Re: Inflation Versus Deflation Debate

Alan C. Lawhon wrote (in part)

Since I (literally) have some money riding on this, (Ha! Ha!), I
decided to do some research on the topic last night. I did a Google
search on ?Inflation Versus Deflation? and got over six million hits!

http://www.google.com/search?hl=en&q=inflation+versus+deflation&aq=0&oq=Inflation+Vers&aqi=g9

This is obviously a topic of great interest to economists, market
participants, business leaders, and, I suppose, politicians up to and
including President Obama. I decided to turn to a more distinguished
panel, (i.e. RGP), for your views and opinions. So what do you folks
think it will be? In the next 2-4 years will we be seeing inflation,
(rising wages and prices), or deflation, (falling wages and prices)?

======================================

Here is an interesting take on both possibilities:

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2009/07/06/make-sure-you-get-this-one-right.aspx

or

http://tinyurl.com/lnlr32

[In part from the article:]

Are we facing a deflationary spiral or will the monetary and fiscal stimulus
ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question
that, in a cash based economy, printing money (or 'quantitative easing' as
it is named these days) is inflationary. But what actually happens when
credit is destroyed at a faster rate than our central banks can print money?

....

So now, two years into this crisis, where do we stand and where do we go
from here? History offers limited guidance, as we have never experienced the
bursting of a bubble of this magnitude before. The closest thing is the
collapse of the Japanese credit bubble around 1990. As the Japanese have
since learned, recovering from a deflated credit bubble is a long and very
painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a
strategy of buying time, hoping that a recovery in economic conditions will
allow our banking industry to re-build its capital base. The Japanese
pursued a similar strategy back in the early 1990s. It failed miserably and
set the country back many years in its recovery effort. Ironically, the
Japanese approach was almost universally condemned as hopelessly inadequate.
It is funny how you always know better how to fix other people's problems
than your own. A little bit like raising children, I suppose.

....

So now, two years into this crisis, where do we stand and where do we go
from here? History offers limited guidance, as we have never experienced the
bursting of a bubble of this magnitude before. The closest thing is the
collapse of the Japanese credit bubble around 1990. As the Japanese have
since learned, recovering from a deflated credit bubble is a long and very
painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a
strategy of buying time, hoping that a recovery in economic conditions will
allow our banking industry to re-build its capital base. The Japanese
pursued a similar strategy back in the early 1990s. It failed miserably and
set the country back many years in its recovery effort. Ironically, the
Japanese approach was almost universally condemned as hopelessly inadequate.
It is funny how you always know better how to fix other people's problems
than your own. A little bit like raising children, I suppose.

Another lesson learned from Japan is that once you get caught up in a
deflationary spiral, it is exceedingly hard to escape from its grip. The
Japanese authorities have used every trick in the book to reflate the
economy over the past two decades. The results have been poor to say the
least: Interest rates near zero (failed), quantitative easing (failed),
public spending (failed), numerous attempts to drive down the value of the
yen (failed); the list is long and makes for painful reading.

....

The point I really want to make is that the inflation v. deflation story is
the single biggest investment story right now and being on the right side of
that trade will effectively secure your investment returns for years to
come. If I am wrong and inflation spikes, you want to load your portfolio
with index linked government bonds (also known as TIPS for our American
readers), gold and other commodities, commodity related stocks as well as
property.

If deflation prevails, all you have to do is to look towards Japan and see
what has done well over the past 20 years. Not much! You cannot even assume
that bonds will do well. Recessions are bullish for long dated government
bonds but a collapse of the entire credit system is not. The reason is
simple - with the bursting of the credit bubble comes drastic monetary and
fiscal action. Central banks print money and governments spend money as if
there is no tomorrow, and all bets are off. Equities will do relatively
poorly as will property prices. But equities will not go down in a straight
line. The market will offer plenty of trading opportunities which must be
taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment
returns. It is also not what governments want and need right now. With a
mountain of debt hitting the streets of Europe and America over the next few
years, as the cost of fixing the credit and banking crisis is financed, one
can make a strong case for rising inflation actually being the favoured
outcome if you look at it from the government's point of view. The problem,
as the Japanese can attest to, is that deflation is excruciatingly difficult
to get rid of, once it has become entrenched. I am in no doubt which of the
two evils I would prefer, but we may not have the luxury of choosing our own
destiny.


.

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