deflation

All posts tagged deflation

I read a very interesting article on called De-leveraging is Not Deflation.

Here’s a partial extract:

“Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages.”

— Ludwig von Mises

It’s true that just about every asset class is coming down in price right now. This, however, is not deflation — as I have said so many times recently, much to many readers’ unqualified chagrin. To the contrary, these declines are the products of de-leveraging — not deflation — and the distinction is nearly incalculably important, although the subtlety seems to elude even the most astute these days.

If the previous premise is true (which it is), any removal of money from the economy would eventually result in an increase in the value of our currency, relative to everything else. And that, in turn, would eventually translate into lower prices in dollars. But that’s clearly not what is happening. No, the Fed is printing money, sending the amount in the economy higher than ever seen in U.S. history. That’s not deflationary. That’s inflationary.

Just so you’ll know, here’s the definition of inflation I’m using. And before you pooh-pooh it with too much eagerness, remember that one of its authors, F.A. Hayek, won the Nobel Prize in economics in 1974.

Look, the thing we should be worried about is relative value, not “inflation,” per se. It’s not about the growth of M0, or M1, or M2 (or even M3, if you keep up with shadowstats.com), so much as it is about what the money supply is doing relative to everything else that is happening. I know assets are falling in price — believe me, I get no shortage of reminders every single day. But the amount of money in the system — not just M0 — is increasing at a tremendous rate. I won’t argue that the relative value of things like real estate and equities are going to continue to drop — maybe even dramatically, and for a long time — in terms of demand (or lack thereof). No, what I’m most concerned about is that demand will stay extremely low, and yet prices will rise anyway because of the increase in the amount of money in the system.

But it’s not just money; it’s also Treasuries. The Fed has specifically stated that its objective is to stimulate “inflation” (by its definition). It wants prices to rise, and it’s going to do everything it can to find success. But the amount of money in the system is unprecedented. When the Treasury bubble starts to collapse, yields are going to explode. Yes, the Fed will probably print more money to buy down the long-end of the curve, but how long will that work? Some people say years, but how? Do you really think the Chinese and the Japanese are going to keep funding that sort of behavior? Or even more importantly, do you think they’re just going to sit on their current holdings? Probably not, and if they start dumping Treasuries, yields are going much higher.

It’s not a matter of if this is going to happen. Yields can’t stay where they are for any sustained amount of time, and once they start rising, so will prices. But will demand for, say, houses have increased? No. Cars? No. Boats? Televisions? No. Why? The American consumer is tapped out.

Credit card companies are tightening limits prodigiously. Teaser rates are all but gone. Home equity has dried up. The consumer has driven two-thirds of our economy for at least the last few decades, and now the consumer is dead. There’s another aspect to this that I won’t go too deep into: the American consumer protects his or her credit score for one reason — to obtain future credit. But the consumer also knows that loans have dried up — not just today, but for the very distant future as well. You know these consumers have to be thinking about defaulting; if they can’t get loans anyway, why would they not default on thousands of dollars in unsecured credit card debt? I plan on writing more about this in future articles, but suffice it to say, I think credit card companies are going to give us the next blow to our collective stomach, and it’s going to hurt.

So here we have a situation in which demand is gone, and yet prices and rates are rising — because of inflation (printing money) and the Treasury collapse. And that’s the point: it’s not going to come from just one source. It’s not just going to be inflation (printing money). It’s not just going to be the collapse in Treasuries. It’s not just going to be the nearly unfathomable costs of the stimulus packages that are coming online in the next two years. It’s going to be the confluence of all of it. And if I’m right about the continued deterioration in credit markets, things will be even worse.

You think it’s not different this time? Add it all up, in real dollars — the staggering amount of debt, the parabolic rise of currency in the system, the annihilation of real-estate investment, and the demise of the consumer. $8.5 trillion committed to bailouts and stimulus packages. Oh, yes it is different this time. It’s very different.

Credit cards didn’t even exist in 1930, and the dollar was backed by gold. Credit cards barely existed in 1973. Nixon had just taken us off the gold standard, and look what happened? Volcker was immensely lucky to have stopped hyperinflation, and look at the extreme measures he had to employ to do it.

Of course, every time I bring all of this up — which is a lot lately — somebody starts talking about the velocity of money. And pretty soon after that, somebody starts talking about the multiplier effect.

