“Borrowers are nearly always ill-spenders, and it is with lent money that all evil is mainly done?”
– John Ruskin

The borrowing binge that American consumers have been on the past decade is over. Credit cards were doled out like candy. If you had a pulse, you were able to get a mortgage. Increasing home values allowed consumers to tap into that “piggy bank” for additional money. The carefree spending days of yore have now passed. The last time we had that type of credit expansion was in the 1920’s. History shows us there are three main culprits that move an economy into a state of deflation. The bursting of credit bubbles, the hoarding of cash by individuals and credit contraction all play an integral role in the delicate balance between inflation and deflation .

The credit bubble burst we just experienced was a result of lenders providing loans to unfavorable candidates at favorable interest rates. Once these lenders realized their mistake, they were quick to take corrective action.

We believe that the second cause of deflation is also place. People currently are hoarding cash. For example, February was the 16th month in a row where we saw a reduction in credit card balances by consumers. Consumers are paying down debt and saving more. In addition, much of the cash that they are saving is being invested in money market funds, CD’s and bonds. Over the past 14 months, deposits into bond funds have exceeded $425 billion. Domestic equity funds, on the other hand, have seen net withdrawals. This is a sign that individuals are “hoarding cash” and not spending or investing “long-term.” Many people are willing to accept 0% interest rates on cash and short-term bonds in return for security.

The third deflationary indicator is credit contraction. It is much more difficult now to get a loan or mortgage than it was two years ago. Credit standards have been raised and the amount of credit outstanding is falling. Last month was the first month since 1975 during which banks held more cash on their books than commercial loans. If banks do not loan money, the money supply does not grow. If the money supply does not grow, deflation becomes a concern. This is why interest rates are low and may remain low for an extended period of time (which they did throughout the 30’s and 40’s).

Causes of Inflation

There are four main causes of inflation: Cost push inflation, housing prices, credit expansion and money supply growth.

1) Cost Push Inflation is the increased cost of manufacturing being pushed down to consumers. Manufacturing costs are multifaceted: materials, energy, regulation, wages, etc. Even though we have seen some material and energy costs rise over the past twelve months, they are still significantly below the levels in place during the summer of 2008. The largest cost, however, for most businesses is wages. It is also the biggest cause of cost push inflation. With unemployment near 10%, we see no evidence whatsoever of employees demanding higher wages. Most are happy just to have a job.

2) Housing Price Inflation. Not much needs to be said here. With the current backlog of foreclosed homes and tax incentives going away next month for new home buyers, we see no evidence of housing inflation. In fact, we see the exact opposite – housing deflation.

3) Credit Expansion. As stated earlier in this letter, we see credit contraction, not expansion.

4) Money Supply Growth. Many people are concerned (and rightfully so) that the government will “print money” to fund its deficit spending. We are concerned as well, since such action typically leads to inflation. The reason our government’s increased spending hasn’t caused inflation to this point is that the deficits are being funded by US consumers’ increased savings. In fact, the money supply has actually fallen the past three months. Below is a chart showing the current money supply as measured by MZM (M2 plus money market deposits). As illustrated, the money supply is shrinking not expanding. This chart shows that we are experiencing deflation, not inflation. This chart does not bode well for those investing in commodities, especially gold, at this time.

When will inflation return?

The last time we experienced a credit bubble like this was back in the 1920’s. This led to the Great Depression. Back then, as today, the government went on a spending spree to spark the economy. Unlike today, the money supply was tied to gold in the 1920’s. In January of 1934, FDR issued an executive order that increased the price of gold from $20.67 a troy ounce to $35 a troy ounce. This instantaneously increased the money supply by 40%. Even with this huge increase in the money supply, inflation rose only 2% in 1934 and 3% in 1935. Inflation didn’t truly rise in a meaningful way again until 1950, fifteen years after the increase in the money supply.

Why didn’t a huge rise in the money supply cause inflation? If people and banks “hoard cash,” it does not allow capital to flow freely. This hinders economic growth. The reason inflation began to rise again in 1950 is that consumers started feeling better about the economy. This increased confidence translated into increased spending and less hoarding of cash.

Although we believe there are more deflationary forces at work today than there are inflationary, we are watchful for signs of inflation in the future. When that will occur, we do not know. We don’t think it will be 15 years down the road as it was in the 30’s, but it is not right around the corner either. The signs we are looking for include: increases in the money supply, increases in the velocity of money (speed at which money goes through the economy – increased velocity will show that people are no longer hoarding cash), relaxation of credit standards and signs of cost push inflation. If we begin to see these cautionary signs, we will make adjustments in our clients’ portfolios to not only protect against inflation, but also to invest in securities that provide higher returns in an inflationary environment. Such investments might include a commodity fund (if you recall, we purchased a commodity fund in 2004 when we saw the money supply growing at a 20% annual rate), a fund that shorts Treasury Bonds, increased international exposure or gold, to name a few. We will have to see what the market conditions are at that point. Rest assured, we will be keeping a close eye on these factors and will be looking for ways to profit from such movements.