[LateGreatPlanetEarth]

any ideas? seems a viable outcome. Wed, Aug 8, 2007 Read the Jul 2007 Sitka Pacific letter to clients.

Fleckstein (and others) State the Deflation Case I was surprised to see Bill Fleckstein, a long time believer in inflation, state the case for a Japanese style deflation in the US. But it's right here in America follows Japan's misguided path.

....Given all our problems related to debt, I thought it might be worthwhile, particularly for new readers, to provide a brief history leading up to where we are now.

Taking a big step back, the Bank of Japan acted foolishly throughout the 1980s, which caused that country to experience enormous real-estate and stock bubbles. Japan's stock bubble was really a residue of its real-estate bubble -- actually a credit bubble, as the banks lent money to any corporation with a pulse. (Does that sound familiar?) Then the institutions that lent the money took forever to write off the bad loans. That's why Japan's real-estate market, stock market and economy did so poorly for more than a decade.

Free money exacts a price: After [the dotcom] bubble, Greenspan took a page out of the Bank of Japan's book and lowered rates to 1%. That helped precipitate the housing bubble here that ended in 2005. As to why the unwinding has taken so long to commence, only recently has the cause become clear: the mark-to-model fantasy employed by those who have bought the sliced-and-diced mortgage paper.

But the fantasy is unraveling as these structured-credit products are now slowly being marked to market. Just as virtually every subprime-mortgage lender has blown up, Alt-A lenders (the next rung up the ladder creditwise) will blow up -- and, ultimately, many hedge funds will blow up, though we're in the early days of that process.

In the years since our equity bubble peaked, trillions of dollars' worth of debt have piled up throughout corporate America. So now, as we enter recession, we will experience not just a weak economy, real-estate market and stock market, but the exacerbating effect of a mountain of bad debt, completing the analogy to Japan of the 1990s.
Like it or not (and I suspect he might not because he did not use the D-Word itself) Fleckstein described how and why a Japanese style deflation is headed for the US. Economist Paul Kasriel at the Northern Trust also describes how a Japanese style deflation can occur in the US. Please read Interview with Paul Kasriel if you have not yet done so.

The D-Word: Two of my favorite professors on Minyanville are not afraid to use the D-Word (deflation). Point #1 in Kevin Depew's daily dose of Five Things was FOMC Preview: Their Greatest Fear.

..... Stocks may still be up but as Professor Bennet Sedacca noted on the Minyanville Buzz and Banter this morning, financials rallied huge yesterday, but what about corporate spreads, the true barometer of the health of the financial industry? "Believe it or not, spreads on brokerage and bank corporates are actually wider than yesterday morning," Sedacca said. That means someone has it wrong. Either equity investors haven't woken up to credit market problems, or credit markets are overestimating the risk of owning corporate debt. "My guess is the credit market has it right," he said.

This explains in part why it feels so treacherous right now. If the markets have decided that too much credit is too easily available, as it appears they already have, then the Fed can simply lower rates to make credit more available. Problem solved. But what if there are two separate but related forces at work: tightening lending standards and reduced credit appetites? Then the Fed has something more serious on their hands.

The key in all of this is not inflation, as most believe. The Fed says they are most worried about inflation risks, but the reality is that they are most worried about deflation risks. Always. Always deflation. The Fed has no choice but to always remind us that the risks are tilted toward inflation, just as the Treasury Secretary, whichever one happens to be in office at the time, must always say that the U.S. maintains a strong dollar policy, even if monetary policy and fiscal policy are conspiring to devalue the dollar.

As for equities, when the dollar begins to rise, and it appears the Fed finally will begin to cut rates, as they inevitably must to try and sustain credit consumption, then it's time to worry. That means deflation is winning.

The Fed is Keeping the Top Spinning: One of the best articles I've on the subject of deflation was Mr. Practical's (Professor John Succo's) article today on Minyanville: The Fed is Keeping the Top Spinning. The "strong U.S. economy" has been pushed and pushed along by 25 years of hyper credit expansion fostered by the Federal Reserve. When witnessing the tumultuous results of just a slowing down of the credit expansion, one can only imagine the problems that will surface once credit begins to contract in earnest.

