Friday, July 10, 2009

Just when you thought things couldn't get worse...

Greetings good citizen,

You may have heard that the seemingly irrational actions of the Fed (quantitative easing, for example) have been undertaken to fight off ‘deflation’. You may also have heard that when given a choice between inflation and deflation, a central bank will pick inflation every time.

What baffles most of us ‘casual observers’ is why?

If inflation means prices go up, then most of us believe that prices will fall during ‘deflation’…except that they don’t, not until money becomes so scarce as to be worthless.

Now there’s a concept that is not only contradictory but it’s also difficult to wrap your head around.

How does money get ‘so scarce’ that it becomes worthless?

We need to ask a different question, what do you suppose the situation would be after a cascading systemic collapse?

The breakdown of the supply chain would lead to virtually everyone being unemployed.

Once money becomes ‘rare’ we would likely revert to a combination barter/precious metal economy, no one would want your paper dollars (even if you had them because they are backed by credit, which no one will have.)

So as the ‘assets’ that support our credit based currency, er, disappear because they have fallen so much in value, the entire economy collapses right behind it.

Which leads us to tonight’s offering that I sincerely hope opens your eyes to what is going on.

Ilargi: The following is part of an on-going conversation between Aaron Krowne (who runs The Mortgage Implode-O-Meter) and Stoneleigh on the subject of deflation. It began 3 days ago when Aaron sent me an email reacting to Stoneleigh's recent article The unbearable mightiness of deflation. Civilized and well-argued discussions are a welcome delight.

PS: 77 years ago today, July 8, 1932, the Dow reached its lowest point ever at 41.22.

Aaron: [You make] many good points. The way I understand it is that deflation is only happening in the financial economy, not the real economy.

Stoneleigh: Deflation is a monetary phenomenon - the contraction of money and credit relative to available goods and services. It is either happening or it is not. Price falls in nominal terms are a lagging indicator of deflation as a price driver, but there are other price drivers as well, such as wage arbitrage, scarcity, substitutability (or lack thereof) etc. Price movements have no explanatory or predictive value in their own right as they are the net result of many factors that vary for different goods and services.

Deflation will eventually cause prices to fall almost across the board in nominal terms, while leaving them less affordable than they were before due to the collapse of purchasing power. Purchasing power will collapse as access to credit disappears and the ability to earn an income decreases drastically with skyrocketing unemployment. Lack of purchasing power will come from most people having no money. Those (very) few who have preserved their purchasing power in liquid form will find everything is very cheap indeed once we are further into a deflationary spiral.

Aaron: Many assets (i.e. cars, foreclosed houses) are transitioning from one economic sphere to the other. In the real economy (where they are bought outright, not financed), these goods have lower prices. But that doesn't mean "prices are falling" in the same sense as it would for a cup of coffee or your monthly power bill or health insurance -- and in fact all these prices are going up.

Stoneleigh: Prices will fall, but as prices lag a deflationary contraction, many prices have not fallen yet. We have not yet seen the impact of credit tightening on price support for many things, but it is coming. Already we are seeing credit limits cut, cards withdrawn, borrowing against property cut etc. All that will have an effect, especially as it has very much further to go. The market is temporarily rallying at the moment, as we said it would in March, but once the sucker rally is over, the decline will begin again and the impacts will be increasingly obvious.

Aaron: Nobody's savings or wages are actually going up in buying power, which makes the current "deflation" very different from the one in the 1930s, regardless of what one chooses to call it.

Stoneleigh: Savings will go up in buying power, at least those which are not lost to a systemic banking crisis, which is moving inexorably closer. Wages will go up in buying power, for those who still have wages that is, and that part of the population will be shrinking very substantially.

We are going to see circumstances similar to the 1930s. We are seeing the initial stages at the moment. By way of analogy, the sea has pulled back and the tourists are gawping at the newly exposed shells on the ocean floor, blissfully unaware that a tsunami is coming. The quantitative easing that the government is doing will be completely dwarfed by the forces arrayed against them as the power of the collective rushes for the exits over the next year or so.

Unfortunately, timely warnings are rarely credible at the time they are given, as they conflict with the received wisdom of the herd. In this case, the vast majority is expecting inflation, and messages to the contrary can seem laughable, but then so did warnings in 2005 about the housing bubble coming to an end.

Aaron: Come on. How are we seeing a "monetary phenomenon" ("the same as in the 1930s"), when what is going on clearly has more to do with a collapse in credit (not money), and we don't even have sound money as we did in the 1930s? Are those differences supposedly immaterial?

