Inflation, Deflation, and Gold

by JDH on July 13, 2013

And so, as we amble our way through summer, we are faced with a question to ponder: inflation, or deflation?

On the surface, the answer appears obvious: we are in a deflationary environment.  Official government statistics show that prices are dropping. Commodities, such as gold, have dropped in price over the last two and a half years, which would appear to be deflationary.  One can make the case that the economy is weak, full time high paying unemployment is high, consumer spending is contracting, so it’s not surprising that we have deflation.

The other side of the argument is:

That’s crazy!

All governments are printing money like crazy, and if one accepts the definition of inflation as “an increase in the money supply”, we should clearly have inflation.  And yet we don’t.  Why not?

It could be just a matter of timing.  Money gets printed on Monday, but that does not lead to hyperinflation on Tuesday.  It takes time for the money to work it’s way through the system, and that’s where we are now; waiting.  That explanation is somewhat plausible, since a significant amount of the money printed by the U.S. government is not in circulation.

More specifically, if the Treasury prints money to buy crappy assets from banks, like mortgage backed securities, and then banks just hold on to the money they receive, the money doesn’t make it’s way into circulation.  The money has no velocity.  The government can print trillions of dollars, but if it all just sits in a drawer somewhere, it doesn’t create inflation.  That’s probably where we are now.

If I was a bank, and I can’t earn anything lending money, but I can earn 0.25% by leaving my free money on deposit at the Fed, that’s what I would do.  I can make risk free profits.  Sounds good.

But what happens if interest rates creep up, even by a small amount?  Now as a bank I have some incentive to lend, because I can earn more than having money on deposit with the Fed.  I start lending, which puts the money into circulation, which increases the velocity of money, which leads to inflation.

And yes, I realize that I am giving an overly simplistic explanation, and in practice the economy is more highly nuanced than I am making it out to be.  However, even in these simple terms, I believe the case can be made that the apparent deflation we have today is likely to be replaced by inflation at some point in the future, perhaps even the near future.

A Thought Experiment

If you are bored, try this exercise: make a list of ten things you consume regularly, such as milk, gas, beer, or whatever.  Write down the price of those items today, and compare it to the price a year or two ago.  I suspect that many of those items cost more today than they did in the near past, so it is quite possible that inflation is already here, but is hidden by the obfuscation of government statistics.

The government can manipulate the numbers however they wish.  I won’t bore you with the details (of which I’m sure you are already familiar), but you can check out John Williams’ Shadow Stats website if you want further education on the subject.

My point is this: just because it would appear that deflation is here to stay does not mean we should abandon gold, silver, and other hard assets and rush to paper.  It is quite conceivable that we are in the pre-collapse stage, and this may be the buying opportunity of a lifetime.

Or not.  I’m merely chatting.

Thanks for reading my ruminations.  See you next week.