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!

Will Gold Reverse The Falling Demand=Falling Prices Feedback Loop?

``The world is lurching through a serious monetary disorder. The proximate cause is the collapse of the housing bubble and the subprime-credit crisis, but the ultimate cause is the inherently unstable monetary system foisted upon us by a banking cartel. Central bankers are called upon to act as lenders of last resort, but in their efforts to inflate their way out of the credit collapse, they risk igniting a hyperinflationary bonfire that will destroy the world's major fiat currencies. Gold was money once, and could become so again.”- Robert Blumen, Is Gold Money?

As discussed in Reflexivity Theory In Commodity Markets, there has evidently been a mounting disconnect between the demand-supply balance accounts in the real economy and the prices reflected in the financial markets, with emphasis for some commodities like gold and oil.

As the financial markets continue to read heavily into the “falling prices equals falling demand” feedback loop, streams of news continue to filter in on how gold coins or physical gold have been getting siphoned off the physical gold market as buyers apparently rushed to secure available physical gold stocks.

From Sify.com ``Mumbai: Financial crisis seems to have no impact when it comes to investor interest in gold. Multi Commodity Exchange of India Ltd (MCX) has witnessed a record delivery of 10,908 coins in its futures contract expired in October, surpassing the previous high of 8,900 coins for the August contract.”

From commodityonline.com, ``New data from London-based online gold brokerage BullionVault has confirmed that Britons are rushing to buy gold as they lose faith in traditional savings accounts, the Evening Standard reported…Accounts from the company show that it has grown by 475 per cent in the past year and now has 40,000 British customers and another 30,000 from around the globe. The appeal of BullionVault resides in its ability to provide the man on the street with a chance to get a fairer deal on gold - an investment of as little as £20 is possible - without additional fees.

From Arabianmoney.net, ``There has been an unprecedented surge in Saudi gold purchases in the past two weeks with over $3.5 billion being spent on the yellow metal, reported Gulf News citing local industry sources. Gold market expert Sami Al Mohna told the leading regional newspaper that this buying had substantially increased the gold reserves of the country: ‘Many Saudi investors see this as the right time for making investments in gold as the price is the most reasonable one at present’….News about the Saudi gold rush is bound to fuel speculation about the alleged large physical gold transactions that have been taking place at prices will above the spot price set in the futures market. It is very unlikely that such a large hoard of physical gold could have been bought for the depressed current price.

It is not just in the private markets but evidently even a minor global player like Iran has reportedly shifted out of the US dollars and into gold. This from Reuters, ``Iran has converted financial reserves into gold to avoid future problems, an adviser to President Mahmoud Ahmadinejad said in comments published on Saturday, after the price of oil fell more than 60 percent from a peak in July…"With the plans of the presidency...the country's money reserves were changed into gold so that we wouldn't be faced with many problems in the future," presidential adviser Mojtaba Samareh-Hashemi was quoted as saying by business daily Poul.”

And there are even reports that China is seriously considering to diversify part of its $1.9 trillion currency reserve into gold; this from Hong Kong’s The Standard, ``The mainland is seriously considering a plan to diversify more of its massive foreign-exchange reserves into gold, a person familiar with the situation told The Standard. ``Beijing is considering changing its asset allocations during the financial tsunami in order to build up gold reserves "in a big way," the source said…Beijing's reserves could easily go up to 3,000 to 4,000 tonnes, Tanrich Futures senior vice president Colleen Chow Yin-shan said.”

And even in the futures market, gold seems to have transitioned into a very rare backwardation or signs of immediate shortages. For basics, Backwardation is a market condition where spot prices exceed forward prices. Contango is the opposite condition, where forward prices exceed spot prices (riskglossary.com).

