The Alta Californian

This inflation versus deflation debate has gone on long enough.  Here are my thoughts on the subject:

Bottom line: if you destroy tens of trillions (credit contraction), but only add trillions (govt. debt spending and Fed balance sheet), you absolutely must have deflation.

Someday, once asset prices have finished coming down (mostly), continued expansion of the money supply could start to produce significant inflation.  But, in the meantime, why buy gold or other commodities now, when you can hold cash through the deflationary period and get in closer to the bottom?  It is not necessary to exactly call the bottom, but we know the near term (6-9 months at least) will be dominated by deflation.  Consider different asset types:

Stocks: earnings will be terrible this quarter, worse than optimists who think they are getting stocks cheap want to believe.  Prices will decline.

Commodities:  Where is growing demand for commodities going to come from?  Most people are trying to buy less, not more.  This means producers of all types will need less, not more.  Prices must come down.

Gold:  I only separate gold from other commodities because of its monetary function.  Aside from jewellery and some industrial usage, a major use of gold is to store value.  Over the spring and summer, gold was caught up in general commodity speculation, and initially was somewhat in sync with the decline in prices of other commodities.  But, since then, the monetary use of gold has kept it from crashing to the same extent that food and industrial materials have (and will continue).  Silver also followed this pattern of demand to some extent, although its industrial usage has been a more significant factor.  But, as long as we do business in dollars (or other currencies), when everyone needs cash to pay debts and operate a business, they are not going be pouring more money in gold.  Eventually, concerns about a collapsing dollar will probably out-weigh the immediate need for cash.  This is the point at which gold with start to rise.  Will that be at 600, 300 or some where in between?  I have a hard time imagining gold staying within its recent 700-800 trading range.

Real estate:  With businesses going bust, or at least trying to reduce costs, vacancy rates will rise.  Lease values will therefore decrease, thereby further pushing down purchase prices.  The same goes for housing.  With the exception of some very constricted regions (like SF city proper), there is plenty of housing available.  Purchase prices have already come down and in some areas rents decreases have lagged behind because, for a time, there are suddenly more people who have to rent who would have tried to buy when credit was easy.  In the end, rents will also have to decline as people lose jobs and opt to live with relatives or in smaller digs.  This is probably already well underway in most markets around the country.

Bonds:  On the one hand, bankruptcies will rise causing loses in bonds.  On the other hand, demand for cash and low inflation (or as I’m arguing, negative) rates will mean that real interest rates increase.  This might not be obvious if nominal rates appear low.  Mish has a great article on high nominal interest rates here: link.  Overall, this trade-off probably means that high-quality bonds will return a high real interest rate (even better than cash), but low-quality bonds will lose some value along with other asset classes due to increased risk and actual defaults.  If I could hold cash only in my 401k, I would, but as it stands the best option I have at my company is to hold a mixture of bonds and cash.  Such is life.

Cash:  This is my investment of choice.  It is the only thing that must increase in value short term.  As I’ve said, I think short term to me means at least 6-9 months, as any study of the Great Depression shows, we could have deflation for a few years.