Maybe Inflation Isn't a Problem

There's always a debate on inflation when you get a bunch of economists, bankers and investors together.  Some cry deflation is the worry while others scream about inflation and loose monetary policy, well what if they're both right?

I'm not an economist by trade, but as an analyst I like thinking about broad economic and business challenges in new ways, which unfortunately is not as well received among the economic elite of the 21st century.  While you have the perennial battles between the Keynesians and Monetarists of the Chicago School, I put myself clearly in the fringe of the Austrian School, which to most would make me a crackpot, survivalist gold bug, but that's really beside the point.  Back to the inflation or deflation debate, some say that inflation is the problem as we see much higher food and energy costs and the Federal Reserve is pumping up its balance sheet and printing ever more dollars in "Quantitative Easing" programs.  Others say that deflation is the problem, with the deleveraging of the consumer, the collapse of housing prices, the overall direction is toward deflation not inflation.  What if they are both right?

In the 40 years since Nixon slammed the gold window shut to the rest of the world, and fulfilling the promise of his Treasury Secretary John Connally, when he said the dollar "is our currency, but your problem," we have been living in a very unusual time, where inflation and deflation have become further abstract concepts divorced from their underlying causes.  We've seen inflation, defined as an increase in the quantity of money relative to the amount of goods and services produced, transformed into a mere "increase in the overall price level" - thus altering the definition of inflation as a symptom rather than the underlying cause.  Similarly, we've seen the results of inflation as illustrated by this simple definition most dramatically in the 1970s, with rampant price increases for nearly every type of good.  Unfortunately the altered definition caused us to miss completely the other result of rampant inflation that occurred in the Greenspan era.  While CPI (however defined) was relatively tame, massive increases in monetary aggregates resulted in excess money flowing into other assets, creating the new "bubble" economy, first with the stock market bubble of the late 1990s and then real estate bubble in the 2000s.

Now we are again seeing inflation in the traditional venue of consumer prices, though they aren't as severe as the inflation of the 1970s, at least not yet.  But are we seeing deflation?  I argue that we are seeing deflation, when we step back from the current dollar regime and thing in broader monetary terms.  Let's look at gold prices (insert Keynesian eye roll here).  Some would argue that gold rising from $282.05 at the beginning of 2000 to $1,405.50 at the end of 2010 is yet another sign of an asset bubble destined to burst.  Well what if instead of an asset bubble, gold is reasserting itself as a currency, and similar to the 1930s, the value of gold, and hence the purchasing power of money is increasing dramatically - the classic definition of deflation!

So from a practical standpoint, what does this look like?  Well, first let's look at a couple of stock charts to give an idea of the rough comparisons.  The first is a chart of the Dow Jones Industrial Average for an 11-year period from January 1929 through December 1939.  During this period, the United States was under a gold standard with the dollar pegged first at $20.67 per ounce, and then after the default and devaluation of Roosevelt's first term it was pegged at $35 per ounce.

Clearly this is a picture of the overall stock market during the Great Depression, where after the crash of October 1929, stock prices rebounded initially and then were in for a multi-year bear market which left prices down more than 50% a decade later.  Compared to this chart, the Dow performance in the first decade of the 21st Century seems pretty tame by comparison, after all we ended 2010 just a little above where we started in January 2000.  In nominal terms this may be true, but what if we adjust prices to reflect the $35 per ounce standard in place from 1933-1971?  Here is what the last decade looks like for the Dow:

Not as comforting as the unusual nominal charts we see, and in fact it looks a lot worse than the chart from the 1930s listed above because it is!  From January 1929 through December 1939, the Dow posted a compound annual percentage LOSS of 6.3% per year, but for the similar period from January 2000 through December 2010, the Dow adjusted to gold standard pricing posted a compound annual percentage LOSS of 13.4% per year!  This is really the mother of all bear markets!

Of course we can't make judgements on inflation or deflation looking just at stock prices, what about gas prices?  Well in nominal terms from 2000 to the end of 2010, average prices for regular unleaded gas rose from $1.289 to $2.993, an increase of 132.2% or an average annual increase of 8.0% per year for 11 years, that must be whopping inflation right?  Well, adjusted to a gold standard, the price of gas fell more than 52% from 15.9¢ to 7.5¢, which is a decline of 6.5% annually.  How about food, cereal prices are through the roof!  In 2000, an 18-ounce box of Kellogg's cornflakes was $2.99 and by 2011, a 12-ounce box was $3.79, a 33% reduction in size for a 26.8% higher price!  However, on a comparable basis, an 18-ounce box which rose more than 90% in dollar terms during the period, would have fallen under a gold standard from 36.8¢ to 14.3¢, a decline of 61.1% or 8.2% annually!  Unfortunately for wage earners the news was even worse.  Even though nominal wages rose 26.6%, or 2.4% annually from 2000-2009, under a gold standard pegged at $35, wages would have collapsed by 63.7% or 9.6% per year!

So it's quite possible to have inflation and deflation at the same time, and perhaps the inflation that we see in nominal prices combined with the deflation in gold equivalent prices are giving rise to the current malaise among consumers, and why the "Summer of Recovery" is feeling a lot more like the hard times encountered by our grandparents and great grandparents during the depression.