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Deflation Isn't the Enemy

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We now live in a world where deflation has become public enemy number one. In this current economic environment, governments seek a condition of perpetual inflation in order to maintain the illusion of prosperity in the developed world. But in reality, deflation is the free-market approach to rectify a secular period of superfluous money supply growth, debt accumulation and asset price appreciation.

In an effort to boost the earnings of private banks and to facilitate sovereign government's largesse, central banks have a well-documented history of rapidly expanding the supply of fiat currencies and manipulating interest rates lower. This creates increasing debt levels and rising asset prices.

As recently as July 2008, the U.S. Fed (with the help of commercial banks) had produced YOY Consumer Price Inflation of 5.5 percent and Producer Price Inflation of 9.8 percent. In the Eurozone, the ECB produced consumer inflation over 4 percent and The PBOC (People's Bank of China) boosted inflation north of 8 percent for Chinese consumers.

Once central bankers are finally forced to confront the inflation they created, they throttle back on the printing press. But the return trip to a more normalized economy brings with it the bursting of debt and asset bubbles.

After the credit crisis set in and the healing aspects of deflation began to take hold, central banks rapidly expanded the supply of base money in an effort to quickly erode the purchasing power of their currencies and bring real estate prices higher. For example, real estate prices in Spain are already down over 30 percent and are expected to drop a further 12 to 14 percent in 2012. The ECB has printed over one trillion Euros to date; in an effort to weaken their currency, elevate home prices and bring solvency back to the European banks.

The problem with the addiction to money printing is that once a central bank starts, it can't stop without dire, albeit in the long-term healthy, economic consequences. And the longer an economy stays addicted to inflation, the harder the eventual debt deflation will become. As a result, central banks are now walking the economy on a very thin tightrope between inflation and deflation.

Once they finally step away from expanding the money supply, deflation rapidly takes hold. However, it then takes an ever-increasing amount of new money creation, on the part of the central bank, to pull the economy away from falling asset prices.

Another example of the roller coaster ride provided by central banks can be found in the price of oil. Oil prices had been historically around the $25 per barrel range throughout the decades of the '80s and '90s. Then, beginning in the early part of the last decade, oil prices started to soar and eventually shot up to $147 by the summer of 2008.

In the midst of the deflationary credit crisis, it fell to $33 per barrel by the start of 2009. Of course, the Fed had already embarked on their quest to eventually print $2 trillion to fight deflation, which helped send oil back to $114 per barrel by 2011.

However, because the Fed and ECB have both proclaimed that they are on hold from debt monetization and currency debasement, the same monetary environment that led to the pronounced deflation that occurred during fall of 2008 has arrived once again.

Now, some will say that a severe recession accompanied by sharp deflation can't occur because banks are currently well capitalized. It is true that the deflationary recession was caused by banks that had previously loaned themselves and the economy into insolvency. However, today the problem is much worse. We now have entire nations which have become insolvent. It would be very difficult to argue that having a banking crisis is better than enduring a sovereign debt crisis, especially since much of the assets banks hold is sovereign debt.

Therefore, we see that oil prices have already fallen 18 percent, from $110 a barrel in February of this year to $91 today. Copper prices have dropped 11 percent, from 3.90 per pound in April to $3.50 per pound today. And equity prices have started to decline, just as they did at the beginning of the Great Credit Crisis.

Japan's Nikkei Index has declined nearly 11 percent in the last month, while the S&P 500 has lost 7 percent since the beginning of May. The Spanish IBEX has tumbled 7.6 percent in the last 30 days and is now down 37 percent during the past year!

These price adjustments are absolutely essential for the long-term health of the global economy, but I doubt the central banks will sit idle much longer.

The plain truth is that the current debt levels, carried by the developed world, demand a period of massive deleveraging to occur. A healthy and cathartic period of deflation is needed; where asset prices fall, money supply shrinks and debt levels are reduced to a level that can be supported by the free market. This is the only viable answer for various nations struggling with solvency.

However, the return journey from rampant inflation and asset bubbles always carries insolvency and defaults along for the ride. Defaulting on debt is deflationary in nature and restructuring your liabilities is the only choice when you owe more money than you can pay back.

The prevalent idea among heads of state and central banks is that a country can borrow and print more money in order to eliminate the problems caused by too much debt and inflation. But more inflation can never be the cure for rising prices and piling on more debt can't solve a condition of insolvency.

Global investors are now being violently whipsawed by the decisions of central banks, as they switch between inflationary and deflationary policies. The choice governments now face is to allow a deflationary depression to finally purge the worldwide economy of its imbalances; or try to levitate real estate, equity and bond prices by printing massive quantities of their currencies.
It is vitally important for your financial well-being to be able to determine which path central banks are currently pursuing. For the moment, they have allowed the market forces of deflation to take hold. However, past history clearly signals to investors that it is only a matter of time before economic conditions deteriorate to the point where governments return to their inexorable pursuit of inflation. The point here is to understand where we are in the cycle between inflation and deflation and then to invest accordingly.

Michael Pento is the President of Pento Portfolio Strategies.