08/12/10 Hong Kong, China – Now that almost every Wall Street economist is looking for the arrival of a Great Deflation, we think investors should begin looking the other way. Keep an eye out for inflation, we say.
You will recall that during the bottom of the previous bear-market, most of the pundits were shunning ‘risky assets’ (stocks and commodities) and they were advocating a heavy exposure to cash and fixed income assets. Back then, the vast majority of strategists and their devotees were erroneously fretting about deflation. According to these folks, deflation was a done deal due to the following reasons:
a. Contraction in private-sector debt – When the credit crisis arrived in the summer of 2008 and asset prices collapsed later that year, over-leveraged consumers and businesses started paying off their debt. After all, this act of deleveraging was a logical reaction to the devastation caused by the most vicious bear-market since the 1930s. So, when private-sector debt began to shrink, the proponents of deflation (deflationists) announced the death of inflation. “How could the global economy inflate when the private-sector was tightening its belt?” was their battle cry.
Although the deflationists had a point, their assessment was flawed because they totally ignored the borrowing capabilities of the governments. While it is true that from peak to trough, private-sector debt in the US contracted by roughly US$800 billion, this debt reduction was overwhelmed by the US government’s debt accumulation efforts.
As the chart below shows, over the past two years US federal debt has surged by a whopping US$3 trillion, thereby more than offsetting the deflationary impact of private-sector deleveraging. If you have any doubts whatsoever, you will want to note that total debt in the US is now at a record high!
b. Excess capacity – The lack of aggregate demand and the excess capacity prevalent within the economy is another factor often cited by the deflationists. Let us explain:
You will recall that in the aftermath of the Lehman Brothers bust, the credit markets froze and the global economy came to a screeching halt. Suddenly, worldwide consumption contracted and the world was left with idle factories, empty buildings and unwanted inventories. Thus, the deflationists argued that with such a lack of aggregate demand and so much spare capacity, we could never experience inflation.
Once again, the deflationists failed to understand that over-capacity has been a constant feature in our economic landscape and price increases (which they erroneously describe as inflation) have very little to do with capacity utilization.
It is interesting to observe that over the past 42 years, the US economy has never operated at full capacity. Moreover, it is notable that even during the highly inflationary 1970s and the most recent inflationary boom (2003-2007), the US economy operated well below maximum capacity. In case you are wondering, the same holds true for the global economy. Therefore, the idea that inflation cannot occur in the face of excess capacity is ill-conceived and absurd.
All the popular deflation myths aside, the reality is that inflation is an increase in the supply of money and debt within an economy. Furthermore, the price increases often described as inflation are simply consequences of monetary inflation – a euphemism for the dilution of the money stock.
Look. Whenever any central bank creates new money and whenever any entity (individual, business or government) takes on more debt, the outcome is inflation. As Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon.”
Today, under our fiat-money system, governments are willing borrowers and central banks are more than eager lenders (money creators). Under these circumstances, a contraction in the supply of money and debt (deflation) is out of the question. Conversely, given the short-sightedness of the politicians and their perpetual urge to “kick the can down the road,” the real risk facing the economy is extreme inflation or even hyperinflation.
Given our grim outlook on inflation, we continue to favor hard assets and the fast-growing developing economies in Asia. If our assessment is correct, our preferred sectors (energy, precious metals and industrials) and our favorite stock markets (China, India and Vietnam) are likely to generate superior long-term returns.
Regards,
Puru Saxena
for The Daily Reckoning
Puru Saxena
Puru Saxena is the founder of Puru Saxena Wealth Management, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.
He also publishes a widely read economic report, Money Matters, which is available from www.purusaxena.com
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This is very interesting.
Inflation and Deflation, as stated, is an increase or decrease in the money supply. However, debt is an asset for the lender and a liability for the borrower.
There is certainly an excess of capacity, both in labor and facilities. To complicate the problem, there is gross disparity between wages in the Western world and wages in the third world. As the West struggles to maintain $50,000 a year gross income, the third world struggle to raise incomes above $5,000 a year. There is a huge supply of these third worlders, who are gaining in education as Westerner’s forgo education for the dole. None of this is inflationary or deflationary. It simply puts downward pressure on high wages.
There is a huge disparity between what it costs to build a house or make an automobile, and what either is worth in the market. This is because of wages. Until there is a balance, manufacturers will have to rebate to get sales, and sales will continue to decline.
Lastly, in our global fiat system, whether we like it or not, capital must be supported by savings. Only federal governments can “mint” money. Money minted and not supported by taxes, must be balanced by debt. In the US, with the exception of the doubling of the value of gold during the “confiscation” in the 1930′s, there is still an outstanding debt for every dollar every printed by the US Government. Bonds from the 1800′s were simply rolled over to this day. But, the debt is still outstanding.
Without an increase in taxes, a point will be reached where the US Treasury cannot continue to borrow, because it simply will not have enough money to pay even the interest on the debt. We are a long way from that, I hope. When that day comes, the Federal Reserve will long since have removed the debt of the Treasury from its books, and it will be the last lender to loan the Treasury a dime, much less print money and drop it from helicopters.
I don’t believe we have deflation. I believe we have a stalled increase in the rate of inflation because there is little or no velocity of money. Those who are borrowing from the Federal Reserve are being very careful with the money, because they do not know when the Fed will want it back. So we cannot get forty dollars loaned out for each dollar borrowed. In general, it is doubtful if more than ten cents is getting into the economy from the trillions doles out by the Treasury. And the trillions doled out are balanced by trillions in additional debt.
Deflation will come when people start stuffing money in holes in the walls of their house rather than spending it or putting it into a bank.
I agree that we are not having deflation. I do not believe we are having inflation. We have prices falling because of supply and demand. In the 1970′s, what was called inflation was really demand for money exceeding supply causing interest rates to rise, the cost of business to rise, and prices to rise. That debt, though rolled over, is still on the books.
I’m 63, so I have no real idea how to deal with a stalled rate of inflation. It hasn’t been stalled most of my life. However, it is unreasonable to assume that governments can borrow and tax forever (though it may seem that way). There will be cycles, like the 1930′s and the 2010′s (’20′s, ’30′s, etc.) when the increase in the rate of inflation will come to a halt. Pray that it does not decline.
the portion of governement debt not financed by the fed is not inflationary since it does not represent new money. Even when the fed purchases new government debt, it is not inflationary when purchased from banks if they do not lend it out. while capacity utilization may not have been maxed out in the seventies, it I suspect that the inflation can largely be explained by demographics.
I think Mr. Saxena wasn’t told that the enormous debt that U.S. society has amassed was government borrowing and spending, but the private sector, which has borrowed FAR more than the government sector. Given his short article, I think he’s trying to justify past inflation-pumping defense advice and is not ready to accept the fact: most of the world is in a deflationary depression, driven by way too much debt all around.
If folks don’t have a job, and folks who do have jobs don’t see any pay increases, where is the inflation going to come from? If the government is printing so much money, who is getting it? It sure isn’t the people on main street who generate the type of inflation you are talking about. Where is all this money???
When people say inflation – they mean price inflation. What does anybody care if there is more money created (inflation) if there is no effect on price inflation?
Inflation is only a problem – and therefore only a concern if there is price inflation.
So if the Fed prints all this money and prices don’t rise – we don’t care about that sort of inflation. We are only concerned about whether there is PRICE inflation.
Debt of course is another matter..
It’s not a problem till it is a problem…
capacity utilization / output gap is a complete crock – at least that point was well made….most f-tards focus on this but the economy is a network connected by the supply chain….what happens at the nodes is not nearly so important as what happens in the edges….