Download February 2012 Aftershock Newsletter Inflation or Deflation? As

February 2012
Aftershock Newsletter
Inflation or Deflation?
As readers of our books already know, we have been predicting that future
inflation and rising interest rates will put increasing downward pressure on our
falling bubble economy, eventually popping the bubbles and causing a massive
economic Aftershock here and around the globe. So far, nothing has happened to
change our minds about any of that, especially about future inflation and rising
interest rates. Even if we did not have a falling multi bubble economy, inflation
and rising interest rates would be a drag on any economy. However, given that
we do have a falling bubble economy, future inflation and rising interest rates will
help cause the coming big multi-bubble pop.
Other books also predict economic troubles ahead, but none seem to see the
falling multi-bubble economy and many don’t foresee future inflation and rising
interest rates that will surely be the undoing of any economic recovery. Some
authors, such as Harry S. Dent in his most recent book, The Great Crash Ahead,
even go so far to say that instead of inflation, we will have deflation. Dent’s
arguments for deflation have created a lot of confusion and questions for many
people, and not surprisingly we get a lot of questions from readers asking about
which one it will be—Inflation or Deflation?
Clearly, both predictions cannot be correct. Either we will have deflation and the
value of the dollar will rise, or we will have inflation and the value of the dollar
will fall. Knowing which one is right is critically important because the steps to
take for protection in each environment are entirely different, depending on
which macroeconomic view you believe. For example, if you think the value of the
dollar will fall (inflation), then it makes sense to convert some dollars to assets
that will not decline when inflation rises, such as gold. On the other hand, if you
think the value of the dollar will rise (deflation), then hanging onto dollars is smart
and owning gold is not. Of course, you don’t NEED to make some of these
investments until we get nearer to having significant inflation although some
investments that protect against inflation will do very well even before we have
significant inflation, such as gold.
The point is that while you don’t necessarily need to make inflation-protected
investments right now, you do need to have the correct macroeconomic view
about whether we will eventually have inflation or deflation, because they each
mean something very different for the active management of your portfolio.
So which is it, deflation or inflation? We feel confident that, when given the facts,
you will conclude for yourself what we see. None of this is too hard to figure out,
it’s just that you are rarely given the right information you need to see it clearly.
Our goal, as always, is to clear the fog and give you the correct macroeconomic
view so you can decide for yourself the right protective actions.
A Fundamental Misunderstanding about Inflation: Symptoms Are Not Causes
At the heart of this debate about whether or not we will have future inflation is a
fundamental misunderstanding about what actually causes inflation. There is a
natural tendency to confuse symptoms with causes. While it is true that prices
generally rise during inflation, it is not true that rising prices cause inflation. Rising
prices are a symptom, not a cause of inflation. The only thing that can cause
inflation is the expansion of the money supply at a rate that outstrips economic
growth. In other words, if you print money faster than your economy grows, you
get inflation. That is why in 1970, Nobel Prize winning economist Milton Friedman
famously said:
“Inflation is always and everywhere a monetary phenomenon.”
By “monetary,” Friedman meant that inflation is always a function of the money
supply. Increase the money supply too quickly (faster than the economy grows)
and you get inflation. Why? Because money is just like any other commodity:
increasing the supply too much lowers its value. Think of diamonds. As long as
diamonds are rare, their value remains high. However, if you flood the market
with diamonds, their value falls. The same is true of dollars: print a lot of them
and the value of the dollar drops. As a result of the dollar being worth less, you
need more dollars to buy things. Therefore inflation causes the cost of goods and
services to rise.
In contrast, deflation is just the opposite of inflation. A money supply that either
grows slower than the economy or a money supply that is made smaller by
removing money from the money supply eventually causes deflation, which
boosts the value of the dollar. Again, like diamonds, when dollars become more
scarce, each dollar is worth more. As a result of the dollar being worth more, you
need fewer dollars to buy things. Therefore deflation causes the price of goods
and services to fall.
Inflation causes rising prices, deflation causes falling prices. But that does NOT
mean that any time prices rise it is always due to inflation, and it does not mean
that any time prices fall it is always due to deflation. Symptoms are not causes!
To summarize:
• Inflation and deflation are both “monetary phenomena,” meaning they both
result from changes in the money supply, relative to the growth of the economy.
• Inflation is the result of increasing the money supply, causing the value of the
dollar to fall and the cost of goods and services to rise.
• Deflation is the result of decreasing the money supply, causing the value of the
dollar to rise and the cost of goods and services to fall.
