July 30th, 2011
By Avi Gilburt, managing member of the financial consulting firm of Gilburt & Associates, LLC.
When we watch the financial news television media, or we read articles published in various other modes of news media, we are continually told that the drum beat of inflation is getting louder and louder. But is the actual drum beat itself getting louder, or is it simply that louder sound equipment is being used?
I, for one, do not believe the inflation argument, since it does not fit the definition of inflation. Furthermore, when I present the evidence for this argument to others, the reply is that the “old definitions no longer apply.” I view this type of argument in the same manner as “this time it is different.” Follow up:
Follow up:So let’s try and understand what inflation really is, and, if it is really causing certain price increases in certain markets and not others.
DEFINITION OF INFLATION
As defined by Webster’s Dictionary:
Inflation is a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money caused by an increase in available currency and credit beyond the proportion of available goods and services.
Written in a calculation format, we would present it as follows:
INFLATION = MONEY/DEBT INCREASE ….. Yields ---> ….. GOODS & SERVICES PRICE INCREASE
In its simplest form, inflation is CAUSED by CREDIT/MONEYBASE EXPANSION. If you think about it, if everyone has more ability to buy goods because there is more money/credit available for them to do so, then the cost of the limited number of goods available must go up based upon the law of supply and demand. Of course, the opposite is true as well.
PERVASIVE MISCONCEPTIONS OF INFLATION
How is a determination of “inflation” actually arrived at by many of our experts today? We hear many pointing to the CPI or the PPI rising and then claim that we have inflation. We hear many pointing to the rise in price of precious metals - and then claim we have inflation. We hear many more pointing to energy and food prices rising and claim that we have inflation.
Yet, these same “experts” seem to dismiss the declining employment statistics, or the declining housing statistics, or the true declining consumer debt statistics. They say that those price declines are happening for “other” reasons.
But, is the fact that we see certain prices rising (even though others are declining) a reason to cry from the top of the financial peaks that “inflation is upon us!?” Let’s analyze the definition of inflation a little more closely and see if these cries for inflation are truly warranted.
A CLOSER LOOK AT THE DEFINITION OF INFLATION
Whenever we analyze definitions, such as the one for inflation, we have to understand that there are two aspects to the equation; one is the cause, and the other the effect.
INFLATION CAUSE: an increase in available currency and credit beyond the proportion of available goods and services
INFLATION EFFECT: a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money
Keep reminding yourself during this exercise that inflating prices is an EFFECT of the definitional cause, and not the determinative factor in making the case for inflation. In order to determine if this effect is actually pervasive in the market and can be termed “inflation,” we need to determine if the CAUSAL side of the equation actually exists. Ultimately, we need to see an increase in available currency or credit which is outpacing ALL available goods and services in the economy in a relative manner.
We have all heard the term that “a rising tide raises all ships.” This is exactly how inflation works. Again, if more people have more buying power through possessing additional greenback notes or additional credit, then the prices of ALL the limited available goods and services in the economy, as a whole, should be rising.
Yet, we have some asset prices which are soaring, while other prices have been declining. But how can some asset prices really be declining if there is true inflation, which is supposedly caused by more “money” available to buy those assets? Shouldn’t the additional purchasing power, if it truly exists, cause ALL asset prices to rise in a true inflationary bout?
It seems to me that most analysts are only looking at the effect side of the equation and ignoring the causal side of the equation. But simply identifying price appreciation in some assets is not how we appropriately define inflation. Have you heard any “expert” point to a rising relative monetary base as the cause of the rising prices they cite? If not, how can one reasonably claim a resulting effect of inflation?
ULTIMATE CAUSE OF INFLATION THROUGH TARGETED CREDIT EXPANSION
Based upon the definition of inflation, the key question we really have to ask ourselves is if the monetary base is increasing so fast that it is outpacing the ability of the market to keep up with the resulting demand for goods and services. The best place to look for this answer would be the M3 chart, which should provide us with answers as to whether our monetary base is truly increasing at an alarming rate, as it is the most inclusive definition of the monetary base that we have.
The chart below shows the long-term variation of M3. A contraction like the current one has not been seen at any other time in the past 40 years.
Editor’s note: The Federal Reserve stopped tracking the M3 aggregate in 2006. The above graph by Now and Futures.com combines the Fed data to 2006 and reconstructed data since.
If you view the charts above, it is clear that there has been a positive uptick in the M3 over the last year. However, the other piece of information that we glean from this chart is that M3 had been in a free-fall since 2008. In fact, we have barely even retraced one quarter of that decline to date. When you consider the Herculean efforts aimed toward monetary base expansion engaged in by our government, especially the significant infusion of credit orchestrated by our FED through Quantitative Easing, this increase is relatively pathetic.
