Inflation or Deflation? 2
Adam Hamilton August 1, 2003 4099 Words
In the perpetually fascinating financial-markets world, it is funny how few things really change.
Today, just like any other day in the past few years, one of the greatest economic debates still swirls around the inflation or deflation question in the States. This old debate continues to rage because the stakes are so high for everyone.
Inflation and deflation are both far-reaching titanic forces that spread out and greatly influence returns across all major financial markets. The outcome of the inflation or deflation question is crucial for stock investors, bond investors, real-estate investors, and gold investors. Some investment classes tend to do well in inflationary environments (gold and silver), others tend to shine in deflationary times (cash and bonds), and still others tend not to thrive in either extreme environment (general stocks).
As I haven’t written about this great inflation or deflation question in any depth since my original “Inflation or Deflation?” essay published in late 2001, I figured it is probably about time for an update. Amazingly quite a few folks still write in today with comments on or questions about that old essay! We are blessed with vastly more data today than two years ago so the most probable outcome of this massive inflation and deflation struggle is gradually becoming clearer.
Just like last time, there is no way that we can constructively discuss inflation and deflation unless we get the definitions out on the table up front to utterly annihilate any ambiguity. For some reason great confusion reigns today regarding the actual precise meanings of these words. Here are the real and true definitions, according to the massive Webster’s unabridged dictionary that keeps my desk from flying away.
Inflation … “A persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency.”
Disinflation … “A period or process of slowing the rate of inflation.”
Deflation … “A fall in the general price level or a contraction of credit and available money.”
There are two key points in these true definitions of inflation and deflation that every investor must understand.
First, note the key monetary nature of inflation and deflation. Both of these macro economy-wide forces are the result of changes in the underlying money supply relative to the available pool of goods and services on which to spend the money. If the money supply grows at a substantially different rate than the US economy, the inevitable result is inflation or deflation.
Second, inflation and deflation are economy-wide forces affecting general price levels. Rising or falling prices in particular narrow sectors of the economy often have absolutely nothing to do with inflation or deflation. Energy prices rising alone in isolation often have nothing to do with inflation. Conversely computer equipment prices falling alone in isolation have nothing to do with deflation. Inflation and deflation are only relevant across economy-wide general price levels.
Inflation is only possible when the general level of prices increases as a direct result of the money supply growing faster than the underlying economy. Deflation is only possible when the general level of prices decreases as a direct result of the economy growing faster than the money supply. Inflation and deflation are purely monetary phenomena ultimately leading to changing general prices, and the root cause is always monetary in nature.
Today’s great inflation or deflation debate is much easier to wade through when one has the benefit of the proper historical perspective on how these two great forces have impacted America. Our first graph shows the popular Consumer Price Index, the most widely accepted measure of “inflation”, since 1925.
The CPI itself is graphed on the left axis in blue, while the right axis shows the annual rate of change in this CPI rendered in red. When general price levels are rising, indicated by a positive CPI YoY change, the red line is above the thick gray zero-CPI-growth line. Conversely falling general price levels are noted when the CPI YoY change falls negative.
As this long-term strategic perspective reveals, rising general prices, inflation, have been much more prevalent in modern American history than deflation. For the past half-century there hasn’t even been a hint of falling general prices, or deflation, so investors should take this into consideration. Since inflation is the modern historical norm, investors need to have very good reasons for dismissing it outright and throwing in with the deflation camp.
The last time the US witnessed real falling general prices was during the Great Depression of the 1930s. As shown above, in the early 1930s near the ultimate post-1929 stock-market bottom general price levels actually fell more than 10% over one year! This environment was truly great for savers because with each passing month the capital they had painstakingly set aside grew more and more valuable. Their same dollars could buy more in houses, cars, food, and everything else we need to survive and enjoy life.
