First let me thank those responding to "the deflation debate". Robert Blumen wrote an article entitled End Game: Hyperinflation on the Mises Blog on July 9th, and David Petch who wrote Diatribes of a Deflationist........Why They Are Wrong on July 13th. I was hoping for a reply from Puplava but if one was made I did not see it.

Without addressing my blogs specifically, Mr. Blumen has this to say:
The most obvious error in many deflationist writings is to point to the large amount of debt and stop there. All of us agree that the debt levels are unsustainable, but there are two ways of getting rid of debt: default or inflation. A cascading chain of cross-defaults would be the deflation outcome, but this is by no means assured. Historically there have been far more hyperinflations than deflations. Debt can be inflated away.

I am not sure who Blumen is referring to but I laid out a concise multi-point discussion that included the debt overhang but certainly did not stop there. Furthermore I agree that debt "can" be inflated away and even stated how: The FED prints money like mad and Congress gives money away at the expense of creditors to the benefit of debtors..

Blumen goes on to say: Another deflationist argument is that wage competition from China is deflationary, and that inflation cannot occur in the US as long as there is wage competition.

Again that is not my position. I did not say inflation can not occur as long as there is wage competition. However, I most assuredly did stress that wage competition does indeed make it much harder for inflation to take hold. There is a big difference in those statements and it is much easier to attack a straw man that does not exist.

Blumen also writes: Another similar argument is that price increases cannot occur in the US for goods manufactured in China. China will always offer these goods at lower prices than they can be produced in the US, thus causing "deflation". This is also wrong for the same reasons cited above concerning nominal and real prices.

I guess it would be helpful to see some direct quotes from some articles about who is saying what. I sure did not say that. Who did? That said, given 20-1 wage differentials and the outsourcing cycle not complete, there is indeed wage pressures and those wage pressures are indeed deflationary. Again that does not mean price increases can not occur but wage differentials can and have made up for huge increases in commodity prices.

The Blumen article quotes Faber's position on the US$ and gold. The question here is, what would the dollar sell off against, and what would investors perceive as a safe haven in such a situation? The Euro? Not very likely! Asian currencies? Possibly, but if China were to weaken simultaneously with the U.S. economy it's unlikely that Asian currencies would be viewed as a safe haven. I suppose that in a crisis of confidence arising from an economic or financial problem in the United States of a scale that would lead the Fed to print money in massive quantities, only gold, silver, and platinum would be regarded as truly safe currencies notwithstanding their current weakness.

Not sure about platinum but otherwise I mostly agree. I do not view that as being in conflict with my views on deflation at all. If the US$ does not drop against Asian currencies, the Euro or the British pound, then where is the inflation in the price of finished goods? Non-existent perhaps? Declining perhaps? Does a price rise in gold affect the average consumer? How?

I guess my summation is that Robert Blumen more or less attacked a straw man that does not really exist without really putting together a comprehensive view of how it all fits together. In affect it did NOT address the seven points listed at the end of The deflation debate heats up. Yes, there are scenarios that may address each point individually but the article is lacking a concrete explanation of how the inflationist argument all ties together. There was also no explanation offered as to why or how soaring gold affects consumer prices.

As best as I can tell there is near universal opinion about a housing bubble and subsequent bust, yet no one has yet addressed all of the associated happenings when that event occurs (eg. loss of jobs, falling wages, rising defaults, lower demand for goods, over capacity, the debt bubble, etc, etc, etc) other than "The FED will print its way out of it". Remember, Japan tried and that and it did not work for them. Is the FED truly all powerful to the point of being able to defeat the business cycle? If the FED is, why have we ever had a recession?

OK Mish next Case.

In Diatribes of a Deflationist, David Petch takes my rebuttal of Puplava point by point and addresses each one. This time I am properly quoted. Thanks David! Let's take a look.

David Petch:
1) The first point Shedlock states is oil is deflationary. Last week, I posted an article titled "Peak Oil and What it Means to You" and the take home message is that competition for resources is going to happen, first economically, followed by military intervention as this century rolls out. I can not remember a time in the 36 years of my life on the planet when oil was deflationary.

