Hyperinflation or Deflation?

Hong Kong, China

At present, the investment community is divided as to whether the world economy faces
hyperinflation or deflation. Some observers are convinced that the central banks’ printing
press will take the world towards hyperinflation whereas others believe that the ongoing
contraction in American private-sector debt will result in outright deflation. So, what will
the future bring?

It is my contention that we will get neither hyperinflation nor deflation.

What is more likely is that over the coming months, we will get another deflationary
scare. Any sell-off in the markets later this year will be met by an even larger stimulus
from the policymakers and this will ultimately result in high inflation.

So, I maintain my view that due to the unprecedented policy responses around the globe,
the world’s economy will face high inflation over the medium to long-term. And the
general price level will double over the coming decade.

In the near-term however, we will probably get another period when the market will
(once again) become concerned about the prospects of a lengthy economic contraction. It
is conceivable that the ‘green shoots’ hype currently doing the rounds will soon be
replaced by more economic worries as a second wave of foreclosures hits America
later this year. So, it is possible that before year-end, we will witness large corrections in
stocks and commodities. Conversely, we are likely to see big rallies in U.S. government
bonds, U.S. Dollar and Japanese Yen.

This near-term vulnerability in the markets is the reason why I have recently liquidated
my ‘long’ positions in resources and emerging markets and gained a heavy exposure to
long dated U.S. Treasuries. In my view, a defensive investment stance is prudent at this
juncture, as it will protect our capital and allow profit from the expected contraction.
Once the pullback in the markets is complete, I will liquidate my positions in U.S.
Treasuries and re-invest our capital in our preferred holdings in energy, materials, mining
and emerging Asia.

Look. In the business of investing, the tape never lies and it is worth remembering that
Wall Street is littered with the graves of those who got married to one particular outcome
and then held on to their ill-conceived notions. At this point, when private-sector debt
contraction in America is locking horns with central bank inflation, I prefer to have an
open mind. Therefore, I am maintaining a defensive near-term investment position. If the
market corrects over the following weeks, I will be in a position to profit from such a
decline. On the other hand, if the major indices simply consolidate here and break above
the recovery highs recorded last month, then I will have no hesitation in changing my
defensive investment position. Put simply, I am currently watching and waiting
patiently for the market to reveal its hand.

“In the business of investing, the tape never lies and it is worth remembering that Wall Street is littered with the graves of those who got married to one particular outcome and then held on to their ill-conceived notions.”

Coming back to the subject of this essay, the reason that I don’t foresee immediate
hyperinflation is because the velocity of money is currently weak. In other words, at least
for the moment, the private sector in America isn’t participating in Mr. Bernanke’s
inflation agenda. Despite the fact that Mr. Bernanke has injected a massive amount of
reserves in the banking sector, this money is currently sitting as excess reserves within
the American banking system. The fact that this money isn’t being lent out rules out
immediate hyperinflation. However, once the American economy stabilizes and the
velocity of money picks up, these excess reserves will trigger a massive inflationary

As far as deflation is concerned, I am of the view that the policy responses and our fiat-
money system will ensure that the purchasing power of cash will continue to
diminish over the medium to long-term. In fact, I am willing to bet that cash will
probably be the worst performing ‘asset’ over the coming decade. Remember, in today’s
monetary system, central banks and governments the world over are free to create money
out of thin air and this will prevent outright deflation in the global economy.

It is worth noting that in the past six months alone, China’s commercial bank credit has
expanded by a whopping US$1 trillion! Figure 1 highlights the surge in Chinese bank
lending. Furthermore, credit is also expanding frantically in other Asian nations. So,
contrary to the West, monetary policy is still alive and well in the developing nations and
this factor also rules out outright deflation in the global economy.

Figure 1: Explosion in China’s bank credit


Source: Bank of China

In my opinion, rather than hyperinflation or outright deflation, we will witness elevated
inflation after the American economy has stabilized. In the interim however, investors
should be prepared for another deflationary scare and the associated market panic.


Puru Saxena
for The Daily Reckoning

The Daily Reckoning