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The Goldenbar Report presents
Inflation Outlook: deflation fears are irrational
22 January 2003


Mises Excerpt: The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the [p. 428] country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy. But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap pater. Nobody wants to give away anything against them. It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last - Ludwig von Mises, Human Action, Chapter 17, "Indirect Exchange, the anticipation of expected changes in purchasing power

by Ed Bugos
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It might be reasonable to think that after writing about a subject once, there'd be no need to write about it again. But it just ain't so. I don't mean to say that readers don't get it. Rather, the writer screws it up. After all, writing I've learned involves communicating my thoughts. Sometimes, however, I don't even understand them. More often, my thoughts are never complete. I'm always learning something new that changes the way I see the same idea as before. In other words, my perspective is constantly changing. I'd like to imagine it's progress but haven't sought a second opinion on that yet.

So consider this an update on our inflation outlook, which is still largely the same. If you haven't seen our past perspectives on the subject of inflation versus deflation, here is a short list of the core essays I remember writing about the debate. Although, I haven't reread them since writing them, so there may be some perspectives we've long since abandoned:

I guess if there's a pattern there, I'm a little early this year. Kidding aside, the three I'm most proud of are Inflation vs Deflation, Inflation Paradox, and the Money is No Good.

In a 1948 Congressional address, Howard Buffett warned of the same fate - as Mises describes in the box to the right and as we argue is our plight today - fifteen years after the gold standard was canned and a couple of years into the notorious Bretton Woods deal that ended almost precisely in the manner Buffett warned it would. Nobody listened as he tried to build a case for the connection between freedom and gold money.

At any rate, our view is not that deflation is impossible, but that it is unlikely until after the worst of the dollar's collapse is behind it.

Note in the Mises excerpt how important a role perception plays. Can public opinion be swayed today? By what goes on in the press these days, it would seem so. By the way, some of you may know Mises wrote an entire text on the theory of money and credit without using graphs to explain any of it. In fact, he even made a point of avoiding the use of the word inflation in that work which is all about it.

I used to think about inflation and deflation constantly. I still do. So do you, I think. We all do. It's important for valuation and strategy. Nevertheless, some gold bulls have determined that gold is as likely to go up in a deflationary environment as it is in an inflationary environment. I couldn't disagree more, though for years during the nineties, I too believed that gold could go up in a deflation, because it was the only asset with no liability, etc., and people would hoard it regardless. But regardless of what is the key question. It's hard to imagine circumstances where participants lose confidence in the dollar that don't fit the model described by either Buffett or Mises, or even just the historical record post 1933. If we're talking about a shift in monetary value, subjectively, from currency to gold during such times, it can't be isolated to gold.

In fact, both gold and the CRB trace the same path historically. And if during such times, where there is a loss of confidence in the dollar that results in such rising commodity values and prices, someone is able to make the case for deflation, they are making the oversized assumption that somewhere along the line there is a policymaker that's infallible. For, how else is a fiat paper monetary regime going to be restricted? To think that somehow, forces beyond our control will result in a contraction in the money supply and deflation in terms of the dollar is to delude yourself. I hope you'll understand why by the end of this report.


Inflation/Deflation: It's About Value
This essay is for the reader that understands why the definition and process of inflation go well beyond what is implied by the CPI and PPI, but is perhaps confused by the array of propaganda nonetheless.


What is the dollar's liquidity premium?
A JP Morgan slide show last September began with the following quote on the cover page:

"The relative price of gold is driven by (and is the reciprocal of) the real rate of return from capital markets." Summers and Barsky

As in Larry Summers ex-Treasury secretary. He is correct on that score. This concept forms the basis for our hypothesis about the dollar's investment premium, or more accurately, its liquidity premium.

Why do we insist the likelihood of deflation is so low when everyone's talking about it?

What it boils down to after a close examination of all the logical paths is the value of the currency that we're inferring to be the money. Is it over or under valued? That's the question. For, aside from the question of the dollar's value, there's nothing but inflation, everywhere in fact. There always has been. And if we're right that the dollar is overvalued, how on earth could policymakers keep a check on prices even if they tried?

Major historical events can be mapped around the history of money and inflation. In fact, if you asked me, the world's entire history could be mapped around the struggle between the State and market over money, its role as well as its possession. Jefferson may have said it better. Still, the point is that fiat monetary regimes are inherently inflationist, and inflation is politically expedient. Greenspan said as much in his controversial gold speech that had nothing to do with gold.

Nonetheless it would be simplistic and naive to think that all of our problems could be solved by eliminating money, since after all, that thinking is precisely the root of the problem. The Fed is after all in charge of alleviating the discipline of money - shifting risk - as if to say money isn't necessary but a central bank is.

