Deflation Looms

This week I published an article at TheStreet.com (here) which asked some questions about what the stock and bond markets are predicting. Do markets predict anything? Well, the way stocks and bonds are priced reflect the expectations of investors: Expectations are "priced in".

The 50%+ rise in the major stock averages has priced in an economic recovery. The rise in bond prices over the past 2-3 months has priced in deflation. It is easy to jump to the conclusion that these two indicators are contradicting each other. The article at TheStreet.com discusses that relationship in detail and asks the question: Can we have a deflationary economic recovery? The question isn't completely answered, but the reader will probably reach the conclusion it is possible.

In this article, I examine in detail what inflationary/deflationary expectations are going forward, and how economic activity appears to be unfolding right now. We start with some startling projections regarding deflation over the next 2-3 years and then move on to indicated economic activity based on flow of money analysis.

Surging Deflation

Quoting SocGen's Albert Edwards, The Pragmatic Capitalist cites evidence (here) that we are about to fall into a deep deflationary period lasting about two years with a cumulative core deflation exceeding 7%. The 7% figure is my calculation from the data in the the following chart showing the two year delayed correlation of core inflation with the ECRI leading indicator.

It is important to emphasize that core inflation does not include the food and energy components of CPI. These are the most volatile components of the consumer inflation measurement and, at times, are larger than the changes in all of the other components. (There is a joke: If you don't eat, need medical attention, heat your home or drive to work, there is no inflation.)

Declining Velocity of Money

To bolster the argument, The Pragmatic Capitalist gives the following graph, showing the continuing depressed velocity of money in spite of a 50% stock market rally.

Looking at the M1 multiplier over a longer period of time gives a better perspective of how unusual the current situation is.

The change in the M1 Money Multiplier has been continuously declining, showing expected increases in the "sweet spots" of the business cycle, for most of the time shown in the graph. At the end of 2008 and in early 2009, there was a monstrous discontinuity. Following this cataclysmic event, there have been very large after shocks, larger and much "sharper" (quicker) than anything else seen in the graph.

Printing Lots of Money

The velocity of money in circulation can be compared to the amount, shown in the following graph.

The amount of money in circulation, M1, has surged by approximately 22% since the beginning of 2008. Broader measurements of money supply have increased more, but cash in the hands of consumers is represented by M1. Much of the new money in the broader classifications (M2 and M3) is going into balance sheet repair for our crippled financial institutions, increased consumer saving and credit reduction.

Economic Activity

Economic activity is proportional to the product of the amount of money in circulation and the velocity of money. This has collapsed, as shown in the following graph developed from the data in the two preceeding graphs.

The graph above is based on the classical equation relating money to exchange value or economic activity:

MV = nQ

where M is the amount of money, V is the velocity of money and nQ represents the economic activity. The equation is often interpreted as Q representing what MV has purchased (GDP) and n is a proportionality constant. For non-mathematicians, this equation is saying than MV/Q is a constant; if MV changes, Q must change in the same proportion to maintain the constant value, n.

Readers can find more complete discussions other the theory of money and transactions in text books. Wikipedia has a readable summary here.

Effect of Credit

Of course, economic activity can also be driven by credit, so we need to look at the level of commercial credit, which is shown in the following graph.

This has been increasing at an annual rate between 2.5% and 3%, hardly enough to make a dent in the 30% drop in economic activity from money in circulation.

According to the St. Louis Fed, there was a total of $9,186.2 billion outstanding commercial bank credit as of August 26. That means the current growth rate is between $230 and $275 billion.

There is a $700 billion hole in economic activity in 2009. The stimulus package is a little more than $700 billion, but the tax cut portion of that (approximately $144 billion in each year 2009 and 2010) is going substantially, so far, to savings and personal credit reduction. The spending of the bulk of the remaining $450 billion is spread over a period of 2-3 years. A back of the envelope estimate is a spending rate of $200 billion per year.

Filling the Hole

The above analysis indicates we have the following things to pour into the $700 billion hole over a one year period of time:

1. Up to $275 billion in commercial bank credit;
2. Up to $200 billion in stimulus money.

That means we are at least $225 billion underwater a year from now. And no consideration has been given to the mounting bank problems documented elsewhere by this author and others that could negatively impact the already low commercial bank credit issuance. All other factors being equal, the hole could be filled by early 2011.

All Other Factors Are Not Equal

This is why there is a debate. The greenshooters cite leading economic indicators predicting a recovery, the slowing of unemployment growth, depletion of inventories, a hesitation in or bottoming in home price declines, an uptick in new housing construction, improved consumer sentiment, and a recently improving ISM manufacturing index.

The brownshooters cite increasing home foreclosure overhang, record length of unemployment, still declining employment numbers, a still declining ISM services index, and decreasing median and average incomes.

I am sure both of the above lists are too short, but it is not my purpose here to weigh those various factors. I just want to be sure to recognize that a lot of other things are changing, both positively and negatively, and they will have an influence on money flows. If the net effect is not positive, the flow of money problems will be aggravated.

Magic Powder

What magic powder can be sprinkled on this mess to make a recovery stick? If the deflationary surge predicted by Albert Edwards does materialize, the outlook may not be equal to the economic pit of 1932, but we will definitely be in over our head.

Deflation is the biggest enemy of debt. Borrow a dollar that buys a loaf of bread and pay back a dollar that buys two loaves is a specification for economic collapse. If deflation as sharp as predicted by So Gen's Albert Edwards occurs, the possibility of deflation and recovery coexisting are greatly reduced.

Geithner says he will be pulling back on accommodation for financial sector firms. He must think he has loaded dice. With this load of crap (pun), honest dice will lose. Or maybe he thinks this is all a confidence game; he just has to proclaim confidence is restored and everything will work itself out.

With all the uncertainty evident in the numbers, this is too early to start reining in accommodation. Unless, of course, we are going to finally follow the path that seemed most reasonable to me in the first place: Put the failures into receivership, quickly separate the bad assets and put reorganized, sub-divided healthy banks back into private hands. The reorganization and break-up process should be designed to produce no banks too big to fail.

Note added after completion: John Mauldin has a full discussion just out in this week's Thoughts from the Front Line (here) discussing the longer term effects of the low velocity of money. The title of the article is "Elements of Deflation, Part II". This is highly recommended reading.

Comments

[John Petersen:]

I have to like those Sunday mornings when two of my favorite writers named John (Loundsbury and Mauldin) explore the same issue in depth. Thanks for a very helpful piece.

