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Battle of Economists - Inflation or Deflation

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December 24, 2007 – Comments (23)

My vote is that by the time the credit crisis finishes unwinding we will see some deflation.  The causes of the hyper-inflation of assets was the loose lending standards and possibly fraud the way they were rated AAA and sold to investors to further hyper-inflate the money supply.  Enough people and funds have been burned that, for example, there were no buyers for the $32 billion that Canadian funds are known to be stuck with.  These things are not selling anymore and investor have wised up and better understand the enormous risk these things presented.

Bring these things back onto the banks balance sheet and tightening up the lending standards both mean a contraction of the existing money supply and hence deflation.  There may be inflation of consumer purchases but overall, the money supply has to contract.  The loose lending standards increased the leverage of the money supply by about 2.5 times without considering the stuff they moved off their balance sheets (I think).

So, I am a highly aggressive bear and I've hedged my bets entirely on deflation.  So, Peter Schiff piece, Not Your Father's Deflation, certainly makes me second guess my analysis. 

My deflation plan means I don't bother concerning myself with how to make  my portfolio grow, but rather how I position myself to be the lesser loser through a deflationary correction.  It means I've sold out of the market and split my funds to as many banks as necessary to ensure they are all covered by government insurance.  It means I've said good-bye to brokerage accounts as I doubt their insurance models have considered deflation and I doubt their insurance would be solvent through a deflation.  I just know a few people are going to be leveraged to the hilt and unable to cover their losses and I don't want to stand in line hoping to get my money back six years down the road.  I can't see this not happening to at least a few people and I choose to ensure that I am not one of them.  If banks screw up sufficiently well, government will at least print money for me and so I will see a devaluation of currency, but it will be a shared devaluation.

Of course, Mish, whom  I think has an amazing ability for analysis and depth of understanding and ability to think out of the box, has countered Peter in his piece, "Not Your Father's Deflation: Rebuttal." The first quote is partly covers my thinking.  It misses my view of the household budget for homeowners stuck in homes they can hardly afford.  They are no longer participants in the economy, but simply exist to pay back debt, the debt slaves.  Vancouver went through this, grossly declining disposible income, but our economy relative to North America is about 1%, so we had things like tourism helping our economy out.  When you get into say 20-30% of your economy with these kinds of problems, well, you have less people able to help the economy (20-30% less) and you have 20-30 times as much of the economy needing help from somewhere to stimulate them.  It is a leveraged difference of as much as 40.  The rest of the economy simply can't help this level of hardship.  I know I've talked with people in the US with my kind of qualifications going to jobs straight out of university paying twice what I could find in Vancouver  with experience.  Several US cities have also had high prices, but I don't think they've had as gross suppression of wages.

One thing I have to say about Schiff's assumption about falling demand due to recession and prices, well, I have been shopping this week.  The one store simply was not crowded on Sunday, nor were the stores anywhere near as crowded today as xmas eve shopping of the past.  I have waited an hour to pay for a purchase in the past.  And, with the reduced crowd, I couldn't believe the deals I got these past two days.  I am one happy consumer! 

Anyway, Mish does a great job of countering the hyper inflation arguments and I am sitting in the deflation camp.  I really have to agree on the psychology part.  In Vancouver our last two bottoms occurred 5 and 7 years after the bottom.  Bubble are a result of psychology, not fundamentals and when a bubble breaks, the revaluation happens slowly as people refuse to accept it and it takes years to slowly chase it down. 

 

23 Comments – Post Your Own

#1) On December 25, 2007 at 1:55 AM, fOOLSONPARADE (95.74) wrote:

I agree dwot. Deflation is where we are headed as banks hoard cash to weather this financial mess. The consumer will eventually reign in spending as the credit cards are maxed out. Recent news has already hinted that this is closely approaching. The dollar broke its trend and, I believe, will continue its upward trend as the dollar strengthens in value over other currencies. I also think gold/silver will drop in value once the need for cash outweighs the need for metal. I hope we can avoid a great depression style deflation but everything seem to point for a stronger recession than most have ever seen; housing prices went higher than ever in history and personal debt is higher than ever. Interesting times. Good luck.

