dwot (99.56)

Betting on Japan Style Deflation

January 10, 2008 – Comments (8)

In my post Battle of Economics: Inflation or Deflation I briefly contrasted Mish and Schiff, one of whom is in the deflation camp, the other in the inflation camp.

First, many people have an incorrect definition of inflation.  Price increases can be a result of inflation, but price increases and inflation are different things.  Inflation is an expansion of the money supply.  When the money supply increases, prices tend to go up.  But, for example, oil is not going up just because of inflation, it is going up more so in response to supply and demand issues. 

The money supply has increased beyond any reasonable measure of restraint, control, prudence and financial security.  The banks loose lending standards have increased the money supply in the range of 150% (ball park number sense figure) this decade, ie it is 250% of what it was.  Do a search on M1, M2 and M3 money supply to better understand the leveraged growth of the money supply due to loose credit.  In the comments in my post Six Degrees of Leverage: Part I I have graphs of the M1 and M2 money supply.  The fed quit reporting M3 money supply, but what you can find of it looks far worse than the M2.

Everyone sees the results of the loose lending standards and gross expansion of the money supply -- housing has gone through the roof and beyond affordability.  Corporate balance sheets have never looked better, so I've read, but how good do they look compared to how much money is out there?  There has been enormous profits and the stock market has leveraged up on the profits.  It makes the entire financial system periless, and leverage unwinds in a very nasty way.  No one saw the Thialand stock market decline of something like 90%.  I am sure there were bears like me, but I bet the 90% decline suprised even them.

This morning my reading list included Naked Capitalism.  The mortgage resets and absolute garbage from the grossly negligent lending standards will continue until about 2010.  Every quarter will bring more of this garbage back to the balance sheets.  The Naked Capitalism post is proposing that we are going to see Japan style deflation because the banks will not be able to lend money due to so many bad loans on their books. 

Stopping lending is essentially a credit contraction and deflationary.  The vast majority of inflation has come from loose lending standards that has cause the money supply to grow to insane levels and the gross asset price inflation in home, in commodities like base metals, gold, food.  

This doesn't mean that we don't see price adjustments.  For example, food and consumer goods have not increased at the same rate that the money supply has increased and although I expect deflation, I do not expect deflation back to the level of money supply that consumer goods are currently priced for.

The credit expansion of the money supply is something like 30 times the existing money supply, and I am not sure if that figure has the off balance sheet stuff included in it.  My instincts are that it does not include it because if you look at Six Degrees of Leverage Part III and the data for a 30 year mortgage you can see the amount a person would qualify to borrow has increased by 177% as rates go from 12 to 2%.  That doesn't include allowing larger percent of of income to qualify, the very change of second mortgages from 10 years to 30 years is actually an increase of 283%.  To me it looks like this increased leverage of the money supply is only about the stuff on the balance sheets.

It means for an enormous contraction of the money supply and deflation and I suspect it will take years to stablize and come back to a reasonable balance, much like Japan has seen real estate price declines for something like 18 years in a row.

As I am in the deflation camp I think it is plausible that there is a large enough decline in the market to cause serious problems for brokers because of leveraged clients. Financial stocks have fallen off a cliff and I suspect there are the odd individuals who were leveraged and not able to cover margin calls.  I expect more of this and it is why I decided to move my money out of a brokerage account.  I don't trust the brokerage insurance any more than I trust the mortgage insurance.  Capitalism has proven itself to be incompetent in adequately pricing risk into insurance.

I also tend to think there would be increased tax burden for property owners as government budgets become more stressed.  The money has to come from somewhere and property owners would be good targets.  Britain has what's known as a Council Tax and households are taxed rather than property owners.  I am not sure, perhaps property owners are also taxed, but everyone shares the municipal costs in Britain.  Who knows, this kind of tax system might be introduced.   But, I think homes will be repricing the carrying costs so that people will be choosing more modest homes.  A larger tax burden for a property also pushes the price down.