Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 31st May 2009.

Money Confusion

The total supply of US dollars, as measured by TMS, is about 10% higher now than it was a year ago. Also, the total amount of credit within the US economy is higher now than it was a year ago thanks to the government's yeoman-like efforts to replace the bursting private-sector credit bubble with a public-sector credit bubble. With the supply of money and credit continuing to expand -- at an accelerated pace, in the case of the money supply -- you have to be inventive in order to make an argument that the US is experiencing deflation. You must either argue that non-monetary quantities such as collateralised debt securities and other derivatives form part of the money supply, which is the tack taken by the author of the article posted HERE, or argue that a decline in the combined market value of debt counts as deflation, which is what Mike Shedlock routinely does at his web site. Neither argument is valid, in our opinion.

The idea that collateralised debt and other products of the "shadow banking system" constitute money holds no water because you can't use these things to buy goods and services. If you don't believe us, try handing an ABS (Asset Backed Security) to the person at the Walmart checkout and see how far you get. Securities of various types can be posted as collateral when purchasing other investments, but that just means they have perceived value, not that they are money. Money is the general medium of exchange.

The idea that a decline in the market value of debt constitutes deflation boils down to defining deflation in terms of prices (the price of debt, in this case). However, the market values of debt and other investments rise and fall for many reasons, some of which are related to inflation/deflation and some of which aren't. The point is that a decline in the market value of anything (including debt) does not, in and of itself, constitute deflation.

What we have observed in the financial world over the past year are the symptoms of a bursting credit bubble. Such an event creates an enormous deflationary bias, but up until now this bias has been more than offset by the inflationary biases built into today's monetary and political systems.

Rising Fear of Inflation

Suddenly, the financial world is again fretting about inflation. Or, to put it more aptly, the financial world is again becoming excited by the prospect of rising prices (most people believe that inflation is equivalent to rising prices and that rising prices are good).

One of the strange things about the way the financial world tends to work these days is that the general level of fear/excitement about inflation moves inversely to the actual rate of monetary inflation. This happens because a) very few people understand what inflation is, and b) the monetary authorities react to the lagged effects of inflation rather than the inflation itself. To be more specific, economic weakness and/or rapid declines in asset prices cause almost everyone (the public, professional money managers, economists, most journalists and newsletter writers, the central bank and the government) to become concerned about deflation, which prompts policies designed to rapidly increase the money supply. Due to the normal lead-lag relationship between changes in the money supply and changes in prices, the initial phase of this rapid monetary inflation is usually accompanied by a further reduction in prices, which leads to heightened fear of deflation. Some time later the INEVITABLE effects of the money-supply growth begin to emerge, but by then the rate of monetary inflation has tapered off. As time goes by the increasingly blatant effects of the preceding money-supply growth lead to the widespread perception of an inflation problem and to more restrictive monetary policies, even while the actual inflation (money-supply growth) rate shifts to a relatively low level.

The inverse relationship described above is exemplified by last year's events. Recall that 12 months ago the fear of inflation was palpable. This fear was a reaction to the combination of rising bond yields, a falling US$, a very strong oil market and sharp rises in goods/services prices, but it was occurring at a time when the rate of monetary inflation was low and had been low for quite a while. Our view at the time was that the stark mismatch between inflation reality and inflation perception created substantial downside risk for commodities and the potential for multi-month rallies in the bond market and the US$. Moreover, by July-August of last year we were talking about the likelihood of a deflation scare. But despite our concerns at the time, it turned out that we were actually UNDER-estimating the downside risk in commodities and the speed with which fear of inflation would transmogrify into fear of deflation.

Naturally, the fear of deflation that overtook the financial world last September-December provoked a massive inflationary response from the central banking community, leading, as usual, to the fear of deflation peaking at around the same time as the rate of monetary inflation was probing its highs of the past 20 years.

Equally naturally, the effects of the September-December monetary binge have recently started to become evident in some prices, causing the public's attention to shift from the so-called deflation monster to the potential for an inflation problem. And this is going on even though the rate of monetary inflation has since tapered off (M2 money supply has expanded by 2% -- equivalent to a relatively modest 5.2% annualised growth rate -- since the beginning of this year, and has not expanded at all over the past two months).

In 2008 the perceived inflation threat continued to grow until July, thanks largely to a relentless upward trend in the oil price. Perhaps it will do the same again this year, but it would be risky to bet on it given the remarkable speed with which financial-market sentiment is now swinging from one extreme to the other.

Our view is that a major inflation problem is growing like a cancer within the US and global economies, but another deflation scare is likely during the second half of this year in response to another round of asset price declines and de-leveraging.

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