Taking a Lesson from the Great Depression

The present deflation is worth putting in context. Below (click to enlarge) is the annual rate of CPI change since 1913:

We are in the first deflation since the Great Depression, albeit a mild one. In fact, raw materials prices have fallen just as far, but our consumption basket has shifted to items whose prices are slower to deflate.

Note that the great deflation of 1929-1933 is followed by a brief increase in inflation (to a 5% year on year CPI gain) before falling back into negative numbers. This was the result of FDR’s devaluation of the dollar against gold, from $20.67 to $35 an ounce (a level that held until August 1971 when Richard Nixon again devalued the dollar). That the effects of the dollar devaluation were quite temporary is evident from the chart.

It seems quite plausible that the dollar will fall sharply against some other currencies, notably the Asians, and against gold and other commodities. That may not, however, interrupt the deflationary tendencies which predominate, for to have actual inflation, someone has to take cash and buy goods rather than (for example) securities. If everyone hypothetically wanted to buy securities rather than goods, prices of goods would crash.

Something like this is happening, of course. An aging population increases its purchases of securities and decreases its purchases of goods as it saves for retirement. Americans have saved nothing for the past ten years, and the capital gains that they considered savings-substitutes have vanished. That means that an enormous savings deficit accumulated over more than a decade has been exposed, and that Americans must attempt to correct it quickly and under the worst of circumstances.

That creates a deflationary shock that a few trillion dollars’ worth of stimulus cannot begin to mitigate. America may have the worst of both worlds: currency devaluation AND price deflation, as in the 1930s. That is why TIPS and other nominal inflation hedges do not convince me. Gold, oil, commodities, and Chinese blue-chips are my preferred hedges against a dollar crash. Most of my portfolio remains in high-quality fixed income. I have sold lower-rated credit and taken profits in anticipation of further market weakening.

Comments

[Dave Wrixon:]

Your theory holds true until you consider the global context. Devaluation of the dollar only reduces the buying power of US residents. It will increase the buying power of everyone around the globe. To the extent that goods and services have their pricing determined locally what you say is true, but unless the US takes a much more protectionist stance then the cost of most things will be determined by a much wider market. This may result in a better balance of payments as imports are wiped out and exports improve, but the dollar would buy a lot less at home, and in the short-term at least American will feel much poorer.

Jul 05 03:02 AM

[Fighting Yoda:]

We are likely headed towards deflation. Author has mentioned a very good point about $/gold devaluation - gold price went up 70% against the dollar but we still had goods and asset deflation. Most people do not understand this phenomena - we can have deflation despite $ devaluation. People assume $ devaluation would lead to commodity inflation - that may not happen. Certain commodities may rise because of specific demand/supply situations - but we can still have huge deflation.

At this point with job losses and wage stagnation deflation is almost a certainty.

Jul 05 03:03 AM

[Egg:]

If, if, if we had a fiscally responsible government then I definitely believe we would be looking at deflation. But with Ben warming up the helicopter fleet and the government running a 2T dollar deficit (and possibly planning another stimulus) I just don't see how deflation can happen.

In real adjusted dollars, yes. But there will be little left of real dollars once the Fed gets done "saving" the economy.

Jul 05 03:35 AM

[nobby73:]

I am of the opinion that we are heading to dollar weakening, which means that prices that are more dictated by the global markets, such as oil and commodities, will rise. As there is little chance of wage increases, except for those on Wall Street, the average worker will feel the strain and coupled with deleveraging and attempts to repair savings accounts, there will be less free cash for discretionary spending. The definition of "discretionary" will change as people reevaluate the difference between wants and needs and this is going to keep residential real estate prices low and also keep rent low. Unfortunately, the housing market and it's continuing problems is going to take at least ten years to correct.

No matter what the Fed or government might think, there is no quick fix, especially by creating asset price inflation, it merely creates an even bigger problem further down the road.

Jul 05 05:23 AM

[jimboy:]

Between 1929 and 1933 about 10,000 banks failed (40% of the total) and, in the absence of Federal deposit insurance, a lot of money simply disappeared. The money supply contracted by over 30% whereas this time around it has continued to grow, due to the extraordinary efforts of the government to counteract private sector contraction with public sector profligacy.
Perhaps then the Great Depression is not such a good guide at least in this one respect. Whilst I agree that the deflationary forces are powerful, recent form suggests that the government and Fed are determined to "choose" inflation and I believe they will get their way though some years down the line.

Jul 05 06:47 AM

[nobby73:]

Good points, and I agree that the Fed believes inflation is the magic bullet, but this requires "extraordinary" efforts to keep the Treasury yields artificially low, which cannot be maintained forever. Unless real economic growth returns, and strongly, within 12 months at the very latest, we risk a catastrophic collapse in Treasuries and the US Dollar.