Yes, the U.S. employs a fractional reserve system, and while that system certainly lends to rising prices and yields, the amplifier effect is not inflation. Like the printing of money, the fractional reserve system is only one ingredient in the poison that lends to the ultimate catastrophe inspired by central banks: rising prices and increased costs of borrowing.

And then there’s velocity…

While I am eternally grateful to my critics for forcing me to defend the theories I hold dear, I sometimes fatigue of the incessant snapping at my heels by people who want me to know that the velocity of money has slowed down. I know the velocity of money has slowed. It doesn’t matter. It’s not going to stay this low for long, and when it starts speeding up, it’s not going to be a “good thing.” Treasuries are going to break, rates and prices are going to rise, and all that money pressing against the dam is going to find a crack. Why? It has to. People will flee from dollars that are losing value. They will extract all the dollars sloshing around the system, and they will buy commodities and durables in order to preserve the value of their wealth.

Remember, just because the dollar is losing value does not mean that the concomitant subsequent rise in certain asset classes necessarily means that demand for all assets has increased dramatically — as it did during previous eras of easy money. Demand for assets economy-wide can continue to wane even as people spend dollars as fast as they can get them in the midst of rising prices. And this is a very important distinction: prices can rise because of demand, but prices can also rise because of excessive increases in the amount of money in the system. If prices are rising without a simultaneous increase in demand, well, I can’t think of a more dangerous economic environment to be in.

You don’t believe it can happen? You think there’s a huge demand for houses, cars, and boats in Zimbabwe? Prices there are rising exponentially, but there is very little demand for assets — other than staples, of course. What do you think their velocity of money is?

Do you think’s long Gold? You bet he is!

In my next post I’ll talk about an interesting long-short bond trade I entered on Tuesday.

The media has been going on and on about deflation. Long-term bond prices have also been trending up and long term yields have been dropping, which means that the market thinks there will be long-term deflation. Even the Consumer Price Index numbers that came out claim that inflation is under 2% annually!

(Of course, if you’re one of the unlucky 533,000 people who lost their jobs last month, you really couldn’t care less about deflation).

Let’s first look at the Government reported numbers.

                      May   June  July  Aug.  Sep.  Oct.  Nov.   ended     ended                      
                             2008  2008  2008  2008  2008  2008  2008 Nov. 2008 Nov. 2008

All items..........    .7   1.2    .9   -.2   -.1  -1.2  -2.1     -12.9        .7

Food and beverages    .3    .8    .9    .6    .6    .3    .2       4.2       6.0
Housing...........    .5    .5    .7    .0   -.2    .0   -.1       -.8       3.1

Apparel...........   -.2    .0    .8   1.0    .0  -1.2    .2      -3.9        .2
Transportation....   2.1   4.0   1.8  -1.7   -.7  -6.0 -10.9     -52.1     -10.4

Medical care......    .1    .2    .1    .3    .3    .1    .2       2.7       2.7
Recreation........    .0    .2    .4    .5    .2    .0   -.1        .8       1.9

Education and
  communication..    .3    .5    .5    .2    .0    .2    .2       1.6       3.4

Other goods and
  services.......    .5    .6    .5    .2    .2    .3    .1       2.4       4.4

Special indexes:Energy............   4.5   6.8   4.0  -3.2  -1.7  -9.0 -17.8     -70.8     -14.3

Food..............    .3    .8    .9    .6    .6    .3    .2       4.1       6.2
All items less
food and energy    .2    .3    .3    .2    .1   -.1    .0        .1       2.0

Lets start with the largest expense for most people, housing.

Yes, house prices have decreased. However, if you’re already a home owner or a renter then you’re probably not seeing any benefit. The only people who’re benefiting are those people who can actually qualify for a home loan and have enough cash for a down-payment. The 100% financing loans have disappeared as a result of the tightening of the lending standards. As I mentioned in the last post, it’s not the cost of credit, buts the availability of credit that is important.

Energy prices actually have dropped down from $147/barrel to around $40/barrel in the past 5 months. However, I heard billionaire T Boone Pickins on the radio today say that OPEC is going to keep cutting production until oil is back up at $75/barrel. In the long run, I agree with him. While a global recession might reduce the demand for oil, there are 3 billion people in Asia who are getting a little richer every day and want air conditioning, cars, motorbikes and other luxuries that consume oil. Without alternate energy sources, oil prices have to rise. The current price drop is likely to be short-lived.

