Monday, October 12, 2009

Part II: Deflation or Inflation? Here is the Answer…

By Paul Mladjenovic
Copyright 2009. Paul Mladjenovic. All rights reserved.

Picking up from Part I of this “two part mini-series”, we are covering the inflation/deflation debate. There are tons of top-notch economic commentators on both side of the debate. As we mentioned, the debate centers on the visible sign of deflation vs. inflation…”prices”.

In part one, we highlighted what I think is an important summary of what affects “prices”:

1. THE MONEY SUPPLY (primarily enacted by government)
2. DEMAND AND SUPPLY (primarily enacted by the marketplace)

Demand and supply are an important factor in this debate and I believe that this becomes a source of misunderstanding. Inflationists talk about the money supply exploding and that this massive increase will (sooner or later) mean higher prices and even to the point of hyperinflation. The deflationists tell us that we are (and will continue to be) in a powerful deflationary environment. What gives?

Demand and supply complete the observation. Look…if a trillion dollars is printed right now but this money is not flowing toward anything (“demand”) then you probably won’t see a price increase. Demand has decreased for some goods, some services and some assets in recent years. However, demand has increased (or has had continued strength) in other goods, services and assets. In other words, BOTH of the inflationists and deflationists can be correct if you break down the picture. You can have inflation in one part of the economic picture but not another. You can have demand and supply bring prices down in one part of the economy and not another.

Demand, for example, has been dropping like a rock in real estate. The real estate bubble of 2000-2006 artificially stimulated supply which increased the national inventory of available property (both residential and commercial) to the highest level in history. Too much supply with falling demand obviously means falling real estate prices. No amount of created money supply was able to overcome this.

The same is true for the labor markets. Labor is priced higher than the market could realistically pay for. We forget that the price of labor is more than just “the gross pay”; it also includes many other costs such as payroll taxes, workmen’s comp, etc. The high cost of labor dampened the demand for labor; especially when demand for products and services fell. Right now, the supply of labor is much higher relative to the demand for labor.

In turn, as there are more and more unemployed, that means that less money is then available for discretionary purposes such as vacations and new cars. You get the picture.

Keep in mind that there is a big difference between “deflationary” and “deflation”. It is much like the difference between “fainting” and “dropping dead”. Lower demand does have a “deflationary” effect. If less people want something then of course the price will likely drop and this can happen even if the government’s central bank keeps expanding the money supply. What does all of this then mean for us as investors and traders?

It is actually simple to figure out what to do with your money given this historic debate:


I tell my readers and students to consider putting their money (retirement or otherwise) into those things tied to “HUMAN NEED”. If you have your money in those things that will benefit from BOTH inflation AND where demand and supply are strong, then this merits your attention.

Stay away from where there is a deflationary impact (such as real estate…unless you really need to buy a home). Go where the money is migrating. Given this, I like gold, silver, grains, energy and other commodities. Investors and traders should consider “human need” and view it as a mega-trend during the coming months and years. I believe that a commodities super-boom is a likely event (and is already unfolding).
I am on record as predicting an “inflationary depression” but to be more precise, we will see inflation in those things tied to “human need”. No matter how good or bad the economy will be, people will still need to eat, drink, heat their homes, etc. For these reasons (and other ones), I like commodities for the long haul.

For those deflationists that believe inflation is not possible when there are bad economic conditions, I say think again. Most hyperinflations in history happened during bad economic times. Germany (1920s), Yugoslavia (1989-1994) and Zimbabwe (2007-present) are good examples. Yes…inflation and a depression can happen simultaneously. Plan accordingly…

Monday, October 5, 2009

Part I: Deflation or Inflation? Here is the Answer…

By Paul Mladjenovic
Copyright 2009. Paul Mladjenovic. All rights reserved.

The debate over deflation/inflation continues as some of our most astute economic observers take sides. It is interesting for me to see some great commentators take opposing positions on one of the most important topics of our time. Frankly, I think that both sides are missing part of the picture. The debate concentrates on the after shocks of inflation/deflation: prices.

“Prices” are the visible barometer that both sides of the debate gauge. The inflationists see (or warn about) “rising prices”. The deflationists see (or warn about) “falling prices”. There are very convincing cases by both sides.

In “real time” October 2009, the deflationists seem to have the upper hand. They point out that we have a “deflationary economic environment” due a variety of factors that are contributing to falling prices (such as deleveraging and unemployment). Inflationists see the current stage being set for future rising prices due to factors such as expanding money supply and a weakening dollar. What is the real deal?

First, let’s set the record straight on the terms…

Inflation: Is the condition where more money (such as a paper currency) is created by the issuing authority (the government’s central bank) and this growing supply of money is chasing a fixed basket of goods and services (and/or assets). Inflating the money supply (“monetary inflation”) is the problem and the symptom is usually rising prices (“price inflation”). Inflation is not the price of things going up…it is the price (or value) of money going down.

Deflation: Generally the opposite…The money supply is stable or shrinking relative to the supply of stuff we
buy and subsequently there is less money chasing goods and services. In this case, the “value” of money usually increases.

Therefore, for prices to rise there needs to be more (and growing) money supplied to the market relative to what is being bought. Two things need to happen for prices to rise from an inflationary perspective:

1. More money needs to be created.
2. This money needs to “chase” what is being purchased (Think “circulation” or “velocity”).

This is a crucial point. Prices won’t go up just because the money supply expands; the money has to be actively “chasing” those goods or services (or assets) for the prices to see upward movement. For prices to go up (“price inflation”), you need monetary inflation (increasing the money supply) and velocity (the money is chasing goods, services and/or assets).

In recent years, the money supply has indeed expanded dramatically…but…relatively little “chasing” has been going on. If the Federal Reserve instantly created $10 trillion dollars and gave it to you, that is definitely monetary inflation but…if you merely put it in your sock drawer and hoard it, then it would not circulate (chase stuff) and therefore you wouldn’t see “price inflation”.

This is where part of the confusion and controversy is. Inflationists point out that money supply is growing dramatically and they are correct. Deflationists point to falling prices in many areas of the economy and they are also correct. Here is what we should be aware of…

1. THE MONEY SUPPLY (primarily enacted by government)
2. DEMAND AND SUPPLY (primarily enacted by the marketplace)

Understanding the money supply (its growth or shrinkage) coupled with understanding “demand and supply” will give you a better picture of the economy. This, in turn, will make you a better analyst, money manager or investor. More on this in Part II.

How about gold and silver? How do precious metals figure in this inflation/deflation debate? The bottom line is that precious metals should be considered in a balanced, diversified wealth-building strategy regardless of which side of the debate is proven correct. Paper currencies can be produced at will but precious metals can not. Therefore, any investor or money manager interested in diversification and safety should consider precious metals (more about this in Part II).