Debunking Deflation

Now that almost every Wall Street economist is looking for the arrival of a Great Deflation, we think investors should begin looking the other way. Keep an eye out for inflation, we say.

You will recall that during the bottom of the previous bear-market, most of the pundits were shunning ‘risky assets’ (stocks and commodities) and they were advocating a heavy exposure to cash and fixed income assets. Back then, the vast majority of strategists and their devotees were erroneously fretting about deflation. According to these folks, deflation was a done deal due to the following reasons:

a. Contraction in private-sector debt – When the credit crisis arrived in the summer of 2008 and asset prices collapsed later that year, over- leveraged consumers and businesses started paying off their debt. After all, this act of deleveraging was a logical reaction to the devastation caused by the most vicious bear-market since the 1930s. So, when private-sector debt began to shrink, the proponents of deflation (deflationists) announced the death of inflation. “How could the global economy inflate when the private-sector was tightening its belt?” was their battle cry.

Decline in Commercial Bank Lending

Although the deflationists had a point, their assessment was flawed because they totally ignored the borrowing capabilities of the governments. While it is true that from peak to trough, private-sector debt in the US contracted by roughly US$800 billion, this debt reduction was overwhelmed by the US government’s debt accumulation efforts.

As the chart below shows, over the past two years US federal debt has surged by a whopping US$3 trillion, thereby more than offsetting the deflationary impact of private-sector deleveraging. If you have any doubts whatsoever, you will want to note that total debt in the US is now at a record high!

Increasing Government Debt

b. Excess capacity – The lack of aggregate demand and the excess capacity prevalent within the economy is another factor often cited by the deflationists. Let us explain:

You will recall that in the aftermath of the Lehman Brothers bust, the credit markets froze and the global economy came to a screeching halt. Suddenly, worldwide consumption contracted and the world was left with idle factories, empty buildings and unwanted inventories. Thus, the deflationists argued that with such a lack of aggregate demand and so much spare capacity, we could never experience inflation.

Once again, the deflationists failed to understand that over-capacity has been a constant feature in our economic landscape and price increases (which they erroneously describe as inflation) have very little to do with capacity utilization.

It is interesting to observe that over the past 42 years, the US economy has never operated at full capacity. Moreover, it is notable that even during the highly inflationary 1970s and the most recent inflationary boom (2003-2007), the US economy operated well below maximum capacity. In case you are wondering, the same holds true for the global economy. Therefore, the idea that inflation cannot occur in the face of excess capacity is ill-conceived and absurd.

All the popular deflation myths aside, the reality is that inflation is an increase in the supply of money and debt within an economy. Furthermore, the price increases often described as inflation are simply consequences of monetary inflation – a euphemism for the dilution of the money stock.

Look. Whenever any central bank creates new money and whenever any entity (individual, business or government) takes on more debt, the outcome is inflation. As Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon.”

Today, under our fiat-money system, governments are willing borrowers and central banks are more than eager lenders (money creators). Under these circumstances, a contraction in the supply of money and debt (deflation) is out of the question. Conversely, given the short- sightedness of the politicians and their perpetual urge to “kick the can down the road,” the real risk facing the economy is extreme inflation or even hyperinflation.

Given our grim outlook on inflation, we continue to favor hard assets and the fast-growing developing economies in Asia. If our assessment is correct, our preferred sectors (energy, precious metals and industrials) and our favorite stock markets (China, India and Vietnam) are likely to generate superior long-term returns.


Puru Saxena,
for Markets and Money

Puru Saxena
Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Puru Saxena is the founder of Puru Saxena Limited, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.
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8 Comments on "Debunking Deflation"

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So why are prices falling and more importantly individuals reducing debt? [with the possible exception of Australia] The Fed can put as much cash as it likes on the balance sheets of the banks [lent at 0.25% and then interest paid back to the banks at 3% for the same balances] but if the banks dont lend that out and consumers dont want to borrow that money (but would rather pay down debt) then you’ll get deflation which is what we’re seeing in the US. Bernanke can talk as much as he likes about making sure “deflation doesnt happen here”… Read more »

Well said.


Private deleveraging and avoidance of borrowing doesnt occur in isolation.

Public borrowing, and massive government spending will be the order of the day. Infrastructure projects as never before seen. This money spent in contracts and wages will inflate the economy. The school hall, insulation batt, etc programs are nothing compared to what may be spent down the track.

Ned S

Easy to be too simplistic Ben – And I may well be doing it? But the ability to borrow money pushes up asset prices. And higher wages push up the prices of consumables. With the two only being fairly loosely linked other than in the long term from what I can see? And there being a very strange wildcard in the deck in Oz called government wanting to put their charges up on everything regardless – You’ve got less so we need to take more so that we can help you out???

Daniel Newhouse

If any of you were to take a look at shadowstats, you would see that the rate of inflation has never fallen below 5% since the start of the depression. The government flat out lies about the numbers – which isn’t a completely bad thing as it slows the growth of the entitlement programs.

The supposedly interesting question is whether we will experience hyperinflation before the final, deflationary collapse of western civilization. I don’t know that it makes much of a difference, really.

Daniel: “…the final, deflationary collapse of western civilization.” Could be a little ways to go yet, Daniel: Breaking News Alert The New York Times Sun, August 15, 2010 — 8:49 PM ET ———————————- China’s Economy Passes Japan’s in Quarter, Becoming the World’s Second Largest After three decades of spectacular growth, China has passed Japan to become the world’s second-largest economy behind the United States, according to government figures released early Monday. The milestone, though anticipated for some time, is the most striking evidence yet that China’s ascendance is for real and that the rest of the world will have to… Read more »

John Williams, the author of shadowstats reckons that hyperinflationary damage will be largely limited to USA, and it will occur in 6 months to one year. We’ll be relatively fine as our strong dollar and economy de-couples from an increasingly irrelevant USA.
I just hope our pollies aren’t flunkies and have enough aussie spine to tell Obama/Hillary to “jam it” if they play the war card. I’m paying for this sh*t as a tax-payer and don’t want Julia crapping on about our strong ally etc


‘… for a fleeting moment on April 10, 1995, in as brief a time as it takes for the latest value of a country’s currency to flash up on the screens of global currency traders, the Japanese economy did become the largest in the world.’ (Richard McGregor, “Japan Swings”, Allen & Unwin, quoted by Frank Devine, More scrutable than we think, Weekend Australian, May 18-19, 1996).

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