Inflation versus Deflation

My father-in-law and I have an ongoing debate.  Which is the greater evil facing the United States and its currency today – inflation or deflation?  My father-in-law comes down on the side of deflation; I am in the inflation camp.  Thus far, I will concede that he has won the first skirmish, but I am convinced that sometime in the next 24 to 36 months or so I am going to win the war.  Unfortunately, I believe the war will be a fairly long one, but mercifully not as long as it was in the 1970s and early 1980s.

I side with the great Milton Friedman and firmly believe that inflation is always and everywhere a monetary phenomenon.  The Treasury and its co-conspirator, the Federal Reserve, cannot create money and expand balance sheets faster than the growth of GDP without creating inflation at some point.  It is simply not possible to have a zero rate interest policy and continue along the path America is on and not face monetary repercussions down the line.  The effects are not felt immediately; our country did not spiral upward (or downward depending on your perspective) into inflation due to the tremendous expansionist policies of the late 1960s until the 1970s, but once inflation expectations took hold, our nation was only able to halt its pernicious effects through the painful medicine Paul Volker administered in the early 1980s.  We will go through this cycle again but since everything happens at a much quicker pace today, I expect the US will cycle through the process in 6 or 7 years rather than the 15 years or so it took the last time around.

There are many economists and pundits who believe that it is virtually impossible for inflation to take root in the current economy because the United States is relatively open to free trade and global competition and is currently operating at low capacity utilization (especially in manufacturing) and high unemployment.  To those economists, just point to Zimbabwe of this decade, Weimar Germany in the 1920s and early 1930s or even the US of the 1970s.    

Will inflation be as bad as it was in the 1970s?  I think the inflation scenario will play out in one of two ways – either it will not be quite as bad as the 1970s because it will not last as long or it will be much worse because it will spiral out of control and dramatically devalue the dollar.  I think the former scenario is far more likely, but the latter scenario is a distinct possibility that cannot be overlooked.  A repeat of 1970s style stagflation is unfortunately a relatively near term future that I can easily envision. 

Once again, the US mañana culture that gladly pays on Tuesday for hamburgers today, has not learned the lessons of history, has not weaned itself off of foreign oil, and oil will once again be the catalyst for the next round of inflation.  The recent turmoil in the middle east will probably only hasten the onset of inflation as food and energy prices rise and then workers will demand wage increases to cover these food and energy price increases.  Higher price expectations will then flow through the entire system.  Price pressures from imported foreign goods where inflation already exists will exacerbate the issue.  Although we have not yet witnessed much of this pernicious cycle in the United States, one can already see its nascent climb in several emerging markets – especially in Asia.

As soon as consumers believe that they can actually handle the amount of debt that they owe (they cannot quite do so today) and that they can pay off their debts with cheaper dollars tomorrow, they will stop paying down debt at the rates at which they are doing so today and the inflation cycle will begin.  Does this cycle begin in 2012, 2013 or 2014?  Well, that is a question for the big hedge funds.  The answer is beyond my pay grade.