According to Minyanville’s Professor Lance Lewis, ``gold very rarely goes into backwardation: This only occurs when 1) The market fears a collapse in the currency, and/or 2) The market is worried about counterparties making good on their promise to deliver gold (which was briefly the case in 1999, when the Washington Agreement was announced and shorts were squeezed).” (emphasis mine)

Figure 5: Minyanville’s Lance Lewis: Backwardation in Gold Means Higher Prospective Gold Prices?

Figure 5 shows that gold lending rates have turned negative indicating emerging signs of shortages, again from Professor Lewis, ``We know gold is now in backwardation because the gold forward offered rate (GOFO) has now gone negative. The 3M GOFO has fallen 12 basis points to -0.07%, and the 1M GOFO has fallen 20 basis points to -0.1167% (see the chart of 3M GOFO below).”

On Friday, Gold made a rare monumental move to soar by 5.76% as shown in Figure 6.

Figure 6 stockcharts.com: Gold Shines Amidst “Deflation”

In the face of a rising US dollar, gold’s fantastic surge has equally been reflected in the US gold mining index ($djuspm) and the Goldman Sachs Precious metal index ($gpx), which suggests that the sudden spurt may have equally been confirmed by its mining counterparts.

Of course, we know that one day doesn’t a trend make. But gold’s one month consolidation seem to be indicative of an interim bottom. And the present surge could imply for a continued momentum over the coming sessions.

And with the global governments concertedly widening the liquidity spigot see figure 7 to defend against the menace of debt deflation, gold’s allure is undoubtedly gaining momentum.

Figure 7: BCA Research/US Global Investors: Gold As Liquidity Play

This tells us that many of the reflexivity justifications of falling demand/prices=falling prices/demand feedback loop will probably be overhauled soon. Once gold’s rise will be sustained, the public will change their rationalization to either safehaven or liquidity or inflation concerns.

Besides, putting the puzzle all together, we suspect that the Mises moment looks likely an imminent event, again Mr. Ludwig von Mises in Human Action [chapter 17: section 8],

``But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.”

We believe that the last laugh belongs to Mr. von Mises.

Oil Below $50! Goldman Recants Super Spike Oil Theory (Signs of Capitulation?!)

With the OIL prices breaking beyond the $50 psychological barrier to a 22 month low (CNN Money), could we be seeing some signs of “capitulation”?

Courtesy of stockcharts.com

Goldman Sachs, once a key proponent of the “super spike” in oil prices theory which they forecasted would lead to $200 oil have now retracted! For them, No more super spike!

This from Barron’s stockstowatchtoday,

``That ‘’super spike” in oil prices that Goldman insisted would lift crude to $200 a barrel ….? Turned out to be a dagger that has pierced Goldman itself. It never really turned out to be that prescient: instead of the 50% jump in oil that Goldman anticipated back in May, when it made the call with crude trading at $132, the price of a barrel never got more than 11% higher. And has since, of course, lost fully two-thirds of that price in the intervening four months.

``Now Goldman is left with the ignomy of summarily abandoning the investors who listen to its research calls, telling them effectively that they’re on their own. On Thursday, Goldman said it was ”closing” its recommendations for oil trades. Meaning that in a perilous time when the traders who pay attention to Goldman’s recommendations could use some guidance the most, Goldman has opted to give them the least. And some traders are furious about it, comparing the maneuver to then-strategist Abby Cohen’s decision to abandon her targets for equity indexes in the fall 2001, citing the uncertainties abounding in the market.

``Goldman specifically talked about four trade recommendations it previously issued, and said clients shouldn’t put any stock in them any longer. One particular trade, a Nymex-WTI swap on the 2012 contract, issued in September, when crude already had declined to below $70, suggested that the contract would reflate to a range of $120 to $140. Obviously, that hasn’t happened.

``In the end, the last laugh is on Goldman, ironically enough. Back in 2005, when Goldman oil analysts first started talking about a ‘’super spike” in energy prices, the prospect of crude going to as much as $105 a barrel, as they suggested, seemed like folly. The market subsequently vindicated them. When those same analysts raised their foreecasts last March, and first spoke of the $200 price point, a lot of traders still tittered. When Goldman spoke more determinedly about $200 in May, it seemed less far-fetched.

