Inflation or Deflation?
An interview with Bud Conrad, Casey Research chief economist
The following interview, conducted by Louis James, a senior analyst and editor with Casey Research, appeared in the March 08' edition of Casey's International Speculator.
Louis James (LJ): The first question we think most readers will want to know about is this: if the U.S. is headed for recession - if not already sliding into one - do you really think we're facing more inflation in the near future, or could falling spending power cause deflation?
Bud Conrad (BC): There are strong deflationary pressures in a credit collapse because as housing prices drop and defaults rise, some of the ability to buy new items is lost. Traditional analysis suggests that we could have deflation such as that which occurred in the Great Depression in the U.S. in the late 1920s, early 1930s. I would point out, however, that in the Great Depression the dollar was linked to gold, limiting the amount of money printing that could be done, a limitation that does not exist today. In addition, with $100 oil it is hard to argue for deflation. My base prediction is that we are heading into an inflationary period.
LJ: If there was any doubt about inflation vs. deflation, has it been settled by the central banks of the world as they responded to last summer's credit crunch with greater liquidity?
BC: Yes. That is the point. The governments and their central banks have no limit on how much money they can create since there is no tie to gold or anything else. It is only logical to expect them to take the easy road and print money. The result is predictable. New government bailouts for whatever problems arise are going to continue.
LJ: With war spending, ballooning entitlements, a crisis of confidence in the U.S. financial system stewing, along with many other woes, do you think there's any chance that the U.S. will not try to inflate its way out of its current economic predicaments?
BC: In a word, no. Inflating its way out of problems has become the default solution for the U.S. government, and governments around the world. Consider, the price tag for the wars in Iraq and Afghanistan is now credibly estimated at $3 trillion. The economic stimulus package passed by the U.S. Congress will cost $150 billion, which will come on top of slowing tax receipts due to the recession, confirming that the U.S. budget deficit will jump to $400 to $500 billion this year.
That kind of deficit will put yet more pressure on the dollar due to the expectation that the government will inflate the dollars to pay for the deficits, as well as further bailouts that may be required as the credit crisis continues to unfold. And just over the horizon, it gets worse because of the unsustainable costs of the entitlements due to the 76 million baby boomers now beginning to look to retirement, and for their government medical payments.
As governments don't actually produce anything, paying for all of this will have to come either in the form of direct taxation, which has well-established limitations past which it becomes counter-productive, or from indirect taxation, in the form of a steady erosion in the value of the dollars that will be used to meet the government's many obligations. In other words, inflation.
LJ: There's a view among many observers that U.S. trading partners will have to devalue/inflate their own currencies, or their own economies will be slammed by a loss of competitiveness of their products in U.S. markets. This could spill over to those countries that supply raw materials or labor to the first tier of dominos. Do you think such a "race to the bottom" is likely? Our survey finds almost universal inflation around the world, and it seems to be accelerating in most places. Is the race happening already?
BC: Again, yes. The Asian exporters want to expand trade to keep their workers employed, and are trying to accomplish that goal by supporting the dollar with unwise, outsized investments in dollar-denominated investments like Treasuries. As a result, our foreign trading partners have accumulated $6 trillion of such assets, an unprecedented level of holdings.
This circular investment strategy - in which we buy from foreigners and they reinvest in our government paper - has provided the capital for the U.S. economy that our domestic saving has not been able to provide. In the process, it has kept a lid on consumer prices here in the U.S. for over a decade, essentially exporting inflation offshore, along with our manufacturing. But the net result is that the U.S. has done the equivalent of selling off about 23% of its tangible net worth to foreigners, leaving the system at risk of collapsing.
If there is a positive, it is that we have an environment that evokes memories of the long-standing military strategy of Mutually Assured Destruction, where no one wants to be the cause of collapse. The Chinese have pegged their renminbi to the dollar rather than let it rise, and that has fostered inflation that is over 6%. The Persian Gulf oil states that peg their currencies to the dollar suffer the weakness of the dollar, causing higher internal inflation.
The world money supply is growing faster than the production of "stuff," resulting inevitably in less purchasing power for all currencies. How much longer this is sustainable is hard to say, but the odds increase every day that foreign holders of dollars will come to believe that the U.S. government is willing to sacrifice the dollar, and then they will begin to unload dollars in earnest. There are signs of this happening already, with the Chinese and others using their considerable dollar reserves to buy up large natural resource deposits, even shares in U.S. corporations. In other words, tangible items.
