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A Bevy of "Flations"


This morning Todd and Fleck had a great back-and-forth on the debate about the current state of inflation (or lack thereof) in the economy and how that might change as a function of the Fed's actions, and the resulting changes in time preferences in the market and prices of certain instruments like the U.S. dollar.

First, it is necessary to make a few points so we're all on the same page. Stagflation is simply simultaneous inflation in some goods and disinflation in others. It is historically associated with rising commodity costs and falling labor costs (read: wages). It is rare, especially in a regime of fiat currency like we have had for the past century, because fiat inflation tends to make its way into the economy in a very diffused way. That is to say, aggressive fiat inflation "affects" all goods and services: foodstuffs, housing, durable goods, wages, healthcare, financial assets, etc. Keynesian macroeconomic theory demands that no product or service can be immune from such forced inflation. That is, such "monetary pumping" (inflation) could NOT result in anything but a generalized inflation in all goods and services.

Of course, they were proven entirely incorrect, as Ludwig von Mises stated they would be decades before the 1970s.

As you already know, inflation and deflation are commonly defined as a general, diffuse, rise in prices of all goods and a general, diffuse decline in the prices of all goods respectively. Stagflation, understood in this context then, is simply a "mix" of the two, with deflationary forces acting in certain sectors of the economy and inflationary forces acting in other sectors.

The Keynesians theory of the impossibility of stagflation was wrong in the 1970s because they believed that credit growth and the resulting spike in economic activity could more than offset any contractionary forces from rising oil prices. Credit inflation causes a boom-bust sequence by creating temporary economic imbalances within certain sectors because of the credit-induced shift in time preferences between spending and investment. The structural imbalances (malinvestment) created via the 1960s credit growth were already there and would have likely resulted in much the same "bust" cycle in the 1970s with or without OPEC; the oil embargo just made things worse.

I have long held the belief that economic periods are highly incomparable even within nations owing to the vastly different structural and cyclical forces that are working at each episode in comparison. In such a complex, evolving system as the U.S. economy, such comparisons are clearly of the apples and oranges type. That said, the point worth making relative to the U.S. economic experience in the 1970s is this: persistent credit inflation distorts time preferences between saving and investment, creating simultaneous and artificial booms and busts in certain sectors of the economy. LBJ's guns and butter policy, prosecuting a war while pursuing "great society" domestic goals (sound familiar?), necessitated such a persistent credit growth policy. [Parenthetically, even a casual perusal of history will illustrate that ALL modern wars have been financed by fiat inflation and not direct taxes precisely because the citizenry would not support such a war if it had "direct" costs. That's one of the reasons governments fund wars via indirect and highly unfair means like currency inflation - by printing money.]

The main point then is that persistent, record credit expansion leads necessarily to distortions within an economy that immediately and temporarily produces either (1) uniform, generalized inflation across all goods and services (inflation) or (2) simultaneous booms and busts in certain sectors of an economy (stagflation). One cannot determine ahead of time based solely on the conditions present in the economy which will immediately and temporarily result: inflation or stagflation.

Note I specifically used the term immediately and temporarily. Austrian business cycle theory holds that ANY credit induced economic cycle will necessarily "boom" at first and then eventually and inevitably "bust" once the reflationary efforts are even slightly diminished.

Importantly, this happens at all degrees of scale. What does that mean? It means that within an economy with a fiat currency regime (and therefore yoked by persistent inflation), there are small, intermediate, and grand cycles of "boom" and "bust" taking place simultaneously. Small cycles of boom and bust taking place over 1-5 years, intermediate cycles of boom and bust taking place over 5-20 years, and grand cycles of boom and bust taking place over 20-60 years. Each has its own "cycle" of peak and trough: with peaks at periods of economic expansion, "boom", and troughs at periods of economic contraction, "bust".

