Does the New York Times confirm deflation spiral theory or signal end of disinflation?
As readers know, I have been unable over the years to resist my deflation obsessed friend Rick Ackerman's taunts. For years and years he's argued that when the credit bubble collapses, the US economy will devolve into a 1930s style deflation spiral with prices falling for years, 25% unemployment, soup lines, and perhaps a return of the Jazz Age. His latest is a response to heat he's getting from his readers to the completely unprovoked attack we launched against the deflationist camp last week with Deflationista takes on iTulip to prove deflation is here! and The truth about deflation.
Over the weekend Rick shot me a note to point out the Sunday New York Times article on deflation: "Even the New York friggin’ Times is onto the story now – on the front page, no less."
This was followed by Rick's latest on deflation that says in part:
"In any event, we’d suggest that readers imbibe articles about the economy in USA Today, the Times, the Wall Street Journal et al, with a grain of salt. The mainstream media did not see this disaster coming and even now seem incapable of imagining how much worse it could get. Conventional news outlets are barely paying lip service to those whose forecasts have been ahead of the curve for years. The truth is, deflationists were regarded as fringe lunatics until relatively recently. Writing for Barron’s and the San Francisco Examiner, we had the subject all to ourselves until around 1998, when the collapse of the Thai baht and its spillover effect on Asia brought a few more like-minded “lunatics” out of the woodwork.
I’ve promised to don a grass skirt and dance a hula in Times Square in mid-February if I am wrong. I wonder what Wall Street will look like with Goldman at $24.
Here's my response.
I always enjoy receiving your notes, but you’ve got to be kidding. Is it possible that you and I both live in the same country, the United States of Goldman Sachs? We both know that our Minister of Finance Henry Paulson’s company recently turned–presto!–into a commercial bank so that it could absorb the assets of failed banks at a fire sale prices. The perks won’t stop there. Yet you say that our Minister’s firm can suffer an ignominious a decline in share price?
Think Gosbank, man!
The disinflationary period we’ve been warning about years before the housing bubble popped, producing asset price deflation and spilling over–if only briefly–into commodity prices and wages, is here. Now all you have to do to see it is look out the window. Your mistake is that you can’t see past it to what is on the other side.
Government, and lots of it!
I sent you the picture of capital flows years ago when you were saying that the Fed can't print to save the soon to be crashed banks. Take another look. It shows what I figured was due to happen when the endogenous credit markets blew up and recession hit households and businesses during the asset price deflation. In a phrase, fiscal stimulus.
Ever go to Japan? I’ve been there several times over the past 20 years. Japan may be famous among economists for its “deflation” but if you go I recommend you bring lots of money because everything is very, very expensive there for us hapless Americans whose currency has been devalued.
Not so bad for the Japanese, though. From 1999 to 2007, Japanese wages climbed 8% while the CPI (theirs isn’t as phony as ours, by the way) fell 2.3%. Stuff got slightly cheaper relative to wages, but not exactly the USA’s 1930s Great Depression. Unemployment never exceeded 5.4% there either–not even close to the 9% unemployment we got here in the US in 1983. Here, after our first bubble in tech stocks popped, it was the other way around: our government's reflation policy after the last “deflation” in 2002 caused consumer prices to increase more than wages, up 24% and 23% respectively since then.
(Hat tip to member Bill for locating the research)
This chart shows what Japan did when its asset bubble popped and its “balance sheet recession”–a euphemism for debt deflation–followed. New Deal, pal, 1990s style. Note government spending produced more than half the total demand for credit in some years.
We’ll do “better” than that. In fact, we already have. How much has the Fed expanded its balance sheet already? How much of the housing bubble is already on the US government’s balance sheet? And that was the last bubble, the first fiscal stimulus ever done in reverse–first the jobs then the government spending rather than the more traditional order of stimulus then jobs.
Whether Obama or McCain wins tomorrow, you can bet that public money will flow like water over Niagara Falls, but to different places. The question isn’t money or not, deflation or not, it’s where to? Orange Country for the military industrial complex or Massachusetts for biotech? Coal or nuclear? Fox News or Frontline?
Where will the money come from? Why, from all of us, my friend! The future savings of the current and next generation are already spent. For the next ten years at least we’re all just cash flow to pay down debt while government spending generates the demand that creates the jobs that generates the income we use to pay down the debt.
Good news! No deflation spiral in Japan or here. The bad news: more government and less private markets. Definitely less consumption. The only way to avoid a slow, grinding decline in our standard of living is a new productivity miracle. Tell the Silicon Valley guys and gals to crank it up! We need another invention like the Internet, but this time let’s not give it away. Wonder how much export income we lost by not licensing the Internet to China? Not that they'd actually pay–they'd rather buy Treasury Bonds than shell out license fees for the hundred million Microsoft software licenses they've pirated.
Look, you got the current crisis driven dollar rally part right years ago. Good work. Now look beyond it. A dollar rally ain’t deflation. It’s a panic out of stupid investments in securities not denominated in dollars. What’s the trade? When it ends so does some of the source of disinflation. Not to say it won't go on longer, but markets appear to already be pricing in what comes next.
Ask yourself this: In the face of crashing global markets and a developing world-wide depression, why does oil hang stubbornly above $60, a “bubble” price just two years ago?* Do commodity markets smell a global orgy of government spending on the way? Also, last we checked, governments aren't all that good at finding commodities, only at taxing them once someone has gone to the trouble and expense of finding and producing them. That's why Mexico and Russia seem to have suddenly run out of oil, coincident with taxation creating disincentives to invest in exploration and kleptocrats chasing off anyone with know-how out the country. (That's not an ad for either McCain or Obama, by the way. It's just a cold, hard fact.)
