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Inflation or Deflation?

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03/22/2005

This much is clear: the massive buildup of debt through the system of fiat money and fractional reserve banking with a central banking as the money printer of last resort cannot conceivably be paid off. It will have to be defaulted in one way or another: either through an outright (nominal) default, or by inflating the dollar down to zero value. But which way?

This "inflation-deflation debate" has been going on for the last few years among hard money advocates and financial contrarians. The system has been sustained for a time through the efforts of a dollar-buying cartel consisting mainly of China, Japan, and Korea, and to a lesser extent smaller Asian nations. But as Roubini, Duncan, and other have argued, we are close to the breaking point because the ability of foreign banks to absorb more dollar-denominated debt is approaching.

China and Japan cannot borrow enough domestically to purchase the volume of debt that would be required to fund US debt growth, so they must instead print money in their own currency to make up the difference, as fact that even Benjamin "Helicpoter" Bernanke acknowledges. There will come a fateful day when the rest of the world cannot fund continuing growth of US debt. 

For any other country than the US, this day would have come long ago, but we enjoy the luxury of being able to print the world's reserve currency. However, even this advantage can only postpone the inevitable crisis. There are visible signs that the system is starting to crack. The central banks of India, China, and Japan have recently started public discussio of "diversifying out of dollar reserves". (Reuters: Asian Foreign Exchange Reserves: A $2.46 Trillion Question, China says it won't change dollar's share in its foreign exchange reserves, Reuters: Asian banks reducing share of U.S. dollar deposits, BIS reports, Bloomberg - China to keep yuan's peg to dollar for 'relatively long time', Bloomberg: Koizumi Says Japan Needs to Mull Diversifying Reserves, Korea Times - You Can't Bet Bottom Dollar).

When the day of reckoning comes, the Fed and the US Treasury will face a choice: to allow the system to collapse, including default on US Treasury Bonds, or to print money and become the buyer of last resort, in essence monetizing the outstanding debt with newly printed or created money. The former choice would, to be sure, put an end to the dollar as the world's reserve asset.

After a massive deflation that would cleanse the mal-investments of the Greenspan period, the US could perhaps reemerge as a somewhat respectable minor nation with a smaller but more sound currency and a national aversion to debt, much as happened after the Great Depression. The monetization option, on the other hand, would just as surely destroy the dollar only through hyper-inflation.

The deflation side has argued for a variety of reasons that the Fed cannot/will not pull the trigger and destory the dollar. One of the arguments that has been offered by the deflationists is that the bond market would not allow a hyper-inflation. The problem with this argument is that the so-called "bond vigilantes" no longer run the bond market. Through institutional reforms, financial asset price inflation has become the channel money growth. Bond prices, stock prices, and housing prices (as housing has become "financialized" through the securitization mechanism of Fannie & Freddie) are absorbing a large share of monetary growth. This is the conundrum of low interest rates that Greenspan has spoken of recently.

But perhaps not much longer - Jim Puplava has written that credit spreads are starting to blow out. Rob Kirby has written in a recent essay Pirates of the Carribbean that, as the long-suffering members of the US debt crack dealers are tiring, Carribean hedge funds are starting to show up as major purchases of US Treasury debt. You can read the article for details, but the main thrust of it is that the numbers don't add up. Hedge funds cannot be buying as much debt as would be needed to make the balance sheet add up, and if they were they would be losing staggering amounts of money as long rates rise..

The only player in the game with the capacity to absorb the scale of loses is the central bank. Kirby writes: "One might surmise that a printing press would be required to come up with that kind of cash on such short notice, ehhh?" If he is correct, then we are now at the inflection point, where the Fed must cast its lot on the inflation or the deflation side.

Robert Blumen is an independent enterprise software consultant based in San Francisco.

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