US inflation or deflation: the effect on the global economy

A Daily Reckoning White Paper Report

By Bill Bonner

US Inflation or deflation: The world economy

Every day a new day. Every day a new battle. Every day along comes a new humbug.

Today’s most fascinating struggle is between the forces of inflation and deflation. Finally, it’s made the front page. The International Herald Tribune sees it this way:

“World economy faces double threat of recession and inflation,” says yesterday’s paper.

And yesterday, deflation delivered another head-butt. The Dow fell 172 points.

Today, in a TV interview, we were asked what we see ahead for the US dollar.

“Not much,” was our reply. “It’s almost impossible to get much near-term visibility on the dollar,” we explained. “Because it is in this no-man’s-land between the opposing forces of inflation and deflation. On the one side, rising prices mean a falling dollar. On the other, falling prices mean the dollar is going up. We’re pretty sure the greenback is going to get shot to pieces... but we’re not sure by which side.”

Prices of assets – stocks and houses – are probably going down in the year ahead. And when they go down, the people who hold these assets feel a little poorer. Naturally, they’ll be less eager to part with the dollars they have left. So, they cut back on their spending. Soon, you have an economic slump... and you could even have a Japan-like slump, with falling consumer prices as well as falling asset prices. This is a classic deflationary situation, in which dollars become more valuable.

But that’s not all that is going on. Every central bank in the world is determined to prevent falling prices. They’re all joining hands to try to make sure prices continue to rise – by lowering interest rates, and making credit more easily available. Ben Bernanke says he’ll drop money from helicopters, if necessary, to keep the cash moving. Ultimately, all this extra cash and credit is going to have an effect... but maybe not right away.

And there’s another thing driving up prices – the China Effect.

US inflation or deflation: The Chinese consumer

Here’s an excerpt from an article sent to us yesterday, describing China’s remarkable effect on world commodity prices, especially food (we can’t remember the source):

China Eats the World

“Per-capita income in China is less than 1/10 of America's and its per-capita greenhouse gas emission is less than 1/5 of ours. But if 1.3 billion Chinese were to consume at the level Americans do, we'd need several more Earths. China's effect on world resources, quantified:

China is:

• The world's largest consumer of coal, grain, fertiliser, cell phones, refrigerators, and televisions
• The leading importer of iron ore, steel, copper, tin, zinc, aluminium, and nickel
• The top producer of coal, steel, cement, and ten kinds of metal
• The No. 1 importer of illegally logged wood
• The third-largest producer of cars after Japan and the United States; by 2015, it could be the world's largest car producer. By 2020, there could be 130 million cars on its roads, compared to 33 million now.

Gobble, gobble, gobble – the Chinese are eating up the world’s resources, putting huge upward pressure on prices.

“But wait,” said our interviewer, “if it is true that Americans are the world’s champion consumers…and if it is true that China imports much of its commodities for the purpose of making stuff for Americans…won’t Chinese demand go down with US consumption? And won’t commodity prices crash rather than soar?”

“Yes…probably…maybe…” was all we could say. We are sorry to be so wishy, washy…but we are definitely, certainly, absolutely unsure. Most likely, a collapse in demand from the US will lead to a collapse in commodity prices… Most likely, the collapse will be only temporary. Domestic demand from Asia will eventually make up for the shortfall from Asia.

But why pretend to see that far ahead? Let’s look at the near term. Next year, we expect a recession in the US….a bear market in stocks…and further decline in house prices. As reported here yesterday, Lehman Bros. expects more than a million foreclosures next year…three times as many foreclosures next year as in 2007. What that means is simple: more people with less money in their pockets. Less money, need we remind you, is deflation.

But how much of it…for how long…? We wish we could tell you...

US inflation or deflation: a looming US recession?

We’re not alone in expecting a recession. Here’s Morgan Stanley economist Stephen Roach in the New York Times:

“The American economy is slipping into its second post-bubble recession in seven years. Just as the bursting of the dot-com bubble led to a downturn in 2001 and ’02, the simultaneous popping of the housing and credit bubbles is doing the same right now.”

“Consumers have no choice other than to retrench. Home prices are likely to fall for the nation as a whole in 2008, the first such occurrence since 1933. And access to home equity credit lines and mortgage refinancing - the means by which consumers have borrowed against their homes - is likely to be impaired by the aftershocks of the subprime crisis.”

“America’s central bank has mismanaged the biggest risk of our times. Ever since the equity bubble began forming in the late 1990s, the Federal Reserve has been ignoring, if not condoning, excesses in asset markets. That negligence has allowed the United States to lurch from bubble to bubble.”

“Fixated on the narrow “core inflation” rate, which excludes the necessities of food and energy, the Fed has ignored new and powerful linkages that have developed between economic activity and increasingly risky financial markets.

“Over time, America’s bubbles have gotten bigger, as have the segments of the real economy they have infected. The Fed needs to rethink its reckless, bubble-prone policy. Once the current crisis subsides, the economy will require the tight money of higher interest rates - the only hope America has for breaking the lethal chain of endless asset bubbles.”

*** Here’s today’s humbug: “$45 trillion gap seen in US benefits,” reports Yahoo Finance. The story line is very simple. Americans now expect to receive much more in Social Security, Medicare and other benefits than the government can possibly afford.

US inflation or deflation: what next?

So, when the feds decide to fight deflation by making more cash and credit available, we have to ask – where does this money come from? If it is real... it must come from somewhere. It must come from the money that was slated to pay Social Security benefits... or pay for houses…or fund retirement plans... or one of millions of other uses. But all of that money is already fully committed. In fact, there is already a shortage of it. So, the money must be unreal... it must be a kind of phantom money... the same kind of phony-baloney money that caused the credit bubble in the first place.

*** And here’s another question that came up in our interview: After US consumers stop spending so much, who will take up the slack? Many say the Chinese? Or maybe the Indians?

As Stephen Roach says above, there is no way Asian buying is going to replace US spending in the near term. What’s more, China is probably more a cause for concern than comfort. The place is a giant humpty dumpty itself, waiting to fall off the wall. Its manufacturing sector depends on exports to people who can’t pay up. And its banking sector is jury-rigged by government regulators and stuffed with non-performing loans. Even when a banking system is run by capitalists it is still prone to booms and busts. But only a few years ago, China’s banking regulators were wearing those silly Mao jackets and waiving copies of his Little Red Book in the air. What will they do when the system blows up? It is bound to be entertaining…but hardly reassuring.

“China is the ’29 economy,” we pointed out. “It is big growth story of the 21st century, just as the US was the big growth story of the early 20th century. But it is also the biggest threat to world financial stability. When China blows up…the blast is going to be heard all over the globe.”

By Bill Bonner - Best-selling investment author, founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.

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