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Inflation Deflation Battle

Economics / US Economy Apr 01, 2008 - 08:54 AM GMT

By: Fake_Ben

Economics Round One Winner: Schiff - In a recent article, I wrote about Mike “Mish” Shedlock of the blog Global Economic Trend Analysis ( ) and Peter Schiff, of Euro Pacific Capital, Inc. ( ). I separated them into the camps of the deflationistas (Shedlock) and the inflationistas (Schiff) .

Peter Schiff wrote me to make a very important point. “Remember,” he wrote, “I too forecast a massive deflation, with both asset and consumer prices falling in terms of gold.  However, these will clearly not be the case in terms of U.S. paper dollars.  While asset prices may indeed fall, consumer goods prices will rise.”

Mish, who is one of the best writers in the blogosphere, has always been careful to specify how he defines deflation. He calls it a contraction of money supply and credit. He does NOT define deflation as a fall in prices (for example, he believes oil prices may go up because of Peak Oil).

What I like about both these writers is their clarity, well-thought out visions, and continual updates.

In retrospect, it was probably unfair to characterize their differences as a Rumble in the Jungle, because they share many similarities. They both have been long-time critics of the insane, rapid, and excessive credit creation in the United States . They both are critics of current Fed policy (Schiff thinks the Fed should be raising interest rates to encourage savings, discourage more debt assumption, and defend the dollar). And they both see the collapse of the credit bubble as inevitable.

The difference between them, according to my understanding, is that Mish believes the government will ultimately be powerless to create more money supply and credit, and the dollar's fall should be limited. Schiff, on the other hand, talks more about the weakness of fiat money. There is nothing backing the dollar and therefore nothing preventing the government from creating more and more dollars. As a result, Schiff focuses on the implications of a weakening U.S. dollar.

Mish sees more of Japanese-style deflationary collapse, where it is likely that prices will go down. He claims that the government will do many things to stave off deflation, but he believes they will not be able to overcome certain constraints. He believes there are many forces outside of the government's control: people consuming less, taking on less debt, and walking away from their homes and bad loans. Job losses will lead to lower wages. In addition, our society is in the process of creating “zombie” banks, which will be unable to expand their balance sheets. “The Fed,” he claims, “cannot create jobs and the Fed clearly cannot prop up home prices.” Interestingly, Mish recommends gold, but he believes the Euro is overvalued (at 1.52, he said it was “riding on the fumes of sentiment”). Mish has made many amazing calls and he has been a true leader in forecasting the credit crisis. His clients at Sitka Pacific Capital Management are no doubt pleased. However, he has made one error to date (he might be ultimately proven correct), which is his belief that the U.S. dollar would hold up.

Schiff recommends foreign currencies, gold, commodities, and other means of actively defending one's savings and purchasing power against the coming crash [you can learn more about Schiff's recommendation in his book “Crash Proof: How to Profit from the Coming Economic Collapse.” ]. Schiff has generally been correct, and it is almost a certainty that his readers and clients have profited enormously from his advice.

My own take is that the economy will slow. The result is likely to be a government that “changes the rules of the game.” The government will alter what the Fed can do, how money is created, and what the government itself does. Part of this rule changing is likely to involve government bailouts of Freddie, Fannie, a large number of banks, and individual debt holders (see Barney Frank's and Hillary Clinton's latest proposals). Rule changing may also include more government infrastructure spending (Obama), tax breaks (Obama, Clinton, and McCain), and Fed monetization of debt. I also expect the Fed to eventually lower the reserve requirements for banks.

More liquidity, however, will not solve the essential problem. The problem, as I will write about in a subsequent article, is that banking reserves have been shrinking while credit and money supply have been growing. In the 10-year period from July 1996 to July 2006, while the M2 money aggregate increased by 83%, total banking system reserves decreased by 17%.  While the Fed would justify this trend as a result of innovations in banking, to me it signals that real wealth is not being created. The Fed is printing money to create the illusion of wealth, and they are mortgaging our future by allowing more of our banking reserves to be destroyed through excessive consumption and not enough savings.

The Fed and politicians are unwilling to accept a recession that would bring spending back in line. They are trying to keep the system moving forward by leveraging our future through a worsening proportion of banking reserves to GDP and to money supply. While short term bursts via liquidity injections and interest rate cuts help prop up the system, they only make the ratios of financial health worse. The Fed always claims its emergency measures are temporary, but it never seems to be able to remove them because the system has become more leveraged and more sick and therefore needs more assistance.

