Inflation, Deflation and the Implications for Gold and the Stock Market

by JDH on August 14, 2010

As the markets muddle through the summer, stuck in a trading range, let’s pause and discuss the question that’s confusing everyone: “Are we headed for a period of inflation, or deflation?”

The answer is: yes.

The “hyper inflation is coming” people will tell you that the massive stimulus spending by the government is very inflationary, so a hyper inflation is inevitable.

The “deflation people” will tell you that, if we haven’t seen a hint of inflation after a few trillion dollars in government spending, it’s unlikely we ever will.

So who is correct? Before I give you my thoughts, let’s talk about what inflation means.

To the average person on the street, inflation means “prices are going up”. That may be the manifestation of inflation, but that’s not necessarily inflation. If I design a really cool new gadget, version 5.0, and I can charge more for it that the old 4.0 version, is that inflation? No, it’s just the price of something going up.

I define inflation as an increase in the money supply. Here’s a very simple example.

In the entire economy there are only ten pencils. In the entire economy there is only $10 in money in circulation. Since the only thing you can buy in this economy are pencils, the price of a pencil is $1.

Then, one day, the government decides to “stimulate” the economy by printing more money. The print $90 more dollars, and give those dollars to the citizens of this economy. There is now $100 of money in circulation. Of course printing money doesn’t actually create any products, or wealth, so the only thing you can still buy in this economy are pencils. Now there is $100 of money chasing ten pencils, so the value of a pencil rises to $10 each.

It would therefore appear that pencils have experienced price inflation, since their price has inflated from $1 to $10. However, the true value of each pencil has not changed; each pencil remains one tenth of the economy. What has changed is that the money supply has increased, and that’s what has caused inflation.

To summarize: inflation occurs when the money supply increases.

Based on that example, it would appear obvious that we are in a period of significant money supply inflation. There are now a lot more dollars chasing the same number of goods. So why are we not seeing inflation?

Good question.

Milton Friedman’s is known for his quote that “inflation is always and everywhere a monetary phenomenon”. I’m not as smart as Professor Friedman, so I will assume he’s correct: past inflations were caused, in large measure, by increases in monetary policy (or increases in the money supply). However, that doesn’t mean that an increase in the money supply automatically leads to inflation. How do I know that? Because we have had massive increases in the money supply in the last two years, but we have had no inflation. One obviously does not lead immediately to the other.

But again, why, with massive government spending, are we not seeing inflation? There are a number of reasons:

The main reason is that no-one has any money.

The government gives a billion dollars in bail out money to a bank. The bank uses that money to “shore up it’s balance sheet”, or to cover it’s loan losses. No new money is lent, so actual consumers, that make up three quarters of GDP, have no additional money to spend. No-one has any money because:

  • consumer’s can’t borrow, because banks are not lending;
  • household income is falling (due to the recession, high unemployment, and declining real wages); and
  • people have no savings (we owe more than we have saved), which means, simply put, we have no real money. If we have no money, we have nothing to spend.

And that’s the point. We have no money; we have nothing to spend, so prices are not being “bid up.” Here’s our story, again:

In the entire economy there are only ten pencils. In the entire economy there is only $10 in money in circulation. Since the only thing you can buy in this economy are pencils, the price of a pencil is $1.

Then, one day, the government decides to “stimulate” the economy by printing more money. The print $90 more dollars, and give those dollars to the banks. There is now $100 of money in the economy, but there remains only $10 of money in circulation, so the actual price paid for a pencil doesn’t change.

As you can see from this example, a massive increase in the money supply does not automatically lead to price inflation; for prices of consumer goods to increase, there has to be demand.

Today, there is no demand. Unemployment is high, and despite all of the government happy talk, the man on the street knows the economy is still suffering. He knows that he could be unemployed at any time, or he is already out of a job. So how does he react? He starts to cut his expenses. He pays off debt. He tries to save money. Not surprisingly, if we are saving instead of spending, prices are not going up. If retailers can sell stuff to us, they have no choice but to lower prices to get us to buy.

Prices going down is not a sign of inflation.

