A critical analysis of popular deflation myths
A critical analysis of popular deflation myths
For the investor today by far the most important question is deflation or inflation. I'd like to update an article from November 2008 (Link) by cutting 7 of the key arguments of John Mauldin's "Outside the Box" newsletter from July 6 (guest-authored by Niels Jensen) into pieces.
preliminary remarks: With 1 million readers "Outside the Box" is probably the electronic publication focusing on fundamental analysis with the widest circulation. Common sense and contrary analysis tell us that quantity and quality can go together only to some degree in the financial markets. The obvious reason: trading futures, options and so on is a zero-sum game, the gain of the one market participant is the loss of another one. Phenomenologically-teleologically one could even claim that the ‚purpose' of the financial markets is to separate market participants from their money... :-) Of course, these considerations apply to the Amanita newsletter as well: if circulation rises 10-100fold, then you shouldn't read it any longer.
quote #1 (right at the beginning):
"You can't beat deflation in a credit-based system." Robert Prechter
rebuttal: An article beginning by quoting Bob Prechter is very bad omen... Prechter accomplished a feat & destroyed 98.3% (!) of the portfolio between 1/1/1985 & 5/31/2009 (Link), an underperformance of an incredible -25% per year versus the Wilshire 5000 index. This requires a profit of almost +6000% just to break even: needless to say, this almost never happens in reality. Deducting transaction fees & spreads an inverted EWI portfolio (do always exactly the opposite of what EWI recommends) would have made a whopping +5000%, even beating Warren Buffett who made 'only' some +4000% during this period.
To be sure, EWI is more a deflation sect than a market service. Prechter astonishingly foresaw both the beginning of the 1982 bull market and the 1987 crash, which made EWI one of the most widespread market letters on the planet. Not surprising, when the number of copies exploded Prechter became the most efficient money destruction machine & the best contrary indicator on the planet.
But what actually happens when credit is destroyed at a faster rate than our central banks can print money?
rebuttal: Hallelujah, verily I say unto you: this couldn't be more wrong. In a fiat money the central banks can create as much money as they want by simply extending their balance sheet, e.g. creating 1000 trillion out of thin air in a minute.
Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades.
rebuttal: Arghhh $!"%&/!!°=&!!! The significant measure in Japan was the increase of government debt and the export of liquidity through the carry trade, but this is light years from "using every trick in the book". However, something different was done in the 1980s in Japan because of exploding inflation figures: the statistics were cooked, e.g. rental payments were removed. The statistics in all major economies have been whitewashed in the past 30 years, a rule of thumb estimate is that the actual Japanese inflation is about 2% higher than the official numbers (although it might be more). One can say that Japanese consumer prices have been stable, which is the best of all scenarios.
Why use every trick in the book, one should ask, when everything is quite ok, inflation is not an end in itself. Japan is still much better off than most inflation countries: Japan has just 5% unemployment (USA 20% according to shadowstats.com), is politically stable and very competitive, it has very little criminality and so on. Look around the globe: the higher inflation, the less favorable the political-economic situation on average. Inflation is the disease, deflation the healing!
Unfortunately, one can observe the inflationary use of the terms deflation, e.g. sometimes you hear people talking of ‘deflation' when the price of a product falls. Ideally, deflation is defined in the narrow sense of the word as a structural and sustainable macro-economic phenomenon (i.e. applying to the entire economy), beyond the statistical impreciseness of at least +/- 1% - and of course beyond all statistical gimmicks. The 4 main criteria for a clean deflation that are usually overlooked by the deflation propaganda:
(1) total view of all goods of an economy
(2) significant (larger than +/- 1%): I also use retests within +/- 1% in the markets as non-significant. Actually the circulating inflation numbers lead 99% of the people including many analysts to believe that inflation can be measured to the tenth of a percent, which is not true.
(3) removing all statistical manipulations: e.g. true US inflation is at least 7-8% higher than the official CPI
(4) longer duration: in order to filter out short-term fluctuations which are totally meaningless. Example German hyperinflation 1914-23, where 10 zeros were added over time: the hyperinflation was repeatedly interrupted by short mild deflationary periods, the last one coming as late as early 1923.
With this ‚clean' definition, deflation is only present in the minds of clueless contemporaries and deflation gurus. Even the massaged official US CPI rose by 0.7% in June, which translates into an annualized inflation of 9%. Short- to intermediate-term the oil price has a high correlation with inflation (especially the PPI), the whopping +127% rally in a few months is a sure sign that the disinflation is over. However, I am not a fiend, everyone should have its personal moments of happiness: this is my personal permission for all deflation fetishists to celebrate their personal deflation if tomorrow the milk is 5 cents cheaper in the local supermarket. :-)
Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.
rebuttal: "And if thou'rt unwilling, then force I'll employ", one could say with Goethe. As soon as early 2009 I stressed that from February 2009 on hedge funds are allowed to directly (!) draw central bank money through TALF without financial intermediaries, which would boost the financial markets (this has come to pass). In China the state banks are allowing credits (and thus create new money) so fast that Confucius would be turning over in his grave. Alone in the first quarter of 2009 the amount was higher than in the entire year 2008, a rise of more than +300% is clearly hyperinflation. The Swedish Riksbank has introduced a negative (!) interest rate of -0.25%, this is again a strong incentive for banks to be less restrictive with loans. The ECB is printing money as if there is no tomorrow (link):
"The Frankfurt-based European Central Bank on Wednesday loaned 442.241 billion euros ($619.5 billion) to euro-zone banks for one year at a 1% interest rate. The first-ever one-year fixed tender is part of the ECB's effort to boost liquidity in the euro zone and free up bank lending."