I say, they are VERY material. Credit collapse in an environment of fiat money produces debt deflation, not monetary deflation. This means that price collapses are isolated to financialized assets, by and large.

Stoneleigh: Inflation is an increase in the supply of money AND CREDIT relative to available goods and services, and deflation is the opposite. The contraction of credit, as credit loses 'moneyness', is a contraction of the effective money supply relative to available goods and services, which is deflation. Inflation and deflation are always and everywhere monetary phenomena. There is no difference between debt deflation and monetary deflation.

Price collapses will in no way be limited to financialized assets, although these should suffer greater losses than material goods. Illiquid securities could go to zero for instance, while oil certainly will not, but the price of oil nevertheless has further to go to the downside than we have seen so far as a result of the coming demand destruction. One would not expect price movements to be equal for different goods, services or financialized assets, but one would expect deflation to decrease price support across the board. Other price drivers, in one direction or the other, in combination with the effects of deflation, will determine the net effect on prices for each item.

Aaron: Note, for example, that the oil price has already rebounded strongly after becoming definancialized (yes the general market has rallied but oil has much more). As inventories are relatively high, this shows oil is likely acting as a substitute sound money against the fiat currency, which cannot constitute any sort of durable safe haven.

Stoneleigh: When oil was over $140/barrel we predicted the price would plummet, and it did. In March when the market began its sucker rally, which we warned our readers was about to happen, we said that the price of oil would rebound with the general return of liquidity, before falling further once the rally was over. We stand by this prediction today, as the combination of the destruction of economic activity, the lack of purchasing power and the need for oil-producing nations to pump flat out in order to bring in as much revenue as possible will further undermine oil prices. However, as we have pointed out in our energy primer (Energy, Finance and Hegemonic Power ), demand destruction will sow the seeds of supply destruction.

We expect oil, and gold, to bottom early in this depression, and to increase enormously thereafter. A price increasing in nominal terms against a backdrop of credit collapse means that prices will be going through the roof in real terms. Ordinary people will find themselves entirely priced out of the market. Fiat currency, and cash equivalents such as short term bonds, are not a enduring safe haven, but are a safe haven for the time being. During the deflationary deleveraging, the preservation of purchasing power in liquid form is the key. Following deflation, it will be necessary to move into hard goods, which will be available at prices that will look very cheap to those few who retain access to cash.

Aaron: Those waiting for their basic expenses to go down and their fiat money to become worth more will be waiting until they are blue in the face. And perhaps it is better they starve themselves of oxygen before meeting the monetary inflationary reality of the near future.

Stoneleigh: Most will see their basic expenses go through the roof in real terms (even as they fall in nominal terms), as they will have almost no access to goods and services, as a result of having no money or credit, and therefore no purchasing power. The very few who hold liquidity, and have been able to avoid losing it in a bank run, will find that their expenses will fall, but they will be a tiny minority. Monetary inflation is likely to be the scourge of the longer-term (ie many years hence), but it is not the scourge of the present or of the near future.

Aaron: I guess my main point of contention is the assertion that "there is no difference between monetary deflation and debt deflation". The reason is because only a minority of assets (and most of them having to do with investing with a long-term horizon) are financialized (financed). That seems factual to me... and the divergent path of the various prices seems to confirm it.

Certainly, while we are getting some spillover areas of prices going down, but some of the same prices are also going up from month to month, and structural costs evidently constitute a long-term rising tide.

Stoneleigh: Those rising prices are temporary, reflecting the previous credit expansion as a lagging indicator. I agree that 'financialization' opened the door to speculative excess and its aftermath, which drove prices up sharply and set them up for a huge fall. Not everything was subject to this kind of 'pump and dump', and therefore not all prices have been as volatile. Price movements are inconsistent as many price drivers operate simultaneously.

However, deflation at its most virulent is an extremely powerful price driver. We have yet to see its effects, and may have to wait until next year to do so, depending on the time lag between monetary contraction and the effects appearing in the broader economy.

I am expecting a late summer top for this current sucker rally, and for the downward trend to resume this autumn. If that downward trend becomes a market cascade, as I expect it to, then the effect on prices may not take too long to kick in. That is not to say that the time lag for everything would be the same. The rollover point for a new price trend could vary substantially. I would certainly expect the price of non-essential consumer goods to fall faster than essentials or regulated utilities, where there is more state influence over prices.

I do expect virtually all prices to fall in nominal terms at some point though, but not in real terms as we have discussed previously. Lower prices do not equate to greater affordability in a deflation, except for the lucky few who still have any money.

