Deflation and hyper inflation - A possible scenario

By Aka

In and amidst the developing credit crunch the fear of deflation and hyper inflation are both present and increasing. Like a ship taking on water and rolling from side to side the global economies are more and more swinging between deflation risk and hyper inflation risk. Volatility on commodity and financial and stock markets has never been so high (oil from $140 to $40 a barrel, global stock markets down 50%, 0% yield on treasury stock etc).

Where fed's around the globe have been very successful in keeping inflation under control and within the acceptable bandwidths, the increasing volatility is likely to cause havoc in the coming years. The only problem is nobody know if it will be deflation, high inflation or both.

One scenario is that the US will accept the dangerous route of high inflation and deflate itself out of its current position. Europe is likely to do the opposite and is more likely to face deflation.

For the US which has already increased its money supply dramatically this is a more logical approach. Being supported by the fact that the US$ is the reserve currency the US has this option to play with. By increasing the money supply and stimulating the economy though infrastructure spent etc it also will cause inflation, deflate its currency (the US$ may fall by half) therefor reduce its overseas and internal government debt, which is north of $10T and allow its export sector to lead the economy toward recovery. This before Europe has worked its way out of the credit crisis.

For Europe that due to the 30-ies in Germany is far more afraid of hyper inflation is not likely to increase the money supply extensively. Also given that this can only be done by the European bank and not by any of the EU counties on its own initiative.

As we are only at the end of the credit crunch and the beginning of the recession for Europe the negative flow into the real economy has still pass through a large number of stages and reinforcing negative cycles. Europe is therefor likely to see a structural drop in demand, leading to price decreases, leading to increased unemployment, leading to further demand reduction, etc.
An extended period of deflation is therefor more likely for Europe leading to an high an overvalued Euro stalling Europe's export leading to further deflationary pressure.

All in all it looks like the US and Europe are on different paths in search of resolving this crisis. Their different path are likely to lead to more problems down the road.