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Minyan Mailbag: Deflation, The Fed and Control


What cures a deflation is marking down the previously high valued assets to their new (much lower) market-determined price.


Mr. Practical,

As a gold bug, my ears always perk up when the potential for deflation is discussed. I agree with Profs. Succo and Pomboy that we've had several years of hyperinflation hidden in asset price inflation. I'm aware that gold does poorly in the beginning stages of deflation. That said, I don't believe that deflation can occur until the Fed really panics, runs its printing presses 24/7 and fails to inflate. In my opinion, deflation cannot occur until the Fed takes rates to 0 and fails. It's hard to imagine how the dollar would not collapse before deflation takes hold. It seems to me that talk of deflation is premature. Am I missing something?

Thanks kindly for your insights. Happy holidays to you and yours.

Best regards,
Minyan Dennis

Minyan Dennis,

Your statement assumes that in fact the Fed is "'in control'' here which is manifestly is not. The idea that the Fed directly controls the creation and destruction of credit is termed the potent director's fallacy.

While the Fed certainly does intervene in the market for capital (by adjusting its cost) its effects are largely a function of the prevailing appetite for risk. Where providers (banks) and users (consumers, corporations, investors) of capital (read: credit) are risk seeking like they have been since 2001-2002, the Fed's easy money policies have a multiplier effect through the economy and financial markets.

We have seen this writ large in tech in 2000, housing in 2005-2006, and credit securitization up until August 2007. But when those collective appetites go from risk seeking to risk averting, there is simply nothing the Fed (or administration) can do to stop the process of asset renormalization (which is a fancy term for write-downs). In the US, the economist Nouriel Roubini has been steadfast in his assessment that an insolvency crisis (which is most definitely what we are facing here) cannot be cured with lower Fed Funds rates. I couldn't agree more. What cures a deflation is marking down the previously high valued assets to their new (much lower) market-determined price. Certain ABX indices trade at 20 cents on the dollar – an 80% decline for assets that traded at nearly par early in 2007.

What the above suggests is that we are in a deflation now. The write downs you see by Citigroup (C), HSBC (HBC), Washington Mutual (WM) et. al plus the 30%+ decline in asset back commercial paper volume since August 1 is in fact a deflation of the most serious kind. What you have not yet seen en masse is this credit deflation rolling downhill into the regular economy – into CPI, into PPI, into wages. Having such a massive – unprecedented – destruction of credit that we have seen worldwide not make its way from the financial economy to the 'regular' economy would be unprecedented in any cycle in any country at anytime in the modern financial era.

Lastly, we must differentiate between a currency hyperinflation – which is what is going on now in Zimbabwe and what happened in Germany under the Weimar Republic – from a credit hyperinflation – which is what happened in the US prior to the great depression and in Japan from mid 1980s to 1991.

They are vastly different things for reasons both theoretical and practical. Suffice it to say that a credit deflation – which I think is taking place as I write - is the vastly more probable path after a credit hyperinflation than is another credit hyperinflation or a currency hyperinflation (which is what you are suggesting the Treasury would be doing if they started running the printing presses).

Further, should the Treasury start printing actual greenbacks like the government of Zimbabwe is printing their currency now, the wholesale – and immediate – selling of USD-denominated securities (read: treasuries, agencies, etc) by international investors would immediacy raise domestic US interest rates, thus exacerbating the credit crisis even more by preventing debt holders (of which there are very, very many in the US) from paying off their existing debts as well as forestall any new debt demand since the cost of capital would then be so high. Thus, even if the Treasury (remember the Fed cannot print money – all they can do is create incentives for market participants to take more credit) were to print currency, the effect – immediate effect – would be a devastating increase in domestic interest rates which would exacerbate the very process of credit deflation they are trying to avoid.

Thus, you can see why I say that all roads lead to a devastating deflation in the US (and very likely the rest of the world, which has been equally drunk on credit this decade).

As for your query about the USD; ironically enough, a significant credit deflation increases the demand for (and value of) the USD against almost all goods and services (and other fiat currencies) precisely because a deflation is an attempt to ''get liquid'' – in the form of short term treasuries (see the US yield curve for supportive evidence on this idea) and in the form of cash and cash equivalents. In a credit inflation (2001-2007) the value of the USD fell rapidly. In a credit deflation, the opposite should happen.

Thank you,
Mr. Practical

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Position in C, HBC and WM.
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