It's Not a Credit Crunch, It's a Deflation 35 comments
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If you’re within one astronomical unit of a TV, by now you’re convinced that we’re in a Credit Crunch. If only those nasty financial institutions would just loosen credit things could get right, right? Not at all; this is a deflation. First, let’s think about this logically in its simplest terms. If you were a lender and asset prices were falling, unemployment rising (inability to repay) and many of your existing loans failing, would you be in a hurry to make loans? Of course not, and pointing a finger at them is ludicrous. Even if they wanted, they haven’t a fraction of the ability to stem this deflation.
In 1913 we hired an agent to oversee our economy, to maximize employment and moderate our animal spirits. When we created the Federal Reserve we opted out of truly “Free” Market Capitalism by making the pact that if they maximized employment, we’d accept the terms – inflation, and the risk - deflation. Inflation has worked like a charm, since the deflationary accident know as the Great Depression, because it compensated for interruptions to organic growth. Like an out of shape distance runner using cocaine to keep going, we deluded ourselves into thinking more credit would always work to mitigate a slow down; that a medicinal “line” of cocaine inflation could grant us perpetual prosperity. It can’t and, under this system, deflations aren’t accidents, they're axiomatic. The lure of cheap money is always too tempting in a tight spot. Ask any of the central banks throughout history, their track record has a perfect 100% failure rate.
We are experiencing a massive deflation to adjust for 1) the latest & greatest credit bubble’s implosion and 2) a GDP no longer artificially subsidized with financing shenanigans. We aren’t as wealthy as we thought, and our standard of living has been adjusted down as a result of this reality check. Deflation has evaporated half the market’s value and a third of the real estate market’s value, which I estimate to be about 18 trillion or a year and a half of our GDP! Now all the funny mortgage money, created to shore up the funny internet IPO money, has lost its value and the US dollar is reciprocally regaining its value. It must again become “real” in terms of its buying power. Since most of us are largely invested in assets, we are all feeling the pain and the more deflation spirals, the greater the intensity. If it is not arrested, bankruptcies will skyrocket.
Now what? There is no intrinsic value to any country’s money anymore. They are all deflating and the world has no choice but to support our currency (as the new gold standard for now), despite our having only made a down payment on the task so far. There is only one cure for a deflation and that is massive deficit spending; for it was only the deficit spending of WWII that broke the deflationary spiral of the Great Depression. Then, the spending necessarily grew our country’s productivity, not our social net. No war is forcing this fix and only if it effectively addresses the deflated housing market* will the dividends of higher productivity lead the world to a quick recovery. If, however, the deficit concentrates too much on expanding the social net, the recovery will be short-lived and the fallout will be like that of LBJ’s well-intended but misguided Great Society: stagnation and eventual high inflation. One can only hope at this point that valor is not mistaken for discretion.
Disclosure: I remain a buyer of US Dollars and am aggressively buying more US equities.
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This article has 35 comments:
AND it's a credit crunch
As far as your comment regarding intrinsic value of money... I perhaps disagree there. The intrinsic value is what it is. It buys whatever the capitalist market allows it to buy. If anything, during a deflationary period the value of this money increases.
It seems like it just comes down to basic Economics 101.
One question I have, if you believe we are in a short to mid term deflationary environment, does it make sense to go long equities? Revenues (price x quantity) are likely to decline, due to reduced pricing (deflation) and reduced quantity (higher unemployment, reduced exports due to USD strength, etc.). However, the implicit discount rate (i.e. the cost of capital) applied to these revenues has shot up sky high (which, in my opinion, is the only mitigating factor to go long equities). I do understand that the cash cost component is likely to fall for firms that have highly variable cost structures. Still, this does not portend well for equities.
Great piece, once again.
I agree with the first half of your article. As I've written on my blog longwavetheory.com and in comments on SA, this is not your garden variety recession nor is it simply a credit crunch caused by a subprime mortgage mess. That said, I don't think the solution is as easy as you imply with your notion that deficit spending will bring us out of the economic catastrophe that we're living through.
I worry about the 50+ trillion in unfunded government liabilities, the real 17%+ unemployment rate, the real wage stagnation and downward pressures on median income, the trillions of consumer debt, the soon-to-be $1.75 trillion budget deficit, the insolvency of all but a handful of money center banks, the lack of a productivity base for our economy, the precarious situation of the currencies and economies of Eastern Europe, Japan, and Asia, the rapacious greed and culture of fraud in the established Wall Street community, the false sense of security that our government is promoting by broadcasting an expectation of recovery in early 2010, our complex and messy geo-political entaglements, the continued appetite of sovereign wealth funds to buy our greenbacks, and finally, the clear lack of understanding of what has gotten us into this mess over the past 20, 50, and 100 years.
