Bubble Economy Endgame

There was an interesting post on iTulip over the weekend about the Bubble Economy Endgame. The post was written by Eric Janszen, and called Door Number Two. Here are some highlights:

Today one of our best and brightest iTulip members posted an excerpt and a link to yesterday's comments by Stephanie Pomboy: Economic Fear Taking Hold. In it she says a US deflationary spiral is a mere 3% away. Our long standing position is that the ongoing asset price deflation, debt deflation, now with rising unemployment, falling demand and recession will lead to further erosion in the purchasing power of the dollar and thus to more inflation.

Pomboy's suggestion sounds like a variation on ideas that Mish and many of the good folks over at Minyanville believe. We call the group Deflationistas. Deflationistas have repeatedly called for a deflation spiral and all-goods prices declines for the past several years, since at least 2005.

Actually we need to stop right there for a moment because Deflationistas, at least this one, have not repeatedly called for "all-goods prices declines for the past several years, since at least 2005". While I cannot speak for others, I am not aware of any Deflationistas on Minyanville making that specific claim either.

The general Minyanville Deflationistas Viewpoint (if indeed there is such a thing) seems to be along the lines of necessities (oil and food) are likely to be somewhat price sticky, while prices of manufactured goods and assets are likely to collapse. I would be in that general group.

Furthermore, the price of oil is irrelevant as to the inflation/deflation argument, at least as far as this deflationista is concerned.

What Definitions Are We Using?

Before one can make a claim as to whether it's inflation, deflation, or hyperinflation lurking behind door number two, we have to agree as to what inflation, deflation, and hyperinflation mean. There can be no debate without agreement to definitions.

I have consistently used an Austrian definition of inflation based on money and credit.

• Inflation is a net expansion of money and credit.
• Deflation is a net contraction of money and credit.
• Hyperinflation is extreme expansion of money and credit leading to complete collapse of faith in the currency.

Prices actually do not enter into the equation. Nor should prices enter into the equation. I have stated the reasons for this many times, but Inflation: What the heck is it? sums things up nicely.

Now if someone chooses to define inflation as rising prices, then we need to start all over. Because of peak oil, I expect the price of oil to go up over the long haul, and I also think the prices of minerals and raw materials will go up over the long haul. Over the short to mid haul, I do expect oil will drop to $65 or lower and prices of things like copper are likely to collapse. This expectation is based on beliefs the recession we are now in is going to be severe.

Should oil sink to $65 it will not be proof of deflation any more than oil rising to $200 if Bush attacked Iran would be proof of inflation. Prices in isolation are meaningless.

Can Deflation Happen In A Fiat Regime?

Some claim deflation in the US cannot happen because we are no longer on the gold standard. I disagree and Japan is proof. Of course others claim Japan never went into deflation at all. Let's pick this line of thinking up with Not Your Father's Deflation: Rebuttal.

Some argue that Japan never went through deflation. One basis for that argument is that "money supply" as measured by M1 never contracted over a sustained period. The other argument is that prices as measured by the CPI never fell much. Once again we have a flawed argument about consumer prices and a flawed argument that only looks at money and not credit.

Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. Those are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark.

In the end, one factor alone is going to seal the fate. That factor is called the psychology of deflation. Simply put, the Fed cannot force consumers or businesses to borrow or banks to lend.

Paul Kasriel On The Possibility Of Deflation

Here are some excerpts from an Interview With Kasriel to consider.

U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero but it would have little positive effect on economic activity or inflation.

Short of the Fed depositing newly-created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances. Again, crippled banking systems tend to bring on deflations. And crippled banking systems seem to result from the bursting of asset bubbles because of the sharp decline in the value of the collateral backing bank loans.

Paul L. Kasriel
Sr. V.P. and Director of Economic Research
The Northern Trust Company

The above are excerpts from an Email exchange. In a followup phone interview I asked about the endgame.

Mish: How does inflation start and end?
Kasriel: Inflation starts with expansion of money and credit.
Inflation ends when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and /or speculation no longer makes any economic sense.

More From Door Number

Eric Janszen continues with a discussion of a May 2005 article I wrote called Deflation is in the Cards. The correct/incorrect determinations of my scenario were made by Janszen (In Red).

• Wages continue to fall due to outsourcing, mergers, and global wage arbitrage (no, they are starting to rise due to inflation)
• Home prices level off then fall sharply (correct)
• Home equity loans stagnate as result of stagnating home prices (correct)
• Home building stalls because affordability finally starts to matter (correct)
• Trade jobs fall with falling home starts (correct)
• Expansion of Walmarts, Home Depots, etc. stops with the slowdown of new home subdivisions (correct)
• Retail expansion peaks and stalls (correct)
• Consumer sales slow with the slowing economy (correct)
• Bankruptcies increase (correct)
• Consumer lending based on rising home prices falls flat (correct)
• Credit growth declines (correct)
• The US goes into a recession (correct)
• Layoffs in the financial sector increase (correct)
• Layoffs in the real estate sector increase (correct)
• Credit is destroyed in more bankruptcies (correct)
• Deflation is finally recognized in hindsight (No. The dollar weakens further as these events occur, leading to further inflation.)
• Hyper-inflationists throw in the towel (No, this is a straw man argument. The choice is not between a US 1930s style deflation spiral and a hyperinflationary spiral that ends with a complete repudation of the currency. The rate of decline of the dollar is buffered by foreign central bank holdings.)

Actually, that looks like a pretty good success rate. I might also point out that with the sole exception of home prices, prices were not mentioned.

What About Wages and Towel Throwing?

