Good article.

I have a classic car, that I am always trying to keep in top shape (there's a debate over whether it's just old or whether it will be a true classic of value).

So I know my local parts dealer on a first name basis (a good dealer can find you anything you need-still talking car parts/service).

He told be commercial orders have dropped off in a very large way (people/businesses are deferring service). Also people are now coming in for the first time to the front desk, and asking how to fix cars, and they don't know how.

All of this further points to the fact that people don't have money or credit to spend. No need to worry about inflation, for now.

?

I agree deflation will occur. What will be the government's reaction when debt service becomes a problem?

Bernanke and Congress will drop money everywhere--as you point out, people will take that money and pay down debt or put it into savings.
Great for the USA, bad for the Washington kleptocrats.

This article contained a fascinating thought, that it is the economic elites that benefit from inflation, but suffer from deflation.

I would really like to know why this would be. It makes sense if the wealthy's assets are largely in properties such as stocks, real estate, fine art paintings, etc. But aren't they also holders of government paper, such as T bills and muni's? Is there any support for the thought that their deflating properties substantially outweigh the stuff that will retain (or at least we can hope) its value, and disproportionately so, relative to the not-so-rich?

I understand your argument, but I don't agree with the last couple of paragraphs that stray from economics to sociology/politics.

It seems to me that the economic elites will in fact benefit from deflation. By and large, that 2-3% will have little or no debt, and while they may be losing money on paper, their relative purchasing power may in fact be increasing. Whereas the the middle 50% may really suffer as their houses devalue and their fixed monthly utilities, food, and mortgage payment are more expensive in real dollars.

The bigger danger to the elites, IMO, is in fact the hyperinflation scenario.

Comments?

Kevin,

Where does the dollar fit in your view on deflation? While the dollar is considered attractive now for various reasons, what will happen to the reserve currency of the world as deflation plays out?

I completely agree with all said...but what is not said is that I think that Government can still find a way to spend us into inflation.

A few trillion in new spending over the next few years could tip the balance into the inflationary side. Government will always overshoot, so once they spend just enough to get us reflated, they will double down and reflate us to where no country has gone before, just in time to crash the dollar as no other country will purchase our debt.

I may be wrong, but it will be both scary and fascinating to watch whatever happens.

-Additionally, in order for hyperinflation to even be a remote possibility here there would have to be at least one economy that is both, stronger than the weakest.S. economic downturn, and larger in size that the state of Ohio's or even California's economy. -

The means and the motive, indeed.

But IF the government begins engaging certain redistributive economics, as well as potential give-aways, there is the threat of monetization of debt in order to pay for it all.

This, if not handled properly (and it usually isn't), would naturally lead to hyperinflation - exactly like the Weimar Republic, which monetized its WWI debt in order to pay it off in cheaper Marks. It's a cycle of disaster.

It's possible that the government can SPEND all this money to shore up the economy, then hold the line on further spending while it replenishes its coffers...thereby paying down the debt. Certainly, debt as a % of the total economy has been much higher before (after WWII) and we didn't have to monetize.

However, it's a tasty solution to an intractable problem. Can you monetize only a small portion? Would that create a hue and cry over winners and losers (undoubtedly).

Sure, in a STANDARD economic model, deflation is the likeliest scenario. I believe the new government is going to pursue anything BUT standard economic solutions.

Great question. I'd also like to know Prof. DePew's opinion on this. Maybe he meant that although inflation is "always and everywhere a monetary phenomenon", the effects of running the printing presses will not result be experienced as inflationary until some point in the distant future...?

Yea, consumers willing/able to take on more debt, but the government sure as heck is. Bad private debt is being nationalized into bad government instead of being written off. Of course, our entire economy is based on our ability to spend money and sell assets at higher and higher prices to one another, so if we cannot take on debt, we have a collapse. There in lies the government. The spender of last resort. The consumer with no credit limit. When the treasury/bond bubble bursts from an absolute glut of supply, look out. No doubt we're seeing some substantial deflation, but I don't think it will last.

^aren't able/willing

I understand that in normal times, gov't pumping money into the system is inflationary. But currently we have debt and wealth being destroyed. Perhaps the money being pumped into the system is offseting money that is being destroyed. It may be a fine balance between inflation and deflation but it would seem that with wealth being destroyed there is a little chance of hyperinflation.

