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Deflation Conveyor Belt



February 24, 2008 – Comments (17)

Counterpunch has an article with a quote I like about the monetary system that is an excellent image of deflation at work:

 "Imagine a 200 ft. conveyor belt with two burly workers and a mountain-sized pile of money on one end, and a towering bonfire on the other. Every time a home goes into foreclosure; the two workers stack the money that was lost on the transaction, plus all of the cash that was leveraged on the home via "securitization" and derivatives, onto the conveyor-belt where it is fed into the fire. That is precisely what is happening right now and the amount of capital that is being consumed by the flames far exceeds the Fed's paltry increases to the money supply or Bush's projected $168 billion "surplus package". Capital is being sucked out of the system faster than it can be replaced which is apparent by the sudden cramping in the financial system and a more generalized slowdown in consumer spending."

And a quote within the article:

 "A year ago $20 million would have gotten Luminent Mortgage Capital Inc. access to $640 million in loans to buy top-rated mortgage-backed securities. Now that much cash gets the firm no more than $80 million. ... (Only) 6 lenders are offering 5 times leverage, while a year ago, 20 banks extended 33 times."

There have been a few debates about inflation/deflation and the definitions are all over the map and inconsistent with each other.  There has already been way more "inflation" than we realize, yet the "price increases" due to the inflation have not worked through the system.

To me, inflation and price increases have been used interchangeably for so long, the concise difference is lost, much like many people interchangeably use minus for negative and vise-versa.  In most cases it doesn't matter, people know what you are talking about. 

You simply can not have a definition of inflation that includes money supply and price increases and have those definitions really describe what is happening in the economy.  They mostly work together, but, the price increases are a delayed response to increased money supply and can be caused by other things.  To better understand the common misuse of these words, give this a read.

The money supply has already increased to the point that we should all feel utterly sick about it, as the graph shows:

M1 and M2 Money

The developments over the past 10 years in the financial industry have effectively increased the rate of growth of the money supply.  I am not sure where the mortgage bonds, etc., show up in the tally of the money supply, and they thwart the intention of regulations that required a level of reserves for credit.  So regulations that were intended to control the increase of money supply through credit completely fail and we have the banks acting like Sammy Slimy with his printing press in his basement. 

This gross level of increased money supply has only been showing up in a few areas, the cities with homes priced 5-12 times median wages, commodies like copper which was under $1 in 2002 but peaked at over $4 and has ranged between $3-4 since the peak.  The same is true for all base metals, and it seems to me with their vast expenditures and need for raising capital to build new mines, well, they are first in the price food chain and responded to the increased money supply early.  Sure there is also supply and demand, but the price increases of the 21st century are far beyond any reasonable historical increases and I would suggest the backroom banking activities comparable to Sammy Slimy with his illicit printing press in his basement are responsible and the only real commodity that we use everyday and see in our home balance sheets that has adjusted to the increased money supply is oil. 

There is no question there are going to be some fairly significant price increases coming, but these are in response to previous inflation, and aren't here yet due to the time delay in working increased money supply into the system.

The US has an increased delay for inflation to translate into price increases because of its status as a world reserve currency.  The volume of US dollars sitting in foreign bank accounts effectively takes those dollars out of circulation and prices are as though they don't exist. Some say the US has effectively been exporting their "inflation" because of this practice... Just look at China's double digit inflation...

The trend of foreigners taking US dollars out of circulation is reversing and that's going to show up as price increases, but it is not an increase in the money supply.  That has already happened to an extent far beyond the current pricing of goods.  There are so many of those dollars out of circulation, well, it has resulted in a totally unrecognized degree of privilege in buying power, and a privilege that has been taken for granted and completely unrecognized as to where it comes from. 

Those dollars head home, or the rate they are bought up by foreigners simply slows down or stops, and the privilege ends and the value of American output gets repriced towards the value the rest of the world gets for their output.  The stagnant wages despite increases in the money supply suggest that that process has begun, although sectors with first access to the gross increases in money supply have seen wage increases far beyond other sectors of the economy over the last ten years, the financial sector and sectors related to home building would be examples. 

And the people who work in the sectors that saw the largest benefit will be the hardest hit with the current deflation of the money supply.  Their wages will decline the most and they will have the hardest time adjusting to the lesser lifestyle.

So, there will continue to be price increases due to the current money supply, but the money supply is deflating and there is a highly leveraged effect of this deflation.  Right now I'd say the mortgage backed bond holders are taking the largest hit of the current deflation, followed by home owners in bubbled cities, and somewhere in there is the highly leveraged investor, either through direct personal choice, or indirect personal choice of a highly leveraged invest fund of some kind.   These price decreases are a result of deflation, or a reduction of money supply due to credit contraction.

17 Comments – Post Your Own

#1) On February 24, 2008 at 11:05 AM, dwot (29.24) wrote:

Daily reading: 

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#2) On February 24, 2008 at 11:09 AM, abitare (30.30) wrote:


You are non stop posting, don't you get to sleep? 

Prof Shiller from Yale Jan 08, comparing todays crisis to great depression.


