So Fellas, Do We Have Deflation?

→ Washington’s Blog.

As Absolute Return Partners wrote in its July newsletter:

The
most important investment decision you will have to make this year and
possibly for years to come is whether to structure your portfolio for
deflation or inflation.

So which is it, inflation or deflation?

This
is obviously a hot topic of debate, and experts weigh in on both sides.
I’ve analyzed this issue in numerous previous posts (and try to make
argue the case for inflation here), and every day there are new arguments one way or the other from some very smart people.

But deflation seems to be winning.

Who Says?

Nobel prize winning economist Joseph Stiglitz says:

Deflation is definitely a threat right now.

Alan Greenspan said on September 30th:

We are still, by any measure, in a disinflationary environment.

And the President of the Chicago Federal Reserve Bank, Charles Evans, said on September 9th:

Disinflationary winds are blowing with gale-force effect.

How Bad Could It Get?

The biggest deflation bears are rather pessimistic:

• Former chief Merrill Lynch economist David Rosenberg says that deflationary periods can last years before inflation kicks in

• Renowned economist Dr. Lacy Hunt says that we may have 15-20 years of deflation

• PhD economist Steve Keen says that – unless we reduce our debt – we could have a “never-ending depression”

These
are the most pessimistic views I have run across. Most deflationists
think that a deflationary period would last for a shorter period of
time.

The Best Recent Arguments for Deflation

Following are some of the best arguments for deflation.

Unemployment

Wall Street Journal’s Scott Patterson writes that we won’t get inflation until unemployment is down below 5%:

A rule of thumb is that inflation doesn’t become sticky until the unemployment rate dips below 5%…

“I
see very little prospect of accelerating inflation” partly because of
the employment outlook, said Mark Zandi, chief economist of Moody’s
Economy.com. “I don’t think the risk shifts toward inflation until
2011, or even 2012.”

It could take a lot longer for unemployment to go back down to 5% (and for consumers to have more money to spend again).

Job losses are accelerating.

JPMorgan Chase’s Chief Economist Bruce Kasman told Bloomberg:

[We've had a] permanent destruction of hundreds of thousands of jobs in industries from housing to finance.

A new report from Advance Realty and Rutgers - America’s New Post-Recession Employment Arithmetic - argues that we will not have a full recovery in unemployment until until 2017, and that:

• The Great 2007–2009 recession is the worst employment setback in the United States since the Great Depression.

•
In the twenty months from December 2007 (the start of the recession) to
August 2009 (the last month of available data as of this analysis), the
nation lost more than 7.0 million private-sector jobs.

• The
recession followed a very much-below-normal economic expansion
(November 2001–December 2007) that was characterized by relatively weak
private-sector employment growth of approximately 1 million jobs per
year.

• This was less than one-half of the job-growth gains of
the two preceding expansions (1982–1990 and 1991–2001), when average
annual private-sector employment grew by 2.4 million jobs per year and
2.2 million jobs per year, respectively.

• In the preceding two
expansions combined, private-sector employment growth per year was
approximately 435,000 jobs higher than the annual growth in the number
of people in the labor force.employment deficit.

• The weak economic expansion sandwiched between two recessions (2001, and 2007–2009) produced a lost employment decade.

•
As of August 2009, the nation had 1.3 million (1,256,000) fewer
private- sector jobs than in December 1999. This is the first time
since the Great Depression of the 1930s that America will have an
absolute loss of jobs over the course of a decade.

• From
1980-2000, the US gained a 35.5 million private-sector jobs. During the
current decade, America has lost more than 1.7 million private-sector
jobs.

• Total “employment deficit” could approach 9.4 million private-sector jobs by December 2009.

New jobs aren't being created.

Even Larry Summers says unemployment will remain 'unacceptably high' for years.

The New York Times points out that U.S. job seekers exceed openings by record ratio.

2 out of 5 Californians out of work.

Almost half of 16-24 year olds are unemployed.

(Note:
hyperinflation is obviously an entirely different animal. For example,
there was rampant unemployment in the Weimar Republic during its bout with hyperinflation ).

