derryl

Extraordinary Popular Delusions and the Madness of Crowds

Tack wrote,
"This scenario has been repeated time and again throughout history. The price of everything, as measured in fiat currencies, only progresses higher over time. The idea that prices will decline systemically and stay there has no factual historical basis whatsoever."

The deflation we are talking about is not the idea that prices will decline and stay there forever. It is the historical precedent of the 1930s balance sheet depression where asset prices (stocks and real estate) collapsed and took decades to recover to their 1929 nominal prices. CPI does not change in direct relation to money supply (productivity gains can produce more goods to absorb increased money without prices rising, for e.g.). Asset prices do. So it's asset prices that inflate and deflate, not CPI prices.

Loan defaults and personal and bank bankruptcy all destroy money supply. Money supply and GDP move together, both up and down. So when money supply is contracting/deflating GDP contracts/deflates with it. Unless there is some renewed exuberance among borrowers to take on new debt to re-expand the money supply and the economy, the contraction can continue for a very long time. That's where we're at right now, overindebted, losing jobs, defaulting and going bankrupt, and unwilling or unable to take on more debt.

A balance sheet recession happens when too many people took on more debt than they can repay, especially if their income takes a hit, and the asset prices that were supported by that debt-money collapse. Those collapsed-value assets are the collateral the banks were holding against the loans and when the assets are marked to a 20% down market value the banks don't have enough capital to extinguish the losses so they are insolvent. By law they are then taken into receivership and restructured or dissolved, but now bailouts that are presumed to be funded by future taxes keep 'too-big-to-fail' insolvent banks alive.

The Fed has created something over $1 trillion of new money to buy toxic assets from failing banks, but this new money ends up on the asset side of bank balance sheets where they must hold it against their liabilities on the other side of the sheet. The banks were failing because the value of their asset side was shrinking. The Fed replaced shrinking assets (mortgages and other loans the banks had made) with "cash".

But banks have to HOLD their assets, or trade or sell them for better assets, so they can meet their liabilities as demanded. So the banks have to hold the Fed's cash, or trade it for a better asset. As an asset cash is sterile for the banks, it pays no interest. What asset is as liquid as cash AND pays interest? Treasury debt for one. And "excess reserves" deposited at the Fed which now pays interest. Any way you slice it this new Fed cash is locked into banks' balance sheets and cannot 'escape' into the economy and contribute to inflation.

Meanwhile bank capital is being destroyed liquidating loan losses. People are paying down their debts which extinguishes both the debts and the deposit money that those bank loans created. Money supply is deflating and GDP is deflating with it.

The Fed can reflate equities markets by making free money available to GS and JPM to game the markets, but this rally is a mile deep and an inch wide. The government can generate some GDP and real estate blips upward with cash for clunkers and $8000 first time homebuyer grants, but on the one hand these are just pulling forward future demand which will leave holes in the future, and on the other hand these are being financed with your future tax payments which will produce holes in your spending later.

This is not "the economy" growing. This is just a transfer of debt from private borrowers (who have quit and gone home) to public borrowers who want to keep playing.

After a really good run since 1947 we have finally reached terminal debt. The economy has reached its debt ceiling and cannot or will not borrow any more. Rapid population growth and productivity growth in the postwar period easily absorbed all the new debt-money that was being created as America's middle class took on mortgages and raised families. That trend is over and there is no new impetus of sufficient scale for renewed economic growth on the horizon.

So from here into the foreseeable future debt growth will trend downward and GDP will sink with it, unless the Fed comes up with some innovative QE program that can reduce total debt without simultaneously collapsing asset prices and the banking system. The secular trend is deflationary. CPI prices will inflate only if the dollar declines and oil and other imports become more expensive (stagflation). But asset prices are in a secular decline and only a renewed period of inflationary real economy growth can reverse this trend.