Yes, it’s possible that the price we pay at the gas pump may go up. It’s also possible that the cost of imported food will also increase. But that doesn’t mean we have inflation. It means we may be spending more on gas and food, so we will have to cut back in other areas, since our resources are limited, and it’s no longer easy, or prudent, to borrow to consume.

So, for now, we are in a deflationary period. We may still get hyper inflation in the future, but for now, expect deflation, not inflation.

Investment Implications of Deflation

Reduced consumer spending is NOT a formula for stock market increases. In simple terms, stock prices increases when company profits are increasing. Company profits only increase if consumers are actually spending money. Since consumers are not spending money, companies will not increase profits, so stock prices will not increase.

But wait, you say, the stock market has increased! No, it is actually down year to date, but yes, I see your point; since the bottom of the crash the markets are higher. How can that be? There are two explanations:

First, the markets are wrong. Investors are assuming the recession is over, and they are pricing stocks based on the assumption of future profit growth.

Second, company profits have increased since the bottom. That’s true, but in most cases they have increased due to a reduction in expenses, not an increase in revenue. If Company ABC’s revenue remains flat, but they lay off 10% of their workforce, and cut 10% of their expenses, their profit will increase by 10%. The earnings per share goes up, so the stock price goes up.

Great! So if companies continue to cut their workforce by 10% per year, we will all be millionaires! Except for the fact, of course, that no-one will have a job, and if no-one is working, no-one is spending or consuming, and the depression gets worse. Again, that’s exactly where we are today. Official unemployment in the U.S. remains stubbornly in the 10% range, but the true unemployment number, when you add back discouraged and under-employed workers, is a lot closer to the the 25% levels that were reached during the last Great Depression in the 1930’s. That’s deflationary, and that’s not good for stocks.

Which is why I am largely in cash at the moment.

The Implications for Gold

If the stock market is poised for a drop, does that mean gold and gold stocks will also drop? That’s two separate questions. Yes, when the tide goes out, all boats fall, so if we have a significant stock market correction, all stocks, including gold stocks, will suffer.

However, gold is a store of value. We humans tend to think of gold in terms of “dollars per ounce”, which is the wrong way to think of gold. We should think of gold in terms of other products. Today, an ounce of gold, at $1,200, will buy you a good man’s suit. Back in the 1930’s, when gold was $35 per ounce, an ounce of gold would buy you a good man’s suit. The price of gold in dollars may change, but an ounce of gold, yesterday, today or tomorrow, will still buy you a good man’s suit.

That same ounce of gold will also buy other products. 20 ounces of gold will buy an inexpensive car, 200 ounces of gold will buy a nice house, and so on. As prices deflate, do I want to store my wealth in a product that is also deflating, or do I want my wealth in something that will hold it’s value?

Obviously I want to store my wealth in something that will hold it’s value. Gold is good for that. So, I will continue to hold gold, because I know that even in the future I will be able to trade in my one ounce gold coin for a nice man’s suit, or other commodities I need. The same can’t be said for fiat currency.

Of course I could also store my wealth in other commodities, like a good shovel for use in my garden, or a bicycle I can use for transportation, or some solar panels for my house. (I have yet to convince my wife to let me put solar panels on the house, since they are not yet cost effective, but I do have good garden tools, and two good bikes).

So to summarize: I expect stock markets to fall, but I plan to continue to hold gold, since in both periods of inflation and deflation, gold will hold it’s value.

As for the muddling markets, that was a nice little drop on Wednesday, if you think a 3% drop on the Nasdaq, and an almost 3% drop on the S&P 500 is a “nice little drop.” It allowed me to close out my September S&P 1020 puts, at a nice profit. I then took the money I originally invested (taking my profits off the table), and immediately bought some September S&P puts with a 990 strike price. Silly gamble? Probably, but most of my money is in cash, and I find if I play with a few dollars it keeps me interested, and prevents me from being silly with larger amounts of money.

The S&P 500 closed the week at 1,079, stuck right in the middle of it’s 1,000 to 1,200 trading range. Which way will it break? If I had to guess, I’d be betting on the lower end of the range, obviously. Of course I have no idea when it will break, so for now, I continue to ponder the impact of near term deflation, I continue to hold cash, and I sit, and I wait.

Until next week, thanks for reading.

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