Inflation or Deflation?
Adam Hamilton December 14, 2001 5425 Words
One of the great debates currently raging amongst sophisticated investors worldwide concerns the near-future prospects for the US economy. An important facet of this mega-melee includes the intellectual firestorm brewing over whether inflation or deflation is the more likely prospect for the United States in the next few years.
The great inflation or deflation question is exceedingly important on multiple fronts. For investors, being right or wrong on this key issue could mean the difference between amassing great fortunes or walking away empty-handed with grievous losses of bubblicious NASDAQ proportions. Some investments that thrive during inflationary times can be as lethal as millstones tied around the neck of an exhausted swimmer in deflationary seasons. Conversely, some attractive destinations to park capital that shine in deflationary times will be littered with shrapnel and bleeding profusely during inflationary times.
After the crucial process of attempting to divine the future trends in major markets, whether they will be bullish or bearish, attempting to understand where we now sit on the great inflation/deflation balances of history is of paramount importance.
Of course, it profits little to discuss inflation or deflation until we assure that we are all on the same page and fully understand the true and proper definitions of the words. With many thanks to our friends who painstakingly create and maintain the current editions of Noah Webster’s massive namesake dictionary, here are the true definitions of inflation and deflation.
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.”
Deflation … “A fall in the general price level or a contraction of credit and available money.”
Also, the oft-confused concept of “disinflation” must be defined, as it is very different from flat-out deflation.
Disinflation … “A period or process of slowing the rate of inflation.”
In order to build a working and profitable investor’s understanding of inflation, it is absolutely essential to know exactly what the above words mean. After the true definitions have been internalized, the concepts of inflation and deflation can only be really understood in the way they were originally intended, having to do with money supplies. Money supplies grease the skids of global commerce in the economy.
I really enjoy reading historical books on economics. One revelation that never ceases to amaze me in economics books, whether over a century-old or modern, is how fabulously complex the underlying economy truly is. The so-called “dismal science” (I always chuckle at that label!) attempts to simplify the most complex man-made entity the world has ever seen, the economy.
While the space shuttle may be the most complex non-biological machine that humans have cobbled together with duct-tape and bailing-wire in history, the effectively infinite complexities of the economy make NASA’s pride-and-joy look like an old wrinkled paper airplane. No wonder economists are perpetually wrong and have such a poor track-record for forecasting!
The economy is so phenomenally complex because of the raw information streams feeding and driving it.
The global economy is actually the sum total of every single decision made by every single person on the planet on how to spend or not spend his or her scarce resources. Of course, out of the six billion or so folks currently hanging-out on our third rock, maybe only one-half to two-thirds are fortunate enough to possess even a small surplus of resources left over after the crucial subsistence needs of food, clothing, and shelter are addressed. These billions of people who are able to accumulate surpluses are forced to make decisions every day, to save or spend, to buy or sell, how to deploy their resources.
The world economy is so fabulously complex because it is the distillation of every single economic decision (involving spending money, trading, or allocating resources) made by every person who buys or sells every day everywhere on the planet. When this unfathomable complexity is coupled with the obvious fact that economists are not omniscient like God, the dismal science of economics has to make enormous abstractions in order to model the economy.
As the global economy is simply the sum total of every single economic decision made by everyone each day, money is often the tool of choice to consummate an economic transaction. Sure, we could use multi-ton stone wheels to trade for goods and services like the famous Yap islanders of Micronesia, but money has developed through history to be highly portable and easy to transport.
Money in itself is an incredibly complex and endlessly fascinating subject. While at first glance money seems easy to define, it really isn’t. The Patron Saint of the Fabled New Era, one Alan Greenspan, once testified before the US Congress not too many years ago that he had no idea what money was or how to define it. That ought to inspire in you a lot of confidence in the poor fellow controlling the very purse strings of America that Article 1 Section 8 of the United States Constitution said belong exclusively to the United States Congress, elected by the people, and not a secretive and unaccountable private bank like the falsely so-called US Federal Reserve!
On a money sidenote, a few paragraphs later in Section 10 of Article 1 of that same glorious United States Constitution, anything other than gold and silver is expressly prohibited from being legal tender money for the states of the United States of America, but that is another subject for another essay. Please don’t tell the Fed, as reading the Constitution might ruin its enormously destructive 88-year-old power-trip!
With the economy simply being the distillation of all economic decisions, and money facilitating the ease of transfer of goods and services, the critical key to understanding inflation or deflation is realizing that it is a pure monetary phenomenon. Inflation or deflation is caused by changes in the relative levels of money available to spend compared to the relative level of goods and services available to purchase. If you glean a single strategic concept from this essay, the indisputable truth that inflation and deflation are caused exclusively by money supply fluctuations is the crucial bit of wisdom with which to walk away.
Please re-read the official definitions of inflation and deflation above and note the tight connections with money supplies. If you ever hear anyone pontificate on inflation or deflation, and they fail to mention money supplies, you can immediately begin to suspect that their understanding of these crucial macro-economic phenomena is inherently flawed.
A little thought-exercise can help clarify these crucial concepts.
Imagine that everything for sale on the entire planet, every good or service in existence today, is quantifiable in 100 units. Also, imagine that all the money in the world is also equal to 100 units today.
Now imagine that, at the end of 2002, because of the hard work of billions of people around the world, that the absolute available goods and services on the planet increased to 102 units, a respectable 2% gain in global GDP. Should global investors be worried about inflation or deflation?
Or course, just like those ruthless trick questions on tests in school that we all loathed, this question is impossible to answer without money supply data. Let’s add to the scenario.
In addition to 102 units of goods and services being available worldwide, imagine that the total global money supply increased from 100 units to 112 units globally in 2002, up 12%. With 112 units of money chasing only 102 units of goods and services, global price levels will gradually rise. Since there are only a finite number of things on which money can be spent, an increase in the money supply that exceeds the increase of available goods and services over the same time period is inflationary.
When relatively more money chases relatively fewer goods and services, inflation is the inevitable result. Period.
There are innumerable current and historical real-world examples of inflation. For a discussion on the infamous French inflation of the 1720s perpetrated by the Alan Greenspan of the day, the rogue John Law, as well as the much more modern Alaska oil-rush inflation, please see our earlier “Exploding Inflation” essay. For a fascinating example of real inflation in the cutting-edge virtual world of cyberspace (your kids may enjoy it too, as it concerns the extremely popular “Diablo” online computer game), you may wish to skim the introduction to our “Deflating the Dow” essay.
As you know by now, if inflation occurs when money supplies grow faster than available goods and services, deflation rears its ugly head when one of a few things happens. First, if the total money supply rises slower than an increase in goods and services, deflation occurs. Second, if the total money supply shrinks and the goods and services expand, deflation occurs. Third, if the total money supply shrinks faster than goods and services contract, deflation occurs. Now to empirically demonstrate these three scenarios.
Continuing our earlier example, if our 100 units of goods and services grow to 105 units in one year, but money supply only grows to 101, then relatively less money is chasing relatively more goods and services. With less money to go around prices begin to fall, or deflate.
If goods and services grow to 102 as in our original example, and money shrinks to 98, deflation will occur because relatively less money is chasing relatively more goods and services.
If we are in a recession, and goods and services available at the end of next year are only 97 but the money supply contracts even further to 94, then deflation will occur because relatively less money is chasing relatively more goods and services.
Deflation is the condition that occurs when relatively less money is available to bid on relatively more goods and services. With less money to go around, everything simply generally costs less.
Piece of cake so far, eh?
With the basic yet crucial understanding that inflation and deflation are broad, macro-economic, strategic monetary phenomena, we are now prepared to stake big red warning flags around the first major trap for investors trying to discern whether inflation or deflation is imminent. It concerns tactical micro-economic supply and demand.
In my experience, nothing presents a more perilous abyss and tarpit in which analysts and investors are annihilated than failing to understand that normal economic supply and demand for individual or even small groups of goods and services are the most important determinants of their respective prices, not inflation or deflation.
For example, just because the prices of DRAM computer memory chips have plummeted in the last couple of years does not mean we are near a deflationary depression. All it means is that more DRAM chips were produced than folks around the world were willing to purchase. In economics and the real-world, when the supply of a good or service exceeds demand, prices fall. Prices continue to fall when addressing a supply surplus until demand meets supply at a new lower price. This is Adam Smith’s famous Invisible Hand in action!