Aaron: The general assumption seems to be that we can only be "in" deflation or inflation, but I think it is evident we are in both, depending on whether you look primarily at real costs or financial assets. Again, this is a source of confusion, but when I say "inflation", by default, I mean the real economy sense -- as previously there was no popular acceptance of "inflation" referring to asset prices (and if you prefer money supply, the credit that financed these assets).

Stoneleigh: The use of the term 'inflation' to describe price movements rather than monetary expansion is a relatively modern convention. It represents the a popularization of the term, but a bastardization of its meaning in that such a usage obscures a very important concept. Inflation is a monetary phenomenon. We cannot, by definition, be in inflation and deflation at the same time, although price movements can certainly unfold in different directions simultaneously, depending on a number of factors.

Aaron: Cui bono -- who would it be convenient for to ignore inflation in asset prices while looking at "deflation" in goods as the bubble expands, then look at deflation in asset prices but ignore inflation in goods as the bubble pops?

Stoneleigh: I wouldn't suggest ignoring the effect on either assets or consumer goods as they are both part of the picture. However, explaining that picture requires a consistent analytical underpinning.

Aaron: I also do not buy the assertion that collapsing employment or "purchasing power" will cause price deflation. This is essentially the NAIRU philosophy and I would have thought it had been thoroughly debunked by the 1970s stagflationary experience and its inverse, the 1990s "great moderation" (low unemployment, low inflation). Withdrawn credit is a new twist to this, but when you think about it this is really no different than considering employment, as you are simply taking stock of the "demand" side. When you consider that most people were already stuck in a position of being able to afford little more than the basics, then you can see that beyond big screen TVs, demand for goods and basic services is relatively inelastic. So overall, I don't think this demand-side argument is compatible with the assertion that inflation is a monetary phenomenon.

Stoneleigh: We have yet to see a significant drop in aggregate demand, but it is coming. Demand is not what one wants, but one is ready, willing and able to pay for, and it is not inelastic when purchasing power is withdrawn. Without access to credit and without an income stream from employment, more and more people will fall by the wayside. Eventually they will be in the majority. We may find it inconceivable that a majority of people will have insufficient purchasing power to afford even basic essentials, but that has been very common pattern in human history - a large proletariat ruled by a small elite, with an enormous wealth disparity.

The 1990s were not a time of low inflation, it was a time of enormous credit expansion. Consumer prices were held in check by global wage arbitrage and international price competition, so the excess found its way into assets.

Aaron: And I agree that inflation is primarily a monetary phenomenon. I just do not believe that "money substitutes" act exactly like money. By and large when we talk about credit and derivatives and such, we are talking about a realm of fiction that is detached from the real economy. So I am surprised so many sharp analysts now seems to assign this realm some kind of central importance. If I write a you a $1M IOU, and we toss it back and forth 1000 times, we have not just done $1B of business, or added $1B to the global economy, or anyone's income or asset base. If we suddenly realize this, that does not constitute $1B of "deflation" either, though it might be disruptive for cloistered bankers or billionaires.

Stoneleigh: The period of time where money was chasing its own tail was adding to wealth expectations, and much of that wealth effect was propping up prices. Those who are of the opinion that they have a claim to a certain percentage of the real wealth pie will not readily concede that they do not. While currency inflation divides a wealth pie into ever smaller pieces, credit expansion creates multiple and mutually exclusive claims to the same pieces of pie. Everyone feels wealthier, but it is an illusion. Little or no wealth has actually been created, but the proliferation of claims has led to a very dangerous situation. Deflation is the process of extinguishing those excess claims once their existence has been generally recognized.

As there are probably at least a hundred claims to each slice of pie, thanks to leverage, the vast majority of claims will face extinction. This will not be an orderly process following legal niceties. On the contrary, those higher up the financial food chain will reach down and grab whatever they can in the way of real wealth in the biggest margin call in history. In other words, say good-bye to anything owned on margin.

Aaron: Back to money, as far as I can tell, so much money has already been printed that we are vulnerable to severe inflation if not hyperinflation if confidence in the dollar suddenly drops out. I reckon that massive interventions and propping have already taken place to prevent this from happening -- who can say? -- but it remains a great risk, and puts the US and the dollar in the same category as Argentina or Zimbabwe.

Stoneleigh: Forecasts of a collapse in the dollar are premature. Deflation will prop up the value of the dollar on a flight to safety, which will also drop bond yields to historic lows for a time. There is more dollar-denominated debt in the world than any other kind, hence its deflation will increase demand for dollars more than any other currency (except perhaps the yen as its carry trade unwinds). Eventually the value of the dollar will collapse, as all fiat currencies do, but that time is not now.

