Has The Deleveraging Process Culminated? Where’s The Next Bubble?

``Many shall be restored that now are fallen and many shall fall that now are in honor.”- Horace, leading Roman lyric poet in Ars Poetica

Global markets rallied furiously over the week, setting stage for what perma bears call as the sucker’s rally. For all we know, they could be right. But I wouldn’t bet on them. Not especially when central banks start to use the first of its available nuclear option of monetizing government debt. Not when government central banks start running the printing presses 24/7 and begin a Zimbabwe type of operation.

We also don’t know to what extent of the forcible liquidations of the deleveraging process is into, what we do know is that governments are today starting to unveil their long kept ‘secret’ final endgame weapons. We appear to be at the all important crossroads. Will it be a deflationary depression outcome? Will it be a recovery? Or will hyperinflation emerge?

What we also know is that forcible liquidations from the ongoing debt deflation process have been responsible for the “recoupling” saga we are seeing today.

Figure 4 stockcharts.com: Gold leads Rally

In figure 4, compared to the previous failed rallies (2 blue vertical lines), gold, oil and commodities haven’t joined the bullish rebellion in global equities as shown by the US S & P 500 (spx), Dow Jones World (djw), and Emerging Market Index (EEM).

This time we see gold leading a broad market rally. The Philippine Phisix too has obliterated its 10.73% one week loss by surging 11.65% this week. And even our Peso has joined the uprising by breaking down the psychological 49 barrier.

In short, this week’s rally does look like a broad market rally. And broad market rallies usually have sustaining power.

The Philippine Stock Exchange’s market internal tells us that even during the other week’s meltdown, the scale of foreign selling appears to have diminished. It had been the local retail investor jumping ship. This week’s rally came with even less foreign selling even if we omit the special block sales of Philex Mining last Friday.

My ‘fallacy of composition’ analysis makes me suspect that perhaps the issue of deleveraging has ebbed, simply because as the US markets cratered to form a NEW low, just about a week ago, key Asian stocks as the Nikkei 225 ($nikk), Shanghai composite ($ssec) and our Phisix have held ground see figure 5.

Figure 5: Stockcharts.com: Asian stocks Show Signs of Resilience

To consider, even as streams of bad economic news keeps pouring in, as Japan has reportedly entered an official ‘technical’ recession or two successive quarters of negative growth, its main benchmark the Nikkei appear to be holding ground.

It’s been said that once a bear market has stopped being weighed by more streams of bad news or despite this they even begin to rise; this mean that markets may have digested all negative info and may have signaled that a bottom has finally been established. As we quoted Jim Rogers on a video interview, ``When people say it is over and when we you see more bad news and stocks stop going down. But when they go up on bad news, that’s when we are gonna hit bottom. We are not gonna scream I don't know."

Although it could be too premature to decipher recent events as a bottom, we’d like to see more improvement in the technical picture and even more participation from major benchmarks of the region (djp2) aside from sustained rise from the market leader-gold.

Furthermore, if indeed the deleveraging process is beginning to fade, then the next phase should be markets factoring in the repercussions from the recent credit crunch to the real economy. But considering the steep fall during the October-November carnage, it is our impression that most of these had already been factored in.

Moreover, the downturn in the real economy should reflect divergences because not all of the Asian region’s economy will experience recessions see figure 6.

Figure 6 IMF: Emerging Asia Quarterly Growth Forecast

As you can see from the IMF’s regional outlook, except for Industrial Asia (Japan, Australia and New Zealand) which is the only class expected to flirt with an economic recession 2009, the rest of Asia’s economic growth engine is expected to only moderate with the Newly Industrialized Economies (Hong Kong Korea Singapore Taiwan) experiencing the most volatility (steep fall but equally sharp recovery). Most of the Asia is expected to strongly recover during the second half of 2009.

Now if the IMF projection is accurate and if stock markets are truly discounting economic growth to the streams of future cash flows of companies, then we should begin to see today’s rally as sustainable, reflective of these projections and at the bottom phase of the market cycle.