The oil shortages of the 70's were politically inspired. The inflationary trend at the peak saw housing prices decline 50% of the gain, yet they remained well above the low prices of the 70's. My parents bought their second house in 1972 for $22,000. By 1980 it was approximately $55,000.

The current shortages in oil are a geological phenomenon, not a politically inspired problem. As everyone is well aware, currency inflation is occurring daily and now a coming shortage in oil will create commodity inflation. Companies will only be able to absorb so much of the cost before it inevitably is passed on to the consumer.

Mish Replies:
There are many mistakes in this logic.
1) It assumes demand for goods will stay constant as prices rise
2) It assumes there is not a switch to or coal or uranium or other cheaper energy sources.
3) It assumes renewable energy sources are not discovered.
4) It assumes consumer discretionary spending in other areas is not drastically reduced in response to rising fuel prices
5) It assumes companies can raise prices and consumers will pay up
6) It assumes the world economy will not slow enough to negate the affect of China's increasing energy demands

That's a lot of assumptions. Points 2 and 3 are long term issues not really suitable for near term discussion but may be important at a later date. Points 1, 4, 5, and 6 were not addressed. Yes oil is in short supply, yes I believe in the concept of "peak oil", but not addresses is the fact that the world is likely headed into a recession and that may negate most or all of that increased demand for quite some time.

Furthermore, rising oil is only inflationary when prices are passed on and wages are raised so that other discretionary spending is not reduced to make up for increased oil prices. I see neither happening right now.

In fact, I see the opposite. This may be hard for inflationists to swallow but here it is in black and white in an article by The Independent.

Factories cut the prices they charge their customers last month despite a record surge in raw materials costs, putting their profit margins under pressure and clearing the way for a cut in interest rates next month.

Official figures published yesterday showed that manufacturers' input costs rose at the fastest pace in June for almost two decades.

Jonathan Loynes, the chief UK economist at Capital Economics, said: "This is good news for high-street inflation, but not for profits. Producers are having to absorb the bulk of the ongoing rise in costs rather than passing it along the supply chain."

Hmmm oil has gone from $25 to $60 and factories are cutting prices. How about that! That is not inflationary in my book. Seems like demand has fallen off the cliff in the UK, and it all started with a slowdown in housing. I have said this before and will say it again: The UK is leading the US in this cycle by 6 months to a year. Expect the same action in the US within a year.

David Petch:
2) Even though the current economy is a credit bubble, the creation of money automatically creates inflation as it feeds into the economy through debt. I am not an accounting type, but I am sure their exists neat little schemes for FED printed money to pick up struggling companies or aid in transactions. Oil production is not increasing and monetary expansion is occurring, therefore prices will rise due to shortfalls, plain and simple. Factor in peak oil which is commodity inflation and the inflationary pressures build even higher.

Assume the automobile sector and housing sectors are commodities. There has been overproduction during both these cycles and when a peak is hit, prices will stabilize before plummeting. More supply than demand dictates commodity deflation will occur (housing and automobile sector). Notice how I am separating the terms of monetary inflation from commodity inflation or deflation.

Mish Reply:
You see asset prices being hit in both autos and houses. Good, so do I. You also see over-capacity. Great. That is a key deflationary argument. Somehow the debate turns back to oil and my response is as above. Peak oil does not equate to unending demand and is no guarantee of either price inflation or monetary inflation with rising oil as just proven by the UK. The point being that commodity inflation, not passed along does not result in price inflation (throwing out the term price inflation in addition to the terms monetary inflation, and commodity inflation). That in fact is where the rubber meets the road. If demand falls sufficiently enough, or production(oversupply) rises fast enough, there will not be price inflation (which is what matters to the consumer and to interest rates as well). We are currently seeing oversupply in autos in spite of commodity prices are we not? Are we not seeing price cuts and mammoth rebates as well. Pray tell, exactly what prices will be rising on finished products if we have a housing bust and an auto bust? If rising oil and copper and steel prices (steel now unwinding) did not cause the prices of cars to rise, exactly what will? Please answer that! As for the credit bubble automatically causing inflation (while the bubble is inflating), once again we agree (the affect is clearly seen in housing). But please look ahead, the busting of that bubble will automatically unwind the affects of that inflation, in other words reverse it. Again I point to action in the UK right now as a good example. Oddly enough you even understand the basic premise (deflating asset bubbles and car price and housing prices) yet fail to come to the proper conclusion about rising oil causing rising prices, and you ignore the demand side issues of oil as well.