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#2) On December 25, 2007 at 4:21 AM, cluelessmorgan (82.87) wrote:

Could you address this point, to which I may be somewhat clueless on?  If all these forclosures that have been happening, (and will, no doubt, continue to a greater or lesser degree regardless of any bailout plan which may reduce forclosures a little, but probably not enough... )

if so many people who cannot truly afford these homes, are losing them, wouldn't it stand to follow that these same people now have more spending power?  Once relieved of their homes and the enourmous debt they could not afford, wouldn't this free up the tight household budgets?

If John Doe has spent the last year with no money to spare because he has been trying to make his mortgage, and now he has to move into a smaller home or an apartment, wouldn't that free up his tightened budget to more spending in the broader economy?

Now relieved of expensive home and that debt?

And bankruptices?  After bankruptcy, wouldn't it follow that Joe Doe (John Doe's hypothetical cousin) now has a new start and is debt free and can purchase what he couldn't a year earlier?

Now then.  If all these John and Joe Does have been hurting and so tight on money previously, looking back, isn't THAT what should have been hurting the economy previously, not presently.  So the Doe's recession is already over in theory right?

Having said that, it still leaves the banks and investors holding the bag.  Thats another story. But as for the consumer, am I right?  OR have I missed something important?

(quite possible, though my logic seems good to me)

 

 

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#3) On December 25, 2007 at 9:41 AM, dwot (39.30) wrote:

foolsonparade, I think history has studied how actions that were taken made the problem worse, so this time around we are seeing government trying to increase liquidity whereas government did things to tighten an already serious liquidity problem.

cluelessmorgan, some of those people in foreclosure have been spending far beyond their means by borrowing more against their rising equity.  I have no idea of the percent, but I was looking at a report from Calculated Risk. I couldn't find it just now.  With an aging population you should be seeing an overall increase in equity in homes, but what you see as the home prices went up was that people borrow against the equity, at incredibly insane levels.

Consumer spending has gone straight up, I just saw a graph of it in the last two days that showed that it was up about 8-fold since about 1990, I think.  I looked at that and around here people are lucky if their wages are up 40-50% since then.  The rate of increase in consumer spending has been insane relative to wages and that has been fed by the removal of equity from homes.  I am in Vancouver and away from my computer that I was doing all my research on.  I calculated the changes in equity for the country based on estimates of declining home values and it looks like home equity would be about 42% with a 15% decline from the peak and 30% with a 30% decline.  Thirty percent equity for a country is like a country of people starting out or relatively early in the home ownership curve.  Money is tight when you are starting out. 

Right now you have people who aren't paying their mortgage to pay credit cards instead, or they are still spending in the economy instead of paying their mortgage.  That spending will stop when they have to start paying rent.  The ones that end up in foreclosure will probably end up being far better off financially, but there is still an awful lot of people who are going to be debt slaves.  I don't think the ones who end up in foreclosure are going to be able to make up for the ones who find all they do is pay debt.

Bottom line though, wages will never cover the degree of consumer spending that has been happening.  They haven't been covering consumer spending for a long time and now credit has tightened up and the ability to finance consumer spending through debt has had the major sources of funding - home equity - dry up.

Then, there is the wealth effect.  People spend less when they perceive their level of wealth has declined.  So those that can spend will probably put more aside for a rainy day. 

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#4) On December 25, 2007 at 9:44 AM, dwot (39.30) wrote:

Oops, I just found the graph on consumer spending, it is since 1980.  http://www.safehaven.com/article-9100.htm

Wages still haven't kept up with spending at all... 

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#5) On December 25, 2007 at 9:56 AM, dwot (39.30) wrote:

http://www.project-syndicate.org/commentary/roubini2

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#6) On December 25, 2007 at 4:00 PM, MakeItSeven (31.63) wrote:

Whether the economy will head into inflation or deflation depends on two variables: the Fed action and consumer spendings.

