Japan Today, Zimbabwe Tomorrow?

A gallon of gas in my neighborhood peaked in mid July at $4.96. Yesterday, the same gas at the same station could be had for $1.84 a gallon ... 63% deflation in a matter of months! Earlier this summer, Steven Colbert joked that, "When I first started paying $4 a gallon for gas, I didn't mind. I thought I was just getting better gas." Let's hope the same theory doesn't work in reverse.

All of this deflation might seem completely backwards at first. Now that Uncle Sam has thrown some $8.6 trillion at the financial fiasco, you'd expect inflation, if not Zimbabwe-esque hyperinflation, to rule the economy, right?

Print now or forever hold your peace
Sort of. Inflation isn't simply the result of the Fed printing money; it's also a function of how fast consumers turn around and spend that money -- called money velocity. Without any velocity, the Fed can create money like no one's business, but inflation won't budge (at least for now ... keep reading.) Think of it this way: You can make as many bullets as you want, but those bullets don't do any damage until they're actually fired.

A good example is Japan in the '90s. In a desperate attempt to pump life into the economy, Japan nearly tripled its money supply over the course of a decade. Did it lead to crippling inflation? Nah. Check out this chart -- Japan struggled to keep prices treading water for years. Why? Check out the blue line in this chart -- the velocity of money fell off a cliff. There were more factors involved here, but Japan's a good example of an explosion in the money supply that didn't come close to inflation.

The reason countries like Zimbabwe get destroyed by hyperinflation isn't just because the government runs the printing presses at full-bore, but because the urge to spend that money is out of this world. There are stories of Zimbabweans prepaying their restaurant bills because the price would surge in the time it took to eat. When you get a situation like that, anyone in their right mind will get rid of (spend) their money as quickly as possible -- likely within hours of getting it. In other words, the velocity of money is off the charts.

So what are we -- Japan or Zimbabwe? Maybe Japabwe?
Right now, the velocity of money in the U.S. is plunging because we're deleveraging like there's no tomorrow. What little money people have is going to either mending debts or saving in anticipation of a dismal future. Even oil companies like ExxonMobil (NYSE: XOM  ) , ConocoPhillips (NYSE: COP  ) , and Chevron (NYSE: CVX  ) are facing the reality of cash conservation.  

That's why it's deflation, not inflation or hyperinflation, that's taking control these days. We can keep the printing presses rollin' 24 hours a day, but it won't become inflationary in the short term simply because no one's willing or able to spend it (more specifically, banks like Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) aren't dumb enough to lend it out to people they know aren't able to pay them back). More importantly, the Fed can pull monetary liquidity out of the banking system before money velocity picks back up, extinguishing an inflationary bedlam before it becomes a problem … at least in perfect world.

Now for the other side of the coin
The big questions are what happens when (a) consumers pull out of the fetal position and start spending while the Fed is asleep at the wheel (cough … Alan Greenspan … cough, cough) and (b) what happens when foreigners finally realize that greenbacks are really just pieces of paper and stop buying Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) securities and Treasury notes, spawning a fire sale of the dollar.

Many economics textbooks mention inflation with a disclaimer of "assume a closed economy," which is essentially asking you to believe we're a self-sufficient economy that doesn't borrow a dime from the rest of the world.

Of course, it's malarkey. As a country hellbent on spending more than we make, the inflationary forces that'll dictate the future rely on the hope that foreign investors will believe we're the world's alpha economy. The major difference between our current situation and Japan's in the '90s is that Japan didn't rely on the world's willingness to fund its indulgences.

Where we go from here
My guess is that the future threat of inflation will be a balance between the two forces:

  1. The Fed raising interest rates and reigning in the money supply before money velocity awakens from hibernation.
  2. A gradual loss of confidence by foreign investors that undermines a lot of what the Fed can combat.

Bottom line: There's no way around a weaker dollar and a hefty dose of inflation in the future. But weigh the two above forces together, and I'm loath to think it'll be as meteoric as hyperinflationist goldbugs like to dream about. There are balancing forces on each side of the equation. On one end, you can't just look at the current money supply and pin down the prospects of future inflation without considering that the Fed can pull liquidity out of the banking system before money velocity picks up. On the other hand, you can't get too comfortable with the prospect of lingering deflation simply because we're beholden to a global financial system that'll eventually lose its appetite of paying for our mistakes.

