Why Inflation Will Trump Deflation (Reasons 1-2)

By: Daniel Amerman | Thu, Feb 21, 2008
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Overview

In this first article of a series, we will discuss why the answers to the inflation versus deflation debate won't be found in impersonal mathematical equations - but the quite personal factors of human incentives and motivations. We will show how inflation always trumps deflation with sufficient government willpower - there is simply no contest. We will show how that willpower is already being unequivocally demonstrated today, and why the results of that willpower will ultimately likely be the annihilation of most of the value of the dollar and conventional investor assets. We will close by briefly discussing how investors can not only survive, but profit from the destruction of the dollar.

A Battle of Titans

Will the current deflationary forces in the US housing market transform into overall deflation in the monetary system? Will the credit bubble - which is already claiming the capital of many of the world's leading financial institutions - end in deflation, or inflation? Subprime mortgage derivative securities make up about one fifth of 1% (0.2%) of the rapidly growing $517 trillion financial derivatives markets. If larger segments of those markets were to also implode - will the purchasing power of the dollar rise, or fall? Will a recession tame inflation, or will we get accelerating inflation and stagflation instead?

Many people look at the answers to these questions as being a battle between economic forces, where the outcome is uncertain. In one corner we have the forces of inflation and hyperinflation, as represented by Germany in the 1920s, Latin America in more recent decades, and Zimbabwe today. In the other corner we have the forces of deflation, as represented by America in the 1930s, and Japan in more recent years. In this battle of titans each side has their highly intelligent and educated advocates, who can use the combination of history and financial equations to make a convincing case that either inflation or deflation will emerge on top - with opposite results for the value of the dollar.

The outcome of this battle is vital for investors. If you invest for the destruction of the dollar (inflation), and the dollar increases in value instead (deflation), then a strategy that looked lucrative on paper could become painful in reality. The opposite is true as well - become convinced of deflation, invest for it, and if the future works out to be inflation the results could be painful indeed. Given the powerful arguments for each side, and the enormous investment consequences - what is an investor to do? How can we find the answer to which force will be stronger?

Rock Breaks Scissors & Inflation Breaks Deflation

Let me suggest that the key to finding the right answer is to first be sure you are asking the right question. Let me further suggest that trying to decide whether inflationary or deflationary forces are stronger in the economy - is asking the wrong question. For as entertaining as the image of a title bout between titanic economic forces would be, this is the wrong metaphor, and is in fact dangerously misleading. A better analogy might be the children's decision-making game of "rock, paper, scissors". In this game, scissors always cut paper, paper always covers rock and rock always break scissors. The rules are absolute, and there is no question about whether the scissors will break the rock instead.

Similarly, when we look to the "battle" between inflation and deflation - there is no real question, but an absolute answer. Any government which controls the supply of its own currency can force inflation at any time - it is merely a matter of willpower. For a sufficiently motivated government, inflation breaks deflation. Always and without exception, period, end of debate. The question between inflation and deflation is not one of relative "power" at all, not one of which force will prove more powerful, but of government willpower and motivation.

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This inherent power of inflation to always break deflation is Reason One of our 24 Reasons why inflation will trump deflation. The source of this inherent power is quite simply the nature of money, as outlined below:

1. The potential supply of money is infinite for a nation that issues its own currency.

2. The supply of resources to purchase with money is always limited at any one point in time.

3. By sufficiently raising the supply of money relative to the finite amount of desirable goods and services, there will necessarily be more dollars competing to buy each asset, and the dollar denominated price will always rise for the asset.

4. The meaning of inflation is an increase in the dollar prices of goods and services, which is the same thing as a decrease in the purchasing power of every dollar.

5. So long as a government is willing to sufficiently increase the supply of money, it has an absolute power to destroy the value of its own currency through the oversupply of money relative to assets, which is an absolute power to break deflation with inflation.

Changing Assumptions = Changing Results

For those readers who are well versed in economics and inflation, my apologies for the elementary nature of the five points above. However, the fundamental principles reviewed above are essential for even the most sophisticated evaluations of inflation versus deflation. The problem is that generally speaking, the more sophisticated the evaluation - the greater the number of assumptions. Which leads to the danger that if you pull out one of the underlying assumptions - the whole elaborate edifice of equations, papers, dissertations and computer models can come tumbling down.

The particular underlying assumption that drives the inflation versus deflation debate is that government and society as a whole are committed to attempting to preserve as much of the value of the dollar as possible, and therefore the government will effectively handcuff itself. The assumption is that the government will act with great restraint, and not use its full powers, out of fear that the resulting economic devastation will be worse than the deflation that is being broken.

