Saturday, May 30, 2009

Krugman versus Johnson: The Inflation-Deflation Debate

The million dollar question on just about every investor’s mind right now has to do with whether the US is headed for massive inflation, crippling deflation, or some even more insidious combination of both. I have a news flash for everyone contemplating the answer to this question: no matter how much data you scrutinize, no matter how many very intelligent and articulate people agree with you, no matter how right you have been in predicting the evolution of this crisis, no one knows for sure. In situations such as this I like to quote PIMCO Co-CEO Mohamed El-Erian. When asked to make a specific forecast or prediction about the markets or economy, he unabashedly says, “The intellectually honest answer is I don’t know.” Of course, El-Erian and Bill Gross have spent the last few months writing and speaking about their concept of a “new normal” in which American consumers and investors are forced to realize that going forward things won’t be like they were during the credit bubble. Though this may seem like blind forecasting, from my perspective there is something more genuine about trying to anticipate major structural changes in the economy than making proclamations of what GDP growth (or lack thereof) will be in Q4 2009.

My honest view is that the situation is too dynamic and has too many variables for anyone to accurately predict how the inflation-deflation debate will eventually play out. None of us have crystal balls. While I sometimes suspect that John Paulson has either developed some form of future predicting device or a time machine (how else can you make $5.7B in two years?), the truth of the matter is that humans are not good predictors. Any data you look at, whether it is handicappers forecasting the winners of horse races or analysts estimating quarterly/yearly earnings per share for a company, indicates that these predictions are often substantially off the mark and any success likely has more to do with luck than anything else.

Despite the mountain of evidence that suggests that our predictive ability is no better than that of a coin flip, every day investors are bombarded with economic, market and company specific forecasts. I guess in some way it is a coping mechanism. In a very uncertain world people look to experts to offer guidance regarding what the future will look like. My personal strategy is to read as much as I can on the subject and pay special attention to material that is contrary to what I would be inclined to believe. Specifically, understanding the other side of any debate is crucial for investors. The best question an analyst can ask himself or herself is “where could I be wrong?” It is only when you understand the potential upside and downside of an investment that you can invest with confidence, assuming you have built in an appropriate margin of safety.

It is within the context of evaluating both sides of the inflation-deflation debate that I stumbled on two articles from two well-respected economists, both published on the New York Times website. On May 28th, former IMF chief economist Simon Johnson articulated his fears about looming inflation and on May 29th, Nobel Prize winning economist made his persuasive case for impending deflation. Now, I am still relatively new to the investing game and this is my first financial crisis, but I am continually struck by the fact that two ostensibly knowledgeable people can look at the same set of economic and monetary facts and come up with seemingly divergent opinions on what the future will look like. Not only that, but for a novice economist like myself, both make compelling enough cases that I almost feel comfortable believing both of their arguments simultaneously.

Briefly, Krugman argues that there is little sign of inflationary pressure in the US right now. He dismisses the idea that rising Treasury rates imply that we are on the precipice of hyperinflation. His take is that it is a misperception to believe that inflation is inevitable just because the Fed is monetizing the debt and printing money. While that may be true in ordinary times as banks would theoretically lend that money out, the fact that banks are actually just holding the money as reserves means there is very little money actually being added to the financial system. He then cites the Japanese experience as evidence that prices can continue to fall even when the government is purchasing its own debt. In conclusion, he believes that deflation represents the more proximate danger.

On the other hand Johnson believes that the Bernanke-led macroeconomic orthodoxy that is desperately trying to avoid deflation has been very wrong over the past two years and cannot necessarily be trusted. His claim is that the Fed’s pumping of money into the system can still cause inflation even if unemployment remains high and there is still a lot of slack in the system. The inflation he foresees is not wage inflation, but commodity inflation exacerbated by the attempts of investors to hedge a continually falling US dollar. This is headline inflation but not the core inflation that the Fed focuses on. Unfortunately, for people who have to fill up their gas tanks and buy groceries this is a very real threat. The ultimate concern is that the Fed will not be able to turn off the spigot in time or feels constrained to keep interest rates low in order to prevent the economy from dipping back into recession, events that cause inflation to surpass 5%. While that does not on its face sound like much, keep in mind that 5% inflation implies a loss of 50% of purchasing power in just ten years. Not quite Zimbabwe but also not something we really want.

So, what is my take on all of this? While it may appear that that both scenarios presented above could not play out simultaneously, it occurs to me that that they are not necessarily mutually exclusive. My fear is that we actually are facing a scenario of financial asset deflation (stocks, real estate, etc) and commodity price inflation (gold, oil, agricultural goods) combined with either stagnation of GDP or negative GDP growth. I am not even sure if there is a word for such a thing bit I guarantee it wouldn’t sound pretty. With unemployment continuing to spike we are by definition already seeing aggregate wage deflation but in a more scary scenario that could be supplemented by the wages of working people contracting (obviously not on Wall Street though) due to the supply glut of unemployed workers and reduced aggregate demand (this of course depends on the inherent stickiness of wages). If you combine financial wealth destruction, cost of living increases, and falling wages, we could be in for a nasty few years. While this is a pretty draconian scenario, my advice to my investing brethren is to not get anchored to one side or another of the inflation-deflation debate. Try to keep an open mind and search for investments that protect you from downside in either case. In such an uncertain time capital protection should be paramount because the honest truth is that we won’t know how it all went down until we have the benefit of hindsight.

(Picture courtesy of the New York Times and Fred R. Conrad)