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Minyan Mailbag: Inflation vs Deflation



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this exchange between two worthy Minyans with that very intent.

Dear Prof. Reamer,

The issue of inflation vs. deflation has been something that I have studied for two years now. In the process, I have had to learn Austrian economics, Keynesian economics, Monetarism and finally, Technical Analysis (in the form of basic TA as well as EWT). While I cannot say I have reached a conclusion that I am willing to defend, I am extremely well versed with the issues in question. With that as a backdrop, let me point out the following: The U.S. has undoubtedly run huge current account and fiscal deficits, and the Asians (Japan, China) have a huge amount of dollar reserves. Most people claim that IF they were to a)stop soaking up our reserves or b) start selling them, interest rates would go through the roof. This is then assumed to imply that the U.S. would go into a deep deflation as the indebted economy would be unable to handle the higher interest rates that are so imposed on it. And I must agree, the theory has intuitive appeal, and makes a lot of sense. Thus, it would appear that deflation is in our future.

The impact of this scenario on the dollar, and on commodities is not as easy to analyze. Depending on the nature of the deflation, I can "analyze" them going either way, and we can talk about it in the future.

What is more interesting to me, however, is a possibility that is less discussed. And that is, that the Asians do *not* sell their dollar (bond) holdings. Rather, as has been seen recently, they TRADE them. What I mean is that they exchange USD debt, for USD assets. What assets? How about Unocal. Newmont. Phelps Dodge. Basically commodities. In fact, they could gobble up the largest producers of commodities with their USD holdings with some left over to have dinner.

What would this lead to?

a) Commodity asset prices would literally go through the roof.

b) Similar to the 70's, given the sale of the bonds, U.S. rates would go higher (or, as Prof Antal Fekete says, you would enter the hyper-oscillator).

c) The impact on the dollar would again be uncertain. Exchange of USD debt for USD assets would be dollar-neutral at the first level. Yes, there would be second order effects, but they are uncertain (attractive assets, vs. unattractive debt, with excess flows determining the likely impact on the dollar).

The net impact of this second scenario would be twofold: higher rates could result in an economic depression, but the massive amounts of dollars dumped into the hands of owners of commodity assets could create rampant asset price inflation in these sectors.

The net impact: stagflation, with a fractured society of haves and have nots. More importantly, it would be the same as a farmer having gone from tilling his land, to having borrowed to drink too much wine, and then having to repay his loans by giving up his land and becoming a "employee"/"slave".

I have studied Robert Prechter's theory of deflation in excruciating detail. I must confess that it has intuitive merit. However, I suspect that the timing is off. My guess is that the deflation might occur AFTER the above hyperinflation (which, by the way, is the prediction of Austrian economics). The only way I can see deflation happening first is China blowing up badly (akin to the U.S. in the 1930's). I have yet to think through WHAT could be done to avoid deflation in that scenario, and that is my next avenue of study.

Just thought of bouncing the above thoughts off of you to see if I'm missing any links in my thought chain.

Minyan AA

Minyan AA,

I am glad that you have done so much work on this very important issue. Bravo. There are many schools of thought on it, as you are now aware, so while I cannot proclaim any specific insight that isn't already embedded in the several schools of thought surrounding the issue, let me make a few points that I think are central.

First, do not forget that deflation affects all things: goods, services, AND assets. What it represents is the desire to lower risk, to move down the risk spectrum (away from stocks and corp bonds and toward shorter duration and higher quality assets).

Second, that deflation at its heart is very much a psychological phenomenon (in fact, if you have been reading my stuff on behavioral economic theorists, you know that irrational behaviors play a central role in determining why economic actors do what they do). You are probably aware of the Kondratieff cycle. This is the manifestation of the psychological forces at work that create long regimes of inflation (risk taking) and deflation (risk aversion).

The creation of massive amounts of credit in the world over the last 25 years is a phenomenon that illustrates the desire to take on risk, to change one's time preferences, to go from saving and investment to spending and consumption. This credit will, as sure as night follows day, contract. And what that implies for the U.S., for the world, is deflation.

The only question then is what assets deflate first, and which deflate later. There is no question (in my mind) that they all will. In my humble opinion, risky assets that were particular beneficiaries of the previous credit creation (stocks, corp bonds, homes, etc.) will see their value deflate seriously. In this deflation you might well see a rush to safer investments with some of the remaining cash generated from selling assets that are going down in price. The beneficiary of this could well be U.S. Treasury debt, owing to its perception - perception - that it is risk free. So as other more risky assets are deflating, you could see, for a few years, less risky assets benefit substantially from a desire to 'switch' into these instruments.

You specifically noted the switch from USD denominated assets to commodities. Despite what you might believe, this is a widely held view on the Street. Indeed, it has become one of the central bullish reasons for owning these stocks and the underlying commodities. The upward movement in this sector from 2000 to present reflects this theme, and reflects it well. Could it have even more benefit on the prices of this sector and cause further inflation in input prices? Sure, but I think the massive size of the credit that has been created, and the inevitable unwinding of that credit and its deflationary impacts, will swamp any inflation benefit that commodities will receive as folks switch out of their U.S. dollars. (Keep in mind that I am highly bullish the USD for the next year at least. After a counter-trend bounce ends however, then the USD will likely fall precipitously).

Hope those thoughts help supplement the already extensive work on this subject you have already completed.


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