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Why Deflation Is InevitableRick Ackerman
Today I introduce you to the deflationist arguments of Whiskey and Gunpowder editor Mike "Mish" Shedlock, whose logic is quite similar to my own perhaps even uniquely so, given its unmitigated vehemence. For one, we both agree that nothing short of outright deflation can cure the world of its debt disease. For two, we both see deflation as not merely likely, but inevitable; and for three, neither of us has met a counter-argument that can't be knocked down as easily as a shooting-gallery duck in the crosshairs of a .50-caliber machine gun. Not that that has stopped the ducks from squawking, In the polemic below, Mish takes on Jim Puplava, whose observations about the economy and stock market at Financial Sense Online usually make good sense. This time, though, facing Mish's impressive firepower, Jim comes off as a sitting duck. You can judge for yourself: . "Sometimes," Mish writes, "I wonder whether I am on the same planet as those who espouse hyperinflation. The debate among inflation, stagflation, deflation, hyperinflation and just plain "'flation" has been raging for years. Most sides do not even state the other side's viewpoint correctly. Now, perhaps I mean that most do not understand my viewpoint correctly, which is indeed a different thing altogether. Then again, there is so much general confusion that it is high time we get a decent dialog going so we can better understand the other points of view. In that regard, I have been following the "deflation debate" on the Financial Sense Newshour with Jim Puplava. Deflationists as Dummies "Let's backtrack to May 7, 2005. In a one-hour commentary (in the segment entitled "The Big Picture") Jim Puplava attempted to explain "Why the Deflationists Simply Don't Get It." Here is a summary of what he said then, at least as I heard it: * Deflationists do not understand what money is * Deflationists mistakenly equate productivity gains for deflation * Imports will cost you more if value of dollar goes down * Deflationists do not understand that there are two economies, a financial economy and the real economy. There can easily be asset deflation in the financial economy but inflation in the real economy, * Deflationists believe the CPI numbers "Let's take them one at a time: First, Deflationists do not understand what money is. This a tough issue. I believe Jim is correct. However, I believe I can simplify the statement and still have it be correct. Let's try this: People do not understand what money is. Thus, I contend that it is not only deflationists that do not understand money, but almost everyone. I suspect part of the reason is that most people do not care, and another part is that because there are so many confusing definitions of 'money,' it is very hard to get agreement from anyone on just what it is. Is Gold Money? "Case in point: We have M1, M2, M3 and MZM definitions. There is also Austrian money supply theory, but I have seen at least three different definitions of Austrian money supply. We have a subset of people that thinks 'gold is money' or 'silver is money.' And finally, we have a tiny subset of people that thinks gold is the only money. If that were not bad enough, people also often confuse wealth with money, as if their house appreciating in value makes them wealthy. Well, I am going to hazard a guess that Jim would agree with me that rising home prices do not make people 'wealthy,' since current replacement costs are high and nothing is really gained by escalating housing prices unless -- and until -- one takes that profit out and decides to rent. Obviously, it would be impossible for everyone to sell his house and rent. "This subject is, in fact, so complicated that I want to devote some time to discussing credit versus money, as well as the various "M" definitions of money in a later essay. As it sits, I will accept Jim's idea that 'deflationists do not understand what money is,' simply because there is no precise agreement as to what money is. Without an agreement as to the definition of money, there has to be confusion, and we can sure see that! Productivity Gains Deflationists mistakenly equate productivity gains for deflation: "I disagree. Perhaps some do, but I suspect most do not. As for me, I believe this statement from Milton Friedman: 'Inflation is always and everywhere a monetary phenomenon.' In fact, let's look at more statements by Milton Friedman (as listed by the Adam Smith Institute) that I accept: 1) 'Inflation is always and everywhere a monetary phenomenon. To control inflation, you need to control the money supply'; 2)' Inflation is like a drug. Its stimulating effect [is] temporary. Only larger and larger doses can sustain the stimulus, before the chaos of hyperinflation removes all the gains'; 3) 'Annual consumption is a function of people's expected lifetime earnings -- not just their income at the current time'; 4) 'Keynes was wrong on just about everything, and his followers are wrong on absolutely everything'; 5) 'State licensing rules limit entry into the professions, thereby allowing professionals to charge higher fees than if competition were more open. That (more than the public interest) is why professionals love licensing'; 6) 'Rent controls have the opposite effect to those intended. Rental property becomes less profitable and is taken off the market. Instead of delivering cheap housing for all, the controls actually produce a chronic shortage'; 7) 'Exchange rates should float freely.' "Thus, productivity is productivity, and monetary inflation/deflation is monetary inflation/deflation. I cannot speak for deflationists everywhere, but the idea that deflationists in general confuse productivity with deflation seems wrong. Cost of Imports Imports will cost you more if the value of the dollar goes down "Jim, I will give you a free shot at taking this one back. Imports may