In the 1960s, when inflation arrived on the scene, Americans feared it, and rightfully so. It was a real threat to their savings, which at the time, were mostly bank deposits. Few Americans invested in stocks. As inflation became a part of our way of life, however, most Americans adapted to it; many learned to profit from it.

Mortgages shrank in real values as the prices of homes climbed in nominal dollars. Labor unions were stronger then and extracted real wage increases for workers. Congress mandated cost of living increases for Social Security and other federal pensions. Risk-taking Americans headed for the stock market.

At first, they dipped only their toes but by the late 1970s were waist-deep. Today, they are up to their necks. Until 1997, the average American's biggest equity investment was his home; now, it is the stock market. In 1998, mutual fund assets exceeded bank deposits for the first time ever. Add individual stock investments, and it is plain to see Americans, whose parents in the 1960s feared the stock market, have a love affair with it. However, now comes talk of deflation that would rip asunder today's accepted investment strategies.

Deflation would raise the real burden of borrowed money and reduce corporate profits, which would send stocks in a downward spiral. Furthermore, deflation would threaten our booming economy. However, the evidence pointing to deflation is not always convincing. Furthermore, economists disagree as to what constitutes deflation and inflation.

Most people in the investment world are now using deflation to mean falling prices and inflation to mean rising prices. Commodity prices fall, and they talk about deflation in the commodity markets. Stock prices rise, and they talk about stock inflation or inflating stock prices. However, falling prices in one, two, three or more sectors of the economy do not mean deflation per se. Likewise, rising stock or commodity prices do not necessarily mean that inflation has set in.

Fifty years ago, inflation meant a rise in the money supply and/or available credit resulting in a higher general price level. Deflation meant just the opposite, a shrinking money supply and/or available credit resulting in falling prices. Over time, inflation came to define a rising general price level, and deflation to mean a falling general price level. Actually, until recently the word deflation was not used much because inflation has been the norm for the last fifty years.

As time passed, inflation changed from meaning a rise in the money supply (which resulted in a general higher price level) to describe rising prices, no matter what caused them. Specifically, the "oil shocks" of the 1970s--when OPEC boosted oil prices--were blamed for rising prices (inflation) of the 1970s and 1980s. When real estate prices rise, economists often say we are suffering (or enjoying) real estate inflation. Everywhere, commentators and analysts talk about commodity deflation, as commodity prices are down across the board. Richard Russell, editor of Dow Theory Letters, often writes about deflation in the gold market when he only means gold prices have fallen.

To learn from the inflation/deflation debate, investors first have to understand what inflation and deflation are and what causes them. The words inflation and deflation are used so loosely that confusion abounds. If economists throw away the classic definition of inflation and deflation, the debate becomes really confusing, even worthless.

Any serious discussion of deflation conjures up memories of the Great Depression, or at least references to it. During that period, prices fell across the board: commodities, agricultural products, real estate, stocks, nearly every thing. Today, economists still debate the cause of the Great Depression.

Some economists say the Smoot-Hawley Tariff Act of 1930 was the primary cause, while others say Smoot-Hawley did not. Nobel laureate Milton Friedman maintains that the Fed causing (or, at least permitting) the U.S. money supply to shrink by one-third brought on the Great Depression. With one-third less money available to bid for goods and services, prices had to fall. With the falling prices, borrowers were unable to repay loans and depositors withdrew their money. Because there was no FDIC to guarantee deposits, the money supply shrank further as banks collapsed. (The late Murray Rothbard discussed this as well in his esteemed work America's Great Depression.)

Earlier this year, The Economist titled a lead article "The New Danger" and warned of the prospects for worldwide deflation. The article itself was a classic example for why we will not suffer deflation but why inflation is what we will face.

The Economist sees over-capacity threatening to cause worldwide deflation as cheap goods flood the world, driving prices down. Yet, The Economist's solution, which is for the world's central banks to increase the money supply, leads to inflation. The article noted that "Deflation is not necessarily bad. Indeed, productivity-driven deflations, in which costs and prices are pushed lower by technological advance or by deregulation, are beneficial because lower prices lift real incomes and advance spending power." Common sense tells us that any consumer likes to see falling prices. So, why do economists fear falling prices?

