Thursday, August 20, 2009 7 comments ++[ CLICK TO COMMENT ]++

The only serious argument against deflation...how valid is it?

Inflationists, as well as disinflationists, present many reasons for why deflation won't materialize. As far as I'm concerned, there is only one serious argument against deflation: 'the central banks of this world won't let it happen.' For a serious argument from the inflationist duo at Pacific Capital Associates, Rich Toscano and John Simon, you may want to review the article, The US Government Will Not Choose Deflation, as well as another one, US Not Going Down Japan's Road, on why they don't see USA following the path of Japan.

(Note: When I say inflationist, I am referring to someone who is attempting to profit off inflation. It does not necessarily mean someone that believes inflation is the best thing for society. Conversely, a deflationist is betting on deflation and may or may not believe deflation is benefitial for society.)

There is certainly some irony in free-market supporters who generally do not believe the government is capable, nor efficient at, manipulating the market to suit its needs in the long run, suddenly believing the government can successfully handle a massive deflationary bust. Leading the inflationist parade tend to be goldbugs who often suggest that the market is stronger than any government. Times have certainly changed when there were many of us who believed the market was stronger than any government, in the long run.

In any case, if you lean towards deflation, like I do, the question really comes down to whether the central banks can prevent it. The suggestion by inflationists has been that the central banks can print an infinite amount of money, so they can ward off any decline in prices (whether a physical good or a financial asset.) For those that argue the money multiplier is collapsing, say because the banks are just sitting on their cash hoard, the suggestion by inflationists has been that the central banks would bypass the banks and interact directly with the borrowers. For those that suggest the multiplier will stay low because borrowers don't want to borrow anymore, the suggestion by inflationists has been that the government will drop money out of helicopters (this has already happened to a minor degree with rumours of Chinese banks, which are all majority-owned, and hence controlled, by the government, handing out money to almost anyone that wants it. It wouldn't be a much of a stretch to see a Federal Reserve bank set up shop in your street corner and lending money to anyone.) So, it appears that the government can prevent deflation by printing as much money as possible and/or lending to as many people as possible. But how feasible is this in the real world?

As I remarked in a recent post, I have been reading Robert Prechter's deflation booklet, and have found it very insightful. He follows Austrian Economics so I don't agree with everything, and he bases many of his investment decisions on pure technical analysis, which I do not follow, but I do think he makes some powerful arguments. With regard to the infinite money printing argument, he makes a very persuasive argument, which is similar to my current thinking on the issue.

In essence, Prechter argues that the anti-deflation strategies suggested by many, including prominent economists such as Ben Bernanke, are nothing more than Ivory Tower concoctions. That is to say, the strategies look good on paper but are unfeasible in real life. In particular, the strategies ignore the reactions of market participants, particularly bond investors. Let me quote two full paragraphs of his argument (bolds by me):

(source: THE Guide to Understanding Deflation by Robert Prechter. Elliott Wave International. Quoted text below from section titled The Coming Change at the Fed on pages 29-30. Bolded text are by Sivaram Velauthapillai.)

When credit expands beyond an economy’s ability to pay the interest and principal, the trend toward expansion reverses, and the amount of outstanding credit contracts as debtors pay off their loans or default. The resulting drop in the credit supply is deflation. While it seems sensible to say that all the Fed need do is to create more money, i.e. FRNs, to “combat deflation,” it is sensible only in a world in which a vacuum replaces the actual forces that any such policy would encounter. If investors worldwide were to become informed, or even suspicious, that the Fed would follow the ’copter course, it would divest itself of dollar-denominated debt assets, causing a collapse in the value of dollar-denominated bonds, notes and bills. This collapse would be deflation. It would be a collapse in the dollar value of the outstanding credit supply.

Contrary to popular belief, neither the government nor the Fed would wish such a thing to happen. The U.S. government does not want its bonds to attain (official) junk status, because its borrowing power is one of the only two powers over money that it has, the first being taxation. The Fed would commit suicide by hyper-inflating, because Federal government bonds are the reserves of the Fed. That’s why it is called “the Federal Reserve System.” U.S. bonds are the source of its power. As long as the process of credit expansion is done slowly, as it has been since 1933, people can adjust their thinking to accommodate the expansion without panicking. But by flooding the market with FRNs, the Fed would cause a panic among bond-holders, and their selling would depress the value of the Fed’s own reserves. The ivory-tower theory of unlimited cash creation to combat a credit implosion would meet cold, harsh reality, and reality would win; deflation would win. Von Mises was exactly right: “There is no means of avoiding the final collapse of a boom brought about by credit expansion.” Observe that he said “no means.” He did not say, “No means other than helicopters.”


