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Inflation v. Deflation

December 09, 2003

Inflation and deflation are monetary phenomenon. The fact that prices rise or fall is not inflation or deflation per se, that is just the visible effect. The Feds thinks that they can contain deflation, because they think they're in charge of the money supply. Just print more money and the problem is solved, right? That is what they have been talking about and doing for the past few years. They think lowering interest rates will inject money back into the system. And it has, so far, via the home refinance market, lower credit card payments, increased margin debt etc. Thus we have had a nice recovery. Business is booming, commodity prices are high, and the POG is high, which would seem to signal inflation.

But if you look at these Steve Puetz charts, and listen to him, he's saying that it is just a temporary phenomenon. Like throwing gasoline onto your dying campfire. Nice and bright for a few minutes, but then it will die back down to embers, and you've used the gas that you need to get yourself home in the morning!

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So everyone has taken on debt because it was easy and that really juiced the economy, but people can't take on any more. Can you? So that's why M3 is falling. Money supply was first increased, then it was borrowed, spent, and now it is gone. Debts? How do you pay them off if you didn't have any money in the first place? If people are unable to keep up with their payments on debt -- which becomes likely once interest rates start to rise -- the cycle is reversed right down the chain. People default, causing others to tighten, loans stop, loans are called, liquidation begins in earnest and the money supply growth goes negative, like it is right now (see chart above).

But there is a lag between the change in the money suppy and its effects. We're just seeing the effects of the increase in money supply, and its already falling been falling for some time now! So we should start to see the effects of the falling money supply shortly. The gas on the fire has made everyone optimistic. Look at how pretty the economy is - best in 20 years! The Dow is near 10K, Nasdaq 2K, unemployment is down, growth is up. But if times are so good, why is the price of gold so high? Because the money washed over all asset classes indiscriminately, like gasoline, and is making them burn brightly. Don't believe the good news for a second, this economy and this system are gravely ill. The economy is rotting from the inside out, and the foul stench of decay is still hidden from most people's perception.

When prices start to collapse in the market, people will sell for liquidity. This will drive markets down further - the whole cycle in reverse. The anti-bubble. "Investors" wil sell their gold, because in the end, they were just speculating -- out to make a quick buck. The gold bugs will hold, but it is the marginal buyers who affect the price. Same for commodities. There are engineers here in Taiwan who are speculating in the DRAM market -- locking in prices on a contract, then quietly dumping it on the spot market, and making a nice profit. The economy here is 'good' too.

So everything will fall in value - but what will rise? Curiously, the dollar. Why? Because everyone's debt is denominated in dollars, so there is demand for them because people need them to pay off their debts. Even though it is ultimately worthless, people are fooled by the illusion. Their perceptions have not yet caught up with reality.

At some point in the cycle, however, the illusion is broken, and people forget about their debts. They realize they'll never be able to pay them off. Instead, they'll use what money they have, or better yet, use borrowed money to buy commodities, real estate, gold, etc. because they're switching out the bad money for good. This is where the hyperinflation begins.

In the end, the question of inflation or deflation has to do with how people feel about paying off their debts. If they think they still can do it, we'll have deflation because people will demand dollars. If they give up hope, that is when the free for all will start with inflation then hyperinflation.

My vote is that people will try to fool themselves for a little longer. It is much easier than facing up to the ugly truth.

On that cheery note, never forget the two fundamental rules of speculation: (which I learned from a late 20th Century issue of Esquire magazine)

1) Don't Panic!
2) Panic First!

Cheerio!

Michael

Posted by manystrom at December 9, 2003 12:20 AM
Comments

I'm just curious about how someone might borrow money to buy commodities/real estate after they're already tapped out and in the middle of a deflationary economy? You kind of lost me there.

I would like to believe in your scenario, as it at least provides for a brief period of ant supremacy before the grasshoppers are able to pay off all of their debts with inflated dollars. I would also prefer if you would be bold enough to predict the approximate timeline for your scenario. Thanks, really like the site. A

Posted by: alfred at December 13, 2003 11:21 AM

Forget the hyper inflation,ain't gonna happen. This is an economy based on massive amounts of debt. Once the money stops flowing,everything stops flowing, food,gasoline,medicines",collapse" is the word. The hyper inflation of Germany was based on what was still a cash/rural economy, with local food producers. While many suffered,many didn't- barter still worked. The situation today is totally different,our food comes from across the country or out of it. Heating gas/oil, where Texas/Canada?.Your water,how many miles away? Don't assume that that because you have gold/silver you are going to be rich and live like a king based on its value. Should we see a collapse in the economy,it will come rapidly. PM's are just an intrim investment for the winter to follow.May I remind you that ALL wealth is an extension of the basics, Food(water),Shelter,Security.All early,or so called primative people put food,clothing,weapons away for a rainy day. Doing so gives a measure of security,,,just in case. thank you for taking the time to read my reply,,,nad

Posted by: nadcarves at January 10, 2004 08:17 AM

I do not agree with the article scenario for hyperinflation because the money supply will contract. First let me give you a definition of deflation (by Robert Prechter) Deflation is the contraction of money and credit; Inflation is the expansion of money and credit. When the money supply contracts there will be little money lent out, this is because banks won't lend because they are afraid the people (the one's that need the money) will not pay it back and the people that can pay back the loan, will not borrow because they do not want the debt. Why would one want to pay back a loan with stronger dollars? This is the reason commodities and housing prices will drop significantly. If you would research, I believe, 1932 real estate in America, you can find the answer. The higher real estate went up, the harder the landing. In some cases, it was pennies on a dollar. I remember reading that houses in Chicago were selling at $15,000 in the beginning of 1932 and at the end of 1932, they were $1,500.

Another reason is liquidity the Fed has dropped interest rates and there was a sizable tax cut that should have increased the money supply significantly and cause the inflation that most people are waiting for. Why is M3 contracting?

As for when will it start? Watch the money supply.

The other item I do not agree with is gold. I agree that gold will rise during the financial panic because of the excess demand. Yes, many people will buy gold, however, gold is no longer money. Which countries exchange their currency for gold?

Posted by: Roy at February 19, 2004 10:34 AM
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