11 Important Points “Deflationists” Miss (And Why They’re Wrong)
by Aaron Krowne
Founder, ML-Implode.com
Many have generated ample prose lately in the latest rumble in the deflationist/inflationist street brawl (a debate still largely ignored by the mainstream media, which continues to broadcast little besides the “Carry On, All Is Fine” message). So I won’t add any more to that prose. But I did want to get across a “hit list” of important points that I think are ignored or undervalued by deflationists, which together make a pretty strong case that our present economy will “die by fire” (inflation), not ice (deflation).
Here they are:
1. Governments and central banks (with the US government and Fed at the forefront) have already responded to what would have been terminal collapses of the banking system and financial markets by extreme, unusual, and in many cases illegal bailouts. These take the form of new debt issued, government guarantees, various “laundering” facilities into sovereign debt, and outright printing (but all amount to outright printing in the long run).
2. While seeming to trust little of officialdom, deflationists are eerily silent on the government’s clear under-estimation of the rate of consumer inflation. Shadowstats.com has a popular set of alternative statistics, which are largely based on rolling back the questionable alterations to the methodology made by the US government in the 80s and 90s (the Shadowstats consumer price index typically runs about 4% higher than the BLS’s CPI. Shadowstats, however, does not even go to the extent of adjusting for under-represented core consumer service expenses, like health care and debt service).
3. Unemployment and the lesson of the stagflationary 70s is ignored. We have obviously high unemployment currently, with recessionary defaults and contracting credit — yet prices are still trending up (no one disputes that, not even the government). These datum in concert prove that the demand side does not govern the overall level of (consumer) inflation, nor does the supply of credit. Clearly they factor in — but they cannot possibly be controlling the total outcome.
Put another way, we’ve clearly gotten a drop in overall credit, and a major effect of defaults on demand. So why hasn’t deflation occurred in proportion? Indeed, why are we getting any inflation at all?
4. Conversion of private obligations to public obligations is ignored (this is the upshot of all of the government bailouts). Were this not happening, the deflationists would have a point, and I’d be on their side. But the precedent is set: “the system” will not be disrupted; all large private financial actors will be bailed out (besides a few token examples like Bear and Lehman, which merely served to galvanize the government’s resolve to “avoid all further pain”).
5. The stock market is near historical record highs. In fact, Bernanke has cited this as a proof the Fed’s money-printing is working. There might be a link.
6. Commodities continue to soar, again, despite a weak consumer base.
7. Leverage in hedge funds is way down… in the ballpark of 2:1 overall. So… less credit, higher commodities prices. Hmmm…
8. More Treasuries do not imply “parked” funds; Treasuries can be used as commodities trading collateral. So the massive issuance of government debt due to “stimulus” and bailout efforts is actually equivalent to current money printing in this sense.
9. 2/3rds of all the dollars in existence aren’t even within the US; they’re held overseas voluntarily because the dollar was historically considered a stable store of value around the world (keep in mind, it was still exchangeable for gold until 1971). Compared to most local currencies, this has certainly been true. But it could change on a dime; most of these dollars are held “at the street” by small holders and they could quickly flee to a variety of alternatives should they get spooked. Put another way, the trend of voluntary dollar holdings overseas only has one way to go from here.
10. Other than a few controlled areas that primarily benefit the government and financial elites, interest rates are not falling. Wells Fargo borrows from the Fed at near-0% and lends to me at 25% on my credit card, and I have a good credit history. This example is the rule, not the exception, for consumers. There are parallels in other large-scale markets, such as European sovereign debt. Essentially all that has happened is that “risk free” interest rates have been kept down by printing new money; either the money printing will have to continue or interest rates will have to be allowed to rise significantly. Hint: the financial economy is wound far too tightly to let this happen — at least not to the full extent needed to restore free market confidence.
11. “Deflation” (in the monetary sense) means that the currency’s purchasing power increases over time. No, stop laughing — deflationists are actually worried that the dollar in their wallet might become more valuable over time; indeed, too valuable. This is ridiculous on the face of it give that our currency is pure fiat. There is absolutely no historical evidence that an increase in value can be the terminal state of a fiat currency.
