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We now live
in a world where deflation has become public enemy number one. In this
current economic environment, governments seek a condition of perpetual
inflation in order to maintain the illusion of prosperity in the developed
world. But in reality, deflation is the free-market approach to rectify a
secular period of superfluous money supply growth, debt accumulation and
asset price appreciation.
In an effort
to boost the earnings of private banks and to facilitate sovereign
government's largesse, central banks have a well
documented history of rapidly expanding the supply of fiat currencies
and manipulating interest rates lower. This creates increasing debt levels
and rising asset prices.
As recently
as July 2008, the U.S. Fed (with the help of commercial banks) had produced
YOY Consumer Price Inflation of 5.5% and Producer Price Inflation of 9.8%. In
the Eurozone, the ECB produced consumer inflation over 4% and The PBOC
(People's Bank of China) boosted inflation north of 8% for Chinese consumers.
Once central
bankers are finally forced to confront the inflation they created, they
throttle back on the printing press. But the return trip to a more normalized
economy brings with it the bursting of debt and asset bubbles.
After the
credit crisis set in and the healing aspects of deflation began to take hold,
central banks rapidly expanded the supply of base money in an effort to
quickly erode the purchasing power of their currencies and bring real estate
prices higher. For example, real estate prices in Spain are already down over
30% and are expected to drop a further 12-14% in 2012. The ECB has printed
over one trillion Euros to date; in an effort to weaken their currency,
elevate home prices and bring solvency back to the European banks.
The problem
with the addiction to money printing is that once a central bank starts, it
can't stop without dire, albeit in the long-term healthy, economic
consequences. And the longer an economy stays addicted to inflation, the
harder the eventual debt deflation will become. As a result, central banks
are now walking the economy on a very thin tightrope between inflation and
deflation.
Once they
finally step away from expanding the money supply, deflation rapidly takes
hold. However, it then takes an ever-increasing amount of new money creation,
on the part of the central bank, to pull the economy away from falling asset
prices.
Another
example of the roller coaster ride provided by central banks can be found in
the price of oil. Oil prices had been historically around the $25 per barrel
range throughout the decades of the 80's and 90's. Then, beginning in the
early part of the last decade, oil prices started to soar and eventually shot
up to $147 by the summer of 2008.
In the midst
of the deflationary credit crisis, it fell to $33 per barrel by the start of
2009. Of course, the Fed had already embarked on their quest to eventually
print $2 trillion to fight deflation, which helped send oil back to $114 per
barrel by 2011.
However,
because the Fed and ECB have both proclaimed that they are on hold from debt
monetization and currency debasement, the same monetary environment that led
to the pronounced deflation that occurred during fall of 2008 has arrived
once again.
Now, some
will say that a severe recession accompanied by sharp deflation can't occur
because banks are currently well capitalized. It is true that the
deflationary recession was caused by banks that had previously loaned
themselves and the economy into insolvency. However, today the problem is
much worse. We now have entire nations which have become insolvent. It would
be very difficult to argue that having a banking crisis is better than
enduring a sovereign debt crisis, especially since much of the assets banks
hold is sovereign debt.
Therefore, we
see that oil prices have already fallen 18%, from $110 a barrel in February
of this year to $91 today. Copper prices have dropped 11%, from 3.90 per
pound in April to $3.50 per pound today. And equity prices have started to
decline, just as they did at the beginning of the Great Credit Crisis.
Japan's
Nikkei Index has declined nearly 11% in the last month, while the S&P 500
has lost 7% since the beginning of May. The Spanish IBEX has tumbled 7.6% in
the last 30 days and is now down 37% during the past year!
These price
adjustments are absolutely essential for the long-term health of the global
economy, but I doubt the central banks will sit idle much longer.
The plain
truth is that the current debt levels, carried by the developed world, demand
a period of massive deleveraging to occur. A healthy and cathartic period of
deflation is needed; where asset prices fall, money supply shrinks and debt
levels are reduced to a level that can be supported by the free market. This
is the only viable answer for various nations struggling with solvency.
However, the
return journey from rampant inflation and asset bubbles always carries
insolvency and defaults along for the ride. Defaulting on debt is
deflationary in nature and restructuring your liabilities is the only choice
when you owe more money than you can pay back.
The prevalent
idea among heads of state and central banks is that a country can borrow and
print more money in order to eliminate the problems caused by too much debt
and inflation. But more inflation can never be the cure for rising prices and
piling on more debt can't solve a condition of insolvency.
Global
investors are now being violently whipsawed by the decisions of central
banks, as they switch between inflationary and deflationary policies. The
choice governments now face is to allow a deflationary depression to finally
purge the worldwide economy of its imbalances; or try to levitate real
estate, equity and bond prices by printing massive quantities of their
currencies.
It is vitally
important for your financial well-being to be able to determine which path
central banks are currently pursuing. For the moment, they have allowed the
market forces of deflation to take hold. However, past history clearly
signals to investors that it is only a matter of time before economic
conditions deteriorate to the point where governments return to their
inexorable pursuit of inflation. The point here is to understand where we are
in the cycle between inflation and deflation and then to invest accordingly.
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