I'm not an AustEcon follower so I have no idea if Ludwig Von Mises is right in saying that all credit expansions must necessarily collapse. But I do think Prechter is right in observing human behaviour—in this case the behaviour of market participants to money printing.

I just don't see how the US government would pursue some of the extreme anti-deflationary strategies (outside of war or total chaos.) As Prechter points out, if the US government loses the bond market access, it will be floating in the air, only supported by FedRes bond purchases.

If there is mass exit from US$-denominated assets, it would collapse the price of nearly all US$ assets. This should lead to a contraction of credit which is generally defined as deflation.

Now, there is something that needs to be said here. Prechter makes it clear in his guide but it is also something that is debated countless times on message boards, the media, and so forth, and causes a lot of confusion. Prechter, like most AustEcon followers, looks at the entire money supply which includes cash/currency plus credit. Some people out there only look at cash.

In my opinion, one should look cash plus credit (it is too complicated to give my opinion here as to why; maybe in another post.) If the FedRes prints a lot of money, someone looking at cash-only may perceive it as being highly inflationary. After all, the currency in circulation would have gone up. However, if you look at the total including credit, you may actually see deflation. This can occur because credit may decline even if currency is printed.

Going back to the conclusion presented by Prechter, is it actually probable that the FedRes (as well as others facing deflationary busts) can print money at will? I would say no. They would kill the government instantaneously. This is something that the inflationists don't address properly. Can any inflationist out there explain how the US government is going to print huge quantity of money and survive?

Tags:

7 Response to The only serious argument against deflation...how valid is it?

Contrariandutch
August 20, 2009 at 7:51 PM

I think the Bernanke doctrine still holds.

"A determined central banker can always create inflation".

What Bernanke, and the inflationistas, are imo overlooking is what we shall modestly call the Contrariandutch corollary to the Bernanke doctrine:

"provided he has unlimited political backing".

I think what we are seeing is a complete lack of political suppport for deliberate inflationary strategies. Add an easily spooked bond market and hyperventilating pundits all over the media and the Fed chooses not to fight but to wind down QE even as debt deflation is increasingly rearing it's ugly head.

I expect no massive money creation that will be effective. That means a debt-deflationary cycle seems inevitable.

(still long USD v EUR)

Sivaram
August 20, 2009 at 10:11 PM

Hey, nice to hear from you again. You seemed super-bearish a few months ago and I hope you didn't get killed shorting the market. Your USD over Euro seems ok in my books.

You are right about political support. That is the crux of the issue. This is another issue where those who are stuck in the economic world and ignorant of the political world will probably get it wrong.

Anyway, what are your thoughts on going long the US Treasuries? Say through the TLT ETF. Any thoughts on the long bonds?

=Contrariandutch
August 21, 2009 at 7:28 PM

I am still bearish. There isn't much that points to a sustainable recovery as far as I can tell. A few countries (France, Germany, Japan) have printed positve GDP changes, but except for France only after truly horrific drops in the preceding quarters. Also, the internals of pretty much every report are terrible, even if the headline number look decent. If it looks like a dead cat and smells like a dead cat it might just bounce like one.

Worst of all, political support for extensive rescue programs seems all but gone. The boneheadedness of bank managements in paying massive bonuses and basically telling John Q. Public to go fuck himself and not even saying "thank you" just months after costly rescue operations defies belief."let them eat cake" somehow sunds like famous last words.

If we have another major financial blowup soon, and this seems inevitable given the number of issues that can go very wrong, governments will probably find it impossible to intervene on share/bondholder friendly terms so massive market disruption would have to follow.

As for shorting, well that is necessarily a short term game as it is inherently levered. So, I shorted and got stopped out. Shorted again, got stopped, etc. well you get the idea. All through july/august basically. The upshot of thight stops is that the losses are manageble, especially after the huge runup march through june.

I appear to be one of the only dollar bulls left in this world... (although there are a few dollar bulls in the financial blogosphere, shorting the dollar seems awfully popular these days). Still, I like the trade.

BTW, since you are now positionign yourself more as a macro theme investor, where are you on the bullish/bearish spectrum re. various equities, bonds and currencies? (ie. US/Europe/JApan/Emerging markets)

Sivaram
August 22, 2009 at 1:26 PM

ContrarianDutch: "Worst of all, political support for extensive rescue programs seems all but gone. The boneheadedness of bank managements in paying massive bonuses and basically telling John Q. Public to go fuck himself and not even saying "thank you" just months after costly rescue operations defies belief."let them eat cake" somehow sunds like famous last words.  "

Yep... It's amazing how arrogant the failed bankers are. So few of them realize that they were rescued by funnelling taxpayer money to failing firms. I was dissapointed that even Warren Buffett criticized fiscal spending in his latest opinion piece while saying nothing of central bank money printing, or his involvement in Moody's, or Goldman Sachs.