And here lies the crux of the matter: what the Fed has done over the last 25 years is artificially decrease the relative value of real money in the U.S. system while increasing the relative value of debt. It has done so with no concern for the level of income generated to pay that debt back. The Fed through their hyper expansionary credit policy and Wall Street through financial engineering have loaded the system with debt not supported by a commensurate level of future (present) income.

But the Fed has been able to accomplish what it has only because investors, for the above reasons, have lost sight of this hidden risk. The Fed doesn’t really have the power to create more and more of this artificial liquidity called debt; they need investors to cooperate. Here is why. The Fed really only can do two things (Prof. Succo has explained this situation, but let's go over it again). [Mish comment: Prof. Succo's previous explanation follows these excerpts]. They can lower margin requirements for banks, the amount of capital they have to hold to make loans. That it has already driven to basically zero. So the Fed cannot allow banks any more “leeway” than it already has.

They can also perform open market money operations like REPOS and coupon passes. The Fed calls up big banks and buys their government bonds out of their portfolio. But they don’t buy them with real money; they buy them with credit newly created just for that purpose. The big bank can then lend that credit out in a much greater amount because the Fed only requires them to keep a small fraction of that credit to support whatever the bank wants to lend out. This is our wonderful fractional reserve system. If everyone went to the bank to get their “savings” at once they would find that they could get out less than 1%.

But here is the key. The bank must ultimately be willing to lend it and then find some investor to borrow it. This has been no problem whatsoever over the last several years. Now most investors realize that they have too much debt, that their level of income cannot support it. Banks realize this too and have increased their lending requirements. The last borrower is always the most aggressive speculator.

So most market participants are now looking for ways to pay back debt (deflation) just when the Fed is desperate to get investors to borrow more (inflation). The top is only beginning to wobble. When people tell me “there is so much money out there” I tell them that no, there is so much credit out there. This will be a muli-year process of debt reduction and deflation to correct what the Fed has wrought.
Best regards,
Mr. Practical

Those are small snips from a great article. I recommend clicking on the link above and reading the entire piece.

Money vs. Debt:As noted earlier here is Minyanville professor John Succo on Money vs. Debt.

Mini-Minyan Mailbag Minyan MC to Professor Succo:
I was given these general statistics on U.S. circulation of dollars, and I was wondering if they were somewhat accurate?
$2 trln was put in circulation from 1776 through 1990
$2 trln more was added and was put in circulation from 1991 through 2000 (for a total of $4 trln)
$2 trln more was added and was put in circulation from 2001 through 2003 (for a total of $6 trln)
$2 trln more was added and was put in circulation from 2004 through 2005 (for a total of $8 trln)
$2.8 trln more was added and was put in circulation from 2006 through 1st half 2007 (for a total of $10.8+- trln)

So, essentially, in the last six and a half years, circulation of U.S. Dollars has increased by 170% (10.8 minus 4.0 = 6.8 trln dollars added to the system). And what do people say about free money? What do you think?

Professor Succo to Minyan MC:
Minyan MC, Yes, but it is not really “money”. The stats you quote are “debt”. There is no “money” any more. The actual money used to be backed by gold. Actual money stock is 0.001% of what people call the money supply. The money supply is really the debt supply.

Thanks to Mr. Practical, Kevin Depew, Paul Kasriel, and John Succo for helping explain how a Japanese style deflation could hit the US. The key point is deflation is caused by a massive increase in credit/debt not supported by a commensurate level of income. In simple terms, there is no way to ever pay back what has been borrowed. It's also critical to understand the distinction between a hyperexpansion of credit and a hyperinflationary printing of money. The former is what caused the Great Depression (and is happening again now), while the latter happened in the Weimar republic and is happening right now in Zimbabwe .
Mike Shedlock / Mish http://globaleconomicanalysis.blogspot.com/

Posted by Michael Shedlock at 12:35 AM Fleckstein (and others) State the Deflation Case

[Iaato]

Here's my WAG as to what is going to happen. A lot more than you asked for, but I think a lot of people are not really getting that this is not business as usual. The last deflation in this country was almost 70 years ago.

