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Heading towards Inflation & Deflation (at the same time)



August 04, 2010 – Comments (14)

Stagflation was fascinating to economists, who couldn't figure out how you got inflation during a period of stagnant growth and high unemployment during the 1970's.

We're heading into another period where economists will be scratching their heads - a period where we have both inflation AND deflation.  The Phd's will be perplexed and shocked.  The talking heads on CNBC will be trying to explain a concept they have no idea about, but it will help ratings of shows like Mad Money.

The answer is quite simple, we have an economy that is heavily dependent on foreign goods, but our bubble was in housing.  Now I haven't heard of a Chinese made home, so home prices will continue to fall as the market is entirely in the U.S., but everything that goes into making a home, except lumber, is made outside the U.S. (actually that's not entirely correct, I believe Owens Corning makes fiberglass in America still).  The point is valid though - a large number of building products, from nails to vinyl flooring, to cheap appliances are made in other countries.  

Existing home prices will continue to fall (as the market is still imploding), but new home prices, pretty much everything sold at WalMart, and food (heavily based on petroleum prices for shipping/machinery) will continue to rise.

Ecomomists will argue - are we seeing inflation or deflation?  Newsweek will run that exact headline, and Krugman will demand more spending (I haven't seem him ever argue the opposite), but the fact will remain we will be experiencing both.

My greatest fear is when oil breaches $100/barrel.  We already have 10% unemployment and oil is above $80 - almost any perceived growth has oil moving higher every day and that will be the catalyst for inflation followed by a weaker U.S. economy and the inflation/deflation scenario I believe we are inevitably headed for.


14 Comments – Post Your Own

#1) On August 04, 2010 at 3:17 PM, Melaschasm (< 20) wrote:

I disagree.  While there is almost always a mix of inflation and deflation in an economy, the official inflation/deflation rate is an average of the stuff people buy.  There will likely be arguements about what should be measured, and how it should be measured.  Once you pick a methodology, there will be a rate of inflation or deflation, but not both.

Regarding your mention of stagflation, that is a possibility, as well as a double dip recession.  I have been trying to figure out which will occur for about a year without coming to a firm conclusion.  By this time next year, we should have a much better idea about the economy, although there is always some uncertainty.

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#2) On August 04, 2010 at 3:31 PM, chk999 (99.96) wrote:

This is one of the best pieces on the inflation/deflation argument I've read. Kudos.

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#3) On August 04, 2010 at 3:33 PM, whereaminow (< 20) wrote:

It really stertches any definition of deflation to call the popping of any asset bubble and the following drop in prices "deflation."  I realize that it is popular use now, but that just goes to show how clueless the sanctified empy suits and skirts are on the babble box. 

The modern definition of deflation is a persistent decline in the general level of prices.  A 0.1% 1 quarter drop in the CPI does not fit that definition.  A 40% drop in housing prices after the popping of a bubble does not fit that definition.  If you take that definition seriously, no post WWII country has experienced anything like real deflation for more than a couple of quarters. 

But to the general point of your post, yes, economists and talking heads will be clueless as to what is going on.

David in Qatar

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#4) On August 04, 2010 at 3:37 PM, binve (< 20) wrote:


I am most definitely in agreement:

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#5) On August 04, 2010 at 4:06 PM, davejh23 (< 20) wrote:

"My greatest fear is when oil breaches $100/barrel.  We already have 10% unemployment and oil is above $80..."

Oil doesn't really need to breach $100 to cause problems...some analysts have been watching for oil above $80  as a recession indicator.  In addition, when oil prices rise 100%+ year-over-year, there has historically been a 100% chance of recession within the following we should expect economic contraction by the end of this year.  I'd actually guess that the economy is already contracting.  You're correct though...with unemployment already around 10%, a renewed downturn could be brutal.  This is probably why the Fed has been talking up their readiness to act "if necessary"...they already know it's "necessary"...get ready for them to make it worse.