The State has always tried to overcome the market's grip on the affairs of money, and the twentieth century was no different in that regard. Moreover, it's always in the name of making life easier that it succeeds. Inflation is a political doctrine. As long as the government has control over money, it won't go away. Indeed, either our governments have become extraordinary deceivers or people have become extraordinarily ignorant. For, not only do we believe the government when it says there is no inflation, but also, the fear of deflation has spread through the investment industry like I would imagine the fear of retribution spread through Massachusetts in 1690's America during the Salem witch hunts. In both cases the fear is irrational.

There is another irony inherent in fearing deflation in our kind of economic system. Think about it for a moment. A government that thrives on inflationist policy has the good fortune of a population that believes it must step on the inflation gas pedal to avoid deflation. If you don't understand the irony, note the "government that thrives on inflationist policy" part.

Okay, in this world of derivatives, futures, multiple markets and financial intermediaries it may be easy to fall into the trap. It's probably enough to make the average person's head spin.

Maybe a little parable and narrative will help.

Consider, for instance, a closed economic system controlled by a profligate Monarch. Assume also that we begin monitoring the Kingdom when it is using a one ounce gold coin for money, and that our act of observing doesn't influence the experiment.

The King's hedonic lifestyle and the Queen's exuberant shopping sprees have pushed the Treasury to the brink. Concern now grows over the economy, which has come to rely on credit expansions. An entire street of vendors grew prosperous by the Queen's generous whims alone. But now after they've stocked up on record inventories of the Queen's favorite shoe, there is no sign of her. The King and Queen are tapped out. Weeks go by, and still, there's no sign of her. Prices fall. The specter of deflation is in the air. Now that everyone's afraid of shoe price deflation, the King declares new coinage.

A new coin will be created, which will stimulate commerce. Only, it won't have an ounce of gold. It will have, say, three quarters (the King's old okay). Suddenly, there is more money, 25% more in this instance. Guess what happens to prices? They go up. Why? Because the value of the coin falls. Though it may not fall by 25% against everything. It might hold its value in terms of the inventories that are surplus at the moment for instance. Its value will be relative and determined by each specific transaction. If the King doesn't tell us how much gold has been shaved off, it might take a little more time, but its value would still fall sooner or later. All the while, the King's CPI index would undoubtedly report that inflation was under control!

Nevertheless, what happened to deflation? Is it accurate to say the King's debasement prevented deflation? Yes. But there's an important point here. It was predictable because the economy had come to rely on the expansion of credit. In other words, how could the King, who brought this on his kingdom, refuse his subjects who too have been spoiled by a profligate monetary system? The economy has become corrupt. It is in fact more than predictable, in some sense it's inevitable that any man-made objection to expand the money supply in a fiat regime based on inflation like ours is a pit stop, at best, fraud at worst. If there was one thing we learned from the German experience of hyper inflation it is precisely the rejection of restrictionist policy for this reason. What, will we all wake up one day and say, we've had enough of this life of excess, let's allow the market to build sound money now?

Yet that's essentially what's required to accept a deflationary fate. One day we'll have to accept deflation. However, the history of human progress is littered with crises because we tend not to deal with problems until they turn into a crisis. So until either the world is filled with an unprecedented moral courage, or until deflation is shoved down its proverbial throat, inflation policy will be the preferred method of postponement. It would be a stretch to believe that contemporary democracy would abolish the Fed and cry out for sound money. After all, none of its participants seem to even acknowledge that it's their own interests the government has in mind when it chooses to inflate/debase. It's as if there's a silent contract between the agent of inflation and its customers. People willingly allow the Fed to inflate so long as it can persuade them inflation doesn't exist.

The Fed really only needs our permission to carry on the inflation. But make no mistake about it, the Fed's job is to sustain the inflation, not fight deflation. It's mere existence is enough to prevent real deflation. Though even if the moral capacity existed to make the transition to sound money, we'd still have to contend with inflation because such a transition would involve the market's determination of what money is.

While in a closed system it may be hard to drum up confidence in the value of the coin (or currency today) after debasing it, in an open system of trade, it's still perhaps hard, but there's a way. If the King would open his Monarch to trade, for instance, and through this scheme were able to persuade foreigners to invest in his Kingdom of excess and counterfeit profits, the value of the coin might even perhaps rise for a time, depending on the success of his promotion. In other words, if "the real rate of return from capital markets" appears strong, the coin will attract new demand (liquidity).

