Inflation: Demand Destruction and Wealth Erosion Trump Money Growth 36 comments
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A major logical error that humans can make is to draw a conclusion from an observation without considering the bigger picture. These days, as folks can clearly see a rise in money supply and deficit spending by the federal government, they quickly jump to the conclusion that we are headed for rampant inflation, with many invoking analogies to Zimbabwe or post WWI Germany. While we could certainly be setting up for an inflationary period once we get through this economic crisis, I believe that it is extremely premature to bet that way.
When one looks at recent money supply growth, it has indeed been strong. I say thank God! It is one of the natural responses of the Federal Reserve to counter the prevailing deflationary headwinds. As you can see in the chart below, the year-over-year growth is about 10%. While this level is high, it is in no way a major aberration.
This is a pretty long-term chart, and it is clear that similar spikes over the past 28 years (when the data starts, at least on my source) haven't led to high levels of inflation. I believe that a look at nominal GDP helps explain the issue as well. Most of the spikes in growth in the money supply occur as the GDP is decelerating, as it is now. I would argue, though, that this time is indeed very different. Not only is GDP in quarterly and soon annual decline (here and around the world), but we have had enormous destruction of wealth, including equity, debt and real estate values as well as many other types of assets from commodities to fine art. Below are the levels rather than the growth rates:
Several observations:
- M2 and Nominal GDP have tracked well over the longer-term
- CPI (and Core CPI) have been consistently lower (real growth is the difference)
- Folks are concerned about a $700 billion increase in M2 over the past year
There are several things going on that I believe those who fear inflation don't fully incorporate, including the velocity of money and the destruction of wealth and diminishment of credit. The absolute dollars of wealth destruction and credit contraction significantly outweigh the expansionary potential of the money supply's recent growth. The irony is that the government isn't doing (and can't do) enough to stop this downward spiral. Those who fear inflation imminently seem to have confidence that they can somehow stave off what I expect will be a year of GDP growth lower than -5%.
I have been in the "no inflation" since June, a time that wasn't exactly as easy to say that in my opinion as now. I have shared my thoughts about the impossibility of getting out of this mess by "saving and spending simultaneously". Clearly, spending will be muted for quite some time. Government spending and debt creation will be more than offset by less spending and debt creation by individuals, companies and state/local governments.
One final chart. I wish I had data going back further, but, quite frankly, I would perhaps question the quality and relevance. Still, this period had some very high inflation at times, but note that it always occurred with strong economic growth. While we can have weak economic growth with above-average inflation (stagflation), I don't see a single example of an "inflationary recession". I conclude that many believe that the patient is going to die from the chemo, while I am worried that the chemo won't stop the cancer. To bet on inflation is to bet that the government can revive the GDP at a time that spending pressures will be intense on the consumer and on businesses and our export growth will be swinging from +10% to -10%. Additionally, state and local governments and not-for-profits will face tighter budgets as well. The growth in the money supply and the expansion of the federal spending are clearly observable, but I recommend that investors consider that they aren't even sufficient to offset the headwinds that we clearly face. There will be a time for inflation, but it is down the road after considerable excess capacity has been wiped out around the world and our savings rate has returned to sustainable levels:
Disclosure: None
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But there are very few borrowers; this is the side of the equation the inflationistas just refuse to accept or see. With $15-30T of true wealth destruction, horrendous cash flow reduction ( un- and under-employment ), and the new rules to qualify, the money is not and will not be flowing into the economy for a long time.
The inflatonistas believe the givernment can force spending, it can't. They believe the gov can spend enough directly to compensate for the lack of consumer spending, it can't even come close.
Gold has risen to the degree it has, not due to inflation fears, but by flight to safety ( one can argue the merits, but thats for another day ).
T-bills are still selling, with very low yields. Why? Flight to safety, yes of course, but also because with deflation factored in for years, any yield is money-making.
The dollar is strong vs. other currencies.
Deflation is here, that cannot be argued, and like the author I see no swing back to inflation for quite some time.
Therefore, no inflation. Yes?
The money the Fed has "printed" is not in circulation, because it's buried in banks, and they are hoarding it ( not really, they are just back to sound lending principles, but more importantly there are no borrowers ).
Businesses surely do not need money to expand into a contracting economy, and the consumer is tap city, we have all the non-discretionary crap we need,err, not need, but wanted.
