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Inflation vs deflation.



July 02, 2009 – Comments (16)

The key argument with the people pointing to deflation as a result of this recession is the velocity of money. Quite frankly, it's a darn good one. They argue that for inflation to occur, you not only need an influx of money, but you need the velocity of that money to change hands in the system to be at least what it was before the money was added. If the speed it goes through the system slows, so does the inflationary impact. We definitely have a huge increase in the amount of money, but we aren't seeing inflation?

The fact is that the money that we pumped into the system did little to help the economy recover. It did stop the bleeding, so to speak, for the time being. A lot of that money sits in the hands of the banks right now. Instead of making loans with it, they are hoarding it to offset future losses. This hoarding of money from the banks is also helping to slow the velocity of money. "But what about the stimulus package?", you ask. Well the theory of stimulus should have accelerated the velocity of money by creating jobs and easing state hardships. It usually concentrates on infrastructure as well, so it helps the basic materials companies, builders and heavy machinery companies. We spent our stimulus package on pork though. I'm sorry, but a Tea-pot museum in North Carolina, or an arrow subsidy isn't gonna create a lot of jobs, help the states, or cyclical industry. It will help some politicians buy villas in Spain, but they usually wait till they are out of office to buy those. Most politicians need the money to cool off for a while, so they hoard it, slowing the velocity of money again.

Now the deflationists say that the beauty of quantitative easing is already taking shape and the banks are paying back tarp money and therefore taking money out of the system, and they are right to an extent. If this is true, even if the velocity of money increases, it would have to increase at a rate that is faster than the money is leaving the system, and if not, the economy has gone full circle.

I'm now going to say something that will contradict a lot of my other posts...

There will be deflation!

Now before you get all excited, it won't be here! A lot of the world will experience deflation, but it's mainly due to our inflation. There will be a shake-up of global economies and a new world order. A few countries will get ahead in the game and a lot of countries will lose ground. 5 countries I'm looking at as possible winners are Canada, Germany, Japan, Australia, and Brazil.

Why did I give you such a good example for deflation and then fall back to my same old inflation play?

1) We still didn't fix anything! Our citizens are still in debt to our eyeballs and we haven't saved anything. Some people argue that the savings rate has shot up drastically, but the measurment of savings makes it look better when we pay down debt. We have been paying down debt and that is a good thing, but we have also have had a ton of foreclosures. Foreclosures artifically remove debt from the system and inflate savings measurements. The consumer goes from building equity with a house payment, to paying rent. This puts the consumer in a poorer posistion even when our measurements point to an easing on the consumer.

2) Get used to the term, "Jobless recovery". You'll start hearing it a lot soon. I know it sounds like an oxymoron, but it is possible. I don't want to spoil further statements, so I'll save the details to later in this post, but the statement itself is inflationary. The more you hear it, the more inflation you're gonna get.

3) The working man. Here lies the second biggest problem! If we don't create jobs, the largest part of the consumer base can't spend money. Deflationists are reading this right now and thinking I'm proving their point for them. Again, with the velocity of money slowing, it should point to deflation. But, they are missing a not so small detail. The working man happens to be this particular president's voting base. They are a vocal voting base and these are the majority of people out of work. In November of last year, President Bush extended un-employment benefits 3 months. The crash was in October though, and the people that lost their jobs in October will have benefits expiring this month. The people that lost their unemployment benefits will increase every month after this one until  at least November and probably more like January 2010. November is 9 months after the March Rally but most investors weren't confident of the rally until May. The romance with voters should be rubbing off this month. Expect to see news stories with "I can't feed my children" to hit papers soon. President Obama has no choice but to print money for these people and they will spend it all as quick as  they recieve it and ask for more. Here's the first step in increasing money velocity.

4) Investment money on the sidelines. This is actually the biggest problem. Again the more you hear the words "jobless recovery" the worse it's going to be. Institutional investors simply have to invest money. They are hoarding cash now, because they believe that we haven't hit a bottom yet. If you take a look at the VIX, it's been at low volume for quite a long time. The problem that exists is when these funds start to jump back into the system the velocity of money will skyrocket. If you really want to see the velocity of money, it's going to hit light speed as soon as the institutionals get confident! These aren't hedge funds, these are mutual funds. When they invest it will have an inflationary impact that the deserted hedge funds can't keep up with.

