Inflation or Deflation? - 6

This is another post in the "Inflation or Deflation?" series, previous posts are available here:

1. Inflation or Deflation - 1 (07/12/2008)
   
2. Inflation or Deflation - 2 (10/12/2008)
3. Inflation or Deflation - 3 (24/01/2009)
4. Inflation or Deflation - 4 (26/01/2009)
5. Inflation or Deflation - 5 (15/02/2009)

Here are a few points that I would like to share with you. The current inflation vs deflation debate is a bit annoying, specially since nobody really wants to commit on any time frame for their predictions.

So my opinion is that on the short term, we are facing deflation in its true and original sense: declining quantity of money and credit. Obviously, with the credit bubble bursting, the mortgage industry in spades, credit card companies tightening lending, it's difficult to see anything but deflation, even if they have been printing like madmen (which they are) at the Fed.

Nonetheless, currently, the prices are not falling as one would expect when the economy falls off a cliff. Prices are actually stable for most things but houses and share prices, or maybe even are rising, as I mentioned in the past: groceries, insurance policies, health care, and all the other things that you cannot escape, like taxes, public transport, etc. Prices are rising while the 2nd birthday of the Greater Depression is just days ahead.

The other point worth mentioning is that the gold prices have been quite steady, and demand for both gold and silver has not declined at all. Even in the current dead cat bounce, with stock markets rallying 40%, and prices of gold falling about 10% and silver about 20%, the holdings of GLD, GBS, SLV, etc. have remained stable.

One thing to note is that if/when investors (and even more so, average Joe) move their savings from 0% yielding (negative yielding) into gold, the money pouring into 'the economy' via this selling will be inflationary (moving from saving account to circulation). So, in some ways, buying gold is inflationary for currencies. Even if this might be marginal, it cannot be completely discarded, since with inflation expectation rising, then actual inflation following, the trend is going to get bigger and bigger.

Finally, something that seems to have been missed somehow, is that banks lending does not lead to sustained super inflation and even less hyperinflation, since as soon as the borrowers start paying their debt or that the overstretched borrower default, the quantity of money is reduced accordingly. If we have seen in the biggest debt binge and credit bubble in history, this cannot last more than about 10 years?

Historically, lending to private enterprise and people does not lead to hyper inflation, but government printing does.

Now thinking and building about this, how does that happen? Usually (historically) this happens when the government has too much debt/commitment — passed the sustainable level. So what happens is that the weight of the debt gets so big that it cannot increase taxes enough to compensate (because you soon reach a level where increasing taxes does not increase revenue, and even decreases it).

So tax revenue fall, and to avoid defaulting on their debt governments start printing. As usual, it would be simpler to default, but those in power blindly believe that they can print and nothing will happen (does that remind you of something?). Usually, the tax revenues fall because of a (severe) recession (does that remind you of something?). The more severe the recession, the more the tax revenue decline, and the more the uneducated people expect their government to do something (does that remind you of something?).

Now add to this already dark picture, the fact that the recession is usual deflationary so that the weight of the debt become heavier and heavier and that unbearable burden will give even more reasons for the government to use the printing presses.

And when it does, the vicious circle starts:

Once the government starts printing, their currency starts falling on the forex markets. A falling currency and a debt level passed the insolvency level makes the government's debt rates to skyrocket. Soon, the currency has fallen enough and the rates have raised enough for the government becoming unable to borrow from abroad. And with the currency falling, the internal pool of savings — if not completely depleted already — becomes worthless. Then starts the hyperinflation and the implosion of the countries economy.

Surprisingly, this process seem to happen quite quickly and within 2 to 3, the rate of inflation can go above 1000%. Once started, it can reach levels completely unbelievable — if it hadn't occurred numerous times just in the past 50 years — of several million percents a year.

[More to come in the next few days]