While today’s socialist Keynesian historians who bow at the idol of Big Government try to tell us that deflation was bad, they are dishonorably bending history to advance their own Marxist agendas. Falling general prices are not necessarily bad, and there is no doubt they helped countless American families survive the Great Depression as each of their dollars went farther and bought more of the crucial goods and services they needed to survive. If you were out of a job and had to feed your family, would you rather live in an environment where each of your dollars was worth more every day (deflation) or each was worth less every day (inflation)?
Since the early 1930s, with the minor and understandable exception of the turbulent World War 2 years, general price levels have risen ever since. Note above how the blue CPI line took off in the mid-1930s and has never looked back. The 20th century could very well be remembered as the most inflationary century in America’s short history.
It is absolutely fascinating that almost a century of CPI data only really has two significant slope changes, one in the early 1930s and one in the early 1970s. Dotted white lines mark these important changes in the rate of inflation. Not surprisingly, these incredibly important events were the direct results of the two greatest fundamental changes in the US monetary system of last century. Since inflation or deflation is the direct product of the relationship of money supplies to the underlying real economy, fundamental monetary changes dramatically impact general price levels.
In 1933, the evil socialist dictator Franklin Roosevelt dishonorably reneged on his campaign promises and immediately after taking office grievously gutted the US Constitution by banning Americans from owning gold as well as attempting to confiscate existing privately owned American gold. Prior to Roosevelt’s horrific thievery US citizens could freely exchange their paper dollars for actual real gold at the US Treasury any time they wished. Before Roosevelt, the US paper dollars were 100% backed by gold, the US was on a Gold Standard, and there had been zero inflation for over a century!
Before 1933 was the Age of Gold. Back then a dollar your grandfather saved in the early 1800s would buy the same amount of goods and services as a dollar you saved in the early 1900s! Can you imagine living in an environment where housing prices never skyrocketed, where grocery prices were always constant, where transportation and energy prices never rose, and where the value of money was as solid as the gold that fully backed it? Compared to today’s tragic environment where the prices of life’s necessities relentlessly rise every year and impoverish millions, the Age of Gold was financial paradise!
Franklin Roosevelt was without a doubt the worst president in America’s history. After destroying the solid golden foundation of the US dollar he built the immoral foundations of the modern Welfare State which steals 50% of the income of the productive today to subsidize the lazy and unproductive in order to bribe them for votes. Almost all of the huge financial and debt problems America faces today would have never happened if Franklin Roosevelt hadn’t betrayed the very US Constitution that he swore to protect. May history curse him and his blighted memory forever.
After Roosevelt’s terrible 1933 infamy, general price levels rose steadily for many decades. Peaceful times brought low inflation and much higher standards of living for Americans, but whenever vain politicians sought war inflation soon jumped and the value of the US dollar farther eroded. But Roosevelt didn’t hate his socialist foreign buddies as much as he despised the good American people, so his 1933 gold ban only applied to American citizens.
From 1933 to 1971 foreign investors holding US dollars could freely exchange them for gold at the US Treasury at any time. This was the Age of Partial Gold, when the US dollar was not backed by gold internally domestically but from a foreign perspective it sort of was. Under the pre-1933 full Gold Standard, the US government and later the Fed couldn’t print money unless it had the gold to back it, so the US money supply grew very slowly and general prices remained stable.
After 1933, a crucial component of Fed discipline was removed so the supply of US dollars started growing significantly faster than the US economy leading to inflation, a rise in general prices. Still though, since foreign governments could demand real gold for their dollars at any time, the supply of freshly printed dollars to “pay for” government largesse and endless foreign wars was somewhat limited.
Then Vietnam came, yet another unconstitutional foreign war waged in a far-off Third World cesspool in which Washington had no casus belli and absolutely no reason to spill American blood there. The combination of the huge costs of a long foreign guerilla war and socialist dictator Lyndon Johnson’s massive Welfare State-expansion “Great Society” programs literally broke the bank. Together they required unthinkably huge numbers of paper, or fiat, dollars to be printed out of thin air to “pay” for both guns and butter. Not even nation states can have it all!
