ebreen

Consumer-Driven Deflation? Not Even Close

You can see how that TBT_GLD is working as a hedge today as the continuing crises trade comes off unwinding $ carry that has been pushing Gold and some other Commodities, including OiL. Your TBT is up 1$ and Gold has crashed already by $50. This should show you that much of the trade in these indexes is based on crises and not necessarily inflation.

Consumer-Driven Deflation? Not Even Close

The problem with the author's definition of inflation and deflation is the failure to identify a demand metric. That is the main problem with monetarism. The author is true to assert, following Friedman, that inflation/deflation are monetary events and not manifestations of some constructed price index. He is right to saw that price change is a result of inflation and not inflation itself. However, he neglects to inform that there are other non monetary situations that drive price change in the indexes. Supply/Demand imbalance in the production and distribution of goods and services is always modulated by price and these price changes always show up in index measures of price change.

So, I have too criticisms of the article, it neglects to confront the role of demand for money in the monetarist paradigm. This is important because the proper response to real growth is to increase the money supply in order to maintain price stability. The second criticism is the failure to distinguish the role of non monetary supply/demand imbalance in the infrastructure of production and distribution of goods and some services that always results in index price change.

I agree that it is critically important to discern whey index prices are changing. If the Fed mistakes price change caused by growth for inflation and reacts to prevent inflation then the result will be a bubble and a contraction. That is of course the mistake the Greenspan made that triggered our current situation.

My last point is that deflation is not the other side of the monetary coin in practice. Monetary inflation is common and monetary deflation is much less common...it occurred during the late 1990's when Greenspan failed to consider the international increase in demand for the dollar (as reserve currency) that was driven by emergin market growth, his failure to respond to that demand precipitated the dot.com bubble and collapse and the manufacturing recession. It also occured previously during Volker's early action to constrain the money supply in 1980 when Volker failed to consider the demand for money that was created by the Reagan tax cuts, that mitake precipated the sever recession of 1981-82 until Volker increased the money supply as he saw the Mexican Peso collapse. These are examples of monetary deflation. But, what makes deflation really different from inflation is that it has a non-monetary manifestation in a credit collapse. Credit is the velocity multiplier of money in a fractional reserve banking structure and its collapse withdraws the value of leverage from all leveraged assets. Generally, those leveraged assets are collateral for the extension of credit, so the sudden withdrawal of credit for whatever reason, will result in a deflationary collateral asset destruction spiral a la Irving Fischer.

What is even more troubling about this type of deflaiton is that it is not so amenable to the remedy of increasing money supply through quantitative easing once interest rates have been reduced to zero. When interest rates are zero any increase in the money supply through the fractional reserve system will be trapped within that system and will not enter the general economy. This liquidity trap is what is happening now and it is what is preventing the increase in the Fed's balance sheet from immediately driving broad price increase in the indexes. When interest rates are at zero the utility of cash is greater than the diminiums risk adjusted returns available out the risk curve so the new money created accumulates on the Fed Balance sheet as excess reserves and does no enter the general economy money supply...velocity remains zero and the general economy continues to deleverage, reduce debt, as the best risk adjusted investment is debt reduction. This in turn results in long term unempolyment and surplus capacity that will limit economic activity to no growth consolidation and capacity reduction, which of course will serve to push restrain any index price increase. Your TBT position is vulnerable to the risk of the continuing crises and its political consequences...Your gold position is vulnerable to the resolution of the continuing crises...I guess you are hedged.

Why Is Deflation Scary?

