Frank Shostak: How Easy Money Drives the Stock Market

Austrian economist Frank Shostak explains at the Mises Institute how easy money (not G-R-O-W-T-H) sends stocks to the moon (bold mine)

In a market economy a major service that money provides is that of the medium of exchange. Producers exchange their goods for money and then exchange money for other goods. 

As production of goods and services increase this results in a greater demand for the services of the medium of exchange (the service that money provides). 

Conversely, as economic activity slows down, the demand for the services of money follows suit. 

Prices and the Demand for Money 

The demand for the services of the medium of exchange is also affected by changes in prices. An increase in the prices of goods and services leads to an increase in the demand for the medium of exchange. 

People now demand more money to facilitate more expensive goods and services. A fall in the prices of goods and services results in a decline in the demand for the medium of exchange. 

Now, take the example where an increase in the supply of money for a given state of economic activity (i.e., production) has taken place. Since there wasn’t any change in the demand for the services of the medium of exchange, this means that people now have a surplus of money or an increase in monetary liquidity. 

No individual wants to hold more money than is required, and an individual can get rid of surplus cash by exchanging the money for goods. 

All the individuals as a group, however, cannot get rid of the surplus of money just like that. They can only shift money from one individual to another individual. 

The mechanism that generates the elimination of the surplus of cash is the increase in the prices of goods. Once individuals start to employ the surplus cash in acquiring goods, it pushes prices higher. 

As a result the demand for the services of money increases. All this in turn works toward the elimination of the monetary surplus. 

Note that what has triggered increases in the prices of goods in various markets is the increase in the monetary surplus or monetary liquidity in response to the increase in the money supply. 

Price Deflation and the Money Supply 

While increases in the money supply result in a monetary surplus, a fall in the money supply for a given level of economic activity leads to a monetary deficit. 

Individuals still demand the same amount of services from the medium of exchange. To accommodate this they will start selling goods, thus pushing their prices down. 

At lower prices the demand for the services of the medium of exchange declines and this in turn works toward the elimination of the monetary deficit. 

A change in liquidity, or the monetary surplus, can also take place in response to changes in economic activity and changes in prices. 

For instance, an increase in liquidity can emerge for a given stock of money and a decline in economic activity. 

A fall in economic activity means that fewer goods are now produced. This means that fewer goods are going to be exchanged, implying a decline in the demand for the services of money. 

Once, however, a surplus of money emerges, it produces exactly the same outcome with respect to the prices of goods and services as the increase in the money supply does. That is, it pushes prices higher. 

An increase in prices in turn works toward the elimination of the surplus of money — the elimination of monetary liquidity. 

Conversely an increase in economic activity while the stock of money stays unchanged produces a monetary deficit. 

This in turn sets in motion the selling of goods thereby depressing their prices. The fall in prices in turn works toward the elimination of the monetary deficit. 

These dynamics can affect a wide variety of markets unequally, but one market in which we can see the relationship between prices and money supply is the stock market.

A Time Lag Between Peak Liquidity and Peak Stocks?

There is a time lag between changes in liquidity, i.e., a monetary surplus, and changes in asset prices such as the prices of stocks.

(The reason for the lag is because when money is injected it doesn’t affect all individuals and hence all markets instantly. There are earlier and later recipients of money.)

For instance, there could be a long time lag between the peak in liquidity and the peak in the stock market.

The effect of previously rising liquidity can continue to overshadow the effect of currently falling liquidity for some period of time. Hence the peak in the stock market emerges once declining liquidity starts to dominate the scene.

Read the rest here

Why there is no such thing as deficiency of demand

The ever eloquent Austrian economist Dr. Frank Shostak debunks the pervasive and populist myth that has pillared today's aggregate demand policies (from the Cobden Center):[bold mine]

There is no such thing as deficiency of demand that causes economic difficulties. The heart of economic growth is the process of real wealth generation.

The stronger this process is the more real wealth can be generated and the stronger so-called economic growth becomes. What drives this process is infrastructure, or tools and machinery. With better infrastructure more and a better quality of goods and services i.e. real wealth, can be generated.

Take for instance a baker who has produced ten loaves of bread. Out of this he consumes one loaf and the other nine he saves.

He can exchange the saved bread for the services of a technician who will enhance the oven. With an improved oven the baker can now produce twenty loaves of bread. Now he can save more and use the larger savings pool to further invest in his infrastructure such as buying other tools that will lift the production and the quality of the bread.

Observe that the key for wealth generation is the ability to generate real wealth. This in turn is dependent on the allocation of the part of wealth towards the buildup and the enhancement of the infrastructure.

Also, note that if the baker were to decide to consume his entire production i.e. keeping his demand strong, then he would not be able to expand the production of bread (real wealth).

As time goes by his infrastructure would have likely deteriorated and his production would have actually declined.

The belief that an increase in the demand for bread without a corresponding increase in the infrastructure will do the trick is wishful thinking.

We suggest that there is no such thing as a scarce demand. Most individuals have unlimited desires for goods and services.

For instance, most individuals would prefer to live in nice houses rather than in small apartments.

Most people would like to have luxuries cars and be able to dine in good quality restaurants. What prevents them in achieving these various desires is the scarcity of means.

In fact as things stand most individuals have plenty of desires i.e. goals, but not enough means.

Unfortunately means cannot be generated by boosting demand. This will only increase goals but not means.

Contrary to the popular way of thinking we can conclude that demand doesn’t create supply but the other way around.

As we have seen by producing something useful i.e. bread, the baker can exchange it for the services of a technician and boost his infrastructure.

By means of the enhanced infrastructure the baker can generate more bread i.e. more means that will enable him to attain various other goals that previously were not reachable by him.