Sep 13 03:04 AM

[Steven Hansen:]

We almost have $2 trillion of excess liquidity complements of the Fed - that is over 15% of GDP. This has never happened before in our economy. Kick in a shotgun stimulus, a Fed which has vowed to inflate, and desperate politicians which must face the people in 2010.

Face this off against the velocity of money (deflation). Does anyone have some evidence which economic force is stronger? I have also argued also we may be faced with a deflationary cycle.

My hero Peter Schiff is arguing we are facing an inflationary cycle. If it were as simple as taking a vote, more people are arguing deflation is the larger threat.

Quite honestly, i could build a case for either way. But I 100% agree with John that real recovery and deflation will not sleep in the same bed.

Sep 13 03:28 AM

[mna:]

John,
Thanks for another fact filled and insightful analysis. I'm of the opinion that deflation is probably the natural tendency in this part of the cycle, the inevitable result of the popping of the private sector "bubbles" last year.

That said, I think substantial deflation will not come to pass because the Fed has within its grasp every tool it needs to force inflation, if necessary, to reflate assets, prop up bank balance sheets, and instill consumer confidence. So I wouldn't worry too much about Timmy and Ben pulling back the stimulus too much. There's just no limit to the amount of money the Fed presses can print. The real question is, will they withdraw the money once velocity picks up? I don't think anyone really knows at this point.

Sep 13 04:25 AM

[adan:]

great info, and glad you mentioned john mauldin's part 2 on deflation also - thanks!

Sep 13 04:50 AM

[markfl:]

If you take into account just the core PCE deflator, some sources have suggested that this has been the weakest period of consumer participation in the economy in several decades (including previous recessions).

Sep 13 05:06 AM

[Faisal Humayun:]

There is no doube that in the near term one can see deflation. It is also worth mentioning that some sectors can have inflation while other deflation. Example - Equities and Commodities went up post March 2009 while housing prices declined.

Moreover, with the massive debt burden of the U.S., there will be every effort to prevent deflation through massive quantitative easing. This might show itself in the form of inflation in the long term.

I think inflation is not just increase in prices (due to demand supply mismatch)...If the Government wants to debase its currency (to get out of the massive debt burden) then inflation will result.

But for sure a good article with lots of supporting charts and data.

Sep 13 05:16 AM

[AlphaDude:]

Great article, can't fault the analysis. I think that deflation in some sectors will occur but with the Fed sworn to fight it with massive Queasing it surely can't persist. Then, helicopter Ben will have to act like a magician to grab back all the $$$ he's thrown into the system. Maybe he can do it without causing massive disruption to growth, if he does I will take my hat off to him, but if he can't/won't then surely there must be inflation to come.

Disclosure : 25% in Allocated physical Gold Bullion

Sep 13 05:54 AM

[CautiousInv...:]

In John Mauldin's piece yesterday he explored deflation in the second part of a two part series.

In his graphs he used both M2 and M3 in describing historical money supply growth and their respective multipliers through the current period. He also plots the M2 and M3 multipliers against changes in the CPI.

As a broad statement, there is what appears to be strong, positive correlation between between money multipliers and the CPI. It was almost concurrent with movements in the M3 multiplier until around 1982 when the CPI starts featuring a "diluted lag".

Presently the M3 multiplier, based upon unofficial sources as the Fed for unknown reasons stopped publishling M3 data in 2006, is at the same level as it was in the early 30's when prices were contracting in the 5% to 6% range. Depepending upon which measure of the CPI you use, prices are currently falling in the .2% to 2% range.

I stronly suspect they will fall further as we proceed with widely herealded "recovery." (An interesting data point: China's producer prices are falling at a 7% rate amid their more substantial recovery)
Growth in M2 (around 8%) and growth in M3(around 18%) are not keeping up with the rates at which their respective multipliers are falling. The growth in M3 has not gone into bank lending, leading one to think it may have sluiced its way into one of the markets.

The bottom line is that the Fed unlikely to unwind its balance sheet anytime soon and could very easily implement new policies to offset contracting money multipliers.

Sep 13 06:42 AM

[Bling Daddy:]

This is an amazing experiment. History books will look back at this time and PhD's will be earned analyzing methodologies and outcomes.

It is amazing that this is still guesswork for so many of our most brilliant minds. Inflation, deflation, stagflation...

I think healthy markets strive for balance. Our balance has been lost, or maybe "taken away" is a more appropriate descriptor. The wonderful book "Economics in One Lesson" by Henry Hazlitt foretold of the consequences of tampering with fundamental market variables. This is being played out in front of our very own eyes.

Thanks to Mr. Lounsbury for once again succinctly and objectively identifying many of these important variables. The interplay of these variables and others seems to be somewhat chaotic. I worry that "correcting" our economy is like "correcting" a car that has begun to fish-tail on ice. Each correction pushes the car into ever bigger fish-tails until it spins out of control... Or until the path is recovered. It's a dangerous game that is best avoided from the get go.

Artificially manipulating markets is akin to playing with fire. The saddest part of the equation is that those in least control get burned the most. I hope we can control the fire.

Sep 13 06:50 AM

[Michael Clark:]

Actually, you took the words out of my mouth. Give me a cup of Lounsbury and a slice of Mauldin and my morning's pretty much complete. (I don't believe the deflation will last for two years -- I think it will last another decade, and that Japan is a model for where we are going -- but I really appreciate the great scholarship of both Johns as rational evidence of why we are going where we are going.

Thank you, John, for posting here.


On Sep 13 03:04 AM John Petersen wrote:

> I have to like those Sunday mornings when two of my favorite writers
> named John (Loundsbury and Mauldin) explore the same issue in depth.
> Thanks for a very helpful piece.

Sep 13 07:10 AM

[Michael Clark:]

Steven: When I consult my 'mythology indicators' deflation trumps inflation. Inflation has already had its 18 years (inflation in the largest sense: inflation of the bubble economy). Now we'll have 18 years of deflation of the bubble economy.

