Welcome to the World of Deflation
"Welcome back my friends to the show that never ends
We're so glad you could attend
Come inside! Come inside!
There behind a glass is a real blade of grass
be careful as you pass.
Move along! Move along!
Cold and misty morning, I heard a warning borne in the air
About an age of power where no one had an hour to spare,
Where the seeds have withered, silent children shivered, in the cold
Now their faces captured in the lenses of the jackals for gold."
- Karn Evil 9, Emerson, Lake and Palmer, from the album Brain Salad Surgery
Deflation hasn't been seen in this country since the 1930s, so there may be some who are unfamiliar with it. What is "Deflation"? Below is a definition from Investopedia:
Deflation: A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. 
Deflation is a topic that has been well covered in Minyanville, from contributors such as Todd Harrison (Mar 18, "Climbing the Wall of Depression"), Kevin Depew, who back in December 2007 made it one of his Five Themes for 2008, and Mike "Mish" Shedlock, (Jan. 18, 2008 "Deflation American Style"). And now, without question, my biggest fear since the Credit Crisis began - the absurd levels of debt on every front, the creation of esoteric instruments based on bad debt - has been what would happen once the crisis unfolds; deflation. I sense it is now upon us.
According to their website, the Federal Reserve's four main goals are:
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Conducting the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices.
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Supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers.
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Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
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Providing certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation's payments systems.
According to the European Central Banks website, their primary goal:
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The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.
So there we have it. The Fed and ECB’s goals are basically to ensure a safe system with price stability. Nowhere in either of the Central Bank statements does it say that a goal should be to avoid price and asset erosion.
This is my greatest fear of all and one that is playing out in real time. In sum, I believe that deflation is either already upon us or is right around the corner. And from my perch, deflation is a far worse outcome than inflation in that inflation can be contained while deflation is not easily contained. Just ask the Japanese.
Where is Deflation rearing its Ugly Head?
Where is deflation rearing its ugly head? Well, pretty much everywhere. Every place I turn, whether it be money supply, real estate prices, equity prices, debt prices, loan creation, commodity prices (except gold), consumer confidence, I see deflation.
When you think about it, it is not terribly difficult to understand how we got into this mess. Too much debt, notably low quality debt was created at every level; Government, consumer, corporate, etc. Then, this debt was levered up at the suggestion of the SEC and then carved up into esoteric investments that were scattered about the globe in an insidious manner.
We are simply now living through the painful unwind of debt creation, that is to say we are living through debt destruction, which is just a nasty version of deflation.
Note the chart below that no matter how hard the Fed and ECB try to pump money into our fragile financial system, the rate of growth of ‘reconstituted M3’ (courtesy of www.nowandfutures.com) is decelerating sharply. This is at a time when the system is starving for liquidity. Banks, brokers and consumers are in dire need of liquidity to solve their levered mess. But just as you can ‘lead a horse to water but can’t make him drink’, you can try to force liquidity into the banking system, but you cannot force banks to lend.
In order for banks to lend, they must first have solid balance sheets and be able to finance their operations at a rate low enough so that they can then lend at a profit. When we consider why lending has come to a near stand-still, we must realize why this is so. In my opinion, the majority of financial institutions have been virtually shut out of the financial markets as confidence levels have shrunken to near zero.
When I wrote my piece entitled Dead Banks Walking?, I wrote that there was a ‘recipe’ for bank failures. This is not an exercise in chest-beating, but many of the names I mentioned are now gone (Fannie Mae (FNM), Freddie Mac (FRE), Washington Mutual (WM), American International Group (AIG), Lehman Brothers) and surely there are many more to follow.
If I had to re-write that piece today, sadly, I could likely come up with north of 25 public companies in the financial space alone that have the recipe for failure. The recipe as I see it is that your balance sheet is impaired from poor loans and ownership of esoteric securities that are constantly re-priced lower which results in write-downs/write-offs. This places you in a position that you either need an equity infusion or need to raise capital in the public or private markets, which in theory, sounds great—all the way until you find out that the current cost of capital is so high that it is un-economic to do so.
For instance, Wachovia (WB), a behemoth with nearly $1/2 trillion of deposits found itself in a rather precarious situation. Their 2 year debt was trading in the 45% yield to maturity area, their ‘hybrid’ preferred securities that were issued in February 2008 at 100 (fixed-to-floating rate perpetual preferred stock) at 22 cents on the dollar or 38% yield and their 8% preferred shares that were issued just last December at $25 per share trade at $6 or a 28% yield.
