Flaws in the Deflation Case
The majority of economists/analysts remain in the deflation camp. Despite the bleak picture, many seem seem to believe that large-scale monetization of our debt won’t happen. For example, Mike Shedlock, aka Mish, just posted a thought-provoking piece. In it, he scoffs at the idea of hyperinflation in the US. He dismisses it as ridiculous given the size of the problems we face. And he makes a good pitch. Mr. Shedlock is a sharp analyst, evidenced by his huge following on the web.
While I disagree with his deflation view (more on that below), Mish does make some excellent points about the headwinds we’re facing. Plus, it’s always good to audit your own beliefs by listening to opposing arguments. So let’s examine the case for deflation. Central to it are three daunting forces in the US: Rising unemployment, the ongoing annihilation of household wealth, and the debt-collapse of Q1 2009. As Mish says:
Think consumers are about to go on a spending spree after a massive $13.87 trillion collapse in net worth? Think banks are going to start lending with this employment picture and household debt? I don’t and boomer demographics makes the situation even worse. Don’t forget the bleak employment picture. There is no source of jobs.
The deflation camp has a solid case at first glance. The picture is bleak indeed. In a truly laissez faire economy, equities would utterly collapse, making this 40% drop look paltry. Unemployment and wages would plummet, resulting in dramatic deflation. As companies fail and people lose their homes, a horrific deflationary spiral would ensue. But there’s a gaping hole in this argument: Our economy is far from lassaize faire. It’s arguably one of the most manipulated and subsidized in the world.
Some in the deflation camp seem to believe our government will allow a massive collapse to happen, without attempting a clumsy (and likely counterproductive) rescue. Printing money is a key component of any government bailout/rescue. Most deflation articles fail to address this, specially these aspects: what effect quantitative easing will have, and whether the Fed will reign in money supply when it’s required. More on that later. First let’s look at just how awful the economic picture is. Knowing the size of the problem is key to understanding how drastic Gov/Fed will need to be, if they are to have any effect at all.
Things Are Really, Really Bad
De-leveraging has barely begun. California is on the verge, the first of many states. Boomers are retiring, medicare costs will skyrocket. The wave of mortgage resets in Alt-A Loans in 2010/11 will be a nightmare (bigger than sub-prime). The case for deflation seems clear, but only if you remove the Fed and Gov intervention from the picture.
Don’t forget, the same players who got us into this mess are still in control. Their response will be predictably bad. For proof, look at the way things have been handled so far. Their answer to a debt crisis is more debt, re-flating the bubble. And the size of this problem is unprecedented:
Don’t forget the $99 trillion in unfunded healthcare and retirement obligations (wsj). It’s no surprise that some are positioning themselves short equity/long cash. Short is probably not a bad place to be for the very near future. But like it or not, inflation will eventually benefit debt-laden companies with good cash flow (they get to pay off their debts with devalued currency). That’s a horrible model, but it seems inevitable.
Governments find the temptation to “fix” these collapses irrestible. And those fixes result in reverse-Darwinism. Companies that should fail don’t, upsetting the entire equilibrium of the invisible hand. For those who think that our leaders will act prudently, and ignore the temptation of inflate, I urge you to recall some of the Gov/Fed actions that got us into this mess:
- Keeping interest rates so low for so long
- Increasing bank leverage to 40x, repealing Glass-Steagll
- Unsustainable deficit spending to fund war/military budgets
- Shifting of mortgage risk to the public via GSEs like Fannie and Freddie
- Allowing elected officials to be openly bribed by instutions they regulate
Will Gov and Fed Stand Idle as Disaster Strikes?
If Mish and others are right, we’re not anywhere close to true recovery. A bigger crash is inevitable, and all we have done is postpone it. I happen to agree. Where we differ is on how the government and Fed will respond. I don’t think they will act to curb inflation when the time comes. Given the size of the problems we face, they will eventually be forced to monetize our debt.
Richard Fisher, head of the Dallas Fed, is probably the loudest “inflation hawk” they have. And even he is making the deflation case. So the Fed, like always, is focused on the immediate future. Since inflation is not an immediate concern, they put it off , essentially saying “we’ll cross that bridge when we come to it”.
In a recent WSJ interview, Mr. Fisher attempted to soothe worries about hyperinflation. While it is reassuring to hear Mr. Fisher say the Fed won’t monetize our debt, he is a black sheep, an anomaly among Fed Presidents. And even he doesn’t sound convinced:
I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program [from this wsj piece, a must-read]
Without signaling? Why not say, “While assuring them that we are committed to not monetizing our debt. We’re not going to do it, period.” Because he’s only one voice, and hugely outnumbered. I like Fisher, he seems like one of the smarter Fed guys. When the time comes to pull in the reigns, his voice will surely be drowned out.
How far will they go to stave off massive economic turmoil; a collapse on the scale that Mish and others forsee? Very, very far. No government wants the it to happen on their watch. The digital printing presses are likely getting warmed-up.
Inflation: Easier to Swallow
Politically, inflation is infinitely more palatable than the alternatives. Voters loathe tax increases, and rightly so. Yet we have also become dependent on ever-expanding programs like medicare. Something has to give, and I think inflation is the easiest option.
The American public is largely complacent. As long as you don’t raise their taxes or slash their benefits, rebellion is unlikely. But if you jack up taxes or cut spending on the scale required to fix this problem, we may see serious social unrest. It’s really that big of a problem. Which is why I remain in the inflation-camp. For more on the effects of continued government intervention, see “Beware Bears: More Bailouts and Inflation Loom”.
