Wikinvest Wire

Five reasons to fear inflation

Tuesday, July 14, 2009

While the debate rages over whether the years ahead will be dominated by in-flation, de-flation, or some combination of the two, a quick look at the reasons why so many people are so terrified of inflation is in order.

This is not meant to be an all-inclusive discussion, simply an overview.

1. They've been printing so much money, it's got to go somewhere

Yes, I know, the newly created trillions of dollars that monetary authorities around the world have sent out to failing banks, auto companies, insurance companies, and others - much of that money is currently just sitting there as bank reserves, not entering the economy in the form of new bank loans that would have this sum leveraged up to who knows how many tens of trillions of dollars.

Of course, that's today's story.

Tomorrow's story (probably sometime next year) will be one of economies that have hit bottom, at which time, banks will be more willing to lend and consumers more willing to borrow. That's when all the newly printed money starts to create inflation.

The doubling of oil prices seen earlier this year is just a teaser for what's to come since central banks quickly lose control over where the money goes once it starts to move again. Of course, if there is no economic recovery, that money will just sit there and there will be little or no inflation. But, if we do manage to pull ourselves up out of this mess, we'll see the highest inflation in generations as policymakers will be loathe to repeat the mistakes that led to the 1937 recession, following the Great Depression.

2. The government's inflation numbers are bogus

When inflation does come roaring back, you probably won't see too much of it showing up in the government's Consumer Price Index (CPI) data since this measure has been systematically neutered over the last thirty years to make rising prices seem as though they're not all that bad compared to what we saw back in the 1970s.

You hear a lot about how economic policies have "defeated" inflation over the last few decades when, in fact, much of the lower inflation numbers have to do with cheap oil from the Middle East, cheap imported goods from Asia, and, most importantly, changes in the way the Bureau of Labor Statistics calculates the inflation statistics.

Since home prices were stripped out of the index in 1983, it's hard to imagine how we could ever see inflation over ten percent again since housing rental costs now account for more than 30 percent of the index. With the glut in housing due to the recently popped bubble (a bubble that would not have been possible if home prices had not been stripped from the inflation data), we'll have downward pressure on rents for years to come.

The bad news is that domestic services and energy will keep on rising and this will feel like 20 percent inflation even when the government says it's only six.

3. Peak oil is real and it is near

The ongoing recession/depression has been a boon to those who have long scoffed at the whole notion of Peak Oil - that cheap energy, fossil fuel that comes gushing up from out of the ground with little or no effort and has served as the very foundation of the world economy over the last 80 years or so, will soon be a thing of the past.

Of course, the fact that economic growth is now declining for the first time since the Great Depression puts a whole new spin on things, albeit, just a temporary one.

That is, unless what we've seen over the last nine months is what we'll be seeing for years and years and years.

Since changes in global energy consumption are inextricably tied to changes in economic growth, the only way that peak oil is not going to be a problem in the years ahead is if the global economy grows at a much slower pace. Slow growth means less jobs which mean lots of people have lots of idle time on their hands and governments don't generally like that.

Look for item #1 above to solve many of the world's economic problems in the near-term while creating even bigger inflation problems in the long-term as a return to world-wide economic growth once again stresses the relatively limited energy production capacity as it did last year.

4. Rich, smart people are buying gold

I don't know about you, but when I hear about people like John Paulson of Paulson and Company buying billions of dollars in gold bullion for his hedge fund and when stories begin to circulate about very wealthy individuals buying bullion by the truck load, apparently OK with the whole idea that it neither earns interest or pays a dividend - then I start to worry a little bit.

Most of the rich people in the world are rich for one very good reason - because they're smart.

And even though most of the investment world still doesn't have much of a clue about the nature of money and how, after almost four decades, a very long experiment with a world overflowing with fiat money is now going horribly wrong, a lot of smart people with a lot of money have figured it out.

In private clubs, board meeting rooms, and social gatherings all around the world, the likes of which neither you nor I will ever experience, they are swapping stories about how to buy and store gold because rich, smart people know the long history of paper money.

Paper money, issued by government fiat and backed by nothing other than confidence in the issuing government to act responsibly, has never endured. Governments always abuse this power and to think that it will be different this time is not only not very smart, it is naive.

5. The central bank does not fear inflation

The single most important reason to fear inflation is that the Federal Reserve and its minions of economists, accountants, and ne'er do wells do not fear it.

Never before have there been so many signs of impending financial calamity that have been missed by so many central bankers, economists, and policy makers around the world that there is absolutely no reason to think that they will be any better able to spot early signs of rip-roaring inflation than they were able to spot signs of a stock market bubble, a credit bubble, or a housing bubble.

