Contributed by Jeff Clark, Casey Research. Jim Puplava, CEO of Financial Sense News Hour, talks to Jeff Clark about the impact of inflationary or deflationary forces, which one he believes will win out, and the effect it will have on our economy—with some disturbing insights into the dynamics of Japan. And he has a very interesting prediction. Below are excerpts of the amazing interview.
Jeff Clark: It's been four years since the financial crisis, and we're still debating inflation vs. deflation. So tell us what you found in your research.
Jim Puplava: The deflationists would argue that in a crisis as big as the financial crisis from 2007 to 2009, the resulting downturn in the economy is always deflationary. But if we look at that period, the money supply continued to expand. In my opinion, inflation is associated with monetary policy.
During the financial crisis, there were only three months where the CPI was negative. Prior to 2008, the last time you saw a negative CPI was in 1954, when Eisenhower was president! So despite all the claims about deflation, all you would have to do is look at a graph of M1 and M2 and see that the money supply actually expanded during this period.
In the middle of the 2007-2009 crisis, Bloomberg sued through the Freedom of Information Act and got access to the Fed’s records of exactly what they did. We found out that they either guaranteed, expanded, or backstopped somewhere around $8 to $9 trillion. That can only be done in a fiat money system – something you can't do with a gold-backed system.
Jeff: Like during the Great Depression?
Jim: Even before that. Step back to 1920-1921… If you look at the statistics during that period of time when we were on an actual gold standard, you saw a huge contraction of GDP and in the price of goods. Between the summer of 1920 and 1921, nominal GDP fell by 23.9%; wholesale prices as measured by the PPI dropped by 40.8%; and the CPI fell by 8.3%. It lasted for roughly two years.
I have yet to see anything like this in Japan. I have yet to see anything like this in the United States – despite the credit crisis and all the fallout we've had. And even in the gold standard we had during the '20s and '30s, we had inflation.
President Roosevelt devalued the dollar by 60% in March of 1933, and when he repriced gold from $20 to $35, he stopped deflation dead in its tracks. By the end of the month we were experiencing inflation. We were running single-digit inflation rates the very month he did that in 1933, all the way up to 1937, when FDR and the Federal Reserve reversed course. So as a result of the devaluation we got large doses of inflation.
Jeff: So your point is that even though we had a gold standard during the Great Depression, the government found a way to cause currency dilution, AKA inflation.
Jim: That's right.
Jeff: You brought up Japan; I assume you're using it as an example instead of the smaller countries because it's a major economy?
Jim: Yes, exactly. Even though the US dollar is the world's reserve currency, we have three major currencies where most trade is conducted – the dollar, euro, and Japanese yen. Argentina's economy is insignificant in terms of global GDP, for example, and they're constantly printing money, so a lot of people don't like to refer to small countries like these.
I'd like to address Japan, though, because of its unique situation. And I think a graph will best make the point. The following is Japan's CPI, year over year, going back to 1982. There were brief periods of deflation, about 1% or 2%, and you can see that most of this occurred between 2000 and 2004 and in the credit crisis following 2009 to 2010.
In that period of falling prices, the CPI was only down 1-2%. If we take a look at Japan's monetary base, however, there was only one period where it actually contracted, and that was between 2005 and 2010. But the period that the deflationists like to talk about – 1989 going forward – Japan's monetary base expanded every year. Government spending expanded viscerally.
Jeff: And now their debt is among the highest in the world.
Jim: But there's something else that makes Japan unique… If a government expands its spending in order to rectify weakness in the economy, there are a couple ways governments can finance that. They can print money – which is what the Fed has been doing – or they can finance it through the bond market with existing savings. One of the very measures that allows Japan to escape a rather severe deflation compared to what we experienced in the early 1920s following World War I or in the '30s during the Great Depression was the Japanese savings rate. Going back to when the crisis began in Japan, the savings rate was 18%.
In other words, Japan has been able to finance its deficits internally. Ninety percent of their debt has been financed and held by domestic savings. If the Fed or US politicians financed government spending with existing savings – in other words, took the savings of Americans and financed the deficit – that would not be inflationary. Inflation comes when we get debt monetization, and fortunately for Japan, they were able to finance 90% of their debt expansion internally through domestic savings.
The second factor that contributes to what happened to Japan was the carry trade. As a leading export nation, Japan exported a lot of its money to the rest of the world, and it gave rise to the carry trade, in which we were able to borrow in Japan at some of the lowest interest rates in the world.
