How a Deflationary Credit Contraction Will Unfold

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Includes: GLD, SLV, UDN, UUP
by: Doug Eberhardt

I have just returned from the 2010 International Conference on Sustainability: Energy, Economy & Environment in Michigan. Speaking at this conference were two individuals who have a good understanding of how the deflationary credit contraction will unfold. This is important for investors to understand as what they hear via mainstream media is always going to be tainted with corporate or government interests. How this relates to one’s investments can be critical for future planning.

These two speakers were Nicole Foss from “The Automatic Earth” and Professor Steve Keen, recipient of the Revere Award from the Real World Economics Review for the economist who most cogently warned of the economic crisis. In this article I will address Nicole Foss’s views on how the deflationary credit contraction will unwind, saving the more technical analysis of Steve Keen for a subsequent article.

Deflation and Credit; the Missing Link

Before going into detail as to what was discussed at the conference, it’s important to have an understanding of the definition of deflation. There are various definitions passed around, but only one that takes into account “credit” along with monetary easing or printing.

Without incorporating into any analysis the unwinding of the credit that was created during the inflationary expansion period, one can not rationalize how quantitative easing is being swallowed up today.

Also, what’s needed to be pointed out in this analysis is the fact that banks weren’t lending since the peak of the real estate bubble. This means there was no additional fractional reserve expansion of the money supply (inflation) occurring since the banks quit lending.

In fact, much of the original bout of quantitative easing amounting to $2 trillion went to the banks to help shore up their balance sheets from their abuses of fractional reserve lending during the credit expansion. The banks were in dire need of cash and without it, more would have failed.

Inflation vs. Deflation

For those who keep screaming “inflation, inflation, inflation,” and have recently been riding the wave of higher prices in oil and food commodities, along with gold and silver, how do they explain why after the first $2 trillion of quantitative easing prices were falling and treasuries and the U.S. dollar were stronger? Where was the result of the quantitative easing (inflation), higher prices, then?

They may point to gold, but the Yen price of gold has risen the entire deflationary episode of Japan the last 15 years. The gold price moving higher in all currencies is an indication of where investors place value, inflation and deflation aside.

The inflation hawks may try to explain it away by saying the CPI didn’t point out the true picture of inflation. But hasn’t real estate been deflating since 2007? Doesn’t the CPI only take into account equivalent rents which at the time were falling? Can certain assets not related to government involvement (oil, food and other commodities), be cherry picked to make an overall claim of inflation when they are just temporary increases in price in an overall decline since their peak?

What will the inflation hawks say when the price of oil starts to fall? How about food prices? Haven’t both of these commodity categories fallen the last couple of weeks? How will they explain this away, especially with the quantitative easing occurring?

In the short term, anything can happen because the Fed has new powers given to them by congress and no one knows what they will do because they can’t be audited. But their effectiveness is what I question for the medium term. Timing is the only issue. Planning today for what is to come is what’s needed.

Technically, the U.S. dollar rising during this time can be explained away by simply pointing out the Euro, which makes up 57.6% of the Dollar Index, was falling with the problems of Greece unfolding and the threat of other European countries imploding. However, most other prices of commodities were falling. The price of gold and silver were rising, but I believe it was because it just isn’t the U.S. citizens clamoring for gold and silver any longer; it’s the world.

Right Back Where We Started From

It seems to me we are heading right back to where we were, despite the media uproar over the latest $600 billion round of Bernanke nonsense. Nicole Foss explains we are simply extinguishing the excess claims to underlying real wealth. It is the collapse of debt that is occurring. Foss likens it to a game of musical chairs with 100 people and one chair. Good luck clamoring for that one chair. She says that credit is over 95% of the effective money supply. This is what the inflation hawks don’t address.

Foss goes on to say that markets invite speculation. She says that prices only reflect perception of things, not actual reality. So yes, it is possible for traders to jump on board a trend and push prices higher than would normally occur. The repercussions of this can be seen with the fall in the price of sugar, as an example, of over 12%, the biggest drop ever that occurred just last week.

Price Discovery Coming Soon

Foss believes there is a price discovery coming soon. While mark to market accounting has hidden true values, those in the know are calling it “mark to make believe.” Banks have been doing this for quite some time with the FASB easing of mark to market rules instituted in 2007.

What we have with many assets are what Nicole Foss calls “virtual wealth.” Until that wealth is cashed in and turned into real wealth, it can’t buy your groceries. This is what most people don’t understand about wealth, especially in a deflationary scenario.

Does Your Home Ownership Constitute Wealth?

What happens when you can’t sell your home? Is that home considered real wealth if you can’t spend that wealth? If you can qualify for a loan against what’s left of the value of the home, sure. But if you decide to move to a state with less taxes for example, or even want to rent instead of being a home owner to allow for flexibility should it be needed as the economy deteriorates, good luck selling that home in a market where there are no buyers.

That’s why keeping an eye on unemployment, which is not improving and has no prospect of improving in a nation of spenders, not producers, is an important piece of the puzzle. You need employed people to buy your home.

How will this person turn that illiquid wealth represented by their real estate into spendable wealth? These are decisions that should be made today, while there is still a possibility of getting out.

Higher Interest Rates Will Trigger Future Debt Defaults

As this deflationary credit contraction unwinds, there will be a reluctance to spend and a fall in the velocity of money. The Fed and government can’t force people to spend and even dropping money from helicopters or handing people money would see them either pay off debt or use for necessities. Are higher interest rates good for the economy, or bad?

The above scenario with real estate and prices in general is what higher rates would precipitate. The economy comes to a halt. Consumers and businesses stop spending. Real estate prices would fall further. With people not spending, prices will fall. Foss says that like oil in the car that keeps the engine functioning. Money is the oil of the economy. Without people spending it, the economy contracts. In the 1929-1933 deflationary episode, prices fell 66%. Foss says it will be much worse today.

Inflation Eventually

This doesn’t mean that eventually we won’t have inflation rearing its ugly head. You can count on Bernanke and company to implement quantitative infinity. The inflation hawks will claim victory, albeit with some egg on their face as 2008 recently revealed. Inflation will come. But any talk of hyperinflation is premature at this point. Deflation is the story of the day.

Disclosure: Long Physical Gold and Silver