Currently we have somewhere between 10-14% inflation. That monetary inflation in things we NEED to buy will continue because of peak oil. At the same time asset and credit deflation will continue to pick up steam. The fed will bump the fed rate down in September, which will trigger a lively dead cat bounce in the stock market and a crash of the dollar. By the end of this year, the stock market will be in the dumpster, we'll be developing a real depression, and the Fed will be machinating reinflation of the dollar. The crash of the stock market will cause asset deflation in almost all categories because people will be forced to sell. One exception perhaps is physical gold, which could may hold its value depending on change in public sentiment. People are already getting panicky.

So in the short term, think of diversifying. Get out of all stocks and other assets and into cash to buffer against deflation (cash is king). If you haven't sold your stocks by now, wait for the dead cat bounce in September after they cut the fed fund rate. Make sure that the cash is distributed in several banks per FDIC rules, and if it's in MMF, that it's in treasuries only, and not in any commercial paper or asset-backed securities (read mortgages). If you use a brokerage, evaluate what it keeps its sweep funds in--Etrade is apparently already having some difficulty there already. Look for the most ethical and conservative brokerage you can find. Check your bank for its bank quality rating, and move your money if necessary (the street.com had a nice article on highly rated banks). Banks that are giving really good rates on CDs may be the banks with the most risky behaviors (witness Countrywide). This is not the time to evaluate banks based on how many ATMS they have or whether you can squeak an extra couple of basis points out of your CD. It also may not be the time to bank online where the bank is 2000 miles away. And keep some money stashed away where it's accessible just in case. Think about what you would do if the bank did fail and you had to wait a year or more to get your FDIC insured CD paid back to you. Read the fine print and make sure that there is not some clause about being able to extend the payback time in a crisis. And consider what might happen to the value of that money in a year's time during a period of hyperinflation.

My guess is that reinflation of this mess will be impossible without changing all the rules--it's just too big of a scale. But changing the rules has never been a problem for the US administration (521 days and counting). So you will see all kinds of major machinations to change the rules to allow reflation, perhaps as soon as this fall or winter. This would be the stage to rebuy gold and oil stocks, as the next step by default will indeed by hyperinflation as the last attempt to fix the problem.

[OilIsMastery]

We have witnessed rapid deflation in both home equity (over the past year) and equities in general (over the last month).

However this will not effect the supply demand equation as far as oil is concerned.

Oil is going up. But I would be careful to assume that all oil stocks are going up. Not all oil stocks are created equal.

For example the supermajors are going to be losers because they are being cut out by governments.

However the companies with the technology namely oil services and rigs (especially deep sea drillers) will benefit. They can tax the governments and the supermajors.

Another beneficiary is the Canadian oil sands companies like Syncrude and Suncor.

Schlumberger (SLB)
Halliburton (HAL)
Transocean (RIG)
Suncor (SU)

[LateGreatPlanetEarth]

good call on lower of the interest rates.
================================
a tremendous quantity of ng will be used to process the tar sands of western canada. but i wonder if the business slowdown will offset that demand.

[Plantagenet]

Gold, oil, and other commodities have been going up in price, not down.

Its bizarre to suggest that oil prices will now start to deflate, when demand for oil is outstripping supply around the world.

[threadbear]

Asset deflation. That includes stocks, housing, big ticket items. Day to day purchases should go up, as the dollar weakens. So you have inflation and deflation simultaneously. So what you could have is a house dropping 20%, in nominal terms and even more, percentage wise, when factoring in the depreciation in the currency. Very bad news.

Gold and precious metals are a wild card. Probably great long term, like by the end of the decade. Steve Moyers on Market Oracle has interesting things to say about asset deflation.

[Plantagenet]

When does the deflation start?

U.S. housing sales had the worst decline in 20 years, but average house prices still went up in 2006.

"Double-digit price gains that sparked a frenzy of condo flipping and speculative building also came to an abrupt halt last year. The median price of an existing home rose just 1.1 percent last year — less than inflation — compared with 12.4 percent in 2005.

[threadbear]

$this->bbcode_second_pass_quote('Plantagenet', 'W')hen does the deflation start?

U.S. housing sales had the worst decline in 20 years, but average house prices still went up in 2006.

"Double-digit price gains that sparked a frenzy of condo flipping and speculative building also came to an abrupt halt last year. The median price of an existing home rose just 1.1 percent last year — less than inflation — compared with 12.4 percent in 2005.

[Iaato]

$this->bbcode_second_pass_quote('Plantagenet', 'W')hen does the deflation start?

