The inflation versus deflation debate has raged for years but since the credit crisis the debate has become highly politicized. If the credit crisis taught us anything it is that the risk of deflation far outweighs that of inflation. Yet there is an entrenched view emerging in political circles that is actively opposed to the government’s attempts at re-inflating the economy following the deflationary collapse of 2008.

One of the most popular icons to emerge from the credit crisis is a long-time Congressman from Texas, Ron Paul. Perhaps more than any other figure, Rep. Paul has done more to capture the imagination of the voting public which has concerns about big government. His loyal followers (“Paulites” as they’re called) share his view that government has become too big and cumbersome to be an efficient servant of the people (indeed, they charge that government is no longer a servant but has become a rather harsh master). The “Ron Paul Revolution” as it has been called is aimed at shrinking government, restoring the Constitution and, significantly, reducing or eliminating the role of the Federal Reserve in the nation’s monetary affairs.

It’s amazing to think that just 10 years ago the “abolish the Fed” movement was rather small by comparison and was viewed by the mainstream as the province of cranks and conspiracy theorists. The movement was barely given even mainstream coverage at all except to highlight its more unsavory elements. Yet today, in the wake of the worst financial catastrophe since the Great Depression, the anti-Fed party has become a force to be reckoned with. The message of Ron Paul’s recent book, “End the Fed,” has resonated with millions of middle class Americans who view the central bank as one of the primary culprits of the nation’s economic woes.

Fear of inflation is perhaps the prime motivator for Paul’s economic platform. In an article spotlighting Rep. Paul’s quest for the chairmanship of the House Financial Committee, Businessweek magazine observed, “Next to the doorway in his Washington office are six framed German bank notes dating from the 1920s hyperinflationary era. The notes are sequentially dated ‘to show how quickly the zeroes were added onto the bills’ as inflation skyrocketed, Paul says.” Clearly, Paul sees inflation as a potential threat to the economy and it’s one reason for his fight against the Fed’s attempts at re-inflating through its quantitative easing program. Many of his followers – millions of working class Americans who have witnessed the decline in the U.S. standard of living in recent years – also fear the return of hyper inflation.

Rep. Paul isn’t the only one in Congress who is actively campaigning against the Fed’s attempts at re-inflating the economy. His son, Rand Paul of Kentucky, recently won a seat in the U.S. Senate and won on a platform of campaigning against the central bank. Another congressman, Rep. Mike Pence, accused the Fed of “masking our fundamental problems by artificially creating inflation.” Another popular figure within the Tea Party wing of the GOP, Sarah Palin, demanded that Fed chairman Ben Bernanke stop his “pump-priming addiction” before it brings “permanently higher inflation.” Clearly, the fear of inflation is another point of agreement among the burgeoning Tea Party movement.

Setting aside the political rhetoric surrounding the inflation/deflation debate, let’s examine the problem of inflation from strictly an economic standpoint. Inflation assumes a rather strong level of monetary, population and industrial growth. Two of the classic benchmarks of true economic inflation are rising wages and rising interest rates. The U.S. has seen neither in recent years; in fact the opposite holds true. Rep. Paul would be the first to admit that America’s industrial base is in the midst of a long-term decline and the country’s demographic trend isn’t conducive for inflation since the number of retirees is increasing relative to the number of workers.

The deflationary phase of the economic long wave has been underway for the last 10 years, greatly undercutting the standard of living for middle and lower class working Americans. While opportunities still abound for the rich, the middle class is finding itself increasingly devoid of the chance for economic advancement thanks to the falling wages and diminishing industrial base which are part and parcel of long wave deflation. Evan Thomas, writing in the Dec. 13 issue of Newsweek, points out that in 1970, the richest 1 percent made 9 percent of the nation’s income. They now make close to 25 percent. He also notes that CEOs who once made 50 times the average worker’s salary made more than 500 times as much as by 2001. “The gap between rich and poor,” he observes, “is growing in ways that mock middle-class egalitarianism.”

