De-Leveraging Is Not Deflation

"Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages."

-- Ludwig von Mises

It's true that just about every asset class is coming down in price right now. This, however, is not deflation -- as I have said so many times recently, much to many readers' unqualified chagrin. To the contrary, these declines are the products of de-leveraging -- not deflation -- and the distinction is nearly incalculably important, although the subtlety seems to elude even the most astute these days.

If the previous premise is true (which it is), any removal of money from the economy would eventually result in an increase in the value of our currency, relative to everything else. And that, in turn, would eventually translate into lower prices in dollars. But that's clearly not what is happening. No, the Fed is printing money, sending the amount in the economy higher than ever seen in U.S. history. That's not deflationary. That's inflationary.

Just so you'll know, here's the definition of inflation I'm using. And before you pooh-pooh it with too much eagerness, remember that one of its authors, F.A. Hayek, won the Nobel Prize in economics in 1974.

Look, the thing we should be worried about is relative value, not "inflation," per se. It's not about the growth of M0, or M1, or M2 (or even M3, if you keep up with shadowstats.com), so much as it is about what the money supply is doing relative to everything else that is happening. I know assets are falling in price -- believe me, I get no shortage of reminders every single day. But the amount of money in the system -- not just M0 -- is increasing at a tremendous rate. I won't argue that the relative value of things like real estate and equities are going to continue to drop -- maybe even dramatically, and for a long time -- in terms of demand (or lack thereof). No, what I'm most concerned about is that demand will stay extremely low, and yet prices will rise anyway because of the increase in the amount of money in the system.

But it's not just money; it's also Treasuries. The Fed has specifically stated that its objective is to stimulate "inflation" (by its definition). It wants prices to rise, and it's going to do everything it can to find success. But the amount of money in the system is unprecedented. When the Treasury bubble starts to collapse, yields are going to explode. Yes, the Fed will probably print more money to buy down the long-end of the curve, but how long will that work? Some people say years, but how? Do you really think the Chinese and the Japanese are going to keep funding that sort of behavior? Or even more importantly, do you think they're just going to sit on their current holdings? Probably not, and if they start dumping Treasuries, yields are going much higher.

It's not a matter of if this is going to happen. Yields can't stay where they are for any sustained amount of time, and once they start rising, so will prices. But will demand for, say, houses have increased? No. Cars? No. Boats? Televisions? No. Why? The American consumer is tapped out.

Credit card companies are tightening limits prodigiously. Teaser rates are all but gone. Home equity has dried up. The consumer has driven two-thirds of our economy for at least the last few decades, and now the consumer is dead. There's another aspect to this that I won't go too deep into: the American consumer protects his or her credit score for one reason -- to obtain future credit. But the consumer also knows that loans have dried up -- not just today, but for the very distant future as well. You know these consumers have to be thinking about defaulting; if they can't get loans anyway, why would they not default on thousands of dollars in unsecured credit card debt? I plan on writing more about this in future articles, but suffice it to say, I think credit card companies are going to give us the next blow to our collective stomach, and it's going to hurt.

So here we have a situation in which demand is gone, and yet prices and rates are rising -- because of inflation (printing money) and the Treasury collapse. And that's the point: it's not going to come from just one source. It's not just going to be inflation (printing money). It's not just going to be the collapse in Treasuries. It's not just going to be the nearly unfathomable costs of the stimulus packages that are coming online in the next two years. It's going to be the confluence of all of it. And if I'm right about the continued deterioration in credit markets, things will be even worse.

You think it's not different this time? Add it all up, in real dollars -- the staggering amount of debt, the parabolic rise of currency in the system, the annihilation of real-estate investment, and the demise of the consumer. $8.5 trillion committed to bailouts and stimulus packages. Oh, yes it is different this time. It's very different.

Credit cards didn't even exist in 1930, and the dollar was backed by gold. Credit cards barely existed in 1973. Nixon had just taken us off the gold standard, and look what happened? Volcker was immensely lucky to have stopped hyperinflation, and look at the extreme measures he had to employ to do it.

Of course, every time I bring all of this up -- which is a lot lately -- somebody starts talking about the velocity of money. And pretty soon after that, somebody starts talking about the multiplier effect.

Yes, the U.S. employs a fractional reserve system, and while that system certainly lends to rising prices and yields, the amplifier effect is not inflation. Like the printing of money, the fractional reserve system is only one ingredient in the poison that lends to the ultimate catastrophe inspired by central banks: rising prices and increased costs of borrowing.

And then there's velocity...

