Berkshire Hathaway
Inflation, Deflation, Contraction, and Commodities

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By TinyArchibald
July 15, 2009

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Maybe just me, but I'm amazed at the level of intellectual caliber you've got in this inflation/deflation debate who are coming to completely opposite conclusions. You've got Buffett, Hussman, Kasriel (, and then you've got guys like Rosenberg and the above firmly in the deflation camp.

Perhaps it is not necessary to have a firm footing in either camp -- at least, not yet.

I think the gold price is still the best signal of monetary inflation/deflation. After a huge rise in the gold price and an accompanying rise in virtually all commodities, the dollar price of gold have been steady since March 2008. The price declines in commodities experienced since this time last year have nothing to do with monetary deflation (a change in the value of the unit of account) and everything to do the sharp abruptness of the global downturn. It really was an unprecedented situation in terms of modern history to have such a huge global inflation and then an abrupt switch to severe recession (even in 1973-74, inflation and the gold price galloped higher as the downturn deepened).

However, despite the abrupt downturn which lead to incredible surges in above-ground supplies and inventories of basic goods and commodities (evident in the change from backwardation toward unheard levels of contango in the futures market, especially in energy), commodity prices did not plunge to levels associated with more shallow recessions (e.g. 2000-02) Why? Simply because the unit of account with which these commodities are quoted is worth less, with gold demonstrating this change in value the clearest. Gold does not hop between backwardation and contango the way other commodities do -- gold remains in contango and does not exhibit varying degrees of contango, instead the contango stays very close to the cost of carry (margin interest rates plus storage costs).

Here is a decent long-term chart of commodity prices;
All commodities are higher in dollar terms in 2008-2009 than during the strong dollar era of 1990-2002, except for the lumber group. It certainly wasn't demand from China keeping prices at a higher plateau over the past 12 months, judging by the sharp inventory bulge and steepening contango.

The biggest part of the problem is that most people do not understand the difference between economic contraction and monetary deflation, confusing the two and believing that they are the same thing. The Great Depression was an economic contraction, not a deflation. Prices fell during the declining economic phase of 1929-1933, but resumed rising when the decline stopped. By 1939, wholesale prices in all countries were higher than their 1929 levels (and higher than 19th century levels), especially after the round of devaluations that began in 1931 (the U.S. devaluing by 69 percent in 1933, the first permanent devaluation in more than a hundred years).

In a true monetary deflation, the general price level is trending lower regardless of whether the economy is expanding or contracting. In the U.S. after the Civil War, prices shifted over a period of years back to the pre-war price level after the government deliberately revalued the dollar to its pre-war, pre-inflation level of $20.67/gold oz..

In Japan from the mid 1980's until roughly 2003, the wholesale price level trended lower, consistent with increase in the value of yen in terms of gold;

Study that chart closely because that is what a true monetary deflation looks like - a persistent rise in the value of the currency that eventually pushes all economic prices lower, beginning with goods and services of short contract duration (i.e. spot prices of commodities) and eventually extending to longer duration economic contracts (wages, leases, interest rates etc.).

Ironically, when Ben Bernanke was giving his 'helicopter' speech in November 2002 about how the central bank could outflank the deflationary threat that was in existence at that time, the gold price was telling everyone that the threat was in the rear view mirror. The dollar's value against gold had already risen to a multi-year low by that time, erasing much of the deflationary pressure that had depressed commodity prices and reversing the damage done to the emerging market economies who had fixed their monetary systems to the deflationary dollar.