Deflation or Inflation?

September 23, 2008

In general, there’re two opinions on where money supply and the dollar are headed:

1. The world and the US are headed for a “nasty” recession, quite possibly a depression. A universal contraction in demand will cause the services sector to shrink very strongly in the US, leading in turn to a halt to manufacturing expansion in Asian nations, and, eventually, to a large number of bankruptcies, as a large part of industrial capacity becomes idle. This will lead to higher unemployment across the globe, and cause deflation in commodities, goods and services, leading to higher dollar.

2. The world economy is headed for a one-two year long recession, as the US government continually bails out increasing segments of the economy, starting with banks. That the Treasury has moved so fast from rescuing the GSE’s to rescuing the entire banking industry of the US, and then some more in the rest of the world, shows that the Americans have no interest in paying the price of the excesses of the past decades, and will instead do whatever they can do save the day, regardless of what happens in the longer term. They will print more and more Treasury bonds to sustain the US consumer and to prevent the necessary adjustment in the consumer’s spending habits, which will prevent the rest of the world from suffering a severe slowdown, but will create inflation and crush the dollar in the process.

What does Washington want? I believe that the answer is very clear. At all costs, they want to prevent a demand contraction, and they have the means to achieve this, albeit only in the short term. “Live today, forget the rest” is more or less the modus vivendi of the American, and it now seems that this will also be how they manage this problem.

To be fair however, the administration is only willing to consider reflating the economy because it believes that the results would be more controllable and orderly than a depression and a collapse in demand. It’s not illogical to think that an artificially induced inflationary environment is easier to live with than a sudden, severe and unpredictable contraction of the economy. Those who oppose this argument suggest that it’s far from clear that the inflationary remedy can resolve the problem, that is, it’s not clear that by resorting to inflation we will not end up with both inflation and a depression. It must be mentioned that there’s no real example of an economy that has averted depression through easy monetary policy.

But I believe that the government at least has the power to devalue its currency: they can create such a great supply of dollars that even the most fearful investor sees little value in holding an asset which is likely to shrink at great speed as soon as the fear factor that is upholding it lessens.

That is why I support number two of the above options. I believe that the dollar is sentenced and damned. The US, as a nation, has chosen to sacrifice its tomorrow for saving the day, and the first to pay the price will be the dollar.