The Wrong 'Flation

Those of us in the very small group that has correctly anticipated that past excesses would eventually come home to roost generally fall into two camps: the deflationists, who believe that another Great Depression is on the cards -- at least initially -- and the inflationists, who argue that hyperinflation -- where prices spiral rapidly higher -- is the most likely near-term outcome.

While there are more than a few reasons for the contrasting perspectives, in my view it largely comes down to a difference of opinion about how the U.S. reached the "tipping point" to begin with. That is, was it "printing presses" that fueled the housing and other bubbles, the malinvestment and imbalances, and the widespread belief in "something for nothing," or was it excessive credit creation?

If the answer is the former, then the dollars that were and continue to be created remain in circulation, stoking inflationary expectations and exerting a relentless upward push on prices. As economists put it, there is too much money chasing too few goods.

If the answer is the latter -- which is what I believe has been and is the case -- then logic and history suggest that when the jig is finally up, it leads to relentless, liquidation-driven downward pressure on asset and other prices. As opposed to paper currency (or even digitally-created "money" that did not come about as a result of central bank buying and selling of government and other securities), much of the credit-money that was created out of thin air ends up "disappearing" (e.g., through default), diminishing overall demand.

In "Worried about Inflation? Just Wait," Reuters columnist James Saft lends further weight to the deflationist perspective and puts paid to growing worries over rising commodity and consumer prices.

Never mind inflation, the powerful and long-lasting effects of the credit crisis will rein it in soon enough.

With oil, gold and other commodities at very high levels and U.S. producer prices up 6.3 percent last year -- the most since 1981 -- fears have risen that an aggressive round of rate cuts by the Federal Reserve will embed inflation.

Consumer price inflation for December was up 0.3 percent and has risen 4.1 percent since a year earlier.

But these are likely to prove lagging indicators, even if demand from emerging markets remains strong for raw materials.

If credit is being strictly rationed and asset prices falling -- as they are in housing and in stocks -- investment, consumption and just about anything else that can be put off will be put off.

"The strong probability is that we will get at least disinflation in 2008," said George Magnus, senior economic advisor to UBS.

"I'm not aware of any banking crisis in history, almost without exception, that was not accompanied by falling inflation.

"When balance sheets are shrinking and credit restriction is being applied, the whole effect is to cause people either to not be able to make spending decisions or to defer them. It puts a downer on aggregate demand," Magnus said.

A round of poor data, notably unexpectedly weak retail sales, prompted rumors of a highly unusual inter-meeting rate cut by the Federal Reserve, whose next scheduled meeting is January 29-30.

The Fed declined to comment. Traders were roughly evenly split on Wednesday in betting on a 50 basis point or a 75 basis point cut this month in the Fed benchmark, currently 4.25 percent.

But even aggressive cuts in interest rates will have a limited and painfully slow impact on demand under these circumstances, according to Magnus. He contrasts the current crisis, which is fundamentally about the solvency of borrowers and the banks that lent to them, with other crises, such as 9/11 or the stock market crash of 1987.

"When solvency is involved and asset prices are declining, monetary policy can help but can't solve the problem."

Yen carry trade and credit cards next?

Ominously for the economy, the Baltic Dry Index BADI of shipping capacity suffered its biggest one day drop since records began on Wednesday, down 5.74 percent and following similar heavy falls on Friday and Tuesday. The index is down almost 20 percent since January 1.

Because trade travels on ships, the Baltic index is often a good indicator of forward demand, both for natural resources and finished goods. Interestingly, the Baltic index continued to climb as the credit crisis unfolded through the summer, supported by strong economic growth in emerging markets.

Tim Lee of pi Economics in Greenwich, Connecticut, thinks prices of many assets and commodities will fall strongly in what he calls an "incipient deflation".

"Ignore gold, ignore oil: they are lagging indicators of the excessively loose central bank policies we had in the past," Lee said.

"The leading edge that is really telling us what is going on is the government bond market and property prices."

Yields on 10-year U.S. treasuries have fallen as low at 3.69 percent, down almost a half a percent since late December.

The credit crunch is breeding new areas of concern, such as credit cards and commercial loans. Another round of losses in a new area would further dampen credit.

Citibank has more than doubled its loan loss reserve ratio on U.S. consumer debt since the end of the second quarter, with the sharpest move in the past three months.

Then there is the risk that cuts in U.S. interest rates will unravel what is perhaps the world's biggest leveraged bet, the use of carry trades, according to Lee of pi Economics.

Estimated at as much as $1 trillion, carry trades involve borrowing cheaply in yen or other currencies such as Swiss franc that have low interest rates in order to invest in higher yielding currencies, or indeed in anything else the borrower hopes will go up.

Both the yen and the Swiss franc have rallied sharply against the dollar in recent days driven by expectations of much lower rates in the U.S.

If funding currencies like the yen and franc continue to rise, borrowers could sustain big losses. For example, many Hungarians have taken out mortgages in Swiss francs and many Korean corporations have funded in yen. Strong moves upward in the currency they borrowed may leave them unable to carry the debt.

"As the carry trade unwinds, liquidations and asset sales will push prices (down) further," Lee said.