``The big losers, of course, would be anybody who continued to trade on Goldman’s recommendations. And the stocks of companies linked to those underlying commodities. Exploration and production names have had an awful go of it Thursday, integrated majors bad to a lesser extent. Apache (APA) lost 6%, Chevron (CVX) fell 2%, and ConocoPhillips (COP) 1%. But Goldman …? What did Goldman lose today? It’s worth noting that, for reasons unrelated to its oil trading call, Goldman shares dropped below their 1999 IPO price in Thursday’s trading.”

Our comment:

The dominant perspective of the present oil dynamics had been principally anchored on the feedback loop of falling prices=falling demand equals falling demand=falling prices.

We are not convinced with the simplified theory of the "falling demand" driver as discussed earlier in Reflexivity Theory And $60 Oil: Fairy Tales or Great Depression?

Especially NOT when we see this…

Courtesy of St. Louis FED: Exploding Monetary Base! (11/20)

Or this…

Courtesy of St. Louis FED: Fed Funds Rate Below .5%!(11/20)

Sucker’s Rally? What and where?

It is held that the recent sucker’s rally had gone bonkers.

Courtesy of Hussman Funds: Dow Industrials During the Great Depression

A sucker's rally basically means a cyclical (short-medium term trend) bull market within a secular (bigger trend) bear market.

For starters let us look at how the Dow Jones Industrials performed during the Great Depression.

This from Dr. John Hussman, ``we should recognize that even during that prolonged decline, it rarely made sense to sell into a major break of a previous low, because investors invariably had a chance to sell on a later recovery to the prior level of support…. Even if one hung on after the enormous rally of nearly 50% that followed the initial 1929 low, the market's initial break of that low (the first horizontal bar) was followed several months later by a rebound to that prior level of support. The break of the second intermediate low of early 1931 (the second horizontal bar) was followed by a rebound later in the year to that same level. Third break, same story.”

As you would notice even during severe bear markets, there had been interim "sucker's rally" as described by Dr. Hussman.

It had been basically the same in the Dot.com Bust…

Courtesy of chartrus.com

The dot.com bust shows two major "sucker's rally" (red ellipse).

Now let us look at the current action in the US markets…

Or in the global markets (Europe, Asia, Emerging Markets)...

Or even in the commodities markets…

Does a 15+/-% rally equate to a relief or sucker's rally? Not at all.

Hence, we don't see any trace of a typical sucker’s rally based on conventional measures, which means there has been no "delusion". What market action tells us is one of a typical meltdown.

Instead, the belief that markets ought to move in a linear fashion in order to prove one's convictions seem to be a product of overweening DELUSION.

The Curse of Deleveraging Haunts Warren Buffet’s Berkshire Hathaway

Warren Buffet’s flagship Berkshire Hathaway has been virtually whacked.

Hence some people have been asking, what’s wrong with Warren Buffett? Has the world’s best stock market investor lost his Midas touch?

Berkshire was down about 8% last night, and has been in a losing streak for 9 consecutive days. And is down by about 50% from the peak.

Courtesy of Bespoke Investments

According to Bespoke Investments, ``While nine straight days of negative returns are not too rare for Berkshire (red dots in chart below), the magnitude of the drop is notable. Since November 7th, which was the last day Berkshire finished up on the day, the stock has declined by 29%. This is by far its largest percentage decline over a nine day period.”

So what’s been troubling Berkshire?

The most likely answer: the widening spreads of the company’s Credit Default Swaps.

According to Fool.com’s Alex Dumortier, ``The five-year credit-default-swap spread hit 440 basis points yesterday. That means the annual cost of insuring $10 million in Berkshire debt against default over five years is $440,000.”