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#6) On August 04, 2010 at 5:21 PM, outoffocus (24.03) wrote:

Great article on deflation

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#7) On August 04, 2010 at 5:24 PM, uclayoda87 (28.73) wrote:


Your observations are the basis for the commodity/PM and foreign investment play that Peter Schiff and others have been advocating for the last 4 years.  I believe that this investment strategy will work, although 2008 showed that wide market shifts can still make even a good plan costly in the short term.  With the tax rates increasing next year, profit taking and a significant market sell off are likely to occur before the fall.

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#8) On August 04, 2010 at 6:51 PM, CharlieBeLong (30.66) wrote:

That's what I have been saying we're in the middle of a bull AND a bear market.

And, the market is about to go up...or down.

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#9) On August 04, 2010 at 9:44 PM, outoffocus (24.03) wrote:

Maybe instead of stagflation we should come up with a new word like "indeflation". Kinda sounds like indigestion and thats what its going to feel like in our wallets.

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#10) On August 05, 2010 at 12:45 AM, ChrisGraley (28.68) wrote:

Excellent post and I'd like to add a bit.

The decline in housing prices is only the first straw and that decline is being propped by our government right now.

The real problem is debt, joblessness and production.

Housing prices are being propped for a very good reason.  Any further decline in housing prices is likely to lead to a mass of mortgage holders to simply walk away from their mortgages. There are plenty of people willing to walk away now, but they are willing to stay in their homes if they can live there without mortgage payments for a while. The government is allowing them to do just that.

The big problem is debt. Government policy has forced the average person to substitute more and more debt in place of financial growth. They do this because of the hidden tax called inflation. As long as the inflation machine keeps running it lessons their debt burden over time  and they can take on more debt. They have to take on more debt because the only way they can keep up their lifestyle in a global marketplace is to borrow. The value of their productivity in relation to the global marketplace is not worth the wage that they command for it. The wage that they command for it is so high because a high portion of it is spent by their government before that wage even hits their hands. While they may not see more and more taken out of their paychecks year over year, the government itself survives on debt and that makes the same dollars that the wage is paid in, worth less today than it was yesterday.

Most of you have heard me use the word "unsustainable" over and over again.  Once I notice something that is unsustainable in the marketplace, that is my "Stone cold lock" and I will invest in something to take advantage of something that I know can't hold true and I've made a lot of my money doing that very thing.

I posted a reply in Betapeg's blog a day or so ago that stated, "without inflation there would be know deflation." His reply was "what's your point?"

Here's my point. When you force the consumer to take on more and more debt, they are much more vulnerable to a market correction than if  you leave the market alone. The market is cyclical even when you leave it alone. The Beta on the market increases with manipulation of the market. When you force the highs higher, eventually the market will counter by making the lows lower.

So now you have a consumer that is much more vulnerable to a market correction because you manipulated the market and a market that eventually has to correct even more than normal because you manipulated the market. Does anybody think that this will end well?

Eventually you have 1 bad choice and 2 worse choices. The bad choice is in the eye of the beholder.

In the world that makes sense, the bad choice is deflation and the 2 worse choices are stagflation and hyperinflation. In the world of politicians the bad choice is stagflation and the 2 worse choices are deflation and hyperinflation. 

I'll start with hyperinflation since I think it's the worse overall choice. At some point as a politician, you'll realize that manipulating the market no longer works and you decide to manipulate it more and faster. that will work for a short period of time and you'll decide to manipulate even more and even faster once it fails.  Eventually you won't be able to manipulate it long enough or fast enough and the market will take away your ability to do so because it will no longer accept your money. Even if you are willing to accept deflation at this point to devalue your money below 3rd world status, the market will take a long time to gain confidence enough to allow you to control your own currency.

I believe that deflation is the right answer, but only if you take the opportunity to stop manipulating the market and spend within your means once you deflate. Even if we did deflate, people are going to be crying out in pain and no politician will be willing to take the fiscal measures necessary.

