Our inflation/deflation discussion continues, prompted by a pen-pal’s letter directing me to a four-part essay written by Steven Kennedy, A Historical Review of the American Gold Market.  Using historical data, Kennedy sets out to prove that the Kondratiev Wave “winter” commonly associated with deflationary depressions is also capable of producing a hyperinflationary one. While Kennedy at least makes his thesis sound plausible, I remain as skeptical as ever that K-Wave winter begun several years ago will produce anything but ruinous global deflation.

Since the early 1990s I have been arguing that any hint of inflation would be smothered by far more powerful forces of deflation that were by then beginning to emerge in the global economy, most evidently in Japan. I’ve insisted all along that deflation has become the more menacing threat by far, even if some of the country’s top economists professed otherwise. Here’s a snippet from a newsletter that I published eight years ago, in July 1996:

Fed Insider Dead Wrong

“Fed governor Lyle Gramley predicted on CNBC yesterday that the Open Market Committee would vote to raise short-term rates by 50 basis points at its August 20 meeting.  He said they didn't do it at the July 3 meeting because there wasn't enough evidence to prove that the economy is starting to overheat.  But by late August, he predicted, we’ll have seen two more months of statistics for the PPI, the CPI, and the purchasing managers' index, and they should provide ample justification for effecting the long-feared rate hike.

“I am predicting otherwise. About the only thing that will look overheated come late August will be the equity averages.  I'd bet against a rate hike, notwithstanding either Mr. Gramley's insider status or the purportedly bullish look of U.S. unemployment numbers.”

…and So Were Economists

That’s a bet that most economists would have taken, and they’d probably have given me odds. But as we now know, inflation remained subdued, and the Fed, rather than raising interest rates, lowered them over the next several years with 13 consecutive cuts. That’s how K-Wave autumn works: inflation fears slowly recede as easier and easier money has no discernible effect on consumer prices. With inflation seemingly (if mystifyingly) in check, the Fed continues to ease even more aggressively, oblivious to the “good” inflation that is pushing financial asset values into the cosmos.

The party was just beginning back then, but it was plain to see that America’s phony economic boom, driven as it was by overconsumption and easy credit, and masking profound secular weakness below the surface, would fade quickly if lending were constrained even slightly. Under the circumstances, I wrote, “For the Fed to tighten the screws would be like injecting an AIDS patient with cholera.”

Tightening Not to Blame

Concerning Kennedy’s essays, I would recommend them to anyone wanting to better understand how gold might react to precipitous changes in the financial economy, whether inflationary or deflationary. While I agree with him that, in terms of purchasing power, gold will do quite well no matter what happens, I am unpersuaded by his thesis. For starters, there are some factual errors that undermine the argument that K-wave winter could produce hyperinflation. Most notably, Kennedy asserts that tight monetary policy helped push us into the deflationary depression of the 1930s. In fact, it has been well documented that the Fed kept credit loose, but that this failed to counteract the economic contraction triggered by the Great Crash.

Also, like many others who have written on the topic of deflation, Kennedy doesn’t attempt to explain how it would strengthen the dollar. Kennedy, Richard Russell and others like to cite the textbook cliché about how cash would be “king” in a deflation. But almost no one has attempted to describe how this would be possible, given that the dollar is already fundamentally and intrinsically worthless.

Dishoarding Debt

Bob Hoye of Institutional Advisors has provided an interesting and provocative insight on this crucial question:  “[A phase] of dishoarding debt and hoarding cash is about to start. In regarding the dollar, unless a senior central banker, academic, or businessperson has read financial history, it is easy to believe that a central bank can issue credit and depreciate the currency at will and forever. Mr. Market teaches something else. Typically, following a financial bubble the purchasing power of the senior currency steadily increased, which brings us to the exquisitely ironic prospect of a chronically strong dollar – despite frantic efforts to depreciate.”

Hoye’s work led me to conclude that the dollar will draw its strength from an increase in real interest rates, and that the road that takes us there will be strewn with the carcasses of bankrupt homeowners unable to handle  a 6.5 percent mortgage. Many will throw in the towel, and refinancing will not be an option, since home values by then will have dropped significantly. For millions or perhaps even tens of millions of Americans, the coming deflation will come down to this: paying lenders 6.5 percent on their money so that one can hold onto a house whose value is falling by 5 percent or more per year. The kicker is that, mortgage paper aside, there will be few classes of assets in which one could hope to earn more than a percentage point or two on one’s own money. Financial survivors will therefore flock to mortgage-backed securities whose safety, though not guaranteed, would be buttressed by the mortgagees’ primordial resolve to keep themselves and their families from getting tossed out on the street.  

Count on Murphy’s Law

As Hoye suggests, the dollar, ironically, could strengthen despite the Fed’s most assiduous efforts to beat it down – to bail out debtors, that is, with printing-press inflation (or rather, printing-press hyperinflation, since the effort would entail monetizing tens of trillions of dollars worth of debt and unfunded liabilities more or less overnight). Monetary theory aside, Murphy’s Law suggests that debtors are hoping for too much if they think a hyperinflation one day will allow them to retire their mortgages with a chump-change deduction from their biweekly, quadrillion-dollar paychecks. Rather, because Murphy’s Law has been a far more accurate predictor of history than any economist, we should expect the opposite: a fatal tightening of the debt noose, caused by an appreciating dollar.

I should also mention that neither Kennedy nor anyone else who has tried to make the case for hyperinflation has attempted to imagine the aftermath – at least, not in any detail. For if they did, it would illuminate the underlying fallacy of their logic. By definition, hyperinflation’s straight-up trajectory is unsustainable, and the pitch of the ensuing downward slope – in a word, deflation – would be just as steep. When hyperinflation crashes and burns, and all assets get marked down to levels commensurate with a credit-less world, what could that conceivably imply other than an intractably deep, deflationary depression? It’s hard to imagine what, at that point, a $5,000 Kevlar-frame mountain bike would command in barter, but I doubt it will be more than an ounce or two of gold or a few pounds of silver.  

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-- Posted Sunday, 29 August 2004 | Digg This Article