Deflationary spiral or inflationary nightmare? I’m more in the big inflation camp. But there are some compelling arguments out there for a more prolonged period of deflation than most people think, and we should know that ignoring outside perspectives is perilous. This piece by Lacy Hunt and Van Hoisington is one of the better cases I’ve read for sustained deflation. (pdf version).

The authors acknowledge the dire situation we’re in, and they make an admirable attempt to debunk the leading theories that say inflation is going to be a big problem, eventually. Overall the authors make a pretty darn good case, but I’m still not sold (see update at the bottom of post for Bill Fleckenstein and other takes on inflation, which I am much more inclined to believe). But here are a few excerpts from the deflationary camp:

Over the next decade, the critical element in any investment portfolio will be the correct call regarding inflation or its antipode, deflation. Despite near term deflation risks, the overwhelming consensus view is that “sooner or later” inflation willinevitably return, probably with great momentum.

Exploding M2 Money Supply and Fed Balance Sheet

These gigantic increases in the monetary base (or the Fed’s balance sheet) and M2, however, have not led to the creation of fresh credit or economic growth. The reason is that M2 is not determined by the monetary base alone, and GDP is not solely determined by M2. M2 is also determined by factors the Fed does not control. These include the public’s preference for checking accounts versus their preference for holding currency or time and saving deposits and the bank’s needs for excess reserves.

These factors, beyond the Fed’s control, determine what is known as the money multiplier. M2 is equal to the base times the money multiplier. Over the past year total reserves, now 50% of the monetary base, increased by about $736 billion, but excess reserves went up by nearly as much, or about $722 billion, causing the money multiplier to fall (Chart 3). Thus, only $14 billion, or a paltry 1.9% of the massive increase of total reserves, was available to make loans and investments.

Are Massive Budget Deficits Inflationary?

Based on the calculations of the Congressional Budget Office, U.S. Government Debt will jump to almost 72% of GDP in just four fiscal years. As such, this debt ratio would advance to the highest level since 1950 (Chart 5). The conventional wisdom is that this will restore prosperity and higher inflation will return. Contrarily, the historical record indicates that massive increases in government debt will weaken the private economy, thereby hindering rather than speeding an economic recovery. This does not mean that a recovery will not occur, but time rather than government action will be the curative factor.

It’s a good argument, but I still believe in Bill Fleckenstein‘s mantra, “In a social democracy with fiat currency, all roads lead to inflation”. Inflation is just too attractive of an option for debt-laden entities like government, corporations, wealthy homeowners, etc. Massive inflation would make all that debt a lot easier to pay off. For a great piece summing up this school of thought, read this article by Ed Bugos. Here are a few excerpts:

But many believe the bank “multiplier” is crippled by exploded balance sheets and a weak consumer, and that the Fed must lean on alternative modes of transmitting its inflation policy – if it wants to avoid Armageddon, that is! -as if money and credit expansion were synonymous with economic growth.

Theoretically, those reserves should already be sufficient to fuel the creation of more than five trillion dollars, easily doubling the money supply (the Austrian School definition) within a couple years. Furthermore, it should be recognized that money supply growth is in no way anemic.

Update: I wrote into Bill Fleckenstein’s Q&A (part of his newsletter, $120/year, great deal IMO), and asked about this case for deflation. Here’s his reply was this:

They don’t have an argument… they compare now to two prior periods 1874 and the depression (when we were on the gold standard) when the USA experienced deflation, and also to Japan slight of hand… and seems to say because the situation is similar so will be the outcome… but what’s different is the printing press and fiat money… it’s just that simple… it’s all about the printing press… there is no chance we will experinece deflation until the printing press is taken away… period…

In case you were wondering, yes, I feel kinda stupid asking the question now. But where else can you get access to an expert like that for $120/year? Pretty killer deal, I highly recommend it.

Update – I tried to include charts, but somehow it screwed the page and my template up. I recommend reading the original sources (both Bugos’ and the deflationary one) to get the full effect with charts and all.