Conversely, when the crude oil price rocketed to over $30 per barrel last year, it did not mean that inflation was roaring across the plains ready to raze the Western world. All it meant was that people around the world wished to buy more crude oil than was immediately available. In economics and the real-world, when the demand for a good or service exceeds the supply, prices rise. Prices continue to rise when addressing a supply shortage until supply meets demand at a new higher price. Once again, this is the incredible Invisible Hand of the free markets in action!
For real-world examples of classical economic graphs illustrating these concepts, please check out the graphs in our “California Electricity Economics 101” essay.
The single most important factor for determining the price of ANY good or service on the planet, orders of magnitude more important than relative strategic money supply fluctuations, is good-old supply and demand for that particular good or service. When investors try to discern whether inflationary or deflationary tides are approaching, they MUST be absolutely sure to study the prices of many very different types of goods and services across the entire economy.
Misreading standard supply and demand-driven price changes in any good or service as a sign of inflation or deflation is the most common analytical transgression in this arena and should be avoided at all costs. Only broad-based, economy-wide general price changes caused by fluctuations in the money supply are properly definable as inflation or deflation. Temporary supply and demand imbalances in narrow micro-economic markets are NOT inflation or deflation.
Inflation and deflation are mighty macro-economic tides that affect an entire economy and they are almost impossible to discern in a narrow sample of goods and services. Only by carefully filtering-out normal supply and demand-driven price changes across a huge array of goods and services can a proper analysis be executed.
Thus far, we know that inflation and deflation are exclusively monetary phenomena, that they broadly affect an entire economy, and that price movements of individual goods and services are primarily supply and demand driven and not indicative of inflation or deflation.
Since money supply fluctuations lead to inflation and deflation, we can zoom into the United States economy and see where the monetary growth or contraction is leading us. If there is relatively more money available than goods or services in the US economy, then inflation will follow as inevitably as winter follows summer. If there is relatively less money available than goods or services in the US economy, then we are assured to see deflation roaring down the turnpike in the coming years. Money is the key.
Our first graph compares the narrow MZM money supply growth in the US with the Consumer Price Index growth since 1985. MZM is Money of Zero Maturity, basically physical and electronic cash including money-market-fund cash balances, checking accounts, and old-fashioned grungy green Federal Reserve Notes (currency and coin). The CPI is an all-but-worthless measure of US inflation due to aggressive statistical manipulation by the Bureau of Labor Statistics (see “Lies, Damn Lies, and CPI” and “Real Rates and Gold”), but nevertheless it remains very popular for lack of any honest competition.
The MZM and CPI below are expressed in terms of their respective percentage growths from the previous year, with the MZM data being weekly and graphed on the left axis in red and the CPI data being monthly and tied to the right axis in blue.
As is quite obvious above, the red MZM money supply rarely ever shrinks in the United States. Alan Greenspan has been Chairman of the Fed for most of this graph, since mid-1987, and he is one of the most relentless inflationists in world history, maybe even exceeding France’s notorious John Law of the 18th Century.
Note that, as marked by the colored numbers in the graph, each huge spike in MZM growth is followed by a spike-up in inflation as measured by the CPI, which perpetually and blatantly understates real inflation but nevertheless is carefully watched by the markets. Each rare moment in history when actual MZM contraction occurred, when the Fed realized that they had been very bad little boys and girls, was followed by a huge decrease in the year-over-year growth rate in the CPI.
As all the classical economists in history intimately knew, yet nary a single brave soul on Bubblevision today will dare to utter such blasphemous concepts out loud, a money supply increasing faster than the economy, goods and services on which it can be spent, will inevitably lead to inflation. Like most great truths, this concept is exceedingly simple yet it continues to be widely misunderstood, ignored, or intentionally obscured.
With the enormous spike in year-over-year MZM growth currently exceeding an eye-popping 21%, the Great Fed Panic of 2001 that we discussed recently in “The Inflation Tsunami” (where you can see a zoomed-in MZM growth graph from 1998 to the present), there is virtually no doubt that inflation will be back in the United States with a vengeance in the near future, probably next year. We have not witnessed such extreme MZM growth in decades, and it will have inflationary consequences. For a chilling comparison, realize that US GDP, total goods and services bought and sold in America, only grew by 0.8% (yes, less than 1%) in the same year that MZM money rocketed by 21%!