Hey, let me know when your realestate taxes go down, and college tuition goes down, and Dr bills go down...

It seems to me that the federal government will soon be paying for the boomers medicare and social security by mailing out more money then they will be collecting from the taxes on the worker bees.
Surely this is inflationary.

Yes, there is significant deflation right now. Your money will buy a whole lot more than it did last year. So far, it is mostly asset deflation - but that includes equities of all sorts, commodities and any debt not absolutely dollar good. Prices for goods and services are beginning to decline. As discretionary spending contracts, discretionary goods and services go on sale. Prices for non-discretionary spending will decline as the perceived value and competition for money goes up. The economy will re-orient itself to provide more of whatever is considered non-discretionary and supply will increase.

Kevin supposes this deflation will not end short of a complete bust, and only then will inflation become possible.

Maybe, but Ben Bernanke, for one, thinks it is a political, rather than, an economic question. He believes he has the means to inflate. The Weimar Republic, after all, did happen. I'm not willing to bet everything on the inability of a desperate government to cause inflation. Things would be quite simple if deflation were an absolute certainty. We'd all know just what to do. But...

I'm behaving as though deflation is here and continuing, but I am watching the political landscape.

Kev,

The relationship between inflation and income inequality actually has been quite inverse since 1970:

GINI Ave.
     Annual
Inflation
1970: 39.4
1980: 40.3 7.8%
1990: 42.8 4.7%
2000: 46.2 2.8%
2007: 46.3 2.7%

Takeaways:

* The middle class did fine hanging on to its share of the economic pie in the inflationary '70s. Wealthy bondholders got creamed. Middle class homeowners saw the value of their homes rise dramatically. COLAs in union contracts kept blue collar workers whole.

* As the inflation rate began to decline in the '80s, the middle class began losing serious ground.

* When the CPI fell below 3% in the '90s, the Million Dollar Bonus Babies on Wall Street were able to *really* put the hammer down.

In the current deflationary spiral, the rich will catch a cold, the portion of the middle class that manages to remain employed will get the flu, and the jobless and poor will get pneumonia.

Wayne

Kevin,

I am confused by your position. There is someone willing to assume massive debts. That the USD will continue to remain strong no matter the amount of dollar printing and US government debt issuance does not make any sense. Somebody eventually has to take our government credit card away. How does that loop get closed? Perhaps this is not hyperinflation but just major devaluation against hard assets like commodities? Could you explain the difference?

A couple of weeks ago the Genuine Parts (GPC) conference call confirmed this exactly, except that they said activity was starting to return in October. Auto maintenance can't be postponed indefinitely.

No. Money velocity is.

The basic argument is that even if government zeros out the cost of capital people may still refuse to spend. But the government doesn't need the people to spend the money. It can cut out the middleman and spend the money itself -- on public works projects as it did in the '30s. The multiplier effect of public works, though, is much lower. More money is wasted, but some economic activity does occur.

The Treasury (as opposed to the Fed) has never successfully primed the pump, but it has flushed the toilet plenty. And it never giggles the handle.

In order to understand hyper-inflation versus deflation, I suggest that someone kindly analyze the historical examples:

Hyper-inflation:
Weimar Republic—what caused the hyper-inflation? What economic steps did the government take? What was the mechanism by which so much money entered the economy? Argentina—same questions re hyper-inflation

Deflation:
Japan in the 1990s—what caused the deflation? Why did the massive government spending on public works not cause inflation? US in the 1930s—same questions.

Wartime economies—generally, economies during large wars suffer inflation. For example, Germany during WW II, or the Confederacy during the US Civil War. Major wars are also periods of extremely high government spending. Why does major war spending seem to cause inflation whereas public works spending does not (at least it appears this way)? If we imagine a world of massive government borrowing for public works, we see no inflation in the Japanese example, but perhaps inflation in the war-time examples. I don't know why.

Of course, any historical period is complex as it involves issues of trade, currencies, local monetary policy, government spending and taxation changes, and effects from prior historical periods. I don't have the answers, but maybe somebody does.