There are no easy answers and simply trying to spend our way out of this mess through government stimulus isn't going to address the litany of issues (and more) that characterize our society today. Thankfully the USD is STILL the world's reserve currency. But to think that CANNOT change is exactly the kind of delusional arrogance that got us into this mess in the first place--I'm not suggesting you suffer this affliction, merely that we cannot take for granted our status. We're lucky the USD remains strong, but I do not think there is clear causation between what you describe (deflation and credit crisis) and the continued strength of the dollar. When, and if, the USD is repudiated by our foreign debt owners, all of the systemic problems I outline will hit critical mass and god help us then.
Nik
It stimulates demand, it makes borrowing easier, it creates wealth effects, and it creates some dynamism in pricing that allows for relative shifts to take place (some resources become more or less scarce relative to others over time, so prices must adjust).
If money has time value (it does), shouldn't it also have a half-life? If someone earns a million dollars today- why should that million dollars- absent investment in productive enterprise- be worth more tomorrow? It shouldn't- it should be worth less. Inflation makes this so.
The problem with our central bank is that they want to pop asset bubbles that could have deflated on their own. The Fed used 18 straight rate hikes to push the housing expansion over the edge, and pulled the rest of the global economy down with it. If you want to blame cheap money, go ahead (though we're there again, aren't we?)- I rather liked the "problems" of 2005 and 2006 more than the problems of 2008, 2009, 2010, ...
This attitude you stated is so clearly the cause of problem we now have to wrestle with ..
"You're spot on in your analysis, except there are positives to inflation.
It stimulates demand, it makes borrowing easier, it creates wealth effects, and it creates some dynamism in pricing that allows for relative shifts to take place."
Right now we are learning that there is a price to be paid for inflation. We are paying the piper now, and probably for the next decade or two. Of course, without inflation you have a hard time making an easy 7-10% return on blind investments. Investors will have to take far more risks for those kinds of returns and there will be a genuine risk to investing.
Here I outline some ways to do it.
scriabinop23.blogspot....
The social and political regime under which contractors can make fortunes in 'rents' for really generic services should come to an abrupt end and over time a social 'information utility' should evolve and extends it's coordination and optimization across whole economies, much in the manner of a reallly efficient corporation. See the brand new IBM 'smart planet' ads. The real question is whether any government in world history would be capable of adopting such a method, or will some sort of 21st century consumers' union realize the project.
Speaking of statistics (and semantics, as in the semantic web), any discussion of deflation involving house prices should be framed in terms of long-term price trends. How to mitigate the failures of capitalism kind of begs the question (petitio principi), but in the economic conditions five years ago I came to understand how US interests rates under the rate of inflation are used to force capital into markets, keeping the circus going. And over the last 13 years (if I heard it correctly on ludicrous CNBC while sun bathing yesterday) even equities are only down the rate of inflation over that period. Oops, that's white a bit, actually.
The modern world is imagined and designed by scientists and engineers, and most of the guys who built Silicon Valley came out of Berkeley engineering, not Stanford B School. Neanderthals and the Republican National Committee were equally greedy, but the latter has the benefit of cheap generic hardware (from Taiwan, I'm sure) and at least they're still around. But maybe it's time for some good old disintermediation. IBM shouldn't get their hopes up.
For many years we had inflation in assets and services but much less in food and consumer products. Conversely, it is quite possible that we will now experience a long period of asset and service deflation combined with stagnation or even moderate inflation in food and consumer products.
Unfortunately, the average American consumer owns assets and is employed in the service industry. Thus, this part of the cycle will be as painful as the the previous part was fun. That is, unless you lose your assets or your job, then it will be much worse.
Yes we are currently in a deflation . But it is temporary. It is a deflation of existing assets only. New money is being created and there is more of it out there all the time . The fed is determined to return to an inflationary economy . They can create as much money as they want .The stimulii (more to come), bailouts and humungous new budget will get that money into circulation. New production prices will adjust to the increasing money supply and rise. If the fed and government have the will to create and distribute trillions of new dollars inflation cannot be stopped. Obamas' Marxist desire to tax the kulaks into oblivion is the only possible impediment on the path to significant inflation within the next year or two.
Only after the current money and its issuing institution have failed (and that will be by inflation) can the true deflation occur.
Inflation is an unmitigated evil, it is institutionalized counterfeiting, which is theft. First it distorts free markets , then it destroys institutions and behaviors vital to a free society.
There is no reason why savings of capital should lose value. Rather as knowledge and physical capital increases it should gain value (think computers - more for less every year, without inflation the same would be true for cars, houses, health care- almost everything). This would make social security and medicare unnecessary .
