Inflation or Deflation Ahead?

<< Back Home                                         Created : Jan 10, 2007
                                                 *** Last Updated : Jan 10, 2007

       This issue is being debated quite a bit in the blogsphere.

       I think it will be deflation, but with a caveat.

    Deflation as in contraction of the money supply, but will be accompanied by
 rising cost of goods as measured in inflation.

    Why a contraction in the money supply? As fewer new homes are purchased, the
 dollar amount of new debt created will reduce. As there are more defaults banks
 will tighten lending rules, and credit will reduce, and less and less new dollars
 will be created from the Federal Reserve's money printing machine.

    Not only that, as more and more loans go bad and have to be written off. It
 will result in destruction of Capital, resulting in fewer dollars circulating in
 the economy, which is deflation.

   Why not inflation or hyper inflation as a lot of folks are arguing? The answer
 is NO, because we already are in a hyper inflation period. The M3 explosion circa
 1995 and the monetary loosening by doing away with the Reserve Requirements has 
 already created a hyper inflationary environment, and we already have been ten 
 years in that phase.

   Equities and property values have soared. But at the same time with an over 
 valued dollar, in the name of globalisation, more and more imported Asian goods
 and services have helped to keep the cost of goods down. And the purchasing power
 of the consumers dollars has been retained to a certain extent. 

   Cheap illegal immigrant labor also helps to keep prices lower for the American
 consumer. And of course the Govt. has devised ways to under measure inflation.

   But the cost of things like health care services that cannot be imported, have
 spiralled out of control.

   Oil prices have soared as there are more and more dollars chasing the near flat 
 oil production. The Asian nations who are getting our dollars, are competing 
 with us to get a bigger share of the produced oil, creating more competition and
 demand, driving up oil prices. Which in turn fuels inflation.

   There is so much debt in the system now, that it is impossible for it to be paid
 back dollar by dollar. One loan default will turn into a cascading chain and the 
 only way out will be to keep writing them off, one after the other. Which will have
 disastrous impact on the banks, and will seriously reduce their capability and 
 willingness to write new loans. Further cascading the effects on the economy. Lack 
 of credit will result in reduced money supply and create deflation.

   Why the argument that the Fed will inflate away the debt by means of printing 
 money does not hold? The Fed has already been printing money and handing it out to 
 the consumer as home equity line of credit, but in the process is only further 
 indebting the consumer. The consumers are servicing their existing loans by taking
 on more debt. And at some point the consumer no longer has the collateral against
 which to borrow money. That collateral has been the rising home values. Which have
 either stayed flat or even declined during 2006.

   It seriously hampers the consumers ability to not just borrow more money, but also
 his ability to service existing debt. And this is the initial default which will 
 create a nuclear chain reaction of defaults in the economy.

   And just as the Domestic Economy weakens, so will the international purchasing 
 power of the US Dollar. The ever widening trade deficit combined with the incessant
 supply of dollars has resulted in trillions of them being stacked as reserves in
 foreign central banks. And with a weakening US economy these banks may just decide
 that they have too many of them, with little use for them. 

   Unlike until now when only the US Central Bank was the source of dollars, dollars
 will start coming out from dozens of foreign central banks. With too many dollars
 for sale and no buyers, the dollar will crash.

   A lot of the products which are imported will suddenly become expensive. The cost
 of those goods will rise dramatically. But again the demand for these goods will 
 continue to weaken in a deteriorating economy.

   Whether this new demand/supply price equilibrium will be acheived by a realistic 
 valuation of the US dollar, or by producing these goods domestically remains to be 
 seen. It is entirely possible that both may happen.

   But if history is any guide, nationalism will lead to protectionism and trade
 barriers. Which makes it more likely that it will be acheived by producing these 
 goods domestically again. Or the markets may just revaluate by themselves that it
 is cheaper to produce these goods domestically again.

   Once a fair price for these goods has been acheived, they too will join the 
 overall deflationary cycle of pricing.

   To summarize, Deflation ahead with a silver lining that the manufacturing jobs 
 that have been lost by outsourcing, some if not all of them, will migrate back into
 the US.

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