2009 Mid Year Outlook: Expect Deflation and an Oil Price Drop

Inflation is not the act of printing more money. Printing more money leads to inflation but inflation is really more money chasing the same amount of goods which results in bidding up prices.

If the government expanded the money supply but as the new money trickled into the economy, everybody put that money into the bank we would NOT have inflation. We would have inflation when that new money came out and started bidding up asset prices.

Right now banks aren’t lending. People can’t get financing for the largest of purchases, home mortgages and cars. Lines of credit are being cut. Even people with good credit are having problems borrowing money, so imagine how people with average and poor credit are faring.

In the go go days anybody could borrow money to buy a home, a car, a European vacation or whatever they’d like on their credit card. The “what’s my monthly payment” mindset took over. American’s racked up obscene levels of debt. They consumed more NOW, but will in turn have to consume less later.

Debt is deflationary

Imagine you were living off of a fixed 50,000 dollars per year for 10 years.

Year 1 you spent 45k, nearly all of your money

Year 2 you spent 55k, all of your money + all of your savings

Year 3 you spent 60k, your 50 plus a borrowed 10K + (low) interest

Year 4 you spent 70k, your 50 plus a borrowed 20K in (low) interest

But now you bring in 50k per year but are 30k in debt. At some point you have to pay down that debt… It hampers your ability to borrow more money in the future. It means less consumption in the future.

If this situation happened to a couple of people, that’s one thing, but when everybody is trying to save more money and reduce consumption at the same time, it means deflation. We have a consumer driven economy ~70% and the consumer is on life support. There was too much cheap money, bidding up of asset prices (mainly homes), we had over consumption and now we are facing less consumption (deflation).

The “inflation camp” sees what the government is doing and they rightly see that printing all of this money is inflationary, true. However there are even larger deflationary forces among us. I believe the inflationists underestimate the size and scope of the credit bubble. The inflationists are only looking at the response, but ignore the credit contraction they are responding to.

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