In a recent article entitled “Hyperinflation or Deflation,” economist and author Puru Saxena wrote:
“At present, the investment community is divided as to whether the world economy faces hyperinflation or deflation. Some observers are convinced that the central banks’ printing press will take the world towards hyperinflation whereas others believe that the ongoing contraction in American private-sector debt will result in outright deflation. So, what will the future bring? It is my contention that we will get neither hyperinflation nor deflation.” [Emphasis added.]
To begin to guess whether we’ll have hyperinflation or deflation, we should first recognize that those two terms are not mutually exclusive since they can occur simultaneously. Why? Because the terms inflation and deflation can apply to two entirely different phenomena. One phenomenon can inflate at the same time the other phenomenon deflates.
Monetary inflation is not possible for a currency that is defined in terms of a fixed mass of some tangible substance (like gold or silver). While the dollar was defined by law to be 1/20th of an ounce of gold ($20/ounce), no monetary inflation or deflation was possible. If you had a dollar in your pocket when the dollar was defined as 1/20th of an ounce of gold, the value (mass of gold) that was intrinsic to your dollar would neither inflate (increase) nor deflate (decrease)—unless the government changed the legal definition. For over a century, the dollar was worth 1/20th of an ounce. It’s value was fixed; it was prevented by law from increasing or decreasing. Yes, there could be price inflation or deflation relative to that dollar, but there could be no monetary inflation/deflation of the dollar that was backed and legally defined by gold or silver.
Monetary inflation/deflation is primarily a characteristic of a fiat currency (although it can also take place when the government redefines the dollar from $20/ounce to $35/ounce to $42.20/ounce). As a practical matter, persistent monetary inflation (say, 2% – 3% per year, year after year) can only take place when a nation has embraced a fiat (undefined) currency. Even then, all monetary inflation is political and caused by the government.
On the other hand, price inflation (and/or deflation) applies to the price of tangible goods and services. Price inflation/deflation is primarily a reflection of pure supply and demand. When the supply of wheat increases and the demand remains the same, the price of wheat “deflates” and becomes lower. Farmers respond to lower prices by growing less wheat, the supply falls, the demand remains the same and the price re-inflates to a higher level. Similarly, if the demand for a particular product falls, the producers will reduce (deflate) the price to match demand (they’ll have a sale). Later, the producers will stop producing so much of the product and the price will tend rise/inflate back to higher levels.
Price inflation/deflation is controlled primarily by the people. Prices will be set by how much the people are willing or able to supply and how much they are willing or able to demand.
Monetary inflation/deflation is controlled almost exclusively by the government. Government controls the inflation/deflation of a currency defined as a fixed mass of gold by changing the definitions ($20/ounce to $35/ounce to $42.20/ounce) or completely abandoning all tangible definition and then attempting to control the purchasing power (it has not value) of the fiat dollar by setting interest rates and controlling the supply or currency in circulation.
Because today’s currency has no assured value (Public Law 95-147, Oct. 28th, A.D. 1977) and is no longer defined in terms of any tangible substance (such as a fixed mass of gold or silver), we can have either monetary inflation (when the purchasing power of our dollars fall) or monetary deflation (when the purchasing power of or dollars rise). At the same time, we can have also either price inflation (when the prices of tangible products increase) or price deflation (when the prices of tangible products falls).
Thus, monetary inflation (or deflation) and price inflation (or deflation) are two entirely different and separate phenomena. Because they are separate, they can occur simultaneously in ways that may seem intuitively improbable.
It is true that price inflation and monetary inflation normally occur at the same time. Prices go up (price inflation) because monetary inflation causes the purchasing power of the dollar to go down. Likewise, price deflation and monetary deflation also usually occur simultaneously (prices go down while the purchasing power of the dollar goes up).
But the relationship between price inflation/deflation and monetary inflation/deflation is not direct or absolute. Because our fiat, paper dollars have no tangible reality, they have no direct relationship to the prices of tangible goods and services as set by the force of supply and demand. The relationship between fiat, monetary dollars and tangible prices is based on the “full faith and credit of the American people” and is thus more psychological than mechanical. Therefore, each phenomenon (monetary or price) may influence the other, but neither phenomenon controls the other.
