No Deflation, Maybe Worse

Talk of deflation has become popular once again. Richard Russell has mentioned it and several people have asked my opinion of a recent article by George Paulos and Sol Palha entitled "A Day Late and A Dollar Short". It is a well-written, well-argued case for deflation.

The word "Deflation" conjures up visions of the 1929 Crash and the economic depression of the 1930's, hence a well-written piece where the authors' views are obviously sincerely held tends to strike an emotional response.

Deflationary talk is not new. It has been around every time the USA has had an economic recession. A very public proponent of a deflationary future is Robert Prechter who published his deflationary tome "How to Conquer the Crash" in 1995. His views are equally persuasive and also sincerely held. To this day he believes that deflation is about to strike.

An examination of the chart below of the M3 money supply in the USA shows that 1995, when Prechter published his book, was possibly an inflection point. This was when the rate of growth in money supply started to increase more rapidly and may be an important clue as to what lies ahead.

For reasons set out below, the good news is that there will probably be NO DEFLATION in the USA. The bad news is that what may replace deflation could be something worse.

Deflation is a collapse of a debt pyramid when it becomes "excessive" and debtors cannot fulfil their debt obligations. This creates a self-feeding downward spiral of debt repudiation leading to recession or worse. The debts could be said to have been settled by the bankruptcy of the debtors.

deflationary collapse requires two special factors to be present:

1. A strong or desirable currency that people are content to hold;
2. An inability by monetary authorities to create new money at will.

Those pre-conditions were present in the 1930's when the convertibility of the dollar into gold ensured that the dollar was money that people could trust and were content to hold. The constraint of gold convertibility prevented the authorities from creating dollars at will and boosting Government spending.

Those two special pre-conditions for deflation are not present today. We have fiat currencies that are nothing but pieces of paper that people are becoming increasingly reluctant to hold. Furthermore, the Federal Reserve Governors keep reminding us that we live in the era of the electronic printing press. They can instantly create any amount of new money whenever it is required - and they have already indicated that they would do so if this became necessary to avert deflation. They have the tools and they will use them. The odds are heavily stacked against a deflationary outcome.

It has been said that excessive debt can be repaid by either:

1. The bankruptcy of the debtor; or
2. The bankruptcy of the currency.

If the former is eliminated by the removal of the deflationary alternative, then the latter becomes more likely, indeed almost inevitable.

Paulos/Palha postulate a short squeeze in the US dollar. They see dollar debt as a short position against the US dollar and envision a rapid rise in the value of the dollar in the event of a deflationary event. The fact is that a short squeeze can only develop when the supply of the item concerned is relatively inelastic, i.e. the supply is limited. In the case of the US dollar, the supply can be instantly boosted by the Fed by whatever amount is required. Thus the conditions required for a short squeeze can be quickly eliminated.

The real situation is that dollars will be created in ever increasing quantities. The huge US Government deficits and debts guarantee this. The necessity to counter any deflationary trends that develop in the economy also guarantee it. The dollar may be in a short-term technical rally, but the long-term trend is down, especially against real assets.

The US economy is moving inexorably towards hyperinflation, the bankruptcy of the currency option referred to above.

Could the deflationists be right? Of course they could.

Fortunately there are a couple of indicators that we can monitor to determine whether it is deflation or hyperinflation that is imminent. The first one is the M3 money supply as depicted on the chart on page 1. If deflation is upon us, this chart will turn down and the change of trend will be dramatic. If it is hyperinflation that we are facing, this graph will begin accelerating upwards at an exponential pace.

The second indicator is the 30 Year US Government Treasury Bond. The reason for monitoring this item is that it will most likely be the best performing asset in a deflationary environment when interest rates will decline and the value of these bonds will rise. Conversely, in a hyperinflation these bonds will be amongst the worst investments.

The chart below shows interest rates on 30 Year Treasuries dipping below 4.3% in May last year. A decline in the yield on these bonds to below 4.3% in the coming months would be an indication of incipient deflation.

In a hyperinflation all bonds, cash and financial items will be ultimately be valueless. Interest rates will rise to extremely high levels. The above chart suggests that 30 Year Treasury rates have broken to the upside. A rise above 5.5% and then 5.9% would signal an attack on the peak of 6.7% reached in January 2000. This is the type of market action that one might anticipate in an inflationary (and ultimately hyperinflationary) environment.

The valuation of all bonds operates inversely to interest rates. As interest rates rise, the valuation of bonds declines. Similarly when rates decline, the value of bonds increase. This is demonstrated in the graph below that covers a much shorter period than the graph above, but it does show the actual price of the 30 Year Treasuries.

A price above 121 for the 30 Year Treasuries would signal deflation while a decline below 102 would be the first serious sign of significant inflation to come, possibly leading to hyperinflation.

One can learn much about how to handle investments in an extreme inflationary environment from the German hyperinflation of 1920 to 1923. The Mark's link with gold had been severed during World War 1 and the German government had the ability to print new Marks in an unbridled fashion. For various reasons the German government proceeded to do this until the Mark was worth nothing.

German investors holding cash and financial assets such as bonds lost everything. Investors who protected themselves by investing in precious metals and in foreign currencies (at that time the Pound, US Dollar and the Swiss Franc were convertible into gold) retained or improved their real wealth.

Investors in German real estate and the German stock market had varied results depending on how they were positioned. Real estate investors who could not quickly increase the rentals received from tenants were bankrupted by higher interest rates and rising property taxes. Others who managed to eliminate their mortgages and had sufficient rental income to meet outgoings survived with anything up to 70% of their real wealth intact.

The situation was similar for stock market investors. Depending on which companies they were invested in, some lost everything and while others managed to retain a modicum or even quite a large proportion of their real wealth. While the stock market indices rose to new peaks denominated in Marks, these indices failed to do so in real terms.

There is a large volume of information available about the German hyperinflation on the Internet. To start with, try www.usagold.com/GermanNightmare.html. A search on Google produced 3,400 additional listings for German Hyperinflation.

An easy to read book that covers all the hyperinflations since Roman times is "The Penniless Billionaires" by Max Shafire (Hardcover January 1981 · Publisher: Times Books · ISBN: 0812909232). The book is difficult to find but there are a couple of second hand copies available on www.amazon.com.

While the best investment in a deflation is likely to be 30 Year US Government Bonds, in an accelerating inflationary environment the best investment results will almost certainly be found in the performance of the precious metals and mining shares.

The chart below shows the performance of gold since the $850 peak in January 1980. I have drawn a line across the 15 year long base at the $425 level and another line across the $510 level that stretches all the way back to 1981.

A London PM fix above $430 would confirm a breakout from the 15-year long base at the $425 level. This upside break would make the $500 to $510 area a reasonable short-term target. After some correction from that level one could confidently anticipate an upside break above $510 to put a 23 year base in place. That base provides such a huge launching pad that it is anyone's guess as to how high the gold price might rise.

That is exactly what one might anticipate in an embryonic hyperinflation.

Alf Field

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Disclosure and Disclaimer Statement: To ensure full disclosure, the author advises that he is not a disinterested party. He has personal investments in gold and silver bullion as well as in gold and silver mining companies. The author's objective in writing this article is to interest potential investors in this subject to the point that they are encouraged to conduct their own further diligent research. Neither the information provided nor the opinions expressed should be construed as a solicitation to buy or sell any stock, bond, currency or commodity. Investors are recommended to obtain the advice of a qualified investment advisor before entering into any transactions. The author has neither been paid nor received any other inducement to write this article.