Deflation We Win, Inflation We Win Big Time

Let’s talk about deflation a little. Like I said in a previous post, deflation today is a different animal than it was in the 30’s. While it is impossible to have monetary deflation today, deflation can happen. That’s why we need to redefine what exactly we mean when we use the term deflation.

Let’s start with a few definitions:

Monetary deflation – In this case, we have the literal destruction of money. This only happened one time in the 30’s when monetary authorities let banks fail and whipped out the savings of millions of people. This is not the case today.

Price deflation – This is more or less the deflation we all know and feel and it’s what I call good deflation. It’s the result of competitive forces, globalization, high inventories and yes, recessions from time to time.

Asset deflation – This is the most dangerous type of deflation. In this case, assets of all sorts get reduced in price across the board. The problem with Asset deflation is that most loans are based on different assets and thus, when assets get discounted, the loan portfolios of banks (which are based on these assets) get eroded and you end up having a banking crisis like the one we are having today.

We do not have monetary deflation today because central banks are printing money like madman. If we had monetary deflation (in which case central banks would not have printed money), chances are that most banks in the known world would have already been broke and most people would have lost all their savings by now. But this is not the case.

By default, if we have monetary deflation, then we will also have price & asset deflation. If the money in circulation becomes less, then all assets, goods and services will end up costing less. This is what happened in the 30’s.

Like I said, we do not have (and won’t have) monetary deflation.

(Let me add a note here so there is no misunderstanding. If your definition of money is anything that can be exchanged for goods and services, including credit, then indeed we are also witnessing monetary deflation. Credit is being destroyed at unprecedented levels. However, I am not using this definition for money.)

Now let’s talk about price deflation. I have been arguing for more than 5 years on my site that the inflation we witnessed is a product of cost push commodity inflation. While the result has been an increase in prices paid by consumers all across the board, nevertheless it had nothing to do with the inflation of the 70’s. Back then, companies raised prices and people paid for them with no questions asked. Today, companies raise prices very reluctantly and only as a last result.

The end result has, over the last 5 years, been an erosion of margins for many companies (ex commodities), especially industrial. But this has been exclusively due to high commodity prices and not the result of anything else.

So if prices today at the CPI & PPI level fall, why is that a bad thing? Well it’s not and that’s why we should not worry about it. Price deflation as we are witnessing according to the latest CPI & PPI data are not only good, but will be a determining factor to getting consumers balance sheets back in order and changing consumer sentiment looking forward. In fact, according to this article, Americans will save $300 billion in 2009 if the price of oil stay this low.

So if monetary deflation and price deflation is not a problem, then that leaves us with Asset deflation.

Well here we have a problem and it’s a big one. Assets deflation (as you have already figured) is the main cause of the current bank problems. Asset deflation erodes corporate, bank and household balance sheets and deters banks from lending. This of course has a negative impact on growth and consumer spending. Compounding the problem is the deleveraging and forced asset sales (which is more the cause than a product of deflation).

So the next question is how do you combat asset deflation?

Well that’s the million dollar question. No one really has an answer. One can argue that monetization by the central banks will do the trick, but that will have an impact on the value of money. Inflation, say many analysts, is the only way out. This might be correct, but first we have to finish with the current deflationary forces before we worry about that problem (Even then, I doubt that we will experience hyperinflation).

My hope is that assets get pulverized so much, that investors start buying regardless of the deflationary forces in play. We might be at such a crossroad now. Not only are stocks cheap at the current junction, but one can argue they have never been cheaper.

While house prices in the EU have a lot more down to go, I don’t think that we will see house prices in the US fall further. While the Bulk dry index has fallen 90%, it’s only a matter of time before it goes up again, because you no one will deliver goods at a loss. Same for oil: from what I understand, many wells are being taken off line because they are operating at a loss. This however, will at some point, have an impact of supplies and logically it will be only a matter of time before prices go up again.

In other words, the best way to remedy deflation is to let the markets discount assets to such a point that investors will be jumping in no matter what.

However, this does not solve the problem of leverage. The pain problem today is that there is not enough cash in the planet to liquidate all these assets put up for sale. That’s why we have central bank balance sheets exploding. It might take a couple of more trillion of central bank printing before it’s all done, but at some point it will be done.