Add it all up and it's disinflation then inflation, just as we’ve been saying for years. Disinflation first–it's here–followed by inflation–it's coming.
The mainstream press, as you know, fulfills an important function in the execution of monetary policy. When the stories on inflation reached fever pitch last year it was time to get out of commodity positions, just as when deflation made the front page in 2002 it was time to back up the truck and buy gold. In this disinflation/deflation cycle–and it's a big one!–maybe we shouldn't wait for the next Deflation: Making Sure "It" Doesn't Happen Here speech from Bernanke like the one he gave November 22, 2002 when gold was trading at $316.
We may have to wait a while for the shots of you hula dancing in Times Square, but we're patient. We promise to post them here on the front page of iTulip.com.
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Last edited by FRED; 11-03-08 at 04:13 PM.
Sunday, January 20, 2008
Inflation or Deflation?
Mere mortal investors and their professional colleagues are (at least if they are honest and have a modicum of sense) a bit confounded as to what to do at this juncture. By all measures, inflationary pressures are gaining strength, and yet recessions lower aggregate demand and with it, price pressures. Ah, but what about the Chinese? Even if things get bad here, they aren't fully in lock-step with the US economy and have plenty of firepower. And what happens when Helicopter Ben throws cash at the problem? Won't lots of money creation debase the currency and by definition produce inflation?
It's very easy to get a headache from this sort of thinking.
Michael Panzner offers a useful post, "The Wrong 'Flation" on this topic, arguing for the deflationary outlook. The most powerful evidence for this view comes from the fact that the monetary authorities have lost control of credit generation (broader money, the old M3) as observers ranging from market mavens like Michael Shedlock to Serious Economists like Mohamed El-Erian have pointed out. The credit crisis means credit contraction, a process the Fed will likely be unable to staunch. That in turns points to deflation.
However, "unlikely" does not necessarily mean "unable". Bernanke is a well known expert on the Great Depression, and well schooled in the dangers of letting contractionary processes feed on themselves. So he and his colleagues will be doing everything in their power from keeping a vicious circle from setting in. The Term Auction Facility was a creative measure that managed to stave off a crisis in the money markets. Perhaps he will be able to use a combination of novel measures, liquidity injections, and smoke and mirrors to keep confidence at a reasonable level (confidence and willingness to extend credit are what really is at risk here).
The problem, ultimately, is that credit extension (witness no-doc loans, mezzanine CDOs, speculative real estate lending, and "cov lite" LBO deals) went well beyond sustainable or sensible levels. There will need to be a reduction in credit, which will inevitably lead to a contraction. But what shape will that take? How far down is down? While I think a financial meltdown is a real possibility, I guesstimate the odds at 30%. That is dangerously high by any standards, but also says the greater likelihood is that a crisis will be averted.
While I am still generally pessimistic about the near-term prospects, the powers that be may be able to forestall a crisis (and by that I mean a credit crunch a la 1990-1991, not a real calamity) and instead engineer a fairly ugly recession (I'd prefer a short and very nasty one, but given the housing crisis, we are more likely to get a prolonged sluggish period). Not pretty, particularly for middle and lower middle income consumers, who will take the brunt of it, but the alternative (most likely a Japan-style deflation due to refusal to realize losses on inflated asset values) would be even worse.
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.
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.
There's no essential difference in the mechanics or outcome of "printing presses", and excessive credit creation. Every cycle of easy money ends with some sort of banking credit deflation to some degree. Commercial banking credit "printing presses" create money just as easily as central banks.
January 20, 2008 4:54 AM
I think it could be argued that a combination of inflation and deflation could occur simultaneously, with the deflationary presures in sectors heavily reliant on credit (and largely discretionary) while sectors traditionally funded out of present income (and largely subject to only modest restriction) will be subject to inflation. The weakened consumer, whose equity withdrawal has averaged 500B per annum over the past 4 years, now meets the newly found financial discipline of his old lender. At the same time, competition for scarce commodity inputs, from foods to fuels, all of which interlink at some level, are being driven up by higher growth rates in poplations much larger than our own. The BRICs are nearly 3B people.
The Fed can surely create massive credit capacity, but that capacity becomes inflationary only when it is used. The sound consumers never relied on it, and the weak cannot now access it or afford it. Only the corporate sector will potentially benefit, if it is optimistic about prospects for growth.
January 20, 2008 8:25 AM
Why was the Japanese experience so bad? We seam to be making the real/nominal mistake in reverse when looking at Japan (no doubt the confusion is made worse by Japanese cultural differences).
1)Deflation in Japan during the period was understated. While the US & many Europeans used trick suck as chain weighting and hedonics to understate inflation the Japanese used an antiquated basket to overstate inflation/understate deflation. Allowing for this Real GDP growth was not bad over the period and combined with demographic trends Real GDP per head was actually pretty good. Evidence for this can be found in the consumption of luxury good which remained strong & even grew over time, hardly the shopping behaviour of the terminally depressed.
2)A strong preference for social cohesion led the Japanese away from mass redundancies towards a social safety net of paying people for non-jobs.
3)People moving into cities, unlike say Brits (an urban people who aspire to be country squires), Japanese dream of living in the heart of the action, the deflationary period allowed many people to move into areas they could only previously aspire to as their (considerable) savings went further.
4)Japanese companies were highly competitive in many sectors, in mobile technology & internet connection speeds they have powered ahead.
Lets hope the bursting of our bubble is dealt with so smoothly!
JackRiddler wrote:As clueless as ever - but clearly at least 50% of the blather economists are also.
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