The Economist went on to say that when deflation reflects a sharp slump in demand, excess capacity, and a shrinking money supply--as in the 1930s--it is dangerous. During the four years prior to 1933, U.S. consumer prices fell by 25% and real GDP by 30%. The Economist sees runaway deflation of this sort much more dangerous than runaway inflation.

Additionally, The Economist sees America's boom as "scary, fueled by an unsustainable stock market, which is now the main prop for global demand." With reduced Asian demand choking U.S. corporate profits, how much longer can stocks hold up? This stock market has engendered optimism that permeates all facets of the economy. If the stock market drops of its own accord, consumers will curtail buying, fulfilling The Economist's worse fear. Even if the stock market does not turn down in a big way, how much longer will U.S. consumers continue to go in debt to buy?

Total private-sector debt is now around 130% of GDP, compared with less than 100% of GDP in 1928. In Japan, private sector debt stands at 200% of the Japanese GDP. If consumers themselves do not see the dangers of such reckless behavior, the lenders will. A consumer-driven economy is fragile because consumers are fickle.

Additionally, a declining stock market would curtail consumer spending that would help bring down the stock market further. Ominously, both stock prices and consumer spending seem set to fall of their own accords. Consumers are borrowing to buy (and to invest in stocks), an economic phenomenon that cannot sustain itself, and the stock market has given clear signals that it has probably topped. Investors should plan for a slowing economy and declining stock prices. Whether the economy will turn down, only time will tell. However, even a slowing economy will send stock prices reeling.

The Economist sees the world's economy as "precariously balanced on the edge of a deflationary precipice." It laments that "monetary policy in the G7 economies, taken as a whole, is too tight."

If The Economist can see the signs of trouble, so can central bankers who control the world's printing presses. In fact, evidence suggests they already have. Most of the world's major central banks are going with loose money policies. In the U.S. the money supply in the U.S. has exploded. For years, while warning of the dangers of inflation, Fed Chairman Alan Greenspan has steadily increased the money supply. With the Asian crisis, Greenspan sped up the rate of increase.

The Japanese, trying to pull their economy out of a tailspin, have driven interest rates to zero, and have become the world's largest borrower, replacing the U.S. Now, The Economist is calling for Japan's central bank, the Bank of Japan, to use "still another instrument in its tool kit: It can increase the quantity of money by buying government bonds--i.e., by printing money." The magazine notes that "this solution is not without it drawbacks" but is necessary to head off deflation.

Such a monetary policy would "push down the yen, and so both lift exports and push prices up" (move from deflation to inflation.) Several prominent economists have called for the Bank of Japan to employ a monetary policy that would guarantee 3%-5% rates of inflation over the next ten to 15 years. Finally, noting stagnant economies in Europe, The Economist calls for the newly-formed European Central Bank to relax its monetary policy.

Relaxed monetary polices around the globe spell trouble for the U.S. Our trade deficit stands at record high levels. For the U.S., weaker currencies mean cheaper imports and more expensive exports. Look for the trade deficit to grow, but listen for the economists tell us it is okay because we are helping head off worldwide deflation.

Many people fail to grasp the significance of our huge trade deficit. Look at the U.S. as your household. When spending equals income, you have a balanced budget (balanced trade). But, when spending (imports) outstrip income (exports), you are living on borrowed money. That can go on for only so long. When your creditors suspect you may have trouble repaying the borrowed funds, they cut you off. This lowers your standard of living because you no longer have the borrowed funds to live on.

Additionally, when you have to pay back the borrowed money, your standard of living is lowered still further. Someday, all those dollars flowing abroad via our balance of trade deficit will become unwanted. Then they will return to the U.S. where they will lay claims to our goods and services. We will see the dollar fall in the world's currency markets and the results (rising prices) of inflation (increased money supplies). Our standard of living will suffer. (Precious metals do very well during such times.)

The issue of deflation vs. inflation has been hotly debated in the gold industry for 25 years. However, throughout history, whenever a nation's money has not been linked to gold, inflation has been the result. For example, the United States enjoyed relatively stable prices from 1790s to the 1930s, when the dollar was linked to gold. Prices collapsed in the 30s because the Federal Reserve shrank the money supply. During the Revolutionary War, the Continental Congress printed continentals to help finance the war, and as the patriots' war efforts took turns for the worse, continentals became worthless and gave birth to the expression not worth a continental, which is sometimes still heard. During the Civil War, Abraham Lincoln's "greenbacks," which were not redeemable in gold, shrank in purchasing power.