Disclosure: No positions in any stocks mentioned.
15 Comments
Like you I have been wrestling with the inflation/deflation conundrum. And I think you have hit upon the nub of the matter – deflation and economic/social collapse would be the result from here IF the govt did nothing. But they won’t do nothing, and will undoubtedly move heaven and earth (to the point of crediting everyones bank account with money if necessary) to prevent that collapse happening. Which can only result in much higher inflation, possibly getting out of control into hyperinflation. The alternative – a deflationary spiral of business collapse, lower demand, lower tax revenue and public spending cuts to balance the budget is too horrendous for govts (both democratic and despotic) to contemplate, and will not be allowed to happen.
@Jim
Thanks Jim, you summed it up well, “The alternative – a deflationary spiral of business collapse, lower demand, lower tax revenue and public spending cuts to balance the budget is too horrendous for govts (both democratic and despotic) to contemplate, and will not be allowed to happen.”
Sustained deflation would break the back of the homeowners, commercial real estate, state govs, and the US as a whole. Doesn’t seem politically tenable. If it does happen, though, be prepared. Things will get ugly, quick.
[...] • Flaws in the deflation case Bearish News [...]
IFF they can, officials will inflate. It is an easy and popular choice, and the consequences can be blamed upon others.
The problem is, it is pushing on a rope. The banks won’t & can’t lend, so the marginal fractional-reserve multiplier is zero or negative. So the “excess reserves” and even the money supply numbers have become currently _meaningless_
Sure the UST can and will cut checks. But most of the small ones are to the usual payees (Soc.Sec et al) and not getting bigger. Ditto taxes. They _are_ cutting many more big checks, but those are for bailouts and few are for shovels. The bailout checks are used to paper over losses whose inflationary effect was in the past.
But there still are people with discretionary income & savings. They, plus shovel injections will eventually ignite inflation.
[...] in the long-run. But that doesn’t change the fact that it is highly unlikely, as I argue in this piece. So even bigger deficits and sustained inflation seem very likely a few years down the road. Those [...]
there’s an important distinction between the debt laden companies that will get boosted and the ones that will get crushed- which is most of them, IMO. in one word, “refi”. the trend in the past 20 years has been to view short term obligations is purely _better_ (for the debtor) than longer term ones. hey, the difference in interest rate must be free money with no tradeoff, right? you gotta go B-School to get THIS kind of stupid.
plenty of companies have blown up (REITs, BDCs, and oh yeah, the investment banking industry) because although they could easily service interest, their assumption of being able to roll over the principal proved reckless.
How to invest then?
If things are going to get worse, maybe now, maybe later…
If holding on to cash were any kind of answer, we’d consider it, but it’s not there are some places that will pay to hold through the next few years — useful commodities, oil, natural gas, only because people will continue to drive to work, heat their houses.
I’m looking at stocks for such a long term, they still appear attractive, if as you so wisely point out, we don’t have further game changing manipulations by government.
We will, so what are the choices left on the table? At a dinner party last Christmas folks told me how they had pulled their retirement funds out at the top of the summer. They were going to sit it out. I don’t know if they ever got back in. Meanwhile, in some areas, again international relative to US markets, some funds and ETFs have returned 30-40% YTD.
But if we learned nothing else in 2008, no equity market is an island. Trying to find a good counter weight, we have the gold bugs, but with only limited usage — and I think that ship has sailed.
Owning real estate, cumbersome, but perhaps fun and the only hedge to the kind of inflation that has to come, 1970′s, at the very least, in light of all the games coming from our elected teams in DC.
Loved the post, keep it up.
Scott – that’s the right question. Not sure of the answer, though. Inflation seems inevitable. I like metals, but mostly just cause I hate the market. Stocks are very expensive right now, P/E of around 134 on the S&P 500. That doesn’t mean they won’t go up, because of manipulation and “creative” accounting.
If you have the motivation, building some sort of business if probably the best investment. Even if it’s just in your spare-time.
[...] following in Japan’s footsteps. I don’t agree with the sustained-deflation argument, as stated here. But a lot of smart people do think our “eternal life-support for zombie-banks” [...]
[...] and plenty of book-cooking via changes to accounting rules and inflation data. See Flaws in the Deflation Case for [...]
[...] coming, that the economy was looking good (and why not, when they’re pumping trillions?). See Flaws in the Deflation Case for more on the general concept, though it is a little [...]
[...] Good Tech Ticker clip featuring Peter Boockvar explaining why any deflation/disinflation will inevitably lead to more easing and ultimately inflation. I discussed this at length last year in Flaws in the Deflation Case. [...]
“We’re not going to monetize the debt,” Mr. Bernanke declared flatly – 25 FEB 2010
Deflation it is.
Inflation is Baaaack!
http://inflationdata.com/inflation/images/charts/Annual_Inflation/annual_inflation_chart.htm
from about 2001 to 2006 we had hyperinflation in hard assets and equities.
we are now in and have been in deflation and that will probably continue for many more years. The evaporation of dollars is happening much faster than the creation of dollars and smart feds know that they will be pushing on a string if they continue to monetize and will probably prolong deflation. its absurd to think that if the fed sent us all 50k 500k ect that would cause inflation all that would do would create a massive flight out of the dollar into gold other commodities and china and japan would refuse to buy t-bills, notes ,if they continued to do so they would want 50% + on the __lending which would be a huge smack down on inflation. just as money is created out of thin air it can evaporate and return to thin air. its called debt default.fannie and freddie are trillions poised to default and proabaly will where are the newer bigger fools to borrow i.e replace this money with.