A Fundamental Fact: Massive Money Printing by the Fed Will Cause Future
Inflation
In response to the global financial crisis of late 2008, the US Federal Reserve has
roughly tripled the US money supply with two rounds of quantitative easing (QE1
and QE2) since March 2009, expanding the money supply from $800 billion to
roughly $2.8 trillion in less than three years. Tripling the money supply in such a
short period of time is unprecedented in recent history. Clearly, the economy did
not triple during that time, so this massive new money printing was not done in
order to keep pace with a rapidly growing economy. In fact, just the opposite is
true—the Fed fired off two massive rounds of money printing in a desperate
attempt to stimulate the falling economy, not to keep up with a growing
economy. So this was “extra” printed money and a whole lot of it.
For the most part, this massive money printing stimulus has had its intended
affect—at least for now. Clearly, the post-2008 stock market has benefited
tremendously from QE1 and QE2, and no doubt the recession of the last few
years would have been far worse without the Fed’s massive money printing.
However, the boost to the stock market and overall economy from QE has not
been enough to create a real and sustainable recovery, and now the Fed is talking
about the potential of doing even more QE in the future, “as needed.” Given that
we have a falling bubble economy, we know it will be needed, so instead of QE
ending, it will continue.
Big Money Printing Means Big Future Inflation
All this big money printing will most certainly cause very significant future
inflation, not deflation. Future rising inflation will also naturally cause rising
interest rates, which together will help fully pop the already falling multi-bubble
economy. (For more details about QE, future inflation, and rising interest rates,
please see Chapter 3 of Aftershock second edition, Wiley 2011.)
It is important to understand that had we increased our money supply by only 10
percent or even 20 percent, the resulting future inflation would be far less. But
we increased our money supply by a whopping 200 percent. Expecting only low
future inflation to result from such a massive increase in the money supply is pure
fantasy. If there was no threat of inflation from massively printing money, why
haven’t we been massively printing money all along? Why does the government
need to borrow any money if they can just print all the money they want,
whenever they want, with no negative consequences? In fact, why do they need
to collect any taxes? Just print instead! Come to think of it, why do any of us need
any income at all? Why don’t we all simply print money whenever we wanted to
go shopping?
Clearly, there must be a serious downside to massive money printing or we would
all be doing it all the time. Printing massive amounts of money, beyond what is
needed to keep up with the growth of the economy, does have a serious
downside: inflation. Nonetheless, there is some ongoing confusing over whether
we will have inflation or deflation. So let’s tackle each of the pro-deflation
arguments one at a time:
Pro-Deflation Argument #1: Falling Prices
When prices decline, such as when real estate values fall, some people say “See,
that’s deflation!”
Not true. As explained earlier, just because an asset loses value does not
necessarily mean it is due to deflation. While it is true that deflation means the
dollar is worth more and therefore goods and services will cost less, it is also true
that other forces can cause the prices to fall, too.
Besides deflation, what other forces can make prices fall? How about a popping
bubble? That certainly causes prices to drop, doesn’t it? And even if there are no
popping bubbles, the powerful forces of supply and demand always impact prices
to some extent. Any time supply rises or demand falls, asset values are negatively
affected. For real estate this will be a double whammy because not only will
demand fall (fewer people able to buy) and supply rise (growing inventory for
sale), there is also the fact that real estate prices were in a bubble (overpriced
relative to income) in the past and that bubble is still falling. So even though
future inflation will drive up general prices of goods and services, home values (in
inflation-adjusted dollars) will fall. That is not deflation, that is declining demand,
rising supply, and a popping real estate bubble! We know this intuitively because
when real estate prices were going up during the housing bubble, nobody called
that inflation; they called it a GREAT INVESTMENT!
In general, falling demand and popping bubbles will cause many asset prices (in
inflation-adjusted dollars) to fall. That is not deflation; that is a price drop.
However, sometimes prices fall due to both falling demand and deflation, as was
the case during the Great Depression, beginning in 1929. At that time, there really
were too few dollars relative to the size of the economy and the federal
government needed to print more dollars to boost the economy.
Today, with the Fed tripling the money supply in less than 3 years and likely to
print even more money in the future, a lack of new dollars is hardly our problem.
We do not currently have deflation nor will we later face future deflation.
Pro-Deflation Argument #2: Demographics
This is where Harry Dent comes in. Dent has made a seemingly persuasive case for
the coming change in demographics and how it might impact the economy. Dent
argues that as people near retirement, they tend to spend less and to invest and
save more. This, he says, is problematic because the very large Baby Boomer
generation is now on the verge of retirement, and they are saving their money by
putting it into stocks, bonds, CDs, etc. As they retire, they will need to convert
these investments back into dollars to live on, and that big wave of selling will
push these asset prices lower and cause a recession.
