Deflation, Disinflation or Hyperinflation

I suppose I’m leaving out the possibility of normal planned inflation, with a recovering economy enabling governments to cut debt levels relatively painlessly – but who am I kidding here?  Personally I’m predicting continued disinflation/borderlined deflation for the next couple years, as I’ll explain below, but I’d like to start with hyperinflation.   

I recently read a rather interesting US hyperinflation theory on http://www.shadowstats.com/  I don’t subscribe, but it’s one of their hook articles that’s free to read.  The argument as I understand it goes like this: 

1. More than half of the $860 billion reported on the M1 fed balance sheet (strictest supply measure including physical dollars, checking balances, etc – not loaned money) in 2008 is held overseas in “dollarized” countries, eurodollars, etc.

2. A 2009 flow-of-funds analysis shows that over $10 trillion in liquid dollar-denominated assets (such as US treasuries) is held overseas and can be dumped at will.  This compares to the US M3 measure around $14 trillion.

3. In 2009, the Fed more than doubled it’s balance sheet (M1) to around $2 trillion.  Due to considerable economic slack in the US economy, lack of lending, and the amount of cash held overseas, the inflationary affects haven’t been felt in the US.  They did, however, have a profound effect on currency valuations for the US dollar which means losses for foreign investors. 

So the story goes that the Fed in the US continues to expand the balance sheet to fight deflation, and to help US exports by devaluing the currency.  The foreign holders of US dollars are hit by this, lose confidence in dollars and treasuries as a safe store of value, and sells them off.  The result is more dollars rapidly hitting the US market, and rising interest rates on US treasuries.  The Fed will expand it’s balance sheet further, purchasing US treasuries to cap rates as it did during and after WW2, and the dollar will devalue further.  The sheer volume of foreign dumping of these assets makes US dollars lose their value rapidly back home, where domestic savers and investors rush to get something tangible for their dollars while they still can.  This is a scenario where you invest in canned food and shotguns to live out the storm following a debauched currency and an economic collapse.  It is an interesting story, as these events are totally feasible, but I don’t think it’s all that likely to happen.

Deflation, or borderlined disinflation, seems to be a much more likely scenario.  This is roughly what happened in Japan following the 1990 real-estate collapse.  The parallels are enormous – bailouts, bank failures, zombie banks, exploding government deficits, rising taxes, continuing Keynsian-style spending and extremely low government bond yields despite record bond issuance and an expanding balance sheet at the central bank with target rates held near zero.  During the last 20 years in Japan, the national savings rate skyrocketed faster than the government balance sheet expanded.  Note one interesting difference – Japan spent fortunes on bullet trains, subways, and other money-losing infrastructure projects (maintenance costs often greater than revenues), while we are spending money on stimulus in the form of extended unimployment, medicare expansion, and temporary credits to boost spending on houses, autos and appliances.  One advantage for us is that, even though we won’t have anything fancy to show when the effects wear off, at least we won’t be carrying an ongoing liability. 

On to the present arguments for deflation… the US is the lone country in the G20 that is advocating more stimulus spending rather than a focus on spending cuts and healthy government balance sheets.  We won’t hold out long – government spending and expansion is unpopular with the bulk of US voters, and the Republicans are unlikely to forward additional stimulus under the form of anything but business tax cuts once they get in office this November.  The economic downturn here in the US is also being felt worldwide – Europe in particular – and consumer spending has not and is not ready to pull up demand.  Also, as the financial regulation follows through across the US and Europe, it stresses higher capital levels – which will reduce lending available to banks.  This is definately deflationary and is likely to continue for some time as the public balance sheets are repaired (according to the WSJ, average household debt dropped from 133% of household descretionary income in March to 122% in April, though this had more to do with defaults than saving). 

This deleveraging will be painful, but is in many ways necessary to return to a new sustainable period of economic expansion.  The excessive borrowing of the last 10-20 years simply must be paid for – either by the borrowers (increased saving & paying down debt) or by the lenders (increased defaults & inflationary actions by central banks).  This cannot just blow over by bailing out Greece or encouraging overconsumption through tax credits -this will slow the process down, but is just as effective as paddling upstream.  We simply have to understand that the conditions of 2006 and 2007 were not sustainable – as it always has been with the business cycle – and that excess spending must be followed by excess saving. 

If you’ve read this far you can sense why I’ve become convinced that Gold is perhaps the best investment out there – because I believe that most assets out there like housing and stocks are still overvalued, and that gold will stand to gain as central banks expand their balance sheets to fight deflation – not just in the US, but throughout the world.  Hyperinflation would make more sense if the rest of the world wasn’t in as much trouble as we are in the US – and if the US population actually supported endless government stimulus over austerity measures – but I don’t see it happening in the current scenario.  We are in an economic slog that will last years, but will be plowed through just like others in the past … it will pass, but in the meantime it will pay to invest conservatively – don’t buy the bull and load up on risk!

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About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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One Response to Deflation, Disinflation or Hyperinflation

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