Will energy show us that inflation and deflation can occur at the same time?

At the beginning of this decade investment advisor Marc Faber told incredulous investors that rising economic prosperity in Asia signalled the beginning of a new bull market in commodities, but would also have deflationary consequences for consumer prices. How could these inflationary and deflationary effects coincide? The answer has important implications for what is currently unfolding in the financial and commodity markets, and, in particular, the energy markets.

Before explaining why Faber believed such seemingly contradictory ideas, let's dispense with the technical monetary definitions of inflation and deflation. In their narrowest sense, inflation means an expanding money supply, and deflation means a contracting money supply. But whether the money supply is expanding or contracting, these definitions say nothing about where exactly that money goes. It is this question that concerned Faber, and it is in this context that he uses the words "inflation" and "deflation."

Most broadly, Faber wants to know whether money is chasing consumer goods and raw materials and thus pushing up what we normally call inflation as measured by the Consumer Price Index or whether it is chasing assets such as homes, equities, bonds, and even art. Policymakers and the general public normally favor the latter kind of inflation over the former. People feel richer as the value of their homes and stock portfolios rise and the cost of consumer goods remains stable or declines. More specifically, Faber wants to know which sectors of the economy are inflating, that is, receiving abnormal flows of money, and which are deflating, that is, experiencing a decline in money flows; to put it more simply, where are relative prices rising and where are they falling?

We should also mention the case in which the public and especially the investor class are clamoring for short-term government debt, bank deposits and money market accounts in an effort to shield their savings from losses. This occurs when we are either experiencing a transient panic or a generalized deflation in which money becomes more valuable as its supply contracts. That, of course, is what many believe is occurring now. There are many fans of asset inflation and even a few fans of raw material inflation--mining companies and farmers come to mind--but there are almost no fans of the generalized deflation we see today where the price of practically everything falls.

The fact that there is almost no political or economic constituency for generalized deflation is reflected in government and monetary policy around the world. Both types of policy have become highly expansive, and both are meant to get lending and economic activity growing again. Whether such policies will succeed at their aims or whether they are wise in their current form is a topic for another time. But it will be useful in the coming months to notice to which sectors of the economy money flows as the deflationary forces of the credit collapse and the inflationary forces of government fiscal and monetary policy collide.

To help us understand how Faber thinks, let's return to his observation at the beginning of this decade about the future course of the world economy, an observation that turned out to be roughly correct. At the time Faber reasoned that as manufacturing vastly expanded in Asia and global trade ferried the cheap goods produced there throughout the world, consumer prices would remain stable or decline. Simultaneously, a bull market in raw materials would emerge as the supply of materials to feed those factories would lag behind demand after two decades of underinvestment in mining, energy, and agriculture. Thus, there would come to be a disconnect between the prices of consumer goods and the prices of the raw materials used to make them. In Faber's terminology, one sector would be deflating and the other inflating.

The simple lesson from this is that money chases scarcity. That's why some sectors of the economy can inflate while others deflate at the same time. The economy never uniformly inflates or deflates. Even the current economic contraction will be no exception. First, what is scarce and in demand by definition becomes more valuable as people bid against one another to have what little there is of a scarce but necessary resource. Second, people tend to hoard what is difficult to get, especially if it is essential to their livelihoods or their peace of mind, and this further increases its scarcity in the marketplace. Third, speculators noticing the trend plow money into the sector of the economy where prices are rising through such investments as stocks, bonds, commodities, real estate and derivative securities linked to these. This further pushes up the price. As Faber would say, the chosen sector is "inflating."

Now, what can be scarce or perceived as such is virtually anything: food, metals, equities (believe it or not), and even financial peace of mind. To obtain financial peace of mind investors most recently sold stocks, commodities and corporate bonds and bought government bonds. Faber would say that the government bond market is "inflating" though clearly we are moving through a period marked by generalized deflation.

What this means for the coming year is that all of the money currently being willed into existence by the central banks of the world in an effort to stimulate the world economy will be going somewhere.* Since scarcity is the key to determining where those who have access to that money might put it, it is worth considering what might be perceived as scarce. (Disclaimer: The following shouldn't be construed as investment advice. Use it as such at your own risk. My task lies elsewhere.)

Certainly, paper promises in the form of stocks and corporate and mortgaged-backed bonds don't seem scarce. The thrill of paper gains that made them seem so has vanished. And, the crooked dealings of so many corporate executives has made owning individual stocks look far more risky than it seemed in the past. With monumental issuance of government debt throughout the world on the horizon, it is hard to see how government bonds will continue to be regarded as scarce much longer even though they may offer peace of mind to their owners for now. And, the various paper derivatives of all these investments could probably supply the world with wallpaper for a thousand years if turned into actual certificates. Hardly scarce!

What may turn out to be truly scarce is energy. There is no Wall Street paper mill that can turn it out as it does various securities. It can only be obtained through skilled, energy-intensive and highly complex processes. Right now the precipitous drop in world demand for energy has pummelled energy prices. What is not so obvious is that low prices and contracting credit are leading to low investment in the oil and gas fields, in the coal fields and in alternative energy technologies and deployment.

Even while many factories may now stand idle, the oil pumps, the natural gas pipelines, and the coal trains are still working relentlessly around the clock to bring us the energy resources we need and are therefore depleting the existing reserves in the ground. Without enormous and continuous investment, the energy industry cannot hope to keep up with this scale of depletion. Already for the past three years, record high prices for oil failed to conjure any additional daily production capacity into existence. Oil production was just about flat for the entire period.

With the ultralow prices we are experiencing now, the necessary capital will simply not flow to the energy industry to replace the reserves we are depleting or invest in alternatives to replace finite fossil fuels which will all reach a peak some day (perhaps soon) and then decline. (Many say that world oil production peaked in July 2008 and may never rise to that level again because of a combination of geologic constraints and the drop in investment in new productive capacity.)

So, my candidate for a surprise comeback this year or next is energy, even if the economy as a whole deflates more or just limps along at this level. If it happens, policymakers and the public need to see it for what it is: a certain sign that we are close to the end of the fossil fuel era. Even with the very high energy prices of this decade, we have not been able to build up the large inventory of new fossil fuel discoveries that might have been expected. It is getting harder and harder to find, extract and refine the nonrenewable energy sources that the world economy relies on for 86 percent of its energy. When the ongoing decline in energy supply capacity unexpectedly crosses with energy demand, that fact will be made plain for all to see if they want to see it.

What is likely to happen, unfortunately, is that once demand rises to meet available capacity or capacity shrinks to meet demand, catapulting energy prices will choke off any economic recovery which will in turn cause energy prices to plummet all over again. The high volatility in the energy markets, cycling from deflation to inflation and back to deflation again will make it exceedingly difficult for the energy industry to invest aggressively in finding new supplies. That is a problem that cannot be solved by central bank money printing or government spending, but which requires serious changes in policy and society, something that now seems sadly delayed though it is arguably more important in the long run than the economic emergency which we currently face.

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*For those who say that it is possible that more money will disappear from the world economy through debt defaults than will be created by central banks, this will still not prevent some sectors of the economy from inflating though they may be fewer and inflate less as a group.