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Inflation versus deflation
April 22, 2005

Here is a question that pops up over and over again: does the future hold inflation or deflation?

Inflationists point out that rising energy prices will cause prices in general to rise, and that is inflationary. Deflationists say that slowing economic growth will cause prices to fall. However, these are not the issues. They are the consequences of events and circumstances.

Inflation is not a general increase in prices, and similarly, deflation is not a general decrease in prices, just as fever is not an infection. Fever is the consequence of an infection and if you don’t know that, how would you know to look for the infection and cure it? You can mitigate the fever with drugs, but that won’t make the infection go away. As long as people think inflation is an increase in prices and deflation is a decrease in prices they will not be able to look beyond the nonsense promoted by the general media.

Monetary inflation is an increase in the supply of money and deflation is a decrease in the supply of money. That is it. But when the money supply increases, money loses value in relation to goods and services and that can lead to a general increase in prices. The increase in prices, however, is a consequence of money losing value. Price increases themselves are not inflation. Suppose that the money supply remains constant but that the supply of steel is interrupted for some reason. The price of steel will most likely rise, but that is not inflation. It is true that if steel output is diminished then the amount of money relative to available steel will increase and the same would occur if steel output remained constant and the money supply increased. Both events would lead to higher steel prices but only the latter increase would be due to inflation.

Deflation, of course, is just the opposite: a decrease in the money supply.

But what is money supply? US Representative Ron Paul asked Federal Reserve Chairman, Alan Greenspan, what he considered to be the best tool to measure money supply. Greenspan plainly admitted that he was at a loss for picking out what such a measure might be. When US Representative Paul suggested that it must be difficult to manage something you cannot even define, Chairman Greenspan not only agreed with him but also said it was “impossible”. What a startling admission by United States’ leading maker of monetary policy. If we don’t know what money supply is, how can we determine whether the money supply is increasing or decreasing?

We could count the number of notes and coins outstanding, but that does not give us a clear picture of money supply since it does not account for debt, and debt plays an enormous role in our current financial system. There are monetary aggregates, such as M1, M2 and M3 that include various forms of deposits at financial institutions as well as notes and coins in circulation. The concept behind these categories is that they represent decreasing levels of activity, with M1 being the most active. I often use M3 for my own calculations since it is the broadest measure of money. But in reality M3 still does not account for all of the money outstanding.

According to the Quantity Theory of Money, MV = PT.

M is the money supply,
V is the velocity of money,
P is the average price level and,
T is the total number of transactions.

While the above equation is not a definition of money, it can give us some indication of what might be going on. The national income (I) is the total income earned in a country and is a known entity. It is also equal to the total number of transactions times the average price level: I = PT (note that P and T cannot be measured directly). That implies that the national income also equals MV, the product of the money supply and the velocity of money.

The US national income doubled from 1990 to 2004, from $5.1 trillion to $10.3 trillion. All we really know then is that the product of money supply and the velocity of money doubled as well. How much of that was due to an increase in money supply and how much of it was due to changes in the velocity of money, we don’t know.

We can get some idea of what the money supply did by looking at M3. From 1990 to 2004, M3 increased by almost 130%. Assuming then that the total money supply increased by a similar percentage, and since that increase is greater than the increase in national income, one could infer that there has been an offsetting decrease in the velocity of money.

Could it be that the dollars that China and Japan are hoarding have reduced the velocity of money relative to the inflation of money? Given that China and Japan together hold over 20% of the outstanding US Treasuries, which is equal to about 9% of M3, I would say the answer is yes.

Now to get back to the question of which will win out: inflation, or deflation.

The United States is saddled with a lot of debt. Individual, corporate and government debts are all at unprecedented levels. Debt expansion in the US is a consequence of record low interest rates during a period of relatively high economic growth and prosperity. Those who argue that inflation is more likely say that the economy cannot withstand a dramatic increase in interest rates and therefore the Federal Reserve will not allow interest rates to rise either too rapidly, or too far. They also contend that the Federal Reserve will most likely reduce interest rates at the first sign of economic trouble and low, or falling interest rates, will be conducive to even more debt creation, which is also an increase in money supply, and therefore inflationary.