Perhaps I am also ignorant on the following issue—but is there not a difference between debt and money? We are so used to treating debt, such at T-bills as money that we fail to see the difference. A dollar bill is not a debt. It is simply the paper that is used to measure exchange rates between market goods and services. It pays no interest and the issuer can not be forced to exchange anything for it (versus a debt instrument). Increased amounts of paper dollars would be inflationary, even in a world of zero debt, since the increased supply of paper dollars would be exchanged for a non-increased amount of goods and services. A loaf of bread would still cost the same amount of copper, but each would have a larger price in paper dollars. On the other hand, increased amounts of debt might or might not be inflationary, as they depend, as Kevin points, out on the demand for debt.

Another difference between debt and currency is that debt is linked to time. Because debt requires the payment of interest by a time certain it must be used to buy something that increases in value or it will have to be paid back from some other source. The clock ticks relentlessly against all debt. Failure to pay interest will result in default and forced sales of assets. This does not happen with currency. A massive failure to find assets sufficient to pay the interest will tend to be deflationary. Falling asset values and debt failures are linked.

If government debt is used to increase the supply of factories that produce consumer goods then we would have deflation, but if government debt is used to increase the amount of consumption (for example, tax rebates) then we might have inflation. Marxist economists used to explain large war spending as inflationary in that more workers are employed making war goods and receive their salaries in currency, yet there are less consumption goods available to be purchased as the goods are war materials which are not available for the public to buy. Therefore, there is increased consumer demand, and lower supply of consumer goods. A government could cause inflation by increasing the supply of currency to consumers.

What is the relationship between stock market prices, which are supposed to represent the value of the assets owned, and inflation and deflation? I once read that the worst US stock market year was 1932 and the best year ever was 1933 (I might be off by one year on this). Yet, shouldn't stock prices go down and stay down during deflation? If stock markets would go down during deflation then wouldn't we all become rich by simply shorting every stock market in incremental bets until the last bet failed to pay off once the markets stopped going down?

If anyone knows the answers to these questions please let me know. Sorry for the long post, but this has been on my mind for some time. Thanks! Bill

There are two phases of life and they sort of blur into each other. There is the dependence phase (sort of the debt phase) and there is the independence phase (sort of the credit phase). And you can map it out in a kind of bell curve whereby independence as a whole is compared to the 'time' as a whole. We understand this quite well as for when we are kids we need help and then we get to be 21 and can buy our first car and we can go anywhere. Then as you age, and you lose your coordination and soil your pants well there you go again, back to being dependent.
If you really think about it, this little bell curve blip is sort of a only a moment that, even as it rises, cannot be sustained for the limits must be met. And if you look at the world's western population as a whole, as well as many of the world's powers, they are all aging rapidly while there is no real mass of people coming after them that has any inherent interest in taking care of them as they age other than their families which are aging also. This too is approaching a kind of world wide 'dependence' phase where there are debts to be paid to those who take care of them.

Economists are so enamored with monetary policy, as if everything can be understood on paper and in number form. but they simply have no idea that all monetary policy is only tautological thought in that it is not something that has truth, only a means to measure something that is, in the end, immeasurable.

I think hyperinflation must occur with an upswing of independence where you have a mass of people wanting to be more independent than others, for that is what money buys you, a temporary freedom from dependence and want. But once that curve goes down into the dependence phase well money cannot buy what is really needed- those who can help you change your pants and wipe your butt. Without that kind of wealth well money becomes almost meaningless. This kind of wealth cannot be bought.

As a physician I have watched this whole scenario play out over the last 20 years. People go from independence to dependence and money almost begins to become meaningless, well as it should, for it is not a true indicator of wealth. Those that have loved ones are the ones who have true wealth. They get taken care of. Those that felt they were better than others and that everything can be bought with cash well they go into a kind of shock that has no end. They begin to realize just how poor they really are for the only way you really can stomach cleaning someone's backside is if you really care for human beings. There is no amount and I mean no amount of money that can make someone do that.

And maybe that is the answer to whether we are entering into a period of hyperinflation or deflation. I think it is going to be deflation in regards to the loss of the industries of independence- need for cars and big houses and big commerce and big debt to a kind of world of dependence where what will matter is whether we will be a society that takes care of our elderly. All the pharmaceuticals in the world mean little once you need help just getting through the day and the night

I will tell you I have little hope for a good ending for our generation has gotten so enamored with money as a true measure of wealth and we have forgotten what wealth really is- a life that sees great happiness in caring for others. I just went to a medical leadership conference where a lawyer gave us all the legal nightmares that occur in medicine. His message is one that has meaning for most of us- loyalty cannot be bought. Nor can good will and we have a tremendous lack of good will right now.