In the terms of our mental game above, focusing on the US economy instead of the world economy, total goods and services in the US went from 100 to 101 units in 2001, while total money available exploded from 100 units to 121 units in 2001. Now please repeat after me, “When relatively more money chases relatively fewer goods and services, inflation is the inevitable result.”
Pretty easy and straightforward, right? Now that you feel reasonably confident that the irresponsible Fed led by an unelected and unaccountable Alan Greenspan is ruthlessly inflating away your hard-earned savings like some two-bit banana-republic dictator, you may think the case is closed. Not even close. Remember, the economy is far more complex than the space shuttle, so we have to dig yet deeper into inflation and deflation.
First we will discuss two easy-to-understand caveats about the above analysis, then a much more subtle and important caveat.
Classically, money chases goods and services. But in societies where investing and speculation become heavily entwined in day-to-day life for normal folks, money also chases investments and speculations. The terrible NASDAQ bubble of the late 1990s was partially created by incredible US money supply growth, much of which of this fiat funny-money migrated towards the equity markets with all the subtlety of a heat-seeking missile. (You can see the amazing correlation between the Fed’s enormous M3 ramp and the S&P 500 bubble of the late 1990s in the second graph of “S&P Perpetual Motion”.)
Since most economists don’t consider irrational investment valuations, which are partially caused by monetary inflations, as classical “inflation”, investors must be careful to realize that money can flow into goods, services, AND investments. When one investor buys an investment from another investor, the seller can certainly opt to use the monetary proceeds to buy goods and services, but often the funds are reinvested elsewhere and continue to slosh around the investment arena.
Imports also create temporary distortions. When Americans buy imported goods and services, money flows out of the United States economy. This factor is extremely important in explaining why we didn’t witness raging domestic price inflation in the go-go 1990s. Enormous money supply growth was temporarily siphoned-away from the domestic US economy by imports like steam bleeding-out of a pressure cooker. Yet, like a great boomerang, US money paid to overseas companies for imports will eventually come home to roost in the US economy, which could greatly exacerbate the coming inflation.
Even more important than the investment and international outlets for money, the concept of “money” is very ambiguous and covers a broad analog continuum, it is not discrete, not digital, and not easy to define.
For example, money and credit are very different beasts, yet at this peculiar moment in history in which we sojourn, they have become interchangeable in the minds of almost everyone from middle-class factory workers to the most elite central bankers. True money does not represent debt to anyone else. (For this essay we are avoiding the important side discussion on fiat currency versus real gold hard money.) If you are fortunate enough to find a $100 bill on the street, it is yours. You don’t owe it to anyone, you don’t have to pay anyone back, and as long as the US government survives someone will probably happily accept your $100 bill for their goods or services.
Debt, on the other hand, is not money. The word “credit” is a misnomer, as it simply means debt. When an American uses his credit card to buy a home entertainment system, he is not spending money. He is simply signing a contract that says he will surrender the money that he expects to earn from his future labors to pay for both the home entertainment system and the borrowing of the funds. One of the greatest financial tragedies in modern America is that the average American seems to believe that “credit” and money are basically interchangeable.
While accumulating debt ensures a lower future standard of living so the debtor can make the bankers rich, money is neutral. If you hold money, you are under no obligation. If you take out debt with your “credit”, then you are subject to a future obligation. The Ancient Israeli King Solomon, one of the wisest men who ever lived and a legendary financial guru in his own right, as he managed far more wealth than Gates or Buffet can even dream of, wrote 3000 years ago that, “The borrower is slave to the lender.”
Want to be a slave? It’s easy, as all you have to do is slide into debt by using your “credit”. You soon become a slave and the bankers become your masters. The shackles of debt binding financial slaves are no less crushing and oppressive than the heavy iron chains binding human slaves throughout history.
Still not convinced that money and credit are very different vehicles? OK, which would you rather have, a $1m credit line with Visa or $1m sitting in your bank checking account? If you chose the cash over the credit, you too agree that money is a very different beast than credit. Money should have intrinsic value in and of itself (again, avoiding the fiat currency issues in this essay), while credit is really debt that must be repaid at a future date with money.
By now, you are probably wondering why on earth I titled this essay “Inflation or Deflation?”. Well, fret no more, because here comes the deflation!