This also means sans further deleveraging prompted liquidations, we could expect some stark divergences in market performances. Unless, of course the headwinds from the collective efforts to inflate impacts every asset class simultaneously, which we think is quite unlikely. But as we earlier said, the bubble structure in the US isn’t going to revive and that any new bubble will come from elsewhere, for example the US dot.com boom bust cycle shifted to the housing industry in 2003 as an offshoot to the inflationary policies applied against a deflating tech industry led market and economic bust.

Boom-bust market cycles always involve a change of leadership. And considering that gold has been the frontrunner during the recent bounce, we suspect that precious metals, energy, commodities, emerging markets and Asia as the next bubbles to blow.

Nassim Taleb 'The Risk Maverick': We May Be Experiencing Something That Is Vastly Worst

This insightful PBS News Hour Interview with great thinkers in Nassim Nicolas Taleb (author of Black Swan: The Impact of the Highly Improbable) and Fooled by Randomness and Benoit Mandelbrot (The (Mis)Behavior of Markets)







Some noteworthy quotes from the interview:

From Nassim Taleb:

"The banking system the way we have it is a monstrous giant built on feet of clay and that topples we’re gone. Never in the history of the world have faced so much complexity combined with so much incompetence and understanding its properties.

"We live in a world that is way too complicated for our traditional economic structure it’s not as resilient as it used to be we don’t have slack it is over optimized."

"Let me tell you what is happening in the ecology of the banking system, there is swelling of large banks because it vastly more optimal to have one large bank than ten small banks. It’s more efficient. And that consolidation is putting us at risk because when one large bank makes a mistake, it’s ten times worst than a small bank making a mistake."

"I think we may be experiencing something that is vastly worst than we think it is."

"The network effect of globalization means that a shock in the system can have much larger consequences."

From Benoit Mandelbrot:

"The word turbulence is one which is actually common to physics, social sciences to economics, everything about turbulence is enormously complicated not just a little bit complicated not just one year more school it’s enormously complicated.

"The basis of weather forecasting is looking from the satellite and seeing the storm coming but not predicting that the storm will form...the behavior of economic phenomenon is far more complicated than the behavior of liquid and gasses."

"Tools have been developed which assume changes are always very small,...then nothing bad happens, if several of them come together bad things can happen and the theory does not take account of that. And the theory does not take account of very large and sudden changes in anything, the theory thinks that things move slowly gradually and can be corrected when in fact they may change extremely brutally."

My comment: Both Mr. Taleb and Mr. Mandelbrot seems to be worrying about the US dollar based global banking system which is getting to be "too big to fail".

With the US government's increasing influence in the consolidation of the banking sector, directly and indirectly, where deal making has surpassed $3 trillion, such risk concerns may not be exaggerated.

Courtesy of Wall Street Journal/dealogic

Could Mr. Taleb be referring to our Mises moment?

How Zimbabwe’s Experience May Apply To The US

The basic difference between the US and Zimbabwe is one of capital structure or its stages of production. Zimbabwe has a primitive capital structure while the US has a more complex capital structure.

To understand the concept of capital structure, we excerpt Ludwig M. Lachmann in his book Capital And Its Structure

``All capital goods derive their economic significance from their mode of use, or rather, from their actual and potential modes of use…We realize that a heterogeneous capital concept compels us to seek the 'common denominator' of these heterogeneous resources, the common criterion of their capital quality, in their 'designed complementarity', their mode of use within the framework of a plan. Each plan is a logical structure in which means and ends are coordinated by a directing and controlling mind. In the functional variety which is of the very essence of capital utilization plans capital resources exhibit those structural relationships we shall have to study.

``All capital goods are, directly or indirectly, instruments of production. Not all of them are man-made (e.g. mineral resources are not) but all of them are man-used. It is indeed characteristic of such 'natural' capital resources that but for the existence of man-made capital designed to be employed in conjunction with them, they would not even be economic goods. The theory of capital is thus primarily a theory of the material instruments of production. It must have something to say about the role of capital goods in production plans, about the mode of their combined use. In other words, production plans are the primary object of the theory of capital.” (highlight mine)

Roger Garrison: Capital or Structure of Production

For a good account of the production process of a pencil see this article, "I, Pencil: My Family Tree as told to Leonard E. Read" (hat tip: Robert Murphy)

But failed policies can undermine a country's capital structure such as in Zimbabwe’s case -Mugabe's confiscation of farms as part of the controversial land reform, Zimbabwe’s intervention in the Democratic Republic of Congo (DRC)’s war in 1998; the parliamentary (2000/2005) and presidential (2002) elections and the introduction of senators in 2005 (at least 66 posts) as part of ‘widening the think tank base’ and the international payments obligations as discussed in Will Debt Deflation Lead To A Deflationary Environment?

