Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.

~ Sam Ewing

Will we have inflation or deflation? This is probably the most important question facing investors right now. There are plenty of smart people who argue convincingly for each. All of them make very good points. But who is right? If you asked me if we should be worried about inflation or deflation, I would probably answer as follows: Yes.

Inflation & Deflation Defined

You know you're going to have a hard time answering a question correctly when the experts can't even agree on the basic definition of the terms of the problem. Not only is there a huge and varied debate in the financial community about whether inflation, deflation, both, or neither is a threat, many analysts can't even agree on what they are.

Inflation is commonly defined as a general rise in the price of goods and services. Deflation, then, is a general fall in the prices of goods and services. But there is a branch of economics (the Austrian school) that contends that price movements are merely the effects of inflation or deflation, and not defining factors.

Rather, those from the Austrian school of economics contend that inflation and deflation are purely monetary phenomena. An increase in the money supply leads to inflation. A decrease in the money supply leads to deflation. Inflation does lead to higher prices, but they do not define it. The converse is true for deflation. If you're interested in delving much deeper into this The Daily Capitalist is currently 2 parts into a 4-part series analyzing the very question that I'm posing here today.

Flation It Is . . .

In some cases, the chief differentiating factor between the inflationists and the deflationists is simply a matter of timing, with some predicting inflation sooner and others seeing deflationary conditions first and inflation many years down the road. It's been my contention for some time now that we will experience a bout of deflation, followed by a period of inflation – maybe even hyperinflation or stagflation. Either way, we're in for a lot of flation. I don't think that's actually a word, but maybe it should be. Perhaps the years between 2000-2025 will eventually be called “The Great Flation“. You read it here first.

We are currently in a deflationary environment. Bond yields across various maturities in many countries are reaching multi-year lows (except for the countries with giant debt problems – Greece, Portugal, Spain, Hungary, etc.). The housing market in the U.S. is rolling over again. Weekly ECRI leading indicators have been weakening, indicating that further economic weakness is around the corner.

Bearish SocGen strategist Albert Edwards says that “we are now walking on the deflationary quicksand that will inevitably suck us toward total fiscal and financial ruin. . . we are only one recession away from Japanese-style deflation.” I know. That doesn't sound very good. If you want a rosier economic forecast, try out the one from BCA economist Chen Zhao who says that a double-dip recession is unlikely and that fears about the European economy are overblown. (Thanks to Larry MacDonald for pointing me to that link.)

In Search of Goldilocks

Too much inflation is not good because the prices of goods and services can rise quickly, eroding the purchasing power of money. At extremes, it can lead consumers to hoard goods, fearing further price increases. This can in turn lead to shortages of goods and further price increases.

Too much deflation isn't good either. While it can lead to greater purchasing power for cash, it can also result in a deflationary spiral. This is where lower prices lead to lower production, lower wages and lower demand. This in turn leads to even lower prices, and the spiral continues. Deflationary periods are usually associated with recessions and unemployment.

A Goldilocks economy is one where there is a balance between inflation and deflation. An inflation rate of 2% or so seems to be “just right” according to many central bankers. Is 2% just right? I don't know, but I'm pretty sure nothing is just right at the moment.

Global debt levels, government/central bank interference and greedy goings-on at corporations worldwide have conspired to contaminate the porridge. Many consider it tainted. It's over-processed, over-cooked, and over-promoted. No one seems to want to eat it right now. Volumes on the exchanges have been pretty low for some time now, and while I have no problem with some algorithmic trading, I don't think that a market comprised 70% or more of computers is a great reflection of global economic conditions.

Are We Turning Japanese?

Some recent economic developments and commentary have lead me to reconsider (or maybe just delay) my inflation forecast. The way things are unfolding right now, I'm starting to wonder if this deflationary patch is a little more intractable than many of us think. After all, Japan faced a similar debt and real estate bubble in the 80s. They have been attempting to ignite some form of inflation for decades now – to no avail.

Why have ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing) in Japan failed to dispense with deflation? Could we see the same thing in North America? I'm going to meekly say that the answer to the latter may be yes. I only say it meekly because I'm really not sure and I don't have the financial degrees behind me to say it louder.

But I wonder . . . Maybe a ton of money supply from Ben Bernanke and company just isn't enough to spark any type of inflation. Maybe what we really lack is money demand. You can flood the financial system with as many dollars, yen, or pounds as you like. But if nobody wants them, they won't create any growth. Maybe the banks are willing to lend me money. Maybe I can't afford to borrow it. Maybe I'm already past my debt quota. Maybe what we are really missing is velocity. We need money to move. That's not happening right now.

We need real, not artificially-induced economic activity. We need people who want to, and can afford to buy goods from suppliers who can in turn build their businesses by providing high quality goods and services. I would love to invest in such an economy. We need leaders with the courage to make cuts where necessary and admit that the gigantic stimulus packages just delayed reality for a while. I would love to vote for such a leader.

But alas . . . I don't see any businesses like that right now. More disturbing is the leadership/integrity vacuum on the political stage. I'm afraid that zombie banks are here and Japanese disease is headed West.

I apologize in advance for the following video link. You can curse thank Mr. Cents and his regrettable penchant for 80s nostalgia for it. Still, this song, called Turning Japanese, seems sort of apropos in its hollow, popish, soulless repetition. (Apparently the bull market in music ended around the same time the bull market in stocks began.) The band is called The Vapours. I think that speaks for itself.

The economy is out of balance. Our culture is out of balance. Truth and integrity are missing in action. I can't invest in that.

I just googled the word flation. Apparently I didn't coin the term. But if you look it up, you'll probably find some interesting articles on this whole debate. Hey – google wasn't a verb a few years ago either, so maybe this flation thing will catch on! 😉

Where do you stand on the flation continuum?

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