Saturday, October 10, 2009

The Great Debate

"I guess it comes down to a simple choice, really. Get busy livin', or get busy dyin'."
--Andy Dufresne (The Shawshank Redemption)

A heated debate currently involves whether we will experience inflation or deflation down the road. This debate is of high interest to market participants because conditions of inflation or deflation require different, perhaps diametrically opposed positioning (e.g., buy General Electric (GE) versus sell General Electric) in order to effectively navigate the situation from a financial standpoint.

This debate finds some very sharp cookies on opposite sides of the fence. A great number of intelligent thinkers are steadfast in their belief that inflation of a great magnitude is pending, while another large group strongly believes that deflation awaits.

How can so many smart people with very respectable thought processes be so diametrically opposed? One reason relates to differences in the definition of inflation and deflation. Some people define inflation/deflation in popular terms of price while others select a definition grounded in classic terms of money supply. Changes in money supply do not necessarily influence prices of all categories (i.e., goods, services, stocks, real estate, etc) in the same manner. Thus, grounding an argument in a price-based definition of inflation or deflation may not be comparable to an argument grounded in a money-supply-based definition.

Differences in time horizon may also be cause for separation. Some folks see only inflation or deflation for the foreseeable future. Others, however, view the future in phases. Some die hard inflationists envision a near term period of deflation before inflation really kicks in. Similarly, some in the deflation camp see a near term inflationary burst higher before lights out deflation.

That said, a great many individuals who possess similar conceptual definitions and time horizons still operate at different ends of the inflation/deflation spectrum. In studying the many arguments on both sides of this debate, I've concluded that differences of opinion seem to hinge on at least three underlying factors.

1) Paper money vs credit money. Inflationists assume fiat money systems permit governments to literally 'print' money at will. Because bureaucrats have a 'printing press' at their disposal, they will indeed print money in attempt to bail the system out during difficult periods.

Deflationists argue that expansion of supply in modern monetary systems does not depend on literal money printing but rather on the creation of credit. The dynamic of credit money creation is different from paper money in that it ultimately depends not on government's willingness to provide a large credit supply, but on credit demand. If demand for credit is low, then money supply may not rapidly expand.

2) Limits on money creation. Inflationists believe that, lacking the political will to do otherwise, bureaucrats will always resort to printing more money during difficult times. A landscape covered in dollar confetti is the logical outcome.

Deflationists argue that there is a limit to how much credit money can be created. More credit means more debt and increased risk. Creditors (in our particular case other countries such as China) will raise the cost of borrowing to offset risk. Facing the specter of higher interest rates, bureaucrats will be forced to let the system deleverage.

3) Monetary vs social phenomenon. Inflationists generally concur with economist Milton Friedman who once stated that inflation is ultimately a monetary phenomenon. Essentially, inflation is a function of the printing press and those who control supply.

Deflationists believe that inflation is ultimately a social phenomenon. Inflation depends on credit creation which depends on willingness to borrow which depends on an appetite for risk. Appetite for risk is a social, not financial, variable. Should collective risk appetite for risk be low, then those wishing to inflate the system are 'pushing on a string.' Essentially, inflation (and deflation) is a function of those who control demand rather than supply.

As I see it, which side of the fence you fall in terms of the above factors suggests whether you'll land in the inflation or deflation camp.

position in USD

No comments: