The Secret Word: Deflation

By Robert R. Prechter, guest columnist

In the first five months of 2012, there were twenty times as many Google searches on "inflation" as there were on "deflation." This is down from a ratio of fifty times in June 2008. If any theme has been overdone over the past six years, it is the theme of inevitable inflation if not hyperinflation.

Inflation reigned for 75 years, from 1933 to 2008. People are so used to it that they cannot imagine the opposite monetary environment. Bullish economists have been calling for recovery, which means more inflation, and bearish advisors have been calling for a crash in the dollar, which means hyperinflation. No wonder those are the terms on which most people have been searching.

But only one word allows you to make sense of what's going on in the world, and inflation is not it. The secret word is deflation.

Understanding Deflation

Deflation explains:

1) Why interest rates on highly rated bonds are at their lowest levels in the history of the country;

2) Why the velocity of money is the lowest since the 1930s;

3) Why huge sectors among investment markets are down over 40%;

4) Why the Consumer Price Index (CPI) just had its biggest down month since 2008;

5) Why Europe is in turmoil.

That's right: Ten-year Treasury notes pay out less than 1.5% annually, their lowest rate since the founding of the Republic. Treasury bills yield essentially zero, their lowest level ever. The velocity of money failed to rise during the past three years of partial economic recovery, and it recently made new lows. Real estate prices have fallen 45% in the past six years. Commodity prices — as measured by the CRB Index — are down 45% in just four years. This group includes oil and silver, two of the most hyped investments of the past decade. Remember in March when articles quoted analysts calling for $5, $6 and $8-per-gallon gasoline? In just three months since then, gas prices have fallen 13%, knocking the CPI into negative territory.

Deflation also explains why European loans are at risk, why Germany is tapped out, why Greeks are protesting in the streets and why U.S. corporations' overseas profits are down. Deflation lets you make sense of the world.

What is deflation? Economists define it three different ways, but I find only one definition useful: Deflation is a contraction in the overall supply of money and credit.

Why must deflation occur? Answer: There is too much unpayable debt in the world.

An Unstoppable Force

As I argued in my book Conquer the Crash, it ultimately does not matter what the authorities do; they can't stop deflation. And look: Since 2007, the Fed has monetized $2 trillion worth of debt; the government has borrowed another $7 trillion; and it has pumped out $1 trillion worth of student-loan credit. Yet real estate and commodities slumped 40%-plus anyway.

These drunken-sailor-type policies have indeed succeeded in nearly maintaining the overall volume of money and credit. But in the long run you can't fight a systemic debt overload by piling on more debt. The Fed and the government are shifting the burden of trillions of dollars' worth of debt obligations from reckless creditors onto innocent savers and hapless taxpayers. The ploy might work if the public's resources were infinite, but they aren't. Perhaps this policy temporarily prevented a series of big institutional disasters, but it was only at the ultimate price of a gigantic public disaster.

Such actions have become politically less palatable. Some observers realize that the student-loan program of lending at below-market rates is exactly the model the government used for housing loans, which ended in a spectacular bust. Others know that the government cannot continue to borrow at the current pace and expect to stay solvent. Politicians on both sides of the aisle are tired of the Fed's massive bailing out of highly leveraged financial-speculation institutions. But whether these policies continue or are curtailed is irrelevant to the outcome. If the government slows its borrowing, the overall value of debt will fall. If the government maintains or increases its present pace of borrowing, interest rates will eventually turn up, and the overall value of debt will fall. There is no escape from deflation.

Cash Is King

Ironically, investors in the past decade have been doing exactly the opposite of preparing for deflation. Convinced of perpetually rising prices, they have bought every major investment. They chased real estate up to a peak in 2006. They bought blue chip stocks into the high of 2007. They pushed commodities up to a peak in 2008. They chased gold and silver up to highs in 2011. And through spring 2012, they continued to buy stocks and commodities on any rumor that promised inflation: European bank bailouts, Operation Twist, the Greek election, Group-of-8 summits, Fed meetings, Bernanke press conferences, improved economic numbers, predictions of QE3, central-bank interest rate cuts, you name it. Meanwhile, the U.S. Dollar Index hasn't made a new low for four years. During deflationary times, cash is king, and investors have chosen to own anything but cash.

My firm was so excited about that lopsided ratio of Internet search terms that we went out and bought the domain name, www.deflation.com, and we just fired it up. Our new site is the only source where you can learn about deflation and what to do about it. It features insights from the few maverick economists and financial historians around the world who recognized well ahead of time the hidden signs of pending monetary reversal that nearly everyone from the Fed's economists on down completely missed. And they said so publicly in no uncertain terms.

It May Already Be Too Late

Deflation is still not obvious to the majority. Even now, most economists expect continued recovery, mild inflation and a rising stock market. But the experts on our site are 180 degrees apart from conventional thinking. It may be too late for you to get out at the top, but there's still time to learn how to sidestep the worst of the crunch.

People will be using the secret "d" word much more often over the next five years. By the end of that time, they will also be using its cousin "d" word, depression. But that's a discussion for another time.

Robert Prechter is author of Conquer the Crash—You Can Survive and Prosper in a Deflationary Depression (John Wiley, 2002).