I'm with Peter Schiff here  since I think the Fed will go all out to avoid a deflation scenario which potentially could make 1929 a walk in the park.  It will completely ignore inflation and even adopt section 13 of the Federal Reserve Act to take on all credit risk if necessary (actually it has been doing that for a few months now by providing money through the discount window via the Fed banks for any stupid scraps of collaterals, even the junks from Countrywide).

As for consumers, I don't think their spending habits will change and they will start to save any time soon, especially if the government continues to encourage them to spend beyond their means and takes on all the risk for them.

I think Mish is projecting from a Japan model but Japanese and American consumers behave differently (the trade deficit/surplus is one example). 

There are two factors which might cause deflation to happen despite the higher odd of inflation:

- Unemployment: unemployment will undoubtedly rise.  In CA, for example, there's a budget shorfall of 14B and, at the minimum, the budget will have to be cut by 10%.  That can't be done without layoffs.  Similarly at county and city levels and in other states.  However, the unemployment rate is expected to rise to around 5.5% only.  If it goes much higher (6.5+%) then all bets against deflation are off as people have to cut back to make sure that they won't end up in homeless shelters.

- Stock market crash: the economy absolutely sucks for the average American in the last few years.  Median wage decreased  after adjusting for inflation which is already doctored to be lower than the real inflation.   Household debt increased from 65% of GDP to 95% of GDP.   Even the most ardent supporters of the Bush admin have nothing to brag about other than the asset bubbles: stock and housing values to claim that Americans are wealthier despite lower income and higher debt.

Now that the housing bubble has busted and people can no longer withdraw from their homes to supplement their spending habits, the consumer economy is now teetering on that one leg: the stock market.   There are signs that people stop making contribution to their 401K and even withdrawing from it (to replace the housing ATM ?) so that will put pressure on the stock market.  However, unless the stock market crashes and, together with the housing crash, causes a big dent in the wealth effect, I don't expect deflation will happen.  Most likely, it will take both factors: high unemployment and a stock market crash to happen first before the 24-year spending habit will be broken and the US will end up with deflation.

Anyway, some people might disagree that I call the stock market a bubble because they think "valuation" is fair.  I don't mean bubble in the sense that it is over-inflated but in the sense that it works like a sprinkler: the more pressure it has, the higher it goes.  When the pressure is strong it might go to some dizzying height, as in 1999-2000 but if the pressure is off, it will flaten in no time.  Therefore, the wealth in the stock market can be illusory because the moment a lot of people need access to that "wealth" and make more withdrawals from the stock market than new money coming in, it will tank like a rock.  It won't be much different from what is happening in the housing market right now, a lot of sellers and not half as many buyers.

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#7) On December 25, 2007 at 6:03 PM, dwot (39.30) wrote:

MakeItSeven, from what I read about 1929 is that after the crash the feds made it even more difficult by tightening up liquidity.  I think we will see deflation, but we will see attempts to keep liquidity. 

I am not sure what you mean by an all out deflation, but I don't see wages catching up with housing prices but rather housing prices coming down to wages.  I see a lot more pressure on disposible income, so perhaps not deflation in all things. 

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#8) On December 25, 2007 at 7:58 PM, MakeItSeven (31.63) wrote:

I did not say an all out deflation, I said the Fed will go all out to AVOID a deflation.  The scenario for a 1929 style deflation is in the link,   Here are some excerpts:

"Liquidity doesn't do anything in this situation," says Anna Schwartz, the doyenne of US monetarism and life-time student (with Milton Friedman) of the Great Depression.

"It cannot deal with the underlying fear that lots of firms are going bankrupt. The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue," she adds.

York professor Peter Spencer, chief economist for the ITEM Club, says the global authorities have just weeks to get this right, or trigger disaster.

"The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are allowing the money markets to dictate policy. We are long past worrying about moral hazard," he says.

"They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don't think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park," he adds.

The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. "We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other," he says.

New York's Federal Reserve chief Tim Geithner echoed the words, warning of an "adverse self-reinforcing dynamic", banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.

The article also mentions what mistakes were made in 1929 and in Japan.

