Our recent commentary, “Calling All Inflationists!” touched off quite an e-mail firestorm. Unwavering deflationists ourselves since the 1990s, we’d challenged readers to explain exactly how inflation might emerge amidst the devastating asset collapse now occurring throughout the world.  Your answers were not merely enlightening, but compelling. Of course, it’s hard to argue with the contention that the dollar is just a worthless scrap of paper, and that, sooner or later, that fact is going to hit home. When it does, perhaps because of some epic train wreck on Wall Street, grocery store shelves will be stripped bare within hours. Food, fuel and other essentials will become scarce overnight, and those who possess such things in salable quantities might not be willing to trade them even for hundred dollar bills.

Hyperinflation will come on like a tsunami at that point, but the question for now is: How much more deflation will we have to endure first, before debt is repudiated by a tidal wave of printing press money?  Jim Sinclair, an unapologetic hyperinflationist who commands the respect of a large readership, thinks the money blowout could start as early as 2009.  Possibly, but we suspect it will take longer, since the fiscal stimulus about to be tried by our new President will put us on the slow track relative to straight monetization.

Those who have been hoarding gold needn’t worry quite as much about such things, since, unless the Government confiscates bullion as it did under Roosevelt’s 1933 edict, there is no easy logic to support a bearish case for gold. As we’ve noted here before, even if deflation is about to cause gold’s price to drop by 50% in the next year or two, all other types of investable assets will probably fall by even more. So far, though, nothing so dire has occurred to undo the defensive strategies of the gold bugs. Far from it. Although some of them might grouse about bullion’s “failure” to soar above $1,000, we trust that they recognize how very well gold has protected them so far, hanging tough near $900 while nearly all other classes of assets have collapsed. Treasury paper alone may have performed better last year, but only because the whacky idea of reward-free risk – Jim Grant’s great phrase – has, like swallowing goldfish in the 1920s, come briefly into vogue.

CDs, Cash & Vanguard Bond Index

We would strongly encourage you to visit the inflation/deflation discussion at the Rick’s Picks forum. Meanwhile, here’s an undiluted sample of what you’ll find – a reader’s hyperinflation scenario that sounds quite plausible to us. The author is Eric Andrews, who notes that as an investor, he has been on the deflation bandwagon since June of 2007, holding five-year CDs, cash and the Vanguard Total Bond Index (VBMFX).  He writes as follows:

“A public debt crisis would precede any serious bout of inflation.  The Federal Reserve has an unspoken mandate to ensure the ability of the US Treasury to pay USD denominated debt. The signs to watch for would be a hockey-stick like Treasury yield curve as investors start to flee long-term, fixed-rate debt; a shift of government funding from the long end to the short end of the curve; Congress re-working inflation measures (Social Security); monetizing gold reserves for USD dollar debt; tension between the Treasury and the Federal Reserve; and the US government borrowing in non-USD.

Rush to Borrow

“Once investors realize that the Federal Reserve can't reign in inflation without bankrupting the Treasury, the flight from cash will begin in earnest.  Investors will rush to take on as much long term fixed rate USD debt as a hedge against (or bet on) inflation.  Those products will disappear from the marketplace (except possibly for gravy trains like GSE loans).  Commodities will pop.

“Only when the savvy have protected their wealth will the rank-and-file start to see the signs of inflation in everyday activities.  The younger generations (with large debt loads) will welcome it (at first) while the old will find themselves in increasingly dire straights.  Wages will have to go up (but real wages may not).  Once expectations of inflation become entrenched and the winners and losers become apparent it will be very difficult to root inflation out of the system.

Japan Farther Along

“Oddly enough, the Japanese are farther along this path than the US is at the moment.  I believe this will take a long time to develop (if it ever does).

“There are only a couple of short-term paths that I could see to high inflation. I'm worried about the large number of off-the-balance-sheet guarantees made by the Treasury (Fannie Mae, Freddie Mac, MM Funds, Bank Debt, etc).  We'd see the public debt triple if investors decided to test that implicit guarantee by fleeing from those markets to Treasuries.  Once the US Government becomes the largest carry-trade player on the planet, it wouldn't take much to trigger a dollar crisis (after all, the carry puts a cap on the rate the US Government can pay for its debt).

Risks of Monetizing

“I'm guessing this risk is why the Fed decided to open the money taps to Fannie, Freddie and the MM Funds and directly monetize the debt.  The implicit threat to FCB is don't flee those markets or we'll monetize the debt.

“But, monetizing long term debt by the Fed has its own risks. Since the Fed can't take a loss (no capital), it is by nature a hold-to-maturity investor, not a trader.  A large amount of long-term monetized debt on the Federal Reserves balance sheet is an implicit guarantee to maintain a minimum size of the monetary base (which has inflation implications).  A monetary base of $14 Trillion of long term debt would certainly make me think twice about holding dollars.

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Information and commentary contained herein comes from sources believed to be reliable, but this cannot be guaranteed. Past performance should not be construed as an indicator of future results, so let the buyer beware. Rick's Picks does not provide investment advice to individuals, nor act as an investment advisor, nor individually advocate the purchase or sale of any security or investment. From time to time, its editor may hold positions in issues referred to in this service, and he may alter or augment them at any time. Investments recommended herein should be made only after consulting with your investment advisor, and only after reviewing the prospectus or financial statements of the company. Rick's Picks reserves the right to use e-mail endorsements and/or profit claims from its subscribers for marketing purposes. All names will be kept anonymous and only subscribers’ initials will be used unless express written permission has been granted to the contrary. All Contents © 2007, Rick Ackerman. All Rights Reserved. www.rickackerman.com 

-- Posted Wednesday, 21 January 2009 | Digg This Article