Deflation and inflation are taking place at the same time. There are two economies, the physical economy is experiencing deflation and the financial economy is at the border of hyperinflation, particularly stock and bond markets.

The central banks world- wide are obsessed with the financial economy, which produces nothing useful but does create liquidity in various forms. Since fractional lending gears with Quantity of Money effect, there is no limit to the amounts of liquidity the finance economy can create – and is creating right now. In this context, central bank interventions are minuscule, the real issues are the rolling over of swaps and other derivatives. These are also forms of liquidity; the total of these denominated in dollars is over $500 trillion and represents the largest amount of available liquidity in the finance economy. This number is from the Bank of International Settlements.

One outcome is the rise in stocks against the decline of the dollar; more funds aren’t sold into the markets, but are lent into existence within the markets themselves. The monetary expansion is reflected in the ‘cost’ of dollars in less inflated currencies. What is also being measured by the declining dollar isn’t the decline of overall investment risk but the increase in derivatives risk, since dollar inflation measures the increase in overall unsecured debt. In other words, the debt is secured by the dollar itself, rather than any productive asset; this is why stock prices have diverged from underlying value; stocks measure the quantity of money- plus- velocity rather than the earnings that will probably never take place.

Meanwhile, the physical economy is constrained by oil prices which at current levels absolutely prohibit inflation. Inflation could take place if the crude price was less than $20. Firms could afford very high wages at same time afford the low priced fuel which could be used to amplify labor productivity.

The $20 price or its relative equivalent will never be seen again. Peak oil is real and took place in dollar terms in 1998.

China’s cheap labor/cheap coal advantage is a wasting asset; increased petroleum prices are racing to catch up with the Chinese advantage and to destroy its economy as it is currently doing to the US, Japanese and European economies. Since Chinese wages are too low to allow workers to afford Chinese products, its race with increasing relative petroleum prices will be, unfortunately, a very short one. The issue is capital allocation; either fuel or other capital/operational expenses can be paid, but not both. The consequence in the US has been offshoring expensive labor and creating asset bubbles as a hedge against rising energy prices. This experiment has failed. Likewise, and the current financial bubble attempt will also fail. The reason being the inability of the physical economy to support the bubble prices.

The only solution in the developed countries is conservation and de- industrialization. There are no other solutions, any other attempts will hasten the depletion of petroleum reserves and accelerate deflation which will result in conservation, anyway.

China is at risk of hyperinflation, its dollar peg allows the US to export its liquidity overflow to China via currency exchange, ‘hot money’ flows and the carry trade. China has sufficient savings to provide ‘fuel’ should the government convince citizens their savings will be worthless and should be spent at one time. Shaky PBOC and government pronouncements increase the likelihood this can happen.