The one writer above is right when he is noticing that the costs of dependence as seen in our property taxes are going through the roof. And it is caused by a society that felt that any dollar they make was all theirs and there was no need to think of the folks who need help. They are always there and they are going to increase exponentially in the next few years and there will be a huge increase in the taxes of dependence until it collapses for it is being put entirely on the backs of the middle class. No one else pays taxes, just the middle class.

At the end of the meeting I turned to a colleague of mine and I said, "Boy we are going to have so much business in the next few years but where are the nurses and the families who are going to help us?"
He said, "That is when I am getting out of this mess..."

The problem is much bigger than inflation or deflation. It is a misunderstanding of wealth...

You said, "Present economic elites benefit from inflation and suffer terribly in deflation."

I think you need to elaborate on this thought. If inflation is the debtor's friend, then it follows that it must be the creditor's enemy. If we assume that "economic elites" are creditors, then how do they suffer terribly in a deflationary environment?

Thank you both for unusally thoughtful and lucid comments. I have often tried to express similar points of view, but have not been able to complete it. Now I will try again. A PhD in economics or other high level advisor/Pundit can not let his many years of education and expirience be reduced to simple grade school type equations, but here it is:
Economy = Productivity
What's Happened is that the total economy needs to represent the requirements of the society it represents. A responsible government should see to this end. Ours' has not. Included in the economy is monetary enrichment and more of the good life, but the social costs required to support a society have been totally neglegted. Social costs include infrastructure, national defense,
social security, medical care, crime prevention and other such items needed to run a society. One glaring measurement of this is the increase in the Federal debt ceiling as the Gov. tries to meet these costs without an increase in the other side of the equation.
Now to the productivity side. The productive side of the economy ncludes goods and services for profit. This is fine, but the cost of the goods and services needs to include labor, materials, overhead, social cost contribution, and profit. A glaring measurement of this is the ever increasing trade deficit as imports are cheap because they don"t pay any social costs or taxes needed to fund our social costs.
Now back to the equation versus what we have achieved: Economy minus unfunded social costs = productivity plus debt. Someone else can work up the ramifications, but we are past any tipping point and are in full crisis mode, as social/economic policies of the past are blowing up as we speak. We have an ineffective government afraid to make the corrections necessary to renew our economy under the mistaken assumption that the populace can not take the pain of correction. We can and would to save our country, but not to save our government.

Andrew, I can see you being in healthcare and dealing with people at their most vulnerable has given you some insights into the truth of it all.

I think we're all figuring out that we won't have the discretionary money that we used to, but we knew this wasn't sustainable in our heart of hearts. For the rest of the world to catch up to our profligate standard of living (and waste) would take 8 planet earths! The rest of the world is trying to "modernize" and so say goodbye to 4% of the world (US) using 25% of the resources.

And now the panic has set in that the glory days might not return, and some are already poo-pooing Obama zero days into office saying "he'll never turn the ship around." Destination is definitely unknown. Obama won't make that comeback. Don't you see, in terms of almost any measure we had the riches of kings - virtually unlimited good nutrious food (if you buy it yourself), amazing shelter, and the freedom of leisure (we weren't all slaves to our jobs, although we may have acted like it). This is unprecedented in the history of man on this scale. Many, many people elsewhere wake up every morning and spend 1hr just to get access to clean water.

America needs a slap in the face (as a collective). We're not going back to the glory days and we shouldn't. The new reality will be more sober, we won't be able to buy as much Chinese junk (and you know it is frivolous when you have to sell the stuff on image, and "brand coolness"). We won't be replacing our automobiles and homes as frequently. Sigh.

