Inflaton or Deflation argument

Helicopter Money Is Path to Deflation ***(note: either deflation or inflation are like poison to stocks, D)
By: Rick Ackerman, Rick's Picks
Rick’s Picks
Tuesday, October 12, 2004
For investors who’d rather be smart than lucky


I’m not yet blue in the face from trying to explain, over the last dozen years, why all roads lead to deflation, but splotches of symptomatic yellow and green have begun to mottle my cheeks. As far as I’m concerned, those who remain skeptical of deflation’s irresistible power have yet to raise an argument that is not easily refuted. Some questions keep popping up, though, mostly from lurkers who evidently are unaware that I’ve answered those same questions dozens of times in Rick’s Picks and in its predecessor, Black Box Forecasts. The most commonly asked question is: How can we have deflation if the Fed is able to bail out debtors by creating money out of thin air?
Here’s how Paul M., a lurker who works for Nomura Bank, asked this question in an e-mail I received from him recently:
“I enjoy your articles and analysis but I don't think you addressed Jonathon O's question that well. How can we have deflation in a fiat currency world. There is no limit to the potential increases in money supply. It does not entirely depend on private sector borrowing as surely the Fed can 1) monetize their own debt and 2) continue to spend heavily on defense/war, space programs etc.
Consumer ‘Tapped Out’
“The way I see it, Greenspan hasn't even started to really crank up the money supply yet ,as clearly the consumer has done enough borrowing for him up to now. But I agree that this phase is surely close to an end – i.e., the consumer is close to being tapped out.
“I imagine we will suffer severe deflation in the not too distant future. But that will be the end-game, when the dollar and/or financial system collapse. Under the current fiat/dollar confidence regime there are plenty more ways to for the Fed to continue inflating.”
I have always respond to this argument as follows, and will continue to do so: Sure, the Fed could continue inflating and even run amok via direct monetization. But that will only make the already cosmically large debt bubble even larger, and trying to arrest its eventual collapse implies not mere inflation but hyperinflation. Since hyperinflation is by definition unsustainable, the end result could only be…a deflationary collapse.
Here’s a variation on Paul’s argument from Geoff P:
“I am one of your ‘lurkers’ who has enjoyed the free articles you've posted. In particular, thank you for your thoughts re the inflation/deflation question. This is a key question for me because my family has suffered the last few years as I have refused to put our entire savings into buying a house in what I have believed to be a grossly overpriced market. I have been cautious in part because I am in an industry with a future that may not be very good, particularly if the economy goes into the can, as I believe it will. The lack of a house, as prices have sky-rocketed, has been extremely painful and lately I have begun to waiver, probably at exactly the wrong time of course! [Side note to Geoff: You are most wise to rent right now. The only thing that prevents some of the deflationists I know from doing so is that their spouses just won’t go for it. Rents are entering a downward spiral and will become an increasing drag on home prices as we get closer to an outright collapse in real estate values.]
Fannie Meltdown
“But back to the issue” Geoff continues. “I believe you are clearly right in the deflation/inflation question up to a point, but then you fail to address (my apologies if I missed it) the inflation camp's key argument. That is, what is to prevent the Fed from simply monetizing massive amounts of debt. Steve Saville has strongly argued that inflation will be our doom based on this near certainty, as he sees it. He postulates for example that when the GSEs meltdown, the Fed might simply offer to buy all GSE debt for 95 cents on the dollar. Such a radical move would accomplish several objectives for the banksters and politicians - it would prevent or postpone a housing collapse and it would vastly boost the money supply, thereby also making other debts easier to pay and the voters happy. There would certainly be adverse consequences - such as a collapsing dollar - if such a policy were carried out but it does seem likely that today's politicians and banksters would choose such a course. “
RA: No one who asks this question seems to have considered what those “adverse consequences” will be. Very simply, when you choose to bail out all debtors, you are necessarily choosing to destroy savers and creditors as a class. This means not only bondholders, pensioners, future pensioners and the like, but the institutions that conduce savings and lending, such as bond markets, banks and S&Ls. If the value of the average home were to skyrocket to a quadrillion dollars because of hyperinflation, can you not see where mortgage lenders, most particularly Fannie and Ginnie Mae, would go down in flames?
