"Inflation is taxation without legislation."
-- Milton Friedman

Since everyone today is fearful of deflation and falling prices for everything from commodities to stocks to housing, this is a good time to consider what causes deflation and its opposite, inflation.

Deflation is caused by a reduction in the supply of money available in an economy, relative to the goods and services available. This usually happens because of a combination of wealth destruction, credit contraction and excess production.

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The most classic example of this is in Japan, which has experienced mostly deflation for nearly two decades despite, enormous efforts to combat it from the government. Many people believe that the U.S. is headed for a similar fate because of our housing and stock market collapse combined with the credit crisis.

Here is why that is not very likely to happen.

First, the Japanese government was very slow to respond to its deflation problem with zero interest rates, quantitative easing and massive government spending. By the time it did get around to implementing these policies, the psychology of deflation had already taken hold among the Japanese people and businesses.

In contrast, the U.S. government has moved forward with these anti-deflationary policies in short order. Although significant damage has been done to consumer and business confidence, the problem has not been going on for years as it was in Japan.



has already come out and effectively said that it is going to target and basically guarantee a certain level of inflation. If the Fed has credibility about anything, it should have it with respect to printing enough money to create inflation, if that is what it wants to do.

In just a few months, the Fed has effectively printed trillions of dollars and the Treasury has spent more than a trillion dollars trying to increase the supply of money. That should demonstrate their seriousness about preventing deflation.

Second, it is in the national interest of the U.S. and the personal interest of most American consumers to create inflation. The U.S. government owes trillions of dollars to foreigners. It has a strong financial incentive to destroy the value of the dollar in order to repay that foreign debt with cheaper currency. Similarly, most Americans are deeply in debt and would benefit from inflation that would effectively reduce that debt burden on their households.

In a social democracy like ours, people support policies and government implements policies that benefit most of the people. In Japan, most people were savers and didn't have much debt relative to Americans.

Japanese corporations and the government have a lot of debt, but it is all owned domestically rather than by foreign creditors. So from a political standpoint, destroying the currency doesn't really benefit Japanese society as a whole.

Third, Japan produces too much and consumes too little, relative to the size of its economy and its stage of development. This is exactly the opposite of the U.S. Here, we produce very little and consume way too much. That has been our economic model, based on borrowing money to spend and speculate, for decades.

An economy oriented toward consumption and away from production like ours is far less likely to fall into a long-term deflationary spiral because there are not likely to be too many goods and services produced relative to demand.

Also, since America imports most of what we consume, our declining currency will create even more inflation because the imported goods will become more expensive in terms of our dollars.

People should not confuse short-term declines in commodity prices and asset prices caused by a recession with long-term deflation, which is always a monetary phenomenon. After the economy bottoms out later this year, inflation is likely to resume even stronger than before because of all the excess money in circulation and also because of all of the productive capacity that will have been eliminated during the recession.

The only way deflation could have a chance of happening long term in America would be if our economy continued to shrink for many years. Somehow I don't believe that the government is going to allow that to happen because the American people would definitely replace that government in the next election. That is another difference with Japan.

The Japanese electorate has shown extraordinary patience with their government's mismanagement of their economy. Americans are notoriously impatient and quick to "throw the bums" out if we don't like the immediate results that we're seeing.

For investors, what this means is to avoid long-term Treasuries, which are assuming deflation or no inflation in the economy. It also means that gold and other hard assets are a good long-term value to protect your cash against future inflation.

On a relative basis, oil is probably the best value of any investment today, because it has collapsed down to unsustainably low levels and almost has to go up substantially over the next six to 12 months.

The best ways to play this rebound in inflation and in oil are to own

U.S. Oil Fund ETF

(USO) - Get Report


ProShares Ultra DJ Crude

(UCO) - Get Report

; both are for more aggressive investors.

Oil stocks are not as good, but investors could also benefit from owning

Energy Select SPDR

(XLE) - Get Report

, which has among its holdings


(CVX) - Get Report



(XOM) - Get Report


Occidental Petroleum

(OXY) - Get Report


Anadarko Petroleum

(APC) - Get Report


Another choice is

Oil Services HOLDRs

(OIH) - Get Report

, which holds shares in


(HAL) - Get Report


Baker Hughes International




(SLB) - Get Report


Gold could be owned efficiently through

SPDR Gold Shares

(GLD) - Get Report


PowerShares DB Gold Double Long ETN

(DGP) - Get Report

; again, both are for more aggressive investors. However, gold is overvalued right now relative to other commodities, especially oil. It may be a good idea to wait for a pull back in gold before buying.

Another way to benefit from future inflation is to take advantage of low-interest rates and lock in long-term financing to buy income property such as apartments in supply-constrained markets that will benefit from future inflation through increased rental rates and higher cash flow to the owner.

Do not believe the hype about deflation. It could be dangerous to your financial health. Right now is the best time to start hedging against future inflation because most people don't believe it's going to happen. Now is the classic time to buy a straw hat in winter, because people are just giving them away.

Christopher Grey is a managing partner of Third Wave Partners. He currently has positions in UCO as mentioned in this article. This article should not be interpreted as personal investment advice or a recommendation to buy or sell any security. Interested readers may contact the writer by emailing cg@thirdwavepartners.net or visiting the company's Web site, www.thirdwavepartners.net.