After hearing the dire warnings of deflation that have become the standard talking points of most economists, American investors may be reaching for a bottle of Prozac. I believe that their anxiety is misplaced. Unfortunately, modern economists don't understand what deflation is or why, in reality, we have much more to fear from inflation.
Moderate deflation is actually the natural trend of a productive economy. If a producer can increase his output per unit of input, then he can afford to expand his market by lowering prices while still increasing profits. In that way, deflation allows consumers to buy items that they may not have previously afforded. It also promotes savings, which is essential for investment and capital development.
Deflation is also the normal consequence of a contracting economy. In a recession, there is a reduction in the amount of goods and services available for consumption. In order to keep prices from rising (due to shrinking supply), the central bank should allow the money supply to fall in line with the reduction in output. Also, during an economic contraction, consumers put downward pressure on prices by responsibly selling assets to pay down debt.
Many economists mistakenly claim that the Great Depression of the 1930s was caused by a 30% contraction in the money supply. The truth is that all depressions are caused by the reversal of a massive credit expansion. The reduction in money supply is part of a healing process that brings the overall level of prices back to a sustainable condition.
Looking at today's situation, just because we have a few months of sequential declines in CPI and PPI doesn't mean that deflation has become a secular trend. Year-over-year (YOY) growth in the M2 money supply is 2%; therefore, since the money supply is still growing, we are experiencing inflation rather than deflation.
Considering that evidence of inflation abounds, the Federal Reserve has pulled off a good trick by convincing Americans that we are about to "suffer" through a protracted period of deflation. Why have we been so easily duped? In the past ten years, the monetary base has grown from $600 billion to $2 trillion. This expansion has accompanied a rise in the price of gold from below $300/oz at the beginning of the decade to around $1,200/oz today. The price of gold is the best arbiter for a currency's purchasing power. Therefore, gold is still telling us that inflation is eroding the value of our dollar.
Other commodities, like crude oil, are telling the same story. Ten years ago, a barrel of oil was trading for $25. Today, it is $78.
Since 2001, the US dollar has lost over 30% of its value against our largest trading partners and more than 7% of its value since June alone. These facts are causing the mainstream economists to wring their hands about deflation?
More recently, YOY increases in the CPI, PPI, and import prices were 1.1%, 2.7%, and 4.5% respectively. Even though these YOY increases aren't evidence of runaway inflation, they still can't be construed as deflation.
The truth is consumers should be allowed the advantages of falling prices. Aggregate hours worked are down 8% since their peak in March of 2008. Since the money supply should fall along with the decline of the number of people in the work force, price levels should be falling too. But that is not what we see today.
If the monetary base continues to stagnate and banks stop lending to the government through Treasury purchases, we could see a deflationary environment sometime in the future. But given the current policy drift, that scenario appears unlikely.
Even if deflation were to take hold, it would not be something to fear. Lower prices are beneficial for those who have been thrown out of work, and falling prices allow asset values to reach a level that can be sustained by the free market. The fact is that prices should currently be falling in order to reconcile the imbalances brought about by decades of profligate spending and borrowing. Deflation... I say bring it on!
But that is not what is occurring today. Because of the towering level of US sovereign debt, it is inflation that remains the clear and present danger.
The national debt now stands at $13.24 trillion -- nearly 92% of the entire output of goods and services in the US economy this year. In its mid-session review, the OMB revised its 2011 federal budget deficit projection to $1.42 trillion, down only slightly from the $1.47 trillion estimate for this year's deficit. Given this intractable and unsustainable level of obligations, the last thing the Fed and Administration can tolerate is to increase the burden of that debt by allowing the money supply to shrink.
A reduction in the supply of money (deflation) would cause the cost of debt to rise. An increase in the purchasing power of money also means it is more difficult to acquire the new money needed to reduce debt levels. Conversely, increasing the supply of money (inflation) reduces the cost of debt. With these incentives firmly entrenched, the last thing Americans will have to "worry" about is deflation.
Given the obvious mathematics, one wonders why Treasury yields remain at historic lows. The bond vigilantes are indeed in a coma. However, despite the mountain of complacency that their slumber has inspired, this golden age of E-Z financing can't last forever.
Michael Pento is the Senior Economist for Euro Pacific Capital
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He should be saying, why fear deflating the value of our currency? That would be a better argument to make. But, all of the big wig investors would black list him. Hence, he promotes the status quo.
It would be more instructive if Mr. Pento was giving a time horizon and telling us where he has parked 'his' investments today. Given his view, a test of his conviction would be how much of his portfolio is in inflation risk bets, such as gold or other assets.
His analysis is more dismissive of deflation risk than I think we have a right to believe. The risk remains small, but landing in a period of deflation is an event that should be avoided. There are more tools at hand to reign in inflation, than either fiscal or monetary tools available to escape deflation.
Treasury yields are low because economic activity is low and fiscal measures are the equivalent of 'pushing on a string'.
If US sovereign debt is the clear and PRESENT danger that presages inflation, then I will put a time horizon on the inflation prediction that Mr. Pento has not. Let's arbitrarily, bit not nonsensically, place the 'present' at one year out.
Given that, we should see the lack of deflation and the presence of inflation occur before August of 2011.
Place your bets. I think inflation will not be present above current levels, plus 50 basis points by this time next year.
Of course, geo-political events can upset all predictions.
Let's see.
thats great! there's only one problem. we arent a manufacturing economy and we cant rely on productivity. we built retail capacity on a bubble. so we lost circuit city and a host of others and there will be more..
"Also, during an economic contraction, consumers put downward pressure on prices by responsibly selling assets to pay down debt."
like houses! you remember...the thing they leveraged to buy goods during the bubble. and then of course the unsellable assets the banks created and then leveraged to be able to supply more money to the bubble.
In the end I believe in politicians buying votes until the bond market stops them, and Ben Dover's Helicopter.
The only real sources of inflationary pressure are government and private insurance payments driving up wages and prices in medicine, and government grants and loans driving up the price of college tuition.
The other deflationary issue you tend to neglect is the buy now or buy later conundrum. In an inflationary situation, it is in the consumers best interest to buy things as soon as possible to avoid the sure to come price increases. In a deflationary economy, one would be foolish to buy today what one can acquire even cheaper tomorrow. In this situation, economic activity spirals downward because it is in the best interest of a person who has money to postpone purchases indefinitely. As fewer people retain their jobs because of a lack of work due to postponed purchasing the spiral continues. The only people this works for are short sellers and the very wealthy who can buy assets on the cheap.
Inflation comes from too much money chasing too few goods. Just the opposite is true; there isn't enough money flowing in our economy to sustain it. Prices will drop and the danger is that they will drop to the extent that it becomes impossible sell a product and break even, much less profit.
As the Great Depression developed, farmers were plowing their crops back into the ground and dairy farmers were pouring their milk out on the ground. It just wasn't worth the effort to harvest their crops.
I think this blogger is wrong!
The scenario we are seeing in the country today is Vonnegut's "Player Piano" writ large, with outsourcing and illegal immigration joining mechanization and automating in beggaring the American worker. In the end, we will produce nothing that isn't produced in a "lights out" manner (with zero worker input at the production level), but who will be able to buy it?
I agree and believe high inflation is the way to relieve the debt/save housing.