[mattduke]

$this->bbcode_second_pass_quote('LateGreatPlanetEarth', 'B')ut here is the key. The bank must ultimately be willing to lend it and then find some investor to borrow it.

[threadbear]

$this->bbcode_second_pass_quote('mattduke', '')$this->bbcode_second_pass_quote('LateGreatPlanetEarth', 'B')ut here is the key. The bank must ultimately be willing to lend it and then find some investor to borrow it.

[evilgenius]

Exactly as the title states, who thinks that the loss of so much money from the financial system will create deflation? I know that the mainstream on this site thinks that the response by central banks around the world will be to hyperinflate, but what if they don't or can't? What if attempting to hyperinflate can't overcome the loss of so much tangible and semi-tangible money? What say you?

[halcyon]

Based on my heuristic reading of blogs and very unscientific sampling, I'd guess:

1. Deflation of majority of investment assets (esp. US, but also parts of EU)
2. high-moderate inflation of consumables and main consumer goods (within US/EU) - ie. no hyperinflation
3. Continued loss of value of USD compared to Euro and Yen
4. Reduction in M3 money supply (US at least)
5. Economic (productivity) growth declines faster than just a soft/short landing (in the US)

Is this all possible at the same time? My macroeconomic understanding says: not enough data to compute.

[MacG]

I think hyperinflation is the very last stage of a state collapse, and the various actors in the system will do just about anything to avoid it. They would rather accept 50% unemployment than hyperinflation. It's not until they can't control the "social unrest" using their old tricks of fraud and force that they resort to hyperinflation.

50% unemployment, deflation and a confused public won't affect life very much for those who HAVE that precious money. Money will just become more precious.

[americandream]

Now, lets engage in thinking outside the box. Let's assume that that the economy of capital is global, that nation states are essentially a fiction, that we are confronted with a vast pool of what is in effect pliable labour and consumers...and that we have this mismatch of asset valuation, resource certainty and consumption patterns. I wonder how the economics pan out there. Any ideas?

[JPL]

$this->bbcode_second_pass_quote('americandream', 'N')ow, lets engage in thinking outside the box. Let's assume that that the economy of capital is global, that nation states are essentially a fiction, that we are confronted with a vast pool of what is in effect pliable labour and consumers...and that we have this mismatch of asset valuation, resource certainty and consumption patterns. I wonder how the economics pan out there. Any ideas?

[Chaparral]

I'd argue that deflation would slow consumption in the affected areas. The result is less money to spend in a consumer-driven economy followed by ever higher unemployment. It could turn into a nasty autocatalytic event. Already I'm seeing less traffic on the roads here in LA and of the vehicles that are on the road, more are small sedans and minivans of increasingly older vintage. The big shiny new SUVs and trucks are surprisingly scarce on the roads relative to their numbers. I'm guessing this will translate into reduced oil and gas consumption, which means reduced energy prices which means a whole lot of people building ethanol plants will take a big financial hosing. That might take the wind out of corn prices which will in turn affect wheat and soybeans. As people find that their investments are tanking, and they lose their jobs, their investments in stocks, bonds, commodities might be liquidated to pay the bills.

It should also be mentioned that while commodities such as oil and grain will drop sharply, they'll do so less than things like meats and industrial metals and other absolutely non-essential items. Even if we see oil back at 50 bucks a barrel, it won't matter a whit in the face of 20 to 30% unemployment in the consuming areas. It may in the long run, buy time for all of us. I tend to agree with MacG that deflation is far far more preferable to hyperinflation. KD over at tickerforum.org has talked of this at length.

WRT americandream's thoughts, we know that certain real estate and equities and shiny trinkets are hideously overvalued relative to their use in an energy impoverished world. As the cost of labor decreases relative to the cost of fossil fueded machinery, we'll see desperate people migrate to careers in fruit picking instead of selling real estate and luxury cars. As the cost of essentials stays high relative to purchasing power, people might start market gardens and small agriculture businesses enmasse. Areas with abundant water and decent climate and soils will be the new hot real estate markets. Los Angeles and Miami and Manhattan will tank while rural areas of say, Missouri, Ohio, Michigan, Pennsylvania that are served by rail will see increases in market value. It'll be a wholesale shift of capital and population. Just as these areas emptied out on the basis of cheap energy, they may fill back up on the basis of energy poverty. Investors with few liabilities and deep pockets might try and front-run this trend when it looks as if deflation is at its deepest. Those who lost their capital will have their labor, and they will be legion.