The current economic difficulties are the outcome of past and present reckless monetary and fiscal policies of central banks and governments.

Read the rest  here

Quote of the Day: Statistical Economy is a Fictitious Device to Justify Interventions

In a free market environment free of government interference the “economy” doesn’t exist as such. A free market environment is populated by individuals, who are engaged in the production of goods and services required to sustain their life and well being i.e. the production of real wealth. Also, in a free market economy every producer is also a consumer. For convenience sake we can label the interaction between producers and consumers (to be more precise between producers) as the economy. However, it must be realised that at no stage does the so called “economy” have a life of its own or have independence from individuals.

While in a free market environment the “economy” is just a metaphor and doesn’t exist as such, all of a sudden the government gives birth to a creature called the “economy” via its constant statistical reference to it, for example using language such as the “economy” grew by such and such percentage, or the widening in the trade deficit threatens the “economy”. The “economy” is presented as a living entity apart from individuals.

According to the mainstream way of thinking one must differentiate between the activities of individuals and the economy as a whole, i.e. between micro and macro-economics. It is also held that what is good for individuals might not be good for the economy and vice-versa. Within this framework of thinking the “economy” is assigned a paramount importance while individuals are barely mentioned.

In fact one gets the impression that it is the “economy” that produces goods and services. Once the output is produced by the “economy” what is then required is its distribution among individuals in the fairest way. Also, the “economy” is expected to follow the growth path outlined by government planners. Thus whenever the rate of growth slips below the outlined growth path, the government is expected to give the “economy” a suitable push.

In order to validate the success or failure of government interference various statistical indicators have been devised. A strong indicator is interpreted as a success while a weak indicator a failure. Periodically though, government officials also warn people that the “economy” has become overheated i.e. it is “growing” too fast.

At other times officials warn that the “economy” has weakened. Thus whenever the “economy” is growing too fast government officials declare that it is the role of the government and the central bank to prevent inflation. Alternatively, when the “economy” appears to be weak the same officials declare that it is the duty of the government and central bank to maintain a high level of employment.

By lumping into one statistic many activities, government statisticians create a non-existent entity called the “economy” to which government and central bank officials react. (In reality however, goods and services are not produced in totality and supervised by one supremo. Every individual is pre-occupied with his own production of goods and services).

We can thus conclude that so called macro-economic indicators are fictitious devices that are used by governments to justify intervention with businesses. These indicators can tell us very little about wealth formation in the economy and thus individuals’ well-being.

(bold mine)

This is from Austrian economist Dr. Frank Shostak at the Cobden Center.

M3 Not A Valid Measure Of Money

In an earlier post [see Contracting Money Supply, Deflation Bugaboo And Dubious Statistical Models] we argued that some experts have used wrong models to fear monger about deflation and or market crashes.

Where in most occasions experts fall victim to associating correlation with causation, we argued that the actions of M3, a monetary aggregate statistic, has even had inconsequential correlations to even suggest for a meaningful causal link.

Dr. Frank Shostak points out why the use of M3 as basis for predicting the path of the economy isn't reliable.

Mr. Shostak writes, (bold highlights mine)

``It is quite possible that monetarists are reaching valid conclusions with respect to the economy in the months ahead. We are of the view however, that money M3 is not a valid measure of money.

``In order to account correctly for money, one must make a distinction between money that is deposited and money that is loaned out.

``When an individual exchanges goods for money he in fact increases his demand for money and when he lends his money he is lowering his demand for money. Individuals can exercise their demand for money in a variety of ways. For example, they can keep money in a jar, or under the mattress, or in their wallets, or place the money in a bank warehouse. From this it follows that the overall amount of money in individual holdings should be the sum of money they hold in bank warehouses also known as demand deposits plus the money they hold outside banks warehouses.

``This, in turn, means that the inclusion of various term deposits such as large time deposits and money market mutual funds deposits into the definition of money such as M3 produces an erroneous account of the amount of money in the economy.


Dr. Shostak further says that his preferred monetary statistics, the AMS, appear to be saying a different story.

Read the rest here.

Fruits From Creative Destruction: An Asian and Emerging Market Decoupling?

``But innovation, in Schumpeter’s famous phrase, is also “creative destruction”. It makes obsolete yesterday’s capital equipment and capital investment. The more the economy progresses, the more capital formation will it therefore need. Thus, the classical economist-or the accountant or the stock exchange-considers “profit” is a genuine cost, the cost of staying in business, the cost of a future in which nothing is predictable except that today’s profitable business will become tomorrow’s white elephant.”- Peter F. Drucker, Profit’s Function, The Daily Drucker.

We read from creditwritedowns.com that Morgan Stanley Asia Chairman Stephen Roach made some predictions, namely:

1 “Asia will have a less acute impact from the global financial and economic crisis”

2. “Export-led regions are followers, not leaders.” Hence would recover after their main export markets, the US and Europe, recovered.

3. “The only possibility (to recover earlier) is China, as it has large infrastructure spending in place that could provide support for economic growth.”

Dr. Roach has been one of the unassuming well respected contrarian voices, whom I have followed, who sternly warned of this crisis.

Nonetheless while we agree with some of his prognosis, where we depart with Dr. Roach is on the aspect of a ‘belated recovery’ of Asia because of its “export dependence” on US and Europe.

Creative Destruction: The Telephone Destroyed The Telegraph

While it is true that the Asian model had functioned as an export-led region over the past years, our favorite cliché, ``Past performance does not guarantee future results” would possibly come into play in the transformation of the playing field.

Let us simplify, if a business paradigm doesn’t work do you insist on pursuing the same model or do you attempt a shift?

