A Minority View

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Recently there’s been a spate of articles about the inflation/deflation debate.

According to the dominant view, the inflation the U.S. has experienced these past 75-plus years will inevitably continue and very likely accelerate as the managers running the Fed and U.S. Treasury attempt to deal with a monstrous overhanging debt bubble by cheapening the dollars with which repayment is made.

This logic appeals because the only history anyone can recall is one of continuous inflation. When I graduated college in the depth of the 1982 recession I earned a starvation wage of about $16,000/year as a laboratory technologist. I shudder to realize that in 2008 dollars that’s a whopping $35,680.83, a figure many people today would not consider the pittance that it was and remains. Such is the evil of relatively low, creeping inflation; it hides a painful reality of declining living standards.

That gradual inflation was bad enough. Today, however, there’s near unanimity that the smoldering inflation of the recent past will burst into the flaming inflation of the 1970s when mortgage rates and bond yields were well into double digits, or even whip up into the firestorm of a Zimbabwe-style hyperinflation as the U.S. dollar burns down to a charred crisp.

Given such consensus of opinion regarding inflation expectations, it may be useful to examine why the potential for a crushing 1930’s style of deflation is worthy of consideration.

One of the better exponents of the minority (deflation) view has been, so far, left out. As an occasional guest on financial TV and print Robert Prechter does not have the media cache of Peter Schiff or Jimmy Rogers but he has an approach to markets that is consistent and accessible to anyone willing to do their homework. Possibly his lesser notoriety stems from the fact that his analysis rarely appears for free in the public domain and when it does so it is in conjunction with an overt invitation to subscribe to paid services. One hopes that proponents of the free market are not somehow offended by the presence of such profit-seeking behavior.

Prechter’s methods also represent a direct challenge to the way most people understand the world, so despite an interesting track record of forecasting (with stunning accuracy and some acknowledged mistakes), his is not among the names mentioned when the prophets of the recent economic debacle are listed. Those who wish to examine this challenge are encouraged to do so and make up their own minds.

Prechter’s position on deflation shows up in the subtitle to his 2002 book Conquer the Crash. In a nutshell, his position is that there’s a critical difference between currency inflation and credit inflation, and that as long as the monetary authorities, banks, and public are collectively optimistic and trusting, both currency and credit appear to have the same effects on prices, but that if credit builds up to a fantastic level as now, when pessimism and distrust take over then a crucial difference between currency and credit is revealed.

This is why historical comparisons are so challenging. The same action can have very different effects if underlying conditions change. In the past whenever the Fed plowed lots more fuel into the credit creation machine called the fractional reserve banking system, that system enjoyed conditions that turned that fuel into multiples of credit and it was promptly borrowed and spent. After 1995 a manic level of optimism led to a vast extension of credit outside of that tidy little cartel called the banking system, so people became even more convinced that credit is the same as currency.

All that debt rests on trust. Creditors count those loans as assets, trusting that they’ll be repaid. The debtor looks at his Jet Ski or Harley Hog and includes it in his asset ledger, too, and trusts he’ll be able to make the payments until the loan is retired.

The trouble is that trust is getting tougher to come by as rising unemployment and declining asset values work together with declining confidence.

One pillar of the inflation-expectation view is that the managers of the Fed can and will exercise the "Helicopter Option" if they decide it’s inflate or die. We should never forget that politicians (and Fed governors are clearly politicians) are inveterate liars. Just because they talk about helicopters and bags of cash, it may be instructive to note that as central planners they are continually subject to the Law of Unintended Consequences.

People of libertarian persuasion used to know this. We used to know in our bone marrow that human beings are not machines programmed to yield predictable results from known inputs.

If the managers of the Fed actually started to punch the "zero key" one space to the left of the decimal in their own account balances and use that to purchase an endless number of electronic T-bonds from the U.S. Treasury, what would those holding T-bonds do? Better yet, to whom could those holding T-bonds sell their T-bonds in the open market?

If the Fed becomes the buyer of last resort for the assets that form its own reserves, what exactly are those reserves worth?

Nothing.

The Fed is not an island in the economic ocean. Neither it nor its managers are omnipotent. Does anyone honestly believe that today’s central bank managers have discovered what the Alchemists could not? On the contrary, their fraud is on the verge of general recognition.

Depending on one’s figures, there is somewhere between 50 and 100 trillion dollars worth of debt in existence today, even now growing exponentially as the Obama Administration takes over as the consumer falters. In this regard credit growth looks like a graph of home prices did two years ago.

This analogy is critical. Inflation has until today, like home prices rises prior to 2005, not significantly reversed since nearly a lifetime ago. As with the reversal of fortune in real estate, an event’s rarity should not be confused with impossibility. A prudent person might keep the possibility of a credit collapse deflation on the radar screen. Should the conventional wisdom be in error, the consequences of an historic deflation do not invite casual disregard.

June 27, 2009

David Calderwood [send him mail] a businessman, artist, and author of the novel Revolutionary Language, selected January 2000 Freedom Book of the Month at Free-market.net.

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