We agree that changing demographics will have some impact on the future
economy but it will not be nearly as significant as Dent believes. More
importantly, even if it did cause a recession, a recession does not cause deflation.
Only decreases in the money supply (relative to the size of the economy) cause
deflation. In a recession, prices may fall, but that is not necessarily because of
deflation, but because of falling demand (more sellers, less buyers).
In addition, Dent also says that as Baby Boomers increase their savings rates,
dollars will be hoarded into savings accounts and therefore dollars will become
scarce, in effect decreasing the money supply and causing deflation. In reality,
Boomers are hiding money under their mattresses or burying it in their backyards,
all that “saved” money is still very actively moving through the economy. That is
because when you put money into a bank savings account, it does not go into
hibernation. The bank lends that money to other people and businesses. Money
does not leave the economy or the money supply simply because it was deposited
into a bank!
But even if Boomers did bury all their extra savings in their backyards and did not
put it into banks to be lent out to others, the idea that Boomers will be able to
remove so much money from the money supply that it will offset the massive
money printing by the Fed is ridiculous and impossible.
Pro-Deflation Argument #3: Debt Write-offs and Bankruptcies
Another common argument for future deflation made by Harry Dent and others is
that when debts cannot be repaid, the resulting write-offs and bankruptcies will
effectively decrease the money supply, causing deflation.
This argument seems to come from the idea that money is created as debt, and
that therefore when debt is destroyed, so is the money. But that is not the case. If
you lend me $20 for lunch and I never repay you, that $20 is still out there in the
money supply, moving from me to the restaurant to the wholesale food
distributor, etc. It is still in circulation. Destroying my debt to you does not
destroy the money itself.
Lending increases the money supply, and so it is true that a slowdown in lending
does create a slowdown in enlarging the money supply. But any potential
contraction caused by financial institutions lending less or going into bankruptcy
will be more than offset by the Fed’s massive money printing. Therefore it will not
decrease money supply and it will not cause deflation.
Pro-Deflation Argument #4: The Fed Won’t Allow Too Much Inflation and We
Will End Up with Deflation Instead
The pro-deflation idea here is that the Fed is not made up of fools who never took
Econ 101. They know that printing money can cause future inflation and they
have a plan to nip inflation in the bud, before it becomes significant. That will
allow the other problems (listed in #1, 2, and 3 above) to cause deflation, not
inflation.
We agree that the members of the Fed fully understand that printing money
causes inflation. That danger is the main reason they have never printed this
much money before and they only did it now because they felt they had little
choice. While we cannot know for sure what the Fed is thinking, our best guess is
that they are hoping they will eventually be able to sell the bonds they bought
with QE, essentially taking that extra printed money out of the money supply, in
effect doing “reverse quantitative easing,” reducing the money supply before
inflation gets too high. In other words, they hope to decrease the money supply
and stop inflation before it gets out of hand.
However, this plan simply won’t work because it is missing one vital ingredient: a
booming economic recovery. In order to sell the bonds and reverse the money
printing, they would need a booming economy in which there are investors willing
to buy these bonds. So far, that hasn’t happened. Not only do we not have a
booming economy in which the Fed can do reverse quantitative easing, we have a
falling bubble economy that will lead the Fed to do even more money printing.
That will cause significant future inflation, not deflation!
If QE Causes Inflation, Why Don’t We Have Inflation Right Now?
Having addressed the major arguments for deflation, let's turn to the subject of
containing the increase in the money supply to prevent significant inflation. Since
2008, when the Fed began supplying banks with huge amounts of liquid reserves
through quantitative easing, it has encouraged banks to keep those reserves on
hand rather than lending them out by paying interest on them. This is an attempt
to stave off inflation by limiting the effect of the money multiplier.
Earlier, we mentioned that quantitative easing increases the monetary base, from
which all other measures of the money supply are derived. The way this works is
that banks are only required to keep a certain percentage of their deposits in
reserve. So when the Fed increases a bank's reserves by purchasing bonds, the
bank can lend out most or all of that money (and has a strong incentive to do so
in order to earn interest). Once they lend out the money, sooner or later it ends
up in a deposit account either at that bank or another, which can then lend most
or all of it out again. This cycle can continue many times over until the initial
increase in one bank's reserves has led to an exponential increase in the overall
money supply.
By paying interest on reserves of 0.25 percent (the equivalent of the federal funds
rate), the Fed hopes to avoid the massive inflation that would undoubtedly follow
if banks lent out those new reserves.