In some countries it was discussed or even already implemented that governments or central banks are granting credits directly to companies, e.g. suggested by the head of the German Bundesbank, Axel Weber. And, of course, with many banks already nationalized and others to be nationalized soon, the state as the owner can give the direct order to increase the volume of credits.
In a nutshell, there are 100 ways to fend off the credit crunch (at least for some time). In addition to the steps already implemented, many more creative ways "never seen before" (quote by German minister of finance, Peer Steinbrück) are apparently discussed behind the scenes. Who can guarantee that banks are not required by law to increase credit volume? Or that all credits are guaranteed by the state? Or that new credits are financially promoted so much that everyone without a credit looks like a fool? ... or... or?
All major powers want inflation, so guess what will happen?
- elites (illuminati): Already Adam Smith pointed out that, "the problem with fiat money is that it rewards the minority that can handle money, but fools the generation that has worked and saved money" (fiat money always leads to inflation). The illuminati control the global flow of money and are the main beneficiary of inflation. What can be better for them then controlling the world's reserve currency through the Fed?
- (public) companies: because of inflation it is easier to permanently increase nominal sales, profits, and book values (even if they are shrinking in real terms) to satisfy shareholders.
- voters: Research is telling is that the average person considers a wage cut by 2% as unfair but likes the equivalent of a 2% wage increase when inflation is 4%... Sooner or later voters in democracies discover that government debt (government debt and inflation are almost the same) enables to establish a self-service shop. The underlying self-deception is hardly ever recognized. The horn of plenty of never-ending social welfare benefits can only be financed by the printing press which dispossesses the middle class (but even that only works for some time).
This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed.
rebuttal: Yes, but this ratio is only meaningful in the normal times of capitalism but not during hyperinflation. Hyperinflation is always and without exception caused by the government and never by consumers or companies, which is apparently understood only by few people. However, the broad monetary aggregates are primarily tracking private activities, while the monetary base M0 is reflecting the growing government activities. M0 is growing in 3-digit territory, which is hyperinflationary (Link).
There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided.
rebuttal: Good joke, already in March $12.8 trillion were provided and not the $2 trillion he mentions (Link). The latest estimate of the Treasury Department Inspector General Neil Barofsky is $23.7 trillion burden for the taxpayer, which is about 250% of the (real-world) US GDP. However, according to my estimate this is just the tip of the iceberg...
One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilization). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4).
rebuttal: I don't have the output gap for Zimbabwe, the hyperinflation flagship country (in early 2009, 12 zeros were deleted in the currency) but the data appears to be terrible because the Zimbabwe economy got totally destroyed in the course of the hyperinflation. According to Jensen's thesis, a country with very high inflation is supposed to have a non-existing output gap (100% capacity utilization) to drive prices higher. As a matter of fact, to my knowledge all hyperinflations in history were accompanied by an economic collapse (and thus a huge output gap), which is 180° different than the chart shown by Jensen.
So what is the explanation? 99% of the conventional analysts fail to understand that an economy in „hyperinflation mode" is 180° different from a normal economy in many ways. So for me the crucial criterion is not a special inflation number (quantitative) but the change of the macro-economic rules (qualitative). Since 2008 numerous key figures and events confirm that the hyperinflation mode has begun in the Western economies. So the new intermediate- to long-term rule is, "the worse the situation, the higher inflation". More short-term the traditional pattern mentioned by Jensen might continue to work, to fool as many people as possible. 95% of all analysts have a hard timing understanding that a connection on one time level (e.g. short-term) can be just the opposite compared to other levels (e.g. long-term)
This „reversal" phenomenon is well known in energetic psychology resp. kinesiology, where it is called "switching". The human body tissue is polarized which can be measured with a voltmeter, the pioneer in this field is Harold Burr, a Yale University biologist. He measured that 95% of the subjects without cancer had the correct polarity, while 96% of the cancer patients had the wrong i.e. reversed polarity. On the subtle level the meridians may have been switched for a long time, but the situation is not becoming life-threatening before the switching manifests in the cells. On the global level, the subtle socio-economic switching already happened the past decades, although the structural switching didn't happen until last year. The consequence is to expect a cancer-like and probably for the system lethal expansion of money supply.
Jensen should study the Austrian School of Economics to understand what's going on. Rising prices are never the root of inflation but just the symptom, the root is always the expansion of money supply. In a good currency system the money supply can't simply be expanded, that's why after 1815 we had price stability for a century under the gold standard (abolished during WW1). In such a system a group of goods (e.g. commodities) are rising in price, then other goods are falling. However, in a fiat money Ponzi scheme (that should be re-labeled Madoff scheme) just the opposite happens, rising commodity prices are the "gateway" for rising prices in the entire system! A gold standard and an unbacked fiat currency system are as different as day and night and lead to 180° different results, which almost none of the mainstream analysts understands.