Tuesday, February 19, 2008

Hyperinflation or Deflation?

Longtime correspondent Cheryl A. posed this cogent question after reading
System Instability, Redundancy and the Domino Effect:

"Regarding today's column: If I understand correctly, you speak of an implosion in about 4-5 years. Are you referring to a deflationary implosion? Is this similar to what Puplava refers to as a hyperinflationary depression in 2010-2012, except that you believe the price of oil and food will fall?"

Yes. As we all know, there are two "dominant paradigms" which are called upon as models of the near future: a Weimar Republic-type hyperinflation, in which the central banks attempt to re-inflate a bubble via pushing mountains of fiat money into the system, and a Japan-style deflation, in which the central bank pushes interest rates to near zero but people refuse to borrow more, or are so strapped they can't borrow more even if the money is nearly "free."
If we start with the supposition history doesn't repeat, it echoes, we should be wary of "mapping" the present with an overlay of the past (which had its own unique features) and expecting a near-perfect match.

I have been working recently with the idea that neither "hyperinflation" nor "deflation" as concepts do justice to what lies ahead, though each retains some utility. I have been deploying "purchasing power" as perhaps the more powerful concept, for this enables us to see that we might be able to buy more or less of specific classes of goods and services at the same time, regardless of whether money supply is expanding (inflationary) or contracting (deflationary).

Put another way: how useful is it to term an era "deflationary" if your purchasing power for essentials is plummeting? How useful is it to term an era "inflationary" if your purchasing power is rising for essential items?

As always, the categorical answer might be too reductionist to have any value. The human mind prefers a simple, global answer, i.e. one which "makes sense of the entire world." Complexity is confusing, and so we avoid it whenever possible. We seek instead the single causal factor which underlies the complexity. This works for systems such as planetary motion, but less well in systems with millions of interactions, i.e. the immune system and markets.

It might be more fruitful to turn away from seeking "global answers" and look to market forces, which tend to seek equilibrium. Let's take skyrocketing food prices as an example. We all know rising demand for grain-fed meat in China and U.S. demand for biofuels has been rapidly driving the cost of grains and soybeans up.

To my amazement, many seem to take it as an article of faith this trend cannot reverse. But a funny thing happened on the way to an irreversable trend: farmers decided to profit from skyhigh prices by bringing marginal or fallow land into production:More Grain Production Sought.

China has a very entrepreneural culture and in some ways, an entrepreneural economy. With the cost of food rising--recent headlines are full of stories like this-- "Soybean and soybean oil futures in Chicago soared to a record on speculation demand from China will climb after winter storms damaged the nation's rapeseed crop"--will China's farmers respond in some fashion? Do you think it possible that some youth who left the farm for a $150/month factory job hears about the small fortunes being reaped back home and decides to quit and grow the "hot" crop of the day for a much better wage than can be had in a factory?

Has China already completed every possible step in the long process of raising agricultural efficiency and yields? That would be hard to believe. Yes, the dust storms in the dry north are worsening, and everywhere the air, land and water are being threathened by industrial pollution. These problems have been covered here in depth for years. But China is a big country, and the south has plenty of water. To predict China's food production can't possibly rise to meet demand, or that demand won't fall as prices rise is to ignore ag commodity history.

For a history of grain's wild price swings, please read Merchants of Grain (recommended here by frequent contributor Albert T.). Grain prices have and will remain volatile for a number of reasons, most relating to supply and demand which are in constant flux.

The same is of course true for copper (high demand based on construction), oil and every other commodity. As prices rise, new supplies are sought and demand gets crimped.

The global grain bubble: As prices soar, riots rise. But it's not for lack of crops. The cause? A rush to biofuel and grain-fed meat. Let's suppose that a global recession will cut oil demand by a lot more than is currently assumed. Recall that prices in a relatively open market are set on the margin. Thus it is the shortfall or surplus of a few million barrels a day which sets the price on the 80 million barrels a day the world consumes.

When conservation measures cut demand in the U.S. by millions of barrels a day in the 70s and again in the 80s, the price of oil declined. When the Asian Contagion lowered demand for oil in southeat Asia, the price collapsed to $10/barrel in 1999. Yes, I am well aware of Peak Oil, but I have been alive long enough to see many trends which seems fixed break down and reverse as the market sought equilibrium.

So oil demand drops 8 million barrels a day and the price falls in half. What happens to biofuels? They're no longer economical (if they ever were). Ethanol production sags and suddenly there's a glut of corn.

Coal is now shooting up as China's attempts to fiddle with inflation by controlling prices has led to shortages. Recall that manufacturing is a huge consumer of electricity in China. So what happens as the U.S. and the rest of the world slip into recession? Maybe the factories lay off one shift, and other less efficient factories are shuttered. Demand for electricity drops. Then demand for coal drops.

Maybe food prices will continue jumping by leaps and bounds; crop failures could easily make it so. So if we declare "deflation", what does that mean if your money buys less and less food and energy every month?

Conversely, if we declare "inflation," but bumper crop yields cuts the price of grain in half, and a global recession drops oil demand by 10% ( 8 million barrels a day), slicing the price of oil in half, then we can purchase more food and oil with less money, i.e. our purchasing power has increased despite "inflation."

This is why I am wary of declaring "one size fits all" concepts in a complex world. No one knows if rents will rise or fall as the housing bust creates new demand for rentals and millions of empty dwellings are put on the market. Rising demand could raise prices for rentals, while expanding supply of new rentals (formerly spec homes and condos) could drop prices at least in those areas which have abundant supplies of bubble-era housing.

Tight money doesn't mean speculators won't be buying condos to rent out; it simply means they will be purchased for cash, or 20 cents on the dollar. If the investor's cost basis is low enough, then he/she can drop the rents slightly below market to attract tenants.

Conversely, "low interest" loans won't attract investors if rents won't cover taxes, interest and maintenance costs.

My point? Look to market forces and purchasing power before placing too much predictive weight on either "deflation" or "inflation." Based on market forces and the idea that this recession will not be brief or shallow, but deep, long-lasting and global, I expect demand for all commodities and services to shrink significantly just as supplies increase to meet the predicted (and now phantom) demand.

I also expect oil exporters which rely on oil revenues to fund their welfare states/subsidized food and energy to create a feedback loop of ever-rising inventories and ever-falling demand which will drop oil lower and lower as the recession takes its toll on the global economy.

This is just one of many such feedback loops of supply and demand which will play out as equilibrium is sought on a global scale. In the sense that money is also a commodity, then feedback loops of supply and demand for money will also play out. My prediction was based on the notion that equilbrium is 4-5 years away, and that it won't be reached until all bad debt/worthless securities/properties on the planet are written off/sold off/renounced.

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