When these booms and busts "align" together; that is, when the small cycle of boom and the intermediate cycle of boom and the grand cycle of boom align in a self-reinforcing orgy of credit-induced "boom", the results can be truly incredible. The Russian economist Kondratieff attempted to study the "grand" part of this cycle (you may have read about the Kondratieff cycle) in the early 1900s. The 1980-2000 period, it is theorized, is just such a grand "alignment" of booms: where the cumulative credit-induced excesses of the last 90+ years produced just such an orgy of credit-induced economic and financial market activity.

Of course, the bust phases of this cycle theory can be just as incredible: witness the great depression, as that is theorized to be a similarly grand alignment of the bust phases of the boom-bust cycle.

All of that explanation of stagflation and boom-busts was necessary to make the following point about current and prospective economic conditions here in the U.S. The record credit creation that the Federal Reserve has engaged in since 1991, and the subsequent increasing aggressiveness in 1997 and 2001, has, despite its expected inflationary effect on prices, instead produced only nominal "inflation".

What does this mean? That the forces of deflation are even more powerful than whatever forces of inflation the Fed can muster to fight it. Why? Because the grand alignment of "boom" phases that produced the 2000 peak in financial market and economic excess has given way to the inevitable bust phase, which has, slowly, been developing since the 2000 peak in the stock market. 4 years hence, those forces are starting to become more and more obvious.

Specifically, (1) the recent correlation between disparate and heretofore uncorrelated asset classes like corporate bonds, stocks, commodities, and currencies. This type of correlation takes place in a deflationary, not an inflation or stagflationary environment. (2) In his recent Humphrey Hawkins testimony, Greenspan stated emphatically that deflation is no longer a worry of the Federal Reserve. (3) Wall Street economists are uniformly worried about inflation (or its variant stagflation) and NOT deflation. (4) The forces of deflation are rampant in industries that are not highly government "regulated" like PCs, software, telecommunications, media, durable goods, clothing, etc. In industries with heavy government regulation, like healthcare, education, insurance, etc., the forces of deflation are not as present.

This last point speaks directly to the "allure" of the stagflation argument. After all, some things are growing more expensive while others less so. Our observation is this: This period of stagflation is entirely temporary as it represents the transition period between the forces of inflation giving way to the forces of deflation over the last 4 years. After all, you know that trends do not move in straight lines. In such a massive regime change between the forces of deflation and inflation, periods of volatility are to be expected. The most important trend however, is toward deflation, so that is where investors, particularly long term investors, should be focused.

How will this deflationary force affect assets? By and large, in a deflation, everything declines in value. Everything. Real estate, stocks, corporate bonds, currencies, commodities. Usually nothing is spared. Having said that, such a grand "alignment" of boom phases has never occurred before 2000, so it was impossible to know just how manic that period would get. The same will be true of the forces now aligning the other way: it will be impossible to know just how manic the environment will get in a deflationary environment. As a result, tactical asset allocation may not be all that helpful from an asset management standpoint.

Either way, when I combine these macroeconomic observations/conclusions with my technical indicators for the various markets, here is the call for each:

Stocks: major degree bear market, well below the 2002 lows.
Corporate Bonds: same.
Commodities: major degree bear market with likelihood that they see new lows beneath the 1999-2001 lows before seeing a new and massive bull market.
Gold/silver: below the 2001 lows and then starting a new and massive bull market that will see prices exceed all-time peaks.
U.S. Treasuries: new bear market started in June 2003; yields will climb above the 2000 peaks at least.
U.S. Dollar: a mean reverting bounce takes the DXY to 98-103 level in the next 12 - 18 months before it fails and starts a massive bear market falling to all-time lows.

You will note that many of these conclusions are unintuitive. And if you got anything from my presentation in Crested Butte, I would hope it is an appreciation for the non-linearity, the "irrationality", of markets. The forces that are driving these various asset markets are not entirely rational. That is why logic-based "intuition" is not always (in fact hardly ever) useful.

So where do I come out on the inflation, stagflation, deflation debate? Squarely on the deflation side. Stagflation is just a cousin that happens to be visiting for the summer.

And Fall is just around the corner.
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