"If we have another major financial blowup soon, and this seems inevitable given the number of issues that can go very wrong, governments will probably find it impossible to intervene on share/bondholder friendly terms so massive market disruption would have to follow.  "

I don't think a blowup is as likely as you feel (although there is a sizeable chance) but there is little chance the government will intervene to the same degree in the future. It has spent its political capital bailing out AIG and Citigroup, among others, and little chance of them being able to do much more.

My view, which you disapprove, is for the govt to nationalize the failed banks. Even if they decided not to take over the banks, they should break it up. I feel that investment banking, which is akin to gambling wtih the house's money at times, should be kept separate. Banks like Citigroup have compeltely failed and can't continue as they are. It's too bad the govt isn't doing anything.

American banks still face losses--you can tell by observing how Ambac keeps posting losses, and this is at the front of the line--but they have written down a lot of it. So I think major surprises from America seems unlikely. However, Europe seems like a different situation with some rumours of banking not writing down their losses yet.

I think if there is to be some major crisis on par with what happened last year, it will probably come from China. The situation there doesn't look pretty, with growth being supported, it appears, solely on bank lending.

Sivaram
August 22, 2009 at 1:57 PM

ContrarianDutch: "As for shorting, well that is necessarily a short term game as it is inherently levered. So, I shorted and got stopped out. Shorted again, got stopped, etc. well you get the idea. All through july/august basically. The upshot of thight stops is that the losses are manageble, especially after the huge runup march through june.  "

I haven't given it much thought but the problem with shorting is that you may not make any money if we enter a sideways bear market. Unless you are very proficient in timing, and can pick off all the mini-bottoms and mini-tops within a sideways market, it seems like a questionable strategy.


CD: "I appear to be one of the only dollar bulls left in this world... (although there are a few dollar bulls in the financial blogosphere, shorting the dollar seems awfully popular these days). Still, I like the trade.  "

Against the Euro, it seems like a reasonable bet. But it's tougher if you consider the US$ index, which is against a basket of currencies. I'm in Canada and it's a much tougher call against the C$.

Sivaram
August 22, 2009 at 1:57 PM

CD: "BTW, since you are now positionign yourself more as a macro theme investor, where are you on the bullish/bearish spectrum re. various equities, bonds and currencies? (ie. US/Europe/JApan/Emerging markets)"

I haven't found any worthwhile investment opportunities so that's why I'm looking at some macro themes. I have been thinking about buying the long US bond; I have also looked a bit at Japanese stocks; I am also investigating an idea about buying long-term Brazilian bonds (if possible.) I may still not end up doing anything; I really haven't done anything this year, except some special situation investing.

To answer your question, I am neutral and don't have a strong stance on many things. Doug Kass, who is a short-term trader and doesn't share anything with me, recently said that it is risky either way: long or short. He is apparently slightly short but suggests staying neutral. I pretty much share Doug Kass' stance.

My opinion is roughly the same as what it was at the start of the year. A lot of things have happened in the year but we are simply back to where we were early in the year. The market is up, what, something like 15% this year but it can easily go down 10% or whatever, and end up like it was day 1.

So, my view, like it was for the whole year, has been to be bullish towards USA and bearish towards emerging markets. As for Europe, I haven't looked at it closely but I would be neutral towards it. My impression when I looked at it a while ago was that it has bigger probelms than America when it comes to banking, but its social situation (unemployment, incomes, etc) should cushion any problems. The valuations in Europe have looked lower than America so it's hard to be bearish on it.

I have become more bullish towards Japan because there may be economic improvement if a new government comes to power. So I have taken a look at that market. But still no conviction.

I also have been attracted to the US long term bonds, strictly from a contrarian point of view. Contrarian for contrarian-sake can be very dangerous but it does seem as if almost everyone is on one side of the trade. Namely, go short long bonds and US$. It is a natural bet for someone with my current stance but it is risky so I'm waiting to see what happens. I invested in US long bonds a few years ago and lost money (interest rate view was correct but the US$ decline caused big losses.)

Sivaram
August 22, 2009 at 1:57 PM

I think the next few years will be driven by China. Most of the pro-cyclical trades that have been put on by investors lately (in commodities, emerging markets, etc) seem to rely solely on China. If you read that Jim Grant article on China I linked to in my links post yesterday, you'll notice that something like 70% of incremental world growth depends on China. China's number should be high but there is a huge difference between 30% vs 70%. A small underperformance in China should caush big crashes in all the cyclical markets that depend on it.

To make matters worse, all the growth in China seems to be coming from bank lending. As Americans, and all of us, are figuring out, growing a country on credit is bound to blow up sooner or later.

Post a Comment