The Case for Deflation and Other Considerations: Part 1

The following is an excellent case for deflation, written by my friend Toastmaster:

http://tradingwithtoastmaster.blogspot.com/2009/07/case-for-deflation-and-other.html

I would like to examine the issue of deflation and its ramifications as I believe it is the greatest and most imminent threat to our economy. The case for deflation is currently not in vogue among ordinary Americans or investment managers for good, albeit misguided, reasons. To everyday Americans, the case for deflation seems abstract and detached from the rising price they have been accustomed to their entire lives. Inflation proponents argue that, at best, we will experience a period of high inflation, and, at worst, suffer from the clutches of hyperinflation. They see high inflation as unavoidable given the amount of liquidity the Federal Reserve and our government have injected through interest rate mechanism, stimulus plans and bailout programs. These Inflationists point to the recent rally in commodity prices as confirmation of their views and have been jumping into the gold and silver trades with both feet. Unfortunately, the inflation argument is deeply flawed as it assumes away an imminent and vibrant recovery, fails to acknowledge that the addition of liquidity has not led to a rise in monetary circulation, ignores the rise in layoffs and wage reductions observed across sectors and the rise is saving rate among Americans.

The matters of inflation and economic depression are not mutually exclusive. You are either a Green Shooter and consequently an Inflationist or a Deflationist Bear. The most prominent evidence Inflationists cite to support their claim of impending inflation is the outrageous amount of liquidity the Federal Reserve has pumped into our financial systems. In general, an increase in liquidity directly leads to a rise in monetary circulation: circulation of new money is what causes inflation, not the creation of new money. Since the subprime fallout of 2007, the Federal Reserve has been injecting liquidity not to spur economic growth, but to keep up the charade that our banks are solvent and lending. Try walking into a local bank today and apply for any type of loan. More often than not, you will walk away disappointed despite your stellar credit score, ability to put up a sizable down payment or relatively low loan-to-asset ratio. Banks are not lending because they are bankrupt by every measure other than perception. They are hoarding the liquidity the Federal Reserve has given them in the event the perceptions of their solvency changes, and they were to face a margin shakedown by their counterparties and fellow banks.

Continued layoffs and wage cuts across industries has put tremendous pressure on our economy with no signs of abating. The great economist John Maynard Keynes once spoke of the paradox of thrift that ultimately leads to a vicious deflationary spiral. The cycle begins with layoffs and wage reduction, which causes a decline in demand for goods and services. This decline in demand then leads to reduction in prices. Unfortunately, not even price cuts can spur demand when people either have no job or are saving out of fear of losing their jobs. With significant decline in sales, existing debt becomes a greater burden to businesses, forcing many more into bankruptcies. A rise in bankruptcy leads to more job losses and, hence, this vicious deflationary cycle begins anew. (See picture below)



Our current economic situation is extremely dire and any Green Shooters delude themselves if they believe the worst is behind us. There are deep issues within our financial systems that have not been resolved because there simply were no good solutions. What is regrettable is the lack of courage of the Federal Reserve and our government to accept that a painful correction was needed to clean out the excesses of decades of easy credit. The question should never have been, what can we do to avoid the Second Great Depression? The question should have always been, what can we do so that we don’t prolong or exacerbate the Depression we were INEVITABLY heading into. Due to the lack of wisdom of our current Fed Chairman to see the current crisis in its proper framework, our country and our children will pay dearly for our mistakes. Intervention has not averted the Second Great Depression as Green Shooters would like to believe: instead, it will magnify and extend the economic nightmare that awaits us.

Despite the strong case for deflation, many proponents of inflation have taken steps to protect themselves from what they believe is an impending crisis of higher prices by piling into precious metals such as gold and silver. In the absence of a new monetary order where the Dollar is abandoned as the world’s reserve currency, precious metal bugs may soon find their beloved commodities free fall in value when P3 begins. Remember, gold is one of the most crowded trades and you generally can not pay for groceries, rents or mortgages in bullion. But if anything, we are in a most interesting time. In The Case for Deflation and Other Considerations: Part 2, I will examine a possible scenario where we experience deflation in real terms, but inflation on a nominal basis due to a collapse in the Dollar. In this outcome, gold and silver will break from its inverse correlation with USD and blast off to new extraordinary levels.