Deflation or Inflation – Which is it?

By Tim McMahon, Editor

It seems the debate on whether we will be facing inflation or deflation is heating up.  This week I received emails from two different subscribers insisting that I was wrong.  Well that is always a possibility but we will see…

The first letter I received was from Jeff L.  it said, “Your current “Annual Inflation” chart, graph, and commentary are very helpful.  Thanks very much.  The data would appear to contradict a recent article on your own site predicting a long period of deflation.”

My response was, “Personally, I think we are in for inflation. Robert Prechter (who is much smarter than I am) believes it will be deflation. At this point we are on a “knife edge” and it is still possible to fall either way. So I publish both views”.

The current short term trend appears to indicate that there is more price inflation waiting in the wings and the stock market appears to be indicating that asset inflation has already arrived…

The other email was sent by reader and contributor Jim Step and includes a quote from an article published by Agora and insists that we are in for deflation. Agora makes some good arguments and there is a precedent in the “Great Depression”.  During the 1930’s no matter how hard the government tried it was unable to increase the money supply because it was like “pushing on a string.”

This is how Bill Bonner put it in Agora Financial, “The problem with inflation is that there is none. Consumer prices are falling in China, Europe and America. And if we look harder, we find out why. The feds are pumping the money supply as hard as they can. David Rosenberg reports that the monetary base rose at a 141% annual rate over the past four weeks. But the money fails to reach the real economy. The money supply figures that relate to actual cash in people’s hands – M1, M2, and MZM – are shrinking, at -28%, – 4.9% and – 6.2% respectively. Why? Because the banks don’t lend and consumers don’t borrow.

In short, the feds’ money goes into cool bank vaults and hot speculative trades. When it tries to find its way to the consumer, it gets lost. As Rosenberg explains it, the transmission mechanism has broken down. We live in a bust economy, not a boom one. In a bust, consumers cannot borrow. They have nothing to borrow against. Both their wages and their assets are going down. Who would lend to them under those conditions? Not a bank that almost went broke itself 12 months ago.

And even if consumers had access to credit, they wouldn’t take it. Consumers too, almost went broke a few months ago. Instead of saving money during the boom years, they spent it…or gambled with it. Then, when the bust came in ’08, they realized that they were 10 years closer to retirement with little money saved. Now they have to make up for that lost decade, by cutting spending and saving as much money as they can”.

This is exactly the argument that Robert Prechter makes.  When it is time for a deflation nothing can stop it… See Inflation vs. Deflation? by Robert Prechter to learn more about how deflation can become unstoppable.

On the other hand, in the 1930’s they weren’t able to create money out of thin air like they can today.  Back in the days of FDR there was a pesky thing called a gold standard.  In those days the dollar was backed by gold so they couldn’t just print more money, there had to be gold in the treasury.  Since 1880 the U.S. dollar official gold price had been $20.67 per ounce.  But from 1913 through 1920 inflation (as measured by the CPI) had increased by almost 98% (in other words in 7 years prices had almost doubled) but the price of Gold remained flat (by Government decree). Not surprisingly the “Federal Reserve” was created in 1913 and that is when the inflation began.

But because of the official gold price the government had gold on its books at a much lower price, so the backing was out of sync with the inflated dollars.  So in a classic government swindle FDR mandated that citizens turn in their gold at the then current fixed price and then promptly raised the price to the “real” market price of $35 an ounce. Poof instant money,  no matter that is was stolen from the American people. In those days though it was a one time trick,  FDR couldn’t do it again.  First of all, gold was no longer undervalued and second of all the people didn’t have any more gold to steal.

For more info on the history of gold

These days the Fed just “monetizes the debt” without having to worry about gold at all.  In other words, they create a debt by issuing “T-Bonds” and they sell them to the highest bidder.  Over the last few decades the highest bidder has been foreign countries like China. But recently, unbeknownst to the average American a major shift has occurred. Foreigners are no longer interested in buying our debt (that’s no surprise) the surprise is what does the FED do when there aren’t enough buyers of its debt?  It steps in and buys its own debt.

What?  That’s like printing an IOU and putting it in your right pocket and then transferring it to your left pocket and saying oh look now I have all this money… That is how they can print money out of thin air.  That is true monetary inflation which should result in price inflation.

So to answer Jim’s (and Agora’s) question,  how will all this money get past the banks logjam and into the consumers pockets?  How about through the stock market?  The market is up 50%  so consumers feel richer.  Some might sell stocks, some might borrow against them.  Some might just stop saving so much and spend the extra,  asset inflation may be the vehicle that re-inflates the consumer.