It’s the growing disparity between the “haves” and the “have-nots” that is, in part, fueling the grassroots movement against government spending and the central bank’s efforts to re-inflate the economy. A common worry is that further efforts at creating money will result in debasement of the currency and perhaps an outright dollar destruction. Many leaders within the anti-Fed movement are old enough to remember the high inflation rates of the U.S. experienced in the 1970s, which culminated with a double-digit interest rate in 1981. Memories of that chaotic, inflationary era are still fresh in their minds and motivate them to oppose the Fed at every turn. To them, inflation is always just around the corner.

This abiding fear of inflation is understandable in view of the government’s attempts at increasing consumer prices. This artificial inflation of retail prices is to be distinguished from the economic phenomenon of inflation. True inflation can only occur when there is a large and vigorous working population. It’s normally accompanied by a higher birth rate, i.e. well above the replacement level (in developed countries) of 2.1 births per woman. True inflation, as stated elsewhere, is characterized by rising industrial output, rising wages and rising interest rates.

The phenomenon we’re now witnessing in the U.S. – a preview of which occurred in 2003-2007 – is something I’ve previously termed “retroflation.” Retroflation is a byproduct of the globally integrated economy. Emerging countries like China, India and the Indonesian economy are experiencing something akin to true inflation which comes with high levels of industrial output. Because those countries have a high demand for oil, metals and other industrial and agricultural commodities, they are effectively driving up the prices of commodities, which in turn increases the cost of goods and services in the developed world. A rising PPI and CPI can easily be confused with true inflation, but without the economic underpinning of inflation (which the U.S. doesn’t have) this can’t be called inflation.

Retroflation occurs in countries experiencing systemic deflation (i.e. falling birth rates and declining industrial output). Deflation is at root a demographic phenomenon and retroflation occurs in countries like the present day U.S. when demographic trends aren’t favorable for a long wave economic boom, yet there is just enough productive output to justify rising retail prices. Retroflation is the point along the economic long wave just prior to the beginning of hyper deflation, at which point prices begin to decline vigorously along with falling demand.

As an aside, an email I received from a colleague recently underscores the importance played by demographic trends in the deflationary phase of the long wave. “Its no secret,” he writes, “that certainly the Lost Decade of Japan is one of the worthwhile comparisons to consider for the present USA. Two qualitative similarities to today’s America are: Crony capitalism and distrust of government was rampant in the Japanese lost decade, and declining demographics commenced with Japan’s lost decade.”

Retroflation inevitably ends in a deflationary collapse. This is owing to the fact that the overall demand level of a country in demographic/industrial decline is in a downward trend and this falling demand level must eventually bring pressure to bear on rising prices. We got a rather graphic preview of this during the deflationary collapse of late 2008. It should happen again in a more sustained fashion between the years 2012-2014 when the final “hard down” phase of the Kress 120-year cycle is underway.

The long wave deflationary trend in the U.S. can also be seen in the graph showing capacity utilization. A distinctive downward trend of lower highs and lower lows is visible in this chart. The declining trend in capacity utilization, moreover, closely corresponds to the demographic peak and subsequent decline the U.S. experienced beginning around the late 1960s. In the last 40+ years covered by this graph, capacity utilization has dipped below 75% on four separate occasions: 1974, when the 40-year cycle bottomed; 1982, near the peak of the 60-year inflation/deflation cycle; 2002, when the Kress 12-year cycle was bottoming; and 2008-9, as a result of the credit crash. A capacity utilization reading below 75% is considered to be deflationary and such readings are typically seen at the depths of recessions. A straight-forward reading of the Kress long-term cycle series suggests that by 2014 we will see a capacity utilization reading below that of last year’s multi-decade low reading.

In the interim period between now and late 2011 when the last of the important yearly Kress cycles is scheduled to peak (the 6-year cycle), there is a good chance that the Fed’s re-inflation efforts will succeed in temporarily staving off the effects of deflation in the U.S. The year ahead will present perhaps the last opportunity of the post World War II expansionary era for individuals and corporations to shore up their balance sheets, buy gold on any dips or corrections, and prepare for the hard deflationary winter ahead in 2012-2014.

Gold & Gold Stock Trading Simplified

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Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy. The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment. He is also the author of numerous books, including “Gold & Gold Stock Trading Simplified”. For more information visit http://www.clifdroke.com