For related Foolishness and ideas on how to battle the forces of inflation:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Bank of America is a Motley Fool Income Investor recommendation. The Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (57)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 05, 2008, at 3:12 PM, woodinville wrote:

    This is one of the few balanced viewpoints of the inflation/deflation argument I have seen. Most of the "prose" I am reading these days are screaming hyperinflation and gold going to $5,000. I own a little gold so that would be nice, but it is highly unlikely. I think the stormy cycles we have seen through history will resemble what we are going through now, however, we will probably got a few more inches of rain than we are used to this time !

  • Report this Comment On December 05, 2008, at 5:18 PM, Snertie wrote:

    My theory is that we've already experienced much of the inflation - pre-inflation if you will – through the housing bubble. In many metro areas, new houses start at over half-a-million. Realistically, without flim-flam financing, how many “middle Americans” can legitimately afford that? In hindsight, the answer now is clearly “not that many”.

    My theory is that home prices are going to stay where they are in their currently inflated state for some time to come, while the rest of the economy (services, other goods, and finally wages) spend the next several years trying to get caught up.

  • Report this Comment On December 05, 2008, at 6:50 PM, XMFSinchiruna wrote:

    I echo the above reader's praise. This an excellent breakdown of the factors at play, and you did a great job of presenting your viewpoint. These are highly complex issues moving at the speed of light with experiments in monetary policy that are utterly untested. We can look to historical cases and hope they shed light on our predicament, but under the circumstances I suppose none of us -- on either side of the debate -- can quite be sure.

    We agree on so many points, which makes the ongoing debate all the more enjoyable. If you don't mind, I'd like to reply more fully in a forthcoming article. :)

    In the meantime, just in case I crossed your mind when you referred to 'hyperinflationist goldbugs', permit me just to clarify that 1.) I resist the title of goldbug, since my reasons for investing in gold are based upon objective hypotheses rather than some primordial fascination with the metal as the term might imply; and 2.) by no means at any moment do I 'like to dream about' about a hyperinflationary scenario. I am deeply saddened by the extent to which our financial system has been compromised by the neglectful stewardship of our currency.

    Thanks again for bringing this crucial debate back to the fore, and congratulations on another excellent analysis.

  • Report this Comment On December 05, 2008, at 9:42 PM, theo68 wrote:

    I agree. Good analysis on a subject that is glossed over all too often. However, I'd like to expound on the points below:

    "My guess is that the future threat of inflation will be a balance between the two forces:

    1. The Fed raising interest rates and reigning in the money supply before money velocity awakens from hibernation.

    2. A gradual loss of confidence by foreign investors that undermines a lot of what the Fed can combat."

    The inflation will likely stem from Government efforts to combat the current deflation with massive spending causing it to incur more debt. The increased national debt undermines the stability of the dollar and also perhaps the creditworthiness of the U.S, Government.

    The Fed's primary tool for raising interest rates involves selling more bonds to pull money out of the economy (open market operations). This may be easier said than done if confidence in the dollar is on the wane. If this lack of confidence becomes apparent to the public then the U.S. Government may lose the ability to control the rapid devaluation and possible destruction of its currency.

    Of course the government can raise taxes (especially on the middle class, since they are the primary consumers) or dramatically cut spending, but I doubt it would have the political will to do that; at least not until it is too late.

    I'm not saying that this hyperinflation scenario is certain, or even likely; but to dismiss it as a "goldbug" fantasy isn't quite responsible either. No one can say for certain how things will play out over the next few years, but I do believe we run a higher risk for hyperinflation now than at any time in this country's history.

  • Report this Comment On December 06, 2008, at 3:19 PM, chantillydude wrote:

    The money supply is not now well defined so speculating about inflation is somewhat like describing an elephant while blindfolded. The toxic mortgage assets and other CDOs may have no value at all. If that's the case then 10s of trillions of dollars have been destroyed and the extension of $8 trillion by the USG may be a drop in the bucket that is emptier than we are led to believe. Inflation then would not be a concern but deflation would. If the money supply has shrunk and the velocity of money has declined then the number of transactions and price level are bound to fall and deflation spirals on.