In fact, even if there are indications of monstrous price increases on the horizon, the Federal Reserve and others will likely embrace the arrival of rising prices since what they really fear is de-flation. On this side of the Atlantic, they are determined to avoid a repeat of the 1930s when a sound money system had a completely different set of dynamics and they are loathe to do anything substantive to combat inflation until they are sure that they have vanquished their nemesis - de-flation.

Sure, they'll keep talking about "exit strategies" and how to "remove the accommodation" that has been provided over the last year or so in the form of trillions of newly created dollars, but they don't really mean it.

In the next few years we'll be creating a whole new chapter of economic history, one where inflation will play a central role. When the historians look back at 2009 they'll wonder, "Why wasn't anyone worried about inflation back then? When they could have done something about?"

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AJ said...

1) The printed money is filling the gaping hole left by the wealth lost over the past two years or so. Although I do agree that if a problem with inflation occurs, it will be if the reserves get levered up too quickly.

2) In 100% agreement with you here. Housing should have been factored into inflation, and then this fiasco would have been less likely to happen. I personally believe that commodities will suffer some moderate inflation while housing deflates, until the two are balanced again, and that will be the housing bottom.

3) The problem with Peak Oil is that it doesn't consider more expensive extraction techniques. Sure, all the easy oil is gone, but there's still a ton of difficult oil to get. And there's also natural gas, coal, nuclear, and renewable energy, which will sooner or later start to catch up.

4) Gold is only worth what people are willing to pay for it. I remember seeing a graph that demonstrated how something like half of the demand for gold is for jewelry. If everyone suddenly decided food was way more important than rings, I wager that the price of gold would collapse.

Smart people know that real value is having a skill that you can use for economic gain. Then they don't have to be afraid of inflation anymore (see 5)

5) I agree that the central bank doesn't fear inflation. I haven't yet decided whether or not a little inflation is actually a bad thing.

Sure, it kills the incentive to save, but it puts an emphasis on having an employable skill, which is valuable to someone who has a 4-year degree like me. No matter what kind of inflation happens, so long as I have a skill that is in demand, I will get a wage that can buy me the things I need.

Anonymous said...

The Central Bank does not fear inflation -- controlled inflation is part of its policy. "Normal" inflation (c. 2.6%) was built into interest rates for mortgages/ bonds, etc. Deflation cripples the debtors, and threatens the contracts they have entered into with creditors. The risk is that the Fed loses control of inflation and debt gets inflated away. Liquidity trap, anyone?

Anonymous said...

AJ needs to read some history and see what happened in Weimar Germany to people who had "a skill in demand."

Hyperinflation wipes out everything.

staghounds said...


A dollar is only worth what people are willing to trade for it, too.

As is your (today) marketable skill, if it comes from having some degree.

Here's a tip, college boy- the higher up the degree ladder you go, the more easily your skill can lose all its value, because it takes more and more infrastructure to support your position and make it pay.

In truly hard times, you'd be surprised what high level services and skills people decide they can dispense with.

Prostitutes, repairmen, and roofers are the most crisis safe occupations there are.

ANYTHING can lose some or all of its relative market value in the right circumstances. The trick is to use your mind to figure out how to see those value losses coming and be shed of those soon to decline assets.

For basically all of known history, gold has held its value as compared to fiat currency. If I had to pick one thing to be the best shelter under the most likely events, gold is it.

Besides, you already own your skill. Or are you going to spend everything you make and use none of your income to try to get ahead of your paychecks?

It sounds as though you are fairly youthful. Here's a suggestion- go find someone who's been working for thirty years. Ask them how much he's got in hand. Then ask him how much he would have if, every month of his working life, he'd spent 5% of his take home on gold.

Or even 2%

AJ said...

Anonymous - People survived. I would wager that the skilled workers faired better than those without skills even during hyperinflation, and just imagine how much easier it was for those with a skill to return to a normal life once hyperinflation ended. Besides, I highly doubt the US will see hyperinflation; at the end, the amount of debt issued by the Weimar Republic's Treasury was growing at a rate of six orders of magnitude annually. At our current level, it would take a million-trillion dollar deficit next year to be comparable to the Weimar Republic.

staghounds - "college boy", haha. You don't even know when I got my degree. Hardware and software are my thing, and I think those with knowledge in electrical, computer, and software engineering will be an integral part of the workforce for many years to come; if not developing such technology, then repairing it. (you did mention repairmen...)