It didn’t take long for foreign investors and governments to recognize this inflationary threat to their dollar holdings’ value so they started demanding gold for their paper. At the intense rate gold was hemorrhaging, soon the US wouldn’t have any gold left as it flew out of the Treasury fleeing the Fed’s monstrous monetary inflation. In 1971 Richard Nixon, another absolutely horrible president who hated the US Constitution and betrayed the American people, totally severed the dollar’s link to gold. After his decree, not even foreign governments could exchange their dollars for gold.
With Nixon’s final deathblow to sound American money, the Age of Fiat Paper was born. Now the Fed could print unlimited amounts of inherently worthless fiat paper dollars all the time without suffering any immediate consequences. Needless to say, since 1971 inflation and the CPI have soared and the savings of hardworking Americans have been stealthily stolen to fund the overpowering Welfare State. In the graph above note the huge slope steepening of the CPI in 1971 when the international dollar gold standard was reneged.
In order to truly understand the great inflation and deflation debate raging today, you have to understand where we have come from in the past century in monetary terms and where we are today. Unlike the deflationary early 1930s, when the US was on a gold standard and hence couldn’t print unlimited dollars, today the US has no standards at all. The Fed can and does print (or create via computer) as many dollars as it wants and the money supply growth has vastly outstripped underlying real economic growth since 1971.
Zooming in to the last four decades or so, we can really see the ill effects of the complete severing of the dollar from gold and the resulting torrent of promiscuous monetary growth and inflation unleashed. When relatively more money chases after relatively fewer goods and services, when the money supply grows faster than the underlying US economy, inflation is the inevitable result.
Pre-1971, before Nixon stained American history, both the CPI and broad M3 money supply were growing relatively modestly. Interestingly, their tracks on the graph above are even parallel, dramatically underscoring the fundamental relationship between money supplies and general price levels. After the 1971 severing of the international dollar gold standard, however, both the money supplies and inflation soared.
Of particular interest to investors pondering today’s great inflation and deflation debate, note the extraordinary recent growth in the money supplies since the stock bubble collapsed in 2000. M3, the total broad supply of US dollars, was sitting at $6t in the late 1990s and is now approaching $9t, an unthinkable 50% increase in dollars in circulation in only a half-dozen years or so! MZM, a narrower money-supply measure, has also increased by more than 50% in the same time period, rocketing from $4t up to $6t+. Yikes!
If relatively more money chasing after relatively fewer goods and services causes inflation, and if money supplies are currently exploding like there is no tomorrow, and if the Fed can print unlimited dollars because no one can officially exchange them for gold anymore, where is the deflation threat? The more I watch this supercycle Great Bear bust unfold, the less I am worried about deflation and the more I fear skyrocketing inflation.
Since the end of 1998, the US Gross Domestic Product, or the total pool of available goods and services produced in the entire US economy, has grown by 17.5%. This is impressive in light of the immense financial pain felt in the States since 2000. But in comparison, over the same short period M3 has rocketed up by 46.0% and MZM by 59.8%! Money supply growth in the US, by the Fed’s own measurements, is currently outstripping US economic growth by 2.6 to 3.4 times! As relatively more money chases after relatively fewer goods and services, how can general price levels do anything but rise?
Looking at the raw data and realizing that the Fed has no gold discipline today thanks to pathetic Constitutional traitors like Roosevelt and Nixon, it is hard to imagine another deflationary spell today. General price levels falling while general money supplies are soaring is virtually impossible. For the past year or so I have been paying close attention to who is making these deflationary arguments, and the results of my informal observations are quite revealing.
From my perspective, it seems like the “threat of deflation” is brought up most often by Wall Street and the government/Fed establishment. I am starting to suspect that these deflationary references are merely cleverly crafted misdirections though, designed to distract investors from the real inflationary threat. When you watch a magician perform, he always leads your eyes to focus in one place while the real “magic” is happening somewhere else. Alan Greenspan himself is the master of this grand economic sleight of hand designed to mask the true dangers of inflation.