Debt Overhang and Deleveraging

Steve Keen argues
that the government’s attempts to increase lending won’t work,
consumers will keep on deleveraging from their debt, and that – unless
debt is slashed – the massive debt overhang will keep us in a
deflationary environment for a long time.

Edward Harrison notes:

Nomura’s
Chief Economist Richard Koo wrote a book last year called "The Holy
Grail of Macroeconomics" which introduced the concept of a balance
sheet recession, which explains economic behaviour in the United States
during the Great Depression and Japan during its Lost Decade. He
explains the factor connecting those two episodes was a consistent
desire of economic agents (in this case, businesses) to reduce debt
even in the face of massive monetary accommodation.

When debt
levels are enormous, as they are right now in the United States, an
economic downturn becomes existential for a great many forcing people
to reduce debt. Recession lowers asset prices (think houses and shares) while
the debt used to buy those assets remains. Because the debt levels are
so high, suddenly everyone is over-indebted. Many are technically
insolvent, their assets now worth less than their debts. And the three
D’s come into play: a downturn leads to debt deflation, deleveraging,
and ultimately depression. The D-Process is what truly separates
depression from recession ...

See a presentation by Koo here.

Leading investment advisor Ray Dalio says the same thing.

So does Albert Edwards, who argues
that - even as the government tries to inflate its way out of all its
problems and printing trillion in new treasuries - it is unable to
catch up with the non-governmental balance sheet collapse:

The
US Federal Reserve recently published their comprehensive flow of funds
data for the US. This showed that the household sector continued to pay
down debt for the fourth consecutive quarter. Corporates also started
to pay down debt sharply in Q2 at a similar $200bn pace. The
non-financial private sector paid down debt at a $435bn pace in Q2.
This compares to a $2,116bn pace of expansion in 2007 (see chart
below). Add to that the financial sector unwind and the total private
sector is unwinding debt faster than the government is able to pile it
up (hence the red line is still negative)! The lesson from the balance
sheet recession in Japan is that the massive private sector headwind to
growth has a long, long way to run.

If
that is the case, we can expect, just like Japan, frequent relapses
back into recession. The market now understands how an end of inventory
de-stocking can boost GDP, i.e. it is the change in the change that
matters. Similarly as Dylan Grice points out - link,
it is the change in the fiscal deficit that is a net stimulus or drag
to GDP. A massive 6pp stimulus last year is likely to turn into a 2pp
drag on growth next year (see chart below). With continued
private sector de-leveraging likely next year and beyond, how can one
seriously not expect the global economy to relapse back into recession
next year taking nominal GDP deep into an abyss?

Mish writes:

An over-leveraged economy is one prone to deflation and stagnant growth. This is evident in the path the Japanese took after their stock and real estate bubbles began to implode in 1989.

Leverage is increasing again, according to an article in Bloomberg:

Banks
are increasing lending to buyers of high-yield company loans and
mortgage bonds at what may be the fastest pace since the credit-market
debacle began in 2007…

“I am surprised by how quickly the market
has become receptive to leverage again,” said Bob Franz, the co-head of
syndicated loans in New York at Credit Suisse…

Indeed,
as I have repeatedly pointed out, Bernanke, Geithner, Summers and the
chorus of mainstream economists have all acted as enablers for
increasing leverage.

Mish continues:

Creative
destruction in conjunction with global wage arbitrage, changing
demographics, downsizing boomers fearing retirement, changing social
attitudes towards debt in every economic age group, and massive debt
leverage is an extremely powerful set of forces.

Bear in mind,
that set of forces will not play out over days, weeks, or months. A
Schumpeterian Depression will take years, perhaps even decades to play
out.

Thus, deflation is an ongoing process, not a point in time
event that can be staved off by massive interventions and Orwellian
Proclamations “We Saved The World”.

Bernanke and the Fed do not
understand these concepts, nor does anyone else chanting that pending
hyperinflation or massive inflation is coming right around the corner,
nor do those who think new stock market is off to new highs. In other
words, almost everyone is oblivious to the true state of affairs.