And if so, he might just continue shaving off more and more gold to continue stimulating the so-called economy. And when the excess becomes so decadent that there is almost no gold left in the coin, and he's pushed the Treasury again to the brink such that it has constrained his ability to continue the counterfeit expansion, deflation fears would once again set in. But they wouldn't survive long, because the coin is in fact worthless. Not only does it have no intrinsic value, but its monetary value has been spent. It has become so worthless that the market is about to decide on something else for money altogether, and there's nothing the King or his subjects could to do about it except hope that the economy produced enough garbage in the boom to sustain them for a while. They could call it productivity, and talk about how it'll absorb the inflation.

Anyway, assuming people don't fall for it, at that point all prices would rise, because people have become "suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly." The economy would no longer thrive as it did when the inflation was "under control." And so, at that point, people would no longer fear deflation while rooting for inflation. The wrong prices would be rising! They would learn to despise the inflation. Until we reach that point, we're likely to be surprised at the Fed's creative ability to stimulate inflation each time the threat of deflation appears to mount.

You see, until people decide they want deflation more than inflation, they are unlikely to get it through the current institutional setup. Well, it's not that simple. But up until now, their experience with inflation has been good. It's been so good that Americans now routinely beg the government to "do something for their economy." They mean inflation, more of it, but the good kind. Not the kind that makes the value of the currency fall. Rather, the kind that stimulates commerce and, uh, of course, stock prices! The kind where the perceived rate of return in capital markets is real and caps the relative price of gold (this is how they kept inflation in check through the nineties).

No wonder investors still aren't really listening to the gold argument. They don't want to believe it. They want to believe that the government and Fed are doing all they can for the economy, and their dollar assets, to stimulate commerce. Believe me, they are. Only, there's no gold left in that coin, and the entire world owns dollars, still waiting on those positive real returns to de facto hold down the relative value of gold.

Sure, we'd accept that if the Fed stood aside, and interest rates spiked upward, there would be an escalation of loan defaults. But that's just the point. The Fed's job is to inflate those loan values and thereby sustain unsound credit expansions, and as long as investors have confidence in the Fed, deflation is a misnomer. Deflation is seen to be an evil greater than that of inflation today, but only because we've become so indebted. In other words, we've become vested for inflation and there is not one legitimate institution we'll allow in our way, including the institution of sound money. Of course such a society would fear deflation.

Certainly, if the Fed didn't exist the money would be sound. But we don't want that. We'd rather our children dealt with it.

The deflation noise today largely emanates from sectors feeling the pinch, and it has long outgrown the manufacturing sector. In other words, it increasingly is evident by those sectors of the economy that are most dependent on the success of the King's prior inflation schemes and are pressing for more. The noise is probably getting louder because the schemes aren't working despite efforts.

The Fed has slashed interest rates to almost zero from 6% over the past two years. But the goldilocks economic formula where low interest rates boost consumption, equity values, and even profits for a time has shown no sign of life. The problems surfaced when stock values became overly expensive during 1999 and when that in turn limited the ability of stock market gains to drive increasing earnings momentum. Since then, declining real returns have been weighing on the dollar and supporting gold values. In layman's terms, the ponzi scheme broke down. And now that weakness has become apparent in the bond market, the Fed has indicated it might cap long term bond yields in order to fight deflation!

Meanwhile, they've been trying out a new formula. Inflation of real estate values. But not the kind where real estate prices reflect a growing monetary premium because the dollar is falling apart. The kind where the housing inflation begets the perception of strong real returns so that the dollar doesn't fall, and interest rates stay low, and that credit could expand indefinitely. In other words, their new formula is simply that they're targeting real estate paper markets rather than stock markets per se. Of course they'll deny it.

We aren't arguing that gold should be money. We are just arguing that it often is due to the persistent inflationist dogma inherent in our society. It's so pervasive an entire generation doesn't believe it exists. Almost like the air we breathe, except worse, since at least we acknowledge that.

A growing chorus of analysts are accepting the dollar's overvaluation. Yet there is also a growing chorus of analysts that are forecasting deflation. The two forecasts contradict one another.

I think for the sake of simplicity, our confidence in the inflation hypothesis boils down to these two main facts:

  • based on a subjective analysis, we find that the dollar is overvalued.
  • based on a political analysis, we find participants prefer inflation, uh, period.

The first one implies that the Fed has exhausted its tools to sustain the dollar's phony value.

Anyhow, the deflation argument implies the dollar's monetary value would be unaffected in a credit crisis, or that the crisis would cause it to rise in value relative to most goods as the credit crunch results in contracting "money supplies." This idea originates from the auspices of elastic money theory.