As far as gold, go take a look at a graph of the price of gold in USD going back 30 years. Notice the big spike during the early 80s? I wonder if that was because people wanted an inflation hedge, and when the inflation scare went away, so did the demand for gold, driving the price down to $400 +/- $100 per ounce for almost 25 years...

In fact, I found this nice little excel table comparing the S&P 500 and Gold over 30 years. $1,000 in the S&P in 1977 would be worth $36,000 in 2007; $1,000 in gold would be worth $5,000.

The 20 year 87-07 forecast looks a little better - $1000 turns int $9000 in the S&P and $2000 in gold.

The 10 year 97-07 forecast is where gold wins - $1000 turns into just under $2000 in the S&P and just under $3000 in gold.

It turns out you make more with gold if you only got it 10 years ago, as opposed to 20 years ago.

Anonymous said...

Sorry, you are wrong in inflation. If this were your standard over capacity recession (which seems to be only thing anyone understands anymore), than I would agree. This was DEBT driven. Unless you were alive during the Great Depression, than you've never experienced one. The problem is not too much money in the system, but TOO MUCH DEBT.

Of course the dollar can still implode in this scenario, but it won't be due to inflation.

As for gold, some history lessons:
1. During the last DEBT de-leveraging (the GD) guess what all that gold got you? Nothing, the government confiscated all of it. They WILL do it again if it comes to it.
2. Think. If the day ever comes where gold is the only thing that has any buying power, is it smart to have piles of it IN YOUR HOUSE? The second you try to buy something with all your gold, you'll be a dead man.

Gold does hold value over time, but its also always been impracticable as a currency.

JL said...

AJ: You know, comparing asset performances to the period ending just before the stock bubble of '08 is a little bit out of date, wouldn't you say?

$1000 in the S&P on July 15th 1999 would get you $700 on July 15th 2009.

$1000 in gold on July 15th 1999 would get you $3000 on July 15, 2009.

It's unwise to put all your money in gold of course, and if your paying attention, most gold defender's here are saying that.

Anyone that can afford it, should at least store a portion of their wealth in bullion.

AJ said...

JL: Considering the author of the article I quoted wrote it in the beginning of 2008, I'm not surprised it ends in 2007 and doesn't consider catastrophes that struck at the end of 2008. (I knew I was going to regret not putting a disclaimer about the effects of endpoints on your linear regression...)

Please note that the quoted article compared three time periods - 30, 20, and 10 years. Your point about how gold outperformed S&P for the past 10 years was already addressed, and is moot to the general point I wanted to make; people who bet on gold as an inflation hedge will create a bubble during catastrophes as they create demand for a "safe haven", and as people slowly realize the world isn't ending the bubble will pop because the demand for a safe haven drops. Then they'll want to actually use that value to do something, and they'll start selling their reserves, which will increase supply and deflate the floppy remnants of the bubble even further.

Look at the 30 year graph for gold, which goes back pretty much to when the dollar was unpegged. You're making the same mistake that you claim I made - cherry picking the beginning and end points of your regression. I dare you to calculate the returns for July 15, 1989 to July 15, 2009. I don't have easy access to the numbers for '08 and '09, but I'll bet the tables will have turned in the S&P's favor none-the-less.

I can't argue with diversifying, it sure is a great idea, but don't do it under the impression that gold is an inflation hedge.

Anonymous said...

With trillions of dollars of overpriced houses on their hands, a touch of hyperinflation will make the market value of the properties currently held by the banks suddenly come back into synch with what they can get in rents. This will make BoA and Wells whole again. As for the people who will have their life savings wiped out, they don't contribute to political campaigns in meaningful amounts, and can be considered collateral damage.

Anonymous said...

The bank reserve stuff is misdirection by the central bank. The money is already in circulation, as the bank bought bonds with it. The reserves were not deposited by citizens, so nothing came out of circulation to fund the bond purchases.

The "reserves" are actually a form of double counting. The central bank actually created 2 trillion in new money. Half went into immediate circulation, and the other half is sitting in reserves.

Anonymous said...

Let's not forget that Volker Knows Inflation. If it becomes a threat you will see 15% interest rates show up to suck the life out of it. I wouldn't bet on Hyper-inflation with this team. They will simply let GDP growth solve the problem.

Anonymous said...

"Let's not forget that Volker Knows Inflation. If it becomes a threat you will see 15% interest rates show up to suck the life out of it. I wouldn't bet on Hyper-inflation with this team. They will simply let GDP growth solve the problem."

They do not consult Volker. He has no input. You better hope for at least +10% consistent GDP growth for a ten year horizon to come close to "solving" hyperinflation.


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