Ben to the Rescue?
Geoff: “After all, most of today's ‘leading economists’ and Helicopter Ben will be urging them on, saying that we should not repeat the mistakes of the '30s.”
RA: Helicopter Ben and his cronies at the Fed must surely know better – must know that dumping money from the sky will not return the economy to balance. Or rather, it just might – via hyperinflation leading to a deflationary collapse.
Geoff: “Thus it seems that Mises' crack-up inflationary boom followed by a deflationary bust when our currency fails would be our future. I have no clue how long such a process would take but have been absolutely amazed at how long they have been able to hold this mess up so far with easy money and credit.”
RA: Don’t rule out another possibility I’ve written about here many times before -- that deflation is coming next, catalyzed by falling home prices (and wages) that will make servicing a 6 percent mortgage difficult or impossible for many millions of homeowners. Will six percent nominal rates seem cheap to the debtor whose $400,000 house loses 25 percent of its value? More to the point, will many who have borrowed against their homes survive financially if real estate prices merely flatten out for a spell, as appears to be the rosiest possible scenario for the next couple of years?
Credit Dwarfs M’s
Here’s a very insightful note from “Fencer Fred” that supports my point of view:
“As always, I enjoy your comments, particularly regarding the great inflation/deflation ‘debate’. The most difficult thing that I have found (as you obviously have too) is to get people to understand that the Fed has primarily been expanding CREDIT since its inception in 1913, and that the supply of credit completely dwarfs the M's of the money supply. When people begin paying this back and reducing the amount of credit (either voluntarily or involuntarily through bankruptcies), the change in the various M's will be irrelevant.
“Your sentence, ‘An epic wave of bankruptcies will cause zeroes to disappear from the global balance sheet much faster than the central banks can get us to borrow those zeroes back into existence’ is one of the more perfect summations that I have ever seen.”
To Summarize…
And finally, from Harry H., a summation that that offers food for further thought:
“I'm an economics graduate from Cambridge, running an IT business. Interesting reading your articles on deflation vs. inflation. It all hinges on the speed and effectiveness of the Fed's response to the first signs of deflation. Anyway here's a summary of the arguments:
Things we all agree on:
1. The "real" US economy is in a nosedive, disguised by a) dodgy government figures and b) deficit spending and consumer credit.
2. Interest rates are artificially low and interest-rate-sensitive assets are artificially high, housing but also stocks & bonds.
3. Asian central banks are mopping up excess US dollars at the rate of $500bn/year to keep their currencies undervalued.
4. The US dollar is overvalued against, for one, gold.
5. The Fed is ready to print more dollars if deflation threatens.
Things we probably agree on:
a) Interest rates and the US dollar will eventually revert to their natural values.
b) The usual penalty for excess money-printing is a currency collapse and hyperinflation.
c) When a country is not a banana-republic but an industrial giant, such as Germany in 1921, loss of confidence in the currency may take longer than anyone can imagine.
Things we don't agree on:
1a. The supply of greater fools will naturally dry up, as housing/stocks/bonds become unaffordable in a retreating economy, or
1b. House/stock/bond prices will be pumped up indefinitely by a profligate Fed.
2a. US consumers will stop borrowing and start to clear debt by selling their stocks/bonds/rental-condos/SUVs, or
2b. Logically, consumers must continue to borrow at below-inflation-interest to buy real assets. And if this policy hits the theoretical limit of "pushing on a string" (where eventually no one takes up the offered credit) the Fed will take more drastic action, Helicopter-Ben will come to the rescue.
3a. There will be a "US-dollar-short-squeeze" meaning sudden high demand for dollars as consumers seek funds to repay their loans, or
3b. The central banks of China and Japan control the demand for US dollars. The day they stop buying is the day the US dollar will collapse.
And the conclusions:
A. DEFLATION Due to forced sales of houses/stocks/bonds/SUVs, or
B. INFLATION as the Fed goes berserk and the US dollar collapses.
RA: Thanks for your Inflation/Deflation “Cliff’s Notes,” Harry.
***
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By: Rick Ackerman, Rick's Picks