Wednesday August 01, 2007

Inflation, deflation or depression

A noted contrarian writer, Steve Saville, has recently written :

The idea that weaker economic growth will lead to less inflationary pressure (less upward pressure on prices) within the economy is illogical because less output, or slower output growth, will result in more money chasing fewer 'things' than would be the case if real growth were stronger. Putting it another way, the fatal flaw in the "slower growth leads to reduced inflationary pressure" argument is that inflationary pressure and real growth are INVERSELY correlated.

But what if weaker economic growth caused the supply of money to fall relative to the demand for money due to an economy-wide scramble to de-leverage? Couldn't this more than offset the increased inflationary pressure resulting from a fall in real output? That's a possibility, but it's very unlikely. It's unlikely because counter-cyclical monetary and fiscal policies would by [then be] implemented to combat the tighter monetary backdrop ... due to the way governments and their central banks invariably react to economic downturns, combined with the virtually unlimited powers they have to create new money under the current monetary system, the weaker the economy becomes in the short-term the more inflation there will be in the long-term.

- If there is one thing that divides the trend-spotting contrarian community, it is the issue of whether we are heading for inflation or deflation. Due to the issues with the subprime loan market and its derivatives thereof, the deflationists have been coming back and pointing out the fact that, yes, money can also be destroyed ("See also" section below).

They point to the Bear Stearns hedge fund wipeout : billions of dollars gone. They point to the US$1.3 trillion dollars which disappeared from the US markets last week as the Dow dropped 500 points and the rest of the market followed. They point to the cancelled $12 billion sale of Chrysler. They talk about tightening credit markets, and some of them talk about the (First) Great Depression, where all manner of asset values kept falling, and cash was king.

But we're in a slightly different world now. Compared to the 1930's, governments have much more power to create more money than is destroyed. As legendary contrarian Doug Casey says, your cash is trash. When the tech/telco/dotcom bubble burst in the early 2000, the housing bubble took its place. Now that the housing bubble is bursting, another will take its place. What could that next bubble be? We have several leading candidates : commodities and resources, clean/alternative/renewable energy, and the hot new topic of this year, climate change. It could be any of these, it could be all of these.

The deflationist camp would have you sell everything you own, and park everything you have in cash and physical gold. And wait for a deflationary depression, or perhaps an all-out economic collapse. If you believe them, you could do just that.

On the other hand, the inflationist camp would have you invested in assets that will equal or beat the money supply growth rate. If there is going to be a recession or even depression, it will be an inflationary one.

To borrow a term from the peakoiler community, the way you look at it, perhaps it's a matter of your "doomerosity level". If you are a "doomer", perhaps you might believe in the deflationist/collapse scenario. If you are a "moderate" (like I am), you might believe in the inflationist scenario.

See also :

1. Money is also destroyed
2. For all practical purposes the markets are closed right now
3. "Credit markets are close to closing down" : Goldman Sachs chief economist

(2007-08-01 13:16:10 SGT) [Biz] Permalink

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