The Deflation Scam
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!
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December 19th, 2008 at 11:35 am
Nirav, I had a hard time understanding the point of this post. The title declares that Deflation is a Scam. This implies it is something made up or false, maybe a government conspiracy. But nothing in the post makes the case for any of that. Your data from the Government show that we have experienced a -12.9% contraction on “All Items” through November. That is the definition of deflation. Are you saying those numbers are made up or falsified? The same data show that in some areas, like Education, there has been some small inflation. But overall, we are experiencing a currency deflation.
It would really be quite hard for you to convince me or probably most others, anything else. We can see it all around us, whether it is gas prices, home prices (and eventually rent as vacant homes create competition for apartments), utilities; even food will come down since raw ingredients like grain have dropped a lot in six months.
There is no question that we are experiencing deflation right now, today. The only question that can be debated is really more a speculation: will we experience deflation tomorrow? I commented in my last post that the government is TRYING to create inflation. It is working very hard to push people away from cash. By definition, that is the only way out of deflation. Any increase in price, even just to get us back to zero price change, would be defined as inflation (or maybe “dis-deflation”?)
Because inflation is the only way out of this mess, it is better to just plan for it (invest in the correct stocks and commodities, and probably not bonds), rather than make arguments that we shouldn’t have inflation. Almost all economists agree that some amount of inflation is required in a healthy economy. Inflation means growth. It means there is demand for the economy’s goods and services. It is excessive inflation that is a problem (over 5% maybe?) not inflation itself. Deflation ALWAYS means a sick economy. It is never desirable for declining aggregate prices since it means too little demand for the amount of goods and services the economy can produce at optimum production.
And what does any of this have to do with tax policy? A deflation is not a tax event nor is an inflation. “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.” Huh??? That statement by someone name Strauss-Kahn(S-K for short? I don’t have much regard for economists with the IMF) makes little sense. Is S-K a Republican or conservative? What does he/she mean by “restructure the economy around their own interests while looting the taxpayer”? That is non-sensical.
The assertion by some that a Republican controlled government would “restructure the economy for their own interests”, though I would not agree with the notion, is at least logical. Republican’s generally favor “supply side” economics that reward the captains of industry (high tax bracket) with the hopes of “trickle down” benefits to the proletariat workers. I understand how this could be perceived as “looting the taxpayer” in the way of S-K’s thinking.
But the new Democratic Administration and Congress, which support and are driving our current economic strategy, are trying to reflate and support the massive financial restructuring TO BENEFIT the proletariate, NOT the elite. The Dems are for socialism, if anything. Obama himself said he wants to redistribute wealth from the rich to the poor. So, current policy favors the poor. Seems hard to get to Civil Unrest from here.
Now a good deflation, that is how we get civil unrest. High unemployment goes with deflation, almost by definition: as prices fall because of declining demand, business cuts back its production to decrease supply; to cut back production it lays off workers; fewer paid workers creates lower demand leading to even lower prices; and so on. Once there is 15% or more unemployment with many literally out in the streets with nothing to do: well you know the saying about idle hands. Check out the civil unrest in France the past few years for a reference.
So, stop worrying so much about inflation. It is the least of our worries right now. To get to hyperinflation requires the destruction of a country’s productive assets, ala Germany after WW1. Then, any printing of money is hollow, since it can’t be exchanged for anything tangible (like the dollar can be for desirable American assets like Pebble Beach). As long as money is exchanged for assets, even if impaired, it is not devalued by the action. This is why TARP is not really “printing money” as many proclaim. Something was received in kind for the capital infusions, namely assets, either ownership for taxpayers in the company (80% in a a couple cases) or in securities held, like RMBS’s or CDO’s (which contrary to popular opinion, do have some value).
It is much easier to pick good investments during inflation than right now during a deflation. Do you know even one good asset class right now? The answer is no, unless you cite the horrible US dollar (that no one wants, until right now, when it is all anyone wants). I welcome inflation. 5%, no problem, in fact GREAT; 10%, I can still find lots of ways to make money; 20%, okay, there is a limit, but we saw in 1980 how we get out of that one.
