Depression and Inflation

March 3, 2009
Market Analyst & Professional Speculator, Owner of The Speculative Investor

Clarifying our depression forecast

Although we are anticipating another great depression we want to emphasise that we are NOT anticipating a replay of the 1930s. We are anticipating a drawn-out period of economic contraction, but the details will almost certainly differ markedly from previous depressions.

One of the most important differences between the coming -- actually, "current" is a more appropriate word since it has probably already begun -- great depression and the 1930-1945 episode is that today's version is likely to be inflationary. An inflationary depression is potentially worse because the inflation (money-supply growth) leads to more mal-investment (more wasted savings) and higher living costs relative to incomes.

Another difference is that the government of today will provide a more extensive 'safety net' for people who fall on hard times. Paradoxically, this could lead to even greater economic weakness than occurred during the 1930s. The reason is that the government pays for the safety net with money that would otherwise have been used in productive endeavours.

On a related matter, the government could all but eliminate unemployment during a depression by giving every unemployed person a government job, which is effectively how the Soviet Union eliminated unemployment (that, and by sending millions of people to forced labour camps). Such a massive expansion of government is our greatest fear because it would make the depression permanent.

Lastly, thanks to the technological advances that have occurred over the past 70 years today's economy is structured very differently to that of the 1930s. However, we don't think this will have a significant bearing on whether our grim economic forecast comes to pass. People in semi-capitalist countries naturally view the present day as the "modern era" and the distant past as a more technologically backward era, but in doing so they often fail to appreciate that the people in the now seemingly backward era viewed the situation in exactly the same way. For example, due to the rapid advances in technology and manufacturing productivity that occurred during the first three decades of the Twentieth Century, many people in 1930 argued that things couldn't possibly get as bad as they were in the 1870s, or even as bad as they were in 1920-1921. We now know that things got much worse, despite the great technological progress that had been made and the associated structural changes that had occurred in the interim.

The fact is that throughout history the bursting of an all-encompassing credit bubble has ALWAYS been followed by a very severe economic downturn, regardless of the economy's structure at the time. This is why credit bubbles must be avoided. Government attempts to 'soften the blow' during the 1930s turned a severe economic downturn into a 15-year depression, and the governments of today are making the same mistakes.

"Inflating away" the debt

Based on emails we have received, a fairly common view seems to be that the government will "inflate away" its own debt problem as well as the problems of debt-ridden private-sector consumers. Our view is that the government will TRY to do this, but as is typically the case it won't work as planned/expected.

Let's think this through. Monetary inflation causes a NON-uniform increase in prices throughout the economy, so someone can only benefit from inflation if his/her income and assets are amongst the INITIAL prices to rise in response to the inflation. For example, a steel worker with an uncomfortably large home mortgage will only benefit from monetary inflation if the inflation causes wages in the steel industry and the prices of homes in his location to rise faster than interest rates and living expenses. However, the opposite is more likely to occur. The excess supply of homes relative to genuine/sustainable demand and the excess capacity in the steel industry that resulted from the preceding boom will probably keep lids on home prices and steel-industry wages for a long time to come.

The average person is rarely helped by inflation because he/she is usually near the end of the line when it comes to the so-called 'positive' effects of inflation. Furthermore, in the current economic environment there is even less chance than usual that the average person will be a beneficiary of monetary inflation, and an even greater chance than usual that they will be hurt by monetary inflation, because the inflation will likely increase living and debt-servicing costs relative to incomes and will very likely do little to support home prices (at least initially). Only those average folk who have substantial exposure to gold-related investments stand a good chance of coming out ahead.

It is always the case that the biggest beneficiaries of inflation are the entities that get the new money first. Therefore, the biggest beneficiaries are usually the government, the banks, and large speculators. And as far as the next few years are concerned it is likely that the government will be the biggest beneficiary by a huge margin. This is because the government can borrow in terms of its own currency without giving any consideration to how the loans will ever be repaid, thus allowing it to grow rapidly at the expense of the private sector. Note, though, that the government can never actually "inflate away" its debt; rather, each new dollar that gets borrowed into existence necessarily results in a liability in excess of one dollar due to the obligation to pay interest. In other words, the debt always grows faster than the money supply. It is therefore a good bet that the quantity of debt will continue to expand until the entire monetary system collapses.

In summary, under the current monetary system the debt can never be "inflated away" because inflation occurs via the creation of additional debt. Furthermore, the people and organisations that benefit from the inflation, at least in the short run, are those that get the new money first. In the long run nobody wins, but if you are a Keynesian you don't care because in the long run we are all dead anyway.

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Steve SavilleSteve Saville graduated from the University of Western Australia in 1984 with a degree in electronic engineering and from 1984 until 1998 worked in the commercial construction industry as an engineer, a project manager and an operations manager.  In 1993, after studying the history of money, the nature of our present-day fiat monetary system and the role of banks in the creation of money,  Saville developed an interest in gold.  In August 1999 he launched The Speculative Investor (TSI) website. Steve Saville has  lived in Asia (Hong Kong, China and Malaysia) since 1995 and currently resides in Malaysian Borneo.  

In the Aztec language the name for gold is teocuitlatl which means "excrement of the gods."

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