Yesterday I attempted to answer the inflation-deflation question by asking who would benefit from either environment. Trade of the Decade: The Power Elite's Grand Strategy (October 25, 2010)

Longtime contributor Cheryl A. responded with an excellent question about what some call inflation but which could also be seen as the depreciation of the dollar:

While on one hand I understand the logic of your argument, I have difficulty when I look at the decrease in value of the dollar over the past 80 years ($1 to .05). Why would the elite stop devaluing the currency now?

For an answer, let's look at the Bureau of Labor Statistics' inflation calculator and a chart of the Dow Jones Industrial Average as a handy proxy for the stock market. Let's start at 1913, which is the earliest year the BLS tracks.

It now takes $22 to equal the purchasing power of $1 in 1913 (coincidentally, the year that the banking cartel known as the Federal Reserve was conjured up). Put another way, the dollar has depreciated to about 4.5 cents since 1913.

Cheryl raises a critical point: if the Financial Power Elites allowed the dollar to lose 95% of its value over the past 100 years, why would they decide to hinder inflation/dollar-devaluation now?

I think the answer is that the assets they owned more than offset the decline in the dollar's purchasing power. If we call up a chart of the Dow Jones Industrial Average going back to 1900, we find that in 1913 the DJIA was around 70.

If the DJIA had risen 22-fold to match inflation/dollar depreciation, then it would now be around 1,540 rather than around 11,000. The stock market rose about seven times the rate of depreciation, more than offsetting the loss in purchasing power of cash under the mattress.

Interestingly, the 15-year Bear Market 1966-1981 was a period of rampant inflation which reduced the purchasing power value of stocks by 2/3.

This destruction of value led to reduced participation:

Financial Elites' positions in common stocks in that period (if any) suffered the same destruction of value as those held by retail investors.

But as Harun I. noted in our recent email exchange, the Elites tend to place most of their holdings in bonds and preferred shares, which pay a higher dividend than common stock.

While I have no data on what happened to the holdings of the top 1% who own most of the financial wealth during the 1970s, it is quite possible the Elites' suffered dramatic declines in their purchasing power. The market value of long-term bonds were destroyed as inflation ramped up, but those who avoided the long bonds and kept liquid were able to buy long bonds that yielded 15% by 1981.

Imagine earning 15% every year, rain or shine, for 30 years. Those 30-years bonds from 1981 will finally expire next year.

The oil shock and stagflation created a challenging environment for everyone, Elites included, and I think it is reasonable to assume that Elites' fortunes were made and destroyed in a capitalist dynamic: those who stayed in common stocks suffered a 2/3 decline in their real wealth in 15 years, those who stayed in short-term bonds and rode the gold bubble up did well, as did those who bought long bonds in the early 1980s with spectacular yields.

My point is that the Financial Power Elite is not monolithic. Those whose wealth was based on industrial capital saw their wealth decline, and those who rode the financialization of the U.S. economy prospered mightily.

Just as a speculation, I would say mild inflation (2%-3% a year) is acceptable to Power Elites as long as they can get real asset growth that exceeds that by a significant margin.

In a low-growth or declining economy, though, then zero-inflation or mild deflation would be the preferred environment. If we have indeed entered an era of declining GDP, then it will next to impossible to engineer strong gains. Thus the Power Elites strategy would be to engineer mild deflation (-3% annually) which has the effect of increasing their purchasing power by 3% annually.

If interest rates rise as well, then that would be even better: getting 7% yield in a 3% deflationary environment would equal a real return of 10%.

The reason the Power Elites would not favor aggressive deflation is that this would bankrupt the debt-serfs, central State and heavily indebted corporations which service the debt owned by the Financial Power Elites.

This is why a mildly deflationary environment with rising interest rates would be the optimum setting for cash-rich Elites. Some will say that interest rates can't rise in deflationary times, but I would suggest rising rates are not just possible but inevitable if the demand for cash to roll over old debt meets insufficient supply of cash in a deleveraging, crashing-commodities prices, Central-State austerity era.

Reader KH had an astute question about my confusing statements about gold.

There was one bit that I didn't quite understand -- you say that if you had $5bn you would maintain your precious metals positions, but a few lines later you say that the higher the value of assets (i.e. gold), the quicker they will be unloaded for cash. Isn't that an inconsistency? I'd be very grateful if you could explain.

What I should have said was the Power Elites would retain their precious metals positions as a hedge even as the price plummeted. The sellers would be those trying to raise cash to roll over old debt that's coming due, or to raise cash to service the debt thay can't liquidate.

As the CEO of Cantor Fitzgerald said in the current issue of BusinessWeek: "It's hard for bad things to happen when you have no debt." That might just be the quote of the decade.

KH also made an important observation about interest rates and deflation.

You say that "I would sit on my hoard of cash while the selling created a positive feedback loop". Where would you put the cash, because under those circumstances, you wouldn't want to have a few billion dollars in a bank at a time when the banks would be at risk of going bust. Wouldn't the only comparatively safe place be treasuries in the short term? If so, that would drive down interest rates to near zero levels. In a deflationary environment, that could still mean positive real interest rates.

Exactly. This was the point I tried to make in The Con of the Decade (July 8, 2010). Smart money will sit in short-term bonds until interest rates suddenly leap, surprising "everyone," at which point they will shift into long bonds to lock in high returns.

My recent point is that the other "trade of the decade" will be in commodities--but only after prices are smashed by the crash of demand as the global economy enters the Depression which was temporarily delayed by a gargantuan (and unsustainable) surge of sovereign and corporate debt.

Thank you, Cheryl and KH, for excellent questions. Nobody knows what will happen, and these are simply speculations informed by the question: cui bono: to whose benefit?


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