Flattening Yield Curve Points Toward Deflation

PIMCO's Bill Gross said:

There
has been significant flattening on the long end of the curve,” Gross
said in an interview from Newport Beach, California, with Bloomberg
Radio. “This reflects the re- emergence of deflationary fears. The U.S.
is at the center of de-levering as opposed to accelerating growth.

David Rosenberg, Tyler Durden and Mish also believe that a flattening yield curve indicates deflation.

Bloomberg notes:

The
difference in yield between nominal and inflation-protected Treasury
securities maturing in one year is negative 0.4 percent, suggesting
investors expect deflation during the next 12 months.

Pension Crisis

Pension expert Leo Kolivakis writes:

The global pension crisis is highly deflationary and yet very few commentators are discussing this.

Collapse of the Shadow Banking System

Hoisington’s Second Quarter 2009 Outlook states:

One
of the more common beliefs about the operation of the U.S. economy is
that a massive increase in the Fed’s balance sheet will automatically
lead to a quick and substantial rise in inflation. [However] An
inflationary surge of this type must work either through the banking
system or through non-bank institutions that act like banks which are
often called “shadow banks”. The process toward inflation in both cases
is a necessary increasing cycle of borrowing and lending. As of today,
that private market mechanism has been acting as a brake on the normal
functioning of the monetary engine.

For example, total
commercial bank loans have declined over the past 1, 3, 6, and 9 month
intervals. Also, recent readings on bank credit plus commercial paper
have registered record rates of decline. The FDIC has closed a record
52 banks thus far this year, and numerous other banks are on life
support. The “shadow banks” are in even worse shape. Over 300 mortgage
entities have failed, and Fannie Mae and Freddie Mac are in federal
receivership. Foreclosures and delinquencies on mortgages are
continuing to rise, indicating that the banks and their non-bank
competitors face additional pressures to re-trench, not expand. Thus
far in this unusual business cycle, excessive debt and falling asset
prices have conspired to render the best efforts of the Fed impotent.

Ellen Brown argues
that the break down in the securitized loan markets (especially CDOs)
within the shadow banking system dwarfed other types of lending, and
argues that the collapse of the securitized loan market means that
deflation will – with certainty – continue to trump inflation unless
conditions radically change.

Support for Brown’s argument comes from several sources.

As the Washington Times notes:

“Congress’
demand that banks fill in for collapsed securities markets poses a
dilemma for the banks, not only because most do not have the capacity
to ramp up to such large-scale lending quickly. The securitized
loan markets provided an essential part of the machinery that enabled
banks to lend in the first place. By selling most of their portfolios
of mortgages, business and consumer loans to investors, banks in the
past freed up money to make new loans. . . .“The market for pooled
subprime loans, known as collateralized debt obligations (CDOs),
collapsed at the end of 2007 and, by most accounts, will never come back.
Because of the surging defaults on subprime and other exotic mortgages,
investors have shied away from buying the loans, forcing banks and Wall
Street firms to hold them on their books and take the losses.”

Senior economic adviser for UBS Investment Bank, George Magnus, confirms:

The restoration of normal credit creation should not be expected, until the economy has adjusted to the disappearance of shadow bank credit,
and until banks have created the capacity to resume lending to
creditworthy borrowers. This is still about capital adequacy, where
better signs of organic capital creation are welcome. More importantly
now though, it is about poor asset quality, especially as defaults and
loan losses rise into 2010 from already elevated levels.

And McClatchy writes:

The
foundation of U.S. credit expansion for the past 20 years is in ruin.
Since the 1980s, banks haven’t kept loans on their balance sheets;
instead, they sold them into a secondary market, where they were pooled
for sale to investors as securities. The process, called
securitization, fueled a rapid expansion of credit to consumers and
businesses. By passing their loans on to investors, banks were freed to
lend more.

Today, securitization is all but dead. Investors have
little appetite for risky securities. Few buyers want a security based
on pools of mortgages, car loans, student loans and the like.

“The
basis of revival of the system along the line of what previously
existed doesn’t exist. The foundation that was supposed to be there for
the revival (of the economy) . . . got washed away,” [economist James
K.] Galbraith said.

