Are deflationists missing the elephant in the room? Or are they believing in something more sinister?

August 1st, 2010

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As you scour around the blogsphere, you will see that there are contrarians who still believe that it is impossible for the US to prevail against deflation. The most extreme of deflationists is Robert Prechter (from Elliot Wave International), who is still predicting that the Dow Jones will go all the way down to 1000. Up till March 2009, it seemed that the deflationists’ argument was correct. In the Panic of 2008, deflationary forces were so strong that asset prices were even more oversold than the infamous 1987 crash. Unfortunately for the deflationists, the subsequent rally (reflation) till May 2010 was so enduring that their argument was discredited in the eyes of many.

Our view, on the other hand, belongs to the inflationists’ camp. From what we can see, there is a big elephant in the room that deflationists miss. But as we think about the deflationists’ argument, it suddenly dawn on us that perhaps deep in the soul of the deflationists’ argument is the belief of what some may call a “conspiracy theory.” Of course, we guess not all deflationists hold (or even aware of) such a belief. But the more extreme and strident a deflationist hold on to the deflation argument, the more we suspect that they are holding on to the belief of the “conspiracy theory.” Although we do not know whether that “conspiracy theory” is true or not, it certainly helps to explain the extreme position held by some deflationists.

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  • Pete

    Its a great article CIJ. I haven't read a better explanation of inflation vs. deflation anywhere.

  • Fabian

    Aha! I never thought of that before! Makes sense but I think the conspiracy theory is wrong.

  • Aergrew

    Agree here – even if we get some deflation on the short run the inflation is the thread – and is coming BIG

  • DavidL

    So far, I think, the deflationists are prevailing because they are correct. The supply of money and credit has been shrinking, inspite of all the QE (printing) that various countries are doing. This is especially true of credit when the shadow banking system is included, though that is difficult to quantify exactly–evidence from the regular banking system is bad enough. In terms of real money (ie gold), deflation becomes even clearer as real money keeps increasing in value at a greater rate than anything else. The question is what comes next (and when does next start)?? When does the divergence in real money (Au and Ag somewhat) from fiat money ($'s, AUD's, etc) really get going? And will it look like inflation or deflation to the average unemployed person? I don't think we know the answers to these questions yet. What are your answers CIJ? I know looking at history can be helpful, but never has the whole world fallen into the same trouble at the same time, and never has a the world's superpower, with the world's reserve currency been the one leading the downhill ride before. There are many black swans on the water today, we don't know what we will run into as we race toward the edge of the waterfall still wearing our blindfolds…..

  • Pete

    Nice comments DavidL.

    But didn't Britain used to have the reserve currency? When they were a superpower? I think they led a nice downhill ride…all the way down til they didn't have the reserve currency anymore.

    But that was a long time ago.

    I think we discount history too easily. After enough time passes, people tend to forget those lessons learned and start to make the same mistakes over again. If I had a 90yr old grandfather I bet he'd see this whole thing as shades of his youth.

  • Our guess is that, with Peak Oil, climate change, the gobbling up of the earth's resource from the rise of China/India, the purchasing power of money is going to go down in the long run.

    As for deflation, despite the economic stagnation and deflation in the past 20 years, Tokyo is still the most expensive city in the world (or rather, it's now supplanted by Moscow). The Japanese have quite an economy- despite economic stagnation for the past 20 years, they still have the world's second largest economy (or rather, it's now recently supplanted by China).

  • DavidL

    As you wrote, “in the long run” the purchasing power of money is going to go down. This will certainly be true of current fiat money regimes, will it be true of real money (ie Gold)? The question is what happens between now and “the long run?” Deflation is what is happening now. It is unclear how long it can last. The last big US deflation lasted about 15 years and seemed to require a WW2 to end. But this time is nothing like the great depression, because the world and the US are not at all comparable. Japan over the last 20 years and the US are not comparable for internal reasons and because the world context that Japan was in was one of extreme growth, and Japan has an a export economy. And while some point to the British pound as the last reserve currency to crash, it was at a time when gold was really the reserve currency. The US Dollar is not convertible into anything–you can spend them, that is all. This is very different. My main point is that this situation is unique, there are no comparable historical examples, this is new territory. Yes history can be a helpful thing to look to, but it is easily misleading–for all the reasons CIJ explains in the recommended readings, and because never before has the whole world got together to have a 100 year party and use up a lot of resources revved up on oil before. It hasn't ever happened. What will people and politicians and the environment do as the party ends? No one knows. Are there black swans out there? Yes. Is the US currently in deflation? I think it is. How long will it last? 1, 2, 10, 20 years? That remains to be seen. Will there be deflation at the same time as consumer prices rise? I think so, because of peak oil and peak everything and the environmental crisis and government policies. Is there anything on the horizon that makes me think all the unemployed people will find work? No. What happens politically when chronic unemployment is maintained at 20% levels for prolonged periods and consumer prices rise at the same time, and there is an environmental crisis, and a failed fiat money system, and energy shortages? I don't know, but I don't think inflation or deflation or hyperinflation are what people will be worried about when that happens–at least not for long…..

  • If Chindia, Peak Oil, climate change all come together, plus economic stagnation, then it is even possible for gold's purchasing power to decline in absolute sense. In such worst case scenario, war and disorder is likely. So you are right- in that scenario, 'flations will not be the most important worry.

  • What _is_ the “conspiracy theory” of the deflationists?