Oil and Water: Deflation Forecasts and $70 Oil

Whatever happened to that deflation spiral, anyway? The deflationists have been mighty quiet lately.

Issuing debt in other nation’s currency, no matter how modest at first, signals a return to a stage of devolution that took the US dollar to the brink of losing reserve currency status in the late 1970s. Investors seem to know this, bidding up the prices of oil and other commodities to hedge the loss of future dollar purchasing power.

The dollar has only ever been about oil; a review of history ends the mystery of how the US has avoided a 1930s style deflation spiral or Japan style liquidity trap. Continuing the 1979 TIME story:

“The central bankers were especially doubtful about the President’s ability to cut US oil imports, a chief cause of the dollar’s weakness. Only last week did Congress step up work on the energy program that Carter presented in July. Overriding objections from environmentalists, the Senate voted to create an Energy Mobilization Board that will be empowered to cut through the federal, state and local regulatory barriers that delay key energy projects. This week the Senate Finance Committee is expected to pass its version of the important windfall profits tax that will finance the new projects. The Senate is likely to approve a tax one-third smaller than the $104 billion House version: President Carter originally demanded a $142 billion tax.

“The urgency for action on the energy program becomes clearer all the time. Brandishing the oil weapon in Belgrade, Saudi Arabia’s Finance Minister Mohammed Ali Abdul Khail warned that continued depreciation of the dollars that the OPEC countries are paid for their oil might very well ‘evoke reactions.’ By that he presumably meant that the OPEC countries might force buyers to pay in a ‘basket’ of many currencies rather than just in dollars; if this were to happen, demand for dollars would decline and they would slide further in value.”

The global monetary system was at the brink.

“Though the greenback strengthened a bit late last week as the markets anticipated new dollar defense moves, worry remains deep about the future of the monetary system that helped create the world’s postwar prosperity. The central problem is the roughly 1 trillion footloose dollars that slosh around banks and currency markets outside the US. For many years during the 1950s and 1960s, Europeans complained about a ‘dollar gap.’ Greenbacks were the only currency that was accepted everywhere, though there were not enough of them around to finance world trade and development. But the dollar gap has since become a dollar glut. Due to heavy foreign spending, first to pay for the Viet Nam War, more recently for oil imports, the US has exported enough dollars in the past decade to boost the reserves held by foreign central banks from $24 billion to $300 billion. Private international banks hold another $600 billion in Eurodollars, which are dollars loaned abroad.”

Today these numbers sound quaint. All this before the US worked out the petrodollar recycling program that saved the day by putting oil producers’ earnings on account at the Fed as reserves. But while crisis was forestalled for 30 years the problem never went away.

“Central banks and private holders are reluctant to accept any more dollars, whose value declines almost daily. OPEC countries in particular are attempting to put new oil earnings into marks, yen or gold. Says Washington Economic Consultant Harald Malmgren: ‘The Arabs have learned that they pump oil out of the sand, hold the dollars, and the dollars turn back to sand.’ Nervous central bankers also fear that dollar holders will suddenly try to move large funds into another currency or into gold. Warns Karl Otto Pohl, president-designate of the German Bundesbank: ‘If this mass of dollars ever begins to crumble, it could start an avalanche that would bury all other currencies.’”

The avalanche did not happen. Yet. But imagine three years from now the following report, perhaps in TIME Magazine:

“The ‘foreign moneymen’ worry about the Obama Administration’s resolve to hold down inflation at the cost of higher unemployment as the 2010 mid-term elections pick up steam. They found fresh reason for skepticism this week: it was revealed that to get the banks to join in the Obama re-inflation program, the Administration agreed not to try to penalize any violators of the bank stress test guidelines. Geithner attempted to soothe his colleagues in China by promising that the Administration would ‘stay the course’ in maintaining a strong dollar, but doubt remained. Said one Chinese official: ‘The problem is Obama’s chaotic leadership.’”

Or something like that. Whether we see high, moderate, or modest inflation from here, a question we dig deeply into in Part II of this essay, one fact is certain, throughout the crash we did not nor were we ever in danger of falling into a deflationary spiral. Everyone who made that call can officially throw in the towel.


We have delayed our re-distribution of part of our gold and Treasuries barbell portfolio until we see one of these Fed crashes in action as it attempts to raise interest rates without raising interest rates. Key measures we keep an eye on:

1. Yield curve
2. Unemployment
3. Dollar
4. Commodities
5. Oil
6. Housing
7. Personal Consumption Expenditures
8. Freight Rail Traffic
9. Bank solvency

Staying in gold and Treasuries since 2001 has yielded us approximately 7.4% compound annual returns with zero transaction costs or management fees with no draw down. As the first rule of iTulip is do not harm, and taking a trade minimalist stance, we approach any changes to this position with care.

We have been doing diligence on energy, and oil in particular. We are convinced that the markets have another big crash in the wings, as the Fed experiments with ways to reverse its creative anti-deflation policies in an environment of fiscal stimulus/deficit spending fueled economic growth, and that the rally off March 2009 lows has been driven first by technicals, then by sentiment, and most recently by funds who cannot be seen by their clients sitting in the dust behind funds that got into the rally early.

But as we demonstrate in Part II, there is no fundamental justification for a rally of this magnitude, and nothing to sustain it beyond a widespread fear of not being in it. Not one politically difficult major root cause of the crisis has been addressed, and many new crises set in motion by the collapse or before are about to arrive.

While we read about U and V and L shaped recoveries, we had to go to Russia’s Cryllic alphabet for the “Ч” to find a letter shaped like the outcome we see for the end of the FIRE Economy, a crash, a rebound, and a long decline—unless current policies change.

Click here to read part I & II of Eric Janszen’s “The Cheh Shaped Recovery.”