  • Report this Comment On December 06, 2008, at 9:17 PM, altrue1090 wrote:

    I'm wondering whether population size affects this equation. Consumption makes up 70% of the economy. Consumption is the money spent per person times the number of people. When the population rises, consumption rises. Until 2007, the U.S. population was rising steadily because of legal and illegal immigration. Then we started building border fences and deporting record numbers of immigrants. Population growth stopped, consumption growth stopped, and economic growth stopped. If we want to support the price of houses, don't we need to import more people to buy them? Shouldn't we increase legal immigration and work visas?

  • Report this Comment On December 06, 2008, at 10:47 PM, cooski wrote:

    One small correction - banks not dumb, especially Citigroup? I never will consider myself a genius, but if they aren't dumb, I'm Einstein.

  • Report this Comment On December 07, 2008, at 12:39 AM, bigkansasfool wrote:

    I like the article except for two statements: (1) "what happens when foreigners finally realize that greenbacks are really just pieces of paper" and (2) "banks like Citigroup (NYSE: C) and Bank of America (NYSE: BAC) aren't dumb enough to lend it out to people they know aren't able to pay them back".

    (1) No major currency is backed by anything other than "the full faith and credit" of the government behind it. The US is the reserve currency of the world for a reason. When the sh..stuff was hitting the fan everyone in the world was fleeing to the US dollar. That should be telling you something.

    (2) Citigroup is the prime example of a stupidity run-a-muck bank. Part of Citi's problem is that it is so big that the right hand doesn't know what the left hand is doing. But the lending practices at Citi were, and still are, some of the worst ever.

  • Report this Comment On December 07, 2008, at 4:24 PM, flyingdutchmanjr wrote:

    So, "banks are reluctant to lend money to people they know can't pay them back"

    Well, when did that happen? Too bad the banks didn't get religion sooner. If they had perhaps we wouldn't be in the mess we are now.

  • Report this Comment On December 07, 2008, at 6:40 PM, redneckdemon wrote:

    Thanks for this article! I have been wondering about that ever since the bail out. It is starting to make sence now.

  • Report this Comment On December 11, 2008, at 12:35 PM, rfaramir wrote:

    'So, "banks are reluctant to lend money to people they know can't pay them back"'

    "Well, when did that happen? Too bad the banks didn't get religion sooner. If they had perhaps we wouldn't be in the mess we are now."

    Banks that tried to lend with common sense had "community organizers" protesting outside and suing them so they couldn't get further financing. Suing based on that Democrat maybe-good-intentions-definitely-bad-results Community Reinvestment Act. This is also known as "shaking down" people with money but less political power, also known as Chicago politics as usual.

    And now one Chicago organizer is President-Elect and the people around him are going to jail in droves. No hope for the markets in the near term. Sorry. Maybe once people with common sense and morals are back in power and start repealing the mess that government has created.

    All that said, my new money (as it trickles in), IS going into companies that will survive this market. NOT into "the market" which will surely languish.

  • Report this Comment On February 25, 2009, at 1:19 AM, financegooglecom wrote:

    There is a concept in social psychology called "the <a href="http://en.wikipedia.org/wiki/Social_dilemma">Commons Dilemma</a>". In these situations, the individual's interests are at odds with the collective interests of the group. Want an example: What did you do with your stimulus check? Did you spend it to stimulate a declining economy, or did you reduce your debt, pay down credit card bills, or even worse put it in savings!

    For a stimulus to work, the average American's interests must be aligned with the collective interests of the country. As of now, they absolutely aren't. People aren't being as rash as economists were expecting (isn't it funny how the threat of a global recession keeps people from spending money?). So how do we get people to spend money? Restore faith in our economy. Hopefully Obama becomes our Jesus Christ, Muhammad, or yet to arrive Messiah.

    Instead of hoping, maybe the big bad government might actually have to pull a big brother and pressure the media to report less about the recession and more about local murders and American Idol contestants. Perhaps a tour of confidence and yes, propaganda, to help restore confidence. Did you know the most common cause of a panic attack, ironically, is the fear of having a panic attack? Maybe the public just needs some reassurance to calm down and start spending their bonuses from Citigroup. Which in turn might put up some confidence-inspiring numbers for Wall Street, so we only have a credit market to fix and not a global economy.

    It's an idea. A rather bleak and overly-simplified idea. Let the foolish discussion commence.

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