Which leaves us with stagflation. The more tolerable choice for politicians.  it's being sold in our political circles right now as a China killer. While our money is worth less, our consumers will buy less. China cannot afford less than a 9% domestic growth rate and it's not going to happen if we buy less with weaker dollars. 

The problem is that there are other emerging markets ready to take up the slack, but I'm willing to bet that issue is not being brought up in political circles. Everyone knows that job creation is the number one priority right now and China makes itself an easy target for political aides to sell an agenda to their boss. They just have to sell that jobs lost there are created back here.

Last, lets talk about jobs.  If you want jobs, you have to produce more than you consume. It's that simple. While you can substitute inflation or debt for a while, eventually you have to pay the price for the deception. Government spending erodes production. All debt, consumer, corporate, and government debt erodes production. Any gain from production is lessoned by a weaker dollar or the cost of interest. Corporations with too much debt are easy to red thumb, but for some reason, people think that government debt is different.

So my best guess is that although I really do think that we have enough politicians that are stupid enough to try hyperinflation, our underpaid political aides are smart enough to sell stagflation, because even though they know it won't work, they have a longer job security than if they sold deflation. 

It still is the same main issue as when Obama was elected, it's about jobs.

One day he'll do something about it. 





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#11) On August 05, 2010 at 8:30 AM, russiangambit (28.92) wrote:

Chris, great write up. So, if you think it is stagflation, where to put the money? Isn't that what US had in 70s? I think stocks didn't do that well. There is probably no good place to put money in that situation?

On the indebted consumet and substituting debf for growth - do you notice thate very government program to make something more "affordable" means helping you to take on more debt to pay for something you can't afford. This is not helping, this is a debt trap.

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#12) On August 05, 2010 at 8:56 AM, ChrisGraley (28.68) wrote:

Commodities are a good choice russian.

It is a debt trap indeed and I don't think we'll swallow the deflationary pill needed to get out of it.

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#13) On August 06, 2010 at 12:36 PM, FleaBagger (27.30) wrote:

Russian - gold was below $70/oz for all of 1972. It remained below $250/oz until 1979. It reached a high of $850/oz in 1980, and even after the gold bubble burst, it remained over $390/oz for almost 2 years after the bubble burst, giving late investors (the 1979 investors) ample time to make their profit. If you had bought gold in the early 70's and held for more than a couple of years, you never had a chance to lose money, even adjusting for the substantial inflation of the time.

Silver tells an even more dramatic story: between the end of 1968 and the beginning of 1973, silver never went above $2.05.

The annual highs (lows) for silver:

1973: $3.29 ($1.95)

1974: $6.43 ($3.24)

1975: $5.27 ($3.88)

1976: 5.15 (3.80)

1977: 4.99 (4.30)

1978: 6.32 (4.81)

1979: 35.00 (5.92)

1980: 50.36 (10.20)

1981: 16.53 (7.97)

1982: 11.30 (4.81)

1983: 14.74 (8.38)

1984: 10.17 (6.25)

1985: 6.89 (5.48)

Clearly, buying silver is also a good hedge against stagflation, unless you believe that silver prices were 100% due to the Hunt brothers, and 0% connected to Fed policy. In that case, you are a sheep.

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#14) On August 10, 2010 at 6:45 PM, checklist34 (99.06) wrote:

silver was affected by the hunt brothers during that period, no?

 Stagflation is the lesser of two evils when contrasted with a deflationary episode of significance.  I remain steadfast in that view. 

I wonder if we could get something new this time around, ala "stagdeflation".   Or whatever it would be called.  A period of debt reduction and cruddy growth, resulting in a contracting money supply, but without a dramatic depression oro recession.  A slow, muddled economic period in which debt is paid down.  

Whatever it is, it will rhyme with history but not repeat it, and it won't be what everybody was expecting.

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