Inflation Prospects

In the last few months, we have seen the prices of commodities dropping precipitously. Oil dropped from $150 to $60, Gold dropped from $1,000 an ounce to $750, Copper fell from about $8,900 a metric ton to $3,800, and so on. The mass deleveraging occurring in our economy at the moment is unquestionably deflationary. So it is no wonder everyone is talking about deflation.

Some think deflation is nothing to worry about. Most people like lower prices. But deflation can create economic mayhem and serious damage, because it forces debtors to repay loans in more expensive money. As prices fall while debts stay fixed, companies cannot repay what they owe. That leads to bankruptcies and unemployment. Deflation also causes consumers to delay purchases: if people believe prices will be lower next month, they postpone their purchases. During the Great Depression in the 1930's, deflation was prevalent. Consumer prices fell about 25% from 1929 to 1933, manufacturing output dropped 39%, spending collapsed and every fourth American was unemployed.

But we should not lose sight of the inflation threat. With the Fed and Treasury aggressively fighting the credit crisis and the impending recession, their actions have longer term consequences. They are creating the next crisis, which is hyper inflation.

The Bush administration recently made it abundantly clear they will do whatever it takes to alleviate the credit crisis and stabilize the financial system. The Fed has aggressively lowered interest rates in recent months and has injected tremendous amount of liquidity into the economy. They lent nearly $1 trillion in bailout money and some estimate this number could be much higher before the credit crisis comes to an end. And Washington is incentivized to inflate the currency so they can pay back our mountain of obligations with underpreciated money. Throughout history, and especially at times of war, governments mitigated their ambitious spending initiatives and over commitments by letting currencies depreciate.

As Milton Friedman noted, inflation is a monetary phenomenon. Some economists say money supply growth (M2) will exceed 12% in 2009, which hasn't happened in thirty years. Indeed, the growth of our current money supply is redolent of the 1970's, not the 1930's. In 1979 the Fed also had a policy of easy money, trying to achieve low unemployment even at the expense of sound and stable currency. The Vietnam War and the budget deficit that ensued did not help matters, and inflation was running at 13% that year. Oil rose from $3 a barrel in 1970 to $40 in 1980. Ultimately the Fed, led by Paul Volcker, current advisor to President Elect Barack Obama, was forced to raise rates to 20%. That threw the economy into a recession with unemployment reaching 11%, creating stagflation (rising prices and slowing growth simultaneously), which is the worst possible economic environment.

When we come out of this recession, we will have to deal with the pernicious effects of the recent actions of the country's economic leadership: a credit system flush with cash will be driving inflation to the sky, and an intrusive government owning stakes in private companies will be creating a de-facto sovereign wealth fund with tentacles in every important segment of the American economy.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm.