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October 17, 2008

Deflation Scare the Perfect Camouflage
by Christopher Galakoutis

It is said the market can sniff out prospective problems and price itself accordingly. If so, then someone needs to get this dog some nasal spray, lickedy-split!

The deflation scare currently hovering over the entire market, particularly in the metals and commodities sectors, has been brutal. But the key question today is whether this "scare" will evolve into a genuine deflation threat to the US and the world?

Inflation and deflation are monetary phenomenons. Monetary inflation occurs when the supply of money increases faster than the supply of goods and services. This is different from the concept of price inflation, which, depending on several variables that may impact inputs along a given production chain, can cause an increase in the price level for certain goods and services at any given time. Otherwise said, monetary inflation causes price inflation, but a price rise isn't always a result of monetary inflation.

With monetary deflation you have the opposite effect, in that it relates to a contraction in the money supply. If the supply of money contracts, while the supply of goods and services either remains constant, increases, or contracts at a slower rate, then that can lead to price deflation. Otherwise said, a contraction in the supply of money will in most cases cause asset prices to fall, but falling asset prices are not always the result of a monetary deflation (the oil price can rise if the supply of oil is falling at a faster rate than a money supply contraction, for instance).

What we have today is falling asset prices in, specifically, real estate and stocks, and a rise in the value of the US dollar. This has led many to wrongfully conclude that we are not only experiencing a deflation scare, but that a depression brought on by a deflationary collapse is imminent.

I don't see it that way. Stocks and real estate are collapsing because the US was on a debt binge for many years. Given that real estate purchases are mainly financed by debt, and that many have used margin in stock portfolios, as well as, in the cases of hedge funds and others, dangerously high levels of leverage, the deleveraging that was forced upon the market following the collapse of debt instruments tied to bad loans is what is causing the dramatic declines in these asset prices today.

In a fiat money world with governments controlling the money printing presses you can be sure those governments will do everything in their power to fight off depressions. Anyone who continues to doubt this must have been living under a rock the past couple of months.

With much of the world holding the same toxic instruments and in similar, but not as horrific shape as the US, the ability of the US Treasury to tap its foreign creditors and borrow its way, to the tune of trillions, out of this mess has been severely impacted. On the domestic front, the savings rate is approximately zero, and increasing levels of unemployment will cause tax receipts to collapse. The only alternative will be the printing of money.

The US is the world's greatest debtor. Money printing will bring on monetary inflation, which will wipe out those debts, savings, as well as the US dollar. That is the real scare that markets today, as well as foreign creditors, should be pricing in. It is only a matter of time. To borrow a line from the classic film 'The Usual Suspects': The greatest trick the Devil ever pulled was convincing the world he didn't exist.

Christopher G. Galakoutis
CMI Ventures LLC
Westport, CT, USA
Website: www.murkymarkets.com
Email: info@murkymarkets.com

Christopher G Galakoutis is an independent investor and commentator, who in 2002 re-directed his attention to studying the macroeconomic issues that he believed would impact the United States, and the world, for many years to come. He works diligently to seek out investments for his own portfolio that align with his views, and writes about them on his website. With a background in international tax, he also works with clients holding foreign investments (ExpatTaxPros.com), ensuring their global income tax costs are being minimized.

Copyright © 2006-2009 Christopher G. Galakoutis

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