The most important debate among economists, high-level investment advisors and financial experts is whether the U.S. economy will heat up or cool down - that is, whether it will go into runaway inflation or deflation.

"Hyperinflation" is runaway inflation. This is what Germany experienced in the 1920s's, where people had to literally pay barrels full of German marks to buy a loaf of bread.

Deflation is what the U.S. experienced in the Great Depression, where most people had no one had money to spend, hire employees, or do much of anything else.

If we're going into hyperinflation, then investments like gold - which tend to hold their value in inflation - are best. In this case, the government should stop printing money like its Monopoly money.

If instead, we're going into deflation, then cash or treasury bills hold their value the best. Because prices go down in a depression, each dollar is worth much more, and is a good thing to hold onto for investing purposes. In this case, the government should spend more to get things going.

The Argument for Hyperinflation

Whenever governments inject a lot of money into the system, it tends to cause inflation.

Why?

Because there are more dollars chasing the same amount of goods and services, which increases demand while keeping supply the same, which encourages sellers to raise prices.

The government has been injecting trillions of dollars into the system with its series of bailouts and "loans". Indeed, a Bloomberg analyst says that the supposed $700 billion bailout alone could balloon to $5 trillion dollars. And there are many trillion dollars in numerous other bailouts, federal guarantees of Fannie and Freddie's liabilities, and "loans" to financial institutions through the Fed's Open Market operations.

Indeed, according to the Wall Street Journal:

"The U.S. central bank said Monday it would provide unlimited dollars to the European Central Bank, Bank of England and Swiss National Bank, allowing them to relieve pressure on commercial banks across their regions. "

Do dollars given abroad cause inflation inside the U.S.? Yes - because some proportion of those dollars will be spent by Europeans to buy stocks, commodities, goods and services within the U.S.

No wonder billionaire investor Jim Rogers says we are facing an "inflationary holocaust".

And Peter Schiff, the manager of 1 billion in funds, argues in his bestselling book Crash Proof that Americans should get all of their investments outside the U.S. (and into Europe and Asia), because America will suffer hyperinflation.

The Argument for Deflation

On the other hand, a new report shows that US retail sales are plummeting more than expected.

A second report shows that producer prices are falling.

A new report from the Federal Reserve also points to a slowdown. As summarized by MarketWatch:

A broad slowdown in economic activity was under way by the end of September, according to the latest report on economic activity released Wednesday by the Federal Reserve.

Consumer spending was down in most regions. Factory activity was also slow.

Even more worrisome was the downturn in "nonfinancial services," which has been the backbone of economic activity.

Residential real-estate and construction activity weakened or remained low, according to the report, known as the Beige Book. Most districts also reported slower commercial real-estate activity.

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Labor-market conditions also deteriorated and wage pressures remained muted.

And a report by the New York Fed bank whows that manufacturing is way down in the Empire State.

State and local governments are also facing huge budget shortfalls:

• At least 29 states are facing huge budget shortfalls, and many are begging the federal government for bailouts of loans. For example, California - one of the world's largest economies - is begging the feds for billions
  

• Local governments are also in trouble. For example, facing a huge hole in Chicago's current and upcoming budgets, Mayor Richard Daley announced on Tuesday a plan to partially shut down city government for six days

The federal government has liabilities exceeding $56 trillion dollars, according to the former Comptroller General of the United States, and so is hard-pressed to borrow much more from its foreign creditors, at least at cheap lending rates.

International trade and shipping is declining (for example, see this).

Banks are hoarding cash (instead of lending it out) to try to weather the financial crisis. Indeed, surging foreclosures may wipe out any reassurance to the banks caused by the Treasury's bailouts.

And Americans are spending much less and borrowing much less because of the economic crisis.

Top officials from the Fed are warning of a deepening recession, leading economist Nouriel Roubini is calling a severe recession in the U.S., and the International Monetary Fund is forecasting U.S. and global recession. Indeed, even China is not immune.

