Inflation or Deflation?

People who follow and understand true free market economics, namely, the Austrian economists, know that current policies instituted by the U.S. Government and the Federal Reserve Bank, which “owns” our government, agree that current policies are leading America on a road to economic and political hell. But which road to hell we travel on is of great importance in our attempt as individuals to avoid that trip or at least prepare ourselves with some kind of asbestos suit to reduce the pain and suffering once that hell is thrust upon us by the communist/fascist/crony capitalists who are planning damnation for all of us middle class folks.

The majority of Austrian school advocates envision a hyperinflationary outcome. They simply reason that despite the ability of the Federal Reserve Bank to create an infinite amount of money out of thin air, the currency will eventually become debased and the price of everything denominated in that currency will approach zero. In other words, they envision a hyperinflation that at its extreme would rival that of the German Weimar Republic prior to World War II or that of Zimbabwe today. People like Peter Schiff, John Williams, Ron Paul, and many more whom I have interviewed on my radio show are in this camp.

On the other side of this argument are those who believe that the massive amount of debt is too great for central bankers to overcome, no matter how much money they can create. The deflation proponents believe that creditors will not accept being repaid with worthless money and that they will force interest rates higher, which in turn will force a rise in the currency and thus cause prices to decline. Some deflationists like A. Gary Shilling also believe an excess of supplies play into this deflation dynamic that result in what Dr. Schilling calls “good” deflation. Dr. Shilling has been on my radio show, as has Mish Shedlock. More extreme deflationists who have been on my radio show have been people like Ian Gordon and Robert Prechter, both of whom believe the Dow Jones Industrials are heading for 1,000 or below.

Look to the Markets for Direction

This question as to which path the current economic pathology will take is more than an academic question. It is of paramount importance, because getting it right will determine whether you are successful or not with your investments.

If we are heading toward hyperinflation, you will want to own tangible assets and, to a lesser extent, perhaps stocks that are backed by tangible assets and solid balance sheets. You may even want to take on some debt if it allows you to buy more and then pay back with cheaper dollars. But that may be a very risky choice if you are wrong or economic dislocations caused by hyperinflation lead to disruption of income and markets in general. This is not an optimum for businesses in general, because in many if not most instances, the cost of production may rise much faster than revenues from sales, and depending on how severe the inflation, costs may rise so rapidly that it is impossible to plan your business from day to day or, in very extreme cases, from hour to hour.

On the other hand, if we experience a deflationary depression, asset prices denominated in dollars are likely to crash. In that event if you have debt, you will be in big trouble, because you will owe that debt in nominal terms, but the amount of income you can expect to receive from which to service that debt is likely to decline massively. You will want to hold liquid assets rather than tangible assets. If Robert Prechter is right, the dollar will increase in value and gold will decline relative to the dollar but rise against almost everything else except the dollar. If Ian Gordon is correct, the dollar will decline massively, even with a decline in nominal prices of stocks and all tangibles, with the exception of gold, which he believes will rise to over $4,000, even as the Dow plunges to 1,000.

Which of these views is correct? Frankly, I do not know. I hear and understand complex arguments on both sides and I cannot completely make up my mind, which is why I created my Inflation/Deflation Watch (IDW). So if one lacks the conviction as to which way this economic disease will play out, what is one to do?

I believe Richard Russell has the right attitude about this and other issues, and that is to “let the markets decide.” And so I created my Inflation/Deflation Watch on January 31, 2005, which is pictured above. As you can see from the picture above, both advocates of inflation and deflation have been right.

From January 31, 2005, when I created the IDW with a base value of 100, the IDW climbed by 46.87% by April 18, 2008. That doesn’t qualify as “hyperinflation” but it is an asset price inflation rate of approximately 14.5% annually. For people fortunate enough to own stocks and to own commodities (as opposed to needing to buy to stay alive), these are very satisfying numbers. If you don’t own stocks, as is the case with most Americans, or if you don’t own commodities but must purchase them to stay alive (items like clothing, food, energy, and materials as in the Rogers Raw Materials Fund), this rise in the IDW was an impoverishing event.

The deflationists “won” from April 18, 2008 through March 6, 2009. From the April peak of 146.87, the IDW declined to 93.64 by March 6, 2009. That represented a decline of 36.2% decline in approximately 10 months, or a 43.5% annualized decline. In fact, that decline, which accelerated following the Lehman Brothers failure, fell 6.36% from our IDW starting point of 100 on Jan 31. 2005.

But the inflationists have been back in charge since the Bernanke Fed have thrown everything including the kitchen sink at the market’s natural deflationary movement. Since the March 2009 market bottom at 93.64, the IDW has risen 67.5% to 156.81 as of the close of business today.   Moreover, as you can see from the chart above, the IDW has now broken out above a pennant formation that dates from the 2009 bottom to the April 20, 2011, top. At this point, there seems to be nothing getting in the way of a major breakout to much, much higher asset price inflation.

That is not to say that things are healthy. To the contrary, the global economy continues to become more and more pathological with each new $85-billion-per-month money printing by the Bernanke Fed because it is increasing the amount of debt in the global economy and it is causing mal investment and a massive misallo­cation of capital that will continue to increase the gap between income (GDP) and debt.

Actually as you can see, there has been a discontinuation of total debt for the time being, but that has come entirely from the productive private sector, while the parasitic government sector has increased the debt load of all of us citizens in a very dramatic fashion, which means we will see our standard of living decline over time as our purchasing power declines either from direct taxation or through inflation that reduces our standard of living or through a combination of the two forms of taxation. Those two forms of taxation are pulling in opposite direction. Printing press money aimed at stimulating the economy but only serving to push up commodity and stock prices without adding to the supply side of the economy leads to inflation. On the other hand, loss of purchasing power by the consumer and corporations along with still massive private sector debt enhances deflationary forces. These forces are tugging and pulling in opposite directions. For the moment, the infla­tionary side is winning, so we are going long on assets that work in this environment, like gold and energy. If the tables turn in the other direction again, we will be more bullish on gold shares and less on most other commodities, but still will want to own gold and to a lesser extent silver.

What’s In the IDW?

The IDW is a non weighted and non back-tested index that is meant to give me a broad sense of whether financial assets are expanding in price or contracting in price. As such, I have broad-based stock, bond, and commodity proxies to help me get a sense of direction. Here are the basics for my IDW:

Broad-based U.S. Stocks – S&P 500
Broad-based China Stocks – FXI
Broad-based Indian Stocks – IIF
Consumer Stocks – Wal-Mart
Auto Stocks – Toyota
Housing Construction – HGX
Real Estate Index – IYR
Commodities Basket – The Rogers Raw Materials Fund
Oil – Lt. Sweet Crude
U.S. Dollar Liquidity Index (foreign holdings of US$ Plus Monetary base)
Ratio of Gold/Silver (Rising gold to silver is deflationary)
Ratio of Gold/Rogers Raw Materials Index (Rising gold/Rogers Fund is deflationary)

This index is a non scientific, non back-tested index that simply provides a very broad-based global reading of whether markets are inflating or deflating and the trend on an ongoing basis. As of this writing on February 8, 2013, the IDW has broken out from a pennant formation and appears to be heading toward a new all-time high. Stay tuned. Click our IDW image on the right-hand side of our Home page at for weekly updates.