Inflation or Deflation?

Written by Bruce on October 4th, 2011

Does it matter if our very monetary system is at risk?

In this article I want to address an issue that I truly believe is the most important issue all of us will face in the 2010s. It is an issue that goes to the very heart of financial planning. The issue is whether our personally accumulated U.S. Dollars will become worth more as a global currency in the foreseeable future or in fact become altogether worthless as a monetary system by the end of this decade.

You could buy all the stocks and mutual funds you want in the 2010’s; buy all the best foreclosure real estate, stock up with piles and piles of all the gold and silver you want. But I’m telling you, if you call this shot wrong – Inflation of Deflation – your plans could all be for naught.

But the key questions of concern YOU should be asking in protecting your own security are:

How do inflation and deflation vary in their causes?
How would life in America be different under scenarios of severe inflation or deflations.
Who would be the financial winners and who would be the losers in each scenario?

DEFLATION
A Bubble Bursts, Money Dries Up

John Kenneth Galbraith (October 15, 1908 – April 29, 2 006) was one of the leading chroniclers of the Stock Market Crash of 1929 and the Great Depression of the 1930s. As Galbraith described in a 1970’s filmed documentary:

“I don’t suppose there’s ever a time when the desire to get rich doesn’t operate in this republic. But there certainly was a mood that Americans were meant to get rich sitting down by putting their money in the stock market. And then you had, from the beginning of the mid-twenties on, an accelerating wave of speculation which then became self-perpetuating. The market was going up and the expectation for it to go up more caused it to go up more.

“But then come the day when something changes those ex pectations, and everybody wants to get out. And that is not a matter of weeks or months, that’s a matter then of days. The crash comes very fast.”

Sound a little to familiar? Maybe a little like the real estate and credit bubble crash of 2008?

The common denominator of a deflationary period is that money has dried up, typically due to a prior extended period of over-speculation. And the deeper the prior mania went, dragging with it larger and larger institutional interests that “drink the Kool-Aid”, the more it is likely that credit and available cash go dry as a bone, to boot.

In either case the big seizure that hits everyone in the economy is that banksfail. First they fail to keep depositors’ funds secure. (Don’t forget the FDIC, set up from the lessons of the bank runs of 1929, did not save bank depositors’ money in 2008. Given the scope of this failure the FDIC would have been totally impotent. Rather, banks were kept standing by a whole new act of Congress, the $700 billion Troubled Assets Relief Program [TARP].)

The next thing that happens, if not simultaneously, is that the stock market along with other investment markets crash so that people thereby lose their savings and personal wealth, sometimes faster than they can even think about what’s going on.

Quickly a downward spiral picks up momentum across almost all investment sectors.

Soon, retailers and wholesalers find themselves holding stockpiles of goods they can’t sell to people with no jobs. In fact the only way they can even think of moving goods is to lower their prices. Seems like a good thing, unless you happen to work for the guys cutting their prices, who now need to cut your wages to make up for their losses. And so pretty soon, you either don’t work, or you too become the next victim of wage deflation. But at least you have a job! Deflation is generally marked by massive unemployment.

Winners:

Those holding substantial wealth in cash, and not in the banks that might fail. By “substantial”, I mean that if jobs do not come back again for quite some time, they will survive without work.

Losers:

Those who have been left holding their wealth in hard assets that have caved in on value, such as real estate or stocks. Their wealth is gone.
Those who need to work and earn a decent wage to keep a roof over their head.

INFLATION
Stop the Presses!

Contrary to what happens in deflationary times, during times of inflation money is anything but scarce.

In essence the problem is that there’s too much of it, and the economy gets to where money’s not worth anything anymore.

And although that’s the essential description of inflation, the tricky part is that the exact scenarios that could cause inflation and what its effects might be have been historically much more nuanced.

How Bad Can it Get?

Germany 1923 during the Weirmark Republic

Germany went through its worst inflation in 1923. In 1922, the highest denomination was 50,000 Mark. By 1923, the highest denomination was 100,000,000,000,000 Mark.

In December 1923 the exchange rate was 4,200,000,000,000 Marks to 1 US dollar.In 1923, the rate of inflation hit 3.25 × 106per month (prices double every two days).

Saddled with reparations debt from it’s loss of WWI, the government engaged in simply printing more money in order to “have” more money, amongst other factors at the time.

Zimbabwean with “plenty” of cash

The picture shows a Zimbabwean carrying pile load of cash to buy something. Seems like a lot of money… but fact is the pile of cash is probably worth less than 100 US dollars.