Deflationists argue that the amount of outstanding debt, and borrowers’ ability to pay the interest and principle due on that debt, are the real risks. Should the economy slow down, or interest rates rise, we could see an increase in the amount of defaults and bankruptcies. If the lenders do the correct thing, which is to write the bad debt off their books, the money supply will be reduced and that is deflationary.

I am in the deflationists’ camp.

How will commodity prices and the price of gold be affected?

I expect China will allow its currency to appreciate against the dollar and since that implies it, and Japan, no longer need to hoard as many trade dollars as they are currently hoarding, the dollar exchange rate will fall (see last week’s commentary at www.paulvaneeden.com). It also means that China and Japan will buy fewer US Treasuries, implying US interest rates will rise. A rise in US interest rates will stifle the US economy and that is when the debt load will become a factor. With rising interest rates and a slowing economy we could see a dramatic increase in personal and corporate bankruptcies, which is, of course, deflationary.

But offsetting this deflation of the money supply could be an increase in the velocity of money since Japan and China will not be hoarding as many dollars. An increase in the velocity of money appears inflationary, as it can make prices rise. So even though we may be experiencing deflation in the true sense of the word, it could well be masked by an increase in the velocity of money.

If, indeed, we see a slowdown in US economic growth we should also see an increase in unemployment. An increase in unemployment, rising interest rates, slowing economic growth and an increase in bankruptcies are not going to make US consumers feel wealthy. We will see the wealth effect in reverse as consumers begin to save and cut down on their spending.

But at the same time, the US dollar will be falling. The US is grossly dependent on foreign products, so even though we might be in a deflationary period we could still see the prices of imported goods rise. Oil is one such item. An increase in the oil price, however, ripples through the whole economy and puts upward pressure on prices. Most significantly, it causes the price of gasoline to rise, directly impacting the disposable income of consumers.

The US might surprise me and reduce its oil consumption, but will it be enough to offset the falling dollar? Keep in mind that oil prices could fall in Europe, China and Japan while the price of oil rises in the United States.

Less consumer demand and slower economic growth will have an impact on discretionary purchases. So I expect we will see the prices of capital goods, luxury items and non-essentials go down in the US assuming that they are not imported or made from a high percentage of imported items. Automobiles come to mind. Look at the state of the US automobile industry and you will see that it is already in shambles. I would not be surprised to see an American automobile manufacturer declare bankruptcy.

To people looking only at prices and thinking that they are observing inflation or deflation, the picture will be muddy. Most people look at the Consumer Price Index and assume they are getting a clear picture, but they’re not. The Consumer Price Index is a very unreliable gauge of inflation, real or imagined. Even so, those that look at the prices of food and energy, as well as imported materials, will think we are experiencing inflation. Those that look at the prices of capital goods will think we are in deflation. But if you look at the money supply, I think that the biggest threat is deflation and there is, in my opinion, not a thing the government can do about it.

By having both a trade deficit and a budget deficit, especially given their magnitudes, the government’s hands are tied. China and Japan will decide the fate of the US dollar and the US economy.

Now, regardless of whether we see inflation or deflation in the United States, the price of gold in US dollars will rise if the dollar falls. It is as simple as that. If the US were the only economy in the world, and the US dollar the only currency, then we could have predicted what will happen to the gold price under either inflationary or deflationary conditions. But the reality is that gold is truly an international currency. Its price is relatively constant, and rises over time in proportion to the inflation of fiat currencies. When measured in one specific currency, such as the dollar, the gold price becomes inextricably linked to that currency’s exchange rate.

If you’re trying to figure out whether the gold price will rise or fall depending on whether the US experiences inflation or deflation you are wasting your time. In the short term the gold price in US dollars will rise or fall depending on what the US dollar exchange rate does. In the long term the gold price in US dollars will depend on the inflation rate of the dollar. Since the dollar is a fiat currency, it is bound to be inflated until it is worthless, however long that may take.

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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