As Peter Schiff said, falling asset prices alone does not necessarily cause deflation:

The way I see it there are only two possible scenarios. The more benign outcome would we be one where asset prices fall, even in terms of paper dollars, but consumer goods prices continue to rise. This would be the stagflation scenario.

Mish's argument is based on the premise that there is little the Fed can do since it cannot push on a string and make people and banks borrow even when it makes money accessible (using what happened in Japan as the basis for the prediction). 

Schiff makes a false assumption that the Fed can replace credit out of thin air. The Fed is simply not in control of credit at all. The Fed can encourage borrowing but it cannot force it. 

I disagree with Mish since I think Japanese and Americans are culturally different in terms of spending habits.   Giving American banks Fed-backed money to lend with almost no risk then they will lend.  Giving consumers with shaky credit money to spend "for free" (with the only price to pay is filing for bankruptcies) then they will spend.

But I think Peter Schiff is thinking more along the line of short and medium terms (up to 5-10 years).  In the long term, Ponzi scheme where money gets pumped into "the system" to keep it afloat tends to crash spectacularly and people might just hang on to whatever they have left, causing deflation.

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#9) On December 26, 2007 at 12:34 AM, dwot (39.30) wrote:

MakeItSeven, how do Americans keep spending when the well is dry?  Repricing credit for risk means that many that have been spending can spend no more.  Cultural difference or not, the level of debt is so high the game on spending on what you can not afford is over.

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#10) On December 26, 2007 at 2:14 AM, MakeItSeven (31.63) wrote:

That's why I said the unfolding scenario depends on two variables: the Fed and the consumers, neither of which we can accurately predict. 

Given the spiralling thread of deflation due to the "adverse self-reinforcing dynamic" of rising unemployment, lack of credit, lower asset values, the Fed will likely take drastic action.   That's what Peter Schiff is saying.

What kind of drastic action ?  It might apply Section 13 of the Federal Reserve Act and takes on all the risk.  So, credit card companies can borrow at very cheap rates (maybe 1% funds rate again) and issue credit cards at high interest to anybody who care to apply.  They can then turn around and give all those ABCP from the credit card debt to the Fed as collaterals to get more money to lend so the Fed will take all the risk while they take all the profit.  That will essentially drop money from helicopters as Bernanke once said he might do.

But then maybe neither official deflation nor inflation will happen since the BLS is pretty good at doctoring the CPI numbers to be pretty much anything it wants through the "productivity miracle". 

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#11) On December 26, 2007 at 3:25 AM, cluelessmorgan (82.87) wrote:

ok, so at least in theory, from what I understand, a credit economy poses the risk for deflation as money supply falls.  Since we are now at the point of last resort, where the banks won't even borrow from each other, but instead line up in droves at FED auctions, why is the FED more concerned over INflation and hesitant about cutting rates?

 

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#12) On December 26, 2007 at 8:24 AM, MakeItSeven (31.63) wrote:

The Fed is in a no-win situation.  If it goes all the way to cause inflation to rise then it will be blamed for the inflation which, of course, will hurt everybody without being to prove that its action averted a 1929-like deflation.   If it does too little and causes a 1020-style deflation then again it will be blamed.

Anyway, here is another opinion from the Freddie Mac CEO.  He was not the most prominent person pushing for the idea of "ownership society" though.

“But Syron outdid Mudd in expressing remorse for past business decisions and in describing the trouble that may lie ahead. If home prices decline by 30 percent, as one noted economist has said could happen, ‘We’re all going long apples and boxes to sell them in,’ Syron said, invoking an image from the Great Depression.”

“Syron traced the trouble in the mortgage business to a housing bubble and accepted some responsibility. Fannie Mae and Freddie Mac contributed to the problem by spreading the message that everybody should own a house, he said. In fact, many people who should not have owned houses bought them, he said.”

