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After hearing the
dire warnings of deflation that have become the standard talking points of
most economists, American investors may be reaching for a bottle of Prozac. I
believe that their anxiety is misplaced. Unfortunately, modern economists
don't understand what deflation is or why, in reality, we have much more to
fear from inflation.
Moderate
deflation is actually the natural trend of a productive economy. If a
producer can increase his output per unit of input, then he can afford to
expand his market by lowering prices while still increasing profits. In that
way, deflation allows consumers to buy items that they may not have
previously afforded. It also promotes savings, which is essential for
investment and capital development. (For a simple description of this
process, read Chapter 5 of Peter's new book, How
an Economy Grows and Why it Crashes)
Deflation is also
the normal consequence of a contracting economy. In a recession, there is a
reduction in the amount of goods and services available for consumption. In
order to keep prices from rising (due to shrinking supply), the central bank
should allow the money supply to fall in line with the reduction in output.
Also, during an economic contraction, consumers put downward pressure on
prices by responsibly selling assets to pay down debt.
Many economists
mistakenly claim that the Great Depression of the 1930s was caused by a 30%
contraction in the money supply. The truth is that all depressions are caused
by the reversal of a massive credit expansion. The reduction in money supply
is part of a healing process that brings the overall level of prices back to
a sustainable condition.
Looking at
today's situation, just because we have a few months of sequential declines
in CPI and PPI doesn't mean that deflation has become a secular trend.
Year-over-year (YOY) growth in the M2 money supply is 2%; therefore, since
the money supply is still growing, we are experiencing inflation rather than
deflation.
Considering that
evidence of inflation abounds, the Federal Reserve has pulled off a good
trick by convincing Americans that we are about to "suffer" through
a protracted period of deflation. Why have we been so easily duped? In the
past ten years, the monetary base has grown from $600 billion to $2 trillion.
This expansion has accompanied a rise in the price of gold from below $300/oz
at the beginning of the decade to around $1,200/oz today. The price of gold
is the best arbiter for a currency's purchasing power. Therefore, gold is
still telling us that inflation is eroding the value of our dollar.
Other
commodities, like crude oil, are telling the same story. Ten years ago, a
barrel of oil was trading for $25. Today, it is $78.
Since 2001, the
US dollar has lost over 30% of its value against our largest trading partners
and more than 7% of its value since June alone. These facts are causing the
mainstream economists to wring their hands about deflation?
More recently,
YOY increases in the CPI, PPI, and import prices were 1.1%, 2.7%, and 4.5%
respectively. Even though these YOY increases aren't evidence of runaway
inflation, they still can't be construed as deflation.
The truth is
consumers should be allowed the advantages of falling prices. Aggregate hours
worked are down 8% since their peak in March of 2008. Since the money supply
should fall along with the decline of the number of people in the work force,
price levels should be falling too. But that is not what we see today.
If the monetary
base continues to stagnate and banks stop lending to the government through
Treasury purchases, we could see a deflationary environment sometime in the
future. But given the current policy drift, that scenario appears unlikely.
Even if deflation
were to take hold, it would not be something to fear. Lower prices are
beneficial for those who have been thrown out of work, and falling prices
allow asset values to reach a level that can be sustained by the free market.
The fact is that prices should currently be falling in order to reconcile the
imbalances brought about by decades of profligate spending and borrowing.
Deflation... I say bring it on!
But that is not
what is occurring today. Because of the towering level of US sovereign debt,
it is inflation that remains the clear and present danger.
The national debt
now stands at $13.24 trillion - nearly 92% of the entire output of goods and
services in the US economy this year. In its mid-session review, the OMB
revised its 2011 federal budget deficit projection to $1.42 trillion, down
only slightly from the $1.47 trillion estimate for this year's deficit. Given
this intractable and unsustainable level of obligations, the last thing the
Fed and Administration can tolerate is to increase the burden of that debt by
allowing the money supply to shrink.
A reduction in
the supply of money (deflation) would cause the cost of debt to rise. An
increase in the purchasing power of money also means it is more difficult to
acquire the new money needed to reduce debt levels. Conversely, increasing
the supply of money (inflation) reduces the cost of debt. With these
incentives firmly entrenched, the last thing Americans will have to
"worry" about is deflation.
Given the obvious
mathematics, one wonders why Treasury yields remain at historic lows. The
bond vigilantes are indeed in a coma. However, despite the mountain of
complacency that their slumber has inspired, this golden age of E-Z financing
can't last forever.
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Please note:
Opinions expressed are those of the writer.
Michael Pento
Senior Market Strategist
Delta Global
Advisors, Inc.
Delta Global
Advisors : 19051 Goldenwest, #106-116 Huntington Beach, CA 92648 Phone:
800-485-1220 Fax: 800-485-1225
A 15-year
industry veteran whose career began as a trader on the floor of the New York
Stock Exchange, Michael Pento recently served as a Vice President of
Investments for GunnAllen Financial. Previously, he managed individual
portfolios as a Vice President for First Montauk Securities, where he
focused on options management and advanced yield-enhancing strategies to
increase portfolio returns. He is also a published economic theorist in
the Austrian school of economic theory.
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