Why Inflation Will Trump Deflation

I know this is long, but its well worth the read. It may help you to invest wisly for the impending future.


Why Inflation Will Trump Deflation

Daniel R. Amerman, CFA


In this first article of a series, we will discuss why the answers to the inflation versus deflation debate won’t be found in impersonal mathematical equations – but the quite personal factors of human incentives and motivations. We will show how inflation always trumps deflation with sufficient government willpower – there is simply no contest. We will show how that willpower is already being unequivocally demonstrated today, and why the results of that willpower will ultimately likely be the annihilation of most of the value of the dollar and conventional investor assets. We will close by briefly discussing how investors can not only survive, but profit from the destruction of the dollar.

A Battle of Titans

Will the current deflationary forces in the US housing market transform into overall deflation in the monetary system? Will the credit bubble – which is already claiming the capital of many of the world’s leading financial institutions – end in deflation, or inflation? Subprime mortgage derivative securities make up about one fifth of 1% (0.2%) of the rapidly growing $517 trillion financial derivatives markets. If larger segments of those markets were to also implode – will the purchasing power of the dollar rise, or fall? Will a recession tame inflation, or will we get accelerating inflation and stagflation instead?

Many people look at the answers to these questions as being a battle between economic forces, where the outcome is uncertain. In one corner we have the forces of inflation and hyperinflation, as represented by Germany in the 1920s, Latin America in more recent decades, and Zimbabwe today. In the other corner we have the forces of deflation, as represented by America in the 1930s, and Japan in more recent years. In this battle of titans each side has their highly intelligent and educated advocates, who can use the combination of history and financial equations to make a convincing case that either inflation or deflation will emerge on top – with opposite results for the value of the dollar.

The outcome of this battle is vital for investors. If you invest for the destruction of the dollar (inflation), and the dollar increases in value instead (deflation), then a strategy that looked lucrative on paper could become painful in reality. The opposite is true as well – become convinced of deflation, invest for it, and if the future works out to be inflation the results could be painful indeed. Given the powerful arguments for each side, and the enormous investment consequences – what is an investor to do? How can we find the answer to which force will be stronger?

Rock Breaks Scissors & Inflation Breaks Deflation

Let me suggest that the key to finding the right answer is to first be sure you are asking the right question. Let me further suggest that trying to decide whether inflationary or deflationary forces are stronger in the economy – is asking the wrong question. For as entertaining as the image of a title bout between titanic economic forces would be, this is the wrong metaphor, and is in fact dangerously misleading. A better analogy might be the children’s decision-making game of “rock, paper, scissors”. In this game, scissors always cut paper, paper always covers rock and rock always break scissors. The rules are absolute, and there is no question about whether the scissors will break the rock instead.

Similarly, when we look to the “battle” between inflation and deflation – there is no real question, but an absolute answer. Any government which controls the supply of its own currency can force inflation at any time – it is merely a matter of willpower. For a sufficiently motivated government, inflation breaks deflation. Always and without exception, period, end of debate. The question between inflation and deflation is not one of relative “power” at all, not one of which force will prove more powerful, but of government willpower and motivation.

This inherent power of inflation to always break deflation is Reason One of our 24 Reasons why inflation will trump deflation. The source of this inherent power is quite simply the nature of money, as outlined below:

1. The potential supply of money is infinite for a nation that issues its own currency.

2. The supply of resources to purchase with money is always limited at any one point in time.

3. By sufficiently raising the supply of money relative to the finite amount of desirable goods and services, there will necessarily be more dollars competing to buy each asset, and the dollar denominated price will always rise for the asset.

4. The meaning of inflation is an increase in the dollar prices of goods and services, which is the same thing as a decrease in the purchasing power of every dollar.

5. So long as a government is willing to sufficiently increase the supply of money, it has an absolute power to destroy the value of its own currency through the oversupply of money relative to assets, which is an absolute power to break deflation with inflation.

Changing Assumptions = Changing Results

For those readers who are well versed in economics and inflation, my apologies for the elementary nature of the five points above. However, the fundamental principles reviewed above are essential for even the most sophisticated evaluations of inflation versus deflation. The problem is that generally speaking, the more sophisticated the evaluation – the greater the number of assumptions. Which leads to the danger that if you pull out one of the underlying assumptions – the whole elaborate edifice of equations, papers, dissertations and computer models can come tumbling down.

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Last Edited by SPUD on 10/21/2011 11:46 AM