Marketing Guru Seth Godin has a terse but poignant depiction of “solving a different problem” response to our question. We quote the terrific guru Mr. Godin,

``The telephone destroyed the telegraph.

``Here's why people liked the telegraph: It was universal, inexpensive, asynchronous and it left a paper trail.

``The telephone offered not one of these four attributes. It was far from universal, and if someone didn't have a phone, you couldn't call them. It was expensive, even before someone called you. It was synchronous--if you weren't home, no call got made. And of course, there was no paper trail.

``If the telephone guys had set out to make something that did what the telegraph does, but better, they probably would have failed. Instead, they solved a different problem, in such an overwhelmingly useful way that they eliminated the feature set of the competition.” (bold highlight mine)

In short, we see human action basically at work. To quote Ludwig von Mises, ``Action is an attempt to substitute a more satisfactory state of affairs for a less satisfactory one. We call such a willfully induced alteration an exchange.”

People who relied on old models didn’t see this coming. They would have resisted until they were overwhelmed.

The fact is the telephone replaced an entrenched system. Joseph Schumpeter, in economic vernacular coined this as “creative destruction”. And creative destruction essentially leads to new operating environments: the rise of the telephone.

Similarly, the Asian export model has been built upon the US credit bubble structure. That bubble is presently deflating and would most possibly dissipate. So is it with Europe’s model.

In other words, the global economy’s trade and investment framework will probably reconfigure based on the present operating economic realities. Countries and regions would probably operate under a set of redefined roles.

Here are three clues of the possible creative destruction transformation.

Deepening Regionalism

Figure 3: ADB: Emerging Asian Regionalism

This from the ADB’s Emerging Asian Regionalism, ``In large part due to the growth of production networks just discussed, trade within Asia has increased from 37% of its total trade in 1986 to 52% in 2006 (Figure 3.3). The share of trade with Europe has risen somewhat, while that with the US and the rest of the world has fallen. As set out in Chapter 2, Asia’s intraregional trade share is now midway between Europe’s and North America’s. It is also higher than Europe’s was at the outset of its integration process in the early 1960s.

``But trade has not been diverted from the rest of the world. On the contrary, trade with each of Asia’s four main partner groups has increased in the last two decades—not just absolutely, but also relative to Asia’s GDP (Figure 3.4). For example, Asia’s trade with the EU has more than doubled as a share of its GDP, from 2.6% in 1986 to 6.0% in 2006. The increase is even larger as a share of the EU’s GDP. The aggregate trade data thus suggests that Asia is steadily integrating both regionally and globally.”

The fact is that Asia has steadily been regionalizing or developing its intraregional dynamics even when the bubble structure had been functional. Today’s imploding bubble isn’t likely to alter such deepening trend.

Moreover, the current unwinding bubble structure is emblematic of a discoordination process from a ‘market clearing’ environment.

Under this phase, spare capacities are being shut or sold, excess labor are being laid off, surplus inventories are being liquidated and losses are being realized. Essentially new players are taking over the affected industries. And new players will be coming in with fresh capital to replace those whom have lost. Fresh capital will come from those economies with large savings or unimpaired banking system (see Will Deglobalization Lead To Decoupling?)

And like any economic cycles, this adjustment process will lead to equilibrium. Eventually a trough will be reached, where demand and supply should balance out and a transition to recovery follows.

The post bubble structure is likely to reinforce and not reduce this intraregional dynamic.

So in contrast to the notion of a belated recovery in Asia hinged on the old decrepit model, a China recovery should lift the rest of Asia out of the doldrums.

Asia and not the old stewards should lead the recovery based on the new paradigm.

And in every new bullmarket there always has been a change in market leadership. We are probably witnessing the incipience of such change today.

Real Savings Function As Basic Consumption

The assumption of the intransigence of Asia as an export led model is predicated on Keynesian theory of aggregate demand. In essence, for as long as borrowing and lending won’t recover in the traditional ‘aggregate demand’ economies, there won’t be a recovery in export led economies.

But in contrast to such consensus view, demand is not our problem, production from savings is.

According to quote Dr. Frank Shostak, ``At any point in time, the amount of goods and services available are finite. This is not so with regard to people’s demand, which tends to be unlimited. Most people want as many things as they can think of. What thwarts their demand is the availability of means. Hence, there can never be a problem with demand as such, but with the means to accommodate demand.

``Moreover, no producer is preoccupied with demand in general, but rather with the demand for his particular goods.”

``In the real world, one has to become a producer before one can demand goods and services. It is necessary to produce some useful goods that can be exchanged for other goods.”

A sole shipwrecked survivor in an island will need to scour for food and water in order to consume. This means he/she can only consume from what can be produced (catch or harvest). It goes the same in a barter economy; a baker can only have his pair of shoes if he trades his spare breads with surplus of shoes made by the shoemaker.

Surplus bread or shoes or produce, thus, constitute as real savings. And to expand production, the shoemaker, the baker or even the shipwrecked survivor would need to invest their surpluses or savings to achieve more output which enables them to spend more in the future.

Instead of getting x amounts of coconuts required for daily nourishment, the shipwrecked survivor will acquire a week’s harvest and use his spare time to make a knife so he can either make ladder (to improve output), build a boat (to catch fish or to go home) or to hunt animals (to alter diet) or to make a shelter (for convenience). Essentially savings allows the survivor to improve on his/her living conditions.

To increase production for the goal of increasing future consumption, the savings of both the shoemaker and the baker would likely be invested in new equipment (capital goods).