It seems clear that, as with the credit-fuelled boom that preceded it, the bust has taken on a life of its own.

Comments

[legis]

No banking crises without disinflation? Well there's always a first time isn't there? The world seems to be locked in a Armageddon Dance, with the mercantilist asian economies constantly purchasing depreciating dollars while the US government is blindly leading the dance off the roof by constantly creating that demand with its irresponsible spending habits. How long can the Federal Reserve orchestrate the music of the growing chaotic band and dancers remain to be seen. At some point though, at some interest rate, the minor players will at least, stop buying dollars and start causing a tidal wave of dollar redemptions. Disinflation? Sorry, but all those dollars coming back to roost at home will force an huge surge in interest rates beyond what Volker had to do. We get disinflation only if the entire world collapses economically as a result, if not, you're looking at very high interest rates coupled with very high inflation. Given the heretofore unimagined scale of the financial whirlwind that will sweep through the world, it might be time to give wackos like Kunstler a second glance.

[Bruce]

You know folks, I've been saying for years(long before this crisis broke out)that I don't know where the hell people are getting all their money... Cheap credit, easy loans, maxed-out credit cards(at 30% interest)etc, have all come back to haunt us. The bill is now coming due, and nobody can afford to pay it. Someone said recently that the entire global financial system is practically bankrupt! And were not talking about ordinary modest homes anymore. What I see are huge mansions with three-car garages and yards the size of a football field--sitting empty. The stock market and economy has to implode. No amount of manipulation by the Fed or Bush & Co. will make any difference whatsoever. They can wave their magic wand till their hearts content!

Hey Mike, do you foresee the possibility of a complete global economic meltdown, as some folks like Warren Brussee and Gerald Celente are predicting? My goodness, I don't think people even realize just how serious the situation really is, and where we're standing in terms of our future as a nation and society... Is everybody friggen' blind and clueless as to what's going on, or is it merely because they simply don't want to face reality? Perhaps both?

[Bruce]

You might all want to read this...

http://www.larouchepub.com/other/2007/3438bankers_catastrophic.html

[matt wilbert]

I am not sure what is going to happen, but I'm betting on inflation overall. Since it seems pretty clear to me how badly deflation would screw things up, and since I am pretty sure Bernanke agrees, I think the government will do whatever is necessary to create (maintain) inflation. This is the only way to keep nominal asset prices at levels that avoid widespread solvency problems.

I realize that some people think we will get into a liquidity trap situation and the government won't be able to inflate, but I have confidence in the US government's ability to create and spend money faster than any other entity in the world! I consider it their core competency. If Weimar Germany could do it, so can the US.

The other thing is, we have the example of 1990's Japan to learn from. I think the government knows that they have to more quickly and aggressively to avoid that, and I think they will do it. Of course the ever-eager US consumer will help too, as long as we give them the money.

[Independent Accountant]

I can't make a respectable case for deflation, disagreeing with say, Mish. If anyone thinks Helicopter Ben (HB) is just going to stand there while Citigroup, Merrill Lynch, Goldman Sachs, et. al. fold up like a house of cards, I've got some ocean front property in Arizona to sell him. It ain't happening. From time-to-time HB will throw a disinflationary scare into the market to keep the game going. But that's all it will be, HB's imitation of a Michael Jordan head fake.

[roger pasa]

forget flation think pression witha big D

[GARYALAN]

Unless the American worker's salary is going to increase in the near future, I cannot see where wholesale inflation will occur. Stagnant wages and job losses are highly deflationary. Until Chinese Labor is prevented from competing with American Labor, we will have stagnant or declining salaries. It is possible that if the US is able to destroy the currency by loss of the dollar as the world currency (i.e. loss of the dollar as the currency of oil), that hyper inflation would occur. This would be an extremely short event and would not benefit anyone in this country or elsewhere. That is why it hasn't happened yet. World governments would act to prevent this kind of event, if at all possible. Government can spend, however this would result in further commodity inflation among essentials which would ultimately cause a political backlash from stagflation. Therefore I expect to see a slight deflation in non-essentials along side a continued small commodity increase among essential items, gradually decreasing the American standard of living.

[garyalan]

Chief among the inflation/deflation debate is energy consumption. Inflation in energy is definitely coming, along with inflation in food (an energy by-product) and transportation. This will be highly deflationary for all other items. Peak Oil is here. If we are very lucky, we may be able to get our commercial nuclear energy program started back. The advanced reactor program we have today is one of the bright spots that we have left, along with our 500 year supply of coal in west virginia. Difficult times are coming no doubt, but we still have the basics here in the US to re-build the US after the end of the age of cheap energy.

Post Script: Mr Panzer, I enjoyed your book. I would have like to have seem more of a discussion of "The end of the age of cheap energy". I believe this topic will eventually trump all the other topics you discussed. Maybe this can be the focus of your next book.

