Monday, September 28, 2009
The Case for Inflation
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 said he thinks - in the medium-term - we could have high levels of inflation (and see this and this).
Faber's argument is that a weakening dollar will lead to inflation (as every dollar will buy less goods and services).
Government Printing
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).
Unemployment
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.
Bottleneck Inflation
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.
Conclusion
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.
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I agree with your overall analysis, but I'd like to point out one thing in regards to the natural rate of unemployment.
ReplyDeleteI don't think we're operating in the steady state regime of being able to use these types of data points to judge our inflation risk. I believe we're operating at the limits of debt-carrying capacity.
In pretty much every currency crisis I've ever studied, the economy is decidedly *not* humming along near its capacity utilization level or natural unemployment rate. The country goes bankrupt and has the general choice of trying to devalue the currency or default on its debt.
Inflation will occur when the private sector starts to grow AND the Fed/government does not withdraw its spending in a corresponding manner.
ReplyDeleteWouldn't the US public love a 7% unemployment rate now? I can't see that happening until after 2011.
Most of the "print" is in the financial sector - they can sit on it, invest it, or loan it out. Who is going to borrow? All the inflation we are seeing is in certain asset classes - commodities, equities, bonds.
Inflation is very difficult to control when out of the box - in circulation - debts get paid off with cheap money. The banks will resist that for a long time. Better to foreclose and hold a real asset then liquidate a loan with cheap money.
I think there are a lot of controls in place to keep this stimulus from reaching the people who could need it the most. The question is if and how some of the "print" in the financial sector will leak into circulation.
It's very difficult to have hyperinflation without close to full employment and relative high wages (see Germany/Austria in the 20s). Otherwise, demand collapses due to no income to buy increasingly expensive goods.
Deflation doesn't mean the cost of living decreases. Pressure on incomes continues, the public will continue to reduce consumption - but not enough to drive prices lower to offset income reductions.
I could see a resource-constraint driven consumption collapse - cost-push higher prices with no-growth incomes - basically more of what we have today. If someone can say how and when incomes will rise, then we can start to worry about inflation.
Certainly resource disruptions will cause price increases - who really knows how much oil is left in the world - but that is a different problem from thinking inflation is going to occur because the US has created additional debt.
This isn't inflation in any conventional sense.
ReplyDeleteThis is merely a massive government-dictated jostling of who gets how much for what - and - who pays how much for whatever (including the yellow metal).
We have price controls and market manipulation coming out our ears in this economy. The government is setting the price of virtually everything beginning with oil, real estate and gold.
This economy is wholly rigged and booby-trapped.
Furthermore -the government has for years been paring back how inflation is measured, -until now the only measurement the economists who fabricate the handmade government-numbers are worried about -is how much -has to be paid to the wage-slave- to get him or her to come to work.
Does anyone even remember a few years ago the laughable debate about raising the minimum wage in this country? HFS people have short memories.
Wages haven't significantly increased in twenty years -and wages aren't about to increase either -with unemployment hovering at reality-measurements -somewhere above 20%
The credit economy has all but destroyed the cash economy. Can anyone fathom what that means? Have any of you ever been in business for yourselves before?
Here we are in the middle of a whopping housing depression. And yet, all the many government arms of the mortgage industry, FannyMae, FreddyMac, HUD, The Veteran's Administration, the FDIC, the IRS, all the state-run FHA mortgage conduits etc., etc... -they are actually running advertisements for REO housing they own -being sold "as is -where is" -leaky roofs and all -at or above- where these same homes were priced at the peak of the housing bubble.
That's not inflation in any conventional sense.
That's a government-run monopoly. The government is telling these kids buying homes today, "Put your head in this mortgage-noose. That's the American way. DO NOT look around at all the vacant housing and think you can buy any of it for what it is really worth!"
Inflation in a conventional sense is when your boss is waving money in your face to get you to come to work -and work overtime -because he has orders he cannot fill.
In a conventional inflationary environment, you work harder, longer hours, for higher pay, that buys less, and the government taxes what you make at a higher rate -leaving you massively poorer. That's what happened in the '70s.
Those who talk of hyperinflation today -must think the rest of the world is going to drive the price of everything sky-high with all the dollars they have horded under their mattresses.
It's not likely. Even in Iran, the U.S. dollar is still the preferred currency among street vendors. They'd take MasterCard and VISA, if they could get away with it.
The US should pray for inflation with all the debt bombs going off. Debt destruction has just begun. It's going to take years to work itself out. The Fed and Treasury are madly trying to reflate the toxic debt but the only people interested in borrowing and qualified to borrow are people using leverage to speculate, blowing more bubbles. And a lot of this is the banks using the people's money, since they are insolvent on best accounting principles. Karl Denninger has been documenting this pretty well, for example, over at The Market Ticker.
ReplyDeleteMuch of the toxic debt is still being hidden from view through accounting "ledgerdemain" and other forms of misrepresentation that regulators aren't calling out, and the Fed is calling foul on an audit. Long-term governments will signal when there is an inflation threat on the horizon.
There is still a giant pool of money out there, even more than pre-crisis by some estimates. This pool sloshing around is going to create a lot of volatility in various markets as it rushes from one to another for self-preservation, at least, and also for relative appreciation. This is going to perpetuate risk-taking in these areas, even in an overall atmosphere of risk aversion. The bubble in finance has not yet completely deflated. So remember Xie's bottleneck theory, and don't confuse isolated bubbles with overall monetary inflation that results in across the board price and wage increases — which is not going to happen any time soon.
It is true that the dollar is depreciating against gold, but it has been doing so since 1971. If you're paying attention to the heterodox economists, this is irrelevant, as it government sovereign debt.
Y=C+I+NX+G. Consumers are heavily indebted by historical standards and are paying down debt, as well as and saving is reverting to historical norms. Businesses are at over-capacity and aren't investing. Recent gains are from inventory restocking and cost-cutting, not expansion. World trade is declining rather than expanding, so net exports aren't going to take up the slack. That leaves government as the sole creator of aggregate demand. This is not inflationary.
The problem is with the private debt that can't be repaid. This is weighing heavily on the financial system. as well as consumers. The government is trying to reflate to bailout the financial system of toxic debt. This means screwing consumers, who are stuck with servicing the debt at face value while the banks get the freebies. It doesn't take too much intelligence to see that this is a great big gamble, and that it isn't working so well.
I’m not impressed by Julian Robertson, founder of Tiger Management. He said:
ReplyDelete"It's almost Armageddon if the Japanese and Chinese don't buy our debt. I don't know where we could get the money.” Well, I’ll explain where the money comes from.
Concentrating first on the trade deficit, if Chinese stop buying dollars, the latter would decline relative to other currencies. This would increase demand for US exports (a source of “money”) plus US consumers would buy less foreign stuff and instead, spend their money on US produced equivalents (another source of “money”).
Then there is the separate question, the US government deficit. The Chinese have been in the habit of buying Treasuries. This has enabled US citizens to pay less tax. Thus if the Chinese stop buying Treasuries, that means US citizens pay more tax, or the US government raises interest rates and borrows from US citizens instead of the Chinese.
This all means a standard of living reduction for US citizens (or slower improvement in living standards). There is no good reason for this to cause inflation (Julian Robertson predicts rampant inflation). Though it is possible that unions would react to the living standards hit by demanding higher wage increases. If unions do this they are just pissing into the wind. Someone would need to get it into their thick skulls that Chinese failure to buy Treasuries means an INEVITABLE living standard hit. Demanding higher wage increases would not get round that “hit”.