I'm reminded of this quote from the Great Depression era (actually, we've had quite a few 'great' depressions, and we're in another one):

“We have tried spending money… We are spending more than we have ever spent before and it does not work… After eight years of this Administration we have just as much unemployment as when we started.” - Henry Morgenthau, Jr., FDR’s Treasury Secretary, 1939

Throwing money into a furnace does not create inflation. Inflation is created by a hungry populace all chasing merchandise. That is the 'filling up' part of the cycle, the Day-Cycle: HUNGER. Desire to possess the world. And a willingess to fight to possess the world, competition. The 'emptying out' part of the cycle is the deflation phase, SURFEIT. Satisfied desire. Being full and having no desire for more possessions. A turning away from the world. A THIRST for something less material. A slackening of the will to compete for bodily pleasures.

When the Willl turns inward, the material bubble collapses in on itself. Throw matter at the Black Hole and it simply eats the money, burns it.

The East Indians believe Brahma breathes the world out -- breathes spirit or energy into matter, animates the body, the material world-- this is the Day of Brahma. And then Brahma breathes the world in -- pulls energy out of matter, de-animates the body -- this is the Night of Brahma. In many ways Brahma is like an electric current plugged in during the Day, and removed during the Night.

Another word for 'breathing out' is 'expiration'. This is a wonderful idea because the implication is that the positive experience of life and expansion also has an inborn negative, that anything born also dies. It also suggests that expansion has a built-in 'expiration date'. Another word for 'breathing in' is 'inspiration' suggesting that the death or the deflation period is also positive -- that infusion with vision and excited understanding also accompanies the state of declining bodily strength.

Inflation is the swelling of the body of expression: civilization grows, empire and the idea of empire animate, citizens actually grow larger and fatter, cities get bigger, everything gets bigger. Deflation involves a shrinking of the physical body, the shrinking of ideas, the 'problem' of obesity goes away. Remember the title of one of the most popular environmental books during our last Night-Cycle: 'Small is Beautiful'. Another book title during the same time period: 'Black is Beautiful'. Black as in 'black as the Night'.


On Sep 13 03:28 AM Steven Hansen wrote:

> We almost have $2 trillion of excess liquidity complements of the
> Fed - that is over 15% of GDP. This has never happened before in
> our economy. Kick in a shotgun stimulus, a Fed which has vowed to
> inflate, and desperate politicians which must face the people in
> 2010.
>
> Face this off against the velocity of money (deflation). Does anyone
> have some evidence which economic force is stronger? I have also
> argued also we may be faced with a deflationary cycle.
>
> My hero Peter Schiff is arguing we are facing an inflationary cycle.
> If it were as simple as taking a vote, more people are arguing deflation
> is the larger threat.
>
> Quite honestly, i could build a case for either way. But I 100%
> agree with John that real recovery and deflation will not sleep in
> the same bed.

Sep 13 07:40 AM

[John Bowman:]

OK....great article. But what if the dollar collapses, as many are predicting and the price of oil surges (for a variety of reasons)?

It is convenient to disregard energy prices, but like the author states, reality tells us differently. Just remember, Social Security gave retired Americans an additional 5.8% this past winter due to cost of living increases. So some government entities still feel that it is important.

Sep 13 08:17 AM

[fran:]

STEVE, JOHN--

intersting debate on deflation vs inflation for several weeks on FINANCIAL SENSE NEWSHOUR[J. PUPLAVA]. first two weeks was prechter vs schiff. may be educational for some of your readers.
financialsense.com


On Sep 13 03:28 AM Steven Hansen wrote:

> We almost have $2 trillion of excess liquidity complements of the
> Fed - that is over 15% of GDP. This has never happened before in
> our economy. Kick in a shotgun stimulus, a Fed which has vowed to
> inflate, and desperate politicians which must face the people in
> 2010.
>
> Face this off against the velocity of money (deflation). Does anyone
> have some evidence which economic force is stronger? I have also
> argued also we may be faced with a deflationary cycle.
>
> My hero Peter Schiff is arguing we are facing an inflationary cycle.
> If it were as simple as taking a vote, more people are arguing deflation
> is the larger threat.
>
> Quite honestly, i could build a case for either way. But I 100% agree
> with John that real recovery and deflation will not sleep in the
> same bed.

Sep 13 08:38 AM

[Gary Savage:]

Just curious but how does the price on the 10 year treasury falling from 130 to 119 since the beginning of the year signal rising bond prices?

A more appropriate sign of deflation would be the dollar rising. At the moment the dollar is comfortably below very long term resistance at 80.

Sep 13 09:13 AM

[change is t...:]

One of my professors from Graduate school, as part of his last lecture of the year, gave the insightful comment.."what you need to have above everything else, is the ability to absorb uncertainty". Both inflation and deflation proponents argue with fundamentally sound analysis. This means both are partially right, and will be proven as partially wrong.

Bling Daddy's metaphor of a car on ice is perfect. Navigating a car on ice means knowing when (and how) to correct skidding. Too much liquidity (inflation) and you will spin out of control, not enough (deflation), and you will go so slow as to not move at all. Therefore, the classical analysis of employment's relation to inflation still holds. Until the number of jobs added equals or exceeds the number of jobs lost, deflation will trump (steadily declining demand). If and when that flips, only then look for inflation. As the numbers above indicate, big chunks of the helicopter money is only shoring up insolvent banks, not (or no longer) being lent to people who splurge and then can't pay it back.

We have a long way to go before crossing the ice.

Sep 13 09:17 AM

[I need more...:]

Deflation doesn't loom, it is in the here and now:
- housing continues to deflate, even with gov programs attempting to reflate; not working
- cash for clunkers was good for a quick sugar high; now all those purchases are pulled forward and gone.
- have you been to mall lately? I only buy something that is at least 70% marked down, and it is not a hard search
- I can't believe how cheap my favorite cuts of beef are. Yum.
- restaurants are offering two-fers, kids eat free, etc. This is in Austin, where we are told we haven't been hit as hard
- hotel rates are down 50% if you just look for bargains
- gas prices are the only thing I see that still has pricing power

The people that believe there has not been a seachange in attitude must be blind. The American consumer is not stupid ( anymore that is ); they see beyond the MSM cheerleading, they know the economy is down and out; they see nothing being done to address job creation; they see the out of control DC spending and are rebelling. Once congress gets it that if they want their jobs, they must rein in gov spending, things will really deflate, because that is all the liquidity holding things up to some degree now.

Plus, this is a global issue. Sure, China is still spending, but that cannot go on forever, and they are making the same non-productive lending mistakes we made.

Velocity is shot, wealth destruction of US alone $30T is too big a hole for the Fed or anyone else to fill, and when the crash comes ( and it will ) that will be the final wealth destruction straw.

