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Five Things You Need to Know: Deflation... And the Headstones Climbed Up the Hills

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The question of whether capitalism can survive is irrelevant because a government, by issuing public debt to buy private assets, will have effectively ended it.

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Kevin Depew's Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Deflation... And the Headstones Climbed Up the Hills
2. The Ben Bernanke "Helicopter"
3. The Liquidity Trap
4. The New American Saver
5. One Last Thing

Deflation... And the Headstones Climbed Up the Hills

"Policy makers navigating the U.S. through the global credit crisis may have a new concern on the horizon for 2009: deflation."
- Wall Street Journal, "Amid Pressing Problems, Threat of Deflation Looms," Oct. 18, 2008

"Britain faces deflation for first time since 1960."
- Telegraph, Oct. 17, 2008

"U.S. Federal Reserve Chairman Ben Bernanke on Monday threw his support behind a second round of fiscal stimulus by the government to limit the risk of a "protracted" slowdown in the economy."
- Wall Street Journal, "Bernanke Signals Support for Second Stimulus," Oct. 20, 2008

"And I dreamt of a house
Haunted by all you tweakers with your hands out
And the headstones climbed up the hills
And the headstones climbed up the hills"

- The Mountain Goats, "Palmcorder Yanja"

And the headstones climbed up the hills. Indeed. While a trillion dollars may be just enough to raise the rotting corpses of a handful of banks and send their headstones marching up the hills, the rest of America is going to have to lie quietly "in state," as it were, and wait for congress to dole out another round of "Economic Stimulus"... or "Ec-Stim" as it's known in the trade.

If Congress can rush another round of checks through before the election, or at least distract us with a gaudy show of trying, some incumbent seats will no doubt be saved from voter wrath. But Ec-Stim is political gibberish, of course, and amounts to little more than a second multi-billion dollar bailout... of the online porn industry. That is a fact.

According to AIMRCo, the Adult Internet Market Research Co., the online porn industry reported 20-30% growth in membership rates this summer following the initial round of Ec-Stim checks in mid-May. That's normally the slowest time of the year for online porn, AIMRCo said, which is far more information than we need or want if you really think about it.

"Getting more people to buy porn was probably the last thing Bush had on his mind when he came up with his 'stimulus package,' but we'll take it," Jillian Fox of LSGmodels told United Press International in July.

Oh, I wouldn't be so sure about that, Jillian.

"Go F%&k Yourself."
- Dick Cheney, Vice President of the United States of America

Political dynasties, and those in charge of running them, have a long, cruel history of secretly engineering public orgiastic frenzies to soothe the masses. Virtually all German porn that is considered illegal in the U.S. originated during the Carolingian dynasty. And to this day there are certain places in Bangkok where simply uttering the name Charles "The Hammer" Martel is enough to earn you a life sentence in prison.

No, Jillian, these people are professionals. And they understand that while you can buy more real estate in a day than you can sell in a lifetime, it is possible to consume more porn in an hour than can be produced in a quarter of a century. Yes, that should keep them busy for a while.

Good lord, how did we collapse to this dark and ugly, Cheney-esque level in less than 250 words? Ah, yes, deflation... a broad-based decline in prices across the economy. All it takes is widespread asset price deflation to get the bread & circuses committee ramped up.

Meanwhile, the headstones climb up the hills.

The Ben Bernanke "Helicopter"

Federal Reserve Chairman Ben Bernanke, has long been known by the weird nickname, "Helicopter Ben." But where did this strange nickname come from, and what does it really mean?



In a speech he delivered in November 2002 called, "Deflation: Making Sure "It" Doesn't Happen," then-Fed Governor Ben Bernanke used the phrase, "helicopter drop of money." And since that time this much-misunderstood reference to a "helicopter drop of money" has stuck with him. Most people believe this is an allusion to taking whatever steps are necessary to prevent or cure deflation. But that is not really true.

The Liquidity Trap

Let's look at what Bernanke really said, and what he really meant:

"A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."

Yes, it was Milton Friedman who "invented" the helicopter drop of money analogy, but Friedman's invention was actually based on John Maynard Keynes theory of the Liquidity Trap.

A Liquidity Trap occurs in a low-interest rate environment with stagnant economic conditions and high savings. During this environment monetary policy becomes ineffective. Why? Because under these conditions people believe that they will not receive an adequate return for the risk assumed in owning other financial assets, even bonds, so they prefer to keep cash in short-term bank accounts. In other words, they hoard cash. Sound familiar?

The most frequently misunderstood aspect of the "helicopter drop of money" analogy (from Keynes to Friedman to Bernanke) is that it refers to actions on the part of a central bank, but this is not true.

Bernanke used the phrase in his speech in a section explicitly discussing Fiscal Policy:

"Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."

This may be true, but note he says "almost certainly," and that it presumes that the credit appetite for households will increase - a faulty assumption.

The New American Saver

"The U.S. may be on its way to becoming a nation of savers, whether Americans like it or not."
- Bloomberg News, "Crisis May Turn Americans Into Savers," Oct. 20, 2008

"What we see as stagflation looming on the horizon in our side-view mirror today, may be full-blown deflation up-close as dollars are hoarded to pay down excessive debt and reduce, reduce, reduce."
- Kevin Depew, "Five Things You Need to Know," April 2, 2007

The only thing a central bank can do is make credit available - and the Federal Reserve has certainly been doing this. Whether that credit availability is accepted or rejected will determine whether, and how long, a deflationary credit contraction will last.

One Last Thing

Of course, there is a last resort, one final tool policymakers can deploy. The Fed and Fiscal Policy could come together to help foster a continuation of the game, as Bernanke says:

"[I]n lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets."

Yes, that would help... but the costs are not mentioned, and here we are not referring to the "dollar costs," but something more severe; a steeper price - the nationalization of financial markets.

In plain English, that paragraph is saying that, if all else fails, a government can issue public debt, financed by the Federal Reserve, to purchase private assets. And that is precisely what is taking place right now.

At that point the very question of whether capitalism survives becomes irrelevant, because a government, by issuing public debt to buy private assets, will have effectively concluded it.

And the headstones climbed up the hills.

No positions in stocks mentioned.

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