Follow The Bottom Violation
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Jan
20
De-leveraging Is Not Deflation
“Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages.”
– Ludwig von Mises
It’s true that just about every asset class is coming down in price right now. This, however, is not deflation — as I have said so many times recently, much to many readers’ unqualified chagrin. To the contrary, these declines are the products of de-leveraging — not deflation — and the distinction is nearly incalculably important, although the subtlety seems to elude even the most astute these days.
If the previous premise is true (which it is), any removal of money from the economy would eventually result in an increase in the value of our currency, relative to everything else. And that, in turn, would eventually translate into lower prices in dollars. But that’s clearly not what is happening. No, the Fed is printing money, sending the amount in the economy higher than ever seen in U.S. history. That’s not deflationary. That’s inflationary.
Just so you’ll know, here’s the definition of inflation I’m using. And before you pooh-pooh it with too much eagerness, remember that one of its authors, F.A. Hayek, won the Nobel Prize in economics in 1974.
Look, the thing we should be worried about is relative value, not “inflation,” per se. It’s not about the growth of M0, or M1, or M2 (or even M3, if you keep up with shadowstats.com), so much as it is about what the money supply is doing relative to everything else that is happening. I know assets are falling in price — believe me, I get no shortage of reminders every single day. But the amount of money in the system — not just M0 — is increasing at a tremendous rate. I won’t argue that the relative value of things like real estate and equities are going to continue to drop — maybe even dramatically, and for a long time — in terms of demand (or lack thereof). No, what I’m most concerned about is that demand will stay extremely low, and yet prices will rise anyway because of the increase in the amount of money in the system.
But it’s not just money; it’s also Treasuries. The Fed has specifically stated that its objective is to stimulate “inflation” (by its definition). It wants prices to rise, and it’s going to do everything it can to find success. But the amount of money in the system is unprecedented. When the Treasury bubble starts to collapse, yields are going to explode. Yes, the Fed will probably print more money to buy down the long-end of the curve, but how long will that work? Some people say years, but how? Do you really think the Chinese and the Japanese are going to keep funding that sort of behavior? Or even more importantly, do you think they’re just going to sit on their current holdings? Probably not, and if they start dumping Treasuries, yields are going much higher.
It’s not a matter of if this is going to happen. Yields can’t stay where they are for any sustained amount of time, and once they start rising, so will prices. But will demand for, say, houses have increased? No. Cars? No. Boats? Televisions? No. Why? The American consumer is tapped out.
Credit card companies are tightening limits prodigiously. Teaser rates are all but gone. Home equity has dried up. The consumer has driven two-thirds of our economy for at least the last few decades, and now the consumer is dead. There’s another aspect to this that I won’t go too deep into: the American consumer protects his or her credit score for one reason — to obtain future credit. But the consumer also knows that loans have dried up — not just today, but for the very distant future as well. You know these consumers have to be thinking about defaulting; if they can’t get loans anyway, why would they not default on thousands of dollars in unsecured credit card debt? I plan on writing more about this in future articles, but suffice it to say, I think credit card companies are going to give us the next blow to our collective stomach, and it’s going to hurt.
So here we have a situation in which demand is gone, and yet prices and rates are rising — because of inflation (printing money) and the Treasury collapse. And that’s the point: it’s not going to come from just one source. It’s not just going to be inflation (printing money). It’s not just going to be the collapse in Treasuries. It’s not just going to be the nearly unfathomable costs of the stimulus packages that are coming online in the next two years. It’s going to be the confluence of all of it. And if I’m right about the continued deterioration in credit markets, things will be even worse.
You think it’s not different this time? Add it all up, in real dollars — the staggering amount of debt, the parabolic rise of currency in the system, the annihilation of real-estate investment, and the demise of the consumer. $8.5 trillion committed to bailouts and stimulus packages. Oh, yes it is different this time. It’s very different.
Credit cards didn’t even exist in 1930, and the dollar was backed by gold. Credit cards barely existed in 1973. Nixon had just taken us off the gold standard, and look what happened? Volcker was immensely lucky to have stopped hyperinflation, and look at the extreme measures he had to employ to do it.