Courtesy of Indexmundi.com

The detrimental impact of policy failures has resulted to the economic deterioration (see above) and the shortening or reduction of its economy's capital structure, which has prompted the Mugabe government to become exceedingly dependent on its printing press than from its taxpayer’s capacity to finance or from its impaired ability to borrow from funding abroad. With 85% unemployment government has virtually dominated the economy.

And so, the hyperinflation depression.

Nonetheless, while the US may have a complex capital structure today, a major string of policy failures which may result to the deepening of economic losses and increasing size and influence of its government can increase the risks of reducing its capital structure, thereby giving the same conditions with that of Zimbabwe of having limited ability to tap its taxpayer for funding and the diminishing prospects of accessing foreign taxpayer funds to support the role of its rapidly expanding leviathan.

This also translates to greater reliance on the printing press to sustain the government’s political objectives.

Hence, the risk of a Mises Moment endgame.

Smelling Signs of Inflation: Stubborn High Food Prices and Shrinking Supplies

As we have been saying, media and experts have been insisting to us of the mutually reinforcing feedback loop of falling demand=falling prices centered on a global deflation theme.

But, we have been getting additional evidence of the obverse side, falling prices=falling supply!

This makes the entire episode a race to the bottom.

Courtesy of New York Times

The chart above shows of the stubbornly high food prices despite falling prices in the commodity sphere. Yet, food prices are projected to remain high next year even under an expected recessionary environment.

From the New York Times,

``Now, even though costs for ingredients like corn and wheat have dropped, meat and poultry providers say they still have not raised prices enough to cover their increased costs. And packaged food manufacturers are unlikely to lower prices because commodity costs remain relatively high and they are still trying to rebuild eroded margins.

``Michael Mitchell, a spokesman for Kraft Foods, said that the company’s food ingredient costs this year were running $2 billion higher than in 2007, a 13 percent increase, but that the company had raised its overall prices by only 7 percent.

William P. Roenigk, senior vice president and chief economist for the National Chicken Council, said his industry had been losing money for more than a year. Chicken producers are now trying to recover those costs by reducing production, which will eventually alter the balance between supply and demand. “The time is coming when we’re going to see a very significant increase in the retail price of chicken,” he said….

``When costs go up for livestock producers, they are often unable to immediately raise prices because those prices are set on the open market, which is dictated by supply and demand. Instead, they begin reducing the size of their herds or flocks, which eventually leads to less meat on the market and higher prices. But reducing livestock production can take months to years, and in the interim it can actually suppress prices as breeding animals are slaughtered to reduce production.

``The prospect of more food inflation is inflaming a debate over its causes. Many food manufacturers and economists maintain that one culprit is government policies promoting the use of ethanol fuel made from corn.

``About a third of the corn crop is used for ethanol, putting ethanol producers in competition with livestock farmers and food manufacturers. The result, they contend, is that prices for corn are now higher and more volatile.”

So aside from the unintended consequences from ethanol subsidies, news accounts omit the fact that global government has been throwing tons of money to rescue the global financial system and the world economy and should likely impact food prices overtime.

Same account of falling prices and tighter credit equals falling supply in Brazil.

This from Bloomberg (all highlight mine),

``The collapse of global credit markets that is pushing the U.S., Europe and Japan into simultaneous recessions for the first time since World War II also threatens farmers in Brazil, the world’s biggest grower of coffee, oranges and sugar cane, the second-largest producer of soybeans and third-biggest of corn. Smaller harvests in Brazil may increase costs of commodities next year, said Andre Pessoa, an analyst at Agroconsult who conducts the country’s broadest crop survey.

