Chris Yates of Archeron Investments published a piece a few days ago making the case that deflation is an underappreciated risk to investors.  Here’s a link to the article:

The Case For Deflation

I urge readers to read it in its entirety.  Chris’s analysis is insightful and his conclusions relevant.  Despite my high regard for it as a whole, the focus here will be on what I believe to be some flawed individual contentions.

”We all know the major deflationary forces of today; debt, demographics, globalization and technology.”

Alas, things “we all know” often turn out to be the most serious errors in all of economics, if only because something so widely accepted is met with little critical scrutiny.  Countless economics writers do say this, but only one of these four ostensibly deflationary forces is actually correct:  Debt.  Demographics, globalization and technology have utterly nothing to do with inflation, nor it’s inverse, deflation.  Inflation and deflation are monetary phenomena.

I’ve discussed in detail why before, for example in Inflation is Not an Economic Condition.  As a quick illustration, were the 1970s inflationary or deflationary?  Did the overall price level rise or did it fall?  It depends on what you choose as your unit of account.  Prices rose notoriously in terms US dollars.  Prices fell steeply in terms of gold.  Same economy, different conclusion … all depending on your choice of pricing unit.  We must conclude that there was nothing either inherently inflationary or deflationary in the economy, but that the course of prices was purely a function of your choice of monetary unit.  Inflation and deflation are monetary phenomena.

That of course doesn’t mean these other factors have no effect on prices.  Taking technology as an illustration, if digging a ditch with a shovel took ten hours, and we upgrade our technology to a backhoe and it takes just one hour, there is of course a reduction in cost.  But it’s a real reduction in cost, having nothing to do with deflation.  Conversely, if the price of oil were to rise as a result of running out of it, the cost increase would be real, having nothing to do with inflation.  Genuine inflation and deflation are solely functions of changes in the value of currency, as a result of changes in supply and demand for currency.

At first blush this distinction might seem purely academic.  But confusing real price changes with inflationary ones has had profound implications.  Monetary policy, for instance, can do nothing about demographics, globalization or technological progress.  But it can and does influence the value of money.  A quixotic attempt to offset real changes in prices with monetary policy in turn can only operate by introducing changes in the value of money … that is, by actually causing inflation and deflation.  This has been the policy, and as result, our economy has careened from bubble to bust to bubble to bust to bubble in just the past quarter century.

”Whilst the creation of debt can represent an expansion in the broad money supply, the destruction of debt conversely equates to a contraction in the money supply. As all debts must eventually be repaid, debt by nature is deflationary over time. ”

This cuts closer to the core of the matter.  Money is created by lending it into existence.  This increase in the supply of money is obviously inflationary, since an increase in supply reduces the value of money.  But it also increases the body of debt.  And debt represents demand for money.  Once the expansion ends, the increased level of debt remains, and the increase in demand for money increases its value.  Prices fall.  

Policymakers, failing to recognize the deflationary squall as a consequence of their own prior inflationary policy, respond with an even more forceful inflationary push.  They become trapped in a vicious cycle of their own making, as the economy enters a bubble and bust dynamic even as they tout the stabilizing effects of their exertions.

A deflationary surge in the value of a currency is not unlike that of a heavily shorted stock; too many go too short (borrowing the security and taking a negative position) that it becomes vulnerable to a short squeeze.  This is exactly what happened in 2008.

Declining velocity is merely an epiphenomenon, a side effect of the increased demand for money.

”As debt is a constraint on money velocity, for velocity to increase…”

If we just stop here, that’s all we need to know about velocity.  The rest just confuses the issue.

If it were just about changes in the value of money, the only real economic problem with inflationary policy would be the production of bubbles and busts.  Bad as that is, it assumes nothing about how the increase in money supply is distributed.  In practice the money is not evenly distributed, and the first in line at the monetary bucket brigade are enriched at the expense of those at the end of the line.  Inflation has resulted in a massive transfer of wealth over recent decades, mostly from the working class to the wealthy.  People sense the economic injustice, but aren’t aware of its source, so the policy goes largely unchecked.  As a result social unrest and political animosity has grown.  With the true cause of this inequity being obscure, free market capitalism has ironically become a surrogate target and is being blamed for the ills of central planning*.  Consequently, inflationary policy is eroding the economic foundation of prosperity and poses a growing threat to living standards for a long time to come.

As for the nearer term investment implications, I believe Chris is correct.  The buildup of debt is a deflationary force, and the buildup of debt has been epic.  Yet all we can really say about the stock market is that the risk-reward balance has shifted.  We don’t know from this analysis at what point the deflationary force of debt will overcome the inflationary force of policy.  Longer term dollar depreciation remains the bigger risk, but maintaining a diversified portfolio is sensible.  The current environment warrants holding less stocks and more cash, treasuries and gold than has been the case over the past five quarters.

*Free market capitalism doesn’t really exist anywhere in the world in the twenty first century.  As explained by Michael Lebowitz at RIA, the current US economic system is better described as corporate socialism.