Of course, every time I bring all of this up — which is a lot lately — somebody starts talking about the velocity of money. And pretty soon after that, somebody starts talking about the multiplier effect.
Yes, the U.S. employs a fractional reserve system, and while that system certainly lends to rising prices and yields, the amplifier effect is not inflation. Like the printing of money, the fractional reserve system is only one ingredient in the poison that lends to the ultimate catastrophe inspired by central banks: rising prices and increased costs of borrowing.
And then there’s velocity…
While I am eternally grateful to my critics for forcing me to defend the theories I hold dear, I sometimes fatigue of the incessant snapping at my heels by people who want me to know that the velocity of money has slowed down. I know the velocity of money has slowed. It doesn’t matter. It’s not going to stay this low for long, and when it starts speeding up, it’s not going to be a “good thing.” Treasuries are going to break, rates and prices are going to rise, and all that money pressing against the dam is going to find a crack. Why? It has to. People will flee from dollars that are losing value. They will extract all the dollars sloshing around the system, and they will buy commodities and durables in order to preserve the value of their wealth.
Remember, just because the dollar is losing value does not mean that the concomitant subsequent rise in certain asset classes necessarily means that demand for all assets has increased dramatically — as it did during previous eras of easy money. Demand for assets economy-wide can continue to wane even as people spend dollars as fast as they can get them in the midst of rising prices. And this is a very important distinction: prices can rise because of demand, but prices can also rise because of excessive increases in the amount of money in the system. If prices are rising without a simultaneous increase in demand, well, I can’t think of a more dangerous economic environment to be in.
You don’t believe it can happen? You think there’s a huge demand for houses, cars, and boats in Zimbabwe? Prices there are rising exponentially, but there is very little demand for assets — other than staples, of course. What do you think their velocity of money is?
The other day I wrote that Treasuries and the dollar are not “safer” than gold, and for my efforts I was heckled by several readers. Ultimately, however, flight-to-quality will seek the true risk-free rate of return, and this is yet another factor that will contribute to the imminent ferocity of the move that’s coming. Once Treasuries unwind, people and institutions will scramble to find a place to put the money they had once placed in the “safety” of U.S. government debt. And unless you know of a medium whose historical consistency and safety surpasses gold’s, that will be the place investors find haven.
Just for future reference: when I say the dollar’s going to fail (which it is), and you’re hovering over your keyboard, poised like some bird-of-prey, ready to strike me with all the ire of God-upon-Sodom, will you try to remember that I acknowledge velocity is, at least for the time-being, near zero. Will you also try to remember that I don’t believe the massive increase in currency alone will not be responsible for imminent rising rates and prices? In fact, I think Treasuries are going to play a greater role in the beginning.
Also, I agree with many of you that my timing may be a bit premature, and I exited my TBT after the last run-up. Unfortunately, today the stock market and Treasuries are getting crushed as gold rallies. I wouldn’t want to declare myself “right” based just on the behavior of these markets in recent days. That would be stupid. And yet I sit here and watch TBT move higher, wondering if getting out was even more stupid.
To add to my trepidation, some sort of manager in the South Korean finance ministry came out over the weekend and announced that the time has come to sell U.S. Treasuries. How do you think that made my stomach feel? Of course, Bernanke keeps promising to do battle with the long end of the curve, so maybe he’ll make good on his threat and I can find a point to get back in comfortably.
Of course, if I miss the move because I listened to some of you cynics. Well, at least I still own gold.
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Disclosures: Paco is long TBT, UCO, and gold. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies.
You can buy his novel Discipline wherever books are sold.
11 Comments so far
Partners
I noticed that TBT was green today even though the market was way down. Of course, this could simply be a one day aberration, but maybe they are beginning to decouple. I took a smallish position today and we’ll see how that goes.
Cheers!
Another Pumper attempting to profit……..weak…….very weak…
Interesting post as usual. But what if you’re wrong about the increase in the money supply and this guy is right? Can you please comment on this article? Thanks.
http://seekingalpha.com/article/115553-does-wealth-equal-money?source=feed
Robert,
One question I have to that perspective is – does inflation run rampant when asset values soar? No, because those assets are not liquid, even if your house is worth more money it’s not the same as money in the bank. There may be some inflationary effects, and speculation will run up prices in things like houses and commodities, but it’s not the same as inflation – only certain things cost more.