Zimbabwe is suffering from an inflation crisis. The annual inflation in the African country has rocketed past the 100,000% barrier in Feb 2008, by far the highest in the world (2nd placed Iraq has an estimated inflation of 60%).

Zimbabwe’s currency has tumbled to a record low of 25 million Zimbabwe dollars to one US dollar. 100 US dollars could exchange for nearly 20kg of local currency.

Frankly, it’s hard to imagine how a country would manage to get themselves into this troubled situation. My countrymen would be crying like babies if our annual inflation rates reached 10%… 100,000% inflation? That’s unthinkable.

Inflation In The United States – 1970s

This was a serious example of Cost-Push Inflation. The country was highly dependent on imported oil to run on, when the Organization of Petroleum Producing Countries (OPEC) caused a sudden shock to the economy by severe increases in the cost of oil, coupled with decreases in production. The result was rationing of gas (license plate even or odd numbers determined the day of the week you could buy gas) and lines up to a mile long at gas stations.

In turn, this shock to the economy forced up prices of almost every other type of goods or service, and was not brought under control until the Federal Reserve bank held interest rates close to 20% for an extended period.

Winners:

Those holding substantial wealth in assets which are increasing with the rate of inflation or better, commonly precious metals or inflation protected government securities, but many other commodities can be good bets as well.

Losers:

Those who have been left holding their wealth in cash.

What Are the Current Pressures
for Inflation and Deflation?

Banking Crisis – Round Two?
More Mortgage Meltdown

When you hear about the “mortgage meltdown” of 2008-09, most of what you hear about is what are known as sub-prime mortgages. But sub-prime mortgages were actually just the first wave of toxic assets sold to investors that were poised to burt.

As the orgy of easy credit of the 2000′s grew to its peak, based upon the completely erroneous assumption that banks could take chancesbecause home prices would simply keep rising and rising, (thereby giving them even greater collateral they could repossess if the loan got into trouble) bankers developed even more ingenious ways to make it easier to get into loans for more qualified borrowers, too.

Two such type of loans were (are) Alt-A loans and Option ARM Loans.

“Alt-A” were loans that have less than full documentation, also referred to as“low doc/no doc loans”, or “liars loans”.
Option ARM’s (Adjustable Rate Mortgage) carried the option that in the early years of the loan (typically within the first 5 years) the borrower could decide each month how much of their loan they actually wanted to pay, with potentially outrageous underpayment of the actual loan costs being allowed. In such a case the loan could negatively amortize, (grow in it’s principal amount being owed rather than being paid down), again, considering that any increase in the loan amount would be safe and compensated for by the “inevitable” increase in property values. In many such cases the borrower could make a payment based on a 1% rate, when in fact the loan was charging them a 7% rate. And so what was left unpaid was simply added to the debt owed overall on the loan

What would you do if your payment tripled, while your home value had collapsed by 30-40percent of its value when you took the loan? Would you stay in that loan, or would you walk?

Wait A Minute! That’s not even the BIG picture!
HERE’s the BIG Picture!

So how much total debt exists in the U.S., and what sectors is it held in? We hear so much about the government debt being at $12 trillion or more, but the fact is that there is so much debt in the Financial Sector alone, $17 TRILLION, that if it comes even partially unraveled in another baking crisis, in is highly unlikely that the US government could even print enough money to compensate. Something is going to have to break!

What it Comes Down to….

….is that a tsunami of private sector bad debt still has to burst and unravel. Conservatively it will be multi-trillions of dollars.

And even if the federal government were to throw another $1 trillion-plus of tax payer bailout into the next wave, some say it would be like trying to turn the tide of a tsunami… with a garden hose!

If the Fed stands by and lets that debt wash out, while ultimately it would be good for the e conomy, in the meantime banks will fail, people’s savings will be lost, and assets (stocks, real estate, oil, and yes – even gold) will tumble in a downward vortex in value. Businesses will fail, and unemployment will soar. And there will be a depressionary deflation that could last a decade.

But if the Fed goes all out to buy the bad debt, and earnestly try to replace the contraction of the money supply by running the printing presses full time (not that they could completely) then we could experience a major watering down of the money supply with worthless dollars being pumped into the economy, and we could see the type of hyperinflation that the gold bugs have been warning us about.

The Wave is coming. Now its up to the Fed.

Part 2 – A Strategy to Manage BOTH Concerns

(See below!)

Read the entire strategy to manage both – inflation & deflationary concerns inside the complete FREE report by Bruce Weide