Why Are Investors Swallowing the Deflation Myth?

Dumb and Dumber is the title of the 1994 comedy film starring Jim Carrey and Jeff Daniels. The title could also be applied to the current behavior of both institutional and individual investors. Both type of investors are cowering in the corner, afraid of the bogeyman – deflation. Both types of investors are eagerly purchasing Treasuries at zero per cent or even negative interest rates.

One of the few things I can say for sure about investing is that the crowd always ends up being the long-term losers. And the deflation trade is extremely crowded right now. I challenge anyone to show me when the consensus opinion was ever right in the long term.

It is the few investors who think outside the mainstream consensus that usually end up being the big winners. If you want to be a successful long-term investor, you have to THINK FOR YOURSELF.

Individual investors need to remember where the “sage” advice is coming from that they receive on media outlets such as CNBC. It comes from Wall Street. At 2007's year-end, the five largest Wall Street securities firms paid their employees $66 billion in bonuses. All of these bonuses came from phantom “profits” that we've since discovered to actually be huge losses.

Perhaps these actions by Wall Street are even criminal. At the least, they are immoral. Yet, people still take advice from Wall Street as if Wall Street was Moses coming down from the mount with stone tablets. I cannot believe people are so gullible. Truly dumber.

Dumb and Deflation

Investors' gullibility is really showing with the way they have swallowed the entire deflation myth hook, line and sinker. It's hard to believe that people can't see that Treasuries yielding zero per cent means that Treasuries are trading at BUBBLE valuations. How can an investor spot a bubble?

One major attribute of every bubble in history is that it is “sold” with a great story. We have that today – a great “story” is being told - the fairy tale known as deflation. Deflation has been made out to be this horrible monster of mythical proportions by the government and by the mainstream financial media.

The “story” is being spread by mainstream financial media outlets such as CNBC, where if they are not talking about Apple Computer (AAPL), they're talking about deflation. By the way, I have always amused by the name of CNBC's chief economic correspondent, Steve LIESman. What an appropriate name!

Scary tales of a global recession and collapsing financial markets are spiced up with dark remembrances of the Great Depression of the1930s and Japan in the 1990s. These fairy tales have driven investors to protect themselves against the deflation “monster” by blindly purchasing “risk-free” Treasuries at any price.

Another attribute of every bubble in history is that they are believed to enjoy the support of the governing authorities. The governing authority in this case is the Federal Reserve. I'm sure we all recall how the “Greenspan put” of the 1990s emboldened stock speculators, leading to the dot-com bubble.

Now we had the recent announcement by the Fed that they would be purchasing government bonds. This announcement has led Wall Street to believe that there is now a “Bernanke put”, placing a floor under the Treasuries market. This has led directly to the bubble-like valuations in Treasuries.

Bubble Blowers

One of the biggest culprits in this government bond bubble has been the institutional investors on Wall Street. Many institutions have sold off all other types of bonds and replaced them with Treasuries. Many other institutions have “diversified” into Treasuries since they have held up in value while just about everything else has collapsed in price.

Whatever happened to buy low and sell high? The bond bubble is just the latest example of “herd” behavior on Wall Street. People on Wall Street only feel comfortable inside the “herd”, doing what everyone else on Wall Street is doing. You'll rarely see an independent thought.

The other big culprit in this government bond bubble has been so-called sophisticated hedge funds. They are playing a game of “musical chairs”. They are planning to “ride the wave” while bigger fools buy Treasuries from them. They, of course, hope to get out before the music stops.

When the music does stop, this hedge fund behavior will only lead to everyone rushing for the exits at the same time. As usually happens, most will not get out in time. I continue to maintain the following – I don't care whether a bubble is created by greed or as in this case – fear. A bubble is still a bubble and will end badly as bubbles always do.

I Smell Smoke

The smoke that is wafting toward my contrarian investor's nose smells like future inflation to me. The so-called investors that are acquiring Treasuries now are forgetting about all of the weapons that are at the disposal of “Helicopter Ben” and the Federal Reserve.

With the paper currency system that we have currently, a long-lasting deflation is simply impossible. Why? Because there is no limit to how much money the Federal Reserve can create out of nothing. There are also no constraints on what the Fed can do with the money.

Wall Street is acting as if the Fed can only buy Treasuries and can only pump money into our economy through the banking system. That is typical of Wall Street thinking – no one thinks outside of the box.

What is there to stop the Fed from sending money directly to the populace through a check or debit cards? Nothing! What is there to stop the Fed from purchasing other assets directly – stocks, real estate, commodities, junk bonds, or whatever they wish? Nothing!

That smoke that I am smelling is Ben Bernanke and the Federal Reserve thinking outside-the-box on how to start an inflationary camp fire. The Fed will eventually succeed in starting the fires of inflation. I can't wait to see the Fed roasting those deflation and Treasury “marshmallows” on that camp fire!

The danger will occur if Ben doesn't put out his inflationary “camp fire” soon enough and it turns into a raging forest fire, which consumes the US dollar. This forest fire will not only anger Smokey the Bear but probably leave many Wall Street firms in ashes.

