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July 13, 2005

Diatribes of a Deflationist........Why They Are Wrong
by David Petch

This editorial is a summary of why deflationists are wrong about being at the cusp of a deflationary event. One article brought into the light for discussing these points are from an article Mike Shedlock titled "The Deflation Debate Heats Up: 10 Reasons Why Hyperinflation is Coming". In order to clarify definitions of inflation, deflation, rising prices, declining prices etc. I want to define each term, as they will appear in the article to avoid confusion. Further in the article, I will address the Elliott Wave (NeoWave) count Glenn Neely has been following and recently updated. His count supports the case for hyperinflation, particularly after a bottom in the S&P is due around 2015 (with prices remaining above the 2002 lows) at the end of the article.

Monetary Inflation: Occurs when monetary creation causes a surplus of cash chasing the same number of goods.
Monetary Deflation: Occurs when fiscal responsibility or a lack of monetary creation causes a decline in total cash chasing the same number of goods.
Commodity Inflation: Occurs when a group of commodities in general are declining in supply relative to a monetary pool, with or without monetary inflation. This can include oil, cars, computer chips, wheat, etc. etc.
Commodity Deflation: Occurs when an excess number of commodities hit the market relative to a monetary pool, with or without monetary deflation. This can include oil, cars, computer chips, wheat, etc. etc.

1) The first point Shedlock states is oil is deflationary. Last week, I posted an article titled "Peak Oil and What it Means to You" and the take home message is that competition for resources is going to happen, first economically, followed by military intervention as this century rolls out. I can not remember a time in the 36 years of my life on the planet when oil was deflationary.

The oil shortages of the 70's were politically inspired. The inflationary trend at the peak saw housing prices decline 50% of the gain, yet they remained well above the low prices of the 70's. My parents bought their second house in 1972 for $22,000. By 1980 it was approximately $55,000.

The current shortages in oil are a geological phenomenon, not a politically inspired problem. As everyone is well aware, currency inflation is occurring daily and now a coming shortage in oil will create commodity inflation. Companies will only be able to absorb so much of the cost before it inevitably is passed on to the consumer.

The globe is now a village, with huge disparities between first world nations and developing (rapidly approaching first world status) salaries. Wages in the US will likely not drop, but will be eroded to a near balance with Chinese and Indian (India) salaries in the future via hyperinflation. So in response to Shedlock, wages will appear to decline in purchasing power due to global economic imbalances.....but the US is not the center of the Universe. A transfer of a portion of the US market share of the global economy is underway as we speak. Nothing can be done, particularly since the US now imports 60% of their daily energy needs. Higher energy prices will be reflective of reduced supply and a steady or increased demand from other countries.

2) In the third point of the article Shedlock states "Prices are going to rise in this "depression"? Why?". China is a communist country where the government owns all the corporate companies. The US consumer has aided in the huge trade imbalance with China, essentially trading their land for beads, while the Chinese get a boatload of US dollars. China has excess cash to deploy into financial assets and since they are building a city the size of Philadelphia each month, that requires resources. The Chinese government has been expanding their fiat currency float at a rate of 20% per annum. The liquidity and conversion of currencies around the globe quickly allows this cash to be deployed to buy resources. Enter the US FED. If anyone has not noticed, the US government is essentially carrying the US economy, much the way the Chinese government is carrying theirs. So it should come as no surprise the FED is essentially playing poker with China, matching their currency debasement and adding more. The FED has been creating money and keeping interest rates extremely low to allow the velocity of money to create artificial growth.

Even though the current economy is a credit bubble, the creation of money automatically creates inflation as it feeds into the economy through debt. I am not an accounting type, but I am sure their exists neat little schemes for FED printed money to pick up struggling companies or aid in transactions. Oil production is not increasing and monetary expansion is occurring, therefore prices will rise due to shortfalls, plain and simple. Factor in peak oil which is commodity inflation and the inflationary pressures build even higher.

Assume the automobile sector and housing sectors are commodities. There has been overproduction during both these cycles and when a peak is hit, prices will stabilize before plummeting. More supply than demand dictates commodity deflation will occur (housing and automobile sector). Notice how I am separating the terms of monetary inflation from commodity inflation or deflation. A forest has many trees and plants, so focusing on the whole for an objective answer is required. Housing prices and automobile prices will decline sometime around 2007 until 2014/2015, 20% of the US job force depend on home building. Another 20% depend on the automobile (parts, SuperLubes, auto manufacturers etc.). There could be massive unemployment in the US, but they represent one country on the planet. I think global oil production could suffer a decline to 70 million barrels/day once things get rolling, but a 6% economic decline year over year (YOY) coupled to a decline of global oil supplies 10% YOY still places incredible supply limitations on the supply of oil.

