I’ve maintained for quite some time that the greater risk to the global economy is the continuing threat of deflation (see here). In my opinion the Greek debt contagion clearly shows this to be the case. While signs of inflation appear benign at best, the dollar continues to rally and the inflationistas are once again forced to put their doomsday scenario of imminent US bankruptcy and US dollar collapse on the back burner.
In my opinion, what the inflationistas have all missed is the disconnect between actual “money printing” (I prefer button pressing) and increased money in circulation. Monetarists and Austrians have generally made the false assumption that button pressing equals increased money supply – as if the money is literally dropped out of helicopters into the hands of the public. The last 18 months have proven that is simply not the case. That is not how the monetary system actually functions. So why hasn’t all this “button pressing” turned into higher inflation? Because the money isn’t actually getting into the hands of the public. It’s mostly sitting on the floors of bank vaults (or more appropriately, in on-line accounts). As I’ve said many times before, dumping a canister of iced tea into a pitcher of water doesn’t give you iced tea – at least not until it is stirred in!
In the Fall of 2008 Ben Bernanke made the classic monetarist gaffe of assuming that banks were reserve constrained. In other words, if you can simply fill their vaults with money they will be more willing to lend. Well, that’s clearly not true. This is as silly as assuming that you can sell more apples at the market so long as you double or triple your inventory of apples. But lending, much like any market, is two sided. There has to be demand AND supply. Bankers will lend money to any creditworthy customer – they’re not reserve constrained. As of now, there continues to be very little demand for credit and even fewer creditworthy customers. This is why we have seen no pick-up in lending. Banks are effectively hoarding the cash, loan demand remains low and therefore money circulation remains weak.
Why is this happening? Because, as we’ve previously noted the private sector is still saddled with too much debt and de-leveraging continues. Adding fuel to the fire is the weak situation in the labor markets and generally low capacity utilization. This economy is still very weak despite the recent “mission accomplished” banners strewn across the covers of most major business magazines. The summation of all this has resulted in almost no actual increase in the money in the real economy.
Many have argued that the recent surge in commodity prices is a sign of impending inflation. I don’t see this as a sign of impending inflation, but rather a sign of the long-term changes in the supply/demand picture. As Absolute Return Partners recently detailed, the actual fundamental reasons for increasing commodity prices has been quite positive. World Gold Council also detailed a report on the improving fundamentals in the gold market. In addition, much of this cost push has been due to improving underlying demand in the global economy. Thus far, we are not seeing any signs that corporations cannot pass these costs (what little there are) along.
For those who are still not convinced I would reference the previous few weeks. The last few weeks have been a great example of the flawed inflationista argument. While it’s not entirely fair to cherry pick a few days I do believe the last few have been a fairly good barometer of just how wrong the inflationista argument has been. Most of the hardcore doom and gloom inflationistas believe the world is due for a crippling downturn that will involve massive sovereign defaults, a collapsing dollar and likely a depression. They might have part of that argument correct, but not due to some stroke of brilliance, but rather sheer luck. They have misunderstood the the monetary system and have failed to connect the dots. This is why the asset performance of many portfolio managers betting on such an outcome has been mediocre at best. We continue to see the EXACT opposite of their proposed scenarios play out – that is, the dollar rallies, commodities get crushed and paper assets such as bonds and cash prove to be the only true safehaven. The recent microcosm of the return of the credit crisis in recent weeks is a clear sign of how assets are likely to perform in this doomsday scenario – the inflationistas will get crushed just as they did in 2008.
Why will they get crushed in such a scenario? Because this is a continuing deflationary environment where high debt levels are worked off and asset prices generally correct lower. That is, all of this government intervention is still failing to overcome the deflationary forces at work and this economy could get very interesting over the coming 12 months as government intervention slowly ends and deflationary forces reassert themselves. Of course, it’s important to note that I don’t believe the government can simply print our way out of a downturn, but understanding actual monetary operations and the effects of government intervention is vital in knowing how assets will perform should the markets take another dip. Avoiding paper assets in this environment due to a flawed understanding of fiat currencies will be detrimental to your portfolio’s performance. After all, this is not an inflationary environment my friends. Not even close. Allocate properly.