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Could We Have Both Deflation and Inflation At the Same Time? (June 5, 2006) 
Are we heading into an era of deflation or an era of inflation? Getting it right will
be key to making money as an investor. The general prognosis is solidly in the
"inflation" camp; the argument is powerful and goes something like this:
On the deflationary side, analysts such as Mish over at Mish's Global Economic Trend Analysis, argue persuasively for a deflationary environment, based on the similarities between the property and debt bubble Japan experienced in the late 80s and the housing/debt bubble in the U.S. This deflationary environment is fundamentally a financial retrenching of unsustainable borrowing/debt (see chart above): Both arguments seem sound, but only one can be right. Or can they both be right? I would say yes: assets could suffer deflationary pressure for years, even as the cost of living rises. How could this happen? The key to understanding asset deflation/cost-of-living inflation is the explosive rise of liquidity. Central banks around the globe have created trillions in cheap-to-borrow money; money supply has grown far faster than the underlying economies. China's GDP is supposedly growing at 9%, but their money supply grew at 22%. In the U.S., GDP has been clipping along at 4% while the growth in money supply has often exceeded 10%. Normally, all this borrowed money chases goods and services, creating inflation. For the past decade, it has chased asset classes: stocks and bonds, and more recently, commodities and precious metals. Why haven't goods risen in price along with the vast inflation of easy money? The usual reason given is that tradable goods have migrated to low-cost nations, just as they have for centuries. With labor costs 10% of or less of developed-nation wages, it's unsurprising that goods have dropped in price even as profits hit unprecedented heights. As reported on CBS-Marketwatch: Profits surge to 40-year high: U.S. corporate profits jumped 21.3 percent in 2005 to $1.35 trillion. Profits have been boosted by strong productivity gains and low wage growth, and now account for their largest share of national income in 40 years -- 11.6 percent.So productivity and globalization of production have effectively capped inflation. But why has the world borrowed money to chase assets? Simple: with money dirt-cheap to borrow, and lending standards lax enough for just about any company or individual to borrow vast sums, the flip side is this: saving money makes no sense because the yield on cash is absurdly low. The upshot: a global search for yield which has created a huge appetite for risk and speculation. OK, so as the debt bubble bursts, pulling the prop out from beneath the asset bubbles, then this reduction in borrowing and asset appreciation causes a recession. And in a recession, prices drop, right? Not necessarily. Why? For one, "Baumol's disease." This is an economic term which describes how service labor costs rise regardless of recession or global forces on production costs. If you think about it, it makes perfect sense. The vast majority of the U.S. economy and workforce is service-related--there are 8 million more government workers (22 million) than there are manufacturing employees (14 million), and 76 million "service workers". Net result: even if the price of TVs and particle-board shelving drop to near zero, the majority of household expenses remain service or debt-related. Put another way: if tradable goods make up 5% of household expenses--stuff you cart home from Ikea and Wal-Mart which was made overseas--and those goods drop 50% in price, then the actual reduction in household expenses is actually very small. Meanwhile, if costs in all the services which cannot be shipped from China--college education, medical care, rent, your rising ARM (adjustable rate mortgage), UPS shipping, air travel, etc. etc.--rise, then those higher costs will unavoidably impact household expenses in a major way. There are a lot of tricks played within the Consumer Price Index which tend to make inflation look lower than it actually is. For instance, take medical care. If your provider pays vast sums for tests and medications which weren't even available for treatment ten years ago, isn't that inflationary? In other words, the cost of treating X was $1,000 ten years ago and now it's $50,000. Isn't that inflationary? You'd think so, but adjustments are made to compensate for product/service quality, the so-called "hedonic" calculations. But however you slice it and dice it, medical care as a percentage of GDP has grown far faster than GDP, even as American have become less healthy than our counterparts in other nations. Yet as medical costs continue to rise at a fast pace, the "official" rate of inflation remains at near-historic lows. If you scrape away the fancy calculations, it seems clear that actual inflation is far higher than official statistics suggest. If you add up the parts of the U.S. economy which are largely unaffected by trade, you end up with most of the U.S. economy. As asset deflation eats away at lenders' equity and ability to lend, interest rates rise and liquidity dries up. People spend less because they can't borrow cheaply any longer. While this may mean lower prices on goods, it won't lower the cost of services which are essentially non-competitive: city garbage workers' salaries, medical care and a college education-- industries which exhibit inexorable increases in costs regardless of globalization or the cost of money. So that's how the cost of living could rise even as assets depreciate under relentless liquidation. Yes, yes, there are currency considerations and the cost of energy and much else to throw into the pot; these can certainly influence the cost of living and borrowing, but they cannot cancel out the forces described above. For more on this subject and a wide array of other topics, please visit my weblog. 
copyright © 2006 Charles Hugh Smith. All rights reserved in all media. I would be honored if you linked this wEssay to your site, or printed a copy for your own use.
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