5) The jobless people will cause another even bigger hit on the banks. When unemployment runs out, there will be a bigger hit on foreclosures. Some banks that were returning TARP funds will have to ask for a second round. The government will have to print this money on top of the money that they had to hand out to the jobless to begin with.

6) The returned TARP money won't be burned! The goverment has either borrowed this money from a foreign government or our future tax dollars. They should burn it, but history has proven that they will spend it somewhere else, especially in a democratic economy.

7) Global deflation. A lot of other countries placed bets on our continued ability to consume.  This is a bubble that has to be corrected. China will take a big hit, but will still have slightly positive growth in a global Economy. The European countries will take the biggest hit and some might take a Japan length of time to recover. In my opinion, the UK, France, Ireland, Iceland, most of the  independents from the Soviet block, and Switzerland lose in this scenario. Mexico will hit third world status again, and France will flirt with it.

8) Keysian economics will save the day in the end! We will hit hyper-inflation eventually, but once we hit this point, Keysian basics can carry us out of it. We will lose the title of being the global economic super power, but we won't fall as hard as Japan did.  Our population will insure that we don't get the title back any time soon though. I'm betting that one of the commodity based economys takes over in the short term, but they all have their own flaws. Long term, I'm thinking that one of the tax havens not named Switzerland wins. Switzerland's loans killed them. Is anyone ready for a super power named Nevis?


I'm just a lonely squirell out there in the world, trying to find a nut. The only nuts I seem to find though are squirells with the opposite opinion.

16 Comments – Post Your Own

#1) On July 02, 2009 at 11:45 PM, FreundInvesting (28.64) wrote:

Welcome to what I've been saying for months. Inflation cannot happen without velocity. Jobless people can't afford inflated goods, therefore simply supply and demand dictates deflated prices.

Short the market until recovery (or be in the dollar), then, once we recover, be in inflation hedged stuff or, as I'm doing, strong companies with international presence (earnings in a diverse set of currencies). That's what I'm doing with my clients.

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#2) On July 02, 2009 at 11:46 PM, FreundInvesting (28.64) wrote:

oh and +1 rec.

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#3) On July 02, 2009 at 11:59 PM, FreundInvesting (28.64) wrote:

i just re-read this slightly more carefully and am now confused. can you sum up your opinion regarding deflation/inflation in 1 sentence?

You say global deflation but no deflation here in the US. that's kinda contradictory.

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#4) On July 03, 2009 at 12:36 AM, mistermiranga (99.59) wrote:

Freund - I think he is saying that the velocity of money will accelerate due to social programs for the poor due to the administration's liberal and populist leanings. Not likely to move the needle IMO...

And as far as this sideline money goes...the longer cash stays king, the more screwed we get...this rally was primarily fueled by short covering and the invisible hand on low volume...without true green shoots that money stays where it is... can't really control the deflationary spiral because your options are so limited at this I would argue that deflation is more likely.

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#5) On July 03, 2009 at 7:45 AM, cthomas1017 (98.65) wrote:

The confusion comes from inconsistent uses of the terms 'inflation' & 'deflation'.  For instance, you might hear someone say, "Deflation will subsequently make inflation worse” which is nonsense on its face. A more precise and less confusing way to say what the writer actually meant would be, “Falling asset prices will force even more monetary inflation in response in the form of rescue or stimulus.”

Some people percieve 'deflation' to mean a lowering of consumer prices.  Others use the term to refer to a reduction in money supply.  Some try to measure 'deflation' in terms of 'velocity'.

I'm not going to argue which definition is right or wrong.  I will submit that the majority of the talking heads in the press have no idea how to define 'inflation' or 'deflation' so the terms are used interchangeably - thus the confusion.  If we dig deeper than the main stream talking heads, we add to the complexity by having different ways to measure the money supply or to calculate 'velocity'. 

You get a bunch of PHD's around a table and it only makes things worse, so no one here should feel bad if they are confused.  The more I watch the "experts", the more confused I realize they all are.

