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Why We're Facing Deflation

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How velocity, money supply, and currency-printing affect the economic environment.

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Just as water is formed by the basic elements hydrogen and oxygen, deflation has its own fundamental components. Last week we started exploring those elements, and this week we continue.

I feel that the most fundamental of decisions we face in building investment portfolios is correctly deciding whether we're faced with inflation or deflation in our future. (Later I'll tell you when to worry about inflation.) Most investments behave quite differently depending on whether we are in a deflationary or inflationary environment. Get this answer wrong and it could rise up to bite you.

The problem is that there's not an easy answer. In fact, the answer is, it could be both.

Today I got another letter from Peter Schiff, who seems to be ubiquitous. He says the rise in gold is because of rising inflation expectations among investors. Gold is predicting inflation. Maybe. But the correlation between gold and inflation for the last 25-plus years has been zero. I rather think that gold is rising in terms of value against most major fiat (paper) currencies because it's seen as a neutral currency. The Fed and the Obama administration seem to be pursuing policies that are dollar-negative, and they give no hint of letting up. The rise in gold above $1,000 doesn't really tell us anything about the future of inflation.

In fact, it's my belief that if the Fed were to withdraw from the scene of economic battle, the forces of deflation would be felt in short order. The answer to the question "Will we have inflation in our future?" is "You better hope so!"

I wrote in 2003 -- when Greenspan was holding down rates too long in order to spur the economy -- that the best outcome or endgame over the course of the full cycle would be stagflation. I still think that's the most likely scenario. The Fed will fight deflation and knows how to do that. They also know what to do when inflation becomes too high. But there's a cost.

It's not a matter of pain or no pain; it's a matter of choosing which pain we'll face, for how long, and perhaps, in what order. As I wrote a few weeks ago, like teenagers, we as an economic polity have made some very bad choices. We're now in a scenario where there are no good choices, just less-bad ones.

In a normal world, the amount of monetary and fiscal stimulus we're witnessing would produce inflation in very short order. That's what has the gold bugs of the world excited. It's their moment. They keep repeating that Milton Friedman taught us that inflation was always and everywhere a matter of too much money being printed. The answer to that is that the statement is mostly true, but not always and not everywhere (think Japan). The reality is somewhat more nuanced. Let's review some things in my article from last year called The Velocity of Money. And this time, we're going to go into the concept a little more deeply. This is critical to your understanding of what's facing us.
No positions in stocks mentioned.

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