But the theory only works in one direction in reality, expansion. When since Roosevelt took America off the gold standard has a contraction ever been the case for longer than six months? The reason is always the same. No matter how governments try and restrict or control inflationism, it never works. We've already noted the pushing of the string analogy is more applicable to the effects of monetary policy on real growth than it is to the ability of the King to shave more gold off the coin of the realm, if you will. A contraction in the monetary aggregates is a restrictionist's or deflationist's pipedream.

Besides, the implication also assumes the dollar's monetary value is determined only by changes in its quantity. If that were the case, it wouldn't have gained in value through the nineties. US money supplies grew by double digits in the nineties, and they grew faster in America than in most other developed nations whose currency values declined relative to the dollar's. The Fed explained it away with productivity. What's the Fed doing explaining anything anyway, you might correctly ask? Is it defending itself, or does it have a more active role in this fool's game today?

Change in the supply of a currency does affect its value, but not in a straight line because there is an intermediary. People, and their perceptions. People can only judge the value of something relative to something else, usually the most liquid medium of exchange (liquidity always implies demand, for if there was no demand, there'd be no liquidity). If they want to buy a refrigerator, they need money to do it, otherwise they'd have to have something the seller wants. So money is simply that which people unquestionably accept in exchange for their labor. If there's a question, it's not money, it's probably currency.

Thus, the function of money is to facilitate exchange, and it's meant to be kept on hand in enough quantity to enable its owner to achieve his or her daily goals. Goods then are judged in terms of how much money they command. But when this process of valuation is distorted by volatility in the value of the currency people think is money, participants are probably going to be making bad judgment calls, overvaluing one thing and undervaluing another. This is why inflation is all about value. That's where it strikes the hardest, at heart of the mechanism that structures a market economy: Mises' list of subjective values for each individual.

A common mistake in economics is to assume that markets are inherently volatile. This is a particularly odd claim when the data is corrupted with enormous government spurred interventions over the years anyway.

The idea that money should be stable in value is one of the qualities that markets tend to prefer in it. But the idea that the government should invent a currency then stabilize it is financial alchemy, and economic baloney.

It doesn't work. Left to its own devices, the market would choose a stable money. It wouldn't ever be perfectly stable, but it would be many times more stable than anything any government could create or than anything the world has seen in over 100 years! Ed Bugos

To imagine the likelihood of deflation then, we'd have to imagine the subjects in the King's kingdom rejecting his monetary schemes altogether, perhaps even in rebellion as has been the case historically. They would have to see that inflation is a fool's game where they're the suckers. It would have to make people sick to have to argue with their employers constantly over wage gains. Businesses would have to find that the cost of doing business in dollars is increasingly prohibitive. When we get there, deflation is possible.

As a point in fact, the only deflation post 1934 America ever experienced was "after" periods of rapid dollar devaluation that left the dollar, well, undervalued. And at best, they were symptoms, rather than the real thing. Mere threats, like those overhanging the shoe salesmen in our example, or more accurately, the threat of deflation was an excuse for mandating further inflationary debasement. Our most recent brush with any kind of deflation was in the early eighties, after a massive dollar devaluation. Let me repeat, AFTER a massive dollar devaluation, where the dollar lost almost 90% of its value against gold and other key commodities.

The dollar faces a similar devaluation episode in its current phase on the historical timeline, and largely for the same reasons it did then. And so deflation may be closer in terms of time. But not in terms of the dollar's value. Not until after the dollar devalues by thirty to forty percent would we entertain the notion of deflation even as a symptom.

I don't want to beat this horse to death, but the deflation prognosis makes so little sense to me, yet it is very alive today. Obviously it's a strong horse. But it's also the, yes, time for a cliché, Trojan Horse. I would believe it if I saw any sign of the aspiration to establish a sound monetary regime. Even a phony rig job couldn't pass the public mandate today. People love inflation. It's like the air they breathe. It's the source of their confidence.

Finally, let me be clear on something else. As gold's monetary value increases, to the extent it gradually becomes money, we will be experiencing deflation. The price of most things will fall in value relative to it, particularly those assets whose value is tied to the dollar's. That is going to be our only deflation. In terms of gold.

As for the dollar, it's like the air we breathe, it's everywhere. We believe it's overvalued today, and we believe that the current policy path of world governments is irreversible.

But we also believe that the dollar could in the future again be sound money provided the right steps were taken and after the market devalues it.

Unfortunately for America's libertarians, this future is at the moment nowhere in sight.

Edmond J. Bugos


The GoldenBar Daily Global Market Outlook is not a registered advisory service and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you to confirm the facts on your own before making important investment commitments.
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