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
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
Now to get back to the question of which will win out: inflation,
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
Paul van Eeden
Paul van Eeden works primarily to find investments for his
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