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Home > Merk Research > Merk Insights > July 1, 2003

2nd Quarter - Deflation or Inflation?

Axel Merk, Merk Funds

July 1, 2003

The word 'deflation' has made it to the front pages of both European and US newspapers. But which one is it - deflation, inflation, maybe both, that we need to worry about? What happens if the Federal Reserve Bank and the US administration try to force the economy away from deflationary symptoms through monetary and fiscal policy? How does the European Central Bank react? What are the implications for businesses and our own financial planning?

Good Deflation Versus Bad Deflation

Nowadays, the term inflation is often used in lieu of the Consumer Price Index (CPI). Inflation was originally defined as an increase in money supply; deflation was defined as a reduction in money supply. There is nothing ex ante bad about falling prices – most of the high technology industry is used to perpetually falling prices. However, the falling prices have been met with increased demand, investment and innovation. An industry or economy is in trouble when a price reduction does not stimulate demand, but stifles investment and innovation.

Among others, deflation can occur when there is overcapacity, when consumer demand is saturated, or when there are other disincentives to investing. Greenspan is well aware that the economic bubble at the peak in 2000 has left its scars, and there continues to be overcapacity in select markets. The US consumer has been lured into spending with 0% financing offers, strongly suggesting that it may be difficult to get the consumer to increase spending. The post September 11 talk about threats to our safety, the scaring away of Arab and other investors, as well as the war in Iraq, have left their marks on the investment climate.

In the US, select business-to-business segments have shown repeated cycles of disinvestment. Some of it is healthy, continued capacity reduction, but the vicious cycle starts as companies that continue to face tremendous competition have to save costs at all ends causing other businesses and employees to suffer.

Europe is much further advanced in the deflationary scenario. The consumer has long given up spending, and individuals and companies alike are focused on survival and cost cutting.

What can be done about it?

There are different schools of thought about how to handle the current situation. The “Austrian” school believes that even extended recessions are desirable to reduce excess capacity, to push an economy back on a sustainable path. In contrast, the US is following a Keynesian model that focuses on supply and demand balances, and in which the appropriate stimulus will have the desired effect.

This is not the right place to argue which approach is more appropriate for the US and European economies, but to look at the approaches pursued by the governments, highlight some of their risks and their consequences to us as investors.

What is done about it?

The Federal Reserve Bank has decided that the risks of deflation outweigh the risks of inflation; it has taken aggressive steps to lower interest rates and to make money easily available. On top of that, the Bush Administration passed another tax cut package to “get money into the hands of consumers” hoping it will lead to increased economic activity at all levels.

The Federal Reserve Bank’s recent actions show that it is very concerned. It pursues its aggressive policies even while the Bush Administration has no spending discipline and enacts tax cuts that Greenspan considers misplaced. Indeed, the Federal Reserve Bank is playing with fire while the Bush administration is providing fuel – traditionally, a central bank would have looked for a fire extinguisher to rein in an administration that is unable control its spending. Times are different. The critics say Greenspan is a mercenary of Bush with a mission to get Bush re-elected.

Until recently, the European Central Bank (ECB) had the “fire extinguisher attitude” and tried to control all Euro-zone countries with a single tool, interest rates. However, on May 8, 2003, the ECB had a controversial meeting in which it changed its stance; on June 5, 2003, the ECB followed through with an aggressive interest rate cut to 2%, even as inflation is starting to start moving up. In all likelihood, this won’t be the last cut by the ECB.

Why such extreme measures?

Aside from disinvestment because of the general economic slowdown as well as reduced investments because of a decreased willingness to take on risks in the environment that was created in the period after September 11, major structural changes are in the works. Until recently, most believed that one can export production to low labor countries, but that the service industry is inherently local. However, an educated Eastern European, Indian and Asian workforce is a rapidly rising force providing everything from customer service centers to computer programmers. This is an acceleration of structural changes that few economists thought would happen as quickly.

While much of the “newer” economy in the US is extremely good at adjusting to new environments, “old economy” corporate America has huge issues: old-style US corporate pension funds are “defined-benefit” plans where retirees are promised pre-defined retirement benefits. The problem is that corporations continue to assume an 8%-10% return on their investments – something difficult to achieve when the quality fixed income sector has negligible returns; stock market returns are far from certain, and prudent planning certainly should not let one assume to make up the shortfall. As the work force ages, the problems are exacerbated. The regulators are taking the situation seriously and will require firms to provide much more disclosure on their pension obligation going forward. In the meantime, Greenspan is helping these firms by letting them borrow money cheaply, very cheaply. General Motors announced to issue $13 billion in bonds to help fund their under-funded pension plan; as if that wasn’t enough, GM just announced it increases the bond issue to $17bn.

