Are we heading for a deflation or inflation?

July 13th, 2008

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In our previous article, Australia?s money supply & credit growth in April 2008, one of our readers asked,

I?m a little confused. I thought we had an inflationary problem here, not deflationary

For starters, let us all agree on the definitions of inflation and deflation. Our guide, What is inflation and deflation?, will be used for this article’s definition for inflation (expansion of money and credit) and deflation (contraction of money and credit). Please make sure you understand this guide well because this article assumes that you already know the pre-requisite knowledge contained in that guide.

So, where is the world economy heading? Inflation or deflation?

We read a story that Warren Buffett said that only 2 people in the world know where interest rates are going. Both of them are in Switzerland and both their views are diametrically opposed. We do not know how true this story is, but it underlies are very important point. The inflation and deflation debate is highly polarising, splitting the deflation and inflation camp right down to the deepest bone marrow. There is a very good reason for the deflation case (see Are we heading for a deflationary type of recession?) and there is also a very good reason for the inflation case (see Recipe for hyperinflation).

If inflation is just the expansion of money and credit and deflation is the contraction of money and credit, wouldn’t a reliable statistic of money and credit supply tell us whether we are heading towards the former or latter? Well, as we said before in What is money?,

… in this modern age of finance, money is far more complicated than what it was used to be. It has come to the point that it is very hard to even define what money is, let alone measure its quantity. Alan Greenspan, the former head of the US Federal Reserve was believed to have said ?We don?t know what money is, any more.?

Those in the inflation camp will point to one measurement of money, MZM, to support their case. Those in the deflation camp will point to another measurement of money, TMS, to support their opposing case. Between both of them, they will argue whether credit can be considered money and hence, argue whether MZM or TMS is the valid measurement of the supply of money.

It is no secret that we are more inclined to the latter case. You may have a different inclination than us and that is perfectly okay. The truth is that, no one really knows what will happen (of course, some people in either of the opposing camps will have strong convictions on what is going to happen). We see that the world is resting on a knife-edge between inflation and deflation- it can tip either way. Which way it will tip is not something that economics or finance alone can satisfactorily explain. To do so, we will have to venture into the murky world of politics, law and who-knows-what.

Amidst the arguments between the two opposing sides, we see symptoms of both inflation and deflation- rising gold, silver, oil, food and other commodity prices and falling asset prices. If these two symptoms continue, it will be the most damaging to investors because we will see the nominal value of our assets fall, along with the fall in their real value.

In any case, regardless of whether inflation or deflation will win, life will be very much more difficult for all of us in the years to come. Therefore, it is important to hedge against both.

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