Wachovia likely needed upwards of $20 billion of capital just to remain solvent, but how does one raise $20 billion at 25-45% and expect to make money? Clearly a rhetorical question if there ever was one—you don’t.
The problem, of course, is that Wachovia isn’t alone in this sinking boat. National City (NCC), KeyCorp (KEY), Firth Third (FITB), Regions Financial (RF), Morgan Stanley (MS), Sovereign (SOV), and many others are in the same boat.
So if you are one of these unfortunate institutions, what do you do if you cannot get access to capital?
You either:
a) Fail or are forced into the hands of a stronger institution like WaMu was given to JP Morgan on Friday
b) Shrink your balance sheet,
c) Sell common equity to a vulture investor, forever diluting your existing shareholders or
d) Declare bankruptcy
No matter which you choose, all options are deflationary in nature.
More problematic is that it is not just present at Wachovia and is not confined to the US. It is a global problem and one that won’t go away very easily. No matter how much money the Treasury, Fed, ECB and Congress throw at the Crisis, the Crisis ends up winning. Simply put, the Crisis is bigger than the system itself.
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"c) Sell common equity to a vulture investor, forever diluting your existing shareholders ..."
Uh, as a shareholder, would I rather be diluted or wiped out? Wow, I gotta think about this.
Another excellent article.
By the way in the 80s I heard that ELP song very often on the RU campus, as well as the Stevens Institute of Technology campus.
The other common expression of the day was FUBAR
(Fouled Up Beyond All Repair) {O.K. it wasn't Fouled, make the appropriate substitution}
As the dead banks walking continue, in the end, the US and Fed are providing 2 percent money at the discount window, recapitalizing the big banks at 50 to 60 billion a year per Trillion in assets in interest spreads. This probably wont save any insolvent banks, but will be the form of increased capitalization of any survivors.
The 70 billion dollar shrinkage in the 2.x Trillion commercial paper market the week of Sept 19, as money market funds broke the buck, the commercial paper market goes to 0. All loans will be from banks and money market funds will invest 100 percent in treasuries.
Watch your 401K limited investment choices shrink 5 percent a day and with a money market fund invested 80 percent in real estate securities, and one suspects one could do better just walking it out the door and buying treasuries in an IRA.
http://www.federalreserve.gov/releases/cp/
You are wrong.
Price stability implies avoiding price erosion - just as it implies avoiding price inflation - does it not?
I am not convinced the doomsday scenario was either inevitable or necessary. I believe it was FORCED by politicians who are seeking to win seats and place blame where none can easily be placed.
We are now at a point where it's inevitable that some format of the doomsday scenario MUST play out. Why? Because all the insurance mechanisms (short selling, for one) were eliminated.
Politicians abhor a falling market, but they absolutely detest a falling market that doesn't have them helping people out somehow - regardless of who they say they are helping out. The reality is, people like me, who did things right (no debt, save a mortgage that was less than 50% of value, paid off credit cards regularly, bought what I could afford) are going to be asked to bail out those whose eyes were bigger than their stomachs (this includes ALL politicians who allowed the situation to get to this point with their behavior, then made the situation worse by scaring the bejesus out of the average guy who doesn't understand this stuff well).
It's unfortunate that people make the comments they do after an article like this. I have been counseling my family and friends that we must behave as we always have - that conventional wisdom continues to prevail regardless of circumstances. If we continue to operate on the basis of trust and faith in our fellows, then things don't HAVE to be horrendous.
It's when we give into fear that we all lose because the impact of that fear ripples throughout the economy and creates more fear and panic. The herd mentality is one which becomes predominant, the concept being that "it's not what I prefer, but if I lose at least everyone else is losing". Prisoner's Dilemma in the lose/lose square.
I remain, as always, optimistic in the relative ingenuity of the American people. While ingenuity cannot make a bad balance sheet go away, or improve the value of a home that has lost 40% of its value, it is ingenuity that creates growth. And growth can soak up excess.
Today, we sit at a crossroads of philosophy. We can give in to that which we consider to be inevitable and which we feel helpless to prevent, or we can seek out opportunities amidst the chaotic environment, because there are plenty if we look for them (and as long as the government doesn't block them).