There is one area where we still have not caught up, to "the Riches of Kings" ---> Healthcare. It can no longer be seen as a discretionary expense that big brother shouldn't touch, it is a right, it is an urgent priority for the nation. It may be like going to the moon, but it is catchup. That will elevate our collective standard of living to the top, and simulateously keep our society from breaking down on a mass scale. For those republicans in the house, yes this one will require the government because on critical services like healthcare absolute free markets are more expensive. The forces of competition and little leverage by patients make costs go up, while service provided goes down. (hopefully nobody will bring up the inane response "you don't want the gov. telling you which doctor to go to" and government involvement doesn't mean a single employer)

And the secret here is this: the new destination for America will be much better - should Obama really apply himself to this and not be a shrill for the same powerbrokers as always. It could be - a more engaged society, a healthier society, perhaps - if national service becomes a reality - a more purposeful and humane society. A much wealthier society all considered.

I too can find arguments for either inflation or deflation.

For example, what would happen if the government simply raised the minimum wage to say $30/hour? Wouldn't this lead to hyperinflation?

As this trickled up the economic ladder wouldn't this eliminate the need for foreclosures and the reduction in housing prices?

Wouldn't this also cause the dollar to be further devalued and the price of oil to soar?

Doesn't hyperinflation ultimately lead to depression as the buying power of consumers is eroded away and businesses downsize and shut down due to lack of sales?

Could it also be that whether a country experiences deflation or inflation says more about their culture than their monetary policy?

The Japanese are culturally conservative and savers. I haven't heard this said about Americans for a very long time.

Last thought/question...doesn't the inflationary scenario ultimately lead to war or revolution and a new currency?

I hope we can continue this discussion until some clarity is reached.

But effectively if velocity is so flexible, then monetarism really is dead. If any increase in the money supply can just be neutralized by a decrease in velocity, then there is no hard relationship between money supply and nominal GDP or money supply and inflation. In other words, monetarism isn't valid.

My own view is that the banks will gradually start to lend again rather than de-leveraging (i.e. hoarding cash, which essentially increases their capital ratios), so that the Fed-led expansion of the money supply will translate into inflation. By inflation, of course, I mean a generalized increase in the price of goods and services -- I am not talking about asset prices here.

The banks are really the problem here, I think. You can bail them out with Fed money, but apparently you can't make them lend. Or at least they didn't attach those kind of strings when they injected the capital. Perhaps the new administration will begin to attach such strings, or use "moral suasion" to increase the level of lending.

One misconception that seems quite widespread here is that this asset price collapse is somehow deflationary in the sense that it results in money-supply contraction. It doesn't, of course, or at least not directly (only by making the banks less willing to lend). We need to distinguish between deflation in the conventional sense (a generalized decrease in the price of goods and services) and asset value deflation, which is really a whole different animal.

In the 70's mortgage rates were in the double digits - 16% if I remember right. Imagine having captial and being able to get a 16% return and forfeiture rights, woo-hoo! If you don't have money to lend but are the borrower you're screwed.

If you have now have capital but loan rates are 6% you're not going to make nearly as much money, and if the populace has an aversion to taking on debt or giving you their money (it's in the mattress, not your bank) you don't have as much capital to speculate with.

My two cents...

Oh yeah, if I owe someone with money $100,000 but inflation is high and my wages go up with along with prices; the value of my debt obligation goes down for the lender. If they lent me the money at 6% and inflation is 10% they are on the losing side long term. With every passing year my debt shrinks compared to earnings and the "value" of my dollar. Think of someone on the 15th year of their fixed rate mortgage paying off the $40,000 at 8% but their salary has gone from $25,000 to $70,000.

I have a suspicion that some of the reason ARM's were pushed was that money would be made on the equity of defaults, however, too much debt and too many defaults unwound the whole proposition (oops).

"In the current deflationary spiral, the rich will catch a cold, the portion of the middle class that manages to remain employed will get the flu, and the jobless and poor will get pneumonia."

I would add..."and then the riots will start"

Inflation or deflation, if the rights of the individual are not protected, investment and spending will contract and we will have a Weimar Republic nightmare or revolt against confiscatory taxes and social policy.

As taught in Econ 101 inflation is defined as too many dollars chasing too few products. In 1973 you could go up the road to Cummins engine and get a job out of high school for $50/hour (in today's dollars). At that time the world was not nearly as productive (no robots, computers, etc.). Too many consumer dollars chasing too few products.
I started a small business in 1981 (veterinary clinic) with a 14% mortgage and 20% down. My customers had money to spend and not much debt. Over the year I've seen my own 5 things occur:
1. Wages decrease
2. Consumers with much more debt (living paycheck to paycheck)
3. Increase in world productivity. (Over supply of products)
4. Plant closings and loss of good paying jobs.
5. Demographic changes (We baby boomers are getting older and our spending habits will naturally decrease, except maybe for health care).