Again to quote Dr. Shostak (bold highlight mine), ``What limits the production growth of goods and services is the introduction of better tools and machinery (i.e., capital goods), which raises worker productivity. Tools and machinery are not readily available; they must be made. In order to make them, people must allocate consumer goods and services that will sustain those individuals engaged in the production of tools and machinery.

``This allocation of consumer goods and services is what savings is all about. Note that savings become possible once some individuals have agreed to transfer some of their present goods to individuals that are engaged in the production of tools and machinery. Obviously, they do not transfer these goods for free, but in return for a greater quantity of goods in the future. According to Mises, "Production of goods ready for consumption requires the use of capital goods, that is, of tools and of half-finished material. Capital comes into existence by saving, i.e., temporary abstention from consumption.”

``Since saving enables the production of capital goods, saving is obviously at the heart of the economic growth that raises people's living standards. On this Mises wrote, “Saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material condition of man; they are the foundation of human civilization.”

So what changes this primitive way of production-consumption to mainstream’s consumption-production framework?

The answer is debt. Debt can be used in productive or non-productive spending. But debt today is structured based on the modern central banking.

Think credit card. Credit card allows everyone to extend present consumption patterns by charging to future income. If debt is continually spent on non-productive items, it eventually chafes on one’s capacity to pay. It consumes equity. Eventually, overindulgence in non productive debt leads bankruptcy. And this epitomizes today’s crisis.

But debt issued from real savings can’t lead to massive clustering of errors (bubble burst) because they are limited and based on production surpluses. It is non productive debt issued from ‘something out of nothing’ or the fractional banking system combined with loose monetary policies from interest manipulations that skews the lending incentives and enables massive malinvestments.

To aptly quote Mr. Peter Schiff’s analysis of today’s crisis, ``Credit, whether securitized or not, cannot be created out of thin air. It only comes into existence though savings, which must be preceded by under-consumption. Since savings are scarce, any government guarantees toward consumer credit merely crowd out credit that might otherwise have been available to business. During the previous decade too much credit was extended to consumers and not enough to producers (securitization focused almost exclusively on consumer debt). The market is trying to correct this misallocation, but government policy is standing in the way. When consumers borrow and spend, society gains nothing. When producers borrow and invest, our capital stock is improved, and we all benefit from the increased productivity.”

Now if capital comes into existence by virtue of savings, we should ask where most of the savings are located?

The answer is in Asia and emerging markets.

Figure 4: Matthews Asian Fund: Asia Insight

According to Winnie Puah of Matthews Asia, ``The economic potential and impact of Asian savings have yet to be fully unleashed at home. Indeed, Asia’s excess savings fuelled the recent boom in U.S. consumption and housing markets. Creating a consumption boom in Asia would mean that Asia needs to borrow and spend more. To date, governments are supporting domestic demand with fiscal stimulus packages—but it is household balance sheets that hold the key to developing a consumer culture. Overall, Asian households are well-positioned to increase spending—most have low debt levels and high rates of savings… there is a noticeable divergence in saving patterns between emerging and mature economies over the past decade, particularly since Asia learned a hard lesson from being overleveraged during the Asian financial crisis. Today, most Asian households save 10%—30% of their disposable incomes. China’s households, for example, have over US$3 trillion in savings deposits but have borrowed only US$500 billion.”

Thus I wouldn’t underestimate the power of Asia’s savings that could be converted or transformed into spending.

Asia’s Tsunami of Middle Class Consumers

In my August 2008 article Decoupling Recoupling Debate As A Religion, we noted of the theory called as the “Acceleration Phenomenon” developed by French economist Aftalion, who propounded that a marginal increase in the income distribution of heavily populated countries as China, based on a Gaussian pattern, can potentially unleash a torrent of middle class consumers.

Apparently, the Economist recently published a similar but improvised version of the Acceleration Phenomenon model. And based on this, the Economist says that 57% of the world population is now living in middle class standards (see figure 5)!

Figure 5: The Economist: The Rise of the Middle Class?

From The Economist (bold highlights mine), ``In practice, emerging markets may be said to have two middle classes. One consists of those who are middle class by any standard—ie, with an income between the average Brazilian and Italian. This group has the makings of a global class whose members have as much in common with each other as with the poor in their own countries. It is growing fast, but still makes up only a tenth of the developing world. You could call it the global middle class.

``The other, more numerous, group consists of those who are middle-class by the standards of the developing world but not the rich one. Some time in the past year or two, for the first time in history, they became a majority of the developing world’s population: their share of the total rose from one-third in 1990 to 49% in 2005. Call it the developing middle class.

``Using a somewhat different definition—those earning $10-100 a day, including in rich countries—an Indian economist, Surjit Bhalla, also found that the middle class’s share of the whole world’s population rose from one-third to over half (57%) between 1990 and 2006. He argues that this is the third middle-class surge since 1800. The first occurred in the 19th century with the creation of the first mass middle class in western Europe. The second, mainly in Western countries, occurred during the baby boom (1950-1980). The current, third one is happening almost entirely in emerging countries. According to Mr Bhalla’s calculations, the number of middle-class people in Asia has overtaken the number in the West for the first time since 1700.”

So apparently, today’s phenomenon seems strikingly similar to Seth Godin’s description of the creative destruction of the telegraph.

The seeds of the rising middle class appear to emanate from the wealth transfer from the developed Western economies to Asia and emerging markets. Put differently, Asia and EM economies could be the fruits from the recent ‘creative destruction’.

Some Emerging Signs?

However, there are always two sides to a coin.

For some, the present crisis signify as a potential regression of these resurgent middle class to their poverty stricken state, as the major economies slumps and drag the entire world into a vortex.