So if Japan instituted capital controls, where the excess reserves of the monetary base were not allowed to leave the country, that money would have been confined within Japan itself, and then you would have had more money chasing fewer goods and services.
Jeff: What about Japan's demographics?
Jim: Yes, this is going to play very heavily on Japan. As their population has aged, the savings rate has declined from 18% to roughly 2%. If we look at total Japanese debt, 67% of that debt is rolling over in the next five years. More alarming is the fact that they have 900 trillion yen in sovereign debt outstanding, and the bulk of that is set to mature in the next two and a half years.
This debt is now starting to be sold. Japan's own citizens own a large percentage of this sovereign debt. Japan's Government Pension Investment Fund, which is the world's largest pension fund, sold 443.2-billion of Japanese government bonds in its fiscal 2009-2010 year. That was a result of rising benefit payouts to pension reserves requiring a liquidation of debt.
This is a major concern in our opinion for Japan, because as the Japan Investment Fund owns 12% of the country's outstanding domestic bonds, they are going to be selling an additional couple of hundred billion over the next two years.
So as Japan goes forward, there are only two things they can do to finance that debt. One, they could go into the world bond market, though they could be subject to bond vigilantes where the interest rate spread could be high; or two, monetize it.
Because their high debt to GDP ratio, the only way they're going to be able to keep interest rates down in that country is to monetize that debt in the same way our Fed is doing it through its monetary base and Operation Twist.
My point here is that the same demographics that will force inflation on Japan are the same demographics that are going to force inflation in the United States.
Jeff: So you're saying history shows that when debt blows up in a fiat currency system, inflation has always been the result.
Jim: Exactly. That's the case even in severe downturns. Look at what occurred in Japan between 1989 and 1991… their stock market lost 70% of its value and real estate prices fell 40-50%. Yet you would be hard pressed to find deflation of more than 1% or 2% for brief periods of time.
Jeff: Some will point to the "lost decade" in Japan as deflationary and say that the government's stimulus efforts didn't work.
Jim: During the Lost Decade of 1990-1999, inflation rates in Japan were 3% to 4%. One of the few times where they allowed the monetary base to shrink significantly was the period between 2005 and 2009, and the result was 1% to 2% deflation.
Even in our economy, if we look at the credit crisis of 2007-2009, which had its origination here in the US, the monetary base didn't contract – it expanded. When money is created, central banks can't control it. And what happens with that money is that it finds an outlet. It has to go somewhere – it can go into housing, it can go into commodities, it can go into stocks.
The big warning the deflationists will give is that the world is going to collapse and that we're going to see a repeat of the Great Depression. I would challenge them to prove that, because if we're on a fiat currency, inflation has always been the result.
And let me make a prediction: Right now the world is focused on Europe, and we're seeing all the fallout from that. I think the next crisis jumps from Europe to Japan, and then eventually from Japan to the United States.
The US has the "best-looking house in a bad neighborhood." It has been a big beneficiary of the flight of capital escaping Europe, so we've seen commodity prices go down. This fall in commodity prices has led to a lower CPI, and as a result we're also experiencing lower import prices, so the United States is a beneficiary of the crisis.
We will continue to be a beneficiary of this, however, only as long as we maintain some form of credibility in the bond market, the idea being that the US will eventually get its own financial house in order and will bring its deficits under manageable conditions.
Jeff: Are you saying we won't have a negative CPI again?
Jim: I'm saying that if we did, it won't stay there long because we're operating under a fiat currency, giving the government essentially free rein to print as much money as it wants.
Jeff: Commodities and the gold market, investments my readers particularly care about, could remain weak because investors would still go to Treasuries.
Jim: We're in a period of a rising dollar, and that dollar is competing directly against gold. One of the reasons I think gold investors got disappointed last fall is that the Fed didn't embark on quantitative easing. Instead it announced Operation Twist, which was really not expanding the monetary base, and the result was interest rates came down from 2.5% to 1.5%. So it wasn't necessary for the Fed to do QE. The market was doing the Fed's job for it.
Jeff: Is it your premise that this money finds its way into the economy and leads to inflation, meaning higher prices?
Jim: Absolutely. Which in turn would lead to much higher gold prices. I'm very bullish on gold. I think we're just going through a long consolidation period. Right now gold is competing with falling commodity prices and a rising dollar. [For the whole interview, click here].
Jeff Clark is the senior editor of BIG GOLD, a monthly newsletter that follows the world's best precious metals production and near-production companies.