How Financial Reality Is Hidden By Commonly Used Theory & Jargon

Daniel R. Amerman, CFA * GoldSeek.com

As we will explore in this analysis, when we look at two of the largest sources of net worth in the United States – housing and stocks – then what history shows us is that for 22 out of the 40 years between 1972 and 2012, much of the truth about financial performance has been almost invisible to people who have been relying on the most commonly used definitions for inflation and deflation.

That is, most people phrase the question as being one of either a) inflation, or b) deflation, meaning it has to be one or the other and obviously can’t be both together. As we will explore using simple to follow, round number examples, taking this seemingly common sense approach leaves us unable to distinguish between a 20% gain, a 20% loss and a 94% loss.

We will then apply the type of methodology used by some of the most sophisticated investors in the world, which splits changes in the value of assets from changes in the value of money. When we take this step, then the possible answers are no longer limited to either A) inflation or B) deflation, but expand to also include C), both inflation and deflation occurring at the same time.

As we will discover, for the largest sources of household net worth during the 22 years analyzed out of a 40 year period – the answer was indeed c) both inflation and deflation, at the same time. Thus, the past didn’t work the way most people think it did.

And there are compelling reasons to think that this third possibility of simultaneous inflation and deflation may also define the path ahead of us. If so, those who rely on the most common definitions for inflation or deflation may be unnecessarily placing themselves at risk, simply because they don’t fully anticipate the third possibility, which historically speaking, also happens to be the most common outcome for stressed economic conditions.

Theoretical Economics Perspective

Let’s start with Economics 101, where the definitions of inflation and deflation are fairly straightforward.

Inflation is an increase in the money supply.

Deflation is a decrease in the money supply.

It would seem fairly straightforward, then, that we can’t have both inflation and deflation at the same time, so therefore it must be one or the other.

Unfortunately, that’s where the straightforward part ends. Just what does “money supply” mean anyway? Is it M1? Is it M2? Is it M3? What about credit? What about the value of real estate and other assets? (And for the average person – what do those “Ms” mean anyway?)

Once you have (somehow) picked a definition for “money supply”, what are the practical implications for you and your savings? Unfortunately, that’s another problem with these theoretically correct definitions of inflation and deflation. Any linkage between that commonly accepted definition of inflation and actual price levels is, well, highly theoretical. Some economists write papers saying one thing, then others write papers disagreeing with them – it’s the perfect subject for endless debates, because it’s unsolvable.

An even more dangerous problem can be found when we look at the typical “inflation versus deflation” debate, as if those were the only two choices. For instance, if we look at an asset like a house or a share of stock, then an increase in price means inflation, and a decrease in price means deflation. Again – by the common definition – we can’t have both inflation and deflation at the same time; therefore it obviously must be one or the other.

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