Alternatively, it would mean that when asset values fall, you don’t have less money in your bank account – in fact, the people who sold their houses and stocks now have more money vs. assets. The key is that inflation won’t start until these people get pushed by the stimulus to start moving their money – then it all comes in to the system at once, and what the author of your article missed. He thinks that people are saying that inflation should start immediately when more money is printed. That’s not true any more than house prices decreasing immediately when more houses are built. Fear and speculation will prevent that for a time. But after there are enough of them, and values start to slip, then it falls much faster and farther than it would have without the expanded supply.
Robert, I just don’t think the current state of de-leveraging is going to offset the failure of Treasuries. It’s the perfect storm, and even if housing prices fall another 50%, massive U.S. debt and liquidity are going to crush the dollar. Thank you for that link… that’s a great article.
Are you sure the wikipedia has the inflation definition correct (or rather complete)?
Here is the definition for both inflation and deflation
inflation: expansion in money supply and credit
deflation: contraction in money supply or credit
It’s counter intuitive to have deflation in a monetary fiat, isn’t it? Well, we experience a destruction of credit these days which happens at a greater speed the FED is managing to bring money into the economy (actually FED is failing, as it can not force banks to lend and people to borrow and the money velocity is ZERO; more they pump in the black wholes that are banks, more the deflation will intensify; and this is because the dollars don’t make their way into the economy but in the same time becoming more expensive). So there is nothing inflationary about what the FED is doing.
I’ll offer another view on deflation. In a fiat money system, deflation is about ‘social mood’ rather than supply of money.
Sorry Paco if I’m making your comments into a forum.
Dacian,
The destruction of new credit is a deflationary force in a fiat economy. The destruction of *existing credit* – like a home loan defaulting – is an inflationary force.
If you compare a fiat currency to a gold standard it makes it more understandable – instead of the government holding gold in fort knox, it holds debt that people owe it. The more debt it holds as a ratio to the less dollars it issues, the more dollars are worth (like if you have more gold reserves and less dollars to lay claim on that gold). However, if you destroy gold and print dollars, your dollars are worth less. Similarly, if you destroy what your debt is worth by defaulting on it and print more dollars, your dollar will fall.
Furthermore, the fed, by keeping interest rates at almost zero, is decreasing the value of new debt that people give it – they’re not making any money on new debt stored in the bank. New credit at a high rate that is likely to be repaid is more valuable than new dollars issued and therefore deflationary – not risky debt that returns zero.
Also, foreign debt, as further claims against that store of debt, decrease the value of the dollar further.
You’re right that the immediate effects of deflation are about social mood though, at least until we start getting a run on the bank.
Hi Paco… Personally, I agree with you stance. Von Mises will win out, no matter what the nay-sayers say. I’ve become concerned that even those who follow the Austrian crowd have started using definitions like Dacian does above. Inflation is an increase in MONEY not money and credit. Credit can behave like money temporarily, but in the end, it is not a medium of exchange; it is an asset/liability.
FYI, Dacian did a nice job of quoting Mish without attribution. Mish has been insistent lately that we are seeing DEFLATION because credit is being destroyed. And he did a piece recently on social mood. Hey, Dacian, are you Mish?
Well, I saw Anon’s comment a bit late; I’m not Mish but I read Mish’s as well as Paco. I didn’t quote Mish, even if I agree I’m influenced by his point of view (early in 2008 I was on the inflationary camp, thinking that FED’s moves will create inflation since I started to read Mish and I must say I agree with him). I didn’t quote Mish because I read more than Mish about deflation, but I admit I have no merit in developing a sort of “original” theory about deflation. Now if because of that you want to quote what I say, I have no problem saying “this is Mish”.
PS: It’s still Dacian, but I can’t post with my name?! I selected Anonymous…
Anon, btw…
You have also Keven Depew doing a lots of posts on social mood I read, so I’ll quote him as well just to remove any doubts
PS: Still Dacian
Interesting post as usual. But what if you're wrong about the increase in the money supply and this guy is right? Can you please comment on this article? Thanks.
http://seekingalpha.com/article/115553-does-wealth-equal-money?source=feed