The amount of 'money printing' that as happened so far is completely dwarfed by the scale of credit contraction. We are not vulnerable to inflation as a result of this. On the contrary, most of it has disappeared into the black hole of credit destruction, never to be seen again. Much of the rest is being hoarded. It is doing nothing substantial to increase the velocity of money, although rallies are accompanied by a temporary return of liquidity along with the temporary return of confidence. In a very real sense, confidence IS liquidity. Once the rally is over, both will disappear again and the velocity of money will plummet.

Aaron: I think we are in agreement that long term, the risk is inflation -- but I additionally don't think we are "safe" right now. Specifically, the monetary authorities have no call to dramatically expand any sort of money or credit -- they are seriously playing with fire when they do so, as the vulnerable position of the dollar and the printing that has been done already form an underbrush of dry tinder.

Stoneleigh: I can see inflation in the very long term (ie years away at least), but to say that it represents the real risk is not a position I agree with. Deflation on the scale we are facing is simply devastating. It is a force that essentially sweeps all before it. Those who emerge shell-shocked from a deflationary depression will then have to face hyperinflation, once the power of the bond market has been broken thanks to the collapse of the international debt financing model, but that is a very long way off.

Aaron: Here is an additional argument you might want to consider on the question of whether or not consumer credit being withdrawn implies deflation. There are two main cases to consider -- people who are maxed (or "near maxed"), and those who do not use much credit and have lots of spare borrowing power.

In the latter case, the analysis is easy: credit being withdrawn has little effect on them, their behavior, or the economy (net demand for goods and services). On the other hand, if you are close to being maxed out, you have a problem. You've basically been living off your credit cards, and your lines are being cut (or equivalently your APRs are going up). It would seem you might have to scale back demand.

But here's the the thing: you were probably maxed out on the credit cards because you had no choice. Specifically, whether or not you have the credit lines available, you have to pay your bills, feed yourself (and your kids if you have any), etc. The vast majority of those maxed out are not actually doing so on "discretionary" spending.

This means that when those lines are cut, the spending cannot really go away. Instead, the pressure falls back on state or national government to support these people. Sure enough, we find massive amounts of stimulus money going to extend unemployment benefits, provide matching for "TANF" and other welfare programs, etc. This is essentially fresh money printing to substitute for the withdrawn credit. The paradox of consumer credit is that those with the most of it "need" it the least. But those who need it the most will find other forms of support when they lose it. So, at the end of the day, I don't think the cutting-back of consumer credit will have a very big effect on aggregate demand and hence CPI inflation.

Stoneleigh: Bailouts are never for the little guy, no matter what spin is put on them in order to sell them to the public. They are for the few insiders at the expense of everyone else. The population at large are the designated empty bag holders as the ponzi scheme hits its limit (From the Top of the Great Pyramid).

Saying that those who lose credit, and income from employment, will necessarily find other means of support, and that their demand will not therefore fall, seems completely preposterous to me. No government can afford to supply its populace to the extent that their demand would be unaffected. In fact, no government will be able to supply even the most basic essentials to all, let alone prop up demand at anything like current levels. A government pursuing that kind of strategy would be severely punished by the bond market very quickly.

Eventually this will happen anyway as a result of quantitative easing, but when it does, it will amount to hitting the 'emergency stop' button on the economy. Interest rates will shoot up into the double digits in nominal terms, and much higher in real terms. It will unleash a tsunami of debt default throughout the economy, as debts will no longer be remotely affordable. This will be hugely deflationary.

Governments facing very high interest rates (and there will be many) will have to slash spending to the bone. Just when people are most in need of support, they will be cast adrift in a pay-as-you-go world with no purchasing power. The effects of this will be gargantuan in terms of political unrest and upheaval. There is nothing governments, or anyone else, can do to avoid the consequences of the largest credit bubble in history bursting. We have had the party to end all parties, and now we have to deal with a hangover that will last for decades.

I didn’t ‘emphasize’ anything in this article because it is confusing enough by itself.

That said, I find it difficult to believe that anything remotely resembling ‘social cohesion’ will withstand the sudden catastrophic collapse of the supply chain.

This event does not presage the turning back of the social clock for a hundred years but for a thousand years.

As Stoneleigh points out, deflation is charging in our direction at full steam and it is doubtful any action taken by authority can turn it aside. (Because credit is collapsing so quickly.)

There is no way to use our current system to save the system so it must be abandoned.

Bizarrely, some will try (to ‘save’ capitalism)…but chances are excellent that this ‘new’ brand of capitalism will usher in the return of slavery.

Er, I hope you find this, um, useful.

Thanks for letting me inside your head,


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