Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 10th May 2009.

One of our readers sent us a very interesting article from itulip.com entitled "Everyone is wrong, again -- 1981 in Reverse Part II: Nine Signs of Inflation". The article is an explanation by Peter Warburton (the author of the book "Debt and Delusion") of why generalised 'price inflation' is likely to become an issue by early next year, with comments by itulip's editor (Eric Janszen) interspersed. We don't agree with every aspect of this article, but we do concur with its gist and conclusions. Unfortunately, we can't provide a link because it is in the subscriber area of the itulip web site, but what we can (and will) do is discuss some of the article's main points and tie them in with our own views.

One of the points made by Mr. Warburton is that global supply of goods and services has been damaged at least as severely as their global demand, but before exploring this point it is appropriate to address one of the many critical flaws in the Keynesian theoretical framework. The Keynesians generally view the economy in terms of aggregate supply, aggregate demand, and the so-called "output gap" that stems from an excess of aggregate supply (or potential supply) relative to demand. Right now they perceive a large economy-wide "output gap" caused by "excess capacity", and on this basis conclude that there will not be generalised price increases for many years to come almost regardless of what happens to the supply of money. In a nutshell, they believe that it will take years of increasing "aggregate demand" to use up the "excess capacity" and reduce the "output gap" to a level where businesses will be able to raise prices.

The central error in the Keynesian line of thinking summarised above is that it assumes the economy to be an amorphous blob. This assumption over-simplifies the real-world situation to the point of making the resultant analysis totally worthless. The real-world situation is that the inflation-fueled boom of 2003-2007 led to many ill-conceived investments, including the establishment of new production facilities and service businesses that were not supported by sustainable consumption trends, in SOME segments of the economy. These investments looked feasible for a while, but only because the cost of capital had been artificially suppressed. Now that the cost of capital has risen to a more realistic level the mal-investments of the boom period are in the process of being liquidated, meaning that the associated capacity is in the process of being eliminated. At the same time, there are other segments of the economy in which there was minimal mal-investment in new productive capacity during the boom.

What we therefore have are sectors of the economy where an increase in demand is likely to result in an almost immediate increase in prices (the sectors where there was minimal mal-investment during the boom), and other sectors where it will take some time before increases in demand result in higher prices. However, even in the latter cases the lead time from rising demand to rising prices will likely be a lot shorter than many economists currently believe, the reason being that a rapid capacity contraction is in progress. For example, in the mining sector there have already been large reductions in capacity and plans for the development of new production have been shelved. Furthermore, additional large reductions in capacity are likely over the coming months unless the recent up-trend in prices continues. This should mean that supply will barely be sufficient to satisfy demand by early next year, even in the likely case that the global depression persists. The food-production sector of the economy, on the other hand, never had much in the way of "excess capacity" to begin with and is therefore likely to experience rising prices earlier on.

We'll now return to Mr. Warburton's point that global supply of goods and services has been damaged at least as severely as their global demand. He notes that the credit crisis has had a greater impact on the supply capability of the global economy than on its consumers. In particular: that business expenditures, rather than consumers' expenditures, have been scaled back to the greatest extent thus far.

He goes on to say that as businesses go bust and expansion plans are curtailed due to the increasing cost of capital and the reduced availability of credit, supply will continue to fall. As a result, the demand stimulus that governments are attempting to engineer by increasing their own spending and by creating incentives for additional private-sector spending will encounter inflationary tendencies at lower levels of activity than before. At the same time, there is a high probability that the money supply will continue ramping upward at a fast pace due to the massive monetisation of government debt that will be made necessary by the massive planned increase in government spending.

Falling supplies of goods and services combined with rising money supply is the ideal recipe for an increase in the general price level. This "ideal recipe" is what we were talking about in the 27th April Weekly Update, when we wrote:

Other 'building blocks of generalised price inflation' mentioned by Mr. Warburton include:

1. While governments may avoid an openly protectionist agenda, global trade is likely to suffer because increases in government spending will be targeted to benefit the locals and to not 'leak out' into the global economy. This will tend to put upward pressure on goods and services prices at the expense of asset prices.
2. The public sector is notoriously less efficient than the private sector, so as the public sector becomes more involved in the provision of goods and services the effects of inflation will become more apparent in the prices of everyday items.
3. With the unemployment rate likely to remain in double digits for a long time there will be no political mandate to "fight inflation" until after the inflation threat has become substantial and blatantly obvious to all.

Mr. Warburton's view is that evidence of an inflation problem won't begin to emerge for at least another 6 months. This is also our view. Our expectation is that another DEFLATION scare will occur between now and when the effects of inflation bubble to the surface, so there should be no urgency to purchase inflation hedges. On the other hand, inflation hedges will be a lot more expensive by the time an inflation problem becomes obvious to all. Consequently, it would be a good idea to scale into such positions over the coming 6 months.

We continue to believe that gold will be the best hedge against the problems to come. This is not because gold is always a good hedge against monetary inflation, because it isn't. For example, there have been many times when gold has fared poorly in response to rapid money-supply growth. It is, instead, more appropriate to think of gold as a hedge against government stupidity and the negative economic effects of that stupidity, and rarely in history have the governments of 'free' and developed countries acted as stupidly as they are today. As a result of the way governments are acting and have committed to act in the future, economic and monetary conditions over the next few years are likely to come together to create the ideal environment for gold-related investments. Specifically, we are likely to get the combination of rapid money-supply growth, economic weakness, a strong desire by the public to increase its savings in terms of something stable, low financial-market liquidity (liquidity and money are different things), and, eventually, rising goods and services prices.

_____

© 2009 Steve Saville

ABOUT THE AUTHOR

Steve Saville is the editor of www.speculative-investor.com. The mission of The Speculative Investor is to provide its subscribers with information that not only helps them understand and profit from changing financial market trends, but is also interesting and thought-provoking.

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Everyone is Wrong, Again (Except the gold bulls) by Steve Saville

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