What if that assumption is wrong?

What if the government is not afraid of using its full powers over the currency?

What if the government has extraordinary incentives to use its powers to increase the real rate of inflation, even without any need to break a deflationary cycle?

What if those incentives will build over time, so each new administration and Congress faces steadily increasing pressures and incentives to devalue the currency in order to avoid worse problems?

What if inflation offers the only way out of a crippling economic future that would otherwise mean the bankruptcy of the federal government, most levels of state and local government, and most major corporations and financial institutions?

Leading A Horse To Water

Deflationists can advance some counterclaims in explaining why deflation can effectively resist a government's efforts to break it. For instance, some people might say that you can offer credit to people on increasingly advantageous terms - but you can't make them take advantage of that credit. This variation on the quote "you can take a horse to water but you can't make it drink" was illustrated in recent years by the Japanese government bringing the interest cost of borrowing down to 0%, but still being unable to break out of a deflationary environment, because not enough people would take advantage of being offered interest-free loans.

If you'll forgive me for saying so, all that example shows is that being a weenie is not necessarily effective when it comes to trying to break deflation. Being a weenie in this case means the government allowing the citizens to make the choice about whether to borrow, and create new money through that borrowing. This giving the citizens the discretion is a sign of a cautious government, one that is not fully committed to breaking deflation. Instead, the Japanese government was trying to have it both ways, attempting to break out of deflation but without igniting a powerful round of inflation that might escalate out of control. Rather like lightly tapping on the economy with a hammer.

Swinging A Sledgehammer

There is an alternative for a government that is sufficiently determined to break incipient deflation (perhaps in the housing sector), and that is to pro-actively apply blunt force and hit the economy with a sledgehammer. Yes, slash interest rates so people have the option of creating new money for themselves, but in tandem with the interest rate cuts, just flat-out make up a huge sum of new money out of thin air and give it away. Remove the decision from the consumer, and just send them the checks. You could send $50 billion or $100 billion, but given there is an infinite capacity to create symbols (money), why be cheap about it? Go ahead and send them $170 billion, but instead of calling it "money created from thin air" (which might excessively diminish confidence in the currency), call it a "tax rebate" instead. Whether or not the cash has anything to do with taxes paid is irrelevant. Calling the new money a "rebate" is quite appealing, as it makes it sound like money that already existed and was being generously returned, rather than symbols springing forth from nothingness.

In other words, do exactly what the administration and Congress are doing with their current "tax rebate" stimulus package. This is Reason Two of our 24 Reasons, and it is a powerful reason for believing that it will be inflation that dominates our future rather than deflation. Because this willingness to smash incipient deflation by blunt force isn't some fanciful or paranoid theory about what the government might do. The sledgehammer is already coming down, and it is being swung with few qualms and with enthusiastic bipartisan support.

There is the question about whether this economic stimulus package - whether this creating $170 billion out of nothingness - will actually achieve its desired effect of increasing the supply of real goods and services through stimulating demand. Indeed, when we look at the historical record, there's a pretty good chance that this is more symbol than substance, and that there won't be the desired stimulus effect upon the real economy. That said, there is no question that this stimulus package will have a quite real and direct effect: that of diluting the value of the dollars held by savers, through increasing the number of dollars in circulation, with no corresponding increase in the amount of real resources.

You could say that technically speaking, the so-called "tax rebate" will be financed by selling bonds, and therefore isn't coming out of thin air. Except that of course, the liquidity (money) to purchase the bonds is itself being created out of nothingness, through the Fed slashing interest rates to below the rate of inflation. When we have more money and the same resources, it means the value of everyone's money gets diluted, and real wealth is neither increased nor decreased - but redistributed. (This redistribution is further explained in "Inflation Pickpocket", the initial reading in the "Turning Inflation Into Wealth" series.)

Granted, while increasing the money supply by sending $170 billion straight to consumers does dilute the value of the dollar, it does not by itself destroy the value of the dollar. However, it does establish both the means and the willpower. If the government will create $170 billion and force it into the economy when there is the looming threat of a recession but no official recession - how much money would it create when we do go deep into a quite unmistakable and official recession? If the government will create $600 from nothingness for every man, woman and child in the nation, and say "spend!" when housing prices have dropped a few percent - what would it do if housing prices dropped 15% nationwide? What will the government do if the official unemployment rate passes 10% at the same time?

Are There Limits?