While I am eternally grateful to my critics for forcing me to defend the theories I hold dear, I sometimes fatigue of the incessant snapping at my heels by people who want me to know that the velocity of money has slowed down. I know the velocity of money has slowed. It doesn't matter. It's not going to stay this low for long, and when it starts speeding up, it's not going to be a "good thing." Treasuries are going to break, rates and prices are going to rise, and all that money pressing against the dam is going to find a crack. Why? It has to. People will flee from dollars that are losing value. They will extract all the dollars sloshing around the system, and they will buy commodities and durables in order to preserve the value of their wealth.

Remember, just because the dollar is losing value does not mean that the concomitant subsequent rise in certain asset classes necessarily means that demand for all assets has increased dramatically -- as it did during previous eras of easy money. Demand for assets economy-wide can continue to wane even as people spend dollars as fast as they can get them in the midst of rising prices. And this is a very important distinction: prices can rise because of demand, but prices can also rise because of excessive increases in the amount of money in the system. If prices are rising without a simultaneous increase in demand, well, I can't think of a more dangerous economic environment to be in.

You don't believe it can happen? You think there's a huge demand for houses, cars, and boats in Zimbabwe? Prices there are rising exponentially, but there is very little demand for assets -- other than staples, of course. What do you think their velocity of money is?

The other day I wrote that Treasuries and the dollar are not "safer" than gold, and for my efforts I was heckled by several readers. Ultimately, however, flight-to-quality will seek the true risk-free rate of return, and this is yet another factor that will contribute to the imminent ferocity of the move that's coming. Once Treasuries unwind, people and institutions will scramble to find a place to put the money they had once placed in the "safety" of U.S. government debt. And unless you know of a medium whose historical consistency and safety surpasses gold's, that will be the place investors find haven.

Just for future reference: when I say the dollar's going to fail (which it is), and you're hovering over your keyboard, poised like some bird-of-prey, ready to strike me with all the ire of God-upon-Sodom, will you try to remember that I acknowledge velocity is, at least for the time-being, near zero. Will you also try to remember that I don't believe the massive increase in currency alone will not be responsible for imminent rising rates and prices? In fact, I think Treasuries are going to play a greater role in the beginning.

Also, I agree with many of you that my timing may be a bit premature, and I exited my TBT after the last run-up. Unfortunately, today the stock market and Treasuries are getting crushed as gold rallies. I wouldn't want to declare myself "right" based just on the behavior of these markets in recent days. That would be stupid. And yet I sit here and watch TBT move higher, wondering if getting out was even more stupid.

To add to my trepidation, some sort of manager in the South Korean finance ministry came out over the weekend and announced that the time has come to sell U.S. Treasuries. How do you think that made my stomach feel? Of course, Bernanke keeps promising to do battle with the long end of the curve, so maybe he'll make good on his threat and I can find a point to get back in comfortably.

Of course, if I miss the move because I listened to some of you cynics. Well, at least I still own gold.

Disclosures: Paco is no longer short U.S. Treasuries (although he hopes to be again soon). He is long physical gold, and the Proshares Ultra long gold ETF (ticker: UGL).

Copyright 2009, Paco Ahlgren. All Rights Reserved.

Comments

[iyamwutiam:]

Ricard- Bravo on your observation of Japan. McCain quite candidly stated the US has occupied Germany/Japan for atleast 50 years and South Korea as well for over 30. Can a country truly be sovereign or even loyal to it's own interests when it is occupied by humongous military bases filled with over 100,000 soldiers and missiles etc. Certainly not. But like the British - the cost of occupation will erode the value of its capital and one day -the illusion will snap.

Jan 22 12:29 AM

[iyamwutiam:]

As far as reserve currency- I see it backed by oil - just as the US dollar is -basically.

Jan 22 12:35 AM

[Conan the B...:]

Lest you believe, I am anti-gold, I am not.

The longer the $ rises and Gold does not, the more I expect Gold to drop. I still believe in the Inverse relationship the two have had for decades.

To me, its about the timing of the USD's demise.

Let's say Obama manages to come up with a plan that looks like it might work. Do you think the Dollar will drop?

Or, if another Financial "shoe" drops, will risk aversion cease?

I do not want to lock up my money in an asset which goes sideways at best, especially if it isn't accompanied by a significant dividend.

Jan 22 02:24 AM

[Vox Rationalis:]

no_disclosures wrote: "Is it really true that it would be 'the end of the world' if the US defaults on it's debt?"

Actually, my point was that it would take the end of the world for this to happen. More specifically I guess, the end of the world as we know it. There simply is no rational thought behind the assertion that the U.S. might default.

