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One fool. . .

Richard Russell
Dow Theory Letters
Jul 12, 2005

Extracted from the July 11, 2005 edition of Richard's Remarks

I spent a good deal of the weekend reading (as usual), and pondering what I consider THE economic question of the day, the week, the month and maybe even of the decade. I'm talking about the momentous question of -- INFLATION or DEFLATION. Older subscribers know that I've been using the expression, "Inflate or die" to dramatize the incredible position the US now finds itself in.

Debt in the US plus unfunded liabilities is now running into the multi-trillions. Nobody denies that. The only arguments have to do with how the nation is going to deal with all this debt. So far, nobody has the answers. In fact, nobody, except certain academics, is even talking about the question.

I've been reading some very bright people on both sides of the equation. My friend, A. Gary Shilling, was one of the very first to take the deflation side. Gary even wrote a book entitled "Deflation." Gary has been joined by other bright people, the latest to join the deflation-club being none other than Morgan Stanley's Stephen Roach and Pimco's Bill Gross. On the inflation side, I just read the latest paper by the brilliant Stephen Leeb, editor of the new service, the "Complete Investor."

The deflationists talk about the US and even the world economy slowing down. They talk about global over-production. They point to the steady decline in bond yields. The inflationists point to the Fed and its morbid fear of deflation. They talk about record oil prices. They insist that at any hint of disinflation, the central banks of the world will drive interest rates to zero if need be, while flooding the planet with even more liquidity.

The latest (July) Bank Credit Analyst has the brilliant Martin Barnes saying quite a lot about the picture, as note -- "The perfect breeding ground for inflation has been in place in the past few years: large fiscal deficits and a weak dollar. It speaks volumes that core inflation has remained close to 1.5% (based on the personal consumption price index) in that environment. Powerful structural forces are keeping a lid on inflation: intense global and technological advances are boosting productivity. . . . .

"To the extent that inflation is always, and everywhere, a monetary phenomenon, the Fed's easy stance has had an important impact. It has shown up in rising house prices, rather than conventional consumer price indexes. . . The housing bubble is likely to get bigger before it inevitably bursts. However, when the housing bubble does burst, it will represent a huge deflationary shock to the economy.

"Looking ahead, the risks facing the US and global economies will remain more deflationary than inflationary. Other than burst housing bubbles, there is also the lingering concern that global investors will, at some point, be unwilling to finance US profligacy, forcing a major retrenchment in demand."

Russell comment -- At this point I don't think we can come to a decisive conclusion. That's right, despite the fact that this is probably the most important question of the decade, the answer lies "out there" somewhere -- to be concluded at a later time.

Wait, how about China? China is a growing giant of 1.3 billion people, and the Chinese people are buying cars, They are buying refrigerators, they are traveling, they are demanding more oil, more energy, more of everything. Right, but some people, like my friend Adrian Van Eck, are saying that China is effectively broke, that their banks are bankrupt, and that China's economy could fall apart at any time. And I think to myself -- what if China crashes? Won't China start selling part of its huge hoard of US bonds? And what happens then, if Chinese selling drives US rates up and through the roof?

If, if, what if? It reminds me of one of my favorite Zen kaons -- it runs, "One fool can ask more questions than ten wise men can answer."

Here's a thought that is always on my mind. Somewhere ahead the housing bubble, the stock market bubble, the credit bubble -- one of the many bubbles is going to burst. When that happens, the Fed will react as it always does -- it is going to open the money spigots wide. I don't know whether that will jump-start the economy, but it's going to play hell with the dollar. At that point we'll have monetary inflation. There'll be paper dollars "up the ying-yang." Will that be enough to ward off the deflationary effects of a burst bubble? Guess we'll find out.

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Richard Russell
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