On Jul 05 06:47 AM jimboy wrote:

> Between 1929 and 1933 about 10,000 banks failed (40% of the total)
> and, in the absence of Federal deposit insurance, a lot of money
> simply disappeared. The money supply contracted by over 30% whereas
> this time around it has continued to grow, due to the extraordinary
> efforts of the government to counteract private sector contraction
> with public sector profligacy.
> Perhaps then the Great Depression is not such a good guide at least
> in this one respect. Whilst I agree that the deflationary forces
> are powerful, recent form suggests that the government and Fed are
> determined to "choose" inflation and I believe they will get their
> way though some years down the line.

Jul 05 08:28 AM

[shortpaulso...:]

China......really? You think someone in China making $200 a month is going to bail out the world? most of that going to basic necessities and the rest going to savings? Consider the fact that the $200 a month they make is from selling stuff they maufacture around the globe. Exports are collapsing down 22.6% in April www.nytimes.com/2009/0....
I think too many pundits think China is some kind of magical place that can avoid this financial mess where in....it's just a bunch of commies that will crush the populace if they get out of line. Not getting my investment dollars, and shouldn't get yours.

Jul 05 08:40 AM

[lorddarley:]

The frustrating thing about economists, is that when they discuss "inflation", they are not talking about the stuff I want.

What do I want? The costs are through the roof, and climbing faster than any official index.

1. A secure retirement. Even middle class retirement (if you take a a 4% payout and save a little for inflation) requires $2.5 million of liquid assets, plus social security. God know what it will cost in a few more years.

2. Good health insurance. With "free" Medicare, the costs for Part B and med-ex supplement are about $6,000 per year, a staggering increase, and going up. If married, double that.

3. Affordability to stay in my community. State and local taxes are already too high, and escalating. And the reserves to pay civil service pensions are much too low. These costs are only going up, because politicians spent money instead of putting it aside for the future (which is almost here). A recent University of Chicago study says that the non-federal governments would have to have at least 3 trillion extra dollars just to fund pensions earned to date, not counting future service benefits or post-retirement health promises to public workers. That means quadrupling current levels of non-federal public debt.

It's very clear that a major downward adjustment will have to be made in expectations of the US middle class. The deflation of their "assets" and the failure to save, at personal and government levels, has triggered an impossible inflation in cost of what they expected to have. The big question is whether the world economy can prosper without the US.

Oh, as for deflation. Absolutely. The things we own are going down in value. The things we need, are going up. The world has changed for the US.

Jul 05 08:54 AM

[ain't no fo...:]

The more one looks at things, and the more the numbers come in, the more it looks like we in America have painted ourselves so tightly into the corner that we not only won't be able to reach the door, but there is no door there anymore anyway.

Jul 05 11:21 AM

[Tony Daltorio:]

I'll ignore your anti-China bias.

Who cares about Chinese exports? They don't need to export as much to the US like they did before. Do some research - the interior of China is exploding economically - there is where the majority of the internal growth in China is coming from. Not from the export-oriented coastal cities which Wall Street thinks is the entirety of China.

And why would I, as an American, want to invest in a country which is run by the elitists in Washington & Wall Street who don't give a crap about people like you? No thanks - I'll invest in China where there actually is economic growth and I can invest to secure my economic future.


On Jul 05 08:40 AM shortpaulsonbernanke wrote:

> China......really? You think a Chinaman making $200 a month is going
> to bail out the world. most of that going to basic necessities and
> the rest going to savings? Consider the fact that the $200 a month
> they make is from selling stuff they maufacture around the globe.
> Exports are collapsing down 22.6% in April www.nytimes.com/2009/0....
>
> I think too many pundits think China is some kind of magical place
> that can avoid this financial mess where in....it's just a bunch
> of commies that will crush the populace if they get out of line.
> Not getting my investment dollars, and shouldn't get yours.

Jul 05 11:30 AM

[Maxe Paul:]

Wake up and smell the new world order, you think we here in Australia escaped a recession because we are the "lucky country" ? China saved our arse, and we love it!


On Jul 05 08:40 AM shortpaulsonbernanke wrote:

> China......really? You think a Chinaman making $200 a month is going
> to bail out the world. most of that going to basic necessities and
> the rest going to savings? Consider the fact that the $200 a month
> they make is from selling stuff they maufacture around the globe.
> Exports are collapsing down 22.6% in April www.nytimes.com/2009/0....
>
> I think too many pundits think China is some kind of magical place
> that can avoid this financial mess where in....it's just a bunch
> of commies that will crush the populace if they get out of line.
> Not getting my investment dollars, and shouldn't get yours.

