Deflation or Inflation

Nice summary from Todd Harrison on Minyanville:

Our Wishbone World

The market has been dealt a historic hand and the global stakes have never been higher.

For the last six years, the ace up the Federal Reserve’s sleeve has been the U.S. dollar. They’ve let the greenback devalue with hopes that a legitimate economic recovery would take the place of the credit expansion that has dominated this decade.

Since 2002, the world’s reserve currency declined 37% while everything measured in dollars appreciated in kind. This dynamic passed largely unnoticed by stateside players but it’s been a source of stress for foreign holders of dollar denominated assets.

We call this “asset class deflation vs. dollar devaluation” in Minyanville, which is to say that we’ll toggle between the two as policy makers pull fiscal and monetary strings. While both sides of that equation can potentially falter, the deck is stacked against both the dollar and asset classes rallying in synch.

As global players pile their chips on the trading table, credit jokers have appeared with greater frequency. It started with subprime debt, moved into asset-backed commercial paper, spread to auction rate securities and is now migrating to municipalities.

While near-term nuances are difficult to digest, the big picture has come down to a simple question. Will foreigners allow the dollar to devalue further, paving the way towards hyperinflation, or will capital drain from the system and introduce a prolonged period of deflation?

Critical Crossroads

What’s clear is that the game itself has experienced a seismic shift. Central banks have been extremely proactive in what they do and how they do it. This has been going on for years but the efforts increased appreciably since last summer. We opined at the time that something was afoot and the pieces have seemingly fallen in place.

We are approaching a critical crossroads. Structural imbalances have cumulatively increased since the back of the tech bubble and risk has built to a crescendo. The credit contagion simply served as a catalyst to bring this conundrum to bear. All that remains to be seen is where the bear will domicile.

Let’s look at both sides of the great debate. To the left is the socialization of markets, nationalization by governments and hyperinflation. To the right, we have asset class deflation, risk aversion and the unwinding of the debt bubble.

If the Northern Rock nationalization is the first in series of similar steps, we could conceivably see the stateside assumption of mortgage debt by the U.S government. This would hit the dollar and spike equities, at least until interest rates rose to levels deemed attractive as an alternative investment.

That is the hyperinflation scenario, one that is presumably preferred by the powers that be as an alternative to watershed deflation. The “haves” would fare better than “have nots,” which would include the former middle class that suffers as a result of moral hazard, as the costs of goods and services skyrocket.

The other scenario is the draining of liquidity from the system, which would ignite the fuse for a higher greenback as currency becomes scarcer. Asset classes across the board, from commodities to equities, would deflate and impact the top tier of our societal structure that is tied to the marketplace.

This is, quite obviously, problematic for many policy makers and the constituencies that bankroll them. Deflation in a fractional reserve banking system means that they have, for all intents and purposes, lost control of the economy. It is an admission of defeat, albeit one that may be unavoidable.

No Easy Answers

Last week, while dining with Minyanville sage Mr. Practical, we were discussing the congressional testimony of Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson. We arrived at the conclusion that they must see what we see but their hands are tied with regard to how they publicly posture themselves.

The banking system, stymied with credit contagion, is not operating normally and the communication thereof is delicate. Hidden behind proposed bailouts, stimulus packages, super-conduits, term auction financing, mortgage rate freezes, foreclosure freezes and working groups are politicians attempting to engineer a business cycle that long ago lost it’s way.

As Mr. Practical observed as we surveyed the situation, “None of these plans will affect the larger deflationary credit contraction. Debt deflation is occurring outside of the Fed’s control at the world’s money center banks, where supply and demand for credit has undergone a rapid and significant decline.”

This process will take years to manifest but will ultimately yield positive results. The destruction of debt will allow world economies to build a solid foundation for future expansion that is entirely more secure than what we currently have in place.

Deflation will cause paper wealth to evaporate and rich nations will be forced to pour real money—as opposed to cheap debt—into developing economies as a redistribution mechanism. While the path might be painful, the destination will be a sustainable starting point for future generations.

There is a marked difference between taking our medicine, which is a function of time and price, and injecting the system with drugs with hopes that the pain will pass. The latter matter continues to be the diagnosis of choice, as evidenced by current events, but the patient would be well served to understand the prognosis.

There are no easy answers but there are certainly simple truths. The sooner we prepare for the worst, the better we can in good conscience hope for the best.