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October 12, 2009

Part II: Deflation or Inflation? Here is the Answer...
by Paul Mladjenovic

Picking up from Part I of this "two part mini-series", we are covering the inflation/deflation debate. There are tons of top-notch economic commentators on both side of the debate. As we mentioned, the debate centers on the visible sign of deflation vs. inflation..."prices".

In part one, we highlighted what I think is an important summary of what affects "prices":

THE PRICES OF GOODS, SERVICES AND ASSETS
ARE MOST AFFECTED BY TWO FUNDAMENTAL FACTORS:
1. THE MONEY SUPPLY (primarily enacted by government)
2. DEMAND AND SUPPLY (primarily enacted by the marketplace)

Demand and supply are an important factor in this debate and I believe that this becomes a source of misunderstanding. Inflationists talk about the money supply exploding and that this massive increase will (sooner or later) mean higher prices and even to the point of hyperinflation. The deflationists tell us that we are (and will continue to be) in a powerful deflationary environment. What gives?

Demand and supply complete the observation. Look...if a trillion dollars is printed right now but this money is not flowing toward anything ("demand") then you probably won't see a price increase. Demand has decreased for some goods, some services and some assets in recent years. However, demand has increased (or has had continued strength) in other goods, services and assets. In other words, BOTH of the inflationists and deflationists can be correct if you break down the picture. You can have inflation in one part of the economic picture but not another. You can have demand and supply bring prices down in one part of the economy and not another.

Demand, for example, has been dropping like a rock in real estate. The real estate bubble of 2000-2006 artificially stimulated supply which increased the national inventory of available property (both residential and commercial) to the highest level in history. Too much supply with falling demand obviously means falling real estate prices. No amount of created money supply was able to overcome this.

The same is true for the labor markets. Labor is priced higher than the market could realistically pay for. We forget that the price of labor is more than just "the gross pay"; it also includes many other costs such as payroll taxes, workmen's comp, etc. The high cost of labor dampened the demand for labor; especially when demand for products and services fell. Right now, the supply of labor is much higher relative to the demand for labor.

In turn, as there are more and more unemployed, that means that less money is then available for discretionary purposes such as vacations and new cars. You get the picture.

Keep in mind that there is a big difference between "deflationary" and "deflation". It is much like the difference between "fainting" and "dropping dead". Lower demand does have a "deflationary" effect. If less people want something then of course the price will likely drop and this can happen even if the government's central bank keeps expanding the money supply. What does all of this then mean for us as investors and traders?

It is actually simple to figure out what to do with your money given this historic debate:

CONSIDER PUTTING YOUR MONEY IN THOSE THINGS THAT WILL BENEFIT FROM THE MONETARY SITUATION AND FROM THE DEMAND AND SUPPLY EQUATION.

I tell my readers and students to consider putting their money (retirement or otherwise) into those things tied to "HUMAN NEED". If you have your money in those things that will benefit from BOTH inflation AND where demand and supply are strong, then this merits your attention.

Stay away from where there is a deflationary impact (such as real estate...unless you really need to buy a home). Go where the money is migrating. Given this, I like gold, silver, grains, energy and other commodities. Investors and traders should consider "human need" and view it as a mega-trend during the coming months and years. I believe that a commodities super-boom is a likely event (and is already unfolding).

I am on record as predicting an "inflationary depression" but to be more precise, we will see inflation in those things tied to "human need". No matter how good or bad the economy will be, people will still need to eat, drink, heat their homes, etc. For these reasons (and other ones), I like commodities for the long haul.

For those deflationists that believe inflation is not possible when there are bad economic conditions, I say think again. Most hyperinflations in history happened during bad economic times. Germany (1920s), Yugoslavia (1989-1994) and Zimbabwe (2007-present) are good examples. Yes...inflation and a depression can happen simultaneously. Plan accordingly...

Paul Mladjenovic, CFP
www.ProsperityNetwork.net

Paul Mladjenovic, CFP is the author of Stock Investing for Dummies and his national investing & financial seminars are at www.ProsperityNetwork.net. His blog is at www.Mladjenovic.blogspot.com and he is the editor of the Prosperity Alert newsletter.

Copyright © 2006-2009 Paul Mladjenovic. All rights reserved.

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