-By By Carl Steidtmann

Energy prices are rising sharply. Gold prices have hit record highs, at above $1,000 an ounce. Prices for food commodities are soaring as well, and food riots have broken out in Mexico City, Cairo, and Sao Paulo, among other cities. Everywhere you look, there are signs of inflation.

And yet a close examination of the historical record shows that every past credit event of any size has always led to deflation.

The case for deflation begins with the value of the dollar. While trade balances were once the most important factors in currency valuation, they've been replaced by the movement of capital. On the margin, the movement of capital is driven by its risk/return profile. In each of the 1990s credit events, including the Russian debt restructuring, the Asian currency crisis, the Mexican Peso rescue, and the long-term capital management meltdown, financial market fear created a rush to quality that gave a boost to the dollar and put downward pressure on prices.

So far in the current credit crisis, just the opposite has happened, but this may be about to change. Weaker economic growth overseas, credit issues emerging in European banks, and a cutting of interest rates by the European Central Bank should all drive a strengthening of the dollar. Also, greater default risk in Europe will push the dollar higher. A higher dollar, coupled with weaker global growth, will put downward pressure on commodity prices, beginning the process of deflation.

Irrational fear

Falling commodity prices, however, are not enough to set off real deflation. What's also required is a liquidity trap, set off by the de-leveraging of both bank and household balance sheets.

In the reach for yield, banks went to extraordinary lengths to take on dangerous levels of leverage. This was done through both on-balance sheet borrowing, and the creation of off-balance sheet entities often referred to as structured investment vehicles, or SIVs.

With asset prices falling, banks are being forced to de-leverage by selling assets, raising cash, and reducing debt, creating a bubble-like demand for cash. In a liquidity trap, cash becomes a bubble asset. Interest rates can be pushed to zero but are still no incentive to move out of cash by investing in real assets, because cash is needed to retire debt.

Deflation also generates a real return to the holder of cash, adding to the incentive to de-leverage. Even as interest plunged in the first quarter (see the chart below), business investment in both structures and equipment fell.

De-leveraging deflates asset prices and reduces investment incentives. The Federal Reserve is fighting this by aggressively cutting interest rates.

In this environment of irrational fear, the expectation of falling asset prices reduces all incentive to invest, even with interest rates at zero. This is what happened in Japan in the early 1990s. The need for cash eventually pushes businesses to cut inventories, which in turn puts downward pressure on consumer prices.

While liquidity traps and the deflation they spawn are rare, there are two paths away from them: Allow asset markets to adjust, or demand government intervention.

Herbert Hoover's treasury secretary, Andrew Mellon, described the free-market "liquidationist" approach when he noted that the solution to the 1929 downturn was to "liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate....Values will be adjusted, and enterprising people will pick up the wrecks from less competent people."

Not allowing home prices to fall would be a little like trying to prop up the stock prices of internet bubble stocks. The greater the effort made to keep housing prices from falling, the longer the current recession will last and the deeper the gathering liquidity trap will become.

The other alternative is to have government do the investing that the private sector is unwilling to undertake. Public-sector investments in infrastructure or alternative energy could stimulate economic activity enough to offset the deflationary effects of contracting bank-balance sheets.

 Implications for food retailing

While ever-higher inflation seems like the most likely forecast, there's also a real risk of deflation. A deflationary environment rewards cash, and punishes debt.

For consumers, the emergence of deflation would be particularly punishing, given the high level of household debt. For retailers, possible deflation is something they should consider in their longer-term planning for the future.