Resources such as copper, silver etc. have been in a bear market since 1980, so supplies are tight. I expect copper to hit $5/pound within 10 years due to supply limitations and inflation. Supply and demand is key and 2 billion people trying to elevate their standard of living just a smidgen puts additional pressure on the base metals and energy. The take home message for point 2) is that supply/demand dynamics of commodities are going to keep commodity inflation pressures high due to a shortage in supply. There will be corrections along the way; normal market bull markets experience retracements of 38.2%, 50% and 61.8%, pending the stage of the bull market.

3) They are going to bail and buy what? Euros? Pounds? Yen? Why, why, and why?............. Tell me exactly what everyone is going to buy when they start bailing. Currently the USD index appears to have completed and elongated flat (wave C longer than wave A or B) and this pattern pretty much happens in triangle formations only. A triangle has 5 legs and the first one for the USD lasted 6 1/2 months. This translates into a USD remaining range bound between 80.5 and current levels for another 24-28 months before falling through 80. At this point people will buy gold and silver bullion. They will line up like there is no tomorrow. A side point was mentioned about a genetic breakthrough that could create investor's returns of 5000% for people to plug money into things like this. I am in biotech, so I would like to address this in two points. Point i): American culture has become obsessed with obtaining maximum physical output for minimal input. To prevent the diseases etc., the best one can do is throw out their TV, hop on a tread mill, lift some weights, remove excess sugar and pop from diets, each organic foods, or foods deemed healthy. ii) In order for a drug to make it to market, there are three clinical trials, 90% do not make it past Phase 1, and less than 15% actually get past Phase III to the market. Unless someone has an inside edge on a product, investing in Phase III companies produces the least amount of risk versus reward. I personally do not own any Biotech stocks because of the inherent risk in getting a product to market and lawsuits/class action suits that are always around the corner. Companies must spend large amounts to ensure their intellectual property is not being violated also, so I view this sector far more risky than resource stocks with proven reserves in the ground. As an aside, I see generic drug companies eventually taking larger shares of the market due to reduced expenditures for launching a clinical trial required for Phase I, II and III studies of a drug already understood and fully researched.

4) Jim Puplava writes "The government takes over GSEs owning most American mortgages." Shedlock responds "Even assuming this happens, how does that lead to hyperinflation? (See my answer to No. 7 for more clarification.)". Housing prices will decline as per a commodity deflation. The basic goods of energy, food, gold and silver (even base metals) are in short supplies (world food levels can currently last from 51-53 days, decreasing YOY), so the prices of these items will remain higher. If the banks eventually own 20% of American homes and gas is turned off, the reduced demand may counterbalance the declining supply for a few years. Natural market forces will work this out in the years to come. Just because prices of one sector of the economy declines does not mean that everything else does. As an example, the Nasdaq and major markets in 2000 had severe declines, wiping out 5 trillion dollars of equity, yet oil went from $10/barrel to the recent high of $62/barrel during the correction and since then.

5) Jim Puplava writes "A national retirement security act is passed, forcing private pensions to buy long-dated zero-coupon government bonds that will be inflated away. The reason given will be for plan protection against bear markets." Shedlock responds "Assume such a bill is passed -- I seriously doubt it, but for the sake of argument, I will assume it happens. Pray tell, exactly how is that hyperinflationary? How and to what extent would it increase the money supply or cause prices to rise?" By forcing individuals to buy zero coupon bonds, the government has a larger pool of capital to reduce the effects of their inflation agenda. For example, if the government can forcibly collect $500 billion/year from pension funds, then it can inflate at $500 billion per year without any net addition of capital to the system. This directly does not cause hyperinflation, but rather contains it. Knowing governments, they tend to take cushions as such for granted and print currency beyond that limit and return to the process of currency debasement.