There are three problems with this. First, the nearly $2 trillion increase in the
monetary base is not just theoretical money. It goes into client accounts at the
banks that do business with the Fed and has a direct effect on the money supply,
regardless of the multiplier effect. Holding excess reserves may slow inflation, but
it can't stop it.
Secondly, and more importantly, this strategy is based on the idea that eventually
the Fed can pull that money back out of the economy. But when is this supposed
to happen? As we said earlier, the Fed can't contract the money supply while the
economy is still recovering. The results would be devastating for the markets and
for employment. And even if we did see a major recovery, not only would a
contraction jeopardize those gains, but the only way the Fed can pull that money
out of the economy is by selling $3 to $5 trillion worth of government bonds,
which would send Treasury yields skyrocketing and make an already precarious
public debt situation much worse.
Thirdly, as inflation and interest rates rise, the interest paid on excess reserves
will become excessive. Eventually, the government won’t be able to afford to pay
it and banks will lend out the money rather than keep it on deposit. That will
further push up inflation.
In other words, there’s just no good time to pull money out of the economy once
it’s in circulation, especially in a bubble economy. In the meantime, banks are
sitting on a huge pile of excess reserves which earn a very low rate of interest.
How long will they continue to ignore the profit potential of lending out those
reserves at significantly higher interest rates? Sooner or later, that money is going
to be lent out and inflation will follow. It is already happening to some extent
now.
Why the Delay?
So if quantitative easing began in 2008, why haven't we seen inflation already?
First of all, inflation customarily has a delay of about 2 years following an increase
in the money supply. And, as expected, inflation is increasing. As measured by the
Consumer Price Index (CPI) inflation has risen from just over 1 percent in 2008 to
3.64 percent in 2011. That's a noteworthy increase, but it's certainly far from an
alarming inflation rate. It should be said that we don't consider CPI to be a
completely reliable measure of inflation — the basket of goods monitored is not
necessarily reflective of dollar-value changes. This is partially due to changes in
the way CPI is calculated in the 1990s. By the old measure of CPI, inflation would
be over 7%!
That being said, there are numerous factors we think will make inflation even
slower to respond to the recent money supply increase than usual. In addition to
the excess reserves on hold, current economic factors and the traditional “safe
haven” status of the dollar makes people reluctant to see the dollar bubble for
what it is. It's literally never happened before that a stable, wealthy economy of
this size has printed money on this level, and the economy is naturally slow to
understand the consequences (see the real estate and stock bubbles).
But make no mistake: a down economy and a good reputation will not save the
dollar in the long term. Inflation happens even in poor economic times, and the
laws of supply and demand are bound to catch up with us eventually. And while
inflation often starts slow, it can snowball very quickly.
An Even Bigger Issue: More Big Money Printing Ahead
As we mentioned earlier, the monetary base has tripled since 2008. This alone is
an enormous and unprecedented increase. But more importantly, we believe that
it is very likely that even more — much more — money printing in the next few
years.
Quantitative easing was originally employed to boost struggling markets and
contain unemployment. It has worked (somewhat), which is why we are not in
worse shape right now. However, later, as the bubbles deflate further and
investors begin to panic, the Fed will have no choice but to continue
administering the medicine of money printing. But like any drug, the more it's
used, the less effective it becomes, and it takes more and more meds to achieve
the same results.
As inflation rises to significant levels, interest rates rise, and this just compounds
the problem. Liquidity crises and bankruptcies around the country lead to
bailouts. The federal government will be forced to offer higher and higher yields
on its bonds in order to refinance its mounting debt, and it will be forced to print
more and more money in order to finance an increasing federal deficit, which will
suffer not just from increased costs but also from lower tax receipts due to high
unemployment.
Eventually, after inflation rises past 10 percent, the Fed will eventually have to put
a stop to money printing altogether, but by the time that happens, the huge
damage will be done. We don't predict the death of the dollar, but it certainly will
be a very different dollar than we've grown accustomed to. Rather than a
strengthening dollar due to deflation, we will have a falling dollar due to both
rising inflation and declining demand for dollars and dollar-denominated assets.
In the Aftershock that follows, we will see the odd mix of prices rising due to
inflation, and asset values falling (in inflation-adjusted dollars). That won’t be
deflation. It will be a popping bubble economy.
©Copyright 2012 Aftershock Publishing, all rights reserved.
Aftershock Advisors, LLC
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Herndon, VA 20170
(703)787-0139
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Christine Peglar
[email protected]
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Office Manager
Nancy McSally
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