All this adds up to deflation: too few dollars chasing too many products!

It's sad to see the government getting the banks all dressed up for the party when the party is over ( at least for the American consumer). As a small business person I need a customer with cash in their pocket, not another loan (MORE debt- personal or national). Inflation will not return until the consumer has too many dollars chasing too few products!!

Politics is an amazing game where you almost have a circular argument as the ruling entity- that it is the opposition that has screwed everything up, and 'we' the other side will fix it. This is how the Donkeys fight the Elephants and visa versa. But in the end I am not sure if they really see that the problem is not the other side but the essence of the argument itself- what is the purpose of life, of commerce, of government? Is simply taking a look at numbers from a monetary (big numbers) and psychological (big words) point of view the right way to solve the problem?
I run into this in my own field when I try to explain the complexity of what coma means. It is very complicated and you can get lost in the details but often miss the entire fundamental picture. The more you think you know the less you really understand it....it is not just a description nor is it an EEG pattern. It involves the cerebral hemispheres and the brain stem and the multiple neuronal pathways and the metabolism of the body and the distant organs as well as hormones and electrolytes and white blood cells etc etc etc.... yet there are so may people who want an easy answer to solving this 'health care' problem..... and then we have those bankers who also want to see things in terms of numbers and psychology.....
I read a book in August about the Federal Reserve by a guy from Lehman Brothers. Very well written, and very informative.... but the book made me lose some confidence in these folks for he said that essentially all of these guys view monetary policy as "psychologists view the mind". And, ladies and gentlemen, that should frighten all of us to the extreme for psychologists are as baffled by the mind as any of us, even if they have no idea that they are. For as in the mind, as in coma, as in monetary policy, it is not all just about numbers, definitions, and psycho-philosophy. The market shares much with the brain in that there are folks who think they got it down .... but such a thought is why everyone, from business to politicians to the American people are 'shocked' how what they thought should work, is simply not following the script. Thus something is wrong with our means of discovery for we so easily delude ourselves into thinking we are smart and bright... when the results give another entirely different answer.
For example ...This bailout stilll cocerns me in that our leaders so easily gave away $700,000,000,000.00 in a matter of weeks and now they are all trying to backpedal from it. And all I hear about new revenue is a rise in those who make say $388,000.00 and that there will be an extra 20 or so grand a year they have to pony up. Well if there are 10 million or so folks who pay that, it adds up to 200 billion dollars, so who pays for the other 500 billion? Well maybe that is where psychology plays a part and we can just put it into our nightmares and only deal with it in our sleep. I know people out there will tell me that this is an 'investment' in our banks. And if we (the upper middle class)must pay part of this bill we do want to hope it does not go into a black hole. Perhaps they will give me psychological comfort that they know what they are doing.
And now everyone is going to want a solution to 'health care'. This has been my lifelong field and even I have little idea what this means anymore than I really understand coma in terms that are something beyond descriptive. These terms have a way of becoming Frankenstinian for we lack understanding in what health care means...
... so to me as i try to determine if I should buy gold or bonds I feel like I am back trying to teach that falling into coma can come either from a hyperkinetic delerious state or a hypokinetic encephalopathy. (Kevin is great at discussing this idea for a drunk can die either from too much alcohol or from the withdrawal phase... either way you are dead!)

And that is my worry. What is going to keep us alive and healthy. Inflation or deflation in an aging society will kill many many people. What can we do about stopping this and how do we get both parties to see the danger? This is the best country in the world. If it fails it will be like a heart attack to the world. yes we have been lazy and selfish but we still can get ourselves out of this. I think it will come from Minyanville before anyplace else for this is a community of smart and good people... well that is my hope :) I like being a doc and being middle class and I want what I do to have meaning for everyone.... money in the end won't help me....

correction of my error
we may be in danger of proceeding to coma, not just having a heart attack as the bankers said.... our problem is not in our words or our numbers but in our thinking like alcoholics.... it is the personality that matters and the desires and thus the substance of choice simply gets us there...
we need an AA for our economy and perhaps for our society.... inebriation is a great way to numb oneself from truth and it often never lets truth in ...ever.... and the drunk dies...