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#13) On December 26, 2007 at 9:51 AM, martynanasi (98.20) wrote:

DWOT...I have to agree with the stagfaltion scenerio...in my opinion and my knowledge of macro economics and the markets this seems to be somewhat happening already. US assets are declining through a depreciating US dollar. The US gov't is the largest debtor in the world and quite a bit of US assets are held outside of the US in terms of US bonds by other central banks and real estate, corp bonds and equities held by foreigners. We will see the Fed creep its rates down to 0 if needed to stave off stagflation as well just as Japan did. At one point they had negative interests rates and you actually had to pay the bank there to hold your money! It then becomes a balancing act with having severely reduced interests rates and the strength of the US dollar from a foreigners view in the risks of holding those US assets regardless of the form. Since it is been well known that foreigners have financed the US debt load for decades this becomes a fairly precarious situation as they weigh the costs and losses of holding US assets and start moving that money elsewhere. Globally the US is being looked at as weak, reducing interest rates more than other central banks with a consumer that has had a negative savings rates also for decades. Now we have a banking crisis in which they will tighten lending standards and revert back to a cash flow lending standard rather than an asset based one. Much like we have here in Canada....very big difference in the lending standards as here you have to afford your mortgage depending on your household income...in the US it is based off the house value which is why you see twenty somethings living in houses they can't afford and driving brand new cars.

So basically you will see foreigners start to turn off the financing tap of the US debt (current account and trade deficits) and move that money where they will get larger interest rates compared to the risk. Also some nations will start to move their US currency pegs and free float their currencies causing more strife for the US dollar. When this tap turns off then the mayhem will begin causing much of the 'make the 1929 look like a walk in the park scenerio'. This is a scenerio really because it is happening already and the US Fed doesn't have the tools to combat that since it has to worry about the domestic economy more so than how to react to foreigners pulling the plug. 

So the fed will drop rates which will cause infaltionary pressures to build since they are also using the monetary policy to provide liquidity in the US economy. Viola an inflation beast and price instability. Foreigners will pull out causing the dollar to destablilize and make asset prices move down (markets and real estate) and at the same time cause inflation pressure since we will be paying more for goods from the exchange stand point. Stagflation at it finest and something that will take years if not decades to repair. Just ask Japan.

 

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#14) On December 26, 2007 at 10:00 AM, dwot (39.30) wrote:

If the Fed was to take on all risk we would have not only have inflation, we would have hyper-inflation.  In my Part I of Six Degrees of Leverage I posted graphs of M1 and M2 money supply.  You really have to ask yourself why the fed quit reporting the M3 money supply in 2005, which is even more periless than the M2 money supply.

If the fed takes on all risk be very, very afraid of what that M2 money supply is saying because we will be going Zimbabwe.

Already inflation is coming in at 4.3%

The US is has gotten itself into so much debt trouble, it no longer controls it future.  The US needs people from other countries to loan it money and that completely dries up if they do what you suggest.  Everyone's retirement savings becomes worth pennies on the dollar.

Price increases on necessities, price decreases on discretionary items, or at least price decreases relative to the consumer price index, price decreases on assets and a massive revaluation of wages for what they are worth.  I can't see those that push money from one pile to another continuing to be as richly compensated as they have been.  I bet a lot of formerly good paying jobs go dodo-bird - many jobs have been recipients of the easy money that has dried up and that will leave a lot of people competing for far fewer jobs.

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#15) On December 26, 2007 at 10:11 AM, dwot (39.30) wrote:

Martynansi, I think you said what I'm seeing quite well. 

I think many use inflation and deflation incorrectly.  A price increase is not necessarily inflation, but inflation is constantly used to refer to price increases.  Inflation is an increase in the money supply and ultimately leads to price increases.  You can have a constant money supply, ie, no inflation, but have price adjustments where one thing goes up and something else goes down.  That isn't inflation.

I've been using the money supply definition of inflation/deflation when I say I'm thinking we are going to see some deflation, meaning a contraction of the money supply, but at the same time I think there will be price adjustments, that which we have little choice about buying will go up in price.  

If you look at that M2 money supply, price increases have a long, long way to go to catch up to the M2 money supply.  I think it gets fixed by a combination of a contraction of the money supply and some price increases to catch up to where the money supply has already gone. 