Unless and until securitization rebounds, it
will be hard for banks to resume robust lending because they’re stuck
with loans on their books.

Credit Still Constrained

US credit has shrunk at Great Depression rate prompting fears of double-dip recession:

Professor
Tim Congdon from International Monetary Research said US bank loans
have fallen at an annual pace of almost 14pc in the three months to
August (from $7,147bn to $6,886bn).

"There has been nothing like this in the USA since the 1930s," he said. "The rapid destruction of money balances is madness."

The M3 "broad" money supply, watched as an early warning signal for the
economy a year or so later, has been falling at a 5pc annual rate.

Similar concerns have been raised by David Rosenberg, chief strategist
at Gluskin Sheff, who said that over the four weeks up to August 24,
bank credit shrank at an "epic" 9pc annual pace, the M2 money supply
shrank at 12.2pc and M1 shrank at 6.5pc...

US banks are cutting
lending by around 1pc a month. A similar process is occurring in the
eurozone, where private sector credit has been contracting and M3 has
been flat for almost a year.

The Independent notes:

A
second credit squeeze and a £200bn national "funding gap" threatens to
sabotage the recovery in the British economy, the IMF warned yesterday.

In its latest Global Financial Stability
Report, the fund said that a combination of a soaring government
deficit and the borrowing needs of British companies and consumers –
coupled with a still broken banking system – would leave the UK with a
national "funding gap" of 15 per cent of GDP, or around £200bn next
year, much higher than in either the US or the euro area.

Housing

Moody's forecasts
that housing won't return to pre-bust levels until 2020, "Florida and
California will only regain their pre-bust peak in the early 2030s"

Treasury says millions more foreclosures are coming.

Fannie Mae's serious delinquency rate is skyrocketing.

Half of all borrower who are getting help with loan modifications end up redefaulting.

And apartment rental prices are falling world-wide.

Business

The creation of small businesses is way down.

Experts are projecting unprecedented corporate defaults.

Ghost fleets of unused ships lie rusting in port.

States

State tax revenues have plunged 17%.

More Signs of Deflation

Bloomberg writes:

The U.S. faces the possibility of deflation for the first time since the Eisenhower administration...

Consumer
prices are experiencing deflation, with the consumer price index
sliding for six straight months from year- earlier levels, the longest
stretch of declines since a 12-month drop from September 1954 to August
1955, according to the Labor Department...

While the economy
contracted 2.7 percent during the 1953 recession, it shrank 3.8 percent
in the current recession, the most since the 1930s. Economists at New
York-based JPMorgan Chase & Co. and Goldman Sachs Group Inc., the
second- and fifth- biggest U.S. banks by assets, say there’s so much
deflationary excess labor and plant capacity in the economy that the
Fed won’t raise interest rates until at least 2011.

Paul Krugman writes:

A
new report from the International Monetary Fund shows that the kind of
recession we’ve had, a recession caused by a financial crisis, often
leads to long-term damage to a country’s growth prospects. “The path of
output tends to be depressed substantially and persistently following
banking crises.”

The U.S. Census Bureau reports that 40 million Americans are living in poverty.

AP writes:

As
in the 1980s, much of that shift will be driven by baby boomers. For
the 78 million people born from 1946 through 1964, the Great Recession
hit at a particularly inopportune time – during peak years of earning
and saving before retirement. Boomers range from 44 to 63 today – the
youngest is nearly 10 years older than the oldest was in 1982. They are
running out of time and are most likely to remain cautious spenders and
become aggressive savers even as the economy improves.

The
housing bubble mistakenly led boomers and millions of others to believe
their home was their retirement nest egg. If they left their home
equity alone during the boom, they've taken a hit the last couple years
but are still ahead. But many treated their home like a personal bank
and spent the gains by tapping a home equity line of credit.