OK; say we buy the argument that we're headed for deflation (I especially appreciate Mr. StClair's analysis - too few dollars chasing too many goods).

So here's the $64 trillion question: How does one invest in a deflationary economy?

Most pressingly for me: what should I do with my TIPS? I would imagine that "inflation-protected anything" would become worthless in such an environment.

It is well known that no one can help an alcoholic until they are willing to be helped...usually when they have hit bottom.

The American people need to hit bottom before they will be willing to learn the necessary lessons which I believe means experiencing a long, painful depression.

There are indeed many smart and good people in this country but unfortunately even the best people aren't immune to addiction.

Even this new administration, which I believe is smart and well-intentioned, seems to believe that the answer is to throw more money at the problem. Propping up failed companies like GM or rewarding bad decisions of banks or mortgage holders won't solve anything.

No one seems to care that borrowing trillions of dollars to 'fix' a problem that fundamentally is caused by too much debt is nonsensical. It appears they feel they need to do something and simply can't think of an alternative. I mean we can't just do nothing, can we?

To paraphrase our new President-Elect...

Yes we can!

Exactly!

Enabling failure only induces more failure and prolongs the necessary epiphany.

Great perspective, thank you.

I too hope we can figure a way out. My fear is that too many of the masses don't understand either, and will turn this way and that, support X then Y, until it all collapses.

Positive thinking is great but positive thinking in the face of grim reality is delusion. The people left on the Titanic could sing and pray and think positive all they wanted but it wasn't going to save their lives (though it may have eased their passing).

I believe a PHYSICAL correction is needed because so much of this is, as you said, psychological or occuring in the world of ideas. The numbers on the screen don't equate to tangibles. Bonds are promises; gold is tangible and has intrinsic worth (jewelry, crowns, engineering, etc.).

The physical correction will likely involve bloodshed. The history of humanity is the history of war. Sad but true. I believe the wars come about not out of desire but necessity. We can't so "NO" to conspicuous consumption or living for the moment, with the result that sooner or later the bill comes due.

Let's hope we as a society get to those AA meetings before we fall into a coma.

Thanks again,
Eric

Welcome To The New Improved Depression: Economic Desublimation.

There is a great book called An Analysis and History of Inflation by Don Paarlberg which takes an in-depth look at the causes and effects of inflation dating back to ANCIENT ROME! There was no paper money back then and certainly no credit (as we know it today).
Over 2-century period in ancient Rome, records indicate that the cost of a soldier's uniform rose 300-fold. Inflation happened throughout history and his result was that the price of goods is not only supply and demand of that good but that divided by the supply and demand for the currency. A currency is just another commodity we use to barter for stuff. After the Spanish plundered Sounth America and sent back the gold on treasure ship convoys the value of gold in Spain plummeted as there was too much supply to meet the demand for that currency and hence for a period of time silver became more valuable than gold in Spain. People have a very short term memory especially a short term economic one. Yes the hyper-inflation in Germany is probably the most recent and well-documented but the reasons it happened were the same - the country just kept printing money -- and nowadays I believe it is irrelevant whether or not the money is printed physically or created as credit. The money supply of the world is exploding and yes as the deleveraging process continues it will obscure the true amount of currency that now sits on the market. Markets are very efficient once all the information is processed and anamolies are corrected. Obviously the market efficiency can lag but in a market such as dollars or euros where there are literally perrhaps Billions of market participants (i.e. consumers and producers of anything really) then the market will come to see the glut in currency and the value of this money will decline - making prices in dollar or euro etc. terms rise.
-AH

Good point, and our Fed is just printing more money and extending more credit instead...brilliant.

Look at the bigger, extended bailout with better terms for AIG this morning, unbeleviable!

Not allowing failure at a macro level but allowing it at a micro level will induce continued macro failure.

This is a pretty simple equation; why don't the PhD's get it?

They are plugging the six or seven nine-inch holes in the dike with wads of cash stolen from individual taxpayers, and ignoring the millions of taxpayers standing at the dike with their fingers in their own little holes.

At some point all those taxpayers are going to say themselves "to he*l with those as*holes robbing me while I stand here like a fool!" and pull their fingers out and run for the hills; tulips and windmills be dam*ed.

