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Minyan Mailbag-Deflation

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Different take, same outcome. DOH!

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Toddo,

This article argues for inflation, even hyper-inflation. I am going to take the other side of the coin and suggest deflation is almost 100% inevitable after a short period of stagflation (which we are in now).

Let's start here:

Misplaced Expectations

The markets are operating under four misperceived assumptions. It is imperative that we understand these critical misperceptions to know what lies ahead of us. They are as follows:

1)The rise in inflation is a temporary blip.
2)The economy has hit a temporary soft patch, growth will resume shortly.
3)The Fed will get tough in its fight to contain inflation.
4)The financial markets can withstand a gradual rise in interest rates.

These assumptions will be tested as we head into this fall. There is growing evidence that economic softness is gaining momentum. Global economic growth and corporate profits show every sign of peaking. The Fed has assumed a perfect blend of growth and inflation in its forecast. This is the so-called Goldilocks Forecast.

Deflationists believe that Greenspan will fail. There is too much debt and debt contraction always leads to deflation. They point to Japan and the U.S. in the 1930s as an example. However, Japan has yet to experience the full effects of its expanding money supply. Government money creation in Japan has been offset by a sharply contracting banking system. As the government pumps money into the economy by expanding the monetary base, the banking system continues to offset government money expansion by continuing to contract and refrain from making new loans. Many of Japan's banks are technically insolvent. Like U.S. banks in the 1930s, they are afraid to make new loans or renew existing ones. As long as the economy remains in the dumps, the government can continue to run the printing presses with very few pricing effects. The trick is when the economy revives. Then the full impact of higher prices and inflation are felt. This is what led to hyperinflation in Germany during the 20's and 30's. It is also what has happened to Argentina and what may occur in Brazil, Venezuela, Turkey and Russia next.

Can it happen here?

I believe the answer to that question is yes, it is more likely this time around. Unlike the U.S. in the 1930s and Japan in the 1990s, the U.S. is no longer a creditor nation. It has become the world's largest debtor. The inflation consequences of debtor nations are much different than creditor nations. Debtor nations are more apt to suffer the inflationary consequences of their credit inflations. The recent turmoil in Mexico and Latin America throughout the 1980s and 90's and the Asian crisis are recent examples.

Point by point here is my answer:

#1)The rise in inflation is a temporary blip.

I do not think that is the pervasive opinion. I do think the pervasive opinion is that the economy is undergoing a "blip" and the second half of this year will be strong and next year the economy will be as strong or stronger. There are plenty of people that are screaming about inflation. Even Greenspan seems worried at least a bit about it. In fact he proclaimed victory over deflation in January. If you want a pervasive opinion try this: 55 out of 55 economists polled predicted higher interest rates next year. I am betting against it.

#2)The economy has hit a temporary soft patch, growth will resume shortly.

I agree that this is the sentiment. IMO, however, the economy is headed into a recession. That is hardly an inflationary event. Quite literally no one sees it. Not Greenspan not 55 out of 55 economists.

#3) The Fed will get tough in its fight to contain inflation.

I hardly think this is a universal opinion. If anything the inflationists think the Fed will be forced at some point to get tough about it. Then again, everyone has declared victory over deflation and worried about inflation. Not me. Deflation is the worry.

#4)The financial markets can withstand a gradual rise in interest rates.

Once again I agree that is the pervasive opinion. What is interesting is that the author thinks otherwise (as do I) yet people are still calling for inflation. An economy that is so weak that it cannot stand more than a couple of 25BP hikes is hardly an economy where inflation is ready to head to the moon.

Todd, I am taking the other side of the bet. Everyone, and I mean everyone sees inflation coming. Even Hyper-inflation. Let's take a look at a few more things?

A) Are rising oil prices a function of inflation or a function of decreased supply, Hubbert's peak, geopolitical concerns, and rising demand outside the U.S.? I suggest it is 10% inflation and 90% other factors. At any rate, I can not see any price hikes big enough to cause oil to fall dramatically. I do not see it would fall dramatically even if Greenspan stopped printing. Why would it?

B) Rising oil prices act like a tax. A huge tax. People can argue this point but the fact remains that every cent spent by consumers on energy is less money they have to spend on other things. I believe rising energy prices are one of the factors that is finally leading to a drop in consumer spending. Once again, the EFFECT of rising oil prices is HUGELY deflationary unless wages keep up, and as I pointed out I sincerely doubt most of the rise in oil prices has anything to do with expansion of money.

C) Which leads us to wages... Real wages are falling. They have been for years. Consumers have only been able to keep spending because of lowered borrowing costs, cash out refis, and reduced taxes. Cash out refis are now dead due to paltry 25 BP hike in interest rates with another one to come, business tax credits (conveniently election timed expire in a few months) are spent, and the tailwinds of lower taxes are all but spent. In short, signs of consumers being tapped out are all over the place. There is no way to replace that stimulus. If consumer demand falls..... prices will fall. It is as simple as that. Once again that is deflationary. At some point, and I think we are there RIGHT NOW, the ability of consumers to take on more debt, and the lenders' willingness to lend that money with rising bankruptcies will cause contraction in money supply.