I just take comfort that we have people running our economy  like Msrs. Giethner & Sumner whose predictions on what is happening in the markets has so consistently been spot-on.  Just follow the nightly Jim Cramer investment recommendations and you don't have to worry about whether inflation or deflation will be the eventual outcome.  Just follow the Goldman-Sachs boys and all will be fine.  Trust us. ;)

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#6) On July 03, 2009 at 8:17 AM, dbjella (< 20) wrote:

I am confused which is nothing new :)  If the gov't takes money from one group and give's it to another or takes money from future generations and gives it to someone isn't that the same thing?  Isn't either scenario "stimulus" in the eyes of the gov't?  

I get confused when people say we are not spending the stimulus money the right way to create jobs.  What is the right way?  How can the government create wealth for everyone when they take money from one group and give it to another? 

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#7) On July 03, 2009 at 8:23 AM, ChrisGraley (28.51) wrote:

A 1 sentence explanation for Freund. In order for a recovery to occur, we have to put money in the hands of the consumer and they will spend it as soon as it hits their hands increasing the velocity of money. Investors will jump off the sidelines at the same time to pour money in investments and commodities increasing the velocity of money.


I know that was 2 sentences, but it was the best I could do.

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#8) On July 03, 2009 at 8:53 AM, TMFBabo (100.00) wrote:

It seems the consumer may take any extra money and either save it or pay down debt.  Isn't that the "problem" we have now?

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#9) On July 03, 2009 at 8:57 AM, 4everlost (28.87) wrote:

Here is a very detailed analysis of the inflation vs. defaltion question:

Pushing on a String


Inflationists point to the increase of the balance sheet of the Federal Reserve System, which has shot up faster than at any time in the post-World War II era. See for yourself.

They conclude: serious price inflation lies ahead.

Deflationists point to the M1 money multiplier, which is headed sharply down. See for yourself.

This is the result of decisions by commercial bankers to lend money to the public (no) vs. pile up excess reserves at the FED (yes). Banks are not lending. Deflationists conclude: serious price deflation lies ahead.

Inflationists respond to the falling M1 money multiplier along these lines. "Bankers must pay depositors a rate of return. The banks are being paid by the FED for excess reserves, but only at the federal funds rate: barely above 0%. If banks do not start lending, they will be bled dry by payments to depositors. The bankers at some point must lend, if only to buy Treasury bonds that pay more than what banks pay depositors."

Deflationists reply along these lines. "Bankers are afraid of losing money. They will not lend until the economy turns up, but it cannot turn up unless borrowers apply for loans and banks respond by lending. Meanwhile, real estate prices continue to fall, foreclosures continue to increase, and banks continue to lose capital, thus lowering their balance sheets. They will not lend. The M1 money multiplier will stay low, offsetting increases in the FED's balance sheet, which serves as the banking system's legal reserves."

So far, commercial banks are not buying Treasury debt. They prefer to keep excess reserves at the FED. This is unprecedented in American banking history. Here are bankers, lending money to the FED at 0.15% or thereabouts, who could lend to the U.S. Treasury to buy bonds at 2.5% (5-year T-bonds) or 4.5% (30-year T-bonds). They refuse. They are so fearful of the U.S. government's promise to pay that they have decided to stick with 0.15%. They trust the FED far more than they trust the Treasury. 


There is no answer from economic theory. Their willingness to lend will depend on these factors:

1. Their balance sheets
2. Their fear of private borrowers' defaulting
3. Their fear of T-bonds (rising rates, falling prices)
4. Their fear of running out of income to pay depositors
5. The rate of interest on excess reserves (FedFunds rate)
6. Their fear of nationalization

At this point, I offer my central response to the deflationists.

The Federal Reserve System can force the hands of commercial bankers at any time by charging interest on excess reserves for "safekeeping." The fact that the FED has not done this indicates that it accepts the present situation: a collapsing M1 money multiplier. commercial bank lending – delays the advent of price inflation. This has enabled the FED to achieve the following by doubling the monetary base (the FED's balance sheet):

1. Bail out the big banks (asset swaps)
2. Keep the banking system from imploding
3. Bail out the Federal government
4. Bail out Fannie Mae and Freddie Mac
5. Keep real estate from collapsing
6. Slow price inflation to close to zero
7. Keep T-bill rates under 0.5%

At what cost? Unemployed workers. That is a small price to pay if you are a high-salary central banker with a fully funded pension.