``Reduced fertilizer use will lower Brazil’s soybean output as much as 2.7 percent, while corn may decline 7.3 percent, the government said Nov. 6. Brazil’s coffee harvest may drop 26 percent next year, said Lucio Araujo, the commercial director at Cooxupe, a cooperative representing 11,000 growers in the Guaxupe region.

``Brazilian growers were short of at least 15 billion reais needed to invest in crops, Agriculture Minister Reinhold Stephanes said Oct. 9. Banks and financial companies worldwide, suffering from $969.5 billion of losses and writedowns since the start of 2007, are restricting credit as they struggle to replenish reserves, according to data compiled by Bloomberg…

Ah, high Fertilizer costs has also been aggravating the supply woes, the same report from Bloomberg,

``Fertilizer costs remain high, even as funding dries up and prices fall. The price of the nitrogen-potash mix that Terra, the coffee grower, uses has more than doubled in the past year to 1,800 reais a metric ton, he said. Terra usually buys about 10 tons for his trees. This year he’ll go without.

``The lack of sufficient fertilizer will compound an already smaller crop in Brazil as trees enter the lower-yielding half of the two-year cycle for coffee harvests.

“A lot of people are ceasing to plant because it’s not viable,” the corn association’s Barbieri said. “People have lost hope.”

So of the two competing reflexivity feedback loop premises one will be umasked as a false premise.

Our guess: prepare for inflation.

China Slashes Rates, Shanghai Composite At Critical Juncture

Faced with grim prospects of dramatically decelerating economic growth (World Bank Projections have cut growth forecast from 9.2% to 7.5% for 2009), an alarmed China has opted to aggressively use its monetary policy.

According to a report from Bloomberg (highlight mine), ``China lowered its key lending rate by the most in 11 years, extending efforts to prevent an economic slump less than three weeks after unveiling a 4 trillion yuan ($586 billion) stimulus plan.

``The key one-year lending rate will drop 108 basis points to 5.58 percent, the People's Bank of China said on its Web site today. The deposit rate will fall by the same amount to 2.52 percent. The changes are effective tomorrow…

``The bank lowered the reserve requirement for the biggest banks to 16 percent from 17 percent, effective Dec. 5. The requirement for smaller banks will fall to 14 percent from 16 percent. The central bank also reduced the interest rate that it pays on reserves deposited by commercial banks to encourage lending.

chart courtesy of Dankse Bank: Lending and deposit rate (left), reserve requirement (right)

Yet additional measures are being considered, from the same Bloomberg report,

``Two hours after the rate cut, China's cabinet said it was studying extra measures to help struggling companies in the steel, auto, petrochemical and textile industries; to increase key commodity reserves; and to expand insurance for the jobless.

``The government will also push ahead with fuel-price and tax reforms to help boost consumption, the cabinet said. A fuel-price cut would be the first in two almost years. The government regulates energy prices to contain inflation, which fell to a 17- month low in October.”

Fundamentally, the global contagion is expected to impact China via the export channel (and via portfolio flows), albeit exports still managed to grow robustly by 19.2% last October, but down from last September’s 21% with trade surplus swelling to a record $35.2 billion on declining import growth. A CLSA survey recently showed that export orders have dropped to its lowest since 2004, which possibly indicates that exports have yet to reflect on the substantial decline with a time lag.

But the continuing slump in the real estate industry seems likely a bigger concern considering that many loans from the informal sector could surface or find its way into the balance sheets of the formal banking sector, and increase incidences of Non Performing Loans. This should translate to a significant weakening domestic investment as we previously discussed in China’s Bailout Package; Shanghai Index At Possible Bottom?, which the Chinese government aims to offset with a massive stimulus package.

But, it is our hunch that perhaps China’s markets have already priced in or have discounted much of these somber expectations considering the harrowing bear market losses of 72% (from peak to trough).

Unless, the world will yield to a depression, the recent lows could possibly mark a cyclical transition from a declining phase to a “bottom” phase.

China’s Shanghai index appears to be testing the 50-day ma resistance.