I disagreed, in my ignorance, with Kevin's prescient hypothesis predicting the present deflationary environment. His comprehension of the technical forces dictating a higher dollar, driven by the same factors implicit in the Yen carry trade unwind, was certainly spot-on, and I commend him (and the rest of the 'Ville professors who so astutely called it.) I am concerned, however, with the longer-term perspective. I noticed one comment on this board inquiring why the elites would favor inflation over deflation. The simple answer lies in the fact that the elites derive ALL of their collective power from the current system of government. Our plutocratic paradise keeps them fat and happy, and the system must be sustained should their largesse continue. They are quite cognizant of the nation's ballooning entitlement obligations and impending healthcare costs, and they know of only one way to deal with such daunting debt: inflation. Sure they may feel some pain by way of diminished purchasing power, but Bernanke is stupid like a fox. They put him in charge of the hen house knowing his area of expertise, and knowing that he had the cajones to administer the stimulants that our addict government so voraciously craves.

Deflation presents an end-game scenario to the nation's power brokers. I can't imagine what would happen to government revenues at this point should capital gains become a thing of the past; deflation, especially in our asset-driven economy, invariably leads to greater unemployment. These combined catalysts would annihilate the government's ability to further service its debt, thus resulting in a mad dash to borrowing (a mad dash that we may be witnessing today) from every sucker on the block. As such financing would have to be long-term in nature, the increase in the supply of long-term government bonds would force the yield curve into parabolic shock, raising the market cost of long-term borrowing, and further depressing asset prices. The vicious cycle that would ensue would require numerous politically unpalatable decisions, all of which would invariably crimp any progress towards legitimate economic recovery. Ultimately, the government would default on its debt, leading to massive capital flight from the U.S. If this wouldn't destroy the currency in a New York minute, I don't know what would. Undoubtedly, our foreign financiers would comprehend this end-game scenario and dump their dollar reserves into the open market, as Treasuries would fail to absorb their FOREX reserves given our bankrupt status. Such an act would immediately put upward pressure on anything real that the U.S. had left to offer, leading to hyperinflationary symptoms.

The alternative, however, lies in the Fed's ability to debase the currency through expansion of its balance sheet. Trading sterling, secure assets for dingy, depressed ones has the effect of negating the deflationary implications of asset-devaluation, as the Fed simply restores notional value with a wave of its wand. This failure to permit the market's demand for loss realization will certainly slow the rate of nation-wide asset devaluation; couple that with the Fed's ability to supplement investor credit and consumer credit with stimulus packages of every variety, and it's as though deleveraging disappeared overnight. The downside to this measure, however, is that it requires the same borrowing described under the futile-Fed deflationary scenario described above. Long term rates will rise as the supply of long term debt on the market forces yields, and consequently, interest rates, higher. Anyone think Fannie and Freddie debt can somehow yield less than Treasuries? How, then, will house price declines cease? Such a sequence of actions invariably leads us back to the mid-way point of the deflationary scenario. Under this scenario, however, the caged beast (the Fed) bites back, and floods the system with printed funds in a manner that would make Robert Mugabe blush. Think mortgage subsidies for every home owner and food stamps raining from the sky. Sovereign default is avoided... for a time... but the immediately-inflationary implications of outright currency debasement lead to capital flight once again. This capital flight is followed by our foreign financiers once again diving in and, if possible, buying anything of real worth that they can get their hands on. If velocity of money is everything, wait until entire nations dump our dollars.

Both of these scenarios portend the failure of the U.S. dollar. It is my belief that intentional, controlled, currency devaluation is the medicine of choice selected by the powers that be. It provides them with some cover under which to flee or reorganize. Deflation, as is said frequently in the ‘Ville, knows no prisoners. It appears as though we have paddled too far out into the ocean, with little fresh water for the trip back. How does the dollar maintain its value in the long term in a deflationary environment, when devalued dollars are required to honor our mountain of debt? This isn't the 1930's. We can't live with a stronger dollar for much longer, as our status as world-debtor #1 prohibits it. We will have inflation; the timing is everything.

Kevin, I envy your foresight with regard to predicting the current deflationary environment; had I heeded your words, I would have saved a tremendous amount of money (from my humble perspective.) I continue to hedge against the inflation on the horizon, however, as it will certainly come.

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