D) Inflationists overlook the effect of jobs. This recovery has produced less jobs than any other recovery on record. In fact it will be the first recovery in history to actually lose jobs if I am not mistaken. Greenspan thinks it is temporary. It is not. It is structural and caused by a worldwide glut of cheap labor, cheap manufacturing labor in China and cheap technical labor in India. Thanks to the internet, we have arrived at global wage arbitrage. More and more and more jobs will head for the cheapest cost. Manufacturing is well under way IMO (perhaps the 7th or 8th inning), but services such as accounting and medical diagnosis are probably in the second inning. Far, far, far more jobs will leave and some sectors are just getting started. This is enormously deflationary. People have been able to survive this "blip" because of cash out refis. What happens when those come to a halt? We will not have to wait long to find out IMO.

E) Credit is reaching more and more and more marginal customers each and every day. Many of those borrowers are going to default. Plain and simple, this will be a deflationary credit bust.

F) Housing. Everyone is waiting for the housing bust. Well it is possible they are waiting for the wrong thing. Yes I think one is coming but it will be uneven and spotty and perhaps not even affect some areas of the country, but it could crash in places like California and Florida and Las Vegas. There is no doubt there is a bubble in those areas. The bigger problem and the biggest problem the Fed has to face is not the housing price bubble but the "Housing Economy" in general. Here is a post I did on that on Silicon Investor, it might interest you and your readers. Rest assured there is going to be huge collateral damage to the economy when we start losing housing related jobs. Rest assured that collateral damage will not be inflationary.

G) Underfunded pension plans will contribute to the mess.
Here is a post another post I wrote about that on Silicon Investor .

H) All the inflationists pointed at corn and bean prices as if that was proof of inflation. Well with beans now off 50% the highs, these commodity prices are now conveniently ignored

I) Bankruptcies are rising. This is a destruction of credit and money and it is likely to get a lot worse before it gets a lot better. This is hugely deflationary.

J)Global imbalances suggest U.S. consumers cannot keep consuming and China producing with no buyers other than the consumers of last resort: The USA. Take a gander at Roach's fine piece from yesterday.

K) There is no pent up demand for housing, auto, PCs, toasters, appliances, etc, etc, etc. A housing slowdown will make it worse. Prices will drop. This is obviously deflationary.

L) Japan has already proven deflation can happen with a fiat currency. Yes I understand the differences between Japan and the U.S. I just want to point out 10 years of deflation existing in a country that tried everything it could, even destroying its own currency and still could not produce inflation. It happened before and it can and will happen again.

M) There are many countries as badly balanced as the U.S. Japan for starters and Europe appears on the brink of a recession right now IMO. The UK has interest rates comparatively very high but what happens to the pound and the UK when England kills the housing bubble over there? IMO it will not be pretty. In short, for the U.S.$ to fall dramatically it needs to fall against something and some of these countries (Europe and Japan with their demographic problems) hardly seem like the investment solution. Eventually we both know the solution is gold and silver, but I sense a worldwide collapse in stock markets in the UK, the U.S. and Europe over the next several years. Once again that is hardly an inflationary event. It will literally destroy money IMO.

N) The final answer of the inflationists always comes down to this: The Fed will do a helicopter drop of money. My 100% sure fire answer is they could in theory but they will not in practice. The reason being is that it will allow the debtors off the hook (the public) at the expense of banks and other creditors such as credit card companies. Assume for a second that the gov't printed enough money to allow every debtor to pay off their debts. Debtors will be home free and clear and banks and credit card companies etc. etc. etc. would be left holding a pile of worthless currency. You really think that is likely? I do not. BTW is that what the Weimar Republic did to pay off war debts? If so, that is completely different than the mammoth amount of CONSUMER debt that needs to be wiped out in the USA today. Thus the situation here in the U.S. is nowhere near the same as the Weimar Republic. Not yet anyway. Banks would not stand for it and nor would Congress. Therefore the helicopter drop is not going to happen. AFTER we have destruction and repudiation of mammoth amounts of consumer debts then and only then can we look for hyperinflation IMO. That period could easily be 5-10 years off.

Todd, everyone and I mean everyone is looking at inflation right now. Currently we are seeing stagflation but it will be short lived IMO. Next comes DEFLATION, with everyone looking the wrong way. To fight it, I expect to see interest rates ultimately reach 0% like Japan, or massive bankruptcies wipe out tons of debt first. Greenspan gets in one more hike, 2 at the very outside and we head into a deflationary abyss that nothing can stop. With no jobs to pay off that debt, credit tightens, bankruptcies soar, FNM is put at risk, and price deflation sinks in led by housing, autos, and consumer goods.

IMO the case for deflation is overwhelming. I believe you and the vast populace of Minyans are all looking the wrong way.

Minyan Michael Shedlock

R.P.

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No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

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