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The Specter of Deflation

by Michael Nystrom
December 28, 2006
Arlington, MA

A specter is haunting the US economy - the specter of deflation. The Fed and the Treasury - the central powers of Capitalism itself - have entered a holy alliance to exorcise this specter. The big question is, will they be able to do it?

From what we know of economic history, credit expansions lead to economic booms - this much is clear. What comes next is still up for debate. Austrian economist Ludwig von Mises tells us "The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The credit expansion boom is built on the sands of banknotes and deposits. It must collapse. There is no means of avoiding the final collapse of a boom brought about by credit expansion." (emphasis mine)

Current Fed Chief Ben "Printing Press" Bernanke begs to differ. He earned his nickname in the now infamous 2002 speech, "Making Sure 'It' Doesn't Happen Here" prior to his ascension to the Chairmanship. Though Bernanke never admits to it in his speech, the unspeakable "it" is more than just deflation, but the very "final collapse" that that Mises warns of.

In his speech, Bernanke tells us,
The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.
He goes on to tell us that the best way to cure deflation is to avoid it altogether by preempting it. After the dot.com collapse and the terrorist attacks of 9/11, the Fed lowered interest rates aggressively, making it clear that there would be liquidity for all - no need to panic - move along - continue on with business as usual. In spite of a mild recession, the Fed's liquidity-for-all program helped the economy avoid a deflationary collapse. By creating the housing bubble.

From this compilation of deflation links that I put together, you'll notice that - at least in the press - the fear of deflation reached its zenith in 2003, shortly after Bernanke's "Printing Press" speech, then all but disappeared. Until this year.

What happened? In my opinion two things: First the Iraq war began in 2003. War is always inflationary, and this one was no exception. Hundreds of billions of dollars were pumped into the economy via government spending on military hardware, software and personnel. One of the leading market sectors since 2003 has been the defense industry.

But the second thing that happened was Bernanke's genