Dr. Faber is a Swiss finance manager (with some social conscience) who lives in Thailand and works in Hong Kong.

Last week he was interviewed about inflation/deflation tendencies at the Financial Sense site. On excerpt:

If you impoverish a society through inflation, they take extraordinary measures, and they fall prey to dictators, basically, – I’d just like to point out that Hitler was democratically elected; a lot of villains of this world were democratically elected – and so the country becomes more belligerent.

I have shortened his reasoning (transcript) to about 1/3 of the original length below the fold.

His main line of thought is:

• The US is on a path that will produce a hyperinflation
• Inflation is good for the rich, but bad for the majority, the poor
• The majority will eventually vote for extreme politicians, possibly converting a democracy into a dictatorship
• The world will go to World War Three one day over oil

Considering that "The American Way of Life is not negotiable" his scenario has some plausibility to me. How can we avoid it?

In the 1960s we had high wage inflation, real wages were rising very rapidly and that gave unions – because there was some tightness in the labor market – tremendous power. And then inflation migrated into commodities in the 70s, and along with an increase in commodity prices, we had high consumer price inflation until about 1980, and after 1980 inflation migrated to asset prices.

In other words, after 1980 we had diminishing rate of increase in consumer prices – they were still going up, mind you, but at diminishing rates of growth – and we had very high asset inflation, stocks and bonds rallied and in the last 5 years, especially since 2000, we had this huge increase in housing. So it’s important to understand that basically there has always been, in the last 25-30 years, some inflation in the system.

At the same time, as you know, we had essentially a steady debt-to-GDP ratio between 1950 and 1980, and since 1980, debt as a percentage of the economy in the United States – but also in other countries – has gone from 120% to now over 300%, and that has created a huge kind of financial economy. The financial economy is gigantic in terms of GDP. It’s much larger than GDP in the United States and, in fact, if you look at the earnings of the S&P500, whereas in the 1950s and 1960s corporate profits were still derived 50% from the manufacturing sector, and only about 10-15% from the financial sector, today, more than 50% of S&P earnings are derived from the financial sector, and only 10% from the manufacturing sector. So in the US we have a kind of very bizarre economy where the manufacturing sector has contracted as percentage of the economy and we have what I would call the asset sector of the economy that has been grossly inflated: the financial markets and the housing market.

The Federal Reserve and other central banks of the world will of course do whatever is possible to keep this bubble alive, simply because to deflate the bubble would be economically extremely – and I repeat, extremely – costly. So the moment the Fed sees a crisis – whether it’s the S&L crisis in 1990, or the Tequila crisis in 1994, or LTCM, or they sometimes totally misjudge events, like Y2K – they just print money like there is no tomorrow. And the next time the economy cools down, presumably because the housing market no longer goes up – it doesn’t need to collapse, just no longer going up – or because of an implosion in China, or a slowdown in China, or whatever may happen, you can be sure the Fed will be there to print money, and the other centrals banks the same.

China has a big trade surplus with the United States running right now at an annual rate $174 billion. But last year, China had a trade surplus of only $32 billion overall. In other words, it’s not that China has a totally unfair trade policy. They have a trade deficit with numerous other countries, among them Latin American countries, Asian countries, and so forth. So they’re importing goods, but they’re just not importing a lot of products from the US simply because the US doesn’t have a lot of very internationally competitive products. .. As a hedge fund manager observed to me, he said, “You don’t even see a lot of American cars in America.”

The problem with asset inflation – and I have observed this also in Hong Kong, and in Tokyo – is the asset inflation leads to a boom, say, in stocks or in real estate, and it really distracts the attention of people from actually producing something, because the manufacturer says to himself, “why should I be so stupid and work my butt off for a year, and make a profit of a million US dollars when my friend, he buys a piece of land or a few homes, financed on credit, and makes a few million by just speculating on real estate.”