"I get really worried when people say something is 'unimaginable' - usually it means they don't want to face the prospect."

I would say unimaginable is a code word for "infinitesimally small." I mean, we can IMAGINE quite a few things that ain't gonna happen. To wit:

"Let's pretend that the US magically (and uniquely) faced the rapture, and went to heaven, leaving the rest of the world to plod on. What would happen in your universe of "how things work"?

The space aliens that built the pyramids would come back down and take back all of the gold in the world (after all, they just left it here for safe keeping).

Jan 22 07:59 AM

[De Graaf:]

Reading this article, I fully agree with everything you say about inflation and deflation as long as you make the difference between two types of deflation, namely; monetary deflation and asset deflation.

Your topic should be named either;
Deleveraging is NOT monetary deflation, or
Deleveraging is asset deflation

Thats makes your critics close up instantly, as you have shown them full understanding of the word deflationary.

Jan 22 08:29 AM

[Vox Rationalis:]

iyamwutiam wrote: "First assets are nothing more than loans or credit creation in banking. Real deposits are classified as liabilities. So if the Fed has 4T dollars of foreign currency 'assets' -they have essentially created 4T dollars out of thin air -or basically using debt to pay a debt that has turned bad."

The Fed is no ordinary bank, due largely to its ability to create money out of whole cloth, so the analogy is good only to a point. But I'm happy to explore it. As I recall, the Fed has around $500B in foreign currency reserves, most of which it acquired during the past year. It also has some $800B in cash liabilities, a number which has remained largely unchanged since a year ago. Most of the growth on the liabilities side has been in reserve deposits from banks - which makes a lot of sense since the Fed started paying interest on these. Most of the rest of the growth is in the Treasury supplementary financing program account, wherein Treasury sold additional notes and deposited the proceeds at the NY Fed.

So no 1:1 thin-air creation as you suggest.

"...basically using debt to pay a debt that has turned bad."

I don't understand what you're trying to say here. What debt has turned bad in your example?

"so in short the US -has been buying up foreign currency because central banks in other nations are deleveraging (right?)."

No. In the unprecedented (in most lifetimes) fear of late last year, there was a run to the dollar unlike any previously seen. Though I haven't seen anything written on it (haven't looked), seems to me the Fed's action was designed to prevent local (relative) shortages of dollars that could lead to dramatic localized changes in exchange rates. My thought is that the concern was that if the shortage of dollars was acute enough, minor foreign currencies could have faced collapse simply due to market fear.

"So where do these dollars go? The dollars created are used to what purpose by these foreign central banks?"

The dollars were swapped for the foreign currencies now on the Fed balance sheet. The foreign banks used them to ensure sufficient dollars were available for those fleeing to quality without causing dramatic changes in the exchange rate. At least, that's how my theory goes.

"Losses will eventually lead to bankruptcies and finally be wiped from the balance sheets either by government guarantee or some other method."

Bankruptcies don't affect this exchange. I don't think there are any losses here, beyond those related to exchange rate changes.

"Countries with surpluses will be forced to sell dollars to stabilize their countries core industries from over-leveraged foreign investment mainly from the US/Euro/Pound cartel."

Why?

"In short-Commercial paper and Foreign Currency swaps are both money creation..."

The commercial paper facility is designed to be a wash: the banks left the market, so the Fed stepped in, and as the banks come back, the Fed steps out. The currency swaps are definitely money creation, but my point is that they can be undone simply by buying dollars in the FX market.

"In short -it's the same scam -creating credit to absorb credit losses."

No. There are no losses being absorbed here, beyond the exchange rate related losses. Not in the pieces we're discussing, anyway.

"So the picture I see -is more dollars returning to the US not less."

I think you might think the percentage of dollars that are held overseas is higher than it really is. I don't think dollars returning to the U.S. is a big issue simply because of the sheer size of the monetary base.

"So what happens when all that money on the sidelines comes back as well?"

That's a different market. As risk tolerance increases, demand for risk-based assets shifts, and prices of those assets rise.

Jan 22 08:39 AM

[Whippet:]

Ironically, inflation is the only way out for the US Gov't. It increases real tax revenues across the board, cheapens existing sovereign debt, and creates ersatz "confidence" in consumers as they run to spend/invest/gamble away their dollars before they lose value. Underwater mortgages are suddenly afloat as housing rises in nominal value. It is politically expedient, as no bought-and-paid-for Congressmen have to make tough decisions in implementing it as policy. Obama can blame it on the Fed and the late Bush administration. Don't think we'll see Ben Bernanke's face on the $100 trillion bill anytime soon in this country, but I'm counting on 7-20% dollar devaluation for a protracted period of time (5-10 years). That will be when the last bubble has finally burst.

