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Debating the Odds of Deflation (the text below was published
7/07/2005 in Rick's Picks)
Rick Ackerman: Jim Otis, writing for The
Optimist, insists that the Fed would never allow deflation to occur.
My take is that the debt problem is too big to paper over except by way of a
hyperinflation, and that such a strategy would never be attempted in any
event, implying as it does the wholesale destruction of the bond markets as
well as the downfall of savers and creditors as a class. Jim and I have gone
back and forth via e-mail since mid-June, when I explained in this space why
deflation is inevitable. I have reprinted my dialogue with Jim below for your
interest. For the time being, wrist surgery has made it impractical me to
respond to his latest point-by-point at length, so I will leave up to you,
dear readers, to furnish your own rebuttals. If you have been a Rick's
Picks reader for any length of time, you should be up to the task.
Give it your best shot, and I'll reprint your letters in a forthcoming issue.
Here is the series of exchanges, starting from near the beginning:
Rick A: Deflation is the most powerful force in the financial
universe, Jim, and it can only be postponed, not avoided. But that will take
lots more borrowing, which itself would depend on an already grossly inflated
asset class: housing. The housing market will not collapse as long as the
only two alternatives to the dollar, the yen and euro, remain relatively
unattractive to the investment world. However, there's a trigger that
could cause such a change: plummeting US stocks.
1930s Were Different
Jim O: Thanks for your reply. Deflation may well have been the most
powerful force in the financial world, but that was back in the 1930s when
the quantity of money available was limited to the gold and silver in the
treasury. The fiat paper most people now call money has no intrinsic quantity
limits except the restraint the Fed imposes on itself. The Fed
now has the ability to insure the economy will not have a fiat paper
shortage which could result in a deflationary spiral.
We can agree that depression is inevitable due to very high levels of debt
and the continuing loss of solid manufacturing jobs. Unlimited
availability of fiat, however, now makes deflation an optional choice by the
Fed. Deflation will occur only if the Fed decides to let it happen (or
if an abrupt catastrophic financial accident overtakes their ability to
respond in a timely manner). For so long as deflation is not considered
to be politically correct by the Fed and the power structure in Washington, it
is far more prudent to invest against the inflation devil we are sure about
than the deflation devil which may only be an illusion. There is more
about deflation at this link.
While you are in my site, take a moment to browse through my commentaries
in the commentary tab at the left of the page. If you find something
worth quoting to your readers, I'd be happy for you to include a link to the
source. Cheers! Jim
Time Crucial
RA: Thanks for your thoughtful reply, Jim. I have addressed the
point you make below numerous times, in my newsletter and elsewhere, as
follows: Total indebtedness amounts to hundreds of trillions of dollars, so
nothing less than hyperinflation would suffice to reconcile accounts
between borrowers and lenders. But hyperinflation by definition is
unsustainable, so it is the aftermath that we must consider. What does a
collapsed hyperinflation look like? There can be only one answer: deflation.
There are other factors to consider as well, chief among them the
guvvamint's response time. On a particularly hellish day, settlement issues
that would initially affect short-term paper could back up so that sorting
out the chaos further along the curve would become impossible, practically
speaking. Debt has become a towering house of cards, and there is no way the
G-men will be able to shore it up once the cards start to tumble.
A singularly important fact that all inflationists choose to overlook is
that bailing out debtors would be tantamount to destroying savers and
creditors as a class as well as the institutional conduits of savings --
i.e., the bond markets. They would cease to function for at least a decade
and probably longer if creditors were to get nuked by the Bernanke Plan. If
Motormouth Ben truly doesn't understand this -- which I doubt -- then he's as
hopelessly ignorant of the laws of economics as his boss. Regards, Rick
The Fruit Fallacy
JO: Rick, be careful of the fruit fallacy! The green U.S. $
fiat currency (let's call it green apples) is deteriorating through inflation
so that each year the same goods or services cost more green apples to
purchase. When that inflation proceeds far enough that we need truck
loads of green apples to buy things, the government will help us by issuing a
new fiat currency which could be called a red cherry and which might have the
same purchasing power as a million green apples.
That will be a wonderful improvement since it is much easier to carry a
red cherry to the store than the wheelbarrows full of green apples that it
replaced. The transition from many green apples to few red cherries
will not be deflation. It is simply another example of different
currencies having different numerical equivalents. People who are accumulating
green apples now so they can gain purchasing power during the
"certain" deflation ahead will probably be very disappointed.
The purchasing power of green apples will decrease every day before, during,
and after the conversion to red cherries. Those misguided souls who hold cash
resources now to profit from future deflation are likely to find they have
missed a golden and silver opportunity to conserve purchasing power by
investing with the rising inflation trend.
You raised three other points which I will comment on only briefly because
long emails become unpleasant to read. Your point number 1) Total debt is
trillions of dollars, and only hyperinflation can pay it off.
No Rush to Pay
OK, let's agree that hyperinflation will be unavoidable when the time
arrives that it becomes necessary to pay off all debts. Fortunately,
there isn't any rush to pay off debts now, and the government still has the
luxury of being permitted to continuously borrow more. There is no
evidence now that an abrupt transition to an emergency is just around the
next corner. It may be years before we get back to the same level of
pervasive inflation of the 1970s, and decades before the rate of inflation
"progresses" from double digits per year to triple digits per
year. Hyperinflation, which would be orders of magnitude worse than
that, is not likely to be a near term issue.
Your point number 2) Juggling the markets is complicated, and the Fed
could lose control.
You could be right, but I don't worry that a major accident which is
beyond the Fed's ability to contain will happen soon. I think the Fed
has done an impressive job of conning many investors into concern about the
deflation that isn't, instead of focusing on the inflation that is.
Although I despise the loathsome process of suppressing the truth about the
magnitude of the real inflation problem, I must confess that I am awed by the
masterful way they can manage the data to avoid setting off alarm bells
throughout the economy and the rest of the world. When thinking of
possible financial accidents in the USA which might spiral out of control,
consider that in 2000 we had a major market meltdown, and in 1987 stocks lost
25% in a single day. I find it difficult to imagine domestic events
which would pose a more challenging environment for containing deflationary
pressures. I am solidly convinced that the Fed can prevent deflation
for the foreseeable future, and I want to remain well positioned to take
advantage of the resulting inflation.
Creditors Will Adjust
Your point number 3) Bailing out debtors with inflation hurts creditors.
Agreed, but that bad effect of inflation is no surprise to anyone. The USA
has had essentially non-stop inflation for the last 70 years. Creditors
adjust to rising inflation, and markets continue to function. FYI, I am
working on my next commentary now. It will suggest the results if real
inflation increases from the low to mid double digits over the next decade or
so. It should be a fun topic to write, and I hope readers will
also enjoy it. Introduce your readers to my site now, so they can catch
the next installment while it is hot off the presses! Cheers! Jim
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