or may not cost more, regardless of what the U.S. dollar does, simply because of productivity and other factors, such as wage differentials, as discussed above. Thus, computers, software, underwear, clothes, wheelbarrows, and in fact, most goods coming from China have fallen in price. Congress is currently discussing placing 27.5% tariffs on goods from China, as if that would help U.S. manufactures win back market share from China. Unfortunately, it will not help a thing. Wage differentials are just too great for the United States to win back market share from China. (I presented this idea in 'Would Floating the Renminbi Solve Anything?') More to the current discussion, if tariffs were imposed and prices rose 27.5%, would that be inflation? The correct but non-obvious answer is no, assuming one accepts the statement that inflation and deflation are monetary phenomena. This is another weakness in the arguments of many inflation alarmists who see all price rises as inflation but dismiss all price decreases as 'productivity.' " Two Economies Deflationists do not understand that there are two economies, a financial economy and the real economy. There can easily be asset deflation in the financial economy but inflation in the real economy: "There are two economies for sure, by Jim's definition if nothing else, and we can clearly see some prices inflating and other prices deflating, which, as we discussed, is completely different from money supply inflating or deflating. Adding to the confusion, money supply can be seen as shrinking, slowing in growth, or still exploding up, depending on the definition of money. This conundrum is solved by agreeing on what money is. Many inflationists see hyperinflation based on M3, the broadest measure of money, which includes many items that are clearly (in my mind anyway) credit as opposed to money. If money is credit, then we have one answer. If money is gold, we have another. If money is M1 or M2 or M3 or MZM, we have a third, fourth, and fifth answer. Thus, while we may agree and understand that there are indeed two economies, the lack of agreement about what is money and what is inflation prevents a valid discussion. CPI -Believers Deflationists believe the CPI numbers: "This is patently false, at least as a universal statement. Perhaps some do, but then again, perhaps some inflationists who believe in a strict definition of money also believe in the CPI. Once again, the question arises: Are we debating prices, or are we debating whether 'inflation is always and everywhere a monetary phenomenon'? I am willing to assume (and am awaiting Jim's reply) that he agrees that inflation is a "monetary phenomenon." The question, then, is: How does that phenomenon manifest itself? For the record, I think that the CPI is grossly understated, yet I am a firm believer that deflation is 100% inevitable. "Is this a conundrum? No, not really. For example, right now, is there much doubt that we are in stagflation? The problem is that 'stagflation' is yet another term we need to define. Generally, the term means rising interest rates and stagnant growth. Unfortunately, that definition has nothing at all to do with either inflation or deflation, both of which pertain to rising or falling growth in money supply, discussed above. Thus, we could be in stagflation and deflation at the same time or stagflation and inflation at the same time. In my opinion, the term "stagflation" is just a cop-out used broadly whenever the stock market is not advancing but interest rates are. Monetary Phenomena Finally, we have disinflation, which is the slowdown in the rate of inflation or the downward movement of prices in general. Sheeesh! Neither disinflation nor stagflation are monetary phenomena, but both are discussed hand in hand with inflation and deflation, which -- at least in my viewpoint -- are monetary phenomena! Is it any wonder people are confused? All these terms and all these viewpoints, most of which are not correctly applied by the masses, sure lends credence to the idea that 'there is a whole lot of 'flation going around.' "As for the CPI, there is zero doubt, at least in this long-term deflationist's viewpoint, that prices are currently understated, especially when it comes to housing and energy costs. This, too, will be the subject of a future essay, as once again, the answer is not as simple and straightforward as inflation alarmists believe. That said, right now, the CPI has probably vastly understated the rate of inflation, and in general, I would think that Jim Puplava and I are more or less in agreement on this fact. "Hopefully the above discussion lends credence to my assertions that deflationists are not the only ones who are confused, that they are not the only ones who do not know what money is, and that deflationists in general believe in the CPI. From Here, Where? The big question, however, is not hindsight, but rather foresight. Where do we go from here? Fast-forward to the May 21 Financial Sense Newshour's segment "The Big Picture." The following are some of the key ideas from that discussion: 1) Credit is created in many ways, most notably through the GSEs, including Fannie Mae and Freddie Mac; 2) The U.S. economy added $2.7 trillion in debt last year; 3) The U.S. economy added $10 trillion in debt over the last four years; 4) We are borrowing $20 for every dollar of savings; 5) Real estate prices are rapidly rising; 6) The 'real key' as to what is coming is what happens when the economy starts to weaken; 7) There is a shortage in commodities -- notably oil, on account of 'peak oil.' "In addition, a number of 'tipping points' were discussed: 1. Leveraged carry trades -- after the Fed started hiking, people started looking further and further out on the risk curve 2. The potential to make money drops as the Fed hikes 3. Carry trade could unwind as the Fed hikes 4. Major consumer credit problem 5. Trade wars with China 6. Consumer