Jul 05 11:46 AM

[American in...:]

I don't see why commodities are the preferred strategy in a time of deflation. A time of deflation is a time of slow growth and that means depressed demand for raw materials. You may get lucky given that oil production has probably peaked, but it is not obvious it is a smart strategy. If you look at the early years of the Great Depression, the best strategy was to hold cash and a reap a a real return of 35% (that was the cumulative price decline during the deflationary years).

Jul 05 12:06 PM

[EUARTE:]

There is another angle. For the few who will be able to get to live abroad it may not be so bad. I am not talking about the rich. I am referring to the middle and lower class.

Say one moves to Brasil. Since the US Bonds must pay higher interest the carry trade will start aiming for the United States Dollar. Thus living in Brasil the dollar will buy more R$'s than say now. Plus the Brasilian economy can not exist without strong exports to EU and USA. China will not be able to help. This the R$ will go down in this way also. I know one thing. Living in the United States will be more than hard.

There is the other question which I never see. China, Brasil and others back their currency with dollars. If the dollar really gets ultra bad their currencies good down with the dollar. They can not sell their dollars under such conditions. Who would buy?

Jul 05 12:24 PM

[verite:]

The big secret that the government doesn't want all the people to know is the 43 trillion to 80 trillion dollars of liability that the government took on from these loan garantees. They want sweep it under the carpet and throw money out the window so that true inflation, not manufactured zeel for properties can come back and take the government off the hook. Obama loves this, finally the rich, the haves, are loosing and he plans on playing the have nots, against them. By using govrnment's money he can buy tomorrow's vote and permanent rulership of this country.

Jul 05 01:58 PM

[msgtb:]

China is lying about their recovery just look at there electricity usage. Its down over 30%, we are being lied to about our economic numbers by our government. Why is everyone so eager to believe the Chinese government. Did everyone forget about the Chinese Gymnast and their ages?

Jul 05 02:07 PM

[Swashbuckler:]

Good point. Those Chinese gymnasts that "won" the gold medals were part of the biggest farce at the Olympics in years. Those gals still had at least a couple of years to go before reaching puberty. And of course all the age documents had "inexplicably" been erased at the time of the Olympics. So naturally the results stood. What a crock. Kids around the world spend their lives preparing for their biggest moment only to get screwed by the lying Chicoms.


On Jul 05 02:07 PM msgtb wrote:

> China is lying about their recovery just look at there electricity
> usage. Its down over 30%, we are being lied to about our economic
> numbers by our government. Why is everyone so eager to believe the
> Chinese government. Did everyone forget about the Chinese Gymnast
> and their ages?

Jul 05 02:45 PM

[John Bowman:]

I believe as a country we were pretty much self sustaining in the twenties. We produced our own steel and many other basic commodities. We buit most of our cars, trucks and trains. We weren't as dependent on foreign resources as we are today.

The CPI which factors in wages was more dependent on the manufacturing sector than it is today. I am not sure what the percentage of the work force was in that sector in the twenties, but I believe today it is approximately only 11%.

Except for unionized workers in the service sector which can be a bit more predictable, there is probably larger fluctuations in wages than what is encountered in the manufacturing sector. Obviously with the demise of GM and Chrysler, the future wages in that sector will surely go down.

The tax burden was also not as large an issue in the twenties. Federal, local income, sales and property taxes as well as Social Security taxes can consume presently up to 50% of a middle class earner's wages.

However, except for saes taxes, they are not reflected in the CPI. I reaize that there can be vast differences among various regions within the country for these taxes. And that is probably the reason they are not factored in.

One thing for sure is that with the stimulus package and the measures which the Fed recently took, taxes will increase locally and at the Federal level. If wages remain stagnant or decrease, there will be less disposable income.

So, what I am asking: is the comparison of an 80 year old CPI to today's index like comparing apples to oranges?

Jul 05 05:31 PM

[Alphameister:]

My house and cars are losing value, and my retirement funds were hit hard last year, but my stock investments are up more than 70% ytd thanks to a decision to invest in China and yet they still trade mostly at multiples of 4 to 8 times rapidly growing earnings. I am surrounded by great offers of savings from restaurants, airlines, hotels, sellers of electronics, etc. At a time when I can't find much reason to be positive about the outlook for my country, I have found much reason to be optimistic personallly regarding the future. Thank God for the global marketplace.

Jul 05 09:11 PM

[sett0047:]

On the last point: Obviously large holders of the $ have a vested interest in its stability, but selling the $ is not the only way to reduce exposure (particularly when managing a stealth balance sheet and dollar denominated assets, of the petroleum variety, are incredibly cheap)?

