If you have been with us long enough, you may have heard us mulling over both the threats of inflation and deflation on the global economy (see Spectre of deflation and Have we escaped from the dangers of inflation?). You may be wondering whether we are contradicting ourselves. How can both threats exist simultaneously? Since one is a general rising of prices and the other is the opposite, are they not mutually exclusive?

Today, we will reconcile our views on the twin threats of inflation and deflation.

First, if you have not acquainted yourself with the Austrian School of economic thought on inflation, we suggest you take a read at Cause of inflation: Shanghai bubble case study. Next, you must understand the structure of liquidity in which its expansion is the primary driver of global asset price hyperinflation, which eventually spills over to price inflation?see Liquidity?Global Markets Face `Severe Correction,? Faber Says. Lastly, you would need to understand how such a structure of liquidity makes it highly vulnerable to sudden contraction?see Spectre of deflation.

If you follow us long enough, you would have known that we are decrying the current phenomena of uncontrollable expansion of liquidity (money and money substitutes), which is creating price bubbles in all sorts of asset classes all over the world. Though central banks are currently vigilant about ?fighting? inflation, we know that if you trace the root cause of inflation, it will lead you back to the doorsteps of the central banks.

Now, we know that in the entire history of humanity, all price bubbles eventually burst. The frightening thing about liquidity (at its current structure) is that it is highly vulnerable to sudden contraction. When that happens, we get what is commonly called a ?crash,? which is highly deflationary in nature. A severe downward deflationary spiral caused by collapsing asset price bubble can lead to a recession (if severe enough, a depression). This had happened before in 2001 when the bursting of the tech bubble threatened to bring the US to a deflationary recession. What the Fed did was to pump more liquidity into the economy by slashing interest rates to a low of 1%. Some credited the Fed for ?preventing? a recession, but we disagree with that. We believe that a recession was not prevented. Instead, it was merely postponed, which resulted in the creation of a even bigger bubble (see The Bubble Economy). Now, the housing bubble is deflating and our conviction is that over time, its effect will eventually spread to the rest of the US economy.

Now, faced with the threat of a deflationary recession, what can the Fed do? Politically, it is impossible for them to allow a recession run its full course in order to clean up the prior excesses of the bubble. They will do anything and everything to ?prevent? another recession. The only way for them to do that is to do what they always did?pump even more liquidity into the economy (a.k.a ?print? money). That was exactly what Japan had done when they slashed interest rates right down to zero back in the 90s in order to combat deflation. As we all know, the outcome was useless. When the economy is structurally damaged by mal-investment (see The first step in an economic slowdown?mal-investment in capital), printing of paper money will not help. The effect will be the ultimate loss of confidence in paper money.

That is why we are still advocating gold.

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