As we noted above, when observing the explosive money supply growth in the United States relative to the anemic GDP (goods and services) growth of the US economy, it is simply impossible to make the case for pure monetary deflation regardless of how many talking-heads warn of it. But, and this is a major but, when credit is considered in addition to money, deflation quickly enters the picture.
There are some hyper-critical enormous markets that are pretty-much exclusively debt-driven. For instance, how many of your close friends buy their new automobiles by hauling-in a briefcase full of cash or writing a check for the entire sticker price? How many Americans do you know who bought their houses for cash, writing one check up front and avoiding a crushing mortgage? (Interestingly, the English word mortgage is derived from the Latin roots meaning death, “mort”, as in mortician, and pledge, or contract. A mortgage is literally a “death pledge”!)
The huge and important US residential real-estate market as well as the new and used automobile markets are almost exclusively debt-driven. This obvious truth is really important to grasp, as these markets are absolutely enormous and real-estate in particular is hyper-critical as it represents the last great bastion of wealth left for the American middle-class after Wall Street fleeced them like suckers in the great equity bubbles of the late 1990s.
Do you think that house prices and car prices are kind of silly? Why does a house sitting on $50k worth of land with $100k worth of lumber and fittings cost the outrageous sum of $500k? Why does a new car cost more than the gross salary that an average wage-earner can pull-down in an entire year of hard work? The answer, of course, is the black plague of “credit”!
Without the extreme credit excesses of the great 1990s bubbles which still remain, new houses would only cost a fraction of current prices. New and used cars would also be far, far less expensive. As long as Americans are willing to surrender their financial freedom to become debt slaves to “buy” homes and cars, the prices in these markets, and others like them, are purely debt-driven and will remain high as long as debt remains fashionable.
So, while pure money supply growth in the US points to raging inflation potentially starting next year, the sad truth that debt is so widely believed to be a “money substitute” today has very deflationary implications especially in the particular markets where credit (read debt) rules the roost.
As most Americans are forced to learn sooner or later, sometimes painfully, there is a very real and finite limit to how much debt can be taken-on and serviced. Our next graph shows US household credit market debt outstanding since 1980 as well as US debt service payments as a percent of disposable income. Both axes here are zero-scaled, which really makes the raw magnitude of the consumer credit bubble all the more apparent. Marveling at the red consumer credit market debt line approaching a parabolic slope will probably be nostalgic for old NASDAQ veterans.
If the slope and magnitude of the red consumer debt line above isn’t frightening to you, you probably slept through the last 5 years of NASDAQ action. US consumer debt rocketed by 470% in a little over 20 years! For comparison purposes, the CPI was “only” up 128% over the same period and the US GDP grew by “only” 274%. Obviously there will come a day of reckoning, probably not too far into the future, when US consumers will no longer be able to grow their outrageous debts at breakneck rates.
Note the blue debt service as a percent of disposable income line. Provocatively it has not fluctuated all that much in 20 years. While 14% seems low, please realize that at least two factors distort this number. First, these are huge macro-economic aggregate measurements of total US consumer income and total US consumer debt payments. This includes all Americans, not just the heavily-indebted middle class. Wealthy folks making millions or tens of millions a year that have no personal debt help skew this broad measure lower.
Also, like many government statistics, this one is probably pretty-well lobotomized. I have not yet scraped-out the time to dig into exactly how consumer debt payments as a percent of disposable income are calculated, but I suspect that it is done “strangely”. With the known gross inaccuracy of the CPI, the cryptic and magical positive job-creation wild-guess thrown into the official unemployment calculations each month, and other known government statistical wizardries that wouldn’t fly for two seconds in the private sector, the 14% number could be significantly misstated. It is probably not representative of the average indebted middle-class American.
But, limitations on the number aside, it is interesting that debt service, by this measurement, is almost as high as it has been in 20 years. Can it climb higher? Will consumers be able to pay for food and clothing and their mortgages and cars if this number continues to rise? Who knows, but higher aggregate debt service loads won’t be pretty, especially with two-thirds of the US economy driven by consumer spending!