All of this points to deflation and potentially depression, as most people have less available money, which means fewer dollars chasing the same goods and services, which means falling prices.

No wonder Mike Shedlock of the popular website Global Economic Analysis, and investment advisor at Sitka Pacific Capital Management, argues that we are headed for deflation (Shedlock uses a special definition of how to measure inflation and deflation, which he might be right about).

The Argument for Stagflation

Some people argue that we will get severe stagflation. In other words, high inflation and economic stagnation occuring simultaneously and remaining unchecked for a period of time.
Some believe we might experience conditions that makes America's bout with stagflation in the 1970's look like a walk in the park.

Indeed, some argue that we may experience a hyperinflationary depression, where the economy experiences both hyperinflation and depression. For example, economist and leading inflation expert John Williams argues:

"By the time hyperinflation kicks in, the economy already should be in depression, and the hyperinflation quickly should pull the economy into a great depression. Uncontained inflation is likely to bring normal commercial activity to a halt."

Williams argues that - at least for a while - the entire monetary system will break down when this happens. Williams argues that, in the absence of a monetary system, people will turn to barter.

He makes the following specific recommendations:

With standard currency and electronic payment systems non-functional, commerce quickly would devolve into black markets for goods and services and a barter system.

Unlike Zimbabwe, the United States does not have widely available, for circulation, a back-up reserve currency for use in place of a highly-inflated domestic currency. The alternative here is in the traditional monetary precious metals. Gold and silver both are likely to retain real value and would be exchangeable for goods and services. Silver would help provide smaller change for less costly transactions.

Other items that would be highly barterable would include bottles of a good scotch or wine, or canned goods, for example. Similar items that have a long shelf life can be stocked in advance of the problem, and otherwise would be consumable if the terrible inflation never came. Separately, individuals, such as doctors and carpenters, who provide broadly useable services, would have a service to barter.

A note of caution was raised once by one of my old economics professors, who had spent part of his childhood living in a barter economy. He told a story of how his father had traded a shirt for a can of sardines. The father decided to open the can and eat the sardines, but he found the sardines had gone bad. Nonetheless, the canned sardines had taken on a monetary value.

Reserves of the Necessities of Life. Howard J. Ruff, who has been writing about these problems and issues since Nixon closed the Gold window, rightly argues that it will take some time for a barter system to be established, and suggests that individuals should build up a six-month store of goods to cover themselves and their families in the difficult times. Mr. Ruff covers this and many other excellent fundamentals in his new book How to Prosper During the Coming Bad Years in the 21st Century (see recommended further reading at the end of this report).

Financial Hedges. During these times, safety and liquidity remain key concerns for investments, as investors look to preserve their assets and wealth through what are going to be close to the most difficult of times.

In such a circumstance, gold and silver would be primary hedging tools that would retain real value and also be portable in the event of possible civil turmoil. Also, at some point, the failure of the world’s primary reserve currency will lead to the structuring of a new global currency system. I would not be surprised to find gold as part of the new system, structured in there in an effort to sell the system to the public.

Real estate also would provide a basic hedge, but it lacks the portability and liquidity of gold. Having some funds invested offshore — outside of the U.S. dollar — would be a plus in circumstances where the government might impose currency or capital controls.

While equities do provide something of an inflation hedge — revenues and profits get expressed in current dollars — they also reflect underlying economic and political fundamentals. I still look for U.S. stocks to take an ultimate 90% hit, peak-to-trough, net of inflation, during this period [Williams wrote this in April 2008]. Where all stocks are tied to a certain extent to the broad market — to the way investors are valuing equities — such a large hit on the broad market will tend to have a dampening effect on nearly all equity prices, irrespective of the quality of a given company or a given industry."

Personally, I hope and pray that Williams is wrong, but I have the gut feeling that he is right.

Of course, if the money system does collapse, we can use that as a window of opportunity to build a better world.