In my opinion, this is not pointing to such a dramatic increase in the monetary base,through credit expansion, that would fit the inflation definition that we outlined above. Rather, this is simply showing us that the FED has been fighting a battle with a public that has been engaged in significant credit deleveraging. Now that the FED has stopped fighting that battle, and there is still no evidence that the public has ceased to deleverage, then deflationary pressures should resume, and we should begin to see a resulting decrease in the M3 shortly. Clearly, this would not be inflationary.
IF THERE IS NO TRUE SYSTEMIC INFLATION, HOW DO WE EXPLAIN SOME PRICES RISING?
Remember that each market works on rules of supply and demand. Therefore, if you experience a supply shortage within a specific market, for one reason or another, but maintain stagnant demand, or even a lowered demand that does not keep pace with the reduction in supply, this would clearly cause certain markets to experience price increases. This is NOT inflation, but rather specific supply and demand concerns within specific markets. This is a potential cause for the recent food price increases.
Another reason that specific market prices can rise without having systemic inflation is due to speculation and/or emotion. Examples of markets that are experiencing these price increases are commodity markets such as oil and metals.
Furthermore, we know that we have not been able to make much of a dent in the unemployment rolls over the last 3 years. In fact, if we were to look at true underemployment, we then realize that the number has actually been on the rise. A result of lower employment, coupled with a relatively stagnant productivity number, is that less goods and services are available in the market, which would also cause an increase in prices in certain markets.
Let me provide an example of price increases in a market that is not caused by inflation. If you provide a service that is in high demand for whatever the market reason, and that demand outpaces the market’s ability to provide that service, then the price you charge for that service will rise based upon the laws of supply and demand, until an equilibrium is reached between the price and the demand. Even though prices for this particular market service are going up, it does not mean that the economy as a whole is experiencing inflation.
However, if the price of this service is going to go up relative to rising prices for other goods and services, which is caused by a relative increase in the monetary base, then we can point to inflation within the economy.
WHAT IS AN INVESTOR TO DO?
Ultimately, if we are truly not experiencing systemic inflation, but rather fighting deflation, history has shown that deflation is much more difficult to beat. In fact, if the herculean efforts of our government have not sent deflation running for the hills, then chances are we will lose this battle.
What we have learned from the deflationary scenarios of both the recent and “ancient” past is that almost all asset prices are eventually affected by deflationary pressures. This includes corporate debt instruments, corporate stocks, mutual funds, real estate, commodities, and, yes, even gold and silver. For those that do not believe there is any reason that gold or silver can be affected by deflation, simply looked back at how shocked everyone was in 2007-2008 as the price of gold was dropping at the same time as the equity markets.
However, when we take a close look at what happened during deflations of the past, we notice that the home currency of the country that is being effected by deflationary pressures saw the value of their currency rise, as prices were falling. Of course, based upon the inverse of the definition of inflation, this makes perfectly good economic sense.
As available debt contracts, which is how deflation is caused in our times, so do the value of the underlying assets which have been purchased by such debt. Yet, while we experience debt contraction, the relative amount of Greenbacks in the system rises, since the actual amount of Greenbacks never changes, causing their ratio to the overall M3 number to significantly rise.
As a recent example, if we look at the YEN during a portion of Japan’s credit deflationary period, we see this exact phenomena when comparing equity prices to the value of the YEN.
Editor’s note: The first graph below is for the ratio of 1000 Yen/U.S. $. The second graph below is for Nikeii 225 Index.
As another recent example, if we compare the US dollar index to the S&P 500 during relatively the same period, we see a similar result.
When we are able to point to “other reasons” why only certain prices, and not all prices, go up, and it is not caused by a relative increase in the monetary base, then we are not pointing to price increases as being caused by inflation.
Inflation is defined as an end result of specific causes. It is solely the result of a relative increase in the monetary base as compared to goods and services available in the market. Therefore, if we were truly experiencing a relative increase in the monetary base that would be cause for inflation, then ALL goods and services available in the economic system would be rising as a result, and not simply rising within certain markets, and declining in others.
Ultimately, this must lead us to a conclusion that we are not experiencing systemic inflation. Rather, it is clear from the underlying dropping consumer and housing debt statistics, which the FED has been battling through QE, the true battle has been with deflation. Now that the FED has stated its lack of desire to continue any form of QE, this should become much more clear as more deflationary pressures begin to take hold of the entire economic system.
Based upon history, investors need to start raising cash as the deflationary signs grow more prominent, and store it in a safe place.