David Petch:
3) Currently the USD index appears to have completed and elongated flat (wave C longer than wave A or B) and this pattern pretty much happens in triangle formations only. A triangle has 5 legs and the first one for the USD lasted 6 1/2 months. This translates into a USD remaining range bound between 80.5 and current levels for another 24-28 months before falling through 80. At this point people will buy gold and silver bullion. They will line up like there is no tomorrow.

Mish:
So what? Other than "lining up like no tomorrow" to buy gold and silver I basically agree. You seem to agree with Faber and so do I. I will repeat my reply I made earlier to Robert Blumen: Exactly how does this affect inflation in the price of finished goods? Does a price rise in gold affect the average consumer? How? As for a falling US$, Faber seems to disagree but I think it is likely. Thus we agree again. The inflationary affects of a falling US$ will be resolved by falling demand for goods associate with a housing bust. Using your own words from above "overcapacity".

David Petch:
4) Housing prices will decline as per a commodity deflation. ... Just because prices of one sector of the economy declines does not mean that everything else does. As an example, the Nasdaq and major markets in 2000 had severe declines, wiping out 5 trillion dollars of equity, yet oil went from $10/barrel to the recent high of $62/barrel during the correction and since then.

Mish:
For the sake of clarity, Petch's respons above was in reply to my question to Puplava... [Jim Puplava writes "The government takes over GSEs owning most American mortgages." Shedlock responds "Even assuming this happens, how does that lead to hyperinflation?".....] Petch's answer above seems to be in agreement that Puplava's statement is nonsense as related to causing hyperinflation. Otherwise, trying to tie oil and the Naz together makes no sense at all.

David Petch:
5) By forcing individuals to buy zero coupon bonds, the government has a larger pool of capital to reduce the effects of their inflation agenda. For example, if the government can forcibly collect $500 billion/year from pension funds, then it can inflate at $500 billion per year without any net addition of capital to the system. This directly does not cause hyperinflation, but rather contains it.

Mish: For the sake of clarity the above was Petch's response to the question I posed as follows... [Jim Puplava writes "A national retirement security act is passed, forcing private pensions to buy long-dated zero-coupon government bonds that will be inflated away. The reason given will be for plan protection against bear markets." Shedlock responds "Assume such a bill is passed -- I seriously doubt it, but for the sake of argument, I will assume it happens. Pray tell, exactly how is that hyperinflationary? How and to what extent would it increase the money supply or cause prices to rise?"] It seems Petch has thought out the answer better than I could at the time. I accept that answer. Puplava's hyperinflationary point just does not make any sense.

So....
As best as I can tell Petch agrees that two of Puplava's hyperinflationary points are silly, all three of us (Petch, Blumen, Mish) as well as Faber and Puplava ultimately see a bright future for gold as a result of the FED trying to stimulate the economy in a housing bust. Even so, I fail to see (and no one even tried to explain) how rising gold prices causes other consumer prices to rise. Unless that would happen, rising gold prices are more or less meaningless except to those holding gold. As best as I can tell then, Petch's hyperinflation rests solidly on oil (or perhaps other commodities), even though we have not see much pass thru yet, especially in Autos. For multiple reasons the assumption of forever rising oil prices is in and of itself on shaky ground (near term anyway), in face of a consumer led or housing led recession.

More to the point, I fail to see how either Petch or Blumen or Puplava have addressed the heart of this debate. I will repeat it again one more time.

Here is the nut hyperinflationists need to crack:

1. Falling home prices
2. Falling wages
3. Stagnant employment or rising unemployment
4. Slowing world economy
5. No incentive for the FED to bail out consumers at the expense of banks
6. The K-Cycle is not likely to be defeated by throwing more money at the problem.
7. At some point lenders refuse to lend or borrowers stop borrowing. That time will be at hand when housing plunges. Look at current events in the UK as a prelude for what will happen here.