One reason wages have recently risen because of new minimum wage increases. That is not inflation, that is misguided government policy that will put more people out of work. In addition, what real wage growth we have seen has primarily been at the top end of the salary scale.

With the increased outsourcing or manufacturing and now white collar jobs, we have been removing high paying jobs (for the masses), and replacing them with minimum wage jobs with no benefits at Wal-Mart. And speaking of benefits, companies in general have been cutting back. Benefits needs to be factored into the "wages are increasing" fallacy.

As for the "Deflation is finally recognized in hindsight", I maintain the door number two has not been opened yet. It is premature to place a (no) on that line item.

The same applies to my statement that "Hyper-inflationists throw in the towel". That statement never limited the debate between hyperinflation and deflation. I merely stated that hyperinflationists would throw in the towel. Those looking for a strawman can find it in the rebuttal to that simple sentence.

Janszen Continues...

Clearly we are seeing price deflation in asset prices–stocks, housing and soon commercial real estate–and marked-down consumer goods as the Monthly Payment Consumer buckles under the combined pressures of rising inflation and unemployment. Platinum and other industrial metals are starting to fall in price as markets anticipate falling demand. Gold is rising in anticipation of what the government must continue to do to keep real interest rates negative: inflate, inflate, inflate.

Not exactly. The consumer buckles under a massive heap of debt because rising asset prices no longer bail him out. That is deflationary. Industrial metals will drop under decreasing demand. And gold is rising for two reasons: Gold is the safest money in times of economic stress. The Fed is "trying" to inflate, and that is a good environment for gold.

Janszen Continues...

The critical flaw in the US deflation spiral analysis is that the Deflationistas forgot to ask: In what currency is a US treasury bond denominated? Of course the dollar is deflating with respect to itself! But imports determine a nation's inflation rate. As the dollar deflates that can only mean one thing: rising imports prices and all-goods price inflation.

Rising prices of imports? On what other than oil? Prices are not central to my arguments but for those who think price is everything, I would like to point out Wal-Mart Reduces Prices & Offers 0% Interest. There is virtually no pricing power now except on necessities. Once again, general Minyanville Deflationista Viewpoint seems to have gotten this correct.

Janszen Concludes ...

Behind Door Number One are guys who have been wrong for years on end and will stay that way unless the US enacts the kind of austerity measures the IMF once imposed on debtors: raise taxes, cut spending, send 20 million people into the unemployment lines.

Behind Door Number Three are guys who may eventually be right but three new conditions have to be met first: The US must become as politically and economically isolated and unimportant on a global scale as Argentina was in the 1980s, external demand for the dollar has to fall to the level of the Iraqi Dinar, and there have to be tanks rolling down the street. The probability of all three of those occurring? Zero.

Behind Door Number Two are guys who have turned a few million dollars into more than a hundred million after reaching the same conclusion in 2002 that I did in 2001, that the dollar will decline but will not crash, and the decline will exert an inflationary bias on the economy.

Behind Door number one is someone who was correct about 14 out of 17 items with 3 in dispute. In addition, at least one deflationista has been bullish on gold for the last 5 years while also being bullish on treasuries for the same period. That’s two more correct opinions.

Debate on the purchasing power of the US dollar overseas is a sideshow. The price of oil is a sideshow. Those focused on sideshows simply cannot understand treasury yields at 2% because they do not understand what inflation is.

There are many deflationistas bullish on gold. There is one prominent one who is not. It is a mistake to lump all deflationistas with one lighting rod. That person has been wrong about gold for seven years and may be wrong for another 15. But inflationistas have been wrong about treasuries for the same period.

Two Viewpoints

• Gold is money.
• Money is going to do well in deflation.

That is my simple Austrian economist based belief. Having said that, I do expect a significant correction in the price of gold as deflation forces a reduction in leverage of all kinds (including leverage in gold and leverage in the carry trade). I simply do not know if that starts now or at a much higher level.

The K-Wave

The Kondratieff Cycle is a long one. Briefly it looks like this.

• Spring - Reflation - Characterized by rising equity prices and rising interest rates
• Summer - Inflation - Characterized by rising commodity prices and falling equity prices
• Autumn - Disinflation - Characterized by rising asset prices and falling interest rates
• Winter - Deflation - Characterized by falling asset prices and falling interest rates

During Autumn, with falling interest rates, everyone loads up on debt and asset prices go to the moon. Eventually a point is reached where consumers are unable or unwilling to take on more debt, and banks are unable or unwilling to extend credit. This attitude shift is happening now.

See Changing Social Attitudes About Debt, a Crash Course For Bernanke, and The Business of Walking Away for more about attitudes. Attitudes are crucial to the deflationista debate.

Boomers counting on their home as their retirement now have to worry about saving rather than spending. Social attitudes towards consumption are changing slowly but surely. Those changing attitudes are exactly why Things That "Can't" Happen, will happen.

Because each season is long, up to 25 years, by the time Winter is about to hit, it's been 75 years since there has been deflation. That length of times causes people to think deflation will never happen again. The biggest manifestation this time was the widespread belief "Home Prices Always Go Up". That belief has now been shattered. Somehow, people still believe in the Fed.

Faith In The Fed Is The Last Bubble

The last remaining bubble is faith in the Fed's ability to inflate.

"Door Number Two" was a very well written rebuttal. Unfortunately, the rebuttal was based on a strawman that does not exist. The initial flaw was that no agreement was reached on critical definitions. A major subsequent flaw is the assumption that deflationistas in general have been wrong about gold. Finally, the "Door Number Two" post shows that even after all this time the inflationistas somehow do not understand what the deflationistas have been saying, even when it is spelled out point by point.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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