In addition, there has never been a recorded historical deflation where the currency was not backed by a precious metal. That seems to be the only way its possible for an economy to “collapse into deflation.” (And yes, this was the case in the US Great Depression, which is why FDR confiscated gold, then devalued the dollar. It was the only way to inflate.) This makes perfect sense: if money is simply gold (or silver), then a financial panic will lead to an exodus from investments with default risk to those with no such risk, the primary sort of which is represented by precious metals.
Interestingly, many deflationists are bullish on gold. Perhaps they should connect the dots and re-factor their charts in terms of gold ounces: then they’d see more of the evasive monetary deflation they keep looking for. Which leads to an interesting question: is anything really different compared to the Great Depression, when one looks through the lens of gold?
Further to my comment of 9 August 2016, unlike the old Bank Rate system with its high interest rates, Quantitative…
Comment by ALSM on 6 April 2011:
Good points but the terminology does not make sense. Looks like any kind of demand is caused by mega giants building bridges to everywhere. Not consumer demand. That is way off. Heck Americans could cut about 60% of discretionary consumption and not miss it at all. Rates need to go up but how can people/business be doubling there price with nominal cost increase because they lost half there business and being stuck with massive overcapacity and debt be called inflation. Flush the system – massive debt forgiveness is the only way – no bailout(restructuring) no tax payer booked into 2040. Flush it now and let the bonds hit 0.
Comment by Paul_the_engineer on 7 April 2011:
Historically, deflation is associated with productivity growth. Structural deflation was first noticed in the 1870s when railroads, steam powered factories and mechanized agriculture began to reduce costs. Under the gold standard prices fell, wages rose and workers benefited from both. Mass production of the post World War 1 era was a contributor to the deflation of the Great Depression, along with the real estate bust. Productivity growth peaked sometime in early 20th century. The greatest period of agricultural productivity occurred from the 1940s to the 1960s with mechanized harvesting, cheap fertilizer and the Green Revolution. Now real prices for necessities are rising because of exhaustion of crop yield increases and depletion of oil and other natural resources. Also, now that almost all labor been replaced by machines, there is little labor left to save and productivity gains are harder to achieve.
See: Productivity improving technologies (historical) on Wikipedia for detail and references
Comment by admin on 7 April 2011:
ALSM: What terminology is not making sense? Maybe I can clarify.
Paul: I totally agree; long-term, gradual monetary deflation is actually a good thing. In this article, I mostly refer to the short-term, catastrophic deflation of the sort that Bernanke & co. are concerned about (or at least, pretend to be concerned about — I don’t think they really like the gradual deflation either, because it benefits savers and wage earners and lessens their dependence on bankers).
Comment by bob m on 11 April 2011:
You need to look at Robert Prechter’s analysis of deflation. The bubble was credit induced not monetarily induced. The money supply is not increasing exponentially because debt is being repaid and written off at a greater rate than the Fed is printing. The Fed is swapping assets not creating new money. Prechter believes all assets will decline including gold except cash i.e. the dollar. After the deflation and stock market collapses(new lows) he believes the government response will attempt to monetize the debt by printing money and creating hyper inflation and destroy the dollar. His scenario ends up in the same place except deflation will occur first and then the monetary and fiscal response will create large scale monetary expansion and hyper inflation. Buy gold at about $600 an ounce.
The classical definition of inflation is an increase in the money supply (the cause). This results in price and wage increases (the effect). So far the money supply increases have been offset by debt write offs and a very low velocity of the monetary base. Velocity is turnover and important. It has fallen substantially because of the banks lack of lending and borrowers lack of demand for new credit. Big business is hoarding cash and induviduals are saving at rates we haven’t seen in years. I include all forms of investing as savings. This in essence is the deflationists scenario as predicted by Robert Prechter and the Elliott Wave analysts. Their analysis of the long term and shortterm elliott waves confirms the scenario they predict. They measure the mood(mass psychology) and believe the mass mood drives the markets not cause and effect as most others believe. If the mass mood is negative it leads the market down and not what the fed. does etc. The mood makes the news not the other way around. It’s radical thinking when you consider 99% of analysts think otherwise. Cash is king for now and once the trend is down then short everything and hold on. Get out before the bottom because it will be likely that the government will put restrictions on short selling as another response to blame the decline on someone as the economy tanks and pessimism becomes rampant. The fed. is trying to inflate it’s way out. They don’t really believe there is a risk of deflation contrary to comments made by Bernanke about the great depression. He thought it in September 2008 but not now. They think the eocnomy is rebounding because of their policies when in fact the economy is heading for a great contraction very soon. Matter of fact the markets look to be making a high and we could see a big drop within the next few days. It will come without warning and gap down as the buyers “buy the dips” and get wiped out. My advice is to read Prechter.
