Deflation or Inflation?

Two scenarios are receiving increasing attention in assessments of the US economic outlook – inflation and deflation. Some assessments favour a combination of both – such as a severe deflation followed by inflation, or hyperinflation. Others feel that successive development of alternating deflationary and inflationary periods of increasing intensity is more likely, leading ultimately to a collapse of confidence in the US economy.

With the inflationary scenario, the rise in total US debt becomes so extreme that the level of interest rate required to attract ever higher international capital inflows seriously damages GNP growth. Faced with this dilemma, the Federal Reserve will have no choice but to relax its policies (as it is currently doing), and expand money supply with ultimately inflationary consequences. The interest rate reductions will debase the currency by allowing the real value of debt to be inflated away, a collapse in support for the USD abroad, and together with a retreat into gold by many USD holders.

With the deflationary scenario, proponents see similarities between the 1930s and the current situation. In their scenario, the debt explosion becomes too large to be serviced in many parts of the economy. Asset liquidation becomes endemic, forcing prices down, creating debt deflation in a vicious downward spiral with continuing attrition of debt collateral. Personal incomes and consumer confidence plunge, causing a contraction in spending. As faith in the USD evaporates, there is a flight into gold and other safe haven currencies.

The position of the USD as the major international reserve currency is pivotal to the unfolding of either scenario. The prospect of currency debasement through a monetary reflation by the Federal Reserve would undoubtedly provoke a flight from the dollar by foreign investors. Such a flight would cause a quick reversal of Federal Reserve policy and a surge in domestic interest rates, in an attempt to maintain investor confidence. This move would eventually undermine the corporate sector by raising debt servicing costs in an economy in recession, thereby ultimately triggering a credit collapse with consequent deflationary effects.

It is not possible to prove or disprove these theories and scenarios. Nonetheless, it is sufficient to note that the US has been on a track of increasing financial instability for 40 years and that inflation has been checked only by periodic credit crunches which have triggered debt crises, followed by another round of monetary stimulus.

Nevertheless, the evidence now accumulating in the financial and banking sectors suggests that the outcome is more likely to be a deflationary depression. There is no evidence of new developments in the US economy at this time that might transform international disinterest in the USD. Consequently, the US deficit will have to be internally funded in the future – unless the authorities choose some unforeseen strategy such a mobilising US gold reserves into gold swaps. The question is, however, whether internal funding is a practical option under the circumstances?

The old remedy of inflating out of this predicament by issuing cheaper and cheaper money into the banking system simply will not work this time. The reason is simple – the country is already awash with too many debtors.

Corporations, individual, and the Federal government are already suffering from a gigantic surfeit of debt, from the highest debt total to GNP levels in recent US history. The Federal Reserve can no longer make the inverted debt pyramid grow because the debtors in it are too illiquid – they are unable to go further into debt – no matter how attractive the authorities make interest rates. The lever of expansionary money has been pulled once too often. The next phase will be the rapid descent of investors down the inverted debt pyramid from illiquid assets such as property into quality money – including gold – at the inverted apex. This phase will be prompted by a collapse in confidence in the dollar – triggered possibly by the collapse of a major bank, the stock market, and/or the bond market.

In any case, as it is made clear above, the situation now emerging has all the hallmarks of an insoluble dilemma for the US authorities. Against the background of the global capital crunch, the decline of foreign savings to fund the increasing deficit, the growing global economic contraction, the deflationary or inflationary scenarios are both insoluble. There are no solutions that do not involve a dramatic transformation of the USD in international financial markets, and its role as the reserve currency. Both scenarios ultimately lead to a flight to quality money and liquidity, out of the USD and into gold and other currencies.

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Unfortunately I cannot take credit for the insightful words above. They were written by my former boss - Michael Kile. What is shocking is that they were written in February 1991, one chapter in a 40 page document titled "The case for gold in the 1990s", published by the Perth Mint.

Consider that I had only to remove a few sentences (which included giveaway dates and figures) for it to read as if it was written in 2008. It is worth re-reading it with the understanding that the analysis is 17 years old and realise that during those 17 years the US got away with "the old remedy of inflating out of this predicament by issuing cheaper and cheaper money".

The question is: will the US get away with it this time, or will Mr Kile be finally correct that the old remedy "simply will not work this time"?