And I’d like to mention one more symptom of an asset bubble and this will become more and more apparent in the United States, and in my opinion will also lead to some social problems eventually. This is it leads to a tremendous rise in wealth inequality. The rich run away. They do very well in periods of asset inflation, whereas the middle class and the poor people are basically relatively impoverished – relatively impoverished – and I can tell everywhere I go in the world, I see the same. The middle class and the poor people are lagging way behind, and the rich – admittedly, it takes more money to be rich, but the rich they have a huge increase in wealth. And this is borne out by the statistics about income development over the last 25 years in the United States, and also about the ownership of assets – about the composition: the 10% of the richest of the population have done very well. In fact, the 1% richest have done the best. The 10% have done very well, and the 50% below average – or below the median income or median assets – they haven’t done very well.

I think the CPI in the US is a total fraud. I think that in general the rate of inflation for the average person is 5% per annum [if] he’s very lucky ..  healthcare in the US is 15% of GDP, but only accounts for 8%, or 7%, of the CPI. So if the CPI is a grossly doctored measure of inflation – and I can assure you my cost of living is not rising 2.9% or 3.3% per annum as the CPI would suggest – it is going up much more than that.

Germany after the First World War was faced with very high reparation payments with which they had difficulties. Their reparation payments were so huge that they then embarked on printing money in order to meet these payments and that then led to very high inflation rates in Germany – to the hyperinflation – and to the impoverishment of the poor and the middle class, because there is relatively little investment activity in these asset inflationary times. The rich people move their assets outside the country where the high inflation takes place, and carry out their investments elsewhere, by and large. And so employment doesn’t do particularly well in these very high inflationary times, and wages always lag behind the rate of inflation.

Today, it takes you many more hours to buy the Dow Jones and many more hours of work to buy the house – unless you are in this lucky one percent of the top of the population, which has been riding this asset inflationary cycle very well.

I have also benefited from the Fed replenishing the water lake, and the buckets of financial markets, all the time, because I am involved in the financial services industry. But something doesn’t add up when I compare my compensation – and especially the compensation of some of my friends who are hedge fund managers, who undoubtedly are smart – to say, the compensation of an engineer who is also smart, or a chemist, or a scientist, it doesn’t add up that they earn that much more. Maybe they are smarter, but not that much smarter.

If I look at the US economy and I look at the Asian economies there is no doubt in my mind that the standard of living in the US will, relative to Asia, decline over time. And possibly, one day, decline very meaningfully, because in the US what you have is an asset bubble. In Asia we have basically an investment bubble: we have excessive capital spending in China and we have excess capacity. But if a disaster happens, at least we have built the roads, the bridges, the subways, and we have built the factories, and we have bought the machinery to produce goods. And in India, we have employment gains in high tech industries whereas in the US we have layoffs in high tech industries – IBM is laying off people in America and hiring in India, no wonder if you get wages in India that are 80% lower than in the US.

So I think it is inevitable that, in due course, in the Western world, your children and my children will not have the enjoyment of rising standards of living, because a wealth creation that is purely based on inflating real estate prices and stock prices, isn’t going to work in the long run.

In Japan we had deflation – that is true, between 1990 and recently, real estate prices went down, stock prices went down and also consumer prices went down – but in general this period of deflation in Japan was beneficial for the average household. The reason being, that it became affordable for the average household to buy goods and to rent an apartment and to buy equities. In other words, in this period of deflation in Japan we had a kind of deflationary boom, in the sense that someone who had $1000 in 1990, today, with the same $1000, can buy a much larger basket of goods. I cannot say that of the $1000 you have in the US. You cannot buy with $1000 today in the US a much larger basket of goods than you could buy in 1990, because real estate prices are much higher, stock prices are much higher, and consumer prices – if you measure them properly – are much higher than in 1990. But the deflation can have, in some countries like Japan, if it’s not a totally deflationary collapse, actually a beneficial impact on the typical household.

The problem of this high inflation we have in asset prices in the US and on the high inflation we had in Latin America, and in the Weimar hyperinflation in Germany, is that it impoverished the typical household, because they were not able to capitalize on the speculative earnings: through the financial markets; through the exchange markets; through the real estate markets; and so forth. I am really concerned, if Mr Greenspan and Mr Bernanke really lead the US into high inflation rates, the end result for the United States will be a total disaster.

I would actually argue that if you had a high period of inflation such as we had for the last half century since the 1950s – first in consumer prices and then especially in asset prices – then some deflation may be necessary to redress some of the imbalances that have been created.

But of course, deflation, if you think of it, is disastrous for the rich people, because it means stock prices go down, it means real estate prices go down, so the rich class benefits the least. And as I mentioned in Japan: the rich got hit. I mean, if you look at the pattern in Japan and if you go, today, to Japan you would think that Tokyo is a boom town: you would never think that the stock market is down 70% from the highs in 1989; and you wouldn’t think that property prices are down 70% from the highs in 1989. But a normal family, their wages are the same as in 89, 90. Maybe their wages have actually even increased by 1 or 2% per annum, but they can now rent an apartment 50% cheaper than at the time; they can join a golf club for 80% less than in 1990; and they can buy consumer goods cheaper, because of cheap imports from China and so forth. So, actually, the typical Japanese household isn’t complaining about this deflation, and it’s cash money, and that you have to see.

If you impoverish a society through inflation, they take extraordinary measures, and they fall prey to dictators, basically, – I’d just like to point out that Hitler was democratically elected; a lot of villains of this world were democratically elected – and so the country becomes more belligerent.

My impression is that: the world will go to World War Three one day over oil, because China needs oil, the US needs oil, Japan needs oil, every country needs oil, including also India; and that these rising commodity prices will lead in the next few years to a rise in geopolitical tensions.

I think Iran may not have bad intentions, but maybe they do, and I would understand if Israel would perceive the intentions of the Iranians as being bad. Whether they are bad or not we don’t know, but it is not totally unlikely that the US or Israel will one day go and bomb Iran. I don’t think the US, after their brilliant and glorious military exploit in Iraq, will dare to invade Iran, but I think bombing is quite likely at some point.

Some sectors of the economy may already be in recession in the US. As you know the Index of Leading Indicators has been down for several months now, and the manufacturing sector doesn’t seem to do particularly well. But maybe we go into a situation where real estate prices suddenly start to go down or where something happens, then, yes, I suppose, the modern day John Laws – namely Mr Greenspan and Mr Bernanke, or whoever comes, encouraged, of course by the government, that you have to see –will print money like there is no tomorrow.

That’s what all the hyperinflating countries have simultaneously: a recession in the real economy; and very high inflation rates, which as I mentioned impoverish essentially large portions of the population except for the rich that have moved their money overseas, or in other assets, where they could make speculative gains. I mean we have a democracy in the US and if one day there are more poor than rich people, then obviously it will lead to some meaningful political change.

It goes hand in hand in hyperinflating countries you then get dictators that become populists, who promise things to the poor people and so forth. Usually they fail to deliver, but they promise a lot and they take actions that are beneficial to their reputation and keeps them in power. Although these actions may occasionally be totally wrong. That is a real threat and my feeling is that the US, with this administration has moved a step away from democracy (that’s kind of an observation from overseas); that they have handed power over to a very small group of people – the Defense Secretary, and the President and his entourage – and this group of people is behaving in many ways totally undemocratically, and disregards international laws.

I think the US has disregarded international law and this is reflected in their relative unpopularity, and it’s made the Chinese actually look suddenly very acceptable.
I think, eventually tensions will rise and where governments will have larger defense budgets, and where they will print money, and we will go into an unpleasant, high inflationary environment. .. I’d think that, at this level of interest rates, when I look at the next 10-20 years, for sure, interest rates will be at some point much higher than they are now. That I have no doubt.
It’s easier for a democracy to print money than to take the pain. And it’s easier for a drug addict to keep on taking drugs and for an alcoholic to keep on drinking than to stop it. It takes a tremendous amount of will in a society to take the pain of bringing inflation down and to bring back the country onto the path of totally non-inflationary growth.

I would say in 1980, US families were income rich and asset poor: the Dow Jones was around 800-1000 and home prices were low as a percentage of disposable income. Today, you have high asset prices and relatively low incomes. You have very high Dow Jones compared to the income level of households and you have very home prices compared to the income, of say, your son, if he starts to work and he wants to buy a house. He will pay a very high price for that house compared to his income. He will have to borrow at least 90-100% to buy a house.