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Five Things: Two Economies, One Deflation

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Ultimately, lower asset prices will overwhelm the Fed's attempts at control.

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1. Two Economies, One Outcome: Deflation

Most people mistake inflation and deflation as the simple idea that inflation means rising prices and deflation means falling prices. The problem is, those are simply descriptive of general price changes; in other words, those are simply the effects or symptoms of inflation and deflation.

Deflation: When the volume of money and credit falls relative to the volume of goods available, the relative value of each monetary unit increases, making prices of goods generally fall. In order to understand that dynamic, we have to look at it in real terms.

Because we're built and trained to think in a linear fashion, and because the unit of money we accept as the medium for exchange -- the dollar -- is divorced from the reality of tangible goods, we tend to over-focus on nominal prices when what's most important are real prices.

Let's talk about the difference.

The real interest rate, which is what really matters, is the cost to borrow money in the present versus what that money will likely be worth in the future. To get this we can take the cost of money in the present (the interest rate at which that money is loaned to us) and subtract it from a future gauge of what money is likely to be worth, so, say the T-Bill rate with the Consumer Price Index subtracted from it. (This is something Mr. Practical wrote about on the Buzz & Banter this week as well).

At present, that gives us the T-Bill rate .3% minus CPI, which is last reported at -1.3%, which gives us real interest rate of positive 1.6%. It's true, that's quite low, but only for banks because banks are the only borrowers able to access credit at that real rate. It's why stocks are rising, and why credit markets appear to be improving, and it explains why Treasury yields remain so low, because that simply expresses the necessary conditions for the carry trade: borrowing money at low nominal and real rates, and investing it in higher yielding instruments.

But let's back up for a moment. Let's consider a measure of the "real" economy, the one that is functioning outside of the closed circle of the banking system. Instead of the T-Bill rate, let's look at the 15-year fixed-mortgage rate, less a burden of debt proxy like home prices. We'll be generous and use the best-case current housing price estimate of -5%. In that case our real rates are an extraordinarily high 9.3%.

So, we have two economies; the one the Fed and Treasury can control -- namely, the "Banking Economy" -- and the one they cannot because it is too large -- the "Everything Else" economy.

2. The Irony of Anger

But wait, there's more: While social mood continues to transition to negative and we see increasing expressions against the "Banking Economy" (conventional wisdom is that we're all being screwed over by the fat cats and banking elites), the irony is that this closed system WILL INEVITABLY FAIL. It is without question. The only question is how long the façade can last. That could be another two years, it could be another five years.

Why is that ironic? Because for the rest of us in the real economy -- the one that's too large to control -- we're being forced to repair our balance sheets, forced to save, forced to prepare for lower prices at the same time the other economy is doing everything within its closed system to postpone the inevitable deflation.

Essentially, they're standing around, grouped in a circle, feasting off one another. Eventually, the real economy will overwhelm the false economy, and the so-called banking elite will be replaced by new actors and a new financial ecosystem will emerge.

This isn't to say that the closed Banking Economy is taking place without cost to the rest of us, but simply to point out that the longer banks are unwilling to lend (and I'd argue that it's more the case that they're unable to lend), the better off we'll be. Eventually, time preferences and social mood trends will reverse to positive.

This is where we get to the end game. Initially, without question, deflation will win. But -- and this is where people really fail to grasp the key distinctions between credit, money, and inflation versus deflation -- when enough credit has been destroyed, eventually currency inflation, perhaps even hyperinflation, will begin. The point, however, is that the end result is precisely the same whether we're talking about inflation or deflation. Namely, the destruction of money and credit.

3. Peak Oil, Peak Gold, Peak Everything... Including Demand

This morning I ran across a startling headline from the Telegraph: Barrick Shuts Hedge Book as World Gold Supply Runs Out.

"Global gold production is in terminal decline despite record prices and Herculean efforts by mining companies to discover fresh sources of ore in remote spots, according to the world's top producer Barrick (ABX) Gold," says the Telegraph article.

Indeed. First it was peak oil. Peak water. Peak food. And now, peak gold. Isn't it incredible? We've arrived at the point of peak everything! Including demand. Ah yes, demand -- supply's forgotten stepbrother.

For those focused solely on the supply at current demand levels, any other conclusion but that we're going to run out of everything is unfathomable.

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No positions in stocks mentioned.

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