I.e., if prices are going up, we naturally presume the value of the dollar to be going down. But this presumption is not necessarily true.
For example, it’s entirely possible for the purchasing power of the dollar to be falling due to monetary inflation at the same time that prices are falling due to increased supply and/or decreased demand (price deflation). This possibility is seen in the concept of an “inflationary depression”—a scenario wherein prices are falling at the same time the dollar suffers monetary inflation and an actual loss of its purchasing power. These two forces tend to counteract each other, but if one force (say, price deflation) is too strong, the other force (monetary inflation) may be able to mitigate some of the former’s force, but still be too weak to completely negate that force. Net result? Moderated but continued price deflation.
That’s where we are today. In the past two years, the average price for existing homes has fallen about 30%—that’s price deflation.
Similarly, the Dow Jones Industrial Average (DJIA) fell from 14,000 (July 19th, 2007) to almost 6,000. Yes, the DJIA has recently jumped back up to 9,300—but it’s still down about 33% from its 2007 high. That’s price deflation.
We’ve also seen the prices of automobiles fall. The prices of flat-screen TVs, new carpeting, and even gasoline ($4.00/ gallon to $2.50/gallon) have fallen. That’s all evidence of price deflation and a characteristic normally associated with a recession or depression when supplies persistently exceed demand.
However, over the past two years, we’ve seen the price of gold rise from $675 on July 19th, 2007 (when the DJIA broke 14,000) to about $965 today. Thus, in the two years that price of the DJIA has fallen by 33%, the price of gold has risen by about 43%.
In other words, an investment of $10,000 in the DJIA on July 19th, 2009—when the market hit 14,000 would be worth about $6,700 today. That same $10,000 invested in gold would, today, be worth about $14,400. That’s a comparative spread of $7,700 (77%) based on having invested $10,000 in the DJIA or in gold.
Because gold is the primary “monetary” metal, a 43% increase in the price of gold over the past two years corresponds roughly to a 43% two-year loss in the actual purchasing power of the dollar. That’s evidence of monetary inflation—and double-digit inflation at that. It’s not hyperinflation (50% or more per month), but it’s not 2% per year, either.
My point is that for the past two years, we’ve been experiencing both price deflation and monetary inflation. The reason for this seeming contradiction is that government fears price deflation since it is a cause or attribute of economic depression. Government has therefore used almost every trick at its disposal to increase the money supply and thereby inflate the dollar in hopes of causing prices to rise and thereby offsetting the “natural” supply-and-demand forces now favoring price deflation.
It’s hard to say how much effect the government’s monetary inflation has had on curbing the people’s “supply and demand” price deflation. Without the government’s monetary inflation, the price of homes and the DJIA might be down 50% or even 70% rather than 30%.
But the fact remains that many prices are still down 30% and likely to fall further so long as the supply of houses (or stocks) is greater than the demand. So long as unemployment rises, the number of people able to pay rent and mortgages (demand) will fall. That will lead to more foreclosures, more open apartments, more people choosing to live with friends or family or total strangers rather than live in a private dwelling. As we have more foreclosures, the supply of empty homes will increase, the demand should decrease, and home prices should continue to fall (deflate).
Right now, government’s most pernicious problem is trying to convince the people that everything is OK and it’s safe to buy a new house (or stocks or cars or whatever). Most people aren’t buying it. Most people have gone into a decidedly conservative mood. As their incomes have been diminished or at least rendered unreliable, the people are necessarily spending less and they don’t much care about Obama’s assurances that’s safe to buy a bass boat. If they happen to have more money than they need to maintain, they’re saving rather than spending. All of this points to reduced demand. Reduced demand implicates price deflation. Allowed to persist for long, price deflation will result in an economic depression—even though monetary inflation may still be running hot.
So, in response to Mr. Saxena’s belief that we’ll have “neither” hyperinflation nor deflation, I’d say we’ll get both. Or, more precisely, I’d say that even if Mr. Saxena is correct and we don’t experience “hyperflation” (50% or more per month), we will experience both price deflation and double-digit monetary inflation. I don’t need the gift of prophecy to make that prediction; it’s already happening. All I need are eyes to see.
