Debating the Odds of Deflation (the text below was published 7/07/2005 in Rick's Picks)


Rick Ackerman: Jim Otis, writing for The Optimist, insists that the Fed would never allow deflation to occur. My take is that the debt problem is too big to paper over except by way of a hyperinflation, and that such a strategy would never be attempted in any event, implying as it does the wholesale destruction of the bond markets as well as the downfall of savers and creditors as a class. Jim and I have gone back and forth via e-mail since mid-June, when I explained in this space why deflation is inevitable. I have reprinted my dialogue with Jim below for your interest. For the time being, wrist surgery has made it impractical me to respond to his latest point-by-point at length, so I will leave up to you, dear readers, to furnish your own rebuttals. If you have been a Rick's Picks reader for any length of time, you should be up to the task. Give it your best shot, and I'll reprint your letters in a forthcoming issue. Here is the series of exchanges, starting from near the beginning: 


Rick A: Deflation is the most powerful force in the financial universe, Jim, and it can only be postponed, not avoided. But that will take lots more borrowing, which itself would depend on an already grossly inflated asset class: housing. The housing market will not collapse as long as the only two alternatives to the dollar, the yen and euro, remain relatively unattractive to the investment world.  However, there's a trigger that could cause such a change: plummeting US stocks.


1930s Were Different

Jim O: Thanks for your reply. Deflation may well have been the most powerful force in the financial world, but that was back in the 1930s when the quantity of money available was limited to the gold and silver in the treasury. The fiat paper most people now call money has no intrinsic quantity limits except the restraint the Fed imposes on  itself.  The Fed now has the ability to insure the economy will not  have a fiat paper shortage which could result in a deflationary  spiral.


We can agree that depression is inevitable due to very high levels of debt and the continuing loss of solid manufacturing jobs.  Unlimited availability of fiat, however, now makes deflation an optional choice by the Fed.  Deflation will occur only if the Fed decides to let it happen (or if an abrupt catastrophic financial accident overtakes their ability to respond in a timely manner).  For so long as deflation is not considered to be politically correct by the Fed and the power structure in Washington, it is far more prudent to invest against the inflation devil we are sure about than the deflation devil which may only be an illusion.  There is more about deflation at this link.


While you are in my site, take a moment to browse through my commentaries in the commentary tab at the left of the page.  If you find something worth quoting to your readers, I'd be happy for you to include a link to the source.  Cheers!  Jim


Time Crucial

RA: Thanks for your thoughtful reply, Jim. I have addressed the point you make below numerous times, in my newsletter and elsewhere, as follows: Total indebtedness amounts to hundreds of trillions of dollars, so nothing less than hyperinflation would suffice to reconcile accounts between borrowers and lenders. But hyperinflation by definition is unsustainable, so it is the aftermath that we must consider. What does a collapsed hyperinflation look like? There can be only one answer: deflation.


There are other factors to consider as well, chief among them the guvvamint's response time. On a particularly hellish day, settlement issues that would initially affect short-term paper could back up so that sorting out the chaos further along the curve would become impossible, practically speaking. Debt has become a towering house of cards, and there is no way the G-men will be able to shore it up once the cards start to tumble.


A singularly important fact that all inflationists choose to overlook is that bailing out debtors would be tantamount to destroying savers and creditors as a class as well as the institutional conduits of savings -- i.e., the bond markets. They would cease to function for at least a decade and probably longer if creditors were to get nuked by the Bernanke Plan. If Motormouth Ben truly doesn't understand this -- which I doubt -- then he's as hopelessly ignorant of the laws of economics as his boss. Regards, Rick


The Fruit Fallacy

JO: Rick, be careful of the fruit fallacy!  The green U.S. $ fiat currency (let's call it green apples) is deteriorating through inflation so that each year the same goods or services cost more green apples to purchase.  When that inflation proceeds far enough that we need truck loads of green apples to buy things, the government will help us by issuing a new fiat currency which could be called a red cherry and which might have the same purchasing power as a million green apples.


That will be a wonderful improvement since it is much easier to carry a red cherry to the store than the wheelbarrows full of green apples that it replaced.  The transition from many green apples to few red cherries will not be deflation.  It is simply another example of different currencies having different numerical equivalents.  People who are accumulating green apples now so they can gain purchasing power during the "certain" deflation ahead will probably be very disappointed.  The purchasing power of green apples will decrease every day before, during, and after the conversion to red cherries. Those misguided souls who hold cash resources now to profit from future deflation are likely to find they have missed a golden and silver opportunity to conserve purchasing power by investing with the rising inflation trend.


You raised three other points which I will comment on only briefly because long emails become unpleasant to read. Your point number 1) Total debt is trillions of dollars, and only hyperinflation can pay it off.


No Rush to Pay

OK, let's agree that hyperinflation will be unavoidable when the time arrives that it becomes necessary to pay off all debts.  Fortunately, there isn't any rush to pay off debts now, and the government still has the luxury of being permitted to continuously borrow more.  There is no evidence now that an abrupt transition to an emergency is just around the next corner.  It may be years before we get back to the same level of pervasive inflation of the 1970s, and decades before the rate of inflation "progresses" from double digits per year to triple digits per year.  Hyperinflation, which would be orders of magnitude worse than that, is not likely to be a near term issue.


Your point number 2) Juggling the markets is complicated, and the Fed could lose control.

You could be right, but I don't worry that a major accident which is beyond the Fed's ability to contain will happen soon.  I think the Fed has done an impressive job of conning many investors into concern about the deflation that isn't, instead of focusing on the inflation that is.  Although I despise the loathsome process of suppressing the truth about the magnitude of the real inflation problem, I must confess that I am awed by the masterful way they can manage the data to avoid setting off alarm bells throughout the economy and the rest of the world.  When thinking of possible financial accidents in the USA which might spiral out of control, consider that in 2000 we had a major market meltdown, and in 1987 stocks lost 25% in a single day.  I find it difficult to imagine domestic events which would pose a more challenging environment for containing deflationary pressures.  I am solidly convinced that the Fed can prevent deflation for the foreseeable future, and I want to remain well positioned to take advantage of the resulting inflation.


Creditors Will Adjust

Your point number 3) Bailing out debtors with inflation hurts creditors.

Agreed, but that bad effect of inflation is no surprise to anyone. The USA has had essentially non-stop inflation for the last 70 years. Creditors adjust to rising inflation, and markets continue to function. FYI, I am working on my next commentary now.  It will suggest the results if real inflation increases from the low to mid double digits over the next decade or so.  It should be a fun topic to write, and I hope readers will also enjoy it.  Introduce your readers to my site now, so they can catch the next installment while it is hot off the presses!  Cheers!  Jim



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