Inflation vs Deflation - A No-Brainer.

All the usual economists (including those at Government Sachs) seem to believe that deflation is more likely than inflation. I’ve decided to dedicate my first-ever blog to denouncing this silly opinion. Let's start by making the improper assumption that “inflation” means “rising prices” (the reason this is not accurate will be left for another blog), and hold that definition throughout my rant. To simplify, I’ll just focus on why our government NEEDS inflation, and why deflation is simply not an option. But first a quick look at unemployment…

Ah yes, capacity utilization... Historically America has not seen inflation during times of low capacity utilization. The rationale is this: if consumers are not employed they will curb their spending - lowering the overall demand for goods and services. Low demand prevents producers from raising prices; hence deflation. There are three interconnected problems with this: 1.) Inflation doesn’t hit all goods and services in unison, 2.) Americans are no-longer the world’s only consumers, and 3.) A negative CPI number does NOT necessarily mean we have overall deflation.

Indeed the US consumer is currently very weak, and as a result we see price deflation in digital cameras, homes, flat screens, DVDs and some other things that Americans love to buy. Let’s make the wild assumption that the price of other mildly important consumer products: food, water, industrial materials, education, medical care, etc… are all on the rise (they are by the way). The consumer price index is comprised of about 40% housing, 16% food/drink, 17% transportation, 6% medical care and 6% education (leaving some other categories out to keep things simple). …So if housing prices drop 20%, and the price of EVERYTHING ELSE rises 20% the resulting CPI number is a tame 1-2% (more on this later).

So let’s get back to why the government could use a little inflation and wouldn’t survive a bout of deflation – It’s all about debt and we will use an economically accurate situational metaphor to make my point…

I make $50,000 a year, but I have amassed a credit card debt of $240,000. Right now I have $0 in my checking account and my budget actually adds $25,000 per year to my debt. Yikes! Luckily my credit card only charges me 4% so I’m not that worried (my $800 monthly payment is very manageable given my $4100 monthly income). I sure hope my credit card company doesn’t realize how perilous my financial condition is; otherwise they may not want to lend me any more money; or worse, they may raise my interest rate to better reflect my risk of default. I really should try to get out of debt before my debt servicing becomes an unmanageable portion of my income… There are four ways I can do it: 1.) I could earn more money by asking my employer to pay me more. 2.) I could try to spend less so that my budget isn’t so negative, 3.) I could sell my house, flat screen, and DVD collection, or 4.) I could learn how to produce counterfeit money with my inkjet. Our government is in a very similar predicament; the only difference is that, for me, printing money is illegal.

Our federal government had an income of $2.4 trillion in 2006 (total tax revenue… sorry, I couldn’t find a more recent number). The government's debt is currently $11.5 trillion (not counting debts owed to Americans). The annual budget deficit is over $1 trillion now, but who knows the actual number. America’s credit card rate is currently around 4% (10 year treasury yield). This means that companies, individuals, sovereign nations, and our government themselves (?) are willing to let our government use their money (?!) in exchange for a 4% coupon payment made semiannually with a full repayment of principle in 10 years. Debt servicing is becomming an increasingly unmanagable portion of income - the government should really try to get out of debt, and there are only four ways they can do it: 1.) They could earn more money by asking their employer (the people) to pay them more (taxes), 2.) They could try to spend less so that the budget isn’t so negative, 3.) They could sell assets like bridges, land, parking meters, airports, etc… or 4.) They can print money.

Lets look at these options individually:

1. Raise taxes – This one is easy. Raising taxes is politically unpopular, and Obama promised not to do it… So if he wants to get re-elected, he’d better not go this route. He could probably sneak a few extra dollars from taxing healthcare benefits, but this money is already spent, so it wouldn’t help the budget situation. He could also squeeze a few bucks from Cap&Trade legislation, but this is a drop in the bucket (not to mention an inflationary economic headwind). The only politically acceptable way to raise taxes is to grow the overall economy - increase GDP and therefore increase tax revenue. Too bad GDP is shrinking at an annual rate of 6%. So much for option 1.

2. Cut spending – Afghanistan, stimulus packages, bailouts, healthcare, an aging population collecting welfare, disability, social security, etc… I think it’s a safe assumption that government spending cuts are not in the cards.

3. Sell assets – This is happening as we speak, but its probably not enough. The income generated by all of the nation’s assets is about $12 trillion (our GDP). At a cap rate of 4% the United States of America is worth approximately $300 trillion, but most of this value resides in the innovation and motivation of the American worker/entrepreneur - difficult to sell off. Additionally, selling even a fraction of the assets needed to finance our debt would be political suicide, and a sign of weakness. 3's out.

4. Print money – Now here’s an idea - provided of course that the government is able to do it discretely without tipping off our creditors. Unlike other nations, our debt is denominated in our currency – Happy day!

Can we do it discretely? The statements and actions of our creditors show that they are on to us. China, and other creditor nations are hedging their USD exposure by purchasing hard assets. Barges filled with copper, zinc, and iron ore are sitting of the coast of China because the ports are full. This increased demand raises prices (our crude definition of inflation) on these commodities and any end products for which these commodities are industrial inputs. The United States’ government however reflects a tame 1-2% in their CPI as a result of the housing market collapse (the invisibility cloak that will allow inflation to creep up on us yet again)… (Oooh.. speaking of which, remind me to blog about TIPS securities and the genius behind them next – that’s a good one)

There is a silver (or gold) lining to this story. The United States is still (by far) the world’s largest holder of gold (hopefully), and the golden rule still applies - "he who has the gold makes the rules." Even though China has doubled their gold reserves over the last few months, their stash pales in comparison to ours. If the US dollar collapsed in a disorderly fashion, the value of gold would skyrocket providing the US with a floor to the dollar's decline. In other words there would be a point where the US could once again peg the currency to the price of gold to stop the bleeding. Conspiracy theorists like to claim that the depository at Fort Knox is empty, but these claims are baseless, and most of these people are idiots. So assuming the gold is there, the US government has a fairly solid hedge against its own currency. As a result, hyperinflation (should it occur) would be temporary in duration, and limited in magnitude. Peter Schiff and company thinks that the government will ultimately have to sell the gold, but I think they will just hold onto it, either way... that dude's gonna be rich.

So why is deflation impossible? Anyone with 5 times more debt than income will do everything in their power to prevent deflation (deflation hurts borrowers {the US} and benefits lenders {China}). And believe it or not, the US government has quite a bit of printing power.

So what’s my outlook? Just because China is prepared for (or hedged against) a disorderly USD collapse, doesn’t mean they actually want one. We will probably work this whole thing out politically in a decade long period of equalization (is that a word?). Americans will buy less, and the Chinese will buy more. The brunt of inflation will be born by Americans, whose savings rate has sharply increased as a result of this recession (and whose retirement funds are still predominantly held in USD investments). Remember that inflation hurts savers and unhedged creditors to the benefit of borrowers and intelligent spenders. So borrow dollars, and buy everything else. I think our CPI has infinite support (Bernanke’s helicopter) at or around 0%. Inflation will hover near 0% until enough supply is pulled from the shelves to allow demand to start kicking up prices. I think gold is flat or falls slightly (maybe to around $850/oz) during this period but will perk up above $1000/oz and beyond about 8 months before inflation starts to rear it’s ugly (but welcomed) head.

Ok, That’s it.

As a disclaimer: Most of the people who blog on the internet are charlatans, so don’t put your money behind any of my advice. I have no credentials and I beleive almost everything I read.