Monday, September 28, 2009
As I have recently pointed out, there are strong arguments for ongoing deflation.
But even deflationists think that - after a period of deflation - we might eventually get inflation. For example, in October, I guessed 1 1/2 to 2 years of deflation, followed by inflation.
Moreover, noted deflationist Martin Weiss - after predicting for 27 years straight that we'll have deflation - has now changed his mind, and thinks inflation is a greater short-term threat than deflation.
For these two reasons - and to make clear that the inflation versus deflation debate is complicated and includes many factors - this essay will focus on the arguments for inflation.
Faber and the Dollar
PhD economist Marc Faber said in May:
“I am 100% sure that the U.S. will go into hyperinflation.”
Faber's argument is that a weakening dollar will lead to inflation (as every dollar will buy less goods and services).
The government has injected trillions of dollars into the economy in the form of TARP bailout funds and other programs. Indeed, the government’s own watchdog over the TARP program - the special inspector general - said that number could be $23 trillion dollars in a worst-case scenario.
The basic argument for inflation is - as everyone knows - that the government has injected so much money into the economy (through bailouts, quantitative easing, purchase of treasuries, etc.) that there will be a lot more dollars chasing the same number of goods and services, which will drive up prices. In other words, the supply is the same, but demand has increased.
Indeed, the U.S. has also provided huge sums of dollars to foreign central banks. Could dollars given abroad cause inflation inside the U.S.? Yes - because some proportion of those dollars will be spent by citizens in those countries to buy stocks, commodities, goods and services within the U.S.
Three well-known advocates of the inflation argument are Rogers, Buffet and Schiff.
Specifically, billionaire investor Jim Rogers said we are facing an "inflationary holocaust".
Warren Buffett said:
The policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.
And Peter Schiff has argued for years that hyperinflation will wipe out the value of the dollar, so people should get all of their money out of dollars and into foreign currencies and assets.
But is all this government printing and quantitative easing really enough to cause inflation?
The back-of-the-envelope figures I've seen bandied about say no. Because of the massive destruction of credit (which - as Mish has repeatedly pointed out - must be included in discussions of inflation versus deflation), the government would probably have to print one-and-a-half to two times as much as it already has in order to create inflation.
The government could still do so. Yes, it would be suicidal for the dollar and might cause foreign buyers of U.S. treasuries to stop buying, but the boys in Washington could - if they were crazy enough - increase the money printing and quantitative easing to the point where inflation actually kicks in.
Will they do so? Summers, Geithner and Bernanke have proven themselves willing to do a lot of crazy things over the past year, so I wouldn't rule the possibility out altogether.
Indeed, when the Option Arm, Alt-A and commercial real estate mortgages start defaulting in earnest, there will be a lot of pressure on Washington to "do something". But again, doubling the amount of money printing would turn the dollar into monopoly money, and so there will be a lot of pressure not to turn America into Zimbabwe.
Devaluing the Dollar
Many commentators also argue that the U.S. is intentionally devaluing the dollar in order to increase trade.
And - as everyone knows - the dollar might tank even if the boys don't intentionally devalue it into oblivion. Just look at the amount of printing and easing which has already been done, the tidal wave of debt overhang, and the lack of fundamental soundness in the giant banks, the financial system, and the U.S. economy as a whole.
Moreover, some people argue that the dollar carry trade will drive inflation. Specifically, they argue that we'll get "spec-flation", meaning that investors will buy dollars and - in a carry trade - use the dollars to invest abroad. This will devalue the dollar, creating inflation.
And, importantly, the U.S. is quickly losing its status as the world's reserve currency. Therefore, the "premium" on the value of the dollar for its status as reserve currency will also fade, and the value of the dollar decline.
For these and other reasons, Faber and other inflationists would argue that the dollar will continue to substantially decline and inflation will therefore kick in (Note: Mish is still a dollar bull, and so doesn't concede this point).
I have previously argued that the rising tide of unemployment will contribute to deflation for some time.
However, Edmond Phelps - who won the Nobel Prize for Economics in 2006 - and PIMCO Chief Executive Officer Mohamed El-Erian both say that the "natural unemployment rate" has risen from 5 to perhaps 7 percent.
What is the natural unemployment rate? It just means that if unemployment falls below that a certain percentage, then inflation will be created.
So if the natural unemployment rate has risen, that may mean that we will get inflation sooner (when unemployment falls to 7%, instead of when it falls all the way back to the previous peg of 5%).
End of Foreign Bond Purchases?
Tiger Management founder and chairman Julian Robertson warns that - if foreign purchasers stop buying U.S. treasury bonds - inflation will strike:
If the Chinese and Japanese stop buying our bonds, we could easily see [inflation] go to 15 to 20 percent,” he said. “It's not a question of the economy. It's a question of who will lend us the money if they don't. Imagine us getting ourselves in a situation where we're totally dependent on those two countries. It's crazy.
Finally, Andy Xie argues that "bottlenecks" can cause inflation. Specifically, Xie argues that inflation in a single key market - say oil - can cause inflation, even in a weak economy.
As I have argued for a year, we will probably have a period of deflation followed by inflation. I still believe that.
When inflation will kick in is the million dollar question. The inflation camp argues that inflation will kick in any second now without any warning. In the deflation camp, David Rosenberg argues for years of deflation, and Dr. Lacy Hunt argues for decades of deflation.
Bottom line: In my opinion, the question is when, not if.
But in investing, being too early is being wrong. Someone who is positioned for inflation decades too early will get creamed. Likewise, someone who is betting on deflation for 20 years will get hurt if inflation kicks in next month.
Note: Remember that we could also get mixed-flation. In other words, inflation in some asset classes and deflation in others. Indeed, given that speculators drove up the price of oil last year, it is possible that - especially in a stagnant economy - speculators could drive up the prices of some asset classes and drive others down.