What the Deflationists Are Missing

Despite rosy pronouncements of happy days being here again, a number of prominent analysts look down the tunnel and see serious problems ahead for the U.S. economy. While we very much share the view that we are far from out of the woods, our views diverge from those that see devastating deflation speeding our way down the tunnel. We see devastating inflation.

While we could both be right, with deflation first and inflation later, I'm not so convinced.

For starters, there is already a massive inflation operation being run by the Fed, evidenced in a historic spike in the monetary base over the last two years.

And the Obama administration is far from done.

Congress's reinvigorated focus on jobs - the single most important factor in this November's elections - will soon translate into a flurry of new initiatives designed to put people back to work, most of it funded at taxpayer expense.

To believe in the deflationary case requires believing that Obama and his team are ready to forgo any further political aspirations by collectively putting their feet up on their desks for the balance of what would end up being a single term.

Given Obama's meteoric rise to power - evidence that he possesses a certain drive and competence in matters political - that seems highly unlikely. And so it seems safe to assume we'll soon witness a redoubling of his efforts to keep interest rates down... to make it easy and cheap for strapped consumers and businesses to keep borrowing... and to otherwise flood the economy with money.

In a deflation, the value of the money increases - not altogether a bad outcome. Inflation, by contrast, means that pretty much everything you own in the local currency steadily loses value - forcing investors into a perpetual game of catch-up. It's hard for me to calculate how the government can dramatically increase the money supply as it has been and yet have each of the currency units become increasingly more valuable over a sustained period of time.

Some argue that the U.S. government is making much the same mistakes that were made in the first part of the Great Depression, i.e., being overly tight with the money. And that the velocity of money is falling.

There are a couple of key differences between now and then, however. First, the Fed didn't actually know what the money supply was back then. They literally had no monitoring tools in place, mostly because no one thought it was important enough to track. Second, they didn't have fiat monetary powers. Today, neither of those factors apply.

Everyone knows what the money supply of the U.S. is and watches it keenly. Including our foreign creditors. And so it is not surprising to hear the Fed publicly talking about tightening up a bit. But it's just talk at this point.

With the economy continuing to struggle, the only reasonable assumption is that the Fed - in cahoots with the entirely politicized Treasury - will keep shoveling money onto the economic embers, and continue to do so until economic activity again flares up.

That will, of course, require increasing the quantity of money that actually makes it into the economy - but that should be child's play for today's Washington - with direct hiring and spending, continuing to buy mortgages and other loans to suppress interest rates, forgiving the bad debts of banks, or changing accounting rules so that banks can postpone reckoning day. And that's just for starters, all of it packaged nicely in the name of the public good.

And once the money starts to flow, there will be a pick-up in economic activity, which will beget yet more money moving around. At first, this money will be a palliative for the economic worries, but then comes the inflation - a small trade-off, the politicians will decide, if it buys them enough of a recovery to make it through the November elections.

There is something else that I think the deflationists are missing, and that has to do with confidence in the currency. If the U.S.'s many creditors come to agree with our point of view - that the dollar is being led to the altar as a sacrificial lamb to political expediency - then they'll further reduce their purchases of our Treasuries and start trading their dollars for stronger currencies and tangible assets, including precious metals.

At that point, interest rates will have to begin rising to attract new buyers. Already, long-term Treasury bond rates have made a significant move off recent lows and are looking poised for a breakout to the upside.

Of course, the higher those rates ratchet, the more it will cost the U.S. government to carry its massive debt. While rising rates will continue to drive demand to the short end, suppressing those rates, in time the sheer quantity of paper that will have to be rolled over, and the rising tide of inflation, assures that short-term rates will have to rise too.

At that point, the train begins to leave the track.

Forecasting the future is actually impossible, as there are just too many variables. But that doesn't mean that we can't step back and make certain logical assumptions about the policies the politicians are most likely to deploy in their efforts to retain power.

In the case of today's world, the only politically logical decision will be to keep on spending until that spending itself becomes a pressing problem, at which point the politicians will turn their attention to "solving" the newest in a long list of problems they have created.

At which point they will no doubt find some creative way to blame the inflation on speculators, profiteers, and the free market.