Sep 13 09:42 AM

[axelrod608:]

Lounsbury and Mauldin in 2012. Not that they'd be interested.

A lot of people don't get the simplistic forces at work here. First, real wages adjusted for inflation have not increased since the early 1980's. Increased family incomes were a function of more family members working and working more hours. Plus the bizarre accounting trick of counting equity from mortgage refi's as "income". The feds also counted refi equity proceeds as GDP. Without it, GDP "growth" would have been negligible from the late '90's to 2007.

Second, if you think of credit purchases as pre-spent income, the bubble was formed by the vast majority of America's middle class spending far more than they were earning by accumulating debt. I have yet to see a single writer comment on the function of debt as a reducer of the velocity of money. Today's earnings aren't going into the productive economy for more goods and services. They're going to pay back the last decade's excess.

What one would believe to be a great deal of liquidity is merely being absorbed against continuing capital losses and to repay old debts.

If deflation in the housing and CRE sectors continues at current rates, the Fed can't create money fast enough to replace the losses. So much for futile and failed monetary policy.

Sep 13 09:46 AM

[MrZack888:]

WHAT ABOUT both deflation and inflation happening same time. in different sectors. inflation in consumer items such as food and oil, while deflation in retail items such as cloths, electronics, rent, house prices. Plenty of inflation for guns, weapons, bullets last time I checked. also no change in price for services such as mechanics, doctors, dentists, lawyer fees, insurance, college, barbers etc..

Sep 13 09:48 AM

[axelrod608:]

>> "This is an amazing experiment. History books will look back at this time and PhD's will be earned analyzing methodologies and outcomes.

It is amazing that this is still guesswork for so many of our most brilliant minds." >>

I liked Bling daddy's comment, but this first part isn't true. This is not really an experiment. The results are already in, but this nation's "leaders" are just ignoring the facts.

A few years ago, economists at the World Bank studied all national economic crises over a 30 year period. Amongst their findings was that the length and depth of the following recession were directly correleted with the amount of money the country threw at the problem in order to fix it. This occurred in every case, without exception.

Our nation's "leaders" don't believe this. And based on the tsunami of money they have thrown and are throwing and threaten to continue to throw at the problem, one can safely predict that based on experience, they are creating the longest, deepest recession in global history.

In another comment today I said that economics is not a science, just observation and opinion. Because of that, people like Bernanke can hold their opinions firmly in the face of the opinions of others that were determined by analysis of factual historical examples.

We're going down spending folks, because the folks in charge aren't willing to face facts or learn the lessons of history.

Sep 13 10:06 AM

[oldgoldbug:]

The article and the comments are, for the most part, about as good as it gets in terms of intelligent and thoughtful commentary.

The velocity of money stands out to me as the biggest uncontrollable variable. If it stays down, then the scenario presented by the author appears likely to occur. The recent rise of TLT from 88 to 97 tells us that investors continue to consider deflation a decent possibility- is another economic shoe about to drop? But 97 is still a long way from the 122 high much as 9600 is a long way from the 6500 low, especially when the amount of bond buying from the FED is taken account.

Will the velocity of money skyrocket if holders of dollars panic? There is already some evidence of this in the "hammering" (thank you Peter Schiff) of gold at the $1000 level. $1000 folks - that is a long long long way from $35! (Sometimes I think we are like the proverbial frog in the pan of slowly heated water - we don't get it until it is too late) Add to that the way silver is perking up and my interpretation is that real concern about the value of the dollar is beginning to reach very significant proportions.

Perhaps deflationists take comfort in the belief that should inflation really ignite, all that is needed is a Volckeresque stand and all will be well. But do Helicopter Ben and the government have the fortitude to actually do it?

Sep 13 10:58 AM

[Googlegiiggle1:]

A new middle-east war, which is likely to happen soon, could throw another variable into this chaos.

Sep 13 11:47 AM

[TAS:]

Scholarly article, for sure.

However, over the years many scholarly studies have been proven 180 degrees wrong as to the real outcome.

Intuition tells me that too many dollars chasing too few goods plus high unemployment plus the socialization of the US economy = paying off massive debts the old fashioned way...using inflation to pay off debts and poor policy decisions.

Others, including the author, will disagree. That's what makes predictions an art and not a science.

Sep 13 11:54 AM

[Kevin_T:]

Could the conflicting indicators of the stock and bond markets be caused by the distortions of the markets by the huge Fed and Treasury intervention in the economy?

Since the Fed is doing all in its power to keep longer term bond yields low and has vowed to continue this for "an extended time" large investors may be buying bonds with the expectation they collect some yield and have time to sell again before the Fed changes its policy. This rather than expectations the bonds will further rise in value over time which would be an indicator for deflation.

At the same time the stock market is fueled by the huge increase in M1 money supply and available inexpensive leverage rather than expectations of booming economic times ahead.

In other words, the current stock and bond market run-ups are just the result of huge excesses of cash looking for any potential return in the short term.

If this is the case then we have to expect another economic earthquake when conditions begin to normalize. Stocks and bonds will both sell off at the same time as interest rates rise, fear becomes dominant and inflationary bubbles in hard assets could form as all that excess cash looks for a home outside the stock and bond markets.

Sep 13 12:12 PM

[Alphameister:]

Very persuasive article and many superb comments. Agree with oldgoldbug that this is about as good as it gets in SA.

I read through the comments waiting in vain for some of today's commodity bulls and hyper-inflation theorists to weigh in with a persuasive rebuttal of John's deflation argument, hoping to derive the same sense of peace that comes from seeing proponents of global warming arguing vigorously with those fearing a new ice age, but no such luck.

To the extent that things are not yet out of control and we are still in a position to create, through policy, some outcome comfortably between the two extremes of deflationary collapse and hyperinflation, I'm hoping for an extended period of stagflation since I see that as the best of all plausible outcomes for the foreseeable future.

Regarding those conclusions of the World Bank cited by Axelrod, I suspect that quantitative easing may have spared us from the worst depths of depression but only at the cost of extending greatly its duration such that the integrated loss of output (average depth of depression times duration) will ultimately be exacerbated by today's policy measures.

Sep 13 12:32 PM

[badScooter:]

Thanks, Mr. Lounsbury, for the concise and educational presentation of this position. I tend to consider inflation a more likely endgame, but then, I don't know much...