According to official numbers, education costs have only gone up 1.6%-3.4% in the past year. However, my MBA program has seen a much higher percentage increase in tuition than last year, and it might see another increase next year (according to a letter I received from the Dean of my Business School).

Likewise, medical costs have also gone up only 2.7%, but my health premiums and medical costs seem somehow higher than that.

And while food and beverage prices have only seen an official 4.2-6% inflation, prices of food items that I consider my staple diet like Tyson Chicken Wings and Sirloin Steak Burgers at Costco have gone up about nearly 50% in the past 2 years.

Meanwhile, the Federal Reserve is printing money like its going out of style. (And at this rate, it actually might). In theory, increasing the money is inflationary. That’s one reason why a house that cost $30,000 in the 70’s costs $300,000 today. More money in circulation means every existing dollar is now worth less. At least thats the theory. Increases in productivity and technology have managed to improve our standard of living despite this inflationary pressure, but there must be some point at which you start seeing inflation. Maybe we’re at that point now.

The government has committed to more money on financial bailouts than its ever spent in its history. According to an article in the SF Gate, the Financial Bailout may end up costing the taxpayer $8.5 trillion dollars.

According to an article on CNBC, that’s more than the cost of almost everything else the US government has spent on even adjusting for inflation!

Here are estimates for the major US government expenditures (all figures inflation-adjusted):

Hoover Dam: $782 million

Panama Canal: $7.9 billion

Gulf War: $98 billion

Marshall Plan: $115.3 billion

Louisiana Purchase: $217 billion

Race to the Moon: $237 billion

Savings & Loan Crisis: $256 billion

Korean War: $454 billion

New Deal: ~$500 billion

Iraq/Afghanistan/War on Terror: $597 billion

Vietnam War: $698 billion

NASA Budget since inception: $851.2 billion

World War II: $3.6 trillion

Total = $7.63 trillion

I thought this was the most interesting section of the SF Gate article:

The Fed’s activities to shore up the financial system do not show up directly on the federal budget, although they can have an impact. The Fed lends money from its own balance sheet or by essentially creating new money. It has been doing both this year.

The problem is, “if you print money all the time, the money becomes worth less,” Rogers says. This usually leads to higher inflation and higher interest rates. The value of the dollar also falls because foreign investors become less willing to invest in the United States.

Today, interest rates are relatively low and the dollar has been mostly strengthening this year because U.S. Treasury securities “are still for the moment a very safe thing to be investing in because the financial market is so unstable,” Rogers said [That’s Diane Lim Rogers, chief economist with the Concord Coalition, not Jim Rogers!]. “Once we stabilize the stock market, people will not be so enamored of clutching onto Treasurys.”

At that point, interest rates and inflation will rise. Increased borrowing by the Treasury will also put upward pressure on interest rates.

In the past 10 years gold is up 300%+. That’s about 300% better than the return on the S&P500 over the same time period! This is not an indication of deflation.

And what does veteran investor Jim Rogers think about this? In a recent Bloomberg interview he predicted that the dollar is “going to lose its status as the world’s reserve currency,” adding, “It will be devalued and it will go down a lot. These guys in Washington, they want to debase the currency.”

“They think that if you drive down the value of your money, it makes you more competitive, now that has never worked in history in the long term,” said Rogers.

Paul Watson of the Prison Planet states:

The head of the International Monetary Fund, Dominique Strauss-Kahn, warned that advanced nations will be hit by violent civil unrest if the elite continue to restructure the economy around their own interests while looting the taxpayer. Strauss-Kahn’s comments echo those of others who have cautioned that civil unrest could arise, specifically in the U.S., as a result of the wholesale looting of the taxpayer and the devaluation of the dollar.

How long will it be before Americans realize the looming specter of hyperinflation spells disaster for their life savings? How long will it be before we see rioting in the streets on a par with the scenes witnessed in Iceland over the weekend, where the Icelandic krona has lost half its value in a matter of weeks?

I’m not buying the deflation argument. In fact, I wouldn’t be surprized to see 10-12% inflation for the next several years. I’ve been buying gold coins since gold was $500/ounce and I’ve adding to my position on pullbacks. Maybe in a few years time, $850 gold and $12 silver may look like a bargain!