For us, substantial savings or capital (the key to consumption), deepening regionalism, underutilized or untapped credit facilities, rapidly developing financial markets, a huge middle class, unimpaired banking system, and most importantly policies dedicated to economic freedom serve as the proverbial line etched in the sand.

One might add that the negative interest rates or low interest policies and the spillage effect from stimulus programs from developed economies appear to percolate into the financial systems of Asia and emerging markets.

Although these are inherently long term trends, we sense some emergent short term signs which may corroborate this view:

1. Despite the 30% slump in the global Mergers and Acquisitions in 2008, China recorded a 44% jump to $159 billion mostly to foreign telecommunication and foreign parts makers (Korea Times). Japan M&A soared last year to a record $165 billion in 2008 a 13% increase (Bloomberg).

2. Credit environment seems to be easing substantially.

According to FinanceAsia (Bold highlights), ``The fallout from Japan's banking crisis offers clues to how the current situation may resolve itself. Back then, healing started first in the areas that had been most affected -- interbank lending recovered earliest, followed by credit markets, volatility markets and finally, many years later, equity markets.

``In today's crisis, interbank lending is already starting to recover. The spread between three-month interbank lending rates and overnight rates, which provides a key measure of the health of credit markets, has dropped significantly from its peak of 364bp in early 2008 down to less than 100bp today. As the interbank market recovers, credit should be next to heal.

``However, at the moment, triple-B spreads are at their highest levels in more than 100 years, which makes credit look like an extremely attractive investment opportunity. And there is every reason to expect that Asian corporates will participate in the healing, perhaps even as quickly as their counterparts in the US. (Oops and I thought everyone said divergence wasn’t possible or decoupling is a myth)

3. Asian companies have begun to engage in debt buyback. Again from FinanceAsia, ``Asian companies are buying back their debt with gusto and this could be a sign that credit markets are on the mend, according to Morgan Stanley.

``Asian companies are betting that credit will offer the best returns in 2009 and, like the smart traders they are, executives in the region are busy buying back their debt with gusto.

4. A picture speaks a thousand words…

Figure 6: A BRIC Decoupling?

China and Brazil appear to be leading the BRIC recovery while India (BSE) and Russia (RTS) seem to initiating their own.

For financial markets of developed economies, don’t speak of bad words.

Consumer Deflation: The New Fashion

``All the major institutions in the world trying to deleverage. And we want them to deleverage, but they’re trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up. And there’s no one that can leverage up except the United States government.-Warren Buffett, Interview Transcript

This world is full of befuddling ironies.

Just last year, when consumer prices were rampaging skywards, we were told by media and their experts how “inflation” was bad for the economy. Today, as consumer prices has been falling, the same forces of wisdom explain to us how “deflation” has likewise been detrimental to the economy or perhaps even worst….

As example we are told that declining consumer prices “aren’t just symptom of economic weakness” but are “destructive in and of themselves”. Why? Because as demand weakens and prices decline, companies cut employment and investment, slowing economic growth even further. Thus the chain of inference includes “falling earnings, a weak economy, and the hoarding of cash, fewer investors are willing to buy stocks during deflationary times.”

And the “deflation” theme has grabbed the headlines see figure 1.

Figure 1: Economist: The Deflation Index

According to the Economist, ``Back in August, only six stories in the Wall Street Journal, International Herald Tribune and the Times mentioned “deflation”. In November, there have already been 50, and new figures released this week will mean many more. America's consumer-price index fell by 1% in October from September as oil prices plunged, the largest monthly fall since the series began in 1947. Britain's inflation rate has also fallen from its record high of 5.2% in September to 4.5% in October, the biggest drop in 16 years.

For starters, falling prices basically reflect demand supply imbalance, where supply is greater than demand. Such conditions may be further prompted by either supply growing FASTER than demand or demand declining FASTER than supply.

Paradox of Savings And Growth Deflation

When prices fall because of technological innovation such as the mobile phones, the internet and others, these items become affordable and have rapidly been suffused into the society enough to make it an economic staple.

For instance, mobile phones are expected to hit an astounding 61% global penetration level according to the UN (Europe News) or about 6 out of 10 people will have access or be using mobile phones by this year. According to high profile economist Jeffrey Sachs, the diffusion of mobile communications will revolutionize logistics and education that should benefit the rural economy.

Quoting Mr. Sachs, ``The mobile revolution is creating a logistics revolution in farm-to-retail marketing. Farmers and food retailers can connect directly through mobile phones and distribution hubs, enabling farmers to sell their crops at higher “farm-gate” prices and without delay, while buyers can move those crops to markets with minimum spoilage and lower prices for final consumers.

``The strengthening of the value chain not only raises farmers’ incomes, but also empowers crop diversification and farm upgrading more generally. Similarly, world-leading software firms are bringing information technology jobs, including business process outsourcing, right into the villages through digital networks.

``Education will be similarly transformed. Throughout the world, schools at all levels will go global, joining together in worldwide digital education networks. Children in the US will learn about Africa, China, and India not only from books and videos, but also through direct links across classrooms in different parts of the world. Students will share ideas through live chats, shared curricula, joint projects, and videos, photos, and text sent over the digital network.” (underscore mine)

Moreover, falling prices should translate to more purchasing power.

So how can falling prices be all that bad?

The answer lies squarely on the Keynesian dogma of the “Paradox of Savings”. What supposedly signifies as virtue for individuals is allegedly (and curiously) a bane for the society. The idea is that when people save or withhold consumption, the underlying consequence would be a reduction in investments, employment, wages, etc. etc, thereby leading to a slowdown or even a contraction of economic growth. Seen from the aggregate top-down framework, less consumption equals less economic growth.