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#3) On February 24, 2008 at 11:12 AM, XMFSinchiruna (26.58) wrote:

Another well-researched and informative post from the Queen of CAPS.  :)  Thanks so much!

 So dwot, if I may ask... I know how you feel about many of the metals mining companies being overbought... but where do you stand on the spot prices of gold and silver and where you see those tracking forward in the context of the inflation/deflation dynamic you lay out above.


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#4) On February 24, 2008 at 12:15 PM, dwot (29.24) wrote:

Funny you should ask about that, I was just commenting on that on your post from today.

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#5) On February 24, 2008 at 12:25 PM, dwot (29.24) wrote:

And on the base metals, I still approach them with a very cautious view because I think changes in supply and demand for them could easily catch investors by surprise.  I just don't think the emerging economies are growing fast enough to pick up all the slack from the slowing down in the industrialized economies, and a considerable amount of the demand from the emerging economies has been to build exports to the industrialized economies.

Hmmm, I just looked back at that comment...  I am not sure what you call the G7 economies anymore, but they have essentially de-industrialized in favor of the emerging economies becoming industrialized, so to call them the "industrialized" nations is truly becoming a misnomer.

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#6) On February 24, 2008 at 12:27 PM, dwot (29.24) wrote:

Yeah abitarecatania, so I am a prolific writer...

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#7) On February 24, 2008 at 1:14 PM, dwot (29.24) wrote:

Here's another good read...

I guess what gets my attention is that it talks about the increasing economic power of the emerging enonomies, but also mentions "de-coupling."  Those that argue that commodities are going to continue to increase because of the emerging economies basically believe in de-coupling whether they have formally stated so or not.

I don't believe those economies will de-couple, hence my big caution on the base metals and perhaps why I also think oil will have a downward correction.  (If the US dollar devalues further relative to other currencies downward corrections get hidden in the currency devaluation and that is a separate issue.) 

What gets my attention is "this may be the last time" the emerging economies are affected by down turns in the US economy.  That is exactly what I think, these economies have to slow down through the adjustment to more independent economies, and once they go through that process, then they take off on their own merit.  But I think there are a few tough years for them as the economy adjusts to slowing exports, exports that may slow far more rapidly than ever anticipated. 

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#8) On February 24, 2008 at 1:29 PM, podrag (< 20) wrote:

I would argue that because our currencies are not backed by anything, the inflation of money supply will continue. The Fed is already accepting toxic cra9 as collateral, monetizing debt... basically doing anything to keep the printing presses running. This won't be like 1929 in America. It will be more like Germany in 1923. A credit contraction will not be allowed to happen.

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#9) On February 24, 2008 at 1:47 PM, dwot (29.24) wrote:

podrag, a credit contract is happening. 

The quote about getting 33x the leveage for capital and only getting 5x is an example of a credit contraction.  People having credit cards cancel and HELOC's cancelled are examples of credit contraction.  Fewer people are qualifying for loans, that is a credit contraction.

It seems to me the fed accepting the bad debt as collateral, which is simply in a short term window, has more in common with how Japan did not have bad loans market to market rather than what happened in Germany.

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#10) On February 24, 2008 at 2:35 PM, abitare (30.30) wrote:


You should be writing for some agency or magazine and not us little people.... 

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#11) On February 24, 2008 at 3:30 PM, kurtkalamar (< 20) wrote:

Great article! 

Historically speaking... during the Great Depression silver's value fell by half from 1929 to 1932.  Then tripled in 1933.  Then leveled off a little below its 1929 value in 1934...

Interestingly enough, FDR made it illegal for citizens to own large amounts of gold in 1933.  They had to turn it in to the Federal Reserve for government redemption promises and of course got subsequently screwed... 

Not saying this is likely to play out again.  But you got to watch that government.  They can do some wild things. =)


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#12) On February 24, 2008 at 4:34 PM, dwot (29.24) wrote:

Thanks kurtkalamar.  There are a few stories in history of governance screwing trusting citizens with borrowing wealth.  It makes me feel uncomfortable.

 I just saw this graph, hopefully I can make it show up...  It is pretty scary wrt to how much reserves banks have now, ie, they are now borrowed and that's why they were unable to support the relatively safe municipal bond market.

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#13) On February 24, 2008 at 4:36 PM, dwot (29.24) wrote:

My goodness, the post with that graph says "banks are now subprime."

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#14) On February 24, 2008 at 5:20 PM, abitare (30.30) wrote:


How do yuo post a picture?


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#15) On February 24, 2008 at 5:35 PM, dwot (29.24) wrote:

You have to have the picture somewhere, either stealing bandwidth from someone else's post like what I did above, or uploading your picture to a site designed for that, like I did in photobucket for the m1/m2 graph.

then between the less than/greater than brackets <>, you put:

img src="http:...." 

The web address needs to be in the quotes. 

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#16) On February 24, 2008 at 8:09 PM, abitare (30.30) wrote:

Thank you.

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#17) On February 24, 2008 at 8:43 PM, floridabuilder2 (98.21) wrote:

leverage and the cost of debt are the reason why REIT properties are going down in value.....  as LTV goes up and so does the cost of debt it means the buyer has to pay less in order to meet his return hurdles....

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