Inflation vs. Deflation…What’s Up?

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On the surface, inflation (possibly very high levels) seemed baked into the system. Billions, even trillions, of Federal money (our future taxpayer debts) seem to be being dumped into the system. How could deflation possibly be in the offing?

We have heard about inflation, with which we are familiar. In simplest terms, when there is an excess of money and credit flowing into and through the economy and supplies of goods and services do not rise, prices rise.

We have no real experience with deflation. When there is a shortage of money and credit flowing into and through the economy and supplies of goods and services do not fall, prices fall.

On the surface, inflation (possibly very high levels) seemed baked into the system. Billions, even trillions, of Federal money (our future taxpayer debts) seem to be being dumped into the system. How could deflation possibly be in the offing?

There is a short term and a long term. In the short term, the key term is flowing. This may be independent of the amount of money in the system. Let’s suppose that all of the consumers with available, unencumbered cash (a fairly small fraction) look at the plunging stock market and the monotonic decline in home values and decide to rein in spending. Not that they have to. It just seems prudent.

No plasma TV. No new car. No bigger house. No European vacation. No new furniture. No new Coach purse. Just for now. Oh, and University of Michigan instead of Princeton. Ridgewood High instead of Exeter.

The American consumer is 70% of the national GDP. But on the margin, the high net worth households account for a much larger proportion of discretionary spending. And as gas, heating, electricity, health care, credit card interest rates and food costs rise and plow into stagnant household incomes, Joe Sixpack has less and less left for discretionary spending.

The available money in the system may be constant, but the freedom with which it’s spent, particularly on discretionary goods, decreases. Less money pursuing a constant supply of goods and services. Deflation.

Now let’s suppose that the institutions that are in business to lend money temporarily decide not to do so. Banks can loan/invest about 10X their capital. But if these loans/investments start to go south, do they get more capital or reduce their loans outstanding?

So they call in loans. Sell investments for whatever they can get. Reduce outstanding loans/investments. Reduce the rate at which loans are made, for now. Reduce credit card limits.

Deflation. You can’t get a car or home loan. Village Hardware can’t get an inventory loan. Auto dealers cannot get loans to fund their showroom inventory. Regional Bank can’t get a three-week loan from Citibank. Citi is afraid it will be a bad loan and won’t be paid back. And Citi has to rebuild its asset base.

The concept of velocity is relevant. No matter how much money is (somewhere) in the system, if it doesn’t go somewhere on a daily flow basis, it is useless to the growth of an economy. The economy must shrink to the level that can be supported by the actual flow (spending) of consumers’ dollars and the level of credit actually available to grease the wheels of day-to-day commerce.

When the velocity is cut back, the economy must shrink. Deflation, regardless of how much money is in the system. If the Fed gave every citizen $100,000 tax-free, and the citizens stuck it under their mattresses, nothing would change. If the citizens deposited it in the bank, and the bank held it and did not loan it back out, nothing would change.

If the citizens used it to pay off bills and the recipients did not loan it out again, nothing would change. Deflation.

All of these things are happening today. We are faced with something we have never in our lives seen: a massive deleveraging of the world’s financial system (unwinding the absurd massive leveraging of the last 20 years), coupled with a contraction of consumer discretionary spending in reaction to falling stock markets, falling house prices and flat incomes.

Throwing all of the “money” the Fed can print or guarantee will change nothing, until the velocity picks back up. Anyone with free cash is now in the catbird’s seat. Everything is, or will be, a bargain. High-end consumer goods, cars, houses, office buildings, vacations, high-end clothing…all bargains. Party on, wealth holders.

Until it ends. Eventually (One year? Two years? Longer?) the velocity will be restored. The economy will return to our comfort zone. Then the inflation caused by the massive Federal “bailouts” (paid for by our borrowing from China, Taiwan, OPEC and the Caribbean banking centers) will take hold. The dollar will turn into the American peso.

The prices of gold, silver, commodities, fertilizer and consumer goods will rise dramatically, in dollars. And all of the investments made by today’s wealth holders will soar, in dollar terms.

Relate these comments to your own household situation. Are you reacting as I posited? That’s where we are now, and why we are facing a sharp deflation, followed by a long inflation.

Chuck Greer is a regular contributor to Motley Fool CAPS. He's an active investor, and has spent 15 years studying energy, macroeconomics and investing. He graduated Yale BEE Electrical Engineering, and has a joint MIT/Harvard Business MBA. Before retiring, he worked for McKinsey and Company, and founded two companies — Canberra Industries (Nuclear research electronics), now owned by AREVA, and Commerce Register (which provides data processing for direct marketing industry).

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