What I see is both Petch and Blumen (who have responded and Puplava who has not) failing to address the above scenario in a logical manner, consistent with a housing bust (obviously accompanied by huge job losses in the housing sector) and additional outsourcing of jobs to China and India to cut costs, accompanied by falling demand for goods. Since we all seem to agree on a housing bust, I am still searching for a logical scenario that causes "price inflation" in the face of that. That is where the rubber meets the road. Not only do think we see price deflation (certainly in assets like stocks and houses), but I also believe the destruction of credit (and money) in the next down cycle will be enormous. Rising oil prices is NOT the "hyperinflation answer" for many reasons in theory and as the UK has proven in actual practice. Furthermore, if the recession is deep enough (as I suspect it will be) oil prices are likely to fall, peak oil or not.

For the record, I am convinced that Petch will be eventually correct and that oil prices are going to rise over time, to substantial new highs from these levels near 60. That timeline is a long one however, and near term I expect flattening or declines as the world wide recession kicks off.

There is a nice chart in Petch's article showing inflation headed up for something like forever and I would be remiss if I did not address that. Here goes. Be very, very careful about extending trends to perpetuity. They don't get there. I offer the Naz bubble as proof. Faber warns about that in his excellent book "Tomorrow's Gold". It should be on everyone's reading list. I also recommend "The Dollar Crisis" by Richard Duncan. My thinking has been heavily influenced by both of those authors.

Finally, let me state the inflationist scenarios as best as I can since no one else seems willing to take it on.

Here are two scenarios that will work:
Scenario A:
A1) Increasing demand for commodities from China.
A2) Housing prices stay strong and economic activity picks up worldwide.
A3) US wages rise
A4) Rents rise
A5) Demand for goods in the US stays strong
A6) Demand for goods in Europe picks up
A7) Demand for goods in China picks up

It may not take all of those but it would take a lot of them to be consistant with sustained inflation.

Scenario B:
B1) Increasing demand for commodities from China in the face of a US housing bust
B2) Consumers keep spending money and banks keep lending even as asset prices fall
B3) Should consumers stop spending in the face of job losses associated with the housing bust, the FED goes on a mad printing spree.
B4) Since the FED can print but not force the consumer horse to drink (increase borrowing), a "helicopter drop" is issued (whereby Congress passes laws that literally gives money away to consumers)
B5) The "helicopter drop" is done in the US only and other countries refuse to finance it. (If everyone did it the US$ would not drop).
B6) Banks and other creditors have no say in this and are destroyed along with the FED in the hyperinflation that takes over.
B7) The consumer is bailed out at the expense of big creditors like Citycorp, American Express, Visa, MasterCard, etc.
B8) The business cycle is defeated. There will never be a recession again.
B9) Consumers never need to save again but are bailed out by rising asset prices.

Again it may not take all of those but it would take the crucial ones: The FED and Congress acting together to bail out consumers at the expense of creditors. It would probably have to be a US related thing only to force the dollar to get smashed vs. other fiat currencies.

That is what I am looking for: A logical scenario that addresses the full implications of a housing bust, or some sort of scenario that addresses the full implications of a FED that voluntarily produces hyper-inflation. Petch tries to address the issue with "asset deflation" vs. "monetary deflation" on a scenario mainly tied to oil, but that scenario ignores falling demand issues as well as the possibility (likelihood?) of oil prices falling. Even IF oil prices do not fall, evidence shows lack of pricing power on finished goods.

Should someone think B2 is likely I disagree and point to the UK (now) and Japan for the past 18 years. In addition, it is logical to assume banks will tighten standards to prevent defaults or consumers will pull in their horns or most likely both in the face of falling home prices.

Finally, I do not think hyperinflation was ever voluntarily and purposely attempted (to bail out consumers) but that seems to be what is suggested by all these "helicopter drop" scenarios. Threat yes, but in practice no. Thus I find both of the above scenarios to be absurd. The FED and the powers that be will not voluntarily destroy themselves. Will they fight deflation? Yes. Will they fight deflation to the point of destroying themselves? No. That would not only require printing presses but action from Congress as well. The scenario is simply not consistent with a Congress that passed "bankruptcy reform" to keep consumers indebted forever.

Bottom line: I expect to see a prolonged period (5-12 years looking forward) where deflation is predominate, interspersed by temporary stock market rallies with long term interest rates slowly sinking to 2.5% or so.