A successful breakout from this resistance level could serve as one of our confirmation metrics. Otherwise a failed breakout means a test of the recent lows.

A Video Account of A Contrarian's Ordeal: Peter Schiff Was Right in 2006-2007!

Mr. Peter Schiff of Euro Pacific Capital is an iconoclast economist who subscribes to the Austrian school of economics and has served as economic adviser to Ron Paul’s presidential campaign in the recently concluded elections, and has been one of the grizzly bears who successfully predicted today’s crisis during the boom days of 2006-2007.

The purpose of my posting this video is to show you how contrarians suffer from the ordeal of challenging mainstream or popular thinking at the risk of being mocked, heckled and or excoriated. But of course, Mr. Schiff gets sweet vindication overtime. (Hat Tip: Robert Murphy)

Lesson: Be wary of mainstream or popular views. Most of the popular thinking have been influenced by an oversimplified comprehension of complex problems, the “rear view mirror syndrome” outlook or the “ticker tape performance” outlook where recent performance are interpreted as tomorrow’s outcome.

Enjoy!

Does $7.76 trillion of US Government Guarantees Make The US Dollar A Safehaven Status?

US dollar bulls always insist that the US dollar dispenses its role as safehaven currency when global economies are under strain.

This view has been bolstered by the recent surge of the US dollar fuelling rambunctiousness in their convictions.

While we don’t dispute the US dollar’s role in the past, our belief is that the recent activities of the US dollar has been nothing more than the exercise of deleveraging or debt deflation, the unwinding carry trade and from its status as an international reserve currency standard (where most loans have been US dollar denominated) as discussed in Demystifying the US Dollar’s Vitality.

To consider, we recently cited that US taxpayers were faced with some $4.28 trillion (see The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…), a Bloomberg report now tabulates US government guarantees to hit $7.76 trillion or about 50% of the US GDP!

Excerpts from Bloomberg (HT: C. McCarty), ``The U.S. government is prepared to provide more than $7.76 trillion on behalf of American taxpayers after guaranteeing $306 billion of Citigroup Inc. debt yesterday. The pledges, amounting to half the value of everything produced in the nation last year, are intended to rescue the financial system after the credit markets seized up 15 months ago.

``The unprecedented pledge of funds includes $3.18 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis…

``Bernanke’s Fed is responsible for $4.74 trillion of pledges, or 61 percent of the total commitment of $7.76 trillion, based on data compiled by Bloomberg concerning U.S. bailout steps started a year ago…

``The Fed’s rescue attempts began last December with the creation of the Term Auction Facility to allow lending to dealers for collateral. After Bear Stearns’s collapse in March, the central bank started making direct loans to securities firms at the same discount rate it charges commercial banks, which take customer deposits.

``In the three years before the crisis, such average weekly borrowing by banks was $48 million, according to the central bank. Last week it was $91.5 billion.

``The failure of a second securities firm, Lehman Brothers Holdings Inc., in September, led to the creation of the Commercial Paper Funding Facility and the Money Market Investor Funding Facility, or MMIFF. The two programs, which have pledged $2.3 trillion, are designed to restore calm in the money markets, which deal in certificates of deposit, commercial paper and Treasury bills.

``The FDIC, chaired by Sheila Bair, is contributing 20 percent of total rescue commitments. The FDIC’s $1.4 trillion in guarantees will amount to a bank subsidy of as much as $54 billion over three years, or $18 billion a year, because borrowers will pay a lower interest rate than they would on the open market, according to Raghu Sundurum and Viral Acharya of New York University and the London Business School.

``Congress and the Treasury have ponied up $892 billion in TARP and other funding, or 11.5 percent.

``The Federal Housing Administration, overseen by Department of Housing and Urban Development Secretary Steven Preston, was given the authority to guarantee $300 billion of mortgages, or about 4 percent of the total commitment, with its Hope for Homeowners program, designed to keep distressed borrowers from foreclosure.

``Most of the federal guarantees reduce interest rates on loans to banks and securities firms, which would create a subsidy of at least $6.6 billion annually for the financial industry, according to data compiled by Bloomberg comparing rates charged by the Fed against market interest currently paid by banks.

