An alternative scenario: inflation AND deflation

October 27, 2008

All my predictions and calculations assume governments will intervene to re-inflate the credit bubble. My conclusion was that their efforts would ultimately be in vain as the excess currency loses its ability to generate real economic expansion in the developed nations, instead, it simply causes a plague of inflation that could threaten the viability of the entire currency system. Perhaps governments eventually return to a responsible course and a bottom is reached, perhaps they don’t.

But what if we turn this situation on its head. What if the government does inflate the currency to prevent financial institutions from defaulting (ie. bailouts) but despite their public pronouncements privately support a policy of deflation by discouraging new credit in order to restore some balance to the system. So in this case we have the creation of new currency to prop up the banks and support mergers and acquisitions, but the cash never circulates. Instead, it’s hoarded by the banks and their owners.

The end result will be a growth in the money supply figures but contraction in the number of circulating dollars, so technically inflation and deflation at the same time. The banks capitalize enough to remain solvent throughout the re-alignment process (probably years) but the people go broke as money becomes very expensive. In this scenario, it would appear cash is actually a good investment. Many people who didn’t lose their savings in the stock market crash of 1929 lived quite comfortably throughout the 1930s as the cost of living came down. Could we be in for another decade of price deflation, despite a growing money supply?

I still think inflation is more likely for the following reason — back in the 30s the national debt was insignificant. Today, if America experiences any real deflation it will also deflate tax revenue. But when revenue disappears the debt doesn’t go with it; the government will only be able to repay its obligations through more money printing. So the deflation scenario really requires the debt holders (domestic and foreign) to buy into the process, not just the banks — they must also hoard their returns and continue to support the American project. If they start dumping their dollars in anticipation of depreciation the whole plan falls apart.

I guess it’s not impossible to coordinate such activity, but I’m not one who believes the entire world is managed by a small number of like-minded individuals… It just doesn’t seem sustainable, especially if millions of people around the world who have just recently been given a taste of wealth are suddenly plunged right back into poverty. The social instability that would result is a terrifying and unpredictable prospect. If the government resorts to money printing as a long term strategy to repay its debt the more likely outcome is that people and nations will simply stop investing in federal government debt… Then what happens? Either an end to the American empire or hyper-inflation. The amount of debt throughout the system is just too great to be corrected by deflation without a depression of monumental proportions, so even though it may be the most responsible path, it’s probably also unlikely.

The only long term solution that makes sense is for trade imbalances to be eliminated through a decline in the US dollar and budget imbalances to be eliminate through a decline in spending. Global capital will not return to the US until labor and land are competitively priced. Simply destroying demand through credit contraction isn’t enough, production must also be restored or the only result will be massive unemployment and anger. It’s not just the Chinese who sell products state-side, many Americans work in service based industries that only serve domestic markets. If American demand disappears, so does American income.

If the US dollar continues to rise there will be no incentive for businesses to move production back to America and there will be no incentive for Americans to stop buying cheap foreign goods. Unemployment will rise and demand will continue to fall in an infinite spiral with no end in sight. If the US dollar continues to rise, America may become a feudal state as the middle class disappears. That’s why I don’t believe the status quo is sustainable, the US dollar must reverse course or the problems will only get worse.