The argument persists as to whether our current economic crisis will end with massive inflation or in a deflationary spiral. Ultimately, either one results in a Depression.

For investors, this argument is more than an academic one. It is the single most important variable for near and intermediate term investing success. It is also important in regard to taking actions which can prepare and protect you and your family.

Respected analysts are on both sides of the inflation-deflation debate. Each side makes a strong case for their position. Which group should one believe? In my opinion, the primary difference between the two camps is how narrowly or broadly they view the field of economics. For purposes here, it is useful to view conceptions of economics in the context of an imperfect taxonomy described as “narrow” and “broad.” These are neither technical terms nor normal classifications, although this dichotomyis useful for explanatory reasons.

The Narrow Perspective of Economics

The narrow perspective utilizes current or historical data as he input to mathematical models. Doing so produces a very strong case for massive deflation based on increased saving, lowered consumption and debt defaults. The amount of debt is the overwhelming problem. Government at all levels – federal, state and municipal — are hopelessly insolvent, especially when the ticking time bomb of pensions is considered. Debt in the private sector is also massive, primarily in the mortgage, student loan and consumer finance areas. The banking system is also insolvent and faces another crisis bigger than the previous one.

Bankruptcies and other debt defaults are inevitable. Debt contraction leads to money supply contraction which is the very definition of deflation. Thus the deflationary scenario is quite plausible and would produce a deflationary collapse, otherwise known as a Depression.

A form of “deterministic physics” is the basis for virtually all macroeconomic models. None of these models saw the current crisis coming. It is mechanistic and oriented to past relationships. Economics is a social science dealing with acting and reacting individuals who are constantly shifting their behavior in order to protect and improve themselves. People are not dumb molecules bouncing off walls of laboratory beakers. The rate at which molecules collide with walls can be determined using past behavior (or explanatory theory) because molecules do not change behavior. When human beings bump into walls, it is unpleasant so they purposefully adjust their behavior to reduce the probabilities of it recurring.

A Broader Perspective of Economics

The broad perspective of economics recognizes economics as a science of human behavior. As thinking beings, men act purposefully in order to achieve ends. As such it cannot be modeled like physics which depends on past actions repeating. That does not mean economics does not have fundamental laws which allow knowledge of what a rational response would be toward a particular end. The difficult problem is discerning ends or the intentions of the human being. That piece of knowledge is subjective and problematic, limiting the value of economics as a predictive science.

Future actions are sometimes reasonably predictable. While it is nearly impossible to predict the actions of millions and millions of individuals because of their differing goals, it is possible to reasonably predict the actions of the federal government, at least in the near term. To understand why, one needs to understand the behavior and motivation of politicians.

No politician anywhere in the world wants to have a Depression on his watch. No politician wants to even experience an economic slowdown. Hence, we can be nearly certain that government will take whatever actions it believes will avoid the bad experience. Ironically, prior attempts to avoid economic corrections make a Depression inevitable. As expressed by Bob Chapman:

[The] crisis has been with us for more than 50 years and this portion of that crisis could become a very dynamic closer as massive monetization and inflation is let loose. We are at the stage now that risk is growing exponentially, as central banks and governments aggressively intervene into markets causing major distortions. These actions set the stage for heretofore-unexpected events, now called “black swan” events.

Politicians have tools to defer some crises, but only by making future crises bigger. But future crises are of no concern to politicians who live in the moment, dominated by the Keynesian creed that “in the long run we are all dead.” All political decisions are designed to produce short-term fixes. Most only achieve cosmetic outcomes from which temporary political advantage can be gained. “Kick the can down the road” is used almost exclusively to describe such political actions.

Politicians must not allow a deflation, which equates to a Depression under current circumstances. So long as they control the printing presses, they will flood the system with liquidity in hopes that one final bounce can be elicited from the economy. Two crises are foremost in their minds.

1. The insolvent banking system which will need to be bailed out again. Banks are carrying toxic assets on their books (made attractive by government changing FASB rules of accounting) which are grossly overvalued. If banks recognized these, the entire system would contract, plunging the economy into a Depression. Government knows this and encourages the fraud to continue. What cannot be ignored is a collapse of the banking system in Europe which will trigger a similar result here. The Fed is already surreptitiously involved in an effort to assist in the bailout of European banks.
2. The federal government has no money and will soon be unable to pay its bills from revenues obtained from taxes and bond sales. Politicians will do anything rather than stopping payments on things like social security, medicare, military pay and the like. The government will sell bonds to the Federal Reserve (quatitative easing or printing money, if you prefer), to avoid this. The Fed has become little more than the “buyer of last resort.” Cutting spending back to the levels that can be funded by tax revenues and market bond sales is unacceptable to the political class. That will not happen during a recession, nor with a political class that has conditioned themselves and their constituents to the idea that the government has unlimited resources. A complete and total economic debacle will be necessary before this mindset is altered.

Politicians will not allow deflation. Of course, there is the risk of political miscalculation in the pursuit of this goal, but virtually no risk in determining what they will attempt to accomplish.

We are headed for high inflation which the Fed will undoubtedly rationalize as necessary in order to save the economy. There are two reasons for that:

1. The level of inflation is dependent on the supply of money but also the demand for money. Arguably the Fed may be able to control the former. They are unable to control the latter which is determined by the millions of people who handle money. As inflation increases, people spend their money faster in order to beat expected price increases. This increases the “velocity” of money which changes the relationship between the quantity of money and economic activity. Ludwig von Mises termed this end stage as “the crack-up boom” which is accelerated spending that results in hyperinflation. The purchasing power of money is declining so rapidly that people do not want to hold it. Think Weimar Germany or Zimbabwe.
2. The Fed cannot stop increasing the supply of money unless government limits its spending to what they bring in.

Unfortunately there is no way the Fed can calibrate the level of inflation. It is impossible, for example, to say that we will have an 8% level of inflation with any reasonable hope of achieving it. Neither politicians nor the Federal Reserve are capable of “managing” inflation in the sense that they can dial in some acceptable level and maintain it. Furthermore, inflation will not help the economy but can kill it. Once money reaches the “crack up boom” phase, it ceases being acceptable as currency. People resort to barter which is necessarily inefficient and costly. The economy shrinks and the economy plunges into a Depression. This result can occur in a highly inflationary environment (a hyperinflationary Depression) or it could devolve into a deflationary Depression. The decision as to which occurs is in the hands of the government and the Federal Reserve. If they continue printing, there will be a hyperinflationary Depression.

Whether the government chooses to pursue inflation or allow deflation to play out, economically the end is the same — a Depression. From a political standpoint, it is beneficial to continue to kick the can down the road. The bottom line is that a Depression is unavoidable. I am betting on the inflation choice based on politicians doing what is in their best interest rather than that of the country. There are decades of political greed and cowardice upon which my position rests. That is not going to change, regardless of who is elected in 2012.

If one believes that politicians will behave as I suspect, the only way to believe that deflation is our next step is that printing money is not inflationary. Even with a complete collapse in debt levels, there is no speed that the printing presses cannot match.