I can’t say how long we’ll stay in a condition of price deflation and monetary inflation, but I can’t imagine how that state of affairs could end within the next twelve months. More than likely, that condition will persist to some degree for at least another 2 or 3 years.
So what should we do? How can we protect ourselves in these uncertain times? Is it possible to even profit in the current state of affairs?
No one knows for sure.
But—when we look back and see that, as compared to investing in the DJIA, over the past 2 years gold has generated an 77% return, we can wonder if gold will do as well over the next two years. Hard to say. Maybe yes, maybe no.
But—can you see an objective reason why gold absolutely could not do that well (as compared to the DJIA) over the next two years? I cannot.
Conversely, can you see an objective reason why the DJIA should continue its current rise beyond 9,000 to the 10,000 or even 11,000 levels? I can’t. Unemployment continues to rise; foreclosures must likewise increase; home prices must decline further; car sales are down; government revenues are down 18% over last year; California is on the ropes; the industries we need to supply the jobs required to work our way out of this depression have been shipped overseas; government deficits are almost unimaginable; and the world is eager to install a new “world reserve currency” other than the dollar. If there’s a silver lining in any of this, I’d like to know what it is.
The dollar may not be on its death bed, but it’s clearly suffering from monetary inflation that is massive, intentional and unlikely to end any time soon. That tells me that because gold is the monetary metal, gold will be the principle beneficiary of dollar’s monetary inflation. Whether this benefit translates into higher prices for gold, or merely prices that don’t decline as rapidly as other prices remains to be seen. But it strikes me as extremely unlikely that the actual price of gold will not rise over the next 12 to 24 months.
If it’s true that monetary inflation will cause the price of monetary metals (both gold and silver) to rise significantly, it’s also true that rising unemployment, increasing foreclosures and falling car sales (decreasing demand) should all result in price deflation. That means that the prices of just about everything should get cheaper over the next 12 to 24 months—at the same time the prices of gold and silver are increasing.
You don’t need a genius IQ to place your bet in this investment environment. There’s never a guarantee, but the obvious choice is to buy gold. Lots of it.
And buckle up.
1 Comment
August 14, 2009 at 2:12 PM
Interesting article. But, I would argue that inflation/deflation are not monetary or price phenomena.
The changes we have seen in the price level since the 1930s are reflection of the growth of non-productive labor in the economy – most clearly demonstrated by the growth of the government sector of the economy.
As you point out, when the circulating medium is a commodity, such as gold, inflation and deflation is not possible. Excess money in circulation falls or rises in response to real economic activity – hoarding or dehoarding.
Substitute a non-convertible fiat money for this commodity money and it will rise or fall in purchasing power – since there is no hoard function attached to it – or, what is more accurate, the fiat prices of goods will rise or fall when measured against the gold prices of these same goods.
You now have two prices: the price of the good expressed in units of gold, and the price of the same good expressed in fiat. Individuals react to the over-supply of fiat in circulation by discounting its purchasing power.
So, ideally, if inflation and deflation are impossible with commodity money, it is also impossible with fiat money.
There is, however, a circumstance under which the rise or fall in the price level does reflect inflation or deflation. If there is a general increase in the amount of non-productive labor reflected in the prices of goods, this would be an inflation of prices.
Were government to tax labor, capital, and goods, it would be adding to the cost of goods, pushing prices higher. It would essentially be diverting economic resources to unproductive ends.
But, this is something government cannot do when money is a commodity like gold. So, in history, we find that governments when faced with an undertaking such as war, needs to raise the resources to fight those wars, it will often print paper to temporarily gain those resource.
The result is war-time inflation, and this is usually followed in the aftermath of war by a retirement of that paper, and a period of deflation.
What occurred in the 1930s was just this process, with a caveat: The introduction of fiat was made permanent, and the use of gold for money was outlawed.
There then followed 70 years of government expansion, which has inflated prices. This period now appears to be drawing to a close.