Alix Partners finds:

While
American industry is struggling to get through what could become the
worst recession since the Great Depression, Americans say that even
after the recession ends, their spending will return to just 86% of
pre-recession levels, which would take a trillion dollars per year out
of the U.S. economy for years to come. According to this in-depth
survey of more than 5,000 people, Americans plan to save (and therefore
not spend) an astounding 14% of their total earnings post-recession,
with the replenishment of their 401(k) and other retirement savings
leading the way among their biggest long-term concern.

As Huffington Post notes:

"There
will be a fundamental shift in the kind of cars we buy, a fundamental
shift in the homes we buy, and a fundamental shift in consumption
generally," says Matt Murray, an economist at the University of
Tennessee. "And that is not something that took place in the 1980s."

Fed Paying Interest on Reserves

And Naufal Sanaullah writes:

So if all of this printed money is being used by the Fed to purchase toxic assets, where is it going?

Excess
reserves, of course. Counting for $833 billion of the Fed’s
liabilities, the reserve balance with the fed has skyrocketed almost
9000% YoY. Excess reserves, balances not used to satisfy reserve
requirements, total $733 billion, up over 38,000%!

The
Fed pays interest on these reserves, and with an interest rate (return
on capital) comes opportunity cost. Banks hoard the capital in their
reserves, collecting a risk-free rate of return, instead of lending it
out into the economy. But what happens as more loan losses occur and
consumer spending grinds to a halt? The Fed will lower (or get rid of)
this interest on reserves.

And that is when the excess liquidity synthesized by the Fed, the printed money, comes rushing in and inflates goods prices.

Of course, most people who are arguing we will have deflation for a while believe that we might eventually get inflation at some point in the future.

Comments

[jm]

I have some thoughts about this too.  The plan appears to be controlled deflation.  If deflation is not too severe (which I honestly can't define exactly), let's say -2% CPI (?), we could keep it up as Japan did for years. 

Of course, things could go awry of the plan.  If deflation really catches on (> -2% CPI) and begins to corrode basic institutions, fiat money + Fed could lead to an extreme devaluation/currency reform.

But what then?  Any currency crisis would only amplify the deflationary effect after the event horizon, as much of the world's capital would get a crewcut.

Also, it may be hard to engineer the hyperinflation many think is coming.  Ben has to get Treasury and Legislative approval for helicopter drops, which probably wouldn't be forthcoming.  Aside from democratic opposition, there are big international risks which you understand.

The end result is that risk provisioning will mean something again.  Individuals will be responsible for their success and failure.  No more backstops, safety nets, government insurance on deposits: none of it will exist.  If you want to be affluent in retirement, be prudent and hope for a good string of luck.  People get this, as they are paying down-- and not going into more-- debt.

This is a good thing.  It is how the world invariably works.  Everything else is utopia, and we can only deny it for so long. 

[Anonymous]

"The plan appears to be controlled deflation."

Do you really think it's the plan? I think they'd do anything for a little inflation right now.

[jm]

Yeah, they'd love some inflation.  Maybe "we are satified with Japanification" is a better way of putting it. 

[SWRichmond]

Japanification is not an option, maybe someone can convince me that I'm wrong about this also:

1. Japanese had / have savings; the U.S. has ???
2. Japan could (and did) feed itself on exports to a consumer-hungry largest market on the globe; the U.S. has ???
3. Japan was not / is not borrowing money to support a global military police force / war machine amounting to 20% of government expenditures.
4. Japanese unemployment during the lost decade peaked at about 5.5%.

[jm]

Well, we have negative CPI.  Exploding Debt/GDP.  Corporates in debt reduction mode.  Consumer savings going up.  Propped up banks on life support.

Pass the wasabi.

[Anonymous]

I'm not sure you could argue either of the first two items held true in Japan from the 90's until now. Their consumer savings has always been high compared to ours, at least in the past three decades.

[mrhonkytonk1948]

Very persuasive.  Maybe I suffer from "confirmation bias", but this feels true to me. 

[arnoldsimage]

short equities, oil, gold and banksters.

[bonddude]

I agree. I have been off the near term inflation notion for sometime. Everyone thinks

inflation is right around the corner but it's not. People have to keep in mind how much so called

wealth has been destroyed. This starting to look more and more like Japan, or the great

depression.