Courtesy of Fool.com

In short, the cost of insuring Berkshire Hathaway’s debt has soared. The investing public has priced Berkshire’s credit risk as more than that of Republic of Columbia!

Courtesy of Bespoke: CDS Spread: Safest Financial Company No more

Why? According to many reports, the imputed reason for the surge in the spreads had been due to concerns about Berkshire’s exposure to derivatives. The credit swap market seems to imply that Berkshire is on the hook for some $37 billion, which could risk a credit rating downgrade from its “Triple A” status.

And such downgrade may translate to a call to raise collateral supply to counterparties and subsequently impose onerous demand to raise cash.

Nevertheless, Mr. Warren Buffett acknowledges this in his 2002 annual (emphasis mine),

``Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.”

He even discloses Berkshire’s derivatives risk in its 2007 annual report (emphasis mine),

``First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

``The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion.

``The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written.”

Following observations:

-Worst case scenario for the high yield index exposure will be a loss of $4.7 billion. Yet such losses if it were to materialize will arrive at different expiry dates somewhere between 2009 until 2013.

-Losses from put options sold on four stock indices can only be realized upon the expiration of contracts between 2019 and 2027.

To quote Stacy-Marie Ishmael in FT Alphaville, ``People are freaking out about BRK possibly having exposure of $37 billion, but this is the maximum payout if ALL FOUR major world indices were at ZERO 14-19 years from now!”

-Proceeds from sales of put options are at $4.5 billion. If Mr. Buffett manages to make 7% over the same period this would amount to $17.4 billion or nearly half of the assumed worst case scenario.

-Berkshire still has more than $33 billion in cash which if gradually invested in the present environment should, in the words of Dr. John Hussman, “be associated with extremely high subsequent returns.”

-In addition, when does having a substantial cash position become a liability under the present "debt deflation" environment?

-Of course, all these assume that we are looking at the same risk factors as those who are pricing in a credit downgrade.

Moreover, there is the danger of a self fulfilling prophecy which given the extent of the debt unwind, could lead to a reflexive self feeding action: market outcome influencing fundamentals.

All these add up to only one thing, extreme fear associated with the tidal wave of deleveraging.

As I wrote to a client, ``The seemingly insuperable force of deleveraging is simply looking for any standing issues to bring to its knees. And for securities included in markets that have been globally intertwined, there is no escaping its fury. Whether it is stocks, bonds, emerging markets, commodities, currencies, in the face of debt deflation [Harry] Markowitz's Nobel prize from his portfolio diversification or the Modern Portfolio theory seems non-existent, if not a flawed theory.”

So Mr. Buffett looks more likely a victim of contagion, than from a loss of his magical aura.

The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…

In the face of this crisis, how much money has the US government thrown to “save the system” so far?

CNBC has this tabulation…

``Try $4.28 trillion dollars. That's $4,284,500,000,000 and more than what was spent on WW II, if adjusted for inflation, based on our computations from a variety of estimates and sources.”

Incredible. $4.28 trillion +++ as the days go by! And that's about 30% of the US GDP.

Makes you wonder who's gonna pay for all these and how one can be bullish on the US dollar, except when considering the recent spate of the deleveraging process-which is a short term dynamic.

Table below as of November 18, are CNBC’s estimates (see article)…

Great stuff from CNBC

Also, CNBC made a nifty comparison of how this bill has dwarfed the other major taxpayer programs in the past as shown through this slideshow.

Here are 3 of the ten, courtesy of CNBC.

World War II

Original Cost: $288 billion

Inflation Adjusted Cost: $3.6 trillion

NASA (Cumulative)

Original Cost: $416.7 billion

Inflation Adjusted Cost: $851.2 billion

Vietnam War

Original Cost: $111 billion

Inflation Adjusted Cost: $698 billion

(Pictured: Pres. Lyndon Johnson and Sen. Richard Russell)

Check CNBC slideshow for the write up and the rest of the other largest taxpayer bill

(Hat Tip: Mr. C. McCarty)