Jan 22 10:43 AM

[yank:]

Do you consider an asset class going from $250/oz to $850 in 6 years sideways? I sure as hell don't.


On Jan 22 02:24 AM paultaut wrote:

> Lest you believe, I am anti-gold, I am not.
>
> The longer the $ rises and Gold does not, the more I expect Gold
> to drop. I still believe in the Inverse relationship the two have
> had for decades.
>
> To me, its about the timing of the USD's demise.
>
> Let's say Obama manages to come up with a plan that looks like it
> might work. Do you think the Dollar will drop?
>
> Or, if another Financial "shoe" drops, will risk aversion cease?
>
>
> I do not want to lock up my money in an asset which goes sideways
> at best, especially if it isn't accompanied by a significant dividend.

Jan 22 02:36 PM

[Conan the B...:]

Yank: I Consider an asset which has gone from $1,000 to $700 and back to $850, the mid-point, and which has not been above $900 for the last 3 months, as an asset which has been going sideways at best.

Meanwhile, the USD has gone from 72 to 88 and is currently less than 5% from its high in the past 6 months.

Which asset has performed better?

When push came to shove, the current Crisis has propelled the USD higher than the So Called Haven, GOLD.

In the very short term, say a month, Gold could move above $900 as a last gasp. This would not violate the downtrend line.

Gold moved from $650 to $1000 in 7 months, I guess you did not view it as a Bubble. The fact that it hasn't been able to move higher when Oil Bubbled to $150 or in the Face of a Worldwide Economic crisis which began in the USA has also been lost somewhere.

Numbers game? 1982, DOW 777, gold $850 (around)

Present, Dow 8000, Gold $850 (around)

10 times VS zilch.

Anyone can pick a point in time in Hindsight, try forecasting. Pick a date when Gold will be above $1000 again.

My best estimate is not until 2010.

A Rounding bottom is in progress.

Jan 22 04:22 PM

[derryl:]

bsdetector wrote,
"The space aliens that built the pyramids would come back down and take back all of the gold in the world (after all, they just left it here for safe keeping)."

Finally somebody gets it! You know, there are still people out there who don't put tinfoil hats on their gold before they bury it, easy pickins for the space aliens!

Jan 22 04:53 PM

[BlackyBlack:]

Why not consider this: deleveraging is a reduction in the velocity of money.

Why look at it that way? Because it's an effect, not a cause. Some of the drivers of the money supply collapsed, so the Fed, to compensate, increased its balance sheet. Don't assume this relatively huge increase in the Fed's balance sheet means inflation (in money supply or rising prices) in the near future. Despite these relatively abrubt increase in numbers, the money supply may still be deflating in real terms.

So while deleveraging is not deflation, you still may have deflation even though it appears that the money supply has doubled or tripled in size. People bring up velocity of money and the money multiplier at this point because if money is not moving through the economy its not really money (adding to money supply).

You say all this will change at some point and start up again at which point we will have inflation, but what mechanism will allow this to happen? How can you inflate the balloon with water once it has popped? This is the chief problem - the mechanism of money creation have been largely compromised or broken. Some permanently.

Jan 22 06:28 PM

[CJJ:]

Paco,
I think you are silly to be certain about something 100%. You are following in the great line of doom and gloomers. The dollar will fail the US will fail...eventually. Eventually...Eventuall... Sorry, but eventually doesn't have a time horizon. When you feel like adding a time to your prediction you have a story. The only reason I ask you to do that is you are presenting that your theory is going to happen 100%, there is no other possibility.
Its hilarious that as times get more desperate and unpredictable people can get overdesperate but exact at the same time. I'm sure you've seen this all coming for years.
I'm just happy there are so many bloggers out in the world today who know exactly what the future is going to be, especially in terms of the economy. All smarter than the governments of the world, smarter than the academics and economists. It must be nice to be so smart.

Jan 22 08:09 PM

[CJJ:]

Why do people talk about the dollar becoming less valuable, but then talk about small gains in gold/$ as proving gold is becoming more valuable? You can't have it both ways, pick one argument and stick with it.

Please do the one where a $ today is worth like .08 of what it was worth in 1913, that one always makes me laugh as it amounts to a whole lot of nothing.

Jan 22 08:15 PM

[Conan the B...:]

Not to worry, Paco has already decided that being long TBT is not a good Idea at this point in time.