It's been mentioned a couple of times in the comment thread. In engineering generally, they call it a "positive feedback loop". In nuclear physics, it is known as "prompt critical". Airplane pilots know it as "PIO", or 'Pilot-Induced Oscillation'. Anyone who has driven in ice with rear-wheel drive (as Bling states) has experienced it. It shows up endlessly in the natural world, the notion that tinkering with complex systems can create exponentially changing results. My business partner mentioned to me the other day, "you know, I believe there is such a thing as Economic Physics". Yup. And I'm not so sure that anyone really understands it all, although folks like Dr. Talib seem to be on the right track. I'm not even that confident in Geitner or Bernanke.

Sep 13 12:59 PM

[Jan Paul:]

There are two economies that will influence inflation/deflation.

One is our economy which almost all deflation proponents focus on. When you take the data they provide, it virtually never comes from the "other economy, the "global economy" and the 2 billion middle class consumers in it. I can't find hardly a flaw in the logic of those who view deflation as the "sure bet," because of that limited view.

However, when I take our 300 million people and maybe 200 million middle class consumers and match them against 2 billion and the growth in trade between emerging markets and growth in internal consumption, I have to come away with a different view.

Then, I look at the number of nations making non-dollar trade deals and currency swaps to keep from getting more dollars they have to get rid of, the lending to the IMF to support SDR's, and our continued bad monetary and economic policies and I have still another view that spells, deflation and inflation at the same time, or stagflation as some call it.

Falling asset prices and for now, until we see whether this "global recovery is "real or is it Memorex," falling prices in many consumer goods, we have the effects of a low velocity of money and low money multiplier (we have inflation which is money supply, not price change which is an effect and there is a lag factor that can be years in coming if not reined in soon enough).

It will be the global velocity of dollars as nations buy commodities and those receiving dollars for those commodities try to spend the dollars as fast as they can to get rid of them, that will be one force to deal with. UAE nations are still looking a making a new oil currency even if there is no new global currency to get away from the dollar, just as Iraq did before the war, and Iran is doing now. Even our South American nations are making non-dollar trade deals with each other as China has become their largest trading partner.

As our consumer demand stays down around 60-62% instead of 70% (thanks to debt spending), we become less and less of a reason for nations to use the dollar. Although I expect a market correction and dollar rally and falling commodity prices short term, I see nothing supporting the dollar long term.

Why would you support a dollar coming from a nation that can't grow or tax out of the crisis it is in (Congress was warned of this potential before this crisis even hit in testimony and GAO reports)? Why would you support the dollar when less and less of your exports are going to the nation that has the dollar?

Why would you support the continued use of the dollar when the nation that issues it hasn't changed a single policy regarding monetary and economic policy (borrow to spend) that it used for decades to get in this mess?

The only support coming is that which is designed to avoid a collapse and instead have a slow demise to the dollar. The risk is that just one nation has to sell more than other nations think is needed and a panic starts to get out of the dollar before the other nations do. In a study, many monetary analysts tried to determine what would be the most likely cause of a run on the dollar.

They decided a "rumor" or misinterpretation of a nation's selling of dollars could cause the dominoes to start falling. There didn't need to be a justified cause, just speculation. Of course, we know that today's markets are all based on sound judgment, so speculation isn't a concern.

Whether the dollar fades slowly or rapidly, eventually all raw material prices rise and that includes food stocks that are bid on globally. So, even though we have plenty of food, it would become more profitable to sell on the open market that is used by the world, than to keep prices down to a level we could afford.

Oil at $100-200 a barrel not only kills the consumer but the entire economy, tax revenues, GDP, and any chance of ending deficit spending. So, throwing energy out of the core CPI doesn't change the real world we live in.

However, if the global recovery is revealed to be an illusion (some say the Baltic Dry Index is saying this) then we will have massive deflation and the dollar may stay up for years.

There are just too many variables and unknown factors at play at this time to forecast next month, let alone next year. What we do know is that at some point there will be a global recovery and we will have rising prices in global goods and commodities and a falling dollar. We also know we won't be taking part in it for a decade or more with the policies we have in place.

A nation can't continue to borrow more that it can deal with in the private sector. You can't continue to expand government aid to more and more people with fewer and fewer tax revenues coming from those left in the work force. You can't keep going when the foreign loans are cut off once they get their non-dollar goals within reach.

Months? Years? Who knows but, we know where we are headed and that we can only delay what is coming, not avoid it.

Sep 13 01:06 PM

[John Lounsbury:]

I should look at Seeking Alpha news earlier in the day. The John Mauldin article I cited at the end of my article is still available on John's web site (the link was provided) but is also here on SA seekingalpha.com/artic...

Sep 13 01:41 PM

[dspg:]

Okay--I read this and Mauldin's articles. Where does one invest currently to avoid getting beaten up? Commodity based companies? Big cap growth? Any suggestions?

Sep 13 01:46 PM

[John Lounsbury:]

Garry Savage - - -

You wrote:

"Just curious but how does the price on the 10 year treasury falling from 130 to 119 since the beginning of the year signal rising bond prices?

"A more appropriate sign of deflation would be the dollar rising. At the moment the dollar is comfortably below very long term resistance at 80."

I wrote:

"The rise in bond prices over the past 2-3 months has priced in deflation."

You are correct and so am I. Along about June Mr. Market changed his mind and the inflation theme changed to hesitation and then deflation. This gentleman can change his mind again at any time. The only things I can do as an analyst are (1) look for factors that might influence what Mr. Market mught think next and (2)watch what he does.

With regard to your second point, which is well taken, I would suggest that you not rule out that this is a race to the bottom. If we do have a debt driven deflation, the decline in the dollar index could simply be indicating that, on average, we are ahead in that race and all fiat currencies (which today means all currencies) are in trouble, some more than others.

MrZack888 - - -

I agree. That is why I wrote in the article:

"(There is a joke: If you don't eat, need medical attention, heat your home or drive to work, there is no inflation.)"

Kevin_T - - -

Good argument. I have read discussion from others that relates the QE activity to the rise in stock prices. I have not tried to follow that money trail, so I don't want to try to clarify that. I'll just say it shouldn't be dismissed.

Sep 13 02:07 PM

[Jordan Lindsey:]

First writer I am now following. Someone else who sees the problem of deflation instead of inflation is someone I need to be associating myself with.

Sep 13 02:22 PM

[Ricard:]

Mr. Lounsbury,

Another well argued and most professional essay. I am beginning to wonder if you've accumulated enough material to write a textbook in the near future on economic crisis management...?