``Not included in the calculation of pledged funds is an FDIC proposal to prevent foreclosures by guaranteeing modifications on $444 billion in mortgages at an expected cost of $24.4 billion to be paid from the TARP, according to FDIC spokesman David Barr. The Treasury Department hasn’t approved the program.

``Bernanke and Paulson, former chief executive officer of Goldman Sachs, have also promised as much as $200 billion to shore up nationalized mortgage finance companies Fannie Mae and Freddie Mac, a pledge that hasn’t been allocated to any agency. The FDIC arranged for $139 billion in loan guarantees for General Electric Co.’s finance unit.

``The tally doesn’t include money to General Motors Corp., Ford Motor Co. and Chrysler LLC. Obama has said he favors financial assistance to keep them from collapse.

Amazing stuff. From $4.28 to $7.76 trillion in guarantees, subsidies, bailouts, stimulus packages with more to come.

Our idea is once the deleveraging dynamics ebb, all the recent strength seen in the US dollar will immediately be sapped.

The epicenter or “cause” of the world’s miseries can’t simply account as our safehaven. Such is a delusion.

And all the Keynesian malarkey of falling demand =falling prices loop will likewise evaporate.

The US dollar index had a remarkable one day fall.

Courtesy of Bespoke Invest

According to Bespoke, ``As equity markets stage their second straight day of gains, the US Dollar index is having its worst day since 1985, and its 5th worst day ever (since 1970). And today's fall for the Dollar broke the uptrend the currency had been in over the last couple of months, although it is still in a longer-term uptrend off of its Spring lows. Falls in the Dollar are coinciding with gains in equity markets and economic stability worldwide, since the US currency is now being treated as a safe haven. Go figure.”

Courtesy of Bespoke

As you can see, the US dollar index has broken down from its interim trend, suggesting further liquidations ahead. Pls be reminded the US dollar index is principally weighted against the Euro with 5 other currencies making up the rest of the basket.

Our thought is that commodity and Asian currencies (possibly some EM currencies with current surpluses) could lead the rally.

How has the fall in the US dollar fared to other markets?

Courtesy of stockcharts.com

Well, it’s a contagion in reverse. Former “safehavens” now victims of liquiditations; it’s not just the US dollar but obviously across the Treasury yield curve 10 year note, 3 month bill, 1 and 5 year notes.

And most importantly, some quarters have attributed the recent vigorous stock market rally to the appointment of President elect Barack Obama of Tim Geithner to the post of Hank Paulson or the incoming Secretary of the US Treasury.

While we believe that this causal chain is tenuous at best, a Geithner as 'the messiah rally' will likely to be a sucker’s rally. Yet if the market continues to rally from the recent lows (and establish a bottom!) even with Mr. Geithner doing nothing, as he is yet to assume office in 2009, then he might just be anointed a ‘saint’!

But this doesn’t seem inspired from a Geithner rally…

But probably one from Gold. Gold appears to have provided the recent market leadership.

The recent equity rally during late October hasn’t been confirmed by a rally in the commodities markets or in gold.

This isn’t the case today and looks like a broad market rally. Essentially, it’s a rally among all those asset classes that have been massively sold.

Three thoughts:

1. US dollar’s fall reflects cyclical forces of overbought conditions and may be temporary as the deleveraging dynamics continue. Conversely, equities and commodity markets have been in patently oversold conditions that the present gains reflect simply an oversold bounce.

2. A rotation in deleveraging. Because the US dollar and US sovereigns have immensely gained during the recent market volatility, the deleveraging process could have transferred been into a profit taking carnage in the US Treasuries market and the US dollar and inversely a reverse flow into oversold assets.

3. Markets could incipiently be smelling inflation. With $7.76 trillion of taxpayer exposure in the US and $trillions more from governments elsewhere, perhaps markets are starting to realize that the sheer magnitude of concerted inflationary policies are beginning to have some impact.

To quote CLSA’s Christopher Wood in today’s WSJ Op Ed, ``In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism -- and with it the fiat paper-money system in general -- as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

``The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the "barbarous relic" scorned by most modern central bankers, may well play a part.

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!