Why Deflation is Inevitable

Perhaps someday inflation, but not until the 1.2 quadrillion of outstanding debt are resolved first.

To understand deflation, you need to understand what money really is and how it’s created.

And you also need to read the other articles in the Inflation or Deflation category for this summary to make sense.

Boomers have to save for retirement due to losses in stock market — this will prevent a recovery because our system is based on consumer spending

Very important to understand: prices on ESSENTIAL things like oil and food can go UP in a deflation because people need to have them at any price.  This is NOT inflation.

There’s no way to get money to the 50% of Americans who need it the most short of dropping it with helicopters or drones over their homes (and even then the local gangs will probably come a calling to collect the cash they missed that fell from the sky).

The 1% prefer deflation over inflation.

  • If they lose 50% of their net worth but asset prices fall 80%, they’re up 30%! Buying back the country for cents on the dollar makes them even wealthier.
  • Hyperinflation carries more risk then deflation for the elite. Both pose risks to social stability and the possible collapse of society but in a deflationary collapse the elite would have more of an advantage.

If prices ever drop for any reason, it’s a self-fulfilling downward spiral as people hang on to cash and don’t spend because they know they can buy something even cheaper in the future

The unwillingness of foreigners to finance government deficits indefinitely as their balance sheets are constrained by declining export income (i.e. China, Japan, the Gulf oil nations)

You can only have (hyper)inflation when an economy is so isolated from the world that it prints a new currency rather than offers credit and too much of this money is printed

As demand falls, and with it prices, investment in the energy sector is likely to dry up. Many projects will be uneconomic at much lower prices, meaning that the projects which might have cushioned the downslope of Hubbert’s curve (and the much steeper net energy curve), are unlikely to be developed. In this way a demand collapse sets the stage for a supply collapse that could place a hard ceiling on any prospect of economic recovery. That is a recipe for extremely high energy prices in the future (Foss).

Secondly, our vulnerability to the consequences of debt is extremely high at the moment. The scale of that debt is staggeringly large. The global credit hyper-expansion has been decades in the making and is now significantly larger than notable events of the past such as the South Sea Bubble of the 1720s and the Tulip Bubble of the 1630s. It dwarfs the excesses that led to the Great Depression (Foss).

Inflation typically results from “too much money chasing too few goods.” Today, too much supply is chasing too little demand. That, coupled with consumers’ need to save money to rebuild their finances, raises the risk of deflation, not inflation. As workers compete for scarce jobs and companies underbid one another for sales, both wages and prices will remain under pressure. We began this crisis with household debt at its highest levels since the 1930s. Knowing that monthly mortgage payments don’t shrink even if your paycheck does, families are trying to deleverage and work down what they fear is their excessive debt.

Until employment grows enough to push wages, and income and production levels increase to more normal levels, the most pressing worry will be deflation, not inflation. inflation is easier to put right than deflation. The Federal Reserve can suppress inflation by raising interest rates as high as required to squelch those animal spirits, and the Fed can do that very rapidly. But there is a limit to the Fed’s ability to confront deflation, since it cannot cut nominal rates below zero in order to induce economic growth.

Unlike inflation, which divides the underlying real wealth pie into smaller and smaller pieces, credit expansion creates multiple and mutually exclusive claims to the same pieces of pie. Once a credit expansion reaches its maximum extent, and contraction begins, these excess claims begin to be extinguished. Unfortunately, the leverage is such that there are probably over a hundred claims to each piece of pie. While contraction begins slowly, as is the nature of positive feedback loops, it picks up momentum until a cascade point is reached, whereupon one can expect the excess claims to be extinguished in a rapid and chaotic process. This amounts to a rapid collapse in the supply of money and credit relative to available goods and services, which is the definition of deflation.

Banks hold extremely large amounts of illiquid ‘assets’ which are currently marked-to-make-believe. So long as large-scale price discovery events can be avoided, this fiction can continue. Unfortunately, a large-scale loss of confidence is exactly the kind of circumstance that is likely to result in a fire-sale of distressed assets. The structure of the credit default swap component of the derivatives market makes this very much more likely. The CDS market allowed large bets to be placed on certain prices falling, and by entities which did not have to own those assets. This creates a perverse incentive for some parties to cause others to fail for profit (akin to me being able to take out fire insurance on your house and thereby give me an incentive to burn it down). An added complication is the extreme degree of counterparty risk that resulted from a complete lack of capital adequacy regulation. Many parties with winning bets will not be able to collect, so they may cause financial mayhem for nothing. The CDS market is worth some $62 trillion, and a meltdown is very likely in my opinion.