Regarding Mr. Hansen's comments, I have many of the same concerns:

> We almost have $2 trillion of excess liquidity complements of the
> Fed - that is over 15% of GDP. This has never happened before in
> our economy. Kick in a shotgun stimulus, a Fed which has vowed to
> inflate, and desperate politicians which must face the people in
> 2010.
>
> Face this off against the velocity of money (deflation). Does anyone
> have some evidence which economic force is stronger? I have also
> argued also we may be faced with a deflationary cycle.

I think the key lies with the Fed. Depending on how they react in the face of this evidence (if they ever see it), Bernanke has been exceptionally clear that he will prevent deflation at all costs. Articles like this would then measure not the amount of future deflation that will pervade the economy, but the amount of inflationary stimulus that has yet to be introduced into the mix.

> My hero Peter Schiff is arguing we are facing an inflationary cycle.
> If it were as simple as taking a vote, more people are arguing deflation
> is the larger threat.

I think what Mr. Schiff is predicting is eventual inflation. On the other hand, what Mr. Lounsbury is getting at in this article is how bad the deflation can be if we (or just the Fed, really) do not implement counter-measures to compensate. That's how I read it at least...I see less of a prediction in this article than a forewarning of how bad the deflation can be if we do not act to counter it. If this article was meant to be a prediction, I think Mr. Lounsbury wants to be dead wrong on it...but now I am putting words in his mouth.

> Quite honestly, i could build a case for either way. But I 100%
> agree with John that real recovery and deflation will not sleep in
> the same bed.

I'm actually beginning to change my mind on this one. From my limited knowledge on the subject, I believe deflation fears were mainly stoked during the Great Depression. What deflation introduced was a massive fear of easy-money profligacy and a strict saving discipline, one that served us well for decades following.

From a lesser economic perspective and a more behavioral perspective, maybe deflation is exactly what we need - a shock into the mindsets of Americans to restart a saving mentality. It's unfortunate that this economic prescription for recovery may be opposite to sound, reasonable policy course of action, but, like inoculations and vaccinations, an injection of the actual viral strain may be exactly what we need to protect ourselves in the future from its mal-effects.


BTW, I read the Maudlin article, another great read, thank you. The money quotes I got from it:

"The Fed has more room to print money than most of us realize. How much more? My bet is that we’ll find out. Will they print too much at some point? Probably."

"I am much more interested in learning what the Fed and Congress will actually do and then shaping my portfolio accordingly."

On Sep 13 03:28 AM Steven Hansen wrote:

Sep 13 03:08 PM

[rosey99:]

You have the perfect amount of cowbell! The fact that deflation has the upper hand, in spite of historic efforts to create inflation, is profoundly worrying. Another disturbing fact is that monetary and fiscal policy have limits, and we don't know how close we are to those limits. The scale of the deflationary force at work is difficult to comprehend.

On Sep 13 09:42 AM I need more cowbell wrote:

> Deflation doesn't loom, it is in the here and now:
> - housing continues to deflate, even with gov programs attempting
> to reflate; not working
> - cash for clunkers was good for a quick sugar high; now all those
> purchases are pulled forward and gone.
. . .

Sep 13 03:36 PM

[Gregman2:]

The velocity number has always been the key figure, yet few have paid much attention to it. And that's a huge mistake. Excellent article.
see: www.debtdeflation.com/.../

Sep 13 04:26 PM

[Tony Daltorio:]

The whole concept of money velocity is garbage. It is meaningless theoretical junk that economists think up to keep themselves employed, but it has no real-life practicality.

When the dollar falls off a cliff, you can kiss deflation goodbye.........

Sep 13 04:33 PM

[Northstar10000:]

First deflation will suck dry the green shooters with plunging prices, a market drop, stopped out commodity longs and a rising dollar. when they have destroyed those fools, about spring 2010, they will polish off the deflation nuts who will have jumped on the deflation train at exactly the wrong time. Get the masses on the wrong train going the wrong way at the wrong time and presto Goldman wins another round while the little jokes get toasted again

Sep 13 04:57 PM

[rennert:]

Were did this joker crawel out from under? What does he mean "houses deflate"??? How often do people buy a house? Onced a month??? No, but they have to eat , to the doctor with them selfes and their children and go to the vet all the time!!!!! And guess what, the prices for all those items are constantly going up.
Maybe the author does not know this since his Butler seems to be buying and serving his caviar for him.

Sep 13 07:40 PM

[rappstr:]

You have to combine money supply with money velocity to get the picture. If velocity falls by half then the money supply must increase commensurately to just stay in the same place. So a 50% drop in velocity must be offset by a 100% increase in money supply.

In a weak economy increasing the money supply gets more difficult. An easy way to increase the money supply is to monetize our debt and run up the deficit, which is exactly what Bernanke has wanted to try ever since writing his Phd thesis. Get rid of the IRS and finance all of our budget by printing money. Under his theory the resulting devaluation of the dollar would be less costly than having an IRS. But the Chinese were quick to spot this agenda and they sent over a delegation to put a stop to us monetizing our debt as a way out of our mess, thus undermining the value of China's US Treasury holdings.

So Bernanke is in limbo with no clear path. Once all this seemed so clear to him. "As long as we have an airplane and a printing press we will never have deflation!" The clarity of his idealistic youth is giving way to the compromises of political power.

Honestly we may have no choice other than to monetize our debt.
The Chinese may make good on their recent threat and may become net sellers of our Treasuries. But that would be a bullet to their head too. Like it or not globalism has tied all our fates together and all our teats are in the same wringer.

The key here is to avoid harsh shocks to the system. Buying time is our only course forward. So if velocity falls of a cliff then the fed must expand the money supply by whatever means necessary, including monetizing our debt as a last resort.

Ultimately our country will have to start producing value for the global economy. Our union oriented labor laws are responsible for most of the mess we are in. If we don't have competitive labor then we cannot compete at all. Unions are too unwieldy, ornery, and slow to fuel a manufacturing economy with viable labor. The basis of our economy's value was always largely manufacturing and now that is gone thanks to our labor laws. So until we look ourselves in the mirror, we will skirt the issue and fool with time wasting half-solutions.