Are there limits? Is there a place where the willpower runs out and sanity takes over? A place where the government draws a line and says "$170 billion is fine, and we'll do $800 billion if we have to, but no way will we do a trillion." Or a place where the government says "OK, we'll do a trillion after all, but no way we will do $10 trillion. The amount of inflation that would create and the damage that would do to people's investments and savings is just unthinkable."

If $10 trillion in new money is insane, how about $150 trillion? That would be the equivalent of sending "tax rebate" checks for $500,000 to every man, woman and child in the United States. Now, any reasonable person can see that this idea of creating 1,000 times the money from thin air that we are doing with the current tax "rebates", and pouring $150 trillion out there is completely nuts. That's ten times the size of the national economy, and such an action would annihilate the value of most of the nation's savings and most financial assets.

Except... unfortunately, the $150 trillion isn't theory either. It has already happened - if you believe government promises. In a later reading, we will explore how the $500,000 per person (equivalent) check is already "in the mail", albeit for delivery over a period of decades, and another Reason why inflation will indeed trump deflation.

Self-Protection & Profit

When we look at how to practically apply the information in this article and the articles to follow, it may be helpful to get down to some core principles. Our first core principle is that the symbol we call money has no limitations in terms of supply, and therefore has a potentially infinite supply. Our second core principle is that as the supply of money grows closer to infinity, the value of that money must go ever closer to zero. Our third core principle is that as the value of money goes closer to zero, many financial assets that are denominated in dollars, may also have a value that approaches zero.

Our fourth core principle is that there is a limited supply of tangible assets, such as gold, silver, real estate and energy. As tangible assets have a value that is independent of the supply of money, then the way the relationship works is that as the potential supply of money nears infinity, and the purchasing power of financial assets nears zero, then the value of tangible assets also nears infinity (at least as denominated in a currency whose value approaches zero). The higher the rate of inflation, the greater the return differential between financial and tangible assets will grow, and the greater the benefits to buying tangible assets.

In combination with the tangible asset step, there is a second step to take as well, and that is to gain the knowledge you need to protect yourself, and even turn adversity into opportunity. This will mean looking inflation straight in the eye and saying: "Inflation, you are likely to play a big role in my personal future, and instead of ignoring you or thoughtlessly flailing away at you - I will study you and your ways. I will learn the deeply unfair ways in which you redistribute wealth, and the counterintuitive lessons about how some investors will be destroyed by inflation and repeatedly pay taxes for the privilege, even while other investors are claiming real wealth on a tax-free basis. I will learn to position myself so that you redistribute wealth to me, and the worse the financial devastation you wreak - the more my personal real net worth grows. I will examine the official blindness to inflation within government tax policy that creates the Inflation Tax, and instead of raging or despairing, I will understand that a blind opponent is a weak opponent, and I will take advantage your blindness and use tax policy to multiply my real wealth."

Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation - the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free "Turning Inflation Into Wealth" Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at InflationIntoWealth.com.

 


 

Daniel Amerman

Author: Daniel Amerman

Daniel R. Amerman, CFA
The-Great-Retirement-Experiment.com

Dan Amerman

Daniel R. Amerman is a financial futurist, author, speaker, and consultant with over 20 years of financial industry experience. He is a Chartered Financial Analyst (CFA), and holds MBA and BSBA degrees in Finance from the University of Missouri. He has spent seven years developing a large, unique and intertwined body of work, that is devoted to using the foundation principles of economics and finance to try to understand the retirement of the Baby Boom from the perspective of the people who will be paying for it.

Since 1990, Mr. Amerman has provided specialized quantitative consulting services to financial institutions, with a particular emphasis on structured finance. Previously, Mr. Amerman was vice president of an institutional investment bank, with responsibilities including research, synthetic securities, and capital market originations.

Two of Mr. Amerman's previous books on finance were published by major business publishers. "COLLATERALIZED MORTGAGE OBLIGATIONS, Unlock The Secrets Of Mortgage Derivatives", was published by McGraw-Hill in 1995. Mr. Amerman is also the author of "MORTGAGE SECURITIES: The High-Yield Alternative To CDs, The Low-Risk Alternative To Stocks", which was published by Probus Publishing (now a McGraw-Hill subsidiary) in 1993. Advertised by the publisher as a professional "bestseller" for four quarters, an Asian edition was sold as well.

Mr. Amerman has spoken at numerous professional seminars and conferences nationwide, for a variety of sponsors including New York University, the Institute for International Research, and many others. After the publication of his prior books, he acted as keynote speaker at a number of banking related conferences over the next several years.

This article contains the ideas and opinions of the author. It is a conceptual exploration of general economic principles, and how people may - or may not - interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, videos, books and other products, either directly or indirectly, are expressly disclaimed by the author.

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