The Coinage Act of 1792 called for U.S. money to be gold and silver. Furthermore, Article I Section 10 of the Constitution says that "No state shall coin money; emit bills of credit; make anything but gold and silver coin a tender in payment of debts." This section reserves the right to coin money to the federal government, forbids the states from paying for goods and service with bills of credit (paper money), and forbids the states from permitting anything but gold and silver coins to be used in payment of debts. The Founding Fathers well knew the dangers of paper money.

The establishment of the Federal Reserve System in 1913 set the stage for inflation. Franklin Roosevelt's 1933 gold recall was the second act, and Richard Nixon's "closing the gold window" in 1971 was the finale. Roosevelt's action prohibited Americans from redeeming paper dollars for gold; Nixon stopped foreigners. Since then, the U.S. money supply has skyrocketed, and so have prices. A 60-year-old American has seen prices rise 1,000% in his lifetime.

Ironically, The Economist is anti-gold and often runs articles ridiculing it. The Economist blames "overly tight monetary policies, and the straitjacket imposed by the gold standard for the prolonged deflation in the 1930s."

At times, it admits that "Until about 60 years ago, prices in general were as likely to fall as to rise. On the eve of the first world war, prices in Britain, overall, were almost exactly the same as they had been at the time of the great fire of London in 1666." The Economist fails to mention that until about 60 years ago, the world was on a gold standard.

"In the last 30 years of the 19th century, consumer prices in the U.S. fell by almost half as the expansion of railways and advances in industrial technology brought cheaper ways to make everything; yet annual real growth over that period averaged more than 4%." So, if the "expansion of the railways and advances in industrial technology" brought cheaper prices along with increased growth in the last 30 years of the 19th century, why are not the tremendous technological advances of the last 30 years of the 20th century producing growth instead of dreaded "deflation?"

Because the world is no longer on the gold standard, governments and central banks (acting together) have inflated the world's money supply, which permitted huge over-investment in production capacity. The Economist wants the G7 economies to further inflate their money supplies to head off deflation caused by an already inflated money supply. The Economist sees increases in the money supply as a stimulus to demand, thereby closing the gap between excess production capacity and demand.

The Economist has made a dangerous call, a recommendation based on the flawed theory that central banks can "control" economies. We are about to see that what central banks do best is inflate money supplies and transfer wealth from creditors to debtors as borrowers repay borrowed money with money of less value.

Over the last sixty years, as prices have risen 1,000% in the U.S., borrowers have benefited at the expense of savers. Falling prices--as during the last 30 years of the 19th century--rewarded savers as their dollars gained purchasing power. Now that falling prices are about to reward savers again, the central bankers are setting about to make the world awash in paper money. In the inflation/deflation war, inflation will win.

Just as inflation rewards borrowers, deflation punishes them. Not only does the real burden of debt rise, but falling property prices reduce the value of collateral. This forces banks to write down debts on commercial loans, and it puts millions of home loans with marginal equity in danger of default. In a deflationary scenario, many home owners would find themselves with mortgages much greater than the values of their homes, and they would default. This would be especially true for those home owners who lost jobs. With many mortgages requiring two incomes, a deflation-induced recession would produce more bankruptcies, which are already at record high levels.

Furthermore, the largest borrowers are governments and corporations. Does anyone really believe the U.S. government wants to repay its $5.65 trillion in the national debt with dollars more valuable than those borrowed? Do the international corporations want to repay their debts with more valuable money? Do home owners want to pay off their mortgages with harder-to-earn dollars?

Let us suppose that deflation wins. Will precious metals be good investments? If we suffer massive deflation, the price of nearly everything will collapse. But, so will the banks with their fractional reserve banking, mortgage companies with their "nothing down" loans, and the stocks of highly-leveraged corporations-- which means nearly all publicly-traded companies. The metals would provide safety and security not found in other investments.

Investors should plan for massive inflation. The Economist accurately sees "runaway deflation" as more dangerous than inflation. Alan Greenspan, too, knows the dangers of deflation. Over the last five years, the Federal Reserve has steadily increased the money supply. With no gold standard to hold the Fed in check, inflation is inevitable. Plan your investments accordingly. Precious metals should be the foundation of all portfolios.

Bill Haynes
Certified Mint Inc.
October 14, 1999