Deleveraging Is Not 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.
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January 24th, 2009 at 7:27 am
LOD,
You keep pushing stories about the potential for inflation and that gold will be the thing to invest in. However it seems to me that you are simply trying to sell your visitors some of your french gold coins, rather than teach them how to live off dividends and passive income.
January 24th, 2009 at 8:45 am
I take it you’ve seen Zeitgeist then? I love that documentary. To me, the fact that we stopped backing money with gold was a very big deal.
It is interesting how we just let that happen.
January 24th, 2009 at 11:31 am
bloggingbanks,
You should click on the Passive Income category link to see what I’m doing. You might also want to check out the about page – I’ve never claimed I’m going to teach you anything – I’ll just share what I’m doing. I have been buying gold coins. And I suggest you do as well. And I’ve always provided a good justification for it.
But if you’d rather be spoon-fed as to what stocks to buy and how to quickly start a site that pulls in money with no work, I’m afraid you’re on the wrong site. There’s no free lunch.
January 24th, 2009 at 12:52 pm
This post might be interesting, but it isn’t very accurate, or at least has no exclusive claim to accuracy. Friedrich Hayek and the other “Austrian School” economists, did ascribe to monetary expansion as synonymous with inflation. However, that is not a very widely accepted definition. It is only becomes true when all the other elements of the economy are static, which is not reality.
The author of the article is not referenced, but he needs to dust off his Econ 101 text book and review the more traditional definition of inflation: “A Rise in the general price level of all goods and services – or equivalently, a decline in the purchasing power of a unit of money”; this from “Contemporary Economics – 4th Edition” by Spencer.
In terms of “demand-pull inflation” the same author says: “demand-pull inflation, takes place when aggregate demand is rising while the available supply of goods is becoming more limited.” This is how we typically think of inflation, with the 1970s as the most contemporary reference. Note that the other non-money aspects of the economy (supply and demand) are not static, but are moving in response to price.
Deflation is just the opposite, where aggregate demand is declining while the available supply of goods is becoming more available. This is certainly the situation in real estate, oil and gas and other commodity resources, labor and much more, today. Inflation and deflation are first and formost determined by supply and demand, not by money supply.
Money supply does make a difference, though, all other things being the same (as Hayek maintains). Money supply should stay in balance with supply and demand, according to Nobel Laureate Milton Friedman, as determined by economic growth. In the monetarist view, there is a simple equation that expains the need for an expanded money supply at this moment in time. From Irving Fisher comes this basic formula:
MV = PQ;
where M = money supply, V = Velocity of money, P = the average price for a unit of goods or services and Q = the quantity of those goods and services.
Right now, we are in a period that due to the collapse of the banking system, V is very nearly low. Banks are unwilling (or unable because of their reserve capital) to loan money. It is by spending and lending that Monetary Velocity is established. We all remember from our Econ 101 class, that for every dollar printed, it may be circulated 10 times per year. This is the Multiplier effect created by Velocity. Recessions are signified by a decrease in veocity and the prescription, according to monetarism, has been to increase money supply.
To balance the equation and avoid contraction of “P”, with “Q” fixed, “M” must be expanded. It is really that simple.
The danger that you and the author of the above piece see, Nirav, is that once “V” gets moving again with an upturn in the economy, then there will be way too much “M” in the economy and “P” will take off like a rocket in response. I agree that is a major danger. And because I do not have total faith my government can get off the gas pedal in time, I am long natural resources and gold, and would be short Treasuries. I am hedging for inflation.
But to avoid the absolute carnage that can be wrought by deflation, contrary to the author’s assertions, we do need a monetary expansion right now, today. We need to keep “P” from falling through the floor with a very low “V”. Lower “P” causes people to wait to make purchases or investments, slowing “V” even more and creating the classic downward spiral of deflation.
The extremely low Treasury interest rates tell us that monetary expansion is not inflationary right now. Otherwise, our foreign debtors would require higher interest rates to offset the risk. The stabilization of the stock market, which is a good proxy for real assets, tells us that the monetary expansion underway is working and is well received by sophisticated investors.
Stay tuned. The next 12-24 months will tell the story.
January 24th, 2009 at 4:39 pm
Wow that is an extensive comment. The reality is that this fractional reserve central bank system is designed to enslave the population and keep really rich bankers rich.
January 24th, 2009 at 7:03 pm
Ben, that is an interesting point of view that almost sounds like you believe in a banker conspiracy. But knowing the history of the gold standard would teach you otherwise. Gold has physical limitations in terms of supply that are unrelated to the productive capacity of the world. The basis for money supply, whether a reserve currency or some real asset proxy for money like gold, would ideally be expanded by the exact same amount as productive capacity in order (GNP growth) to keep the equation in balance.
This was the point of Milton Friedman’s work for which he received the Nobel Prize in economics. Gold can be a noose around the neck of the world economy and make people’s lives less rich and rewarding than they would otherwise be. Think what would have happened to the supply and price of gold if China had to match every increase in national GDP (the Q in the Fisher equation) with an equal increase in gold reserves (the M in the equation) with “V” and “P” remaining constant.
A fractional reserve system is much more flexible and responsive to changes in the world economy. Only one country can possess the reference or reserve currency and that is America at this time. This should require an added measure of fiscal responsibility by national policy makers. But our nation (not just the government, but all of us) have done a poor job managing our expectations and have let greed ruin our economy and banking system.
Now we must pay for our mistakes and regain the world’s confidence that we will act responsibly and regulate our banking system for the benefit of the world economy. We need to expand the monetary supply now to get the planet out of its tail spin (for which we are and will be blamed), and then quickly reduce “M” when the economy gets going again in another 12-24 months, as I said before.
Higher taxes to eliminate our deficits and more responsible and conservative investing and saving by our citizens will then allow us to regain the confidence in our system that has been lost. Public policy can help with this by encouraging more savings (more 401k type incentives) and tax consumption (maybe a national sales tax?) This is where I hope our national policy makers will take us.
January 24th, 2009 at 11:47 pm
Brian, your arguments above are well written. You should go head to head with Mish