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Chadwick: Are We Facing Inflation or Deflation?

Tuesday, 3 Aug 2010 | 12:25 PM ET

Some of the smartest and most successful investment brains are on opposite sides of that question.

The right answer matters a whole lot.

A simple definition of inflation is too much money chasing too few goods. That’s easy to understand. If lots of people want the same thing and they all have money to buy it, then the seller is in the catbird seat. Looking at the action of the Fed, there is ample evidence that they are keeping monetary policy easy and flooding the system with money. Their hope is that all that cheap money will encourage people to go out and buy things.

But it is simply not happening.

In fact, the response to the monetary stimulus reminds me of Japan twenty years ago. The country was in a recession (something unknown in that country since the end of World War II) and the Government was literally giving money to people and asking them to spend it. But they wouldn’t. They put it under their mattresses (literally) and saved it. The Government’s plan to encourage the Japanese consumers to spend their way out of recession was a failure.

It was hard for us Americans to understand the response of the Japanese consumers. Not spend gift money? Unheard of! However, that response should not have been a surprise because the culture in Japan for generations was one of saving, not spending. The Japanese had a 20% savings rate at that time and the insecurity associated with the recession only encouraged them to save more, even when it was free money.

"We owe too much money from the good old days when we borrowed and overspent and nobody told us we had to save. Now we are having to mend our ways by simultaneously paying off our debts and increasing our saving." -Ravengate Partners, Patricia Chadwick

So let’s turn to the U.S. today.

We have been a population of spenders, not savers. Heading into the recession from which we are only now emerging, we were spending more than we were saving, i.e. we had a negative savings rate. Then came the recession, with the highest unemployment rate in over a generation, and spending slowed sharply.

In response, Congress enacted an enormous stimulus program to flood the economy with money. In addition, the Federal Reserve logically opened the money spigot to accommodate spending and hopefully to stimulate demand. With our propensity to consume instead of save, that should have been an easy solution. But nothing happened – or at least very little happened.

What is wrong?

Why aren’t we, the greatest spending nation on earth, spending? Why is all that cheap money not chasing the goods and consuming them and forcing the prices up?

Because we, the biggest spending nation on earth, are broke. We owe too much money from the good old days when we borrowed and overspent and nobody told us we had to save. Now we are having to mend our ways by simultaneously paying off our debts and increasing our saving. Those two priorities are overriding our want and instinct to spend, and that is good. Well it is good for our financial health in the long run, but it is dreadful in the near term because it acts as a drag on consumer spending which is what this economy needs to gain more momentum.

AP

So despite all the cheap money around, Americans are not, or better said, cannot take advantage of it, which means that there is not too much money chasing too few goods. Instead, there are too many goods – all the things consumers are NOT buying - chasing the few dollars left in consumers’ hands after they have paid their debt and tried to save.

That is the opposite of an inflationary environment.

That is deflation. And that is certainly what it appears we are experiencing now and will continue to face in the short run. Unfortunately, there is a positive correlation between paltry demand and high unemployment.

On the positive side, the American consumer appears to have accepted the necessity of restructuring his/her balance sheet and once the savings rate has increased and the debt has been reduced, there will be a significant amount of pent-up demand. Then and only then will the spectre of inflation raise its ugly head. That may be years from now.

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Patricia W. Chadwick has had more than 35 years of investment experience. She is the founder and president of Ravengate Partners LLC, a consulting firm that provides advice on financial markets and global economics.

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