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.

To understand our view, we must first understand the crux of the deflationists’ argument. Professor Steve Keen had the best explanation for? the deflationist argument:

Note Bernanke’s assumption (highlighted above) in his argument that printing money would always ultimately cause inflation: “under a fiat money system“. The point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it.

The implication of this paragraph is that Bernanke does not understand how the credit-money system works and hence, does not know how to engineer inflation. Elsewhere, Steve Keen wrote that,

The only way that Bernanke’s “printing press example” would work to cause inflation in our current debt-laden would be if simply Zimbabwean levels of money were printed?so that fiat money could substantially repay outstanding debt and effectively supplant credit-based money.

Based on the deflationists’? credit-money model of the economy, the forces propelling the credit destruction will be so strong that Bernanke will not print money fast enough to cause inflation.

So, where is the elephant in the room?

First, remember that the credit-money model of the economy is just a representation of the real, living and breathing economy- it is not the real thing. The biggest mistake any investor can make is to believe that the model is as good as the real thing and believe whatever the results produced by the model. In other words, a model is just an abstract of reality i.e. a subset of reality.

In the real world, there are many events and happenings that can never be captured by the model. By definition, these events and happenings are Black Swans to the model. As we wrote in our report, How To Foolproof Yourself Against Salesmen & Media Bias,

In the same way, many financial market analysts and economists are highly skilled in creating artificial lab-created models of the real world. These models are highly predictable, with the ?rules? well-defined.

What if the ‘rules’ get broken by real world events? Obviously, the model breaks down. As we wrote in Recipe for hyperinflation,

The main point is, once those ?rules? are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins.

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One thing we have to be clear. Assuming that the ?rules? are strictly adhered to, there will only be one outcome for the current credit crisis: deflation.

Currently, the Federal Reserve alone, with the powers they have on hand, cannot easily create inflation. What if the Federal Reserve, in conjunction with the government, changes the ‘rules’ and act on the changes?

Think about it: the Federal Reserve have more powers today than in 2007. Today, it can buy toxic assets from the banks as collateral, which is something that was against the ‘rules’ prior to the GFC.

Mind you, these breaking of ‘rules’ are just the beginning. Bernanke and his staff had written lots of papers and gave lots of speeches on the crazy ideas they have in mind to fight deflation. These crazy ideas are in the public record. As you can see in Bernankeism and hyper-inflation, some of these crazy ideas are already implemented in response to the GFC. However, there are many more that are yet to be implemented.

But remember this very important point: Many of these ideas are currently illegal. This is where the confluence between economics, politics and law come together. The deflationists have excellent models on the credit-based economy. But law and politics are outside the scope of their models. That is, their models cannot see what’s happening in the legal and political arena. Unfortunately for them, events from these arenas will be the ones breaking their credit-money models. That can only be achieved by overturning some of the existing laws.

Michael Shedlock? (aka “Mish”), who is one of the most strident deflationists insists that it is not in the interest of the powers to be to break the credit-based system. It seems that he sees the Federal Reserve System as some kind of powerful privately owned cartel that wants to preserve the status quo. Hyperinflation will screw up the wealth and power of such a cartel because in such a scenario, credit can no longer play any role in the economy (which is what Steve Keen calls a “fiat-money” system as opposed to the current “credit-money” system). On the other hand, between deflation and some forms of inflation, they would prefer the latter.

Please note that we are now venturing into unknown Black Swan territory. What follows is murky, dark and just our guesses…

For such a cartel to have its way of preserving the status quo, it has to be powerful enough to even subject the US government to the rules of credit. That is, if the US government monetise its debt (by selling its bonds to the Federal Reserve), it is accountable to the cartel (whatever it is). We could be wrong, but we guess this must be what Mish believes? in- a cartel of extremely powerful and secretive bankers is controlling America via control of the credit-based monetary system. In fact, we remembered that in one of his blog articles, he mentioned that contrary to popular belief, the Federal Reserve is a privately owned institution. Contrasts that with what the Federal Reserve describe itself as a “quasi-public” institution.

If this is what Mish believes in, than it makes sense to take the deflationary view. This is because only a cartel that is more powerful than the US government can have the power to prevent the confluence of law and politics from breaking the ‘rules,’ causing hyperinflation and breaking the credit-based system.

Of course, a hyper-deflation scenario? will do the cartel no good too because that scenario implies a total breakdown of the financial system.