This has been profusely peddled by media and the social liberal school as basis for justifying GOVERNMENT INTERVENTION to conduct policies aimed at stimulating growth or rescue, bailout or other inflationary policies to avoid “demand contraction”.

Anecdotally, if savings is truly so bad for an economy then Japan should be an economic basket case by now, yet it holds some $15 trillion in household assets as of June, of which only 13.9% is in stocks and mutual fund and $7 trillion in bank deposits. This in contrast to the US where only 17% is in deposits and 50% is into stocks and pension funds (Washington Post). Japan’s high savings rate has even been reflected in public sentiment where a polled majority refuses to accept government offers to “stimulate” the economy (see Free Lunch Isn’t For Everyone, Ask Japan), as it had learned from its boom-bust cycle experience.

From the Austrian school perspective, the Japanese scenario can be construed as a “Cash Building Deflation” case. From Mises.org’s Austrian Taxation of Deflation by Joseph Salerno, ``Despite the reduction in total dollar income, however, the deflationary process caused by cash building is also benign and productive of greater economic welfare. It is initiated by the voluntary and utility-enhancing choices of some money holders to refrain from exchanging titles to their money assets on the market in the same quantities as they had previously. However, with the supply of dollars fixed, the only way in which this increased demand to hold money can be satisfied is for each dollar to become more valuable, so that the total purchasing power represented by the existing supply of money increases. This is precisely what price deflation accomplishes: an increase in aggregate monetary wealth or the “real” supply of money in order to satisfy those who desire additional cash balances.”

In addition, this Keynesian obsession with “aggregate demand” says economic growth should be associated with “inflation”.

Figure 2: American Institute For Economic Research: Falling US Dollar

Yet, if inflation is measured by means of the increase or loss of a currency’s purchasing power, then the US dollar’s appalling loss of purchasing power since the birth of the Federal Reserve in 1913 (see figure 2) shows that US economic growth hasn’t been primarily driven by productivity (productive economy=an environment of falling prices or “deflation” as more goods or services are introduced) but by inflationary policies or by money and credit expansion!

Note: the chart also exhibits that when the US dollar had been redeemable into monetary commodities (gold or silver), purchasing power of the US dollar tends to increase. Yes, this is defined as DEFLATIONARY ECONOMIC GROWTH or GROWTH DEFLATION (!)

Again from Mises.org’s Austrian Taxation of Deflation by Joseph Salerno, ``In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard.” (highlight mine)

Falling Markets: Debt Deflation Not Consumer Price Deflation

But savings isn’t about the absolute withholding of consumption. There is a very significant time dimension difference: it is a choice between spending and consuming today or in the future. Moreover, there are two types of consumption to reckon with; non productive consumption and productive consumption.

The definition of savings according to the Austrian School, excerpting Gerard Jackson, (underscore mine)``The full definition is that savings is a process by which present goods are transformed into future goods, i.e., capital goods, that produce a greater flow of consumer goods at some further point in time. In short, present goods in the form of money are used to direct resources from consumption (the production of consumer goods) into the production of capital goods.”

When we put cash balances into a bank, the bank functioning as intermediary parlays such deposits into loans (for business or for consumers) or as investments in securities (private e.g. corporate bonds or public-local government e.g. municipal bonds or national government e.g. Treasuries). So essentially, our savings are channeled into the private sector or as financing to government expenditures.

Thus, the paradox of savings or the anticipated rise of savings rate in the US or in countries severely impacted by the deflating mortagage backed credit bubble, given the magnitude of government efforts to “cushion” or “rescue” the financial system and the economy, will effectively be utilized to finance most of these government programmes.

The negative aspect is not that the consumption ripple effect will result to lower economic growth but instead savings channeled into public/government consumption effectively crowds out private investments which should lead to LOWER productivity and thereby lower economic growth prospects.

Furthermore, when media discusses about consumption, it focuses on the consumers which accounts as the non-productive aspect of consumption.

A productive consumption is where one consumes in order to be able to produce goods. A baker who consumes food in order to bake is an example of productive consumption.

And non-productive consumption, as defined by Dr. Frank Shostak, is ``when money is created "out of thin air." Such money gives rise to consumption, which is not backed by any production. It leads to an exchange of nothing for something.”

In short, the recent boom in consumer spending hasn’t been on the account of spending for production but representative of an explosion of “nothing for something” dynamics or where a policy induced free money environment impelled the US populace to go into a massive speculative orgy, thereby giving the illusion of wealth from producing nothing and limitless nonproductive consumer spending. Of course many of these nothing for something dynamics has also spilled over to many developed countries.

Likewise, the recent account of falling prices or economic weakness hasn’t been a direct cause of retrenching consumers but as an offshoot to a reversal in the free money landscape and a bursting bubble. Thus the apparent economic weakness from a slackening of consumer spending signifies as symptom and not the cause.

Put differently, what makes falling prices or what media or the Keynesian perception of pernicious deflation is nothing more than DEBT DEFLATION!

Once more from Joseph Salerno’s Austrian Taxation of Deflation [p.13-14], ``The most familiar is a decline in the supply of money that results from a collapse or contraction of fractional-reserve banks that are called upon by their depositors en masse to redeem their notes and demand deposits in cash during financial crises. Before World War Two bank runs generally were associated with the onset of recessions and were mainly responsible for the deflation that almost always characterized these recessions. What is called “bank credit deflation” typically came about when depositors lost confidence that banks were able to continue redeeming the titles—represented by bank notes, checking and savings deposit —to the property they had entrusted to the banks for safekeeping and which the banks were contractually obliged to redeem upon demand…

``During financial crises, bank runs caused many banks to fail completely and their notes and deposits to be revealed for what they essentially were: worthless titles to nonexistent property. In the case of other banks, the threat that their depositors would demand cash payment en bloc was sufficient reason to induce them to reduce their lending operations and build up their ratio of reserves to note and deposit liabilities in order to stave off failure. These two factors together resulted in a large contraction of the money supply and, given a constant demand for money, a concomitant increase in the value of money.”

