One of the key questions of our day, especially for those who have wealth to protect, is, “What’s going to happen to the dollar?” More specifically, do we foresee an increase in the value of money going forward (deflation), or a decrease in the value of money (inflation)? Should we reserve a small amount of concern for the possibility of hyperinflation, which means the rapid and often total destruction of a currency?
There happens to be a lot of discussion around this topic these days. Unfortunately, much of it is confusing and contradictory, because far too much misinformation is included in the mix. So let's begin by getting ourselves on firm footing before we look at the data.
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Inflation correlates poorly with growth in the monetary base, making that statistic relatively useless as a predictor of inflation. However, inflation correlates extremely well with growth in government spending, meaning that we'd do well to track that statistic closely.
The current economic crisis is being fought tooth and nail by a determined Federal Reserve (in the role of the "enabler") and an equally-determined US government (in the role of the heavy-lifter, assuming all the lion's share of the long-term debt and risk). Together, these institutions have virtually consigned future generations to the enormous challenge of wrestling with bloated budgets in desperate need of trimming, further compounded by coinciding with periods of high inflation.
Chris, as always, thank you for your insights. However, I wanted to raise some devil’s advocates points, paraphrasing Bob Prechter from Elliott Wave, and see if you or ohers have any comments.
Prechter builds a contrarian position in favor of a deflationary depression, followed potentially by intense inflation once the excess credit has been wrung out of the system. This is based on his interpretaion of his wave theory, going back ~200+ years. If I understand his argument properly, I would oversimplify it to these two points:
The dollar will increase in value because so much of the world’s debt is denominated in dollars, and both debtors and creditors are seeking dollars. If the dollar collapses, it won’t be before this deflationary period.
An increase in the money supply based upon massive credit expansion is not necessarily inflationary, because as defaults occur money disappears, faster than the government can pump it back in.
There is much more information about this issue at elliotwave.com, including links to a 3 volume treatise on deflation that might be useful as you dust off the textbooks you were referring to.
You and Prechter agree on almost everything else - it is only the the prospect of inflation vs. deflation in which you fundamentally disagree. I follow each of your arguments with much interest. If you agreed on this topic, I would find that position incredibly compelling.
Very thought provoking report Chris, thank you. Just when I get desperate for a Chris Fix, you come through. Thanks for jumping right into the epicenter of this debate.
I have to say, I hadn’t really thought of things quite this way before. Let’s see if I get this straight:
The federal government spends inordinate amounts of money. That increases the circulating money supply, sure as shootin’. The government gets much of the money by borrowing it. It’s borrowed, then spent. Meaning the enablers of our debt are contributing to inflation every time they buy a treasury security. Can it be that simple?
I do have one comment on the section "Will Inflation Bail Me Out." If a person is counting on wage increases to bail him/her out of debt, I hear you. But (assuming one is willing to bet the farm on inflation) I think a good argument can be made that loading up on debt is OK, or even good, if the borrowed money is being devoted to an inflation hedge.
In China it is said that the people save a large share of what they earn. They do so because of very minimal social safety net programs. In other words the Chinese have a high demand for money, they save it, store it, and thus effectively take it out of circulation. This behavior mitigates against inflation.
What is the probabilty of our baby boomers doing the exact same thing now that our governments’ promises of the safety net programs are in serious question? What about the rest of the population?
What is the proportionality or expected rate of this "savings response" when compared to the inflationary pressures of increased government spending?
The credit bubble is dead. I do not foresee the reflation of credit anywhere near the level that we have just seen. Interest rates will be prohibative and lenders are more risk averse. Borrowers are not as enthused either. Increases in government spending however, are here to stay. The only mitigating influence against inflation I can come up with is the above mentioned "savings response."
Is it true that Japan did not suffer significant inflation during it’s lost decade ( or two )? Why not?
1) The dollar will increase in value because so much of the world's debt is denominated in dollars, and both debtors and creditors are seeking dollars. If the dollar collapses, it won't be before this deflationary period.
The deficit will hit, at a minimum 1.86 trillion in 2009.
Bonds must be sold to cover that.
If the bond sales fall short that amount I only know of one of two things that could occur: Default or monitise the debt.
Both would decrease the dollar’s buying power.
Now, what I have no idea about: If the stock market crashed before that happened would enough people move into what they preceive as a safe haven - bonds?
Would that save the day?
Something I’m trying to hash out in my mind. But IMHO this will end in inflation. Minsky says debt and money will be destroyed in events like this.
Thank you Chris. An excellent article as ever. Looking at the issue of inflation from a British perspective everything which you describe happening in the US is also true in the UK. With the exception that the dollar is still assumed to be the ‘reserve’ currency. I wonder what will happen if/when the petro-nations start demanding to be paid for their oil in a currency other than the dollar? In my mind, if this happens then the dollar will tank big time. Perhaps the more pertinent question should be: would the US allow the petro-nations to get away with it? A perfect storm of a) oil being traded in Euros/Yuan/Gold b) significant proof that Saudi Arabia has peaked c) China and Japan turning their backs on US T-bills would almost certainly cause international friction which could lead to all out war.
We live in very interesting times my friends.
Chris-
Awesome report, and very thought provoking. I am curious on your perspective on the TIC (Treasury International Capital) report that came out today. This certainly has to play into any scenario. Jan neg 144 billion, Feb. neg 91 billion, March pos. 25 billion and April again neg. 53 billion. This is not a very good trend and puts a lot of pressure on our funding options. I have to admit, I am unclear on how this all plays out, but it can not be good. Our Government is not able to fund its operations at this rate - at least not by the sale of Treasury securities… any comments would be greatly appreciated.
Thanks for the thoughts. Since our March lows, the market is forecasting higher inflation of goods that need no leverage (from an end consumers perspective) to buy (food, oil, etc), and deflation on goods that need financing (homes, autos, etc). I think its very likely this continues.
I would think its quite possible to see massive inflation in basic necessities and massive deflation in leveraged goods. As unemployment continues to rise, and wages stagnate, its unlikely those with cash will lend nearly as much. Although the government may be dramatically increasing spending and printing money, how can that create rising prices in leveraged goods when unemployment is skyrocketing and interest rates are climbing? I think we have lots of time before leveraged assets see a floor. However, unleveraged goods have far less constraints to their prices and also are experiencing more and more scarcity (peak oil, poor crops this year…etc). This is in dramatic contradiction to the excess supply found in leveraged goods (supply of homes for sale are near all time highs)
Thanks for any thoughts or counter points to this line of thinking…
Could you please look into the effects of how our money is created and destroyred when talking about inflation?
If the problem of our economy is too much debt and there is no money in exsistance being used as final payment shouldn’t we introduce a final payment money into circulation to pay down and eliminate the debt and restore the purchasing power of our currency through those means instead of just throwing more debt at a debt that is already so large that the interest at 6% alone will soon be greater than the total consumer income?
Rickets,
I think you’ve got a great point. We appear to be in a bi-flationary period and it seems to be getting more exaggerated. Inflation will take its toll on the basic necessities such as food and healthcare. I think everyone has seen their food costs steadily increasing. I’ve seen my healthcare premiums jump 10-20% every year. On the other hand deflation is dominating the leverged items. Housing costs have come down significantly- so much so that in many places houses are no longer worth the sum of their parts. And as the government continues to spend, the interest rates will only go up. So housing prices will go down as affordability tries to stay in line, and necessities go up as business costs of money go up.
At some point, it would seem that once the dollar devalues enough, then all things- even housing, will rise in price. But I think this is later than sooner. For now, its likely many years of bi-flationary stagnation –>stagbiflation?