The debt monetization that is going on has done nothing to increase the supply of money and credit relative to available goods and services, which is the definition of inflation.

Deregulation allowed the reckless to gamble away virtually everything, including bank deposits and pension funds. Globalized finance has created a giant Enron, which while appearing robust is actually almost completely hollowed out. Such structures implode, often without much notice.

Deflation is ultimately psychological. Without trust we will see hoarding of the cash which will be very scarce in the absence of the credit that currently comprises the vast majority of the effective money supply. The combination of scarce cash and a very low velocity of money will be toxic.  Money is the lubricant in the economic engine and without enough of it that engine will seize up as it did in the 1930s, when farmers dumped milk they couldn’t sell into ditches while others were starving for want of the money to buy food. There was plenty of everything except money, and without money, one cannot connect buyers and sellers.  Potential buyers will have no purchasing power as they will have lost access to credit and their ability to earn an income will be hit by spiking unemployment. Those who still have jobs will find that they have no bargaining power and there is therefore no wage support.  Sellers and producers will have no market and will themselves lose the means to purchase supplies or raw materials for the things they would like to produce.  If conditions remain frozen for any length of time, they will go out of business. The deeper the collapse, the more protracted the trough and the more difficult the eventual recovery.

Nicole Foss expects interest rates on private debt to rise before we see problems in the market for government debt, as the latter should benefit substantially in the shorter term from a flight to safety. The risk premium on private debt is already rising, which is a serious danger signal for such thoroughly indebted societies as we see in the developed world.

Some of the largest market rallies on record happened during the course of the Great Depression, as depressions are associated with very high volatility. Look for instance at the great sucker rally of 1930. There are always rallies of all different sizes in any bear market, just as there are pullbacks of all sizes in bull markets. No market ever moves in only one direction.

People tend to extrapolate recent trends forward, but this amounts to stepping on the gas while looking only in the rearview mirror. This is one reason why major trend changes are so rarely anticipated. Another is that the prevailing view of markets is fundamentally wrong. There is no perfect information, perfect competition, stabilizing negative feedback, rational utility maximization or efficient markets.

Markets are irrational, driven by swings of optimism and pessimism, or greed and fear, in an endless tug of war, and largely in an information vacuum. Investors chase momentum by jumping on passing bandwagons, hence demand for financial assets increases when prices are rising and falls when prices are falling, in classic positive feedback loops.

We have just lived through a period of several months when greed and complacency were in the ascendancy, but that trend is about to reverse in my opinion. Looking at markets as constructs of human herding behaviour allows them to be probabilistically predictable, permitting the forecasting of trend changes. For anyone who is interested in pursuing this idea further, I suggest looking into Bob Prechter’s socionomics – a fascinating subject which delves into the many effects of changes in collective mood.

For instance, as pessimism deepens, driving economic contraction, one would expect to see many manifestations of collective anger and mistrust. As this progresses it is likely to lead to xenophobia and a blame-game, with skillful manipulators (such as the fascist BNP leader Nick Griffin in the UK) poised to direct the anger of the herd towards their own chosen targets.

The potential for serious social fragmentation is very high when expectations have been dashed and there is not enough to go around. Having lived through a very long period of manic optimism and increasing inclusion, we in the developed world are not used to expressions of the dark side of human nature, except for entertainment purposes in popular television programmes. It will come as a considerable shock.

Nov 13, 2009 dailyreckoning predicts a Japan-like Slump that goes on for many years

So far, the US is doing almost exactly what the Japanese did…propping up zombie companies and stimulating the economy as best it can.  But if it does the same thing the Japanese did, won’t the US get the same results the Japanese got?

Here is where it gets interesting. Because the US economy is not exactly like the Japanese economy. Japan had high savings…and a positive trade balance. It could run up huge government debts and “owe it to itself.” It could finance its government debts with the savings of its own people, in other words. It never had to worry about foreigners refusing to buy its bonds…or selling them suddenly.

America’s government debt is different. The US doesn’t save enough to finance its own deficits. So it depends on the kindness of strangers. And if those strangers ever lose faith in America’s ability or willingness to repay its debts, they’ll drop the dollar like an annoying girlfriend. And when they do, the whole global monetary system will come crashing down.