Comment by admin on 11 April 2011:
Thanks for your comment Bob M, but I am well aware of the “Pretchter doctrine”. And I would say it argues poorly for that doctrine that you cannot seem to employ it to challenge even a single one of the points I made.
Deflationists/Pretchterites have been flogging for years that we were going to see Dow 4000 and gold 600 (or lower). I think they missed the boat. It is clear to me now that the money-pumping by the monetary authorities and the TBTF “system” has vastly overpowered such deflationary forces.
Also the quibbling about whether credit is money, and “swapping assets versus printing” totally misses the point, IMO. The very definition of “money” changes in a financial panic, as activity moves up the “liquidity pyramid” (read Trace Mayer’s “The Great Credit Contraction”). Cash, and government guarantees that equate to cash, and ultimately gold, end up mattering more to prices and the economy in general.
“So far the money supply increases have been offset by debt write offs and a very low velocity of the monetary base.” <--- total nonsense. Sorry. "His scenario ends up in the same place except deflation will occur first and then the monetary and fiscal response will create large scale monetary expansion and hyper inflation" <--- "will"? And why exactly do Pretchterites not think the first part of this has already happened, and we are well into the second half? Frankly I'm VERY glad I've disregarded Pretchter.
Comment by Manuel on 9 December 2011:
Hello,
The reason I am a deflationist is because I think the outcome of the greatest credit expansion of humankind will be a huge credit contraction. Note that is not possible to have such a great credit bubble if willingness to borrow is not extremely high, that means that the credit contraction will not begin until that willingness to borrow disappears. It has already begun to get weaker but is still strong in the world main credit/debt market which is the American Bond market, mainly because the government is still very willing to borrow and the market still thinks that the debt issued is going to be paid. In my opinion the government won´t quit voluntary his willingness to borrow, it will be the market who is going to say “enough” such as it did with Greece or Iceland.
1. To be more precise, governments are not just printing, they are issuing debt (bonds, dollars, etc). That´s because at 2008 they had room in their liabilities and that´s why the bond market is allowing the situation. Once too much debt is issued, bonds will begin to fall and the Fed will not bailout the USA.
2. CPI will not fall until the government stops borrowing.
3. The level of indebtness of the 70´s was a very small fraction of today’s, there was plenty of room on everybody´s balance sheets to borrow (or to short the dollar, which is the same thing). We are still getting inflation because the willingness to borrow is still very high within the Government.
4. When the government bails-out anything, they don´t have the money, they borrow it in the name of the people. Sadly, the people always loses, hyperinflation would be good for them. It would help liquidating their own debt (mortgages, credit cards, etc) and their own indirect debt (government debt). Those who have the creditor role although they are not really creditors (the Banking System including the Fed) will finally let deflation run on their own interest.
5. Yes, currency printing is still working, it will keep working as long as the Bond market doesn´t collapse.
6. The same reason than above.
7. Hedge fund were not in commodities a few years ago, now they are gone from stocks and “all-in” in commodities
8. Agree.
9. Most debts all around the world are dollar-denominated. Dollars are and will be needed to pay debts.
10. There can be deflation with very high interest rates or even infinite (creditors just won´t lend). This happens when the creditor fears default.
11. Our currency system is “credit-currency” not “fiat-currency”. Fiat currency is not anyone´s liability, it is currency simply by decree. Real fiat currency systems experiments have failed rather quickly. Today, every dollar in circulation is a bank liability. What deflationist fear is that the dollars held at their banks accounts just disappear. The increase of the value of the dollar is a consequence of deflation, not the definition of deflation. The definition of deflation is that the quantity of currency gets reduced.
Not having the currency linked to gold will make deflation much more difficult to fight, because you can not devalue against anything.