Game over.
On Feb 21 08:20 PM philais wrote:
> So, basically you're saying that the definition of inflation is the
> increased supply of money. And, that money is being destroyed faster
> than the Fed, Treasury and the government can put it back into circulation.
>
>
> Therefore, no inflation. Yes?
Mr. Brochstein is thankful for the fed's use of the printing press. We also need to increase savings. Those two things are completely at odds with one another. Yes, inflation is muted right now, but that doesn't increase my confidence in the dollar.
Amazing how often I hear this. Just spend 1/2 an hour studying the economic history of post 1990 Japan, and you'll see this is not true. Monetary base tripled 1990-2005, and every other money supply measure vastly increased as well. Yet inflation never gained traction. If you want to really understand what's going on, look at the ratio between DEBT in private sector and GDP.
So while there may be some short term deflation we are looking at a longer term scenario. So while one can argue that the Fed should step on the gas now and step on the brakes in a couple years or so, we only need to look at what happened after the 2000 internet bubble crash. The Fed stepped on the gas, but did it step on the brakes? Too little and too late; instead the Fed created a massive housing bubble. Why? The Fed learned its lesson after seeing what happened to Volcker--he was dumped after stepping on the brakes. And of course stepping on the brakes is going to cut bank profits--and banks are very influential in what the Fed does (or is it more accurate to say banking opinion totally dominates?). Second looking at the Federal government there are going to massive structural deficits because of the retirement of the baby boom generation (Social Security being less important in this regard than Medicare and Medicaid). Because of the bad economic situation I see frequent changes in power between the Democrats and Republicans--and the Republicans have completely transformed from the balanced budget ideology of Eisenhower and his predecessors to a strategy of massive tax cuts, plus massive defense increases plus maintaining/increasing middle class entitlements--a guaranteed recipe for uncontrollable budget deficits.
While my call on gold initially is certainly mistimed at best (it has increased about 18% since I wrote about it in early October before it quickly dropped 18%), my specific equity calls would seem to more than offset that error. You credit me with them (thanks for noticing), but it is the general theme that underlies my selection process that has been extremely powerful and more valuable at protecting wealth than buying gold. In late December, I shared my basis for identifying still overly expensive stocks employing balance sheet metrics (seekingalpha.com/artic...). In that article, I specifcally concluded:
The Bear Market's first leg down hurt mainly Financials and many cyclicals, while the second leg down (September on) has been very indiscriminate. I anticipate that the next leg down will prove extremely harmful to companies with "too much leverage".
In that article, I mentioned three companies, all of which have declined substantially (T, GE, GM), and I followed it up with specific sell recommendations on GE at 16 (12/29), KFT at 27+ (1/5), WTW at 26+ (1/11) and WMT at 51.5 (1/18). While these have all migrated south for the winter, some of the declines have been stellar (GE, WTW).
I think a better test, though, of the methodology would be to take a look at truly the first time I mentioned the need to focus on the balance sheet. At the end of 2007, I shared my thoughts on "balance sheet accidents waiting to happen": seekingalpha.com/artic.... After running a screen, I identified 8 stocks that I thought had significant downside. One is bankrupt, but the entire list has fallen significantly more than the market in general:
ABD: 16 to 1
FUN: 21 to 8
FO: 73 to 27
HTZ: 15 to 4
NAV: 55 to 28
PAG 18 to 5
SGMS: 33 to 12
SSCC: 11 to 0
I am often wrong and had some horrible calls last year too. The gold call pales in comparison unfortunately to my swinging from bear to bull on FNM. There are several others too. I can't be right all of the time and won't be right a lot of the time. As I have said, if I can be correct 60-80% of the time, I believe that I am not wasting my time, the time of my clients or the time of anyone who reads my blog. I don't expect anybody to blindly follow my conclusions (or anyone 's). My real goal is to clearly explain my views and hopefully contribute to helping others as they think about risks and opportunities. I often get some very helpful input from others as well, even among the often inflammatory gold advocates as well.
I am not a permabull or permabear. I try to remain balanced, sharing both negative and positive ideas no matter what the overall market tone at the time may be. I try to be contrarian, but at the right time. In the case of gold, for which my views have ticked off o lot of folks apparently, I have clearly been early (after nailing a rare quick correct call initially which should have told me I was actually early) and, as I admit, possibly wrong. Unfortunately, if you choose to use me as a negative barometer, I can't be responsible for your methodology. I never got bullish on internet stocks after shorting them beginning in 1999. I never got long DELL after shorting it in 1998. Unfortunately, I am not consistently wrong enough for anyone to profit!