Which leaves us to the next question: What will become with all the money printed by central banks?

Well your guess is as good as mine, but let me offer a few suggestions.

A big portion of this liquidity will be reversed and take out of circulation at some point. Why? Because all these transactions are sterilized. This is not money going to main street but into a black hole for bank balance sheets and derivatives.

Hopefully, asset prices will in the future rise again and there will be buyers at some point and central banks can reverse many of these trades. This might take several years, but it will also be done at some point.

Let now offer a different and more radical answer and perhaps something you have not heard of before.

The problem today is not that there is too much liquidity, but that there is not enough of it. Especially in third world countries, the problem is that there is not enough cash going around.

What I want to say is that maybe the world needs all this liquidity to operate and maybe it might be a good thing that it will end up on the street in the future. Maybe the deflationary forces at play are a way for the markets to force more liquidity in the real economy as opposed to having only credit to go by? Who knows?

I’m sorry, but I have always (in my writings) feared asset deflation than inflation. Maybe China and India need more currency in order for people to have more money to spend. I mean, how can you expect people to live better in $1 a day? And how can people get a raise if there is not enough money in circulation?

Suppose that we were on the gold standard. Suppose that we had a major population increase but the central banks didn’t buy enough gold to justify the demand for more printed money. Forget about credit and bank loans and deleveraging, you would still end up with deflation if something like that happened. More goods chasing at less money is another good definition of deflation.

Bottom line

• Monetary deflation is not an issue (depending on your definition of money)

• Current price deflation in the PPI & CPI is a good thing 

• Asset deflation is the big problem and honestly, we don’t know how to solve it. Chances are that all the central bank printing will do the trick, but, if they are not careful in mopping up several years ahead, it can have inflationary consequences.

At the end of the day, perhaps the system needs all this liquidity that the central banks are creating and perhaps it’s prudent that it enters people’s wallets after several years. You can’t have 10% growth in china with credit alone, at some point you need real money in people’s pockets.

Where does that leave us as far as stocks are concerned?

Well, asset deflation will end at some point and assets will again go up in value. Equities are so distressed and so mispriced that, at this point, I see a win-win situation no matter what happens from here on end.

Deflation we win, inflation we win big time.

Comments

[granger:]

Good stuff, keep it coming.

One of the best articles detailing inflation I have read. Thank you.

2008 Nov 24 05:52 PM

[Bobco23:]

Your article stirred a concept I have been wrestling with for a while. This is a bit simplistic, but perhaps you can flesh it out.

If we do include credit in the definition of money, then the constriction of credit reduces the total of the combined components of "money supply," i.e., cash and credit. If we print a few trillion dollars, are we not merely replacing the "lost" credit component of the "money supply?" Don't we just get back to zero at some point (from very negative), and given the unimaginable amout of credit losses is it not unlikely that we will not get above zero (inflation comes after we exceed zero) any time soon? Monetary inflation thus becomes a low probability.

2008 Nov 24 08:04 PM

[George Kesa...:]

Theoretically, central banks can simply write off all the assets they have exchanged with the banks and harm will be done. The problem with that is this: Who will determine who will get a free lunch?

If every central bank simply forgives the banks and everyone who has taken advantage of the system, then everyone will do it and you have what we call moral hazard.

However, your assumption is correct. In terms of monetary aggregates we will end up with a zero sum scenario. However, then all this liquidity will end up on the main street and it will have inflationary results. How much however is anybody’s guess, especially since as I think that we need more liquidity in the world and not less.



On Nov 24 08:04 PM Bobco23 wrote:

> Your article stirred a concept I have been wrestling with for a while.
> This is a bit simplistic, but perhaps you can flesh it out.
>
> If we do include credit in the definition of money, then the constriction
> of credit reduces the total of the combined components of "money
> supply," i.e., cash and credit. If we print a few trillion dollars,
> are we not merely replacing the "lost" credit component of the "money
> supply?" Don't we just get back to zero at some point (from very
> negative), and given the unimaginable amout of credit losses is it
> not unlikely that we will not get above zero (inflation comes after
> we exceed zero) any time soon? Monetary inflation thus becomes a
> low probability.

2008 Nov 25 06:22 AM