Monday, August 24, 2009 2 comments ++[ CLICK TO COMMENT ]++

Thought about deflation: can debt save a debt-addicted world?

(This post is more of a random thought and isn't well written. It's just to generate some thought...)

I have been thinking a lot about what Robert Prechter said in his deflation booklet that I referenced in the past. As crazy as this may seem, I have also been thinking about betting on long-term US Treasuries. Last time I made a macro bet on US Treasuries (using the TLT ETF) I lost money (interest rate call was correct but the US$ decline caused a loss.) It's kind of scary thinking about it because you are going against almost everyone—I can't think of anyone who is not bearish on the US$ or US Treasuries!

I think Prechter is right in suggesting that more debt can't save the indebted. I'm looking at China and I'm thinking 'this is just crazy.' Depending on the numbers and who you listen to, China is creating debt equivalent to almost half its GDP in one year! We are seeing the biggest economic collapse since the 1930's but I'm not sure if this is quite the way to go. The problem, as Prechter and others have suggested, is that you need as much credit growth the next year. If you don't issue a ton of debt again, you are back to square one.

The only thing with Prechter is that I find him too extreme. On top of relying too much on technical analysis and cycles—for instance, he compares the current central bank chairmen to the ones from the 1920's and 1930's, as if things will repeat—I think his calls for a roughly 90% collapse of the stock market sounds extreme.

Having said that, his timing may be off but some of his extreme calls have been spot on. Just reading that booklet of his, it's amazing how right he was on some things. For instance, he predicted several years ago that a lot of AAA-rated bonds would get downgraded during a deflationary bust (just like during the Great Depression.) True to his words, a huge number of AAA-rated credit instruments were downgraded in the last 3 years. Most of them were mortgage bonds but we also had companies like AIG, GE and Berkshire Hathaway lose their AAA ratings.

Anyway, for anyone thinking of betting of deflation, I think it comes down to whether the Federal Reserve will print money en masse and drop them out of helicopters. Prechter suggests that they won't. I have gone over the reason why he thinks that (namely, the FedRes will lose credibility.) What Prechter suggests is that the FedRes will keep creating credit to ward off deflation. This is what the FedRes, not to mention the Chinese government, has been doing lately. Taking cue from Ludwig von Mises, Prechter suggests that expanding credit simply delays things and will result in a bust. How likely is that? That's what I'm thinking these days...

SIDE NOTE about credit vs physical money:

According to Prechter, expanding credit will not be inflationary because it can implode and dissapear. In contrast, currency that is printed stays in circulation so it is highly inflationary. The public and some amateur investors are often confused between the two. Central banks, unless they were totally reckless, rarely ever print money (in the US, currency has grown at 6.1% between 1995 and 2008). There is roughly $800 billion in US$ in circulation. In contrast, depending on the measure you use, there is 10x more credit outstanding. To give you an idea of how little currency is in circulation compared to our daily usage, consider the fact that the value of all the stocks on the American exchanges are a little over $10 trillion. If everyone in America sold their stocks and wanted to hold cash, there wouldn't be enough cash! In such a case, stocks will collapse (i.e. currency will strengthen). Now replace stocks with credit (i.e. debt) and you'll see why credit can vaporize easily while currency can't. The $800 billion in currency will always be there (unless someone physically burns it) but the countless trillions in credit can dissapear.

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2 Response to Thought about deflation: can debt save a debt-addicted world?

Daniel M. Ryan
August 24, 2009 at 11:51 PM

I never fell for Prechter, even though I first read of him back in the '80s. Except for this part of his writings: "socionomics." His article about how cultural and market trends both spring from people trends, I found fascinating.

An intro to the concept is here:

Sivaram Velauthapillai
August 25, 2009 at 10:42 AM

I never read any of his stuff or paid too much attention because he relies on technical analysis way too much for my liking. He views a lot of things as cycles, and although I think events are cyclical in the long run, I don't expect them to be as repetitious as Prechter believes.

You are right in saying that he believes in the interaction between culture/social behaviour and markets. The crux of his deflation argument isn't so much that prices are too high or that debt levels are too high. Instead, it is essentially his view that the public and market participants will switch their views from an inflationary one to a deflationary one. Once that happens, he argues, that no one can stop deflation. What central banks, governments, corporations, banks, and others, do can't overcome the psychological shift from inflation to deflation. Essentially, if debtors believe they cannot service debt, and lenders believe debtors cannot service debt, he suggests deflation will be unleashed.

He's certainly interesting. Very extreme calls--like Marc Faber--and partly wrong at times, if not early, but some of his ideas are non-mainstream and appealing to me...

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