Ecological factors like climate change and overpopulation might make a purely economics driven transition impossible though and therein lies my reason for doomerism.

[Iaato]

$this->bbcode_second_pass_quote('halcyon', '1'). Deflation of majority of investment assets (esp. US, but also parts of EU)
2. high-moderate inflation of consumables and main consumer goods (within US/EU) - ie. no hyperinflation
3. Continued loss of value of USD compared to Euro and Yen
4. Reduction in M3 money supply (US at least)
5. Economic (productivity) growth declines faster than just a soft/short landing (in the US)

[firestarter]

According to Karl Denninger:
$this->bbcode_second_pass_quote('', 'H')elicopter Ben? Bah. This weekend's entry is a focus on "hyperinflation" .vs. "deflation" as the possible paths forward for The United States.....
....So let's assume that the bankers lend you $300,000 to buy a house. You buy a house, but can't make the payments. This is a microcosm of what's going on right now. The bankers have a choice - they can force foreclosure, in which case they own a house, or they can force hyperinflation, in which case you can pay them. Those are, in fact, the two options, although of course those are endpoints and "something in the middle" can happen too.

Which of the two would you, as a banker, prefer? When you made the loan that $300,000 was, roughly, the equivalent of a small yacht, or a (very) fancy car. In a deflationary environment the banker gets as much of your money as he can, and then he also gets the house! You lose big, but does he lose? Well, not really. He started with an asset (money) that was roughly the utility value of the home, and he ended up with the home itself, which has the same utility value. Further, the money he gets before you default goes up in value, as premium comes out of hard assets.

That is, he might have not only the house, but enough money to buy a yacht as well (at a distressed sale.) The banker makes money in terms of real value in a deflationary environment. You, on the other hand, being debt, get rammed.

Ok, now let's look at hyperinflation. Let's say that the government prints up $300,000 and sends it to everyone in the country. Hurray! You can pay off your mortgage, and you do so. But what happens to the banker? He gets reamed in both holes. Yes, he has his $300,000 back, but what does that $300,000 buy? Oh, not very much eh? Go look at Zimbabwe, Argentina, or any other place where hyperinflation takes hold. The banker gets stiffed in a big way (as does anyone else who's business it is to move and hold money) because what once bought a house now only buys half a house, or less.

Those who argue that Bernanke will "hyperinflate" have a tiny little problem with their thesis. That thesis depends on Bernanke and the rest of the banks (who are, in fact, his masters as well as his servants) acting in a fashion that is explicitly against their own self-interest. Oh, and by the way, they know this.

See, banks normally want a small amount of inflation. Just enough to make it not worth it for you to hoard cash, as it slowly devalues. This forces you to spend and invest, lest you see your purchasing power disappear. But what a bank never wants to see is an inflation rate that is above their lending "spread", or the difference between their cost of funds and what they charge. If that ever happens then they lose big; remember, all banks are leveraged and as such small "percentage" base losses get multiplied by their leverage ratio!

So exactly what is all this "poppycock talk" about helicopters and such? Quite simple, really. You start talking about deflation and people freak out. You want to be Fed Chairman? You don't dare say that you'd respond to a credit crisis by allowing deflation to take place. Never mind that it would help you and your buddies - it positively reams everyone who is in debt, and that's 80% of the population, plus the government itself!

So no, you put on a happy face. But would you really, if push comes to shove, choose to hyperinflate? Oh hell no. Look at what people do folks, not what they say. Especially when dealing with public officials. Every one of those folks is in their office because they're good liars.

[DantesPeak]

There are so many holes I don't know where to start, but one main thought to keep in mind is that the US will directly or indirectly be paying for most of the losses.

That is the example of a bank wanting to foreclose on a greatly depreciated amd incur substantial leagl costs is ridiculous. It will the government bailing out those banks through the FDIC or F & F bailout plan.

Would the government rather increase taxes to pay for the $3 trillion in potential mortgage related losses or inflate to reduce housing losses and not increase taxes?