For many decades, the U.S. benefited by issuing dollars and sending them abroad. We manufactured a fiat currency, while other countries sent us goods. The result was that we had less inflation (because of a cost of money that was artificially low), a greater sense of productivity, and a high standard of living. Today, around 70% of the entire world's reserves are in U.S. dollars. This amounts to trillions and trillions of dollars residing outside the U.S. Now, the process of massive dollar creation is reserving itself and having the opposite effect. The U.S. will suffer from this unwinding, while the rest of the world will benefit from no longer having to subsidize our consumption.

For many years, sensible people who argued against increasing levels of leverage were shocked and awed as the markets rallied higher in response to Fed incentives to create more and more leverage. The bull market became a self-fulfilling prophesy. Now, however, the grand illusion has been revealed to be, well, an illusion. Any move by the Fed now will only spark inflation. So it's either the stock market or the dollar (the same choice as the Great Depression, interestingly --- when they chose to sacrifice the markets). We'll see if sacrificing the dollar works any better this time around.

Throughout the world people are losing faith in the dollar (there are even reports of Chinese peasants not wanting to hold dollars). Meanwhile, our people and government cannot show restraint and continue to spend and incur debt in the face of a slowing economy and deteriorating personal, banking, and governmental balance sheets. We are addicted to spending. We are addicted to debt. The mantra is not: “We need to live within our means.” The mantra is “We need hope and more creativity from Washington .” The mantra is not “Let's cut back because the government is broke and cannot afford Social Security and Medicare.” The mantra is “A country as rich as ours should provide healthcare for all its citizens.” [Note: Mish would argue that the culture of America is already changing towards reduced spending and increased savings and there is nothing the Fed can do about it now]. Already, in the first four months of this fiscal year, the run-rate of our budget deficit has doubled.

We have so much faith in the dollar, we think of macroeconomic choices as either-or. Either we raise rates and the economy slows, or we lower rates and the economy expands. We are not seeing the complexity and the true nature of what is happening. We can lower rates, but risk destroying confidence in the dollar and eroding our country's good credit (and therefore ability to borrow). We think that lowering rates will jump-start our economy, whereas it could lead to investors fleeing to other safer havens. Lowering rates further and engaging in bailouts could create a sense that the game is rigged and therefore should be avoided. When Argentina devalued their currency, it led to a currency decline AND an economic decline.

In his most recent article, Schiff writes: “Bernanke also seems to think that if the economy does somehow slip into recession, that inflation will subside as a consequence. This is pure nonsense, as diminished demand here at home will be offset by enhanced demand abroad. As a weak dollar forces Americans to cut back on their consumption, strengthening foreign currencies will give foreigners added purchasing power to consume more. Therefore fewer foreign made products will be imported while more domestic made, or in most cases grown, products will be exported. The result will be reduced domestic supply putting additional upward pressure on prices.”

It has been so long since we have seen inflation and a prolonged decline in our currency that we do not realize the old playbook will not work. If we lower rates, we risk destroying our currency and impoverishing ourselves. Foreigners will buy more of our agricultural products, coal, lumber, and clothes, and we will have less purchasing power to import the same products. Foreigners will buy up our real estate and assets. We will have to sell our foreign holdings. While politicians may blame the foreigners, WE are the ones creating this situation.

So, while the rest of the country becomes poorer as a result of misguided Fed policies, it is not too late to protect your own wealth, by buying gold, commodities, foreign currencies, and other inflation hedges.

In the last article, I wrote: “I'm closely watching the dollar (especially the 1.49 line), gold (especially at $930 on the upside and $895 on the downside), oil (at $97 on the upside), and stocks (1310 on the downside for the S&P500). If any of these lines are crossed, then I think new trends are in place that could last a while.” Well, all those lines have been crossed. As I write, the dollar is at 1.56, gold is at $935, oil is above $101. As Schiff predicted, a slowing economy is not leading to Bernanke's predicted disinflation. Could it be any more clear? Stagflation is here, and Peter Schiff has the vision that predicted and continues to explain what is happening in the markets. Mish's vision is similarly compelling. It will be interesting to see if Mish is correct, and the dollar turns around, or whether dangerous creativity continues to come out of Washington and the world's reserve currency continues to implode.

By Charles Zentay

FakeBen is a blog to monitor the Fed and its actions and encourage community participation. At FakeBen, we believe that the Fed policy of the last two decades has created a credit bubble as large as that created in the 1920s. This bubble will lead to either inflation, a recession, or both.

We believe that the Fed's policy of lowering interest rates to encourage more credit creation is misguided, will eventually lead to 0% interest rates, and will not solve the long-term problem, which is too much credit relative to GDP.

Copyright © 2008 by Charles Zentay. All rights reserved.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Do your own due diligence.

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