Also, in light of the unprecedented number of brutal corporate layoffs in 2001, there are literally millions, maybe over 10m Americans who have recently lost jobs and now have or will have zero income as soon as their short severance packages run-out. With corporate profits plunging and layoffs abounding, the odds are that consumer income as a macro-economic whole will continue to stagnate or even fall. The plague of layoffs following the great bubbles of the 1990s will continue as long as corporate profits weaken, and there is no end in sight for that particular ominous development.
Consumer debt can’t be put into proper perspective without a quick gander at the US personal savings rate.
Hmmmm… Record levels of consumer debt, high debt service, and the lowest personal savings rate in over 40 years? One does not have to be an economist to see that this cannot possibly be a positive omen for US consumer spending and future consumer debt creation. Since 1959, the average personal savings rate has been 7.9%. Before the fun-loving-criminal Clintonistas were voted into power by only 42% of the Americans voting in the 1992 election (thanks Ross Perot, you fruitcake!), the average US personal savings rate was 8.9% between 1959 and 1992. The latest data point, October 2001, weighed-in at a terrifyingly low 0.2%!
If widespread debt with no saved surplus was healthy, Rome would still be ruling the world. If excessive debt with no savings was a good thing, Enron would be one of the flagship companies in America rather than a nuked derivatives wasteland. Heavy debt and no savings is not the recipe for prosperity, but for disaster.
Back to the great inflation or deflation debate, can US consumers afford to continue to ramp-up their debt to buy homes, cars, and other debt-financed items? With corporate profits plummeting, leading to massive layoffs, leading to aggregate consumer income dropping, will US consumers keep “buying” new homes, cars, and other debt-financed items on time at the same frenzied pace? We believe, of course, that the answer is not a chance!
With no savings, record debt, bleak job prospects, and a brutal bear market in stocks, we believe that US consumers will gradually begin to retrench and slowly begin to whittle away at their enslaving debt. Freedom from debt is incredibly alluring! In addition, in secular bear markets, with all the major US indices hemorrhaging year after year, the best investment in the world is paying off debt. After all, where else can you get an instant and guaranteed 20% return (paying off credit card debt) or an instant 7.5% return (paying off mortgage debt) in a brutal bear market?
When the dynamics of the post-bubble stock market bear trends are coupled with crushing consumer debt, deflation in the levels of outstanding private US debt are virtually inevitable. Due to the fraud of fractional reserve banking, every $1000 in debt that an American pays off does not just take $1000 of credit off the market. Assuming an effective bank reserve requirement of 3%, a $1000 debt principle payment destroys $33k worth of credit. As more and more Americans come to grasp the great folly of their excessive debt and begin to pay off the bankers and then kick the blood-sucking bankers out of their lives and business, a credit deflation is a virtual certainty.
The coming deflation of credit will severely slash the prices of typically debt-financed items, like residential real-estate and cars. With relatively less credit chasing relatively more goods as cash-strapped consumers sell houses and cars to pay down debt and make ends meet, we fully expect deflationary forces to slam into the debt-financed markets with a vengeance.
Bottom line, US money supply growth is exploding, an unmistakable harbinger of monetary inflation, while Americans are being fired and losing their incomes and their ability to service more debt, an unmistakable harbinger of credit deflation. Can the clash of these two titanic forces be reconciled?
We believe it can.
Goods and services that are usually purchased with MZM types of money, cash and checking accounts and money market balances, are almost certain to rise in price significantly next year in response to current outrageous 20%+ MZM inflation. Next time you go to the grocery store or movies, note the fact that your bills go UP every year, not down as you would see in a general deflation. If you generally pay for a good or service with cash or a check, you will probably, in a macro-economic general sense, be paying more in the near future for these particular goods and services.
Goods and services that are usually purchased on time with debt, like houses and cars, will fall dramatically in price as credit becomes less fashionable and even harder to obtain for the lion’s share of Americans sporting really ugly personal balance-sheets. The deflating credit bubble will decimate the prices of these debt-financed goods and services and force their new equilibrium prices much lower to more fundamentally reasonable levels.
On balance, inflation will probably win the epic struggle for the cash markets and deflation will probably emerge victorious in the debt markets.
So what’s an investor to do? Unfortunately, with this essay already far too long, thoughts on this crucial front will have to wait for a future essay. Meanwhile, the great inflation or deflation debate rages on.
Adam Hamilton, CPA December 14, 2001 Subscribe at www.zealllc.com/subscribe.htm