As you can see Salerno’s description of a Debt Deflation landscape as “depositors lost confidence that banks were able to continue redeeming the titles”, “revealed for what they essentially were: worthless titles to nonexistent property”, “threat that their depositors would demand cash payment en bloc”, and “a large contraction of the money supply and, given a constant demand for money, a concomitant increase in the value of money” have been all consistent and cogent with today’s evolving activities in the banking system, the global financial markets or the real economy.

As we have pointed out in many past articles as the Demystifying the US Dollar’s Vitality or It’s a Banking Meltdown More Than A Stock Market Collapse!, the collapse in the US mortgage market which accounted for as a major source of collateral for an alphabet soup of highly geared structured finance (e.g. ABS, MBS, CMBS, CMO, CDO, CBO, and CLO) instruments which likewise underpinned the $10 trillion shadow banking system, resulted to a near cardiac arrest in the US banking system last October, where banks refused to lend to each other reflecting symptoms of an institutional bank run (see Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?).

The sudden surge or “increase in the value of money” in terms of the US dollar against the an almost entire swathe global currencies (except the Japanese Yen) reflected its role as international currency reserve where its dysfunctional banking system incited a systematic “hoarding” of the US dollar, the unwinding of the US dollar carry trade or almost a near contraction of money supply (until the US government’s swift response see The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…).

Similarly such dislocations have been transmitted via synchronous selling and an astounding surge in volatility across global financial markets and an intense disruption in the $14 trillion trade finance market, all of which has combined to impact the global real economy.

The present selloffs in the global equity markets as reflected by the activities in the US markets have reached milestone levels see Figure 3.

Figure 3: chartoftheday.com: US Stock Market Corrections

The meltdown in the US markets have been on short, in terms of duration, but whose magnitude has been more than the average of the typical bear market losses.

Why should it be that a selldown be remarkably drastic if it were to account for only a consumer recession? The answer is it isn’t.

Thus, the so-called destructiveness isn’t about US consumers retrenching but an intense deleveraging process backed by the heuristic reflexivity concept of a self-feeding loop of falling prices=falling demand and vice versa.

Eventually false premises tend to be corrected.

Will Debt Deflation Lead To A Deflationary Environment?

``Let's get to the bottom line. A deleveraging process is under way. It can happen against a background of bankruptcy, deflation, declining cash flows and bank bankruptcy or in a slower way against a background of inflation. Both reduce the debt burden, but one is socially jarring and led in the past to mass unemployment and arguably WWII. Democracies will choose the inflationary approach. This is not evident today, but it will be more evident soon enough as the BoJ, ECB, BoE and others realise that their current monetary policy is driving them not to slower growth and lower inflation but to deflationary calamity. Today, you can see the calamity of the deflationary disease but what will you see tomorrow, or the day after, if the monetary cure pours from the medicine jars of the global central banks?”-Russell Napier of CLSA (courtesy of fullermoney.com)

Not if you ask, Dr. Frank Shostak, ``We however, maintain that it is not the size of the debt that determines the severity of a recession, but rather the aggressiveness of the loose monetary policies of the central bank. It is loose monetary policies of the central bank that cause the misallocation of resources and the depletion of the pool of funding and in turn can be manifested in over-indebtedness. So to put the blame on the size of the debt as the key factor in causing depression is no different to blaming the thermometer for causing the high temperature.” (underscore mine)

Or Joseph Salerno in Austrian Taxation of Deflation, ``Bank credit deflation represents just such a benign and purgative market adjustment process.”

Many have cited the Great Depression as a prospective model of today’s deteriorating environment as having a deflationary character. Yet, the reason debt deflation transformed into the Great depression wasn’t due to the deleveraging process itself, instead it was debt deflation aggravated by economic policies which crushed profit incentives.

Again Mr. Salerno (highlight mine), ``Unfortunately such benign episodes of property retrieval have been forgotten in the wake of the Great Depression. Despite the fact that the bank credit deflation that occurred from 1929 to 1933 was roughly proportional in its impact on the nominal money supply to that of 1839-1843, the rigidity of prices and wage rates induced by the “stabilization” policies of the Hoover and early Roosevelt Administrations prevented the deflationary adjustment process from operating to effect the reallocation of resources demanded by property owners.”

Myths of Liquidity Trap and Pushing On A String

Deflation proponents have further used the Keynesian concepts of “liquidity trap” and or “pushing on a string” to advance their Armageddon theory.

The concept of “pushing on a string” suggests that US Federal Reserve policies will be rendered ineffective or impotent and won’t jumpstart the economy by stimulating lending.

While the US Federal Reserve have the boundless powers to add into bank reserves by purchasing assets (usually government liabilities), commercial banks might not lend money to take advantage of this. It’s like leading a horse to a pool of water, but doing so won’t guarantee that the horse will drink from it.

A liquidity trap environment is seen almost similar to the “pushing on a string” concept, but here, as interest rates nears or is at the zero regime, traditional policy tools might also be unsuccessful to spur lending (again!).

So should we fear these as media and Keynesian experts paint them to be?

We doubt so.

Why?

