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Op-Ed: The "Other Side" of Deflation

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Six reasons for more inflation.

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The following is an editorial op-ed by longtime Minyan Jeff Wachtman.

I have long debated (yet eagerly sought out and respect the rationale of) savvy Minyanville professors who make a strong case that deflation will be the irresistible conclusion of the bursting of the debt/leverage laden financial bubble.

As the $700 billion bailout bill is readied and strings are attached to hinder rapid capital injection, I will take another long overdue stab at arguing why an inflationary outcome is more probable than consensus would assign to one of the two viable outcomes. I am sticking my neck out here in that the compromises in the bailout bill actually strengthen the deflationary argument in the short-term. (CEOs might rather collect private sector salaries as they ride their companies into the ground and maintain excess optimism about their ability to overcome challenges right up to the moment before collapse.)

It still remains to be seen whose view of consequences in this unfortunate debate will ultimately be judged the dominant force. I have opined that (in an environment with no rival other than the period encompassing the Great Depression) our government and financial leaders will choose an inflationary consequence. There are certainly risks to that assessment (as evidenced last week) in that deflation is much more difficult (at best) to manage when it gains spiraling momentum. Nonetheless, I'm still leaning toward the inflationary consequence scenario.

I would also argue that the consumer is still experiencing inflation. I don't agree that going from $1.29 gallon gas to $4.25 and now $3.70 is deflation. I'm not saying it can't happen: I would just disagree with how to score the inflection point with anyone who may be scoring it that way. I would also agree that if sufficient inflation is not injected soon, deflation will naturally gain traction. I think that the inflationary drugs that have not yet been administered are becoming, and will become more, apparent as we continue through this crisis.

Why an inflationary consequence?

1) Because we can.

In the Great Depression, the US was on the gold standard and the US was hamstrung in its ability to create the amount of inflation necessary to overcome deflationary forces. That is definitely not the case today.

2) I have confidence in "Helicopter" Ben Bernanke.

I read what he said in his oft-recited speech as well as its context. Bernanke projects himself as the great student of the Depression era and a financial professor par excellence. What I take away is that Chairman Bernanke is not only confident in his ability to prevent a deflationary spiral, but he seems to have made it a personal issue where his ego is involved and he may view severe deflation as a personal failure. (Yes, I factor this personal judgment into my assessment.)

3) Inflation has been the economic medicine of choice for serious imbalances around the globe for the last 50 years.

With the exception of debating Japan's course of adjustment, most countries have chosen an inflationary consequence over a deflationary one. Another judgment call, but I have faith in Congress to choose to spend what we do not have in spite of the consequences, rather than make tough choices that encompass deep spending cuts and debt reduction.

4) Math & US self-interest.

If you assign 1x consequence to 1x excess; you won't get an argument from me. However, I believe that the way for consequences to be spread most broadly would be for foreigners to pay a portion of the cost via a partial quasi-bankruptcy on US debt. The way to accomplish it is for the US to pay foreigners 100% of the dollars that we owe them with dollars that we "create" which pays them "in full" without paying back the value that we actually borrowed.

5) The government will end up in bed with the private sector.

The government will have a greater self-interest in avoiding deflation. If the taxpayer allocates $700 billion in discounted mortgage-backed securities and the economy moves forward without a very severe recession, then the $700 billion can reasonably be expected to repay the taxpayers with interest. If the US heads into a deep recession, then taxpayers could lose much of the 700 billion. This will provide further incentive for Congress to approve future inflationary socialistic programs.

The nature of the bailout forming suggests that we are yet again forestalling the inevitable and turning an event into a prolonged process. I also agree that before this debate can conclude, the fate of the consumer has to be stabilized. In the inflationary scenario, the government will likely have to directly intervene, (more communism), and/or unofficially foster an inflationary environment that includes wage inflation in addition to the consumer inflation we already experiencing. That would make the current debt burden relatively smaller and perhaps manageable.

6) Communism isn't a sufficient barrier.

All is fair in love and war, and when it comes to politics, look out below! I think that up to this point the argument that we can't get capital into the economy once deflation begins to take root has been predicated with a disbelief that the US could even conceive of extensive socialistic methods. I would think that it is now clear that when it comes to politicians, they will not hesitate to justify the means with the hope of an end.

No card player worth his salt would allow other players to see the cards he has not yet played. In my opinion; the overseers of the US financial system are no different. I don't expect Bernanke or Paulson to show any more of their cards than necessary. If the other players (foreign holders of US debt) sense what we hold and how we intend to play, there will be undesirable consequences sooner than what the US might hope. I am also not expecting a South-American style hyper-inflation to be purposefully instigated by our leaders.

I would call my expectation an attempt at "Metered Hyper-inflation." I think the US will try to hyper-inflate just enough to stay above being sucked down a deflationary vortex. I also think that they would ideally like this process to unfold as gradually and unnoticeably as might be possible to achieve. I'm not arguing that it is right. I'm not arguing how successful they might be either. But I'm arguing the rationale for the path that I suspect they will attempt to pursue, because understanding what it might look like has a direct bearing on weighting probabilities in the investments that I choose.
No positions in stocks mentioned.

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