US Airlines also carry tremendous debt levels, sharply increased from a few years ago because of the numerous challenges the US has faced in the past years. By pushing interest rates to extreme levels, the airlines have a better chance of survival. Again, I shall not answer here whether much of the “old economy” companies ought to survive, but for now, the political decision is that everything possible is undertaken that these firms have a chance at getting their balance sheets in order.

The same applies to the US consumer that is given an opportunity to restructure his or her debt burden. In recent months, there were signs that the US consumer was indeed paying down some debt. However, this may have merely been a temporary result of the heightened fear levels that discouraged spending; on the contrary, the Bush Administration wants the consumer to keep borrowing and spending to keep the economy running.

One may agree or disagree with current policies. However, it shall be noted that US corporations have begun to take their pension obligations seriously. Cynics say that automotive companies only produce cars to pay pensions for retirees, and that no profit will be left for shareholders. Yet, Europe, where the governments tend to administer pension plans, has mostly avoided the issues that are no less serious.

What are the consequences?

Let’s look at the positives first: the main fighting in the Iraq war is over; low-interest rates encourage spending and home ownership. Everyone is jubilant that the worst is over, and both bond and stock markets have been rallying.

One reason why Europe has been hesitant about pursuing an aggressive monetary policy is because Europe remembers the severe risks of excessive money printing: uncontrollable inflation leading to hyperinflation. But don’t we have a deflation problem? The Federal Reserve Bank is so concerned about deflation, that it has determined to induce inflation. The one wild card that Greenspan does not like is Bush whose spending he cannot control. But Greenspan believes it is still the lesser evil to let Bush pursue his expansionist policies even if there is a risk that inflation may go out of control.

A direct result of printing money at a record pace is that the dollar has weakened. The Federal Reserve Bank is not overly concerned about it, as it helps to stimulate the economy while it imports a great amount from China with a fixed exchange rate towards the dollar. The Chinese are only secondarily interested in profit, they are foremost interested in employment for their people. However, other Asian countries suffer with a weaker dollar, and so does Europe.

It’s the aggressive US policies that have forced Europe to abandon their restrictive monetary policy. Until recently, Duisenberg could always refer to his job description and say that he had no business to worry about deflation. At the same time, European governments are revolting and refuse to abide by their debt ceilings. It shall be noted that the only reason why European governments were able to stay within their debt ceilings in the years leading up to monetary union was through Enron-style accounting tricks.

The United States has flexible enough an economy, so that it can risk pursing its path. Historians will call it irresponsible should it fail, but if a country has a chance to succeed with expansionist policies, it is the US. Europe’s structures are too rigorous to be suited for an aggressive expansionist policy. At the same time, Europe has decided it cannot be the sole fortress left in the world defending its currency and restricting domestic investments until a sustainable base is found again. Europe is hoping that the joining of Eastern European economies to the Union will be their savior.

The big question is what forces will prevail, deflation or inflation? If deflation indeed takes over, debt will be your worst enemy and only cash flow positive businesses survive. As investment winds down, companies and individuals must try to be cash flow positive to survive. If the Federal Reserve Bank has it its way, mild inflation will be introduced, which will yield a well functioning economy.

A serious risk with the Fed’s policy is that it doesn’t work as intended. I have no doubt that the Fed can introduce inflation, but it cannot control well where it is introduced. The business environment remains extremely competitive, and additional incentive to produce will only add to capacities that may not be sustainable in the long run. For companies to operate profitably in this environment, they have to continue to cut costs. Cutting costs means layoffs or moving jobs to lower cost areas. At the same time, commodity & import prices rise as inflation is introduced and the dollar weakens. The net result is that it will be very difficult for old-economy style corporations to thrive as high costs cannot be passed on to consumers.

What do we do?

We have to be prepared for all scenarios. If indeed we are right and inflation is going to come, taking on debt to leverage oneself would be advisable. However, the risk that deflation wins has to be taken into account. Let’s not forget that all this debt is likely to encounter higher interest rates a few years down the road, and will cause more severe problems than we are facing today. As a result, we should only take on as much debt as we know we can manage with our cash flow. This is not the time to be cash-flow negative (in plain English: to live beyond our means), nor is it the time to believe that high cash flow from an unstable job may continue and rise forever.

In an inflationary environment, cash is bad, debt is good, real assets are good. For the reasons stated above, I would advise against betting on debt. Real assets may include gold, real estate and stocks.