Without inflation you could actually save (store money) and not need to be paid interest (invest). You, through your saved capital would reap the benefits of productivity increases, rather than having these be invisibly stolen by the central bankers, government and their friends.
Instead everyone has to run around and try to find some way to invest their excess capital so as to beat inflation (government/bank theft) . The less discerning actually think they are getting wealthier.
federal reserve delendum est
Of course, this benefits the better off parts of society, so we have to expand the social net to give something to the bottom. Universal health care would be easy to afford with the increased revenues from elimination of the mortgage deduction. Maybe double the bracket for the 15% tax rate too.
You're a man after my own heart. I just offered a similar approach - seekingalpha.com/artic...
scriabinop23.blogspot....
We're all thinking along the same lines.
For better or worse, it appears interconnected global supply and demand constraints are trumping local disconnected monetary policy FOR EVERYTHING.
This is usually when globalization breaks down local sovereignty takes over, and interconnectedness gives way to fear. If trade wars are avoided, then, I agree with you this IS the time to buy cash generating equities. If trade wars and fear are unavoidable, then buy gold (or oil).
The shadow market created artificial credit (my nice words for fraud)
in the trillions, and then suddenly this disappears with their defaults.
I think that this is a normal adjustment.
The govt. is now committed funds and printing money to restore an equilibrium of sorts. And THAT will cause a true inflation.
deflation of assets vs. deflation of a currency are two distinct things, and more precision is required for many writers trying to make their points.
currency inflation will come, only question is when, how high and how long it stays. this will help reflate our assets to some extent, yet the real wild card here is if our wages deflate strongly in advance of the onset of generalized inflation. if that happens, the progress will be very slow in terms of real recovery.
best of luck on those aggressive equity buys. i might see the modest logic of averaging in to some things if you're a committed long=term buy and hold type, but even given that, picking individual companies is still very risky, imo. sounds to me like you're overly willing to lose a bunch of your money (at least on paper) well before there's a mature plan and any real results.
So it is both.
We've been 'stimulated',
Why not try deleveraging.
The bubble in the dollar is also unsustainable, but much less visible, because the dollar has not really gone up much on the exchanges. The over valuation is more a function of the increase in circulation by the Fed which up until now has not been met in a meaningful decrease in the exchange rate.
Devaluation of the dollar is, however, going to cause huge problems with your major creditors. The great boast that America has never defaulted on its debt will mean nothing when most of your creditors feel defrauded.
To recover the US needs massive increases in fixed investment. Unfortunately, the Stimulus largely panders to the consumer as ever, so a huge opportunity has been lost there, but it is really Private Investment that is required. The problem has largely been cause because market conditions in the US have made it much more attractive for US companies to invest overseas. Many US companies are not going to have the financial strength to do much investing of any kind in the near future, so the US is going to need massive investment from abroad. This is not going to happen the way the tables are rigged against such investment.
Devaluation of the dollar is the only thing that is going to turn this around. Once it has been seen to stablize at a much lower level, it will remove the fear of losing ones investment against a depreciating currency and it will make cost of production in the US more realistic. However, it will mean that statistically the relative size of the GDP will be much smaller than previously. This is what is known as waking up to reality. The US economy just isn't four times as big as Chinas. The false sense of wealth because of the distortions in the financial markets is in the process of destroying the US economy. To salvage what is left and to start to rebuild these distortions need to be removed and the propensity to invest in non-productive precious needs to give way to the old virtues of risk and return.
And yes, devaluation of the currency is going to inflate prices and everyone is going to poorer, but that ultimately is the price you pay for financial mismanagement. The problem comes with wage inflation. Wages do need to increase substantially in order for people to actually repay their debts. This will in effect be a redistribution of wealth between the Haves and Have Nots. However, wages need to rise less than prices, or the competitive advantages of devaluation will simply evaporate, and the economy will spiral into hyper-inflation.
This is going to take a decade to unwind, and anyone that thinks it is going to be easy and doesn't require great sacrifice has not understood the problem.
<Doesn't ANYONE understand what inflation is? Inflation is an addition to the <currency above and beyond the rise in production. A deflation is the opposite.
<The shadow market created artificial credit (my nice words for fraud)
<in the trillions, and then suddenly this disappears with their defaults.
<I think that this is a normal adjustment.
<The govt. is now committed funds and printing money to restore an equilibrium of <sorts. And THAT will cause a true inflation.
During the civil war in China, they kept printing money, the inflation rate was 100% a day.
We could control inflation only by produce more goods. We are not going to get better till every unployed back to work. There is plenty work, we can make our own shoes and grow our own tomatos. Why we have to buy from China and Mexico and put our own people with unployment check - printed money for inflation.