Greenspan is already one of the greatest inflationists in world history and he will go down in infamy next to the notorious John Law from three centuries ago in the history books. All the Greenspan Fed does is print money and foment bubbles, like the late 1990s stock-market bubbles and today’s bond-market and real-estate speculative excesses. The problem with printing unlimited amounts of fiat money is that price levels will have to rise as a result.
So if you are Greenspan and want to distract investors from the real threat, why not pretend you are fighting the nonexistent “threat of deflation” rather than edging towards all-out dollar hyperinflation? While inflation has been universally recognized as a great evil and an immoral regressive stealth tax for millennia, perhaps inflating can be rendered acceptable if investors are duped into believing that it is “necessary” in order to prevent the bugaboo of deflation.
If this deflationary-sleight-of-hand-to-mask-huge-inflation hypothesis is correct, what is the motive? I suspect the motive of Greenspan and the pro-inflation crowd is simple. They want to flood the markets with dollars to try and prematurely end the Great Bear bust in the stock markets, but they don’t want the bond markets to recognize the true monetary inflation and collapse.
A bond collapse could send long interest rates into the stratosphere, which would slaughter the majority of Americans with adjustable-rate mortgages and single-handedly disembowel the refinancing boom. And if Americans are forced by rising long rates to stop extracting equity from their homes to buy cars and TVs, the US economy is toast and another full-blown Depression, albeit an inflationary one, is probably assured.
Our next graph compares the annual change in the CPI since 1940 with the 30-year Treasury Bond yield, or long interest rates. Naturally higher inflation leads to higher bond yields as investors and savers sell bonds until their yields are high enough to compensate for the annual stealth losses in purchasing power spawned by monetary inflation.
Long rates generally track inflation, or more precisely inflationary expectations, fairly closely. If bond investors expect high inflation as in the 1970s after the Vietnam War and Great Society Welfare State initiatives, bonds will be sold off until long rates rise high enough to compensate the bond investors for the high risks to their capital posed by inflation. Excess money leads to rising general prices, and this inflation inevitably leads to higher long rates in the debt markets.
Interestingly, in the pre-1971 Age of Partial Gold long rates seldom exceeded 6%, while in the subsequent Age of Fiat Paper long yields seldom fell below 6%. If the US Fed can print unlimited dollars with no inherent worth totally devoid of all immediate consequences and discipline, what will stop rampant inflation? When bond investors also start to think this way, and they will, a substantial rise in long rates is virtually assured.
So when bureaucratic Fed or government types like Greenspan ignore true monetary data and constantly publicly proclaim they are “fighting the threat of deflation”, odds are they are just stage-managing bond-market expectations. The sleight of hand is designed to draw the huge bond markets’ attention away from the real monetary growth that will lead to inflation and instead refocus it on the manufactured threat of falling general price levels. Unless someone nukes the Fed, it is hard to imagine general prices ever really falling in the States under this sad fiat-paper regime with which we have been saddled by the Keynesian socialists.
The long rates matter so much to the government and Fed because the only thing holding back the necessary Great Bear bust in the States is the mammoth wave of mortgage refinancings by American consumers. With general debt levels so high, stock-market valuations so extreme, and the economic situation so dire, any disruption of so-called “equity extraction”, which is really just digging deeper into debt using houses as collateral, will lead to much lower consumer spending in the States. Since businesses are not investing and their excess capacity remains so high from the bubble years, if consumers in the US substantially slow their spending a very long recession or Depression is virtually assured.
Higher long rates, the natural consequence of monetary inflation, are the greatest threat to the mortgage-refi boom in the US and hence the entire fragile basis for today’s consumer-driven US economic “recovery”. Our final graph shows the Long Treasury rates, the 30y mortgage rates, and the ballooning money supplies tossed in for good measure.
Mortgages, literally Old French for “Death Pledges”, are totally dependent on long rates established by the free bond markets. As you can see above, the appropriately black line for mortgage debt prices closely tracks the yields in long US Treasury Bonds. If the bond markets suspect inflation is coming and sell off, yields will soar higher and the mortgage refinancing game delaying the inevitable bust in the US economy will suddenly end. Provocatively this has already started since June!
