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It’s a popular notion when the financial winds are blowing unfavorably:
Money is being printed uncontrollably … inflation is the only option … fiat currencies are doomed.
The thing is, if you’re buying into this idea, you’re mostly perpetuating a misconception. Actually, inflation isn’t as simple and certain as it’s cracked up to be.
Until the global economy recently got tossed on its rear end, prices were rising in most every part of the world. The focus, of course, was on the cost of energy, food and various other raw materials. Central banks in a position to stand firm on monetary policy did so at all costs. Inflation was the real threat.
But did that idea get turned around in the blink of an eye or what?
Prices for natural resources have collapsed and continue lower still. Economies, developed and emerging, are feeling the pain of a U.S.-led slowdown. Global capital flow is shifting direction and composition. In other words, money is escaping risky assets and making a beeline to safer U.S.-dollar based assets and cash.
The majority is starting to agree that deflationary forces are becoming strong. And at times when recession spans much of the globe, any upward pressure on prices nearly vanishes.
But even those joining the deflation camp now have no idea what to expect in the future. They see all the money being pumped into the system and feel as though that seals the deal on a nasty wave of inflation not far down the road.
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To That I Say, “Not So Fast”
Simply printing money can be the cause of inflation, but that is not always the case in a sophisticated economy where money and credit combine to produce wealth. Money must be spent, or make it down into the real economy where real people buy real stuff, otherwise it won’t do the trick for those harboring inflation expectations — i.e. it does not provide economic stimulus in the form of rising prices. The best recent example of this comes from Japan.
When the stock market bubble burst in Japan back in 1989, then the real estate bubble burst a couple of years later, the Bank of Japan pumped massive amounts of yen into the financial system. In fact, the bank pushed interest rates to zero in Japan. If it was all about money, then Japan should have experienced runaway inflation. But the money pumped into the system never made it to the real economy because, even at zero percent interest rates, no banks wanted to lend and few showed up to borrow.
Why? Japanese banks had a massive amount of bad debts on their books. And they were using the Bank of Japan in providing liquidity to save themselves first and worry about lending later. Japanese consumers, after being crushed by the stock market crash and watching real estate investments crumble, weren’t interested in borrowing anything at any rate. And many had no collateral left to borrow even if they wanted to. Does any of this sound eerily familiar?
There was a major sentiment shift in Japan when the bubbles broke. Despite all the money the Bank of Japan continued to pour into the system, and no matter how much fiscal stimulus the government provided, real people shunned borrowing, lending, and investing.
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| When the Japanese stock market burst, fiscal stimulus packages failed to boost borrowing, lending or investing. Sound familiar? |
The bottom line: Japan became locked in the bear hug of 14-year long deflation. Many believed they finally emerged from this grip, thanks to a positive 1% print in the Japanese consumer price index. But the credit crunch that is morphing into a threat to the global financial system, is pulling Japan back into the vortex of deflation. In the final analysis, all that money didn’t matter.
Sayonara, Conventional Wisdom
This example proves that despite the best efforts of government officials to eliminate the business cycle and fight against the forces of the market, they usually end up prolonging the problem. Had Japan allowed for a huge wave of bankruptcies, effectively clearing the deck of all the dead wood and debris, they would likely have shortened this deflationary period considerably and set the stage for the strong, well-managed companies to prosper.
This is a critical point, because if we think of a world with unlimited resources, it is the most efficient use of those resources that provides healthy growth for the entire system. It is why poorly managed institutions that waste resources should be allowed to fail, and the best managed allowed to profit without being hampered by competition that otherwise wouldn’t exist if it weren’t for the best intentions of government.
The question is, will the weight of all this money become inflationary at some point?
The answer is maybe. We are in the midst of a major global debt implosion. Writing off bad loans is deflationary because resources (money and credit) that could otherwise be used to create real value in the economy in the form of loans to businesses and entrepreneurs, are basically poured down the rat hole of past malinvestment.
The question of when inflation returns may be more social or psychological than anything purely quantitative. Until real people are willing to borrow and lend again, in what we consider a rational risk-taking approach, it is unlikely monetary stimulus will do anything than allow the economy to muddle through at best.
So inflation returns when sentiment shifts back to a world with a healthy risk appetite. The two key sentiment and wealth drivers for most investors in the developed world is their house and their investments for retirement — both have been ravaged and continue to be. It means a return of healthy risk appetite may be further down the road than is now expected.
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| Writing off bad loans is deflationary because resources that could create real value in the economy are poured down the drain of past malinvestment. |
What Does This Mean for the Dollar?
My long-term view has been, and continues to be, that the U.S. dollar has entered a multi-year bull market. That view is only validated in this environment.
The U.S. dollar is the raw material, or fuel, for risky asset investing around the globe. When people want to target higher returns, they move money offshore to the periphery, to emerging and developing markets of the world that grow the fastest when money and credit are abundant. Thus, think of the dollar as greasing the wheels of financial markets around the globe.
And despite what you hear from so-called gurus, the buck is the world reserve currency; a status that is not in jeopardy. Thus, as sentiment concerning risk taking continues to spiral lower and lower, more and more funds flow back from the periphery to the center where capital markets are deepest. U.S. capital markets are the deepest by far. It’s why you see U.S. Treasuries rallying as big pools of money run to hide. So in this deflationary, risk-adverse world, the U.S. dollar is king once again.
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There is one chart I think best expresses this reality. It is the commodities index divided by the U.S. dollar index.
When global growth is humming and money is flowing, investors want to be involved in emerging and developing economies that benefit mightily from commodities demand.
As you can see on the chart, that sentiment has run its course and is diminishing fast — and that’s very bullish for the dollar.
Best wishes,
Jack
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