On Jul 05 12:24 PM EUARTE wrote:

> There is another angle. For the few who will be able to get to live
> abroad it may not be so bad. I am not talking about the rich. I am
> referring to the middle and lower class.
>
> Say one moves to Brasil. Since the US Bonds must pay higher interest
> the carry trade will start aiming for the United States Dollar. Thus
> living in Brasil the dollar will buy more R$'s than say now. Plus
> the Brasilian economy can not exist without strong exports to EU
> and USA. China will not be able to help. This the R$ will go down
> in this way also. I know one thing. Living in the United States will
> be more than hard.
>
> There is the other question which I never see. China, Brasil and
> others back their currency with dollars. If the dollar really gets
> ultra bad their currencies good down with the dollar. They can not
> sell their dollars under such conditions. Who would buy?

Jul 06 04:50 AM

[Peter Cooper:]

You could also short the S&P 500 - a deflation or inflation event would crash stocks short term even if it pulled them up later, see:
arabianmoney.net/2009/.../

Jul 06 09:03 AM

[Peter Cooper:]

You might consider taking profits on China - its stock rebound looks the largest current bubble - exports are down 26%, really by more than a quarter! Only an explosion of local credit has pumped up the economy and that money has also gone into stocks, so save yourself from your next investment disaster and sell...


On Jul 05 09:11 PM Alphameister wrote:

> My house and cars are losing value, and my retirement funds were
> hit hard last year, but my stock investments are up more than 70%
> ytd thanks to a decision to invest in China and yet they still trade
> mostly at multiples of 4 to 8 times rapidly growing earnings. I
> am surrounded by great offers of savings from restaurants, airlines,
> hotels, sellers of electronics, etc. At a time when I can't find
> much reason to be positive about the outlook for my country, I have
> found much reason to be optimistic personallly regarding the future.
> Thank God for the global marketplace.

Jul 06 09:05 AM

[Seeking Advice:]

"Americans have saved nothing for the past ten years, and the capital gains that they considered savings-substitutes have vanished. That means that an enormous savings deficit accumulated over more than a decade has been exposed, and that Americans must attempt to correct it quickly and under the worst of circumstances."

This is the theme I keep returning to. The expected way to pull the U.S. out of recession is increased consumer spending (accounts for 70% of the economy). Yet, how can consumers spend when the only reponsible action right now is to save?

Jul 06 09:46 AM

[commoinsens...:]

Right on the money!!


On Jul 06 09:46 AM Seeking Advice wrote:

> "Americans have saved nothing for the past ten years, and the capital
> gains that they considered savings-substitutes have vanished. That
> means that an enormous savings deficit accumulated over more than
> a decade has been exposed, and that Americans must attempt to correct
> it quickly and under the worst of circumstances."
>
> This is the theme I keep returning to. The expected way to pull
> the U.S. out of recession is increased consumer spending (accounts
> for 70% of the economy). Yet, how can consumers spend when the only
> reponsible action right now is to save?

Jul 06 10:58 AM

[commoinsens...:]

zzzzzzzzzzzzzzzzzzzzz, thanks for letting us in on the secret.


On Jul 05 01:58 PM verite wrote:

> The big secret that the government doesn't want all the people to
> know is the 43 trillion to 80 trillion dollars of liability that
> the government took on from these loan garantees. They want sweep
> it under the carpet and throw money out the window so that true inflation,
> not manufactured zeel for properties can come back and take the government
> off the hook. Obama loves this, finally the rich, the haves, are
> loosing and he plans on playing the have nots, against them. By
> using govrnment's money he can buy tomorrow's vote and permanent
> rulership of this country.

Jul 06 11:06 AM

[frenchy967:]

Ageed, Alpha. I am having a much better experience this year than last. I am however, diversified among commodities, credit fixed income (munis and corps) and have to believe that we are in a period like 76, 81, 94. I am licking my chops to get back in the game. But when ??? I do not agree with you about overseas investing, there are no rules, and if you invest here now, there is virtually no risk. 666 SP was unreal, I loved that it ended there. I have traded for 35 years, I still wear green shirts to work... but that bottom was the final touch to my superstition !!!!!!!

Jul 06 12:25 PM

[upgrayed:]

Nice chart, the current CPI drop is large in the context of the past 20 years but pretty mimimal compared to historical variation - I would guess that we still have a way to go. Also interesting that the early 80's saw similar deflation to the early 30's.

Jul 06 01:33 PM

[Fred Linn:]

Nice chart. Only one problem. The government keeps changing the parameters of the measurements to make themselves look good. Notice how the lines keep evening out over the long run. It is called lying. It means that statistics are worthless. As worthless as the $ is going to be when people wake up and realise what is happening.

The USD (and most other currency) is just paper. There is too much paper chasing too little goods and services. Pretty soon, someone will drop a $100 bill in the parking lot and not even bother to pick it up----the same way they do pennies or nickels now.

Jul 09 01:24 PM