On Feb 22 01:05 AM John Polomny wrote:
> Yawn, another anti-gold article by Brochstein. I also enjoyed your
> Feb 18 article when you declared gold a bubble right before it kissed
> $1000. I also found your Dec 8 article about folding on gold quite
> wrong. Now that gold just touched a short term resistance level and
> is overbought on MACD and RSI it will probably correct over the next
> few weeks and we will see a "I was right all along" article here
> on Seeking Alpha by Brochstein. As I said on another comment thread
> with regard to Alan's non calls on gold and inflation, I am using
> him as a reverse barometer. When he eventually gets bullish on gold
> that will be the top. LOL. I will give him credit in that he has
> advocated shorting stocks and has been negative on the economy but
> who hasn't? Bosun where are you when we need you or when Brochstein
> publishes an article here on SA?
In terms of trying to gauge the impact, I believe, I guess differently from those that look at money supply and federal debt expansion apparently in isolation (federal debt is replacing personal and commercial debt that is being wiped out through bankruptcy, foreclosure, etc.), that these two things in conjunction with each other will create an environment of extreme demand pressure for years to come. While inefficient government spending over the next several years may help slow the pace of GDP erosion due to the declining Consumer and Business contributions, it is clear at least to me where we are headed. Sounds like you are onto it too...
On Feb 22 11:03 AM GreyGhost wrote:
> Is there a number out there that estimates the dollar value of wealth
> destruction in the last six months? If that destruction has an impact
> on forward looking GDP what is the estimate of that impact on an
> annual basis? If Consumption in the past few years has been around
> 70 percent of GDP versus around 60 percent prior to the expansion
> of the last decade, what will the impact to forward looking GDP be
> in terms of dollars if we fall back to consumption being around 60
> percent?
>
1) GDP and CPI data are manipulated through hedonics, substitution, and weighting. These manipulations have not been consistent through the past 40 years, but rather have been growing (or shrinking) depending on what is more convenient. Basically, we are being lied to: our GDP is not as large and our CPI is not as low as the US Gov't claims. We can't even look at the trends in these graphs since the level of distortion has been changing.
2) M2 is not a valid measure of money right now because it includes:
· M0: currency (notes and coins) in circulation and in bank vaults, plus reserves which commercial banks hold in their accounts with the central bank (minimum reserves and excess reserves). M0 is usually called the monetary base - the base from which other forms of money (like checking deposits, listed below) are created - and is traditionally the most liquid measure of the money supply.[7]
· M1: currency in circulation + checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits) + traveler's checks. M1 represents the assets that strictly conform to the definition of money: assets that can be used to pay for a good or service or to repay debt. Although checks linked to checking deposits are gradually becoming less popular, debit cards linked to these deposits are becoming more popular. Like checks, debit cards, as a means to complete a transaction through their links to checkable deposits, can also be considered as a form of money.[8]
· M2: M1 + savings deposits, time deposits less than $100,000 and money market deposit accounts for individuals. M2 represents money and "close substitutes" for money.[9] M2 is a key economic indicator used to forecast inflation.[10]
But not
· M3: M2 + large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. M3 is no longer measured by the US central bank.[11]
What category do you think that the bailout money will fall into? And guess what, we can't measure M3 anymore because its secret since 2006.
Here is a video of a guy that paints a plausible picture of deflation (depression) in our future.
www.youtube.com/watch?...
His explanation is purely qualitative, but he comes to the same conclusion that you did. I think that both have good points. However, the big question to me is what will happen when the banks are made whole after the bailouts are done. Even if there is a period of deflation or depression, the banks will not make money unless they lend out the money that they have been given. With fractional reserve requirements of 10% (some claim much less) the banks will be able to lend out at least 10x the amount of money that they have in reserves. Either that or they will buy assets that will yield a higher return (it is hard to imagine a better return, though). So my thought is that we will have deflation followed by high inflation when the banks start lending and put bailout money gets back into circulation.
Any thoughts?