The US government tries to destroy its currency. During the Great Depression in the 1930s, there was a gold standard. Nowadays, there is nothing that will stop the Fed from printing money. As a result, the dollar is likely to weaken and commodity prices are going to rise. Much is said about whether gold is still a substitute for money – there is no need for it to be “equivalent” – it acts as a neutral currency not only because it is one alternative for central banks to keep their reserves in, but also because it is a pure commodity not subject to quite as many influences as e.g. oil, sugar or coffee are. But as the US is promoting inflationary policies and the Bush Administration is alienating countries around the world at record pace, central banks will adjust their foreign currency reserve holdings. Arab countries are likely to increase their gold reserves to be less dependent on the dollar. China is likely to build larger gold reserves to accommodate its trade surplus while keeping its exchange rate pegged to the dollar.

And what about the Euro? As said, there are signs that the ECB is fed up with keeping a strong currency. In European tradition, the ECB’s moves will be less radical. Forecasting the Euro-Dollar exchange rate is an almost impossible task – the increased economic activity in the US may well keep the Dollar at its current level relative to the Euro. However, only if both Euro and Dollar are both weakening, for the benefit of commodity prices; gold is a suitable hedge, even it may be a weaker hedge for the Euro as it is for the Dollar. Should Greenspans plan not work out, it is quite likely that a lot of damage will be done to the currency system, and that we will be glad to hold gold.

Real Estate

The Fed is betting that the economy can walk on a fine edge, and that inflation will increase prices nominally, making the consumer feel wealthier (consumers used to inflation feel poorer in a low inflation environment even if real earnings remain the same). This is also the best-case scenario for the US real estate market where record low interest rates have caused prices to continue to climb – should inflation arrive, those buying houses in five years can only afford the same prices at higher rates if their income is higher. As I have serious doubts that real income can rise in this cost-savings environment, the only way out is a collapse in housing prices or increased nominal income. The Fed has made it clear that they are betting on the latter. We might be able to avert a disaster in the US housing market by making home owners believe they have a profitable investment. Thought of it differently, the Federal Reserve Bank is giving the ageing Baby Boomers a last chance to buy their dream house before retirement – anyone considering buying a house for retirement should be very careful to only take as much debt as they know they can afford well into retirement.

Europe’s housing markets cannot be adequately covered in the context of this newsletter, it’s simply too diverse. The dynamics of most European housing markets are much less linked to the monetary and fiscal policies discussed herein.


During the 2nd quarter, the Dow is up 12%, the Nasdaq is up 21%, the Dax is up 33% (all in local currency), while the Dollar lost another 5% versus the Euro. One couldn’t help but get the feeling that there was panic among money managers that they might miss the recovery in the market. Many institutional managers complained that the increase was too sharp, too quick, to be sustainable. The stock market has consistently been able to cause us as much pain as possible – in the past years, we have been either unhappy to be invested or unhappy not to be invested enough.

Stocks are one type of inflation hedge. However, we must be careful as there will be many companies that will not be able to thrive in an environment where companies cannot pass on higher costs. We must also be careful to see whether new bubbles are created with the current aggressive policies. We focus on cash flow positive companies, on companies that have shown that they can adjust quickly as their revenues declined.

Last newsletter, I mentioned the German travel company TUI as an investment we like in this environment. It was depressed because of SARS, the Iraq war and the general economy. It had closed March 31 at €8.74, and three months later has jumped 48% to €12.95. Even at these levels, it remains far below its highs, and we will continue to expand our position; we now hold it because it is one of the few European companies that will benefit from a stronger Euro, and as a longer term holding as I believe the travel industry is a growth sector in years to come. Also, unlike US travel companies, TUI has a healthier financial position.

A quarter ago, the Iraq war had just started. Now the main fighting is over. Blair in the UK is struggling to defend his actions. Bush, on the other hand, has not had to justify himself much about the continued attacks on US soldiers, nor on whether going to war in the first place was justified. With elections coming closer, I would not be surprised if Bush’s leadership is not called into question; having said that, there is no opponent that could challenge him right now.

I continue to believe that Europe will tackle some of its structural issues and that the German government will succeed with some of its reforms. On June 28, Germany’s powerful IG Metall union backed off from a month old strike in Eastern Germany unconditionally, i.e. without having reached a single of its (unrealistic) targets. That’s unprecedented in Germany, and carries huge symbolism that few have noticed so far.

Axel Merk
President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Merk Investments LLC makes no representation regarding the advisability of investing in the products herein. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice and is not intended as an endorsement of any specific investment. The information contained herein is general in nature and is provided solely for educational and informational purposes. The information provided does not constitute legal, financial or tax advice. You should obtain advice specific to your circumstances from your own legal, financial and tax advisors. As with any investment, past performance is no guarantee of future performance.