For the past several years there has been an ongoing debate among bears about how numerous U.S. imbalances would be resolved: debts, deficits, under-saving, over-consumption, and asset bubbles. The deflationists argue that bubbles always burst and when they do, debtors default. Inflationists make the case that in a social democracy the government will do everything in its power to bail out the debtor class, even run the printing presses. Cynics point out the obvious: a central bank will always try to mitigate the pain of its banking constituents. Their contentions all have merit.

Four years ago deflation fears were rampant. The tech bubble was bursting, the economy slipping into recession, and the Fed seemed impotent to stem the slide. The Fed responded with a massive dose of ultra-cheap credit which at first had little effect, but eventually made its way into the next asset bubble: real estate. Today inflation - particularly "asset inflation" - is the toast of the town; speculators are bingeing on stocks, real estate, and commodities; professionals are reaching for yield with exotic debt instruments; and the Fed chairmanship has returned to rock star status. Meanwhile, expectations for consumer price inflation remain guarded; U.S. economists predict a 2.4% rise in the CPI this year and inflation-indexed bond investors expect the CPI to average 2.5% over the next 10 years. In the February 2006 issue of The Gloom, Boom & Doom Report, Hong Kong-based investment adviser Marc Faber discussed this atypical state of affairs:

I regard the current investment scene as most unusual, in the sense that everybody is very positive about one or another asset class. Equity fund managers around the world are positive about equities in both the developed economies and in emerging markets, while commodity traders are positive about commodities, gold bugs about precious metals, property developers about real estate prices, art aficionados about art prices and collectibles, and bond investors about bond yields declining further. This universal bullishness about all asset classes is uncommon... So, as a sceptic and contrarian investor, I am deeply concerned about this "continuous asset inflation" consensus amidst a benign "consumer price inflation" scenario.

The inflationary side of the boat has clearly gotten crowded. What will cause it to capsize? Dr. Faber offers two possible scenarios: a crash in asset prices or an accelerating consumer price inflation in which asset prices decline in real terms, though not necessarily in absolute terms.

Before exploring each of these scenarios, let's take a closer look at the inflationary process.

What is "inflation?" Before World War II, the term was defined as an artificial increase in the supply of money and credit (brought about by a central bank in cahoots with the banking system). Since then, inflation has been spun to mean a general increase in prices. As Ludwig von Mises pointed out, there is a reason for this:

To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices.

Inflation is the disease and rising prices are a symptom. Sometimes the symptom goes undetected due to productivity gains from new technologies, the dumping of commodities by a splintering empire, or the entry of billions of capitalists into the global economy. Sometimes the only rising prices are in assets, which no one ever seems to complain about. Or if prices do start to rise at the checkout counter or at the gas pump, economists can simply strip them out, leaving a less volatile index of "core" prices.

Of course inflation is an insidious tax, transferring wealth from one group to another, but the damage to the economy adds insult to injury, as Frank Shostak, chief economist with Foresight Research Solutions, explains:

We have seen that increases in the money supply set in motion an exchange of nothing for something. They divert real funding away from wealth generators toward the holders of the newly created money. This is what sets in motion the misallocation of resources, not price increases as such, which is only the manifestation of this misallocation.

Moreover, the beneficiaries of the newly created money, i.e., money out of "thin air" -- are always the first recipients of money, and so they can divert a greater portion of wealth to themselves. Obviously, those who either don't receive any of the newly created money or get it last will find that what is left for them is a diminished portion of the pool of real funding.

Additionally, real incomes fall not because of general rises in prices, but because of increases in the money supply, which gives rise to nonproductive consumption. In other words, inflation depletes the real pool of funding, which undermines the production of real wealth -- i.e., a lowering of real incomes.

How exactly does our government create inflation? The Federal Reserve does not literally "drop money out of helicopters" or "run the printing presses," though these counterfeiting metaphors are apt. Instead, the Fed engages in a clever two step process: 1) it purchases, or "monetizes," assets with money created "out of thin air" and 2) it allows the banking system to pyramid credit on top of this new money. In The Case Against the Fed (1994), Murray Rothbard explained how this process works:

Suppose that the "money multiplier" - the multiple that commercial banks can pyramid on top of reserves, is 10:1. That multiple is the inverse of the Fed's legally imposed minimum reserve requirement on different types of banks, a minimum which now approximates 10%. Almost always, if banks can expand 10:1 on top of their reserves, they will do so, since that is how they make their money. The counterfeiter, after all, will strongly tend to counterfeit as much as he can legally get away with. Suppose that the Fed decides it wishes to expand the nation's total money supply by $10 billion. If the multiplier is 10, then the Fed will choose to purchase $1 billion of assets, generally U.S. government securities, on the open market.