The deflationists should simply heed the words of Ben Bernanke from his famous November 2002 “Helicopter Ben” speech. Here are two direct quotes below from that speech:

Quote #1 -

The US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices of those goods and services.

Quote #2 -

We conclude that, under a paper money system, a determined government can always generate higher spending and hence positive inflation.

Ben Bernanke and the Fed seem to be very determined to me to start that inflationary camp fire. Why isn't Wall Street following the old adage - “Don't fight the Fed”? Why are they fighting the Fed? I guess they are just dumb.

Comments

[patio:]

Yeah, THINK FOR YOUSELF. There are a thousand gold bug articles pounding their fists saying inflation is coming ( all better written than your silly little rant ). What a unique perspective you bring....NOT.

Jan 21 08:53 AM

[prudentinve...:]

Deflation is impossible if central banks don't want it. After all, they have the power to increase money supply, arbitrarily and endlessly.

Naturally, the central banks have other considerations including preventing hyperinflation and preventing a global crisis if one major currency loses value too rapidly relative to others. So, they may allow modest deflation for relatively short periods, perhaps up to a year, but they will prevent deflation of any significant magnitude and duration.

Jan 21 08:54 AM

[Timmothy Posey:]

To be fair, the Fed also has the tool of purchasing Treasuries themselves (monetizing the debt), and have signaled their intentions to do so. This could keep the Treasury Bubble going much longer than we expect.

Jan 21 09:25 AM

[Tradememe:]

People swallow the deflation story because of the doom and gloom environment. If you believe that this global recession is depression 2.0, then deflation is the logical conclusion.

Jan 21 09:32 AM

[John Polomny:]

Everytime that one of these articles comes out I post a link to Mervyn King's (Former UK Central Banker) research paper 'No money, No Inflation" I always get many more thumbs down but I wonder if anyone ever reads it. The paper shows that in a fractional reserve type system that creating inflation has been done many times in many countries over the years, usually with a time lag, and can be done by the US and UK central banks. This article is exactly correct in that the central bank can create money out of thin air and directly buy assets. The Fed has committed to buying $500 billion in MBS securities and who knows how many treasury bonds. Thats why the yeilds on these have come in. With productive capacity contracting and money being created (all money aggregates MZM, TMS, M1, M2 are up) of course prices will eventually move higher.

Jan 21 11:27 AM

[patio:]

To date, the losses in housing value and stocks equals $10T, expected to be $12T by mid-2009. $12T of wealth, poof. Thats just in the US, now add in global wealth losses.
Now explain to me how the Fed, and other central banks globally are going to print enough money, that actually goes beyond banks into the system, to replace that lost money?
Everything being done is to avoid a car wreck, while choosing cancer instead, and hoping the chemo over time cures the cancer. The Fed doesn't have the power to resolve decades of easy credit, and the over-leveraging malaise it has created. Perhaps the power to soften the crash...perhaps.


On Jan 21 11:27 AM John Polomny wrote:

> Everytime that one of these articles comes out I post a link to Mervyn
> King's (Former UK Central Banker) research paper 'No money, No Inflation"
> I always get many more thumbs down but I wonder if anyone ever reads
> it. The paper shows that in a fractional reserve type system that
> creating inflation has been done many times in many countries over
> the years, usually with a time lag, and can be done by the US and
> UK central banks. This article is exactly correct in that the central
> bank can create money out of thin air and directly buy assets. The
> Fed has committed to buying $500 billion in MBS securities and who
> knows how many treasury bonds. Thats why the yeilds on these have
> come in. With productive capacity contracting and money being created
> (all money aggregates MZM, TMS, M1, M2 are up) of course prices will
> eventually move higher.

Jan 21 12:55 PM

[peterthepai...:]

i don't think i have heard anyone prediction perma-deflation...

just a period of it...

if the fed, bank of england, boj etc. are sh*t scared of it...

to the tune of trillions of dollars of a fight against it...

then they must have some faith in it's reality...

in the FT today (lex)...they look at yield curves...

as a result of this absolutely massive stimulus...

the expectation is that deflation will happen...but much and not for long...

they also expect, after this said massive stimulus...

that inflation will be only 2-3%ish...

ps...i think most people are hiding in treasuries for the return of their money...not a return on it...

Jan 21 01:02 PM

[John Polomny:]

Did you read Mr. Kings paper? Inflation is the one outcome that the Central bank can 100% ensure. Do not sit here and tell me the FED cannot create inflation as they did it in the 1930's. The money supply went from around $20 billion in 1933 to around $30 billion in 1936. PPI went from around 10 to about 15 over the same time period. The DJIA went from around 100 to about 150 from 1933 to 1936. This is consistent with Mr. King's assertions in his paper. This was not real economic growth because if you look at the data you will see that beginning in 1937 the monetary spigot was shut off and all of the above indicaters went into reverse. You are confusing the time lag in the application of the policy with a failure in the policy. You can go to the St. Louis Fed website and look at the monetary aggregates they are published every week and they are up over 10% year over year.