The Federal Reserve can re-ignite monetary inflation at any time by charging banks a fee to keep excess reserves with the FED.





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#10) On July 03, 2009 at 9:24 AM, outoffocus (23.86) wrote:

I wish I could rec that last comment

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#11) On July 03, 2009 at 9:29 AM, Entrepreneur58 (37.67) wrote:

Inflation is a tax.  Deflation is a tax cut.

Government revenues are trending to zero.  Government expenses are trending to infinity.

Are we more likely to get a tax or a tax cut?

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#12) On July 03, 2009 at 4:37 PM, uclayoda87 (28.54) wrote:

I know its has been a long time since other countries bought more from us than we bought from them, so it is understandable that we forget that China and other countries have a lot of US dollars that they might like to trade for food, energy and other commodities.  If this happens, local prices will go up, independent of what happens to US wages, US real estate prices or other secondarry marker of inflation.  Inflation will come back to us when more US Dollars chase the limited amount of items which can be exported out of the country.  So the US service industries won't see their prices increase, which will keep wages down.  This is how I suspect that we will get high inflation with depressed wages.  The only way I can see the US government preventing the return of major inflation is for the US to ban exportation of food, energy and other commodities.  This would end the US dollar as the reserve currency.

Just a thought.

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#13) On July 04, 2009 at 4:22 AM, kaskoosek (30.22) wrote:


I second what you just said.


To Freund

The dollar is not the ultimate safe haven and does not represent any kind of wealth, because the country issuing the currency is basically bankrupt.

I will use any fear in the market to stock up on precious metals and multinational stocks.

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#14) On July 04, 2009 at 5:16 AM, uclayoda87 (28.54) wrote:

fiat money
inconvertible paper money made legal tender by a government decree.

In the case of the US dollar, there is no gold or silver backing anymore.  It is literally worth the denim it is printed on or what someone is willing to trade for it.  So as long as there are foreign fools willing to take this fiat money in trade, we are OK.  Like in A Streetcar Named Desire, our US currency lives by the motto: "I've Always Depended On The Kindness Of Strangers."

For now your US dollar is relatively strong, but a year from now who knows what it will buy.  Is it reasonable to believe that with more money in the system that the buying power of the US dollar will increase with time?  The current flight to preceived safety improves the short-term strength of the US dollar, which creates a good opportunity to begin divesting from US dollars into the hard assets of your choice (gold/PM, oil/energy, food/agriculture, and dividend paying foreign or multinational stocks).

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#15) On July 06, 2009 at 10:00 AM, brocksamson (28.35) wrote:

My question to your analysis would be:

   What are you benchmarking your "deflation" against?


Prices can drop across the board, credit and the velocity of money can all be decimated--yet if commodity prices or supply-side costs fall at a slower rate, everyone has less disposable income.  If income is driven primarily by asset prices (equity extractions on homes) and those prices fall, it effectively makes the prices of all other goods more expensive relative to available wealth.  Basically, you can have decreased absolute prices, yet increased relative asset prices and less disposable income in a CPI-deflationary environment.  Absolute prices don't matter.

Furthermore, if you are an enormous importer of goods and your currency weakens substantially, you will pay an inflation tax automatically.  We are in this scenario.  Our consumption numbers in GDP are unsustainable.  We are now at 70% of GDP consumption to 30% production.  That's a roughly 5 trillion dollar discrepancy.  We have previously been able to do this through liquidating our savings, as well as taxing the world through our inflation because of our status as the reserve currency.  Our reserve currency status is in question now.  Also, we have to finance our consumption binge with ever increasing (and scary) levels of debt.  Debt destroys purchasing power through currency destruction, so I would consider this equivalent to inflation.


Sadly, I believe we are headed towards an inflationary depression which will have increasing unemployment, falling asset prices, relatively higher commodity prices relative to DI, decreased demand through lower consumption, increased debt load, and currency devaluation all simultaneously.

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#16) On July 06, 2009 at 3:02 PM, biotechmgr (< 20) wrote:

Some good points here, but the message gets mixed. The only areas which may experience inflation are those growing where the demand outstrips supply. I see demand declining in the US for a long time. There's no imbalance at the consumer and wage level for an inflation. The Greatest Bubble must be accompanied by the Greatest Deflation.

India might be the place you want to look for the next winner.

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