Keynes contends that when consumers and business won't spend, government must step in to fill the void. But if consumers and business were given tax relief equal to the total amount of the stimulus package, they would de-leverage (through savings) to the point of comfort (which they must ultimately do anyway) and then begin spending in ways that would get us out of this recession/depression much sooner than will occur under the Democratic spending programs.
eye-on-washington.blog...
All the economic data show that the bottom of the Great Depression was reached in 1932 (when Roosevelt took office) and from then until World War II the GDP began climbing, until 1936, when it was almost at the 1929, pre-crash level.
www.economics-charts.c...
There was a mild recession in 1937 but from 1938 to 1942 (remember that the war started for the United States at the very end of 1941) the American GDP increased.
Unemployment was the big problem that didn't go away but even unemployment improved from 25% in 1932 to just under 10% in 1941 the year BEFORE America entered the war.
books.google.com/books...
If current unemployment statistics were calculated the same way they were in the 1930s American unemployment would be closer to 14% than it is to the official numbers, during the last ten years.
Most historians and political scientists, who keep a healthy distance from economics, think it was the complete defeat of all America's major competitors that was the principle cause of America's economic prosperity after World War II, not the economic stimulus that came from fighting the war.
In fact, the war certainly crippled the American economy because it killed and injured hundreds of thousands of productive American workers and diverted precious resources to into goods and services that were ultimately destroyed by the enemy. In addition, these goods and services were produced INSTEAD of other domestic goods and services such as cars and refrigerators.
We need to argue for government fiscal spending with other, more reasonable arguments.
That is about the debt to equity that Enron had before it tanked.
Lets call this what it really is: The broke loaning money to the broke.
Won't work.
Just as we are doing our government should be tightening its belt and only spending on what will allow people to get through this period, not just throwing money around, hoping it will solve the problem. It will, in fact, lengthen the problem.
This appears to be a complex problem but the solutions are simple: we need to let bad companies go under without taking the entire economy down with them and we need to get our balance sheets in order. This will take time and I think that if this were explained to the people and the government quit changing the rules every few days we would have less panic and more optimism, even as we endure the hardships we must endure.
On Mar 01 12:31 PM carey_jim wrote:
> Again, it's not clear, and probably not true that it was the fiscal
> stimulus of World War II that ended the Great Depression.
>
> All the economic data show that the bottom of the Great Depression
> was reached in 1932 (when Roosevelt took office) and from then until
> World War II the GDP began climbing, until 1936, when it was almost
> at the 1929, pre-crash level.
>
> www.economics-charts.c...
>
> There was a mild recession in 1937 but from 1938 to 1942 (remember
> that the war started for the United States at the very end of 1941)
> the American GDP increased.
>
> Unemployment was the big problem that didn't go away but even unemployment
> improved from 25% in 1932 to just under 10% in 1941 the year BEFORE
> America entered the war.
>
> books.google.com/books...;pg=PA211&lpg=...
>
>
> If current unemployment statistics were calculated the same way they
> were in the 1930s American unemployment would be closer to 14% than
> it is to the official numbers, during the last ten years.
>
> Most historians and political scientists, who keep a healthy distance
> from economics, think it was the complete defeat of all America's
> major competitors that was the principle cause of America's economic
> prosperity after World War II, not the economic stimulus that came
> from fighting the war.
>
> In fact, the war certainly crippled the American economy because
> it killed and injured hundreds of thousands of productive American
> workers and diverted precious resources to into goods and services
> that were ultimately destroyed by the enemy. In addition, these goods
> and services were produced INSTEAD of other domestic goods and services
> such as cars and refrigerators.
>
> We need to argue for government fiscal spending with other, more
> reasonable arguments.
On Feb 28 10:44 AM utilitus wrote:
> The irony is that the greatest opportunity for increased productivity,
> the foundation for economic progress, will be through the expansion
> and reengineering of the 'social net'. For example, medical record
> standardization and automation are the first ingredient for the primordial
> soup of bits that will inevitably evolve into a world-wide informatic
> understanding of the human genome and the principled application
> of such ever expanding knowledge, creating profound human benefit
> and value achieveable no other way. There may be some opportunities
> in the process for our little 'patriotic enterpriser' friends, but
> the utility will derive from the power of applied statistical knowlege
> across whole populations, not romantic capitalism, as reflected in
> recent HMO equity price declines.
>
> The social and political regime under which contractors can make
> fortunes in 'rents' for really generic services should come to an
> abrupt end and over time a social 'information utility' should evolve
> and extends it's coordination and optimization across whole economies,
> much in the manner of a reallly efficient corporation. See the brand
> new IBM 'smart planet' ads. The real question is whether any government
> in world history would be capable of adopting such a method, or will
> some sort of 21st century consumers' union realize the project.<br/>