Either that or he received a margin call or something, yeah, that must be it.

The two go hand in hand, short Treasuries, long gold.
If you are no longer shorting Treasuries, being long Gold is not a good idea.

Jan 23 01:15 AM

[RTF 360:]

Paco,
"Deflation" is a 2 choice menu;

1) cannibalize each other
2) starve to death

I have great pity on the urbanites when the Democrats hold a $ 3 Trillion Treasury auction and the whole world tells 'em to "shove it".

Deflation will be defined for you when you go out and try and get your first job and there are no more cabs to lease for because you were busy offering opinions based on no experience on the internet for free.

Please remember I wrote this to you in 3 to 6 months

Jan 23 01:22 AM

[Vox Rationalis:]

"The two go hand in hand, short Treasuries, long gold. If you are no longer shorting Treasuries, being long Gold is not a good idea."

Not necessarily. Yes, these could be paired if you are looking at the eventual move back to risk, in which case both Treasurys and gold face downward pressure. But if you're looking at them both as dollar hedges, which I think most people do, then these are two sides of the same coin. With a declining dollar, Treasurys should fall and gold should rise. So, if this is the reason for the positions, getting out of one trade without getting out of the other doesn't reduce the risk level much, it just reduces the amount at risk.

Jan 23 08:25 AM

[Paco Ahlgren:]

Well, say what you will. I called it. I hit it right on, and you know it.

The only short-term hope your arguments have is that the Fed will buy the long end of the curve to drive yields down; I actually think they're foolish enough to do that, which is why I exited TBT, and if they DO start buying, I can't wait to get back in.

By the way, you had to have guessed from the chronology of my posts what my cost-basis was, right? You had to have known I made money on the position...? Can you get a margin call when your account value goes up? I didn't think that was possible... :-)

No matter what the Fed tries -- and whether or not I miss the move -- yields are going higher. Much higher.

Thank you for the interesting thoughts...

Jan 23 10:45 AM

[adan:]

really interesting article

the only thing i didn't hear defended or put into the mix, is what mish on his site brings up, the role debt plays

that the amt of debt is so large, and being destroyed so quickly, it (currently) overwhelms the currency creation (printing)

since i'm no expert, and have a hard time getting more than a semi-handle on all this, i'm gonna have to see how all this comes out

who knows, maybe cash and gold will get re-tied in some form eventually....

Jan 25 08:08 AM

[EEB:]

I find the amount of certainty expressed in the opinions of economists and finance experts to be mystifying. I don't think that anyone can claim any decent level of certainty when it comes to macroeconomic predictions with so many variables and conflicting plausible outcomes. In other words, none of us has a clue if the future holds serious inflation or a deflationary spiral. There are strong arguments on either side and also historical precedent for either outcome. We could wind up like Japan in the 90's or we could have very high inflation.

In such cases, the prudent thing to do is to truly hedge one's bets, and I don't mean the kind of "hedging" done at a hedge fund. If you are worried about hyper-inflation, then buy some gold or refrigerators or a variety of things that are likely to retain value in such an environment. (In Russia during the 90's people bought extra refrigerators because they held their value. Maybe we should move to the Refrigerator Standard.) If you are worried about deflation, then put cash away somewhere. It would be prudent to do some of both.

Of course, if people had truly hedged in the first place, we wouldn't have so many problems. People, including investors in mortgage backed securities, would not have assumed that home prices would continue to climb, etc. They would have included the possibility of declines into their decision making procedures.

But some people will not hedge now, just like they did not hedge then. And some economists/financial experts do not offer qualified predictions. Why?

I think that the answer to both these questions can be traced to human nature. We are generally selfish and want to be on top. If we hedge our bets, then some other lucky s.o.b. will out do us in terms of profit. Also, we are proud. If we seem to lack certainty in our predictions, then we display a lack of knowledge, conviction, courage, etc. What will people think of us if we admit ignorance?

A bit more humility in the field of economics is long overdue, but, alas, I haven't seen it yet.

Jan 25 09:30 AM

[popey:]

Japan is large global creditor. USA is a large global debtor. Capital flows are polarized. It is absurd to compare USA and Japan.


On Jan 21 09:40 AM bricki wrote:

> Yes the Fed is printing money like crazy. But the loss of value in
> equities far exceeds what they have printed. Add to that the loss
> of housing values, consumer and bank deleveraging and yes we are
> in a deflationary environment.
>
> The Bank of Japan did what the Fed is doing and MORE when Japan had
> their real-estate crash. Japan did not go through an inflationary
> episode as a result.

May 17 10:46 AM