First is to understand how Central banks operate, according to Murray Rothbard in Man Economy and State (emphasis mine), ``The central bank can increase the reserves of a country’s banks in three ways: (a) by simply lending them reserves; (b) by pur­chasing their assets, thereby adding directly to the banks’ deposit accounts with the central bank; or (c) by purchasing the I.O.U.’s of the public, which will then deposit the drafts on the central bank in the various banks that serve the public directly, thereby enabling them to use the credits on the central bank to add to their own reserves. The second process is known as discounting; the latter as open market purchase. A lapse in discounts as the loans mature will lower reserves, as will open market sales.”

Next, Murray Rothbard in Making Economic Sense tells us why deflation isn’t likely to occur given the innumerable powers of Central Banks, ``What deflationists always overlook is that, even in the unlikely event that banks could not stimulate further loans, they can always use their reserves to purchase securities, and thereby push money out into the economy. The key is whether or not the banks pile up excess reserves, failing to expand credit up to the limit allowed by legal reserves. The crucial point is that never have the banks done so, in 1990 or at any other time, apart from the single exception of the 1930s. (The difference was that not only were we in a severe depression in the 1930s, but that interest rates had been driven down to near zero, so that the banks were virtually losing nothing by not expanding credit up to their maximum limit.) The conclusion must be that the Fed pushes with a stick, not a string.”

Figure 4: Dshort.com: US Monthly Inflation Chart

A dainty chart from dshort.com shows of the historical bouts of deflation in US history. Most of the incidences of deflation came on a post war basis after a massive expansion in money supply and artificial demand from a war economy resulted to massive adjustments during in the post war economy.

Since the gold has come off the monetary standard in 1971, despite the strings of crisis during the period (Savings and Loans, Black Monday 1987, LTCM, & dot.com bust), there has been no incidence of deflation.

The Nuclear Option: Currency Devaluation

Another, US Federal Reserve Chairman Ben Bernanke in 2001 spelled out his unorthodox “helicopter” means of avoiding a deflationary recession.

The Fed has always the luxury to use its printing presses, this from Mr. Bernanke’s speech Deflation: Making Sure “It” Doesn’t Happen Here, ``To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”

Or even consider massive devaluation as its nuclear option (emphasis mine), ``Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

About fifty years ago, in his magnum opus the Human Action, Mr. Ludwig von Mises presciently elucidated of the endgame option available to central banks wishing to escape a credit bubble bust, ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Our Mises moment.

In short, a government single-mindedly determined to inflate the system won’t actually need a functioning private credit system to do so. As we previously said, it only needs the bureaucracy and 24/7 operational printing presses, or it can simply invoke massive devaluation as its nuclear option.

Proof?

Zimbabwe should be the best living testament of such government driven tenacity.

From Albert Makochekanwa, Department of Economics, University of Pretoria, South Africa “Zimbabwe’s Hyperinflation Money Demand Model”

``Borrowing from Keynes (1920) suggestions, namely that ‘even the weakest government can enforce inflation when it can enforce nothing else’; evidence indicates that Zimbabwean government has been good at using the money machine print. Coorey et al (2007:8) point out that ‘Accelerating inflation in Zimbabwe has been fueled by high rates of money growth reflecting rising fiscal and quasi-fiscal deficits’. As a result of that, the very high inflationary trend that the country has been experiencing in the recent years is a direct result of, among other factors, massive money printing to finance government expenditures and government deficits. For instance, the unbudgeted government expenditure of 1997 (to pay the war veterans gratuities); the publicly condemned and unjustifiable Zimbabwe’s intervention in the Democratic Republic of Congo (DRC)’s war in 1998; the expenses of the controversial land reform (beginning 2000), the parliamentary (2000/2005) and presidential (2002) elections, introduction of senators in 2005 (at least 66 posts) as part of ‘widening the think tank base’ and the international payments obligations, especially since 2004, all resulted in massive money printing by the government. Above these highlighted and topical expenditure issues, the printing machines has also been the government’s ‘Messiah’ for such expenses as civil servants’ salaries.”

As you can see, no consumer or industrial or any sorts of borrowing-spending Keynesian framework. It's plain vanilla print and distribute, where money supply exponentially outgrows the supply of goods and services, hence hyperinflation.

So even as US government policy tools have seemingly been unsuccessful to stoke up on its much desired rekindling of the inflationary environment after coughing up about $4.28 trillion of taxpayers money (see The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…), to quote Asha Banglore of Northern Trust, ``The lowering of the Federal funds rate, the Fed’s innovative programs to provide liquidity to financial institutions – PDCF, TSLF, and other programs – and more lenient rules for borrowing through the discount window appear to have exhausted the gamut of possibilities routed through monetary policy changes to influence aggregate demand. The provisions of the Emergency Economic Stabilization Act of 2008 allow for recapitalization of banks. The FDIC is working on obtaining an approval for the anti-foreclosure plan to address the housing market issues that are central to the current crisis. In conclusion, the probability of a hefty fiscal stimulus package with the Fed buying these securities is growing everyday,” the nuclear option or our Mises Moment endgame seem likely a looming reality as the day goes by.

Conclusion: Preparing For The Mises Moment

Finally, as shown above deflationary fears under a Paper money standard seems unwarranted and is not a likely scenario, given the unrestricted powers of the central bank to either use the printing press or its nuclear option- massive debasement of its currency.

Debt deflation in itself is a salutary process which involves the cleansing of malinvestments or the excesses of “exchange of nothing for something” dynamics.

The Great Depression was a product not of debt deflation dynamics only, but was exacerbated by the adaptation of rigid economic policies by the incumbent leadership that crushed business profits and the economic system’s ability to adjust.

Governments determined to inflate don’t need a functioning private banking or credit system as the Zimbabwe experience shows. All it needs is a printing press and an expanding bureaucracy.

Once the inflation process starts to gain ground be prepare for the next bout of inflation!