07 September 2008

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.


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"?


  1. I have an understanding of the value of Gold and silver in an inflationary period. What I am lacking is a clear picture of how PM's function in a delationary scenario. Your insights would be most welcome.

  2. check out mises.org and do a search for "gold as an inflation hedge". you will see that gold doesn't do that well in inflationary times that are short period. (ie. 10-30 years) but historically maintains it's purchasing power. gold does best when fiat money comes into question.

    **** hey Bron **** if you work at perth, maybe you can solve this whole shortage conspiracy thing to begin with. Why not post here the available silver in both retail and investment sizes that are available for immediate purchase. Maybe you could even get an average of what your monthly sales of retail and industrial silver are. I can't imagine it's confidential since, if I phone to buy silver why wouldn't they just say what they have available? I do it all the time. This would go a long way to placating the people who say that perth doesn't have any silver to sell.

  3. Martin, interesting that at the same time I wrote this blog, this post https://www.kitcomm.com/showthread.php?t=22691 on Kitco was put up. Worth reading the article he references http://www.gold-eagle.com/editorials_02/kennedy011602.html It cannot be any better said that Mr Kennedy:

    During periods of inflation - currency and credit expansion - precious metals will rise in absolute terms, but as pointed out above in the discussion regarding hyperinflation, even precious metals will fail to keep pace with currency depreciation under a fixed-price system until such time that a monetary panic takes place. Therefore even though the price of precious metals will increase, the purchasing power is negative relative to prices of other goods and services until the panic begins at which time, not only do precious metals increase in absolute terms but also increases in purchasing power due to a limited supply.

    During periods of deflation - currency and credit contraction - precious metals will fall in absolute terms, but will increase in purchasing power as the economy contracts. In other words, the price of precious metals do not fall as quickly as other goods and services traded in the economy. In fact, as the contraction worsens over time the purchasing power of precious metals actually increases at a faster rate.

    Anonymous - as I say in my About this Blog, i don't want to get into defending the Perth Mint. I've given the contact details of who to call to get silver, that's enough.

    The info you want actually is very commerically sensitive - the Mint's competitors and wholesale customers would love to know that info.

    Other problem is that the detractors would just say that the inventory numbers are lies anyway. If they believe that the Perth Mint can hide hundreds of millions of dollars of missing silver over many years of internal and external audits and the WA Auditor General then why would they believe published inventory numbers?

  4. Some people simply refuse to be placated and no amount of evidence is going to convince them, especially where there may be financial incentives to continue with the misinformation.
    Rather than replying with a counter argument to Bron's responses to hysterical assertions about Perth Mint, some people immediately commence another baseless Perth Mint smear campaign.
    Posting of inventory on the internet would be of little benefit - witness NYMEX metal warehouse stocks - the ranters don't believe it anyway!
    Customers can either place an order or not - the refiner's / mint's response to an order is the telling point.
    If certain lying ranters are to be believed over and above finding out for oneself, then I guess there's not much that can be done about it.
    I have no doubt that there are many problems being experienced in the US.
    All the more reason to wonder why certain self-appointed experts and free market advocates seek to shut down American demand from being satisfied by Australian suppliers.

    On topic - a few thoughts :
    Australia will be facing an inflationary price spike short term, due to the massive devaluation of the AUD over the last month or so.
    This has an immediate impact on our already high levels of importing.
    Additionally, this has occurred when many of the retail importers actually commence their buying for the Christmas season.
    In the usual run of things, deals are done in September, and imports ramp up to a peak in late October.
    That means that even if the AUD recovers, two quarters of CPI data will be impacted at least.
    The good old RBA just took 25 points off the target rate - great timing, but then again, they are more concerned about growth at present.
    Higher prices however may temper demand, and enable Oz to have positive trade balance for a couple of quarters, with the consequential boost in export earnings.
    The foregoing doesn't rule out deflation, however.
    Deflation is commencing in the housing and other finance fuelled consumption activities.
    Activity has slumped, and prices are starting to follow. So I don't think its a case of one or the other.
    Both can exist simultaneously within a multi-sector economy.
    No doubt each sector influences the others, and this interplay will become more important if the size and extremity of the inflation/deflation in a given sector starts to outweigh opposing trends in other sectors.
    Eventually some sort of equilibrium will occur.
    My bet longer term is deflation, given the colossal debt load being carried by the average Australian family - they can't borrow any more to spend.
    Less money in circulation should lead in turn to a stronger AUD, eventually.

    For a good discussion about economics check out Professor Steve Keen's web sites :
    No prizes for guessing his stance.
    Steve is also appearing on Dateline tonight at 8:30 EST

  5. 19 YEARS!!!!! This is exactly what drives me nuts about the whole deflate/inflate dilemma. How many rabbits can the pigmen pull out of their hats????
    These guys are luckier than the Turkish soccer team in the last EUFA Cup.

    We even have the same geopolitical stalemates as we had 19 years ago. Can it be a complete repeat?