debt -- U.S. consumers keep putting off the day of reckoning 7. Consumers are now relying on the inflationary increases of the housing market to support spending 8. If consumers get in trouble, banks will be holding a lot of worthless paper 9. Banks had a cushion previously because of the 20% down payment required -- there is no cushion now because of 100% or even 125% housing loans 10. There is less equity in housing, so it's easier to walk away from property if the situation worsens 11. Loan standards have been lowered via "no-doc" and "stated-income" loans 12. GM is in trouble 13. Pension plans are in trouble, with invalid assumptions about future returns 14. To keep the recovery going, everything must be perfect... foreign funding deficit, no trade war, no hedge funds go under, no banks go under, consumers don't go under, real estate prices stay inflated, etc. As to the last point above, Jim asks the question, "What are the chances we will get that lucky? I just do not see it." Don't Count on Luck "Bingo! Jim, I concur 100%. We will NOT get that lucky. Consumers will go under, housing will implode, perhaps some banks will get in trouble, people will attempt to walk away from housing loans that go bad, hedge funds' overleveraged carry trades will go awry, and consumers will face their day of reckoning for taking on additional debt. If ever a case was made for deflation, Jim, you just made it. I listed 14 tipping points, all of which I agree with and all of which have the potential to destroy the leveraged malinvestments in housing, carry trades, consumer spending, and consumer debt. In 'Deflation Is in the Cards,' I outlined 10 reasons for deflation. Oddly enough, or perhaps not oddly enough, some of them sound like the 14 tipping points above. Without further ado, here are Mish's top 10 reasons why deflation is inevitable: 1. Enormous consumer debt 2. Falling wages 3. Global wage arbitrage 4. Credit expansion that cannot be maintained 5. Malinvestments 6. Overcapacity 7. A worldwide housing bubble 8. A reinflated stock market bubble 9. The normal business cycle 10. Past history "This is the scenario I envision: Wages continue to fall, due to outsourcing, mergers, and global wage arbitrage Home prices level off, and then fall sharply Home equity loans stagnate as result of stagnating home prices Home building stalls because affordability finally starts to matter Trade jobs fall with falling home starts Expansion of Wal-Marts, Home Depots, etc. stops with the slowdown of new home subdivisions Retail expansion peaks and stalls Consumer sales slow with the slowing economy Bankruptcies increase Consumer lending based on rising home prices falls flat Credit growth declines The United States goes into a recession Layoffs in the financial sector increase Layoffs in the real estate sector increase Credit is destroyed in more bankruptcies Deflation is finally recognized in hindsight Hyperinflationists throw in the towel Inflationists' Achilles Heel "Falling home prices, and the resultant slowdown in trade jobs coupled with rising unemployment, are the Achilles' heel of inflationists. They cannot explain how this scenario leads to further inflation. Nor can inflationists tell me how home prices can keep rising as long as we have global wage arbitrage, falling wages, and loss of jobs. Home prices cannot rise above wage growth over the long haul! The destruction of credit and money, along with an increasing number of bankruptcies that will accompany a significant downturn in housing, is the very essence of deflation. "There it is in a nutshell. From where we are, continued inflation or wimpy forecasts of stagflation are simply not possible. The whole hyperinflation theory will blow up as soon as consumers hit the brick wall in their ability to take on more debt. Show me rising wages, and I will accept that inflation might be a possibility. But I see no reason to believe rising wages are about to happen, and although housing may (for some time) continue to support consumption, when not if -- housing turns, the result cannot be anything other than deflationary. "On two key points, however, I believe I am in complete agreement with Jim: 1. The Fed will attempt to fight the upcoming battle every step of the way 2. The Fed's attempt to fight deflation will ultimately be good for gold. It's sad to see, but this Fed has learned nothing from history. More Money No Answer "The root cause of the great depression was an overexpansion of credit, not a lack of stimulus to fight the downturn, as Fed Governor Ben Bernanke has suggested. One cannot defeat the business cycle by throwing more money at it. "All hyperbolic credit expansions end the same way: in a credit crunch and a contraction. It will NOT be different this time. The Fed's latest attempt to beat the cycle just added to the housing and consumer credit bubbles additional debt that will eventually be deflated, not inflated, away. Ultimately, I do not believe Greenspan will be any more successful at beating the business cycle than Japan was. "I repeat: Deflation is in the cards." *** Taming the Mini-Futures Trading the S&P futures with a stop-loss of one point or less? Come visit our archives to see how it's done. You can get a free one-day pass to visit the site, or a two-week trial subscription with no risk, by clicking here. Rick Ackerman *** Information and commentary contained herein comes from sources believed to be reliable, but this cannot be guaranteed. Past performance should not be construed as an indicator of future results, so let the buyer beware. Rick's Picks does not provide investment advice to individuals, nor act as an investment advisor, nor individually advocate the purchase or sale of any security or investment. From time to time, its editor may hold positions in issues referred to in this service, and he may alter or augment them at any time. 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