On Sep 13 07:10 AM Michael Clark wrote:

> Actually, you took the words out of my mouth. Give me a cup of Lounsbury
> and a slice of Mauldin and my morning's pretty much complete. (I
> don't believe the deflation will last for two years -- I think it
> will last another decade, and that Japan is a model for where we
> are going -- but I really appreciate the great scholarship of both
> Johns as rational evidence of why we are going where we are going.
>
>
> Thank you, John, for posting here.

Sep 13 07:40 PM

[rappstr:]

You have to combine money supply with money velocity to get the picture. If velocity falls by half then the money supply must increase commensurately to just stay in the same place. So a 50% drop in velocity must be offset by a 100% increase in money supply.

In a weak economy increasing the money supply gets more difficult. An easy way to increase the money supply is to monetize our debt and run up the deficit, which is exactly what Bernanke has wanted to try ever since writing his Phd thesis. Get rid of the IRS and finance all of our budget by printing money. Under his theory the resulting devaluation of the dollar would be less costly than having an IRS. But the Chinese were quick to spot this agenda and they sent over a delegation to put a stop to us monetizing our debt as a way out of our mess, thus undermining the value of China's US Treasury holdings.

So Bernanke is in limbo with no clear path. Once all this seemed so clear to him. "As long as we have an airplane and a printing press we will never have deflation!" The clarity of his idealistic youth is giving way to the compromises of political power.

Honestly we may have no choice other than to monetize our debt.
The Chinese may make good on their recent threat and may become net sellers of our Treasuries. But that would be a bullet to their head too. Like it or not globalism has tied all our fates together and all our teats are in the same wringer.

The key here is to avoid harsh shocks to the system. Buying time is our only course forward. So if velocity falls of a cliff then the fed must expand the money supply by whatever means necessary, including monetizing our debt as a last resort.

Ultimately our country will have to start producing value for the global economy. Our union oriented labor laws are responsible for most of the mess we are in. If we don't have competitive labor then we cannot compete at all. Unions are too unwieldy, ornery, and slow to fuel a manufacturing economy with viable labor. The basis of our economy's value was always largely manufacturing and now that is gone thanks to our labor laws. So until we look ourselves in the mirror, we will skirt the issue and fool with time wasting half-solutions.

On Sep 13 07:10 AM Michael Clark wrote:

> Actually, you took the words out of my mouth. Give me a cup of Lounsbury
> and a slice of Mauldin and my morning's pretty much complete. (I
> don't believe the deflation will last for two years -- I think it
> will last another decade, and that Japan is a model for where we
> are going -- but I really appreciate the great scholarship of both
> Johns as rational evidence of why we are going where we are going.
>
>
> Thank you, John, for posting here.

Sep 13 07:41 PM

[Bacon:]

A $30T loss of asset value translates into an unprecedented loss of trillions of "dollars" in the sense that $30T of asset value is no longer available to secure loans, support spending, back derivatives, multiply, etc.--velocity has cratered. To make up for that missing $30T and related reduced velocity, Bernanke would have to print double digit trillions of $ before there would be significant inflation. He will never have the stomach or political freedom to print as fast as he probably should. (His efforts to date have been a tiny drop in the bucket.) As a result, there very well could be a shortage of and increase in the value of the dollar for an extended period of time. Look at the Japanese Yen, banks, debt, and economy over the past 2 decades. We will have a huge deflationary bust in internal US asset prices, just like Japan, and inflationary pressures will be kept in check because the $ is still the international currency and Bernanke won't have the nerve to print enough $ to counteract the decline in world asset prices, a majority of which are traded in $.

Sep 13 07:57 PM

[Ichabod:]

Someone please explain what happens to the value of the US Dollar when "helicopter Ben's" printing press does not get enough dollars into the hands of debtors of today and tomorrow? He can print trillions of 'em, but if they lie in banks own accounts, and still debtors do not have them in THEIR accounts with which to pay bills, the value of each dollar increases. Yes? No?

Does this scenario predict some pressure toward deflation?

Sep 13 09:47 PM

[Ichabod:]

If you concentrate with an open mind, reading this article will explain the concept of money velocity.

seekingalpha.com/artic...

If, after reading it, you still believe money velocity to be "garbage," try reading Keynes's "The General Theory of Employment, Interest and Money."

Best wishes for preparing your finances for the future.


On Sep 13 04:33 PM Tony Daltorio wrote:

> The whole concept of money velocity is garbage. It is meaningless
> theoretical junk that economists think up to keep themselves employed,
> but it has no real-life practicality.
>
> When the dollar falls off a cliff, you can kiss deflation goodbye.........

Sep 13 10:15 PM

[Econ 101:]

HAVE YOU SEEN THE Rolling Stone Article??????

www.rollingstone.com/p...

Sep 13 11:29 PM

[C.S. Jefferson:]

Look, deflation risk is here if you talk about the main vehicle for household finance--namely, declining property value.

So much of our capital markets are tied to housing and leveraging off phony appraisals that asset collapses only increase the negative debt to equity ratios--suffocating any breathing room by consumers hoping to dump their properties on the next turn.

Sep 14 12:26 AM

[Michael Clark:]

It does. Actually the Fed prints money, the banks invest the money (instead of lending it to consumers, because the banks know the depression is going to get worse, and loans will fail)--and then, the stock market collapses, and the Fed's loans to the banks are consumer in Vulcan's forge...more impetus for deflation.


On Sep 13 09:47 PM Ichabod wrote:

> Someone please explain what happens to the value of the US Dollar
> when "helicopter Ben's" printing press does not get enough dollars
> into the hands of debtors of today and tomorrow? He can print trillions
> of 'em, but if they lie in banks own accounts, and still debtors
> do not have them in THEIR accounts with which to pay bills, the value
> of each dollar increases. Yes? No?
>
> Does this scenario predict some pressure toward deflation?

Sep 14 01:08 AM

[Michael Clark:]

That's how I see it.


On Sep 14 12:26 AM C.S. Jefferson wrote:

> Look, deflation risk is here if you talk about the main vehicle for
> household finance--namely, declining property value.
>
> So much of our capital markets are tied to housing and leveraging
> off phony appraisals that asset collapses only increase the negative
> debt to equity ratios--suffocating any breathing room by consumers
> hoping to dump their properties on the next turn.

Sep 14 04:29 AM

[Dirk McCoy:]

The problem is that there will be a mixed bag of inflation and deflation. US labor, housing, solar, healthcare, college education- things that are not in short supply- will continue to drop in price. Oil, precious metals, oceanfront property- those will go up in price.