This phenomenon is even more of a threat today since the majority of Americans refinancing their mortgages foolishly chose to fall into the deadly trap of accepting hyper-risky adjustable-rate mortgages. With mortgage rates near 45+ year lows the prudent course of action would be to lock in fixed rates at these anomalously low levels. But the greedy mortgage industry encouraged Americans to take on more crushing debt at variable rates instead. So as the bond markets sell off and long yields and hence mortgage rates soar, the majority of Americans will see huge increases in their monthly “death pledges”. There is nothing like debt to destroy prosperity and lead to poverty!
As the graph above ominously shows, between 1974 and 1981 the US M3 money supply doubled from $1t to $2t leading to soaring long rates in the 1980s. Similarly today the US M3 money supply has doubled from $4.5t in 1995 to almost $9.0t today, a similar span of time. Is deflation really a threat in the coming years after a rapid 100% increase in the US money supply much like the 1970s?
To tie this long essay all together, the longer I contemplate the great inflation or deflation debate and study the actual data, the less concerned I become about deflation and the more I fear extraordinary inflation. Deflation, a fall in general prices, is only possible with a shrinking money and credit supply, which we obviously certainly don’t have today.
With Alan Greenspan, a notorious inflationist, unfortunately at the helm of the Fed today, and with the Fed able to inflate at will sans any restraining influence of a true full Gold Standard or even partial international gold standard, investors really ought to be preparing for widespread inflation, not deflation.
General prices are certain to rise in light of recent monetary excesses. Some narrow sectors will no doubt see generally falling prices, probably even including real estate, but a fall in specific-sector prices while most other prices rise is not deflation.
For example, computer prices were falling in the early 1980s as they are today, but it was still a generally inflationary environment. When rising long rates kill the residential real-estate boom and lead to falling house prices, it won’t be deflation but just the end of a narrow debt-financed speculative mania in houses. Even in an inflationary environment the prices in some sectors are bound to fall from sector-specific supply and demand factors.
As I mentioned in my original essay on this topic, anything typically financed by debt is likely to see its prices plunge dramatically, like houses and cars, as the ongoing Great Bear bust continues to destroy the gross excesses of debt via higher long rates. Conversely, anything not typically “paid for” with debt including groceries and general living expenses is almost certain to rise in the coming years. We are staring down a brutal environment of widespread inflation marked by various sectors witnessing falling prices as debt leverage implodes.
While general deflation was possible in the early 1930s with a Gold Standard severely limiting monetary growth, it is all but impossible now in the Age of Fiat Paper when central bankers can print unlimited amounts of inherently worthless fiat currency which inevitably leads to steep rises in general price levels.
So what’s an investor to do?
Inflationary environments marked by rising long rates decimate bond portfolios and lead to horrible bear markets in equities. The US stock markets essentially traded sideways to lower for a decade in the 1970s until the early 1980s, the very inflationary time marked in the graphs above. Inflationary price rises spawned by fiat monetary excess are bad for all intangible paper assets, not a good omen for stocks or bonds.
The ultimate financial asset to own in times of excessive monetary growth and hence widespread inflation is gold. Both the Ancient Metal of Kings itself and stocks of quality unhedged gold-mining companies thrive in such ugly environments for the general stock and bond markets. We have already been blessed with 30%+ actual annual realized equity returns in recent years in the exciting gold-stock arena, the ultimate inflation hedge. And we ain’t seen nothin’ yet!
As these highly inflationary trends are unlikely to abate as long as the Fed is free to print and create unlimited fiat dollars, we will diligently continue seeking out great investments that will thrive in these dark monetary times for our Zeal Intelligence newsletter subscribers.
Please consider joining us before Greenspan’s mega-inflation totally destroys your hard-earned savings and precious investment capital!
Adam Hamilton, CPA August 1, 2003 Subscribe at www.zealllc.com/subscribe.htm