But suppose savings rates go up in America – to, say, 10% of GDP, like they were before the bubble years. That would make $1.4 trillion of savings available to finance the feds’ deficits. And suppose the slump continues…as we think it will, with another big scare in the investment markets. People will seek safety in…yes, you guessed it…US bonds. This will take the pressure off the dollar and permit the US to finance its countercyclical spending without depending heavily on foreigners. The recession/depression will be annoying…but not insufferable. And Bernanke will figure het has more to lose by undermining the dollar than to gain from it. In that case, the Japan- like slump could go on for many years – just as it has in Japan!

Nov 11, 2009 Bubbles, Inflation and Overcapacity

here’s the dynamic which enabled low interest rates and low inflation even as credit exploded and bubbles rose in one asset class after another.

1. Massive expansion of credit was paralleled by a massive expansion of industrial capacity in China and indeed the entire world.

2. This expansion of capacity was matched by an expansion of supply in commodities. As the industrialization of China (one of the so-called BRIC nations–China, Russia, India and Brazil) and other developing nations drove demand for commodities, the incentives to exploit new sources drove up supply of almost everything: oil, iron ore, coffee, etc.

3. While prices have fluctuated in an upward bias, at no time did the cost of commodities rise to levels which threatened global growth except for the oil spike in 2008. Adjusted for inflation, oil is well within historical boundaries even at $80/barrel.

4. To feed the giant credit-dependent machine they’d fostered, central banks kept lowering interest rates and increasing liquidity/money supply. This drove the returns on savings and bonds down to absurdly low levels, forcing money managers to chase riskier assets to make a decent return on investments.

5. This need to earn higher returns drove vast floods of money into assets, inflating one bubble after another.

6. Though consumption also skyrocketed, the vast expansion of industrial capacity and commodity supplies actually outpaced rising consumption, keeping supply and demand more or less in balance and prices relatively stable.

In essence, the hot money was forced to chase assets for higher returns while China’s capacity to make goods matched and then exceeded global demand for goods.

The only way credit can drive inflation is if the supply of desired goods is limited. Many of us foresee a time when oil will be that commodity which is no longer able to match demand, but for now, the rise of production in Russia, Africa and elsewhere has kept pace with (now slackening) demand. Indeed, we might well see demand fall enough as the global recession takes hold that oil will fall to $30/barrel.

China’s capacity to produce goods now exceeds global demand. Add in the rest of the world’s enormous overcapacity and you get deflation, not inflation. In one industry after another, massive overcapacity is the stark reality. For example, the world can manufacture twice as many vehicles as there are customers for those vehicles.

The two key exceptions are grain and oil. If grain supply doesn’t match demand, and reserves have been drawn down, then prices could rise suddenly.

At some point oil supply will fall below demand, but when that point will occur is unknown.

Until either or both grain and oil fall into scarcity, then inflation in goods and services has no foundation. As long as interest rates remain near-zero, then the pressure to borrow money and chase asset prices higher remains in force.

No trend lasts forever. At some point interest rates will rise, risky assets will fall from favor and global scarcity in key resources will arise.

How long can the central banks inflate the exponentially-expanding credit bubble? No one knows, but we can say the end-point will arrive when no one wants to borrow more money even at zero interest rates.


Taipan Daily: Gold Stocks – Poised for an Epic Bull Run?
by Justice Litle, Editorial Director, Taipan Publishing Group

Major factors are pointing very much in a deflationary (falling price) direction:

* falling wages
* falling revenues
* brutal cost cuts
* imploding state budgets
* contracting credit lines
* rising unemployment
* rising credit defaults
* rising construction loan defaults
* rising government debt issuance
* rising consumer savings (long-term trend)

Hard assets aside, such factors are powerful bad juju when it comes to deflationary risks. If a “double dip” recession indeed takes hold – a possibility more likely than not in your humble editor’s estimation – the result could be a classic equity implosion, of the sort to send equities back to the general vicinity of the March 2009 lows (if not guaranteeing an actual test).

The grizzliest of deflationary bears argue loudly that the U.S. Federal Reserve (and various central bank counterparts around the globe) are helpless in the face of such headwinds, doomed to the prospect of “pushing on a string” – that is to say, flooding the economy with liquidity to no avail.

The classic liquidity trap is one in which all the excess liquidity created simply pools unused in bank vaults… like water in underground reservoirs that never gets distributed to an economy in drought.


Nov 2009 Forget Inflation, Deflation Is a Bigger Danger  Mortimer Zuckerman

October 30 2009: An interview with Stoneleigh – The case for deflation



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