One problem with the discussion is that you have to define deflation as a monetary phenomenon apart from a fiscal result. Index measures of inflation/deflation capture supply/demand imbalance as well as monetary imbalance. A slight monetary deflation could take place in a diversified large economy and not result in an immediate reduction in output growth. This is what happened in the U.S. economy in the run up to the Asian monetary crises...we were running a deflationary monetary policy that was absorbed in out economy but that could not be absorbed in those smaller economies that tied their currencies to the dollar...so imported the deflation and did not have the capacity to absorb it. A similar effect occurs in the inflation of the dollar where the inflation is translated to smaller economies (due to reserve character of $) and can lead to big problems in emerging markets magnified beyond the effect on our market. The issue in a depression is really the effect of a credit collapse. Fisher's theory addresses the spiral of collateral asset devaluation that occurs when credit collapses in a previously leveraged economy. That credit collapse, which you call a "shock" does not need to have strict monetary predicate...as in the case of the Collapse of theh Knickerbocker Trust that sparked the credit collapse that lead to the panic of 1907...you can have a fiscal or market or bubble event that collapses credit and then leads to a collateral asset devaluation as the panic and defaults spread...not exactly a deflation cause ...if you define deflation only as an imbalance in the suppy of money in relation to the demand for money. In any case, once you have a collateral asset devaluation spiral in progress the result is one of expected decline in asset values until you find a market clearing price and a managed return to credit liquidity.

The Misuse of Language in the Financial World

It is not necessary to embed the misuse of language in a long philosophical history to understand the simple immediate problem...which is that most of the commentators and participants in the discussion are ignorant, or worse blind, with regard to the meaning of what they are talking about. It's a stupid discourse of the stupid leading the stupid.

The Demographic and Economic Record Prior to the Housing Meltdown

You neglect to discuss the effect of tax law change on home ownership during your sample period. Housing has long been the most popular tax shelter for the common man because the mortgage interest is deductible from earned income and the capital gains had been deferred until retirement with a high deductible on those gains. This feature becomes more important during times of high inflation as the inflation pushes the common man into higher tax brackets. The scheme was made even more attractive in 1996 when the tax law was changed to exempt the first $500,000 of capital gains from primary residences on a current basis so that there was no need to wait until retirement to capture the deferment and the mortgage interest remained deductible. The 1996 tax change had a significant effect on the appreciation of home prices during the period 1998 to 2008.

With regard to Gabe's comment above, the real mistake that Greenspan made was not so much his reducing the interest rate to 1% after he had made a deflationary mistake the collapsed the Asian Currencies the Argentine peso and the US manufacturing base...after all there was no real inflation during the period Greenspan left the FFR at 1%...the real mistake was the way he raised the rate, experimenting with "Gradualism". Greenspan theorized that by telegraphing to the market that he would raise rates incrementally by .25% each month as he sought to find the holy grail of interest rate 'neutrality' (don't ask Alan what it is but be sure he will know it when he gets there). This was terrible mistake as it was based on a rate raising policy that was supposed to fight an inflation that was not present but had the unintended effect of causing future transactions to move forward in a way that created inflation. Stated differently, by telling the market that he would raise rate a little bit each month indefinitely, he encouraged all potential borrowers and developers to move thier plans forward in order to avoid the promised higher rates. This exarcerbated the housing demand and refinancing demand that was already being pushed by low interest rates and tax law subsidy and drove a housing appreciation bubble. It also put false information about supply and demand into the market encouraging builders to overbuild to meet the false demand that was actually a pulling forward of future demand. When the trough finally hit as the rate increase accumulated we were in a terribly overbuilt and overbought situation. The evolution of mortgage backed securities during this period turned the real estate bust into what has now become a credit collapsed fueled by asset collateral destruction.

Monetary Mechanisms: Then and Now

You neglect to point out the effect of inflation that followed the breakdown of Bretton Woods as the driver for the demise of Reg Q and therefore the antecededent cause of the transformation of homes into phantom savings accounts.

New Accounting Practices Will Boost Bank Equity Values

The critical problem with mark to market theory is how it interacts with Sarbanes-Oxley and the present state of securities law. This issue is usually left out of the discussion as it has been here in your post. Mark to Market has always contained an alternate method of valuation when there is no functioning market provided the rational for the alternate value is fully disclosed in footnotes. However, in practice where SarBox has criminalized accounting practice that turns out to be overly optimistic and where the securities bar targets all grey area decisions, there is no reward for any CFO or Accountant Firm to apply any leway where there is some market value information, no matter how distorted that infrormation my be. There is simply too much risk..including the risk of personal freedom and liability...to apply an alternate risk adjusted mark to maturity value where there has been any reported market sale no matter the duress of that market sale. So, the real problem is SarBox defeats the flexibility of FSB 157 and causes a mark to non-market lowest value. SarBox is the law that needs the reform.