Inflation vs. Deflation: Endgame Approaches

This post first appeared on Minyanville and Cirios Real Estate.

Of the myriad highbrow economic debates currently raging throughout the world of punditry, academia and government policy, few are as contentious as the one over the future of prices: Inflation vs. Deflation.

Indeed, the endgame for this issue is not insignificant, as many believe our economic future hinges on the Federal Reserve’s ability to deftly engineer a return to steady, manageable inflation. To say the least, this is no easy task.

With the unemployment marching upwards, credit markets still largely frozen and global trade grinding to a halt, the American economy is in desperate need of a monetary jolt. The trouble for Fed Chairman Ben Bernanke is that with interest rates already at zero, he’s being forced to rely on so-called “quantitative easing” to pump money into our badly bruised financial system.

These efforts are being managed through the alphabet soup of new lending programs like TALF, TAF, CPFF and others.

Meanwhile, a glut of savings from the developing world coupled with reckless financial alchemy caused debt loads to skyrocket to unsustainable levels. The ongoing destruction of that debt, discussed often by Minyanville's Kevin Depew and Mr. Practical, is now raging at full speed, as assets of all types have come screaming back to earth.

Bloomberg highlights the debate by focusing on 2 highly regarded economists with divergent views on inflation and its causes.

John Maynard Keynes, a 20th century British economist gained notoriety for his thesis that inflation was controlled by supply-demand fundamentals within an economy. He advanced the view that well-directed government spending could help a country balance economic growth with a moderate, healthy rise in prices.

Western politicians jumped on the Keynesian bandwagon during much of the last century to support a vast expansion in government spending and intrusion into the private sector.

Opposing Keynes was Milton Friedman, who instead believed that “inflation is always and everywhere a monetary phenomenon.” Friedman’s focus on monetary policy, that is, interest rates and controlling the flow of money through a country’s economy, clashed with the Keynesian view that inflation could be controlled with fiscal measures and legislation.

Bernanke is doubling down on Keynes, evidenced by recent lending initiatives, bailouts of financial institutions like American International Group (AIG) and his support of President Barack Obama's massive fiscal spending program. The Fed’s involvement in cleaning up the balance sheets of Citigroup (C) and Bank of America (BAC), along with efforts to jumpstart the mortgage market have also diminished its ability to remain apolitical and tend solely to the needs of the economy.

The Fed's gamble is a bold one, as inflating our way out of a deflationary debt unwind could lead to a rapid, uncontrollable rise in prices should the economy rebound sooner than expected.

For example, big oil companies like Exxon Mobil (XOM) and Chevron (CVX) will be reticent to invest in new technologies or drill new wells should crude prices remain low. Limited production capacity could squeeze supply when demand picks back up, leading to a rise in prices.

This trend of firms retrenching in response to rapidly waning demand for goods is being mirrored throughout the economy. And although the Fed promises to take back the monetary stimulus when the economic growth returns, the timing and political implications of such a move are anything but a slam dunk.

And unlike other more esoteric debates over economic ideology, the result of the inflation vs. deflation slugfest has real implications for all Americans.

Inflation, while generally viewed as a necessary evil for economic growth, lines the pockets of those invested in financial and other economic assets at the expense of those on the lower rungs of the economic ladder. If real incomes rose at the same rate prices did since the Fed was created in 1913, they would currently stand at $300,000 per year, six times the current median household income of around $50,000.

In other words, Americans earn about 80% less, in real terms, than they did 100 years ago.

Deflation, while causing a drag on the economy at large, benefits those making less money as each additional dollar they earn stretches further. Meanwhile, at the top of the economic spectrum, the wealthy dislike deflation since their stocks, bonds, commodities, homes and Rolexes all fall in value.

As calls for a stock market bottom and impending economic recovery gain momentum, so too will predictions of rampant inflation. Ironically, Bernanke and fellow central bankers around the world are counting on the hangover from the financial crisis to be bad enough to forestall a resurgence in demand and enable them to slowly, carefully withdraw their monetary steroids.

Whether that will be possible, or even politically acceptable is anybody's guess.