[james saft]

Hi,

Thanks for posting my story. I'm a reader. I'm going to Davos next week and would be interested to know what you'd be asking the great and the good (and the bankers). Please drop me a line.
cheers

[Contrarian Investors' Journal]

I think I am closer to Michael's view point. As I wrote before in Recipe for hyperinflation (http://cij.inspiriting.com/?p=337), the Fed alone does not have the power to prevent deflation. If the US leave it all up to the Fed, we will have the Great Depression style of deflation. But if the US government, with its executive power intervenes in the current scheme of arrangement and attempts to fight deflation till the bitter end with unprecedented and presently unheard of course of actions (e.g. completely nationalising the Fed), then the outcome will be hyperinflation.

Already, we have seen Ben Bernanke recommending Congress to give the US economy a shot of economic 'stimulus.' In effect, Ben is saying that the Fed cannot solve the problem- it's up to the US government to do something 'extra'. Depending on how aggressive and determined the Fed and the US government is in combating the threat of deflation, it is possible that deflation is not given the chance to run its proper course.

I believe the ultimate destination is hyperinflation. But the path towards this destination is debatable. Your guess is as good as mine.

[Tim]

If the US consumer is 70% of the economy, then we have to look at the future from his perspective. Wage arbitrage is here to stay, and US workers in general need too much pay relative to what they produce. Mainly what they have been producing is an inflated lifestyle, kept afloat with credit.

This is not sustainable, as we are presently seeing. JSP wants to have a wealthy lifestyle but he doesn't have the means. Simple as that. He has been able to visit the wealthy lifestyle via home-equity extraction, but it's becoming evident that he can't live there permanently. This will be highly deflationary. Debt that will never be paid back will be highly deflationary. We may see inflation in essentials, but without the wage increases to pay for it all, non-essentials will have to fall to a price JSP can actually afford. That will be highly deflationary.

We have had the inflation. We've had inflated house prices, inflated tuition, inflated auto prices -- all on borrowed money. Now JSP's inflated expectations are going to get deflated by reality.

No matter how many US dollars get repatriated via SWF's buying up bank debt, it isn't going to flood down to JSP as it did the past few years. And remember the old adage; sellers don't set prices, buyers do. If buyers don't buy because they don't have the money, then there CAN'T be inflation, at least not for the average wage-earner and not for non-essentials.

Wealth will be concentrated at the top, as in the past, and JSP will go back to living within his means. The gap between rich and average will be evident again, as the average woman will not be buying $2k Louis Vuitton purses and the average cubicle worker will not be buying a new Lexus every 2 years. The truly wealthy will not have to rub shoulders with JSP at the exclusive resorts any more and Tiffany's won't be the favorite jewelry store of grade-shool teachers and realtors. In other words, we've had a democritization of the luxurious lifestyle that can't be sustained, and that will be highly deflationary.

[Scott Brooks]

It would seem to me that some sectors would inflate and others deflate. Real estate in cali and miami would deflate as the banking sector and financials weaken while ag and other areas which are exportable would not fall nearly as much.

The big question is once Ben really gooses the money supply at 25-45% Argentina style..what will he do when it does not help..In essence how many helicopters will he bring to the party :) and how long will he try to save us from deflation?

[Jay]

Thanks for your post, Michael. Can you please elaborate on the difference between "running the presses" and "excessive credit creation", because somehow I dont'really grasp it. Doesn't it both imply increasing money supply beyond economic fundamentals?

[Michael Panzner]

In Zimbabwe, for example, the government is literally printing new paper currency (which they are using to pay their bills), so the more of it they create, the less value each unit of currency has. Regardless of what happens afterwards, those dollars remain in circulation.
In the U.S., the Fed creates "money" by acquiring securities through repurchase agreements (which are essentially a form of secured lending) and the banks create "money" by issuing loans (i.e., "fractional-reserve banking") or through other mechanisms (e.g., derivatives). In the first instance, there is effectively no accounting/double-entry offset; in the latter, there is.
Hence, if the loans that played a role in boosting the money supply are not repaid (e.g., because of defaults), that "money" essentially disappears (which is not the case with paper currency that is simply printed and spent). In other words, money supply shrinks (i.e., deflation), causing demand (and prices) to fall.

[Bob K]

The general cycle seems to be deflation followed by inflation.

First, asset deflation and unemployment take hold, and scare the bejeesus out of everybody. Then the printing presses are forced into action. But since business has already been squeezed, and inefficiencies (and competitors) eliminated, then consumer price inflation takes hold.

This seems to fit what happened in the recovery from the Depression and in the 1970s era.

[farang]

Bruce:

Care to rethink what you posted?

[Since it seems pretty clear to me how badly deflation would screw things up, and since I am pretty sure Bernanke agrees, I think the government will do whatever is necessary to create (maintain) inflation. This is the only way to keep nominal asset prices at levels that avoid widespread solvency problems. If Weimar Germany could do it, so can the US.]

So, allowing the US dollar to careen into worthless Wiemar Marks you would need a wheelbarrow full for a loaf of bread, is desirable?

How does that "avoid widespread solvency problems"?

Let's see: The dollar sinks in value, the loaf of bread rises with inflation, you label that "keep(ing) nominal assets prices"? Huh?

Sorry, I can't follow that logic.

Please clarify.

[Bruce]

Actually, it was Matt who wrote that....