> of amounts of liquidity - ran huge deficits and stimuluses- year
> after year- it was still 10+ years of deflation and recession. We
> are attempting the exact same thing despite well documented Japanese
> failures and our criticisms for Japanese policies.
we may be attempting the same solutions that Japan employed in the 90's to revive their economy, but there are fundamental differences between the two scenartios.
after the market crashed in Japan manufacturers were still able to find markets to export their high quality/superior tech products. export success allowed the country to run a trade surplus throughout, providing support to the yen and maintain jobs. this is much different than the huge trade deficits in the U.S.
also, japan went into the crisis with savings, U.S. is huge debtor nation, most have no savings.
the U.S. owes upwards of 10 trillion to foreigners, most who are facing their own recessions. Japan did not have to deal with this aspect either.
Japan supported most businesses, large and small, throughout the crisis and continues to do so today. the U.S, actively competes with companies for capital.
misc. the work ethic in the U.S. has deteriorated more than Asia. Our education system is not keeping up with foreigners. The huge millitary, medical, and retirement expenses is disproportionate to Japan then and now. Unions play much less role in Japan and do not shut down businesses as quickly, more company loyalty in Japan.
Based on those points I do not think it's a given we are headed for the same deflationary cycle that plagued Japan for many years.
On Feb 21 06:23 PM SB-tiger wrote:
> I belong to the deflation camp and agree with the author. To expand
> on the point:
>
> Liquidity trap : It is the classic liquidity trap. Lenders don’t
> want to lend, borrowers don’t want to borrow. Low interest rates
> add to the confusion and disruption. What lender wants to lend at
> low rates in a risky environment. Businesses don’t see good prospects
> and will not expand (will contract as evident) their business. So
> all the liquidity gets trapped in the system and velocity of the
> money is lost – the real money in circulation actually decreases.
> This is what happened in Japan in the 90s – the govt. pumped in huge
> of amounts of liquidity - ran huge deficits and stimuluses- year
> after year- it was still 10+ years of deflation and recession. We
> are attempting the exact same thing despite well documented Japanese
> failures and our criticisms for Japanese policies.
>
> Keynesian Stimulus: This does not work because of Govt. inefficiencies
> – leads to misallocation of capital. This has never worked – did
> not work for us in Depression, nor for the Japan in the 90s.
>
> Gold: Gold price has not tracked inflation very well at all in course
> of history; else it would be $2500+ today. However gold tracks anxiety
> pretty well. These are anxious times with no place to hide; people
> are losing faith in currency. Gold would rise as safe haven play
> (not inflation), as clearly evident. How far gold would go will depend
> on lot of dynamics most importantly role of central banks (and IMF).
> Lot of them may be forced to sell gold to raise hard cash– rumors
> of Russia and IMF abound. Central banks would try to protect and
> prop their fiat currency. All this would put downward pressure on
> the price.
> Do not forget the dynamics of deleveraging – they apply to gold too.
> We recently had seen gold fall from $1022 to below 700.
>
> Destruction of wealth: all assets have to be measured by current
> value (mark-to-market), about $30 Trillion has been lost. This puts
> downward pressure on all balance sheets, including household. What
> can you use for collateral (even to pawn). The less wealthy I am
> the less I spend. All this talk of money on the sidelines does not
> compensate the wealth destruction. Cash funds including money market
> etc have increased to 84% of market value; in 1974 it was 121%. There
> is good article on today’s WSJ “Will Queasy Money Return” – the author’s
> opinion was emphatic No.
>
> Overall I am very bearish on the market, predicting S&P 650 in
> a month or so. (Do not use double shorts - they don't work)
> of history; else it would be $2500+ today.
That is indeed where it's headed, in fits and starts. Let's put it this way: If gold doesn't track monetary inflation over time (or over "the course of history" as you put it), then why is $870 gold normal today - even a bargain? Whereas, in 1980, $870 gold was an absurd price that could not be sustained (and was not). Come on. Gold *obviously* tracks monetary inflation "in course of history".
> of history; else it would be $2500+ today."
History didn't start on the day you were born. Maybe you check the 4000 years before you were born.
I don't even think it takes an economic recovery to trigger the switch from deflation to inflation. We saw just the other day that China is not too psyched about so exposed to the dollar.
We'll know who is right, in another year or so. Meanwhile, the "GDP is in decline" argument doesn't impress me, because it hasn't stopped commodity prices from going up and, you know, there is such a thing as "stagflation" (or even "inflationary depression").