The effect of price stickiness and controls (minimum wage, managers unwilling to lower prices) will translate to decreased utilization and lower economic activity.

I think the wildcard is energy- if natural gas and oil prices go up, that will force some inflation in many things. If US labor is not allowed to depreciate, that will cause both inflation and reduced utilization.

Sep 14 02:51 PM

[bobbybutte:]

as usual the author is very intelligent. I think the powers that be would prefer inflation or deflation and their policies should reflect that.Deflation causes people to not want to buy houses because it would pay for them to wait longer Just my 2 cents peace

Sep 14 03:08 PM

[Plant the s...:]

China might be seeing the brunt of deflation in this cycle, given that the demand for goods shrank more than for services.
I do applaud the thoughtful analysis. We are seeing the Federal Reserve and Federal Government fight deflation driven by the collapse of debt support for consumers leading to consumer demand falling and production capacity not being able to adjust.

On Sep 13 06:42 AM CautiousInvestor wrote:

> In John Mauldin's piece yesterday he explored deflation in the second
> part of a two part series.
>
> In his graphs he used both M2 and M3 in describing historical money
> supply growth and their respective multipliers through the current
> period. He also plots the M2 and M3 multipliers against changes in
> the CPI.
>
> As a broad statement, there is what appears to be strong, positive
> correlation between between money multipliers and the CPI. It was
> almost concurrent with movements in the M3 multiplier until around
> 1982 when the CPI starts featuring a "diluted lag".
>
> Presently the M3 multiplier, based upon unofficial sources as the
> Fed for unknown reasons stopped publishling M3 data in 2006, is at
> the same level as it was in the early 30's when prices were contracting
> in the 5% to 6% range. Depepending upon which measure of the CPI
> you use, prices are currently falling in the .2% to 2% range. <br/>
>
> I stronly suspect they will fall further as we proceed with widely
> herealded "recovery." (An interesting data point: China's producer
> prices are falling at a 7% rate amid their more substantial recovery)
>
> Growth in M2 (around 8%) and growth in M3(around 18%) are not keeping
> up with the rates at which their respective multipliers are falling.
> The growth in M3 has not gone into bank lending, leading one to think
> it may have sluiced its way into one of the markets.
>
> The bottom line is that the Fed unlikely to unwind its balance sheet
> anytime soon and could very easily implement new policies to offset
> contracting money multipliers.

Sep 14 04:57 PM

[Plant the s...:]

Important point, there is global price setting scheme that may create a set of contradictory outcomes such as stagflation was in the 1970s.

On Sep 13 08:17 AM John Bowman wrote:

> OK....great article. But what if the dollar collapses, as many are
> predicting and the price of oil surges (for a variety of reasons)?
>
>
> It is convenient to disregard energy prices, but like the author
> states, reality tells us differently. Just remember, Social Security
> gave retired Americans an additional 5.8% this past winter due to
> cost of living increases. So some government entities still feel
> that it is important.

Sep 14 05:06 PM

[wongcy:]

It only takes one or two government policies to increase the velocity of money, e.g. mandate an energy efficiency in households that is say 10% higher than the current average. Then jobs will be created to measure household energy efficiency, builders have to be hired to insulate houses, or install solar panels and so on. Low or no interest loans can be provided to meet the legal requirements, it is like creating expenditure similar to a world war!

Sep 25 05:42 AM

[Luis de Agu...:]

This perennial discussion, deflation vs. inflation, Keynesian vs. classical or even monetarist, more than what statistical data one chooses to make one's case is at the root of identifying which economic event will likely develop. In a recent simple review of their approach to the topic, H.C. Wainwright & Co. Economics offered a synthesis of the classical view.

Wainwright's economic diagnosis and forecasts diverge from the mainstream for deep reasons. Wainwright differs from conventional thinking at the very beginning of the logic chain. In the classical perspective that Wainwright takes, spending does not drive the economy. Neither demand nor supply drives the economy; and neither money nor credit drives the economy. These are manifestations of economic activity, and Wainwright believes it's a great mistake to see them as causative. Such was the prevailing view of economists until the Depression created a great dumbing down of macroeconomics with the advent of the New Deal and the Keynesians.

Demand cannot exist without supply, and supply would have no purpose without demand. Like two sides of a single coin, demand and supply are inseparable; and to manipulate one automatically involves manipulating the other. What drives the economy, ridiculed by Keynes as “animal spirits,” is will-power: will to make the effort to put resources to intelligent use and to engage in trade. Without trade, the effort is wasted; that's why freedom of trade is a vital requirement for economic recovery.

This perspective explains why, despite conventional wisdom, inflation has often coexisted with stagnation and rapid growth is compatible with low inflation or deflation. It also explains why Franklin Roosevelt never managed to pull the US economy out of the Great Depression, and why prosperity returned after international free trade was restored at the end of the war.

Put most crudely, and in the broadest sense, the economy is driven by sweat. “Sweat” includes not just manual labor but mental labor, management, innovation, enterprise and the willingness to undertake responsible risk. One more factor that is emphasized by Prof. Luigi Zingales is trust in the financial system, which he argues cracked during the recent crisis, and it is closely related to risk tolerance. All but one of the ingredients of “sweat” are present all of the time, subject only to varying incentives and constraints. The one ingredient that is fragile and can change quickly is risk tolerance.

The simplest explanation for a recession like the one we have just come through is a temporary drying up of risk tolerance. That would explain the fact that quality spreads in the bond market correlate very closely with national output in the immediate future. Given that risk tolerance can return almost as rapidly as it evaporates, this also explains why recessions tend to be V-shaped events. In Wainwright's view, the cause of the recession was fear and uncertainty, to which the federal government greatly contributed by its lack of transparency and its forceful policy switches.

The classical perspective also explains how a recovery can appear to be “jobless” and, in the present case, how it can appear to be “credit-less” as well. People actively looking for jobs are utilizing their time very efficiently, but they are described in official statistics as “unemployed." Businesses that are cash-rich enough to finance some of their customers and some of their suppliers are constantly creating credit in the form of “trade debt” that does not appear on the Fed's radar screen. According to Wainwright's view, quality spreads are the best leading indicator of growth and the price of gold is the best leading indicator of inflation. That implies that, in the short term, the economy will experience continuing and accelerating inflation, coupled with rapid but decelerating growth.

Luis de Agustin
Wainwright Economics

Oct 05 04:06 PM