LJ: What other factors do you think might mitigate or exacerbate inflation worldwide? Do you think the overall trend will be for increasing inflation that will continue for some time, or are there mitigating factors that might slow it?
BC: The slowing of world economies we expect in the mid-term may somewhat mitigate inflationary pressures. However, as we also expect governments to react as they always do when faced with an economic downturn - namely attempting to stimulate growth through further monetary creation - this will only plant the seeds of much higher inflation over the next decade.
LJ: Do you think robust economies like China's can handle whatever inflation is likely ahead without too much trouble - or is this a serious worldwide storm that's brewing?
BC: The storm is worldwide. China depends on Western countries to buy its exports and there will be convulsion from overcapacity in an economic slowing. They are not immune to U.S. slowing. The Shanghai stock market that went from 1,000 to 6,000 has already pulled back to 5,000 with some anticipation of further slowing. The world is not decoupled; it is even more coupled than ever. But on an inflationary view, China has strengths, most importantly goods that the world wants to buy, and that results in a trade surplus.
LJ: Can you think of any countries insulated enough from the spreading loss of value that it makes their currencies safer places to put cash? Switzerland?
BC: I look to the countries that are rich in natural resources to maintain an edge because of the commodity boom. Russia is not a safe country from an investment perspective, but their oil has given them a completely new life. Canada has benefited greatly from the natural resource boom and should continue to do so.
LJ: It's clear from the research you've done that the advent of a pure fiat monetary system in the early 1970's has triggered a significant increase in monetary inflation, but why hasn't that caused a greater level of price inflation than we have seen in recent decades?
BC: Well, we have seen it, but most people don't seem to realize it. The U.S. dollar has lost 81% of its value since 1971. Bad as that is, it would have been much worse, if not for the Chinese and others buying our treasuries. That, in effect, funded our deficit spending and exported our inflation to their shores. Look at the inflation in China: it's headed higher. Their purchasing our government and corporate debt was like a vendor financing program for the sale of their exports to us. In effect, they loaned us the money to buy their goods.
We haven't faced the ominous task of paying off what is equivalent to a maxed-out credit card; and when we do, it could spell disaster for the dollar. We have imported Asia's computers, TVs and clothes, produced with their cheap labor, keeping our price indexes lower. The bubbles of foreign investment capital went into the pool of financial assets supporting our stock markets and housing markets, which certainly had big price inflation, but which are not included in the common price measures of our inflation like our Consumer Price Index. Just applying the methods used in 1980 for the CPI, before the government adjusted the statistics, would suggest that the dollar of 1971 is worth about 7 cents today.
The Chinese and Japanese have actively supported the dollar to maintain their exports, but should world dollar holders reverse course, a floodgate of even worse inflation could come from too many foreign holders all wanting to exit the dollar at the same time. That almost happened in August 2007. They stepped back from the potential melt-down, but it's still not safely removed from our future.
The process is on the track for even more price inflation in the future, because more people will be waking up to the sham of tissue paper money.
LJ: General loss of value among fiat currencies is obviously good for the price of gold and the kind of investments we have been recommending here at Casey Research. Do you have any other suggestions for investors who believe that inflation of major world currencies is "baked in the cake"?
BC: Watch out for agriculture price rises. A situation you might call Peak Food is developing. We have the lowest supplies of grains ever compared to usage. The prices of wheat, corn, soybeans and rice are all double from what they were a year ago. Dangers of energy shortages leading to food shortage are growing daily and are not widely enough understood. Rising food prices will be important additional drivers of inflation across the planet this year.
LJ: May we ask what you're doing with the cash in your own portfolio?
BC: I am, not surprisingly, overweight in precious metals.
LJ: Any final comments?
BC: I usually confine my analysis to economic measures, but the world political situation is extremely important and intertwined with the economic consequences. As we look at Asian ascendance, and their expanding importance on the world scene, we should be aware of the dependencies of their claims on our assets.
Similarly, the competition for resources is likely to continue, and the worries over peak oil probably have much to do with our presence in the Middle East. How these unravel is a bigger discussion than we have time for here, but I urge watching the international landscape almost as much as our own internal actions, as the outside forces will direct our future as much as the decisions at home.
Bud Conrad, chief economist at Casey Research, is a regular contributor to the International Speculator, Casey's monthly flagship publication. The International Speculator focuses on undervalued junior exploration companies in the gold and precious metals sector that provide the very real possibility to generate double- or triple-digit returns within 12 to 24 months.
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