On Jan 21 12:55 PM patio wrote:

> To date, the losses in housing value and stocks equals $10T, expected
> to be $12T by mid-2009. $12T of wealth, poof. Thats just in the US,
> now add in global wealth losses.
> Now explain to me how the Fed, and other central banks globally are
> going to print enough money, that actually goes beyond banks into
> the system, to replace that lost money?
> Everything being done is to avoid a car wreck, while choosing cancer
> instead, and hoping the chemo over time cures the cancer. The Fed
> doesn't have the power to resolve decades of easy credit, and the
> over-leveraging malaise it has created. Perhaps the power to soften
> the crash...perhaps.

Jan 21 01:50 PM

[Jim Hawthorne:]

prudentinvestor hit the nail on the head (again!)

The Greenspan/Bernanke Fed has always been focused on fighting inflation; the devil they know. Their experience tells them (and shows us) that they can deal with inflation simply and effectively.

Deflationary spirals lead directly and unerringly down into depression, and in my opinion are just about unstoppable unless the money supply is dramatically increased.

Our Fed (and also the other global Central Banks) will pick the path of least resistance and simply fire up the printing presses in order to prevent a deflationary spiral.

We have seen commodity and all asset prices decline to the point that most if not all Central Banks are about ready to flip the switch.


On Jan 21 08:54 AM prudentinvestor wrote:

> Deflation is impossible if central banks don't want it. After all,
> they have the power to increase money supply, arbitrarily and endlessly.

>
>
> Naturally, the central banks have other considerations including
> preventing hyperinflation and preventing a global crisis if one major
> currency loses value too rapidly relative to others. So, they may
> allow modest deflation for relatively short periods, perhaps up to
> a year, but they will prevent deflation of any significant magnitude
> and duration.

Jan 21 02:01 PM

[Tony Daltorio:]

I totally agree with you. The $12 trillion lost is a drop in the bucket as compared to what the Fed can do.


On Jan 21 01:50 PM John Polomny wrote:

> Did you read Mr. Kings paper? Inflation is the one outcome that the
> Central bank can 100% ensure. Do not sit here and tell me the FED
> cannot create inflation as they did it in the 1930's. The money supply
> went from around $20 billion in 1933 to around $30 billion in 1936.
> PPI went from around 10 to about 15 over the same time period. The
> DJIA went from around 100 to about 150 from 1933 to 1936. This is
> consistent with Mr. King's assertions in his paper. This was not
> real economic growth because if you look at the data you will see
> that beginning in 1937 the monetary spigot was shut off and all of
> the above indicaters went into reverse. You are confusing the time
> lag in the application of the policy with a failure in the policy.
> You can go to the St. Louis Fed website and look at the monetary
> aggregates they are published every week and they are up over 10%
> year over year.

Jan 21 02:02 PM

[Tony Daltorio:]

You do know what they say about people who assume........ I am not a gold bug. In my portfolio, I have only a very small percentage in gold.


On Jan 21 08:53 AM patio wrote:

> Yeah, THINK FOR YOUSELF. There are a thousand gold bug articles pounding
> their fists saying inflation is coming ( all better written than
> your silly little rant ). What a unique perspective you bring....NOT.

Jan 21 02:15 PM

[PROXIMO:]

Global equity markets are highly correlated. If you doubt that, take a peek at any multi-year global equity chart. And world wide markets are currently in freefall. The excesses of the past few decades must be eradicated, and the only way for this to happen is through deleveraging. Global asset values must shrink. And it is a process that is not measured in days, weeks, or months. The treasury secretary can do his asinine useless bailouts, the buffoons Barney Frank and Chris Dodd can give their speeches, and Bernanke can fiddle with interest rates from here on. Regardless, the reality of the worldwide deleveraging will remain intact until the process has purged the excesses.

Jan 21 03:04 PM

[patio:]

I'd rather listen to Irving Fisher, who Milton Friedman and others believed to be the most brilliant of US economists. He stated that debt deflation, when severe, would entail massive wealth destruction, check, income, check,and spending, check. He contends that in such an occurence, fiscal and monetary becomes impotent. It is impossible to solve a debt and insolvency issue with more debt. He further contended that monetary policy revolves around the ability to initiate a new round of lending and borrowing. Lenders must be able to lend ( and willing ), and borrowers must be ABLE and WILLING to borrow.
Aint happening.


On Jan 21 01:50 PM John Polomny wrote:

> Did you read Mr. Kings paper? Inflation is the one outcome that the
> Central bank can 100% ensure. Do not sit here and tell me the FED
> cannot create inflation as they did it in the 1930's. The money supply
> went from around $20 billion in 1933 to around $30 billion in 1936.
> PPI went from around 10 to about 15 over the same time period. The
> DJIA went from around 100 to about 150 from 1933 to 1936. This is
> consistent with Mr. King's assertions in his paper. This was not
> real economic growth because if you look at the data you will see
> that beginning in 1937 the monetary spigot was shut off and all of
> the above indicaters went into reverse. You are confusing the time
> lag in the application of the policy with a failure in the policy.
> You can go to the St. Louis Fed website and look at the monetary
> aggregates they are published every week and they are up over 10%
> year over year.

Jan 21 06:05 PM