December 20th, 2008 at 3:04 am
Extremely low bond yields does not necessarily imply that “the market thinks there will be deflation.” Hell, they even went negative, it’s the flight to safety, it seems pretty obvious that these rates will not even keep up with inflation, 2% 10 year, 4% 30 year..bonds are in a bubble now too
December 21st, 2008 at 12:14 pm
Clay, why do you say: “Extremely low bond yields does not necessarily imply that “the market thinks there will be deflation.””
Of course that is what low interest rates imply. Interest rates don’t exist in a vaccuum. They are the price or value of money. Right now, money is very expensive. Everyone wants cash as they sell other assets. Deflation is what happens when too many goods are chasing too little money (the opposite definition of inflation). The value of money increases as the value of goods priced in the currency decreases. Deflation.
You go on to correctly state the US Treasury bonds are in a bubble. Yes they are. That is what happens during a deflation. See 3-month T-Bill interest rates from December 1932 for another example: http://www.federalreserve.gov/releases/h15/data/Monthly/discontinued_AH_M3.txt
December 22nd, 2008 at 4:22 am
Brian, do you even remember the inflation of the 1970s?
http://reason.com/news/show/130352.html
Inflation is a pernicious disease that breeds overindebtedness and overconsumption. It destroys the value of a currency, and makes it almost impossible to even hold on to wealth (given that one has to pay taxes on phantom “gains”) without excessive borrowing (and we have recently seen how well that works).
Deflation is often good for those who have more assets than debts (which is why governments hate it so much).
December 23rd, 2008 at 5:55 am
Hey Oldtimer, Yes, I was in college in the mid 70s. I remember inflation very well. I wasn’t invested at the time since I was a poor student, but charts show stock markets held their own in absolute terms, though inflation adjusted, they did less well (still, nothing as bad as right now).
I must say, I think you have your analysis backwards. Hard Assets do very well in times of inflation and very poorly in times of Deflation (like right now). The very term deflation should be expanded to “asset deflation” because that is what the term references (check it out on Wikipedia). It is a deflation in assets relative to currency. Right now, everyone wants to be in currency (Treasuries) because they are the safe harbor and hard assets are poison.
During times of inflation, assets INFLATE (become more valuable) in respect to the dollar. This is the definition so really can’t be debated. That is, assets become MORE valuable, not less and the dollar becomes weaker in respect (it will take more dollars to buy the same asset). So, if you are like me, and you have most of your wealth in hard assets, you are wishing and hoping for some inflation. That is what I am wishing for right now and I think the Fed will deliver!
I don’t agree with the statement: “(it is) impossible to even hold on to wealth (given that one has to pay taxes on phantom “gains”)”. No, a person owning hard assets will do very well during inflation as those assets hold their value relative to depreciating currency (paper assets). And on what “phantom gains” must one pay taxes? You lose me there. No taxes are paid until there is a sale and a capital gain, unless you are talking about zero coupon bonds or something more esoteric.
I do agree with the first part of the analysis in respect to EXCESSIVE inflation (as opposed to healthy 2-3% inflation). Oil and gold were the best assets to own the last half of the 70s. RE was good, too, until the inflation became excessive making RE financing too expensive (14% interest rates).
December 23rd, 2008 at 6:32 am
Nirav, not that it is a real big point, but the numbers you got from your CNBC source on the “real cost” of capital projects is quite wrong.
I have been over the Hoover Dam a couple of times and know just from looking at it, that it could not be built today for anywhere near $782 million in today’s dollars. I researched the actual cost and it was $165M in 1935, at the depth of the Great Depression. Because the dollar is now worth 1/30th of 1935, the actual cost would have been more lide $3B. And that is if you could find workers for the inflation adjusted wages of that time. The HIGHEST paid workers made only a little over $5 per DAY. If the average then was around $3 / Day, using the same inflation factor, today those same workers would be paid $90. What kind of laborers on this type of project can be had for $10 / hour today?
This finding casts doubt on all the other numbers cited. For example, I highly doubt all of the New Deal (which would include this Hoover Dam project) was only $550B.
December 23rd, 2008 at 6:33 am
I meant to add my Hoover Dam citation:
http://www.constructioncompany.com/historic-construction-projects/hoover-dam/
December 31st, 2008 at 3:13 pm
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February 14th, 2009 at 9:57 am
I appreciate your thoughts. BTW, Diversified Trading Strategies is linked to your page. What has been your experience with them?