6) Jim Puplava writes, "As the U.S. economy goes into a hyperinflationary depression, the rest of the world's economies follow suit. Money printing on a grand scale occurs in Western and Asian economies as governments wrestle and try to satisfy the demands of a social welfare state and an angry, aging populace." Shedlock responds "The entire world goes into a hyperinflationary depression at the same time. Hmm. Do home prices head to infinity?". Housing prices are likely to start declining around 2007 as mentioned above. Wages globally or further credit extensions will have to rise for housing prices to increase in price. Basic commodities mentioned throughout the article on the other hand will increase in price due to shortages. Higher commodity prices will cost governments more, so more currency will be printed to secure resources. The US is most vulnerable to hyperinflation, because if US dollars are rejected for purchasing oil, gold, silver or other commodities on the open market, conversion to another currency (Euro, Yen, Yuan, gold) will be required for the transaction to proceed. With so many US dollars floating around in the future, further debasement could create more USD required to buy one barrel of oil.

Gold will return to the monetary environment to simply "peg" a currency to an allowable limit of money (so many outstanding USD per ounce of gold). After hyperinflation ravages the global economy, deflation will set in, due to people having no more money to stimulate the economy and a bubble closes the commodity bull market. This is a prerequisite to deflation under the current global environment as I see it. At this point, governments will be flat broke and the levels of employment will quickly decline. Prices of things will decline most likely due to rapid declines in the human population as described in the prior article I wrote titled "Peak Oil and What it Means to You". Peak oil will simply put prices of items out of the market; transporting fresh vegetables from Mexico to Canada will cost too much etc. etc. so a break down in the food transport chain will begin. Water treatment plants will not likely be able to be completed due to population declines or lack of funds.

Round-Up
The above information if it has not proved convincing will hopefully be cast in concrete with the following chart from this data: http://woodrow.mpls.frb.fed.us/research/data/us/calc/hist1913.cfm

The Y axis shows the cumulative inflation since 1913 till present. Notice that rates were very low until they started creeping up around 1940. Going off the gold standard in 1933 occurred when the US was in deflation due to the contraction of money supply based upon a gold-backed currency. It was not until World War II started those inflationary pressures kick-started the economies. After 1973 when Nixon totally went off the gold standard, inflation rates went up after a very short lag at a rate indicated by the red line. When the severe recession of 1980 hit, there was no evidence of inflation, actually there were three gap up years of inflation. Around 1994 when the Fed started jigging the rate of inflation, the trend of the points has drifted to the right of the red line. Even with interest rates at half of what they really are, the trend is your friend and it spells inflation. The trend of inflation has occurred during booms, recessions, war, peace etc. Inflation is based upon monetary expansion. No matter how much less people make, or how cheap some finished goods get in price (due to oversupply==>commodity inflation), the basic necessities of life, such as food, energy etc.etc. when in a shortage from natural pressures are compounded when currency inflation occurs.

Rapid expansion of currencies in South American countries, Germany, China etc. etc. has always resulted in hyperinflation. Since the US currency is global, I think all currencies will be debased at a similar rate, driving commodity prices to ridiculously high. The size of the bubble and the global linkage of all currencies suggest the currency bubble will continue to escalate. When all is said and done, owning physical gold and silver will be important, because WHEN deflation hits AFTER hyperinflation, they will retain their value relative to surrounding assets falling precipitously.

Here is one article further by Mike Shedlock that continues with his basic arguments: http://www.safehaven.com/showarticle.cfm?id=3010. All of his top 10 reasons for deflation are NON-MONETARY events.

Elliott Wave (NeoWave) Supports Hyperinflation
Glenn Neely predicted the 1987 crash and stated the DOW would be over 10,000 by 2000. People then thought he was nuts, but were silenced from what happened. His original forecast had the DOW hitting 100,000 around 2050, but he made an incredible one change to his count in a time period of 15 years to having wave (III) from a top in 2000, with wave (IV) underway until 2014-2017ish. A fifth wave is to follow, taking the DOW to 100,000. This sounds like a marvelous return at first, but compare that to Weirmar, Germany in the early 1920's. Their stock market went from 400 or so into the hundreds of millions by time hyperinflation had run its course (their car company could have been purchased for an equivalent amount of money to buy 300 of their cars). A DOW of 100,000 will not mean much in hyperinflation because of currency debasement. For further reading on Glenn Neelys longer term Wave count or his methodologies, I would refer the reader to his book "Mastering Elliott Wave".

The world has several huge hurdles that must be addressed in the coming decade and the one way to ensure economic survival is to be invested in resource stocks or companies that provide essential basic necessities to life. The focus of this article has been directed at diatribes of the deflationist camp and why it likely will not occur until hyperinflation via currency inflation or commodity inflation runs its due course. Deflationists have been wrong for 50 years and are likely going to be proven wrong for the next 10-20 years. A broken clock is right twice a day, but only once if it is in military time.

David Petch
TreasureChests.info

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