Below is a great letter to David Rosenberg that was published by Glusken Sheff today, in which “Rosie” reader lays out in laymen terms why both deflation and inflation will be the topics of conversation for years to come.

“David,

Great work lately, spot on as usual. A few observations from Upstate NY, a place where the economy is always depressed, since cash for clunkers not many new cars on the road. A new health club opened, very nice, we live in the high rent part of town, (my wife is a health club instructor and they are hiring), but no new sign-up’s or slow sign-up’s. In other words, no recovery here. FYI, both parents are brokers at major wirehouses, I can assure you the income theme is alive and well and one will attest that the gold fever is coming to life, but nowhere near bubble territory. Your deflation theme and charts are right on, prices everywhere except for the grocery store are low. I side with you on deflation, all evidence points towards it.

However, I also believe inflation is a fat tail event that is not understood fully yet. I believe we will go from deflation to inflation very quickly thanks to QE from the Fed. Bear with me on this one, in The Depression: A Diary, Benjamin Roth feared inflation which never happened, but that debt was never really paid off, we grew our way out of it, basically. But, we did have a bout of higher prices in the 50’s, a small fat tail from the 30’s? When the 60’s hit we spent on Vietnam to the Great Society and that created a shorter fat tail event, i.e. the 70’s stagflation. Is it possible that inflation is the next fat tail as the fat tails are picking up steam and happening at an increasing rate? I say this because sovereign default can be prevented through printing, avoiding technical default, while it is default in my eyes, still you get the point.

Couldn’t we suffer inflation through QE or dollar devaluation because of the monetization of our debt? From my lens this fits into your scenario of deflation and into Bernanke’s need to create inflation. I love your work, you are right and most of us believe, I own treasuries, gold and income securities and am very happy because of your guidance.

Thank you”

Bottom line, the next decade will not be about how much your capital (or your banked wages) appreciates but rather whether your capital will be returned to you at all. I don’t believe the street is positioned for deflation at the moment and here are three reasons why:

1. Everyone and their brother has long term bullish view on oil and base metals. It seems to me that not too many people are underweight commodities and therefore the air could come out of the asset class rather quickly.
2. 1% of money managers were bullish on Treasury’s at the start of the year.
3. Everyone is long emerging markets, which is the same theme that gives their long-term bullish outlook on emerging markets.

Therefore, I think investors should have a healthy balance of Treasury’s, gold and defense stocks. The teeter totter is tilted too far towards the inflation trade and will swing towards deflation very quickly. About the time everyone is talking about how you must own MCD and oil is trading at $50, position for the teeter totter to swing towards (hyper?) inflation.

“In 1983, the Bureau of Labor Statistics began to use [for CPI] rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since “owners’ equivalent rent” is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years.”

So what does owners equivalent rent really mean according to the BLS?

“(The) BLS asks each homeowner for their estimate of the house’s implicit rent and what occupants would get for their rent (how many rooms, etc.) if the owner did rent their home.”

When the Bureau of Labor and Statistics do their surveying for shelter index portion of CPI they ask the following question (verbatim):

“If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”

Man I would love to get one of these calls.

If you ask someone about their home value, that is something they probably know about, but if you ask someone about their house’s implicit rental equivalent is, now that is a different story. Most people do not understand the economics of rental properties well enough to give such an opinion. Furthermore, how many people living in Mc-Mansions can even contemplate what their monthly rent would even be when they live in a neighborhood that may not even have on housing unit that charges on a monthly rent basis?

I think Gjerstad and Vernon know what Hazlitt knew decades ago: inflation numbers are blatantly cherry picked and scrubbed to make it seem like the COLA estimates are much lower then they really are.

Furthermore the BLS states that, “Because rents are not volatile, the CPI can use a longer interval between pricing observations than it uses for other consumer items.” I guess we will have take that statement about volatility at face value.

Click here for more information regarding the housing index and CPI

“Like every other tax, inflation acts to determine the individual and business policies we are all forced to follow. It discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse.”

-Henry Hazlitt (Economics in One Lesson)

· Discourage prudence and thrift- government encouraging spending ?

· Gambling and speculation -Flipping houses, LBO’s-?

· Desperate remedies-monetizing debt-?

I believe that the above statement by Hazlitt not only summarizes how we got into this “credit crisis” but also summarizes where we will end up. Monetizing debt is just the start of the desperate remedies. I fear that the impudence of the governments of the world will lead to further instability. Now, as brutal is this instability may end up being it is my job, I still look for future investing opportunities.  That’s why I have coined the GGO Investment Theory- Guns, Gold & Ordinance (perhaps we should substitute oil for ordinance?). That is not to say that I recommend running out and buying stocks, because I actually wholeheartedly believe that equity indexes will cough up another 40%–that’s right I said 40%–within a year. When the cough up comes, however, I will be ready to pick up some defense stocks on the cheap. As far as gold goes, well you better have some of that before that cough up comes, because otherwise you will be paying up to own the bullion.

Ah, yes, nary a week should go by without hearing from our good friend Frederic Bastiat.  The French economist, who died too early and too soon after his emergence as a economist.  Bastiat died at the age of 49, only six years after truly finding economics, as a theoretical study, at the age of 44 (thanks Wikipedia!). In that time Bastiat published some real economic gems.  This from his Selected Essays on Political Economy:

“But what relief can the landless find in the proclamation of the right to employment? In what respect will this new right increase the amount of food or the number of jobs available to the masses? Is not all capital employed in giving them work? Will it increase by passing through the public treasury? By taking it away through taxation, does not the state close at least as many sources of employment on one side as it opens on another?”

Fast forward to today and we face a similar, but different problem for the masses.  In all of their zeal to get reelected save the economy, the government spending trillions of dollars.  Some of these ‘stimulus projects’ will help select portions of the masses, but in the end, the only real stimulus will be in the green ink industry.  What will the masses be left with?  At the very best significant inflation, at the very worst hyperinflation.  Inflation always falls upon the masses the hardest.  And thus, the masses are being plundered without even knowing about it.