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#16) On December 26, 2007 at 12:57 PM, dwot (39.30) wrote:

More support for my position, http://bespokeinvest.typepad.com/bespoke/2007/12/q4-sp-500-earni.html

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#17) On December 26, 2007 at 1:53 PM, floridabuilder2 (99.33) wrote:

my bet is deflation.. however, in the interim I'll stay long stocks as long as the major indexes are not falling off a cliff....  land (as I posted in the comments section of TDRH's latest blog post) and my earlier blog posts is in a huge deflationary vacuum...  the 40% Lennar got for book was impaired book...  I will stand by my point that land prices for residential future land use is down 65% on average across the US.... it makes those 20% drops in housing look like a blip.... 

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#18) On December 26, 2007 at 6:01 PM, dwot (39.30) wrote:

The battle of the economists continues, they both counter, http://globaleconomicanalysis.blogspot.com/2007/12/peter-schiff-replies-to-deflation.html

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#19) On December 26, 2007 at 8:44 PM, camistocks (< 20) wrote:

The "economists":

-"Mish"- when I went to his blog I first had to look closer to make sure I would not click on an advertisement. In fact he seems to be making quite a decent income from all those bears clicking on his webpage and ads and generating commissions.

-Peter Schiff . from WikipediaSchiff is known for his extremely bearish views on the United States stock market, bond market, the US dollar, and the United States economy in general for which he has earned the nickname "Dr. Doom." He is also credited as a contributor to his father's 1985 book, "The Great Income Tax Hoax: Why You Can Immediately Stop Paying This Illegally Enforced Tax".

He even wrote a book and guess how the title is: "Crash Proof - How to profit from the coming economic collapse" 

Heck this feels like a time machine, I feel like being warped back to 2002/2003, when the US and the financial system were supposed to collapse... I read all the same kind of pessimistic articles back then. Hey I confess, at a time I was a reader of "The Daily Reckoning", a super bear site, to which coincidentally Mish is a contributor...

 

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#20) On December 27, 2007 at 1:27 PM, dwot (39.30) wrote:

I know that you are not bearish Camistocks.  However, even for your investing strategy Mish's latest post is probably worth reading.

How does one Invest for Inflation and Deflation? 

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#21) On December 28, 2007 at 12:16 AM, camistocks (< 20) wrote:

Why does he only talk about extremes, like hyperinflation or deflation...?

Also, I noticed a google ad on the left (it disappears from time to time, but comes back) which says the following:

'08 Stock Market Crash is

only the beginning of troubles for America, leading to it's demise. www.the-end.com 

If you click on the link you come to an armageddon website by some religious lunatics. The other ads are all gold bugs websites. Hey, dwot, are you becoming a gold bug...?!?! ;-)

 

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#22) On December 28, 2007 at 5:57 PM, dwot (39.30) wrote:

No, I am not a gold bug, but with the recent rise in the price of gold I wish I'd gotten some.  I was seriously considering it when it bottomed a while back.  I suppose if the bottom had lasted a week longer I'd have gotten some.  But now it feels like chasing it and I don't chase investments.

I personally think what has happened in the market is extreme and the correction will be extreme, a combination of a contraction of credit and with that some deflation, but the money supply has been so grossly increased due to loose credit and off balance sheet activities, I don't see all of that excess money supply disappearing.  

If you look at the money supply, in order for wages to have kept up with the money supply they needed to pretty much triple in the past 5-8 years.  I was thinking about it last night and I don't think all that excess money supply hasn't worked its way into the economy.  We have seen it in excessive price increases in housing.  You have had people absorbing it through savings, not domestic savings.  The world is holding a lot of US dollars and if they stop being horded and are put back into the money supply and you feel that money supply through gross increases in food and other consumer products.

The money supply can't be fixed at this point but it is going to have to find some kind of new balance.

 http://i169.photobucket.com/albums/u235/dwothers/m1andm2money.jpg

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#23) On January 10, 2008 at 10:07 PM, mgiv (97.96) wrote:

the solution to the credit crisis is default. free up cash flow so the rest of the economy can breath. how many banks and financial institutions could there possibly be.  the space is so competive flimsy institutions forced down risk

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