In the first step, the Fed directs its Open Market Agent in New York City to purchase $1 billion of U.S. government bonds. To purchase those securities, the Fed writes out a check for $1 billion on itself, the Federal Reserve Bank of New York. It then transfers that check to a government bond dealer, say Goldman, Sachs, in exchange for $1 billion of U.S. government bonds. Goldman, Sachs goes to its commercial bank - say Chase Manhattan [editor's note: now a part of JP Morgan Chase] - deposits the check on the Fed, and in exchange increases its demand deposits at the Chase by $1 billion.

Where did the Fed get the money to pay for the bonds? It created the money out of thin air, by simply writing out a check on itself. Neat trick if you can get away with it!

Chase Manhattan, delighted to get a check on the Fed, rushes down to the Fed's New York branch and deposits it in its account, increasing its reserves by $1 billion.

But this is only the first, immediate step. Because we live under a system of fractional-reserve banking, other consequences quickly ensue. There are now $1 billion more in reserves in the banking system, and as a result, the banking system expands its money and credit, the expansion beginning with Chase and quickly spreading out to other banks in the financial system. In a brief period of time, about a couple of weeks, the entire system will have expanded credit and money supply another $9 billion, up to an increased money stock of $10 billion.

As Rothbard pointed out, the Fed is the conductor while the banks play the music. Over the past five years we can see how they acted in concert to create the latest inflationary cacophony. Fed holdings of U.S. government securities increased by $229 billion while money supply (M3) grew by $2,996 billion, or 42%. Clearly, credit expansion is not only critical to the inflation process, it does the heavy lifting. (Note: The expansion of credit does not just take place through the banking system. The U.S. boasts the most advanced credit distribution system in the world, aided by government-sponsored mortgage lenders, the derivatives market, the repo market, and Wall Street's ability to package and "securitize" loans. Foreign central banks also assist in providing credit.)

This brings us back to our original inflation-deflation debate. After throwing the inflation switch on full throttle, the Fed has backed off somewhat with 14 "measured" rate increases over the past 20 months. Why? Perhaps they no longer believe their own sales literature. As the table below shows, the official inflation measures are grossly understated. Over the last five years, prices for practically everything have exceeded the CPI, driven by rapid growth in money and credit. (The lone exceptions: grains and large-cap equities, which were held back by the deflating 2000 technology balloon.) Notice that the inflation aggregates still experienced strong growth in 2005 despite higher rates.

Are investors overestimating the Fed's ability and will to inflate? For at least the short-to intermediate-term, we believe that to be the case. The Fed appears to be in a box. They have allowed the inflation genie out of the bottle, leaving asset bubbles, a declining dollar, and rising consumer prices in their wake. An aggressive easing - at least at this point - would surely exacerbate the situation, and appears highly unlikely. Further, newly anointed Fed chairman Ben Bernanke must establish his "inflation fighting" credentials and paint a picture of continuity with the previous regime.

Meanwhile, the air is slowly leaving the housing bubble. Its deflation appears to have plenty of room, perhaps for the next six months, to gain momentum. By the time the Fed reacts to declining home prices and rising defaults, it will be too late. Once a bubble starts to burst, there is no stopping it, as the Bank of Japan proved from 1991-1995 with the Nikkei bubble and the Fed proved from 2001-2003 with the Nasdaq bubble. In a post-bubble environment, the credit creation machine becomes crippled, as lenders, borrowers, and speculators go into post-traumatic shock.

At some point we would expect the debtor class to beg for inflation, and for the Fed to give it to them. The Fed will probably be forced to rely less on banks and other intermediaries and more on monetization - purchasing various assets and paying for them with money created out of thin air. Some have suggested that the Fed will branch out from buying U.S. government securities, purchasing stocks, corporate bonds, mortgage-backed securities, and even houses, if necessary. This is certainly among Bernanke's contingency plans (as some of his academic papers indicate), though it would be a radical departure from Fed procedure. It will certainly not happen anytime soon and will come far too late in preventing the housing and consumption balloon from popping.

Some in the inflation camp are convinced we are on the road to hyperinflation. While we don't necessarily disagree, the path may take more twists and turns than they expect. Mr. Market tends to follow the course that inflicts the maximum amount of pain. A relative decline in asset values would bail out the speculator, whereas an absolute decline would take him and his creditor out to the woodshed. The investing crowd would then likely react to the new deflationary reality by selling off assets, paying down debt, and actually saving... just in time to get smashed by a new wave of inflation.

Under either scenario - a real or absolute decline in asset values - gold will almost certainly outperform real estate and the shares of mortgage lenders.