have to look at all goods, services, AND assets that can be purchased. But all of these do not have to rise at the same rate. Given the predicted aggregate price level, some items can fall below while others rise above that level. So if one, say, claims that aggregate prices dropped in a given year by 10%, it is possible that stocks dropped 40%, commodities dropped 30%, houses dropped 20%, and simultaneously consumer goods rose 5%, gold rose 7%, and health-care and education increased by 15%. So the average price drop would still be 10%. But all this didn’t do one good, unless one prepaid healthcare and education which is difficult to do, owned gold bullion, shorted the other assets, and held the remainder in cash or bonds which now on average buy about 10% more.

So even the inflationists are careful to not buy everything and leverage this on top, since right now historically-expensive stocks and real estate could be lagging badly or even fall. Ask how anyone did in 2008 who was long oil-, silver-, S&P-futures, or real estate (with say 5 to 1 leverage). On the other hand, even the deflationists are recommending being careful and not outright shorting stocks or commodities. For they know that risks/rewards are in favor of the long versus the short, especially in the long-run, and stocks and real estate have an income component that the long receives and the short pays. One dividing line seems to be the prediction of government bonds (all maturities). While providing low yield, the deflationist could be right on a short-term speculation by being long bonds if we get a severe credit contraction before the later inflation (it worked well until the beginning of 2009). On the other hand, the inflationists would recommend taking out long-term loans to buy homes since the destruction of the value of the loan trumps the fall of the asset. Dan Amerman seems to propose this, and also Peter Schiff prefers this to buying a home outright.

Peter Schiff also delivers the other "not-in-a-vacuum" argument, and that is the impact that foreigners have besides the domestic forces. Dollars (and bonds) are not just confined to the U.S. as it would be in a closed-country analysis. So if foreigners decided that they do not need to hold pieces of paper that long, for whatever reason (less trade, fear of loss, speculation), then the velocity of money increases as well, and prices in dollars rise. This depends again on human action, in this case the foreigners', and it is not clear how savvy they are or if they just follow the trend. In the latter case they would just amplify a rise or fall in the dollar, similar as foreigners are usually late when investing in other countries' equity bubbles (Marc Faber).

So where are we now and going from here? First of all, looking at last year, the sum of money and credit has contracted slightly (or at least not expanded significantly), see Fig. 2. Most investable assets dropped during that time, and being in debt generally wasn’t a good idea. So I have to say no matter if that period was all there is to the "deflationary phase", it stands 1:0 for the deflationists who warned of stalling of the aggregate of money and credit and drop in prices. So kudos to Mike Shedlock (Global Economic Analysis) and Bob Hoye (Institutional Advisors) who really prevented people from losing money if they pulled in their horns before 2008. Bob Prechter would have also earned high honors, but his timing was a few years too early, and as he admits his assessment of a sharp drop in gold was wrong. On the other hand, if we continue the rebound in aggregate prices further from here, all of the drops will soon have been erased and in that case the inflationists would tie in 2009 to a 1:1 versus the deflationists.

Fig. 2: M3 plus credit plus all government debt, short term [nowandfutures.com]

While the above simple model of consolidated money and credit can approximately explain the events of the last years (including the rise and fall of the markets), it won’t work as well if credit markets shrink and the government expands money by huge amounts. In this case, one should treat money and credit differently, and several authors (Jim Puplava, Peter Schiff) have argued that credit is used to buy assets that are historically bought with loans, while money rather buys everyday necessities (see Fig. 3). In this case, an expansion of money and a contraction of credit could see necessities going up in price and certain assets such as real estate falling in price.

Fig. 3: Theory of Separated Money and Credit.

Although this model is certainly more correct, there are severe spill-over effects of money and credit into other than their respective categories, since rising prices in one category create arbitrage (or a wealth-effect) for other categories. For example, commodities are used to create necessities as well as to build houses, so it becomes very hard to judge how the individual price levels change. And how the overall price-level changes is also not obvious (if we want to forecast if cash or bonds are a worthy investment during the next years). For all the above discussion I am indebted to Rich Toscano (Pacific Capital Associates), who has written similar articles on this subject.

In conclusion, time will tell where we go from here and if there will be price-destructive periods that are more pronounced than in 2008. As described above, due to human behavior and with the choice of investable assets, it is hard to make a sure bet. The pair trade of being long gold and short equities that has worked since 2000, might have a few more years to go, especially if equities get more headwind from multiple-contraction and government interfering in the economy. But in the long-run, time is against that trade too, since equities have the income component. So, one might not short the lower-multiple or certain consumer-staples and commodity-related stocks. Without shorting, being long the latter stocks, being long gold, and having some cash (1/3 each) is probably the common-sense approach, and with a little luck, one can deploy the cash in the next "deflationary" wave should it occur.