Sunday, July 18, 2010

The money supply is increasing, that is technically inflation, why then does it feel like deflation?

By Nick Sorrentino

Technically we are not in deflation. The money supply is increasing. The money supply is in fact inflating.

The problem is that there is so much debt, personal, municipal, state, sovereign, etc. that as each new dollar floats out into the universe, the debt black hole pulls that dollar into its depths, gone forever. This is why in the “real” economy I believe we are in deflationary situation.

Many of my friends have been making the case for inflation, hyper and otherwise for a while, and I think that in the long run it is possible that they will be right. In the near and medium term I think they are wrong at least as far as the “real” economy is concerned. Technically they are already right.

What does this mean?

Will gold prices head down for instance? This is an interesting question for a number of reasons, but I question whether the fact that gold is likely to go “down” in dollar terms matters.

An old gold dealer I knew said something to me a long time ago now. “What do we do when the price of gold goes down? Buy more.”

Most people still think of gold as going up or down based on its value in a dollar defined economy. If the price of gold goes up is must be because its value is perceived as higher than before by investors. This is of course an important part of the gold equation. But it is less important than what is happening to the currency that gold is priced in.

Its not that the gold price goes up or down, it is that the currency the gold is priced in is more or less valuable.

Gold has held its value at a very stable level for thousands of years. An ounce of gold in Jesus’ time would buy you a pretty nice tunic and a good pair of sandals. 100 years ago it would buy a nice suit and pair of shoes. Today an ounce of gold will still buy a decent suit and shoes. 100 years ago an ounce of gold was roughly $20. You could get that suit and shoes for $20. Today that $20 would barely buy you a handkerchief at Brooks Brothers. But the $20 gold piece from a century before would get you almost any suit in the place.

The value of gold is fairly stable. It is paper that fluctuates.

So in a “deflationary” situation such as the one I believe we are looking at gold “prices” in dollar terms are headed south perhaps for a bit. But the “value” of this gold will continue to rise because the “deflation” is happening despite all efforts by the central banks, which means that things are even worse than we may have thought. At least with a hyper-inflationary situation you can say that the banks just pushed the accelerator too hard and that the answer is to ease the foot off of the pedal, or to slam on the brakes if need be. At least there is some sense of some kind of control.

But what happens if the central banks press the accelerator, gasoline pours into the combustion chamber, but the engine doesn’t turn over? What then? What if the combustion chamber has a huge debt leak in it and no matter how much fuel comes into the thing it just ain’t gonna ignite?

Well then it’s time to take the economy to a new mechanic. Maybe an Austrian mechanic.

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About Me

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Nick Sorrentino is the Editor of The Liberty and Economics Review and CEO of a social media management company.