Deflation is often referred to as falling prices, but that is not the correct definition. Falling prices are the effects of deflation. The opposite holds true when discussing inflation. Deflation results when the overall supply of money and credit contracts, which means that there is a lower supply of money -- or better yet, purchasing power -- to go around. Money supply can contract when debtors are unable to repay their debts; hence a bond worth 100 cents on the dollar one day can be worthless the next if the debtor declares bankruptcy. That loss of wealth, or purchasing power, is deflationary. Multiply this risk -- one that is layered across an economy choking on debt and further magnified by leverage, such as in the US and much of the Western world today -- and you’ve got a recipe for disaster. Yet the argument for imminent inflation rests on the fact that food bills are going up, taxes are going up, health insurance rates, etc; i.e., everything Americans need on a daily basis is going up.My response to that is quite simple. For starters, salaries of employed workers have not taken a major hit yet here in the US. In other words, workers are not being called into their boss’s office and being told they either take a 40% pay cut or get fired. That is coming. Second, many of these institutions and businesses are themselves choking on debt, yet seeing revenues fall due to the unfolding depression and fall in consumption. So what are they doing? They're raising their prices and/or increasing taxes. This is wrongly being interpreted as inflation when it is clearly price rises brought about by deflationary forces and foolish management. Inflation-leaning analysts got very excited earlier this year when Mohamed El-Erian, co-chief investment officer and chief executive of bond powerhouse PIMCO, made the following comments about the current environment as well as what he expected in the months ahead:
We're looking at a world where not only is demand going to pick up, but there's also going to be a lot of supply disruption. The old normal was a world where credit was freely available. Well, credit will no longer be easy. So we're going to have demand picking up, and we'll also have supply coming down. So you think, Okay, there's a recession going on -- I should be able to buy a plane ticket cheaply. And initially you can. Then suddenly they take a lot of planes out and park them in the desert. They take the supply out, and you get inflation coming back. Toward the end of next year, with all the liquidity that's been put in place, at some point we're going to face an inflation risk, and most people are not prepared for that.
Now, what is wrong with these comments? Well, a lot. First of all, inflation and deflation are monetary phenomenons. And Mr. El-Erian points to a deflationary trend in that he expects credit will be constrained. If decades of credit inflation got us into this mess, wouldn’t a reversal of that trend be deflationary?Second, what in the world do industry-specific demand and supply decisions that he raises have to do with a discussion on inflation and deflation? Talk about a wrong premise. If in an economically collapsed world there was only one plane in operation in the entire US, flying only rich bankers like Mr. Ben Bernanke and his friends around the country, would Mr. El-Erian be advising investors to seek inflation protection because those seats would necessarily fetch a higher price?If Ferrari decides to manufacture just one limited-edition car instead of the 50 or 100 it might otherwise produce, would the higher price it might demand for that one car be caused by inflation? And to think the überinflationists were tripping all over each other in patting Mr. El-Erian on the back after that one.Perhaps folks have had their heads in the sand for the last 97 years. Inflation is all we have had, for all intents and purposes, since the creation of the Fed in 1913. That changed in 2007-2008 with the collapse of the credit bubble and the onset of a deflationary period that I believe will run for years. Continuing to expect inflation because of a liquidity rally within a larger deflationary wave is akin to the balding man pointing to the few strands of hair on his head that continue to grow and expecting a return of the plentiful locks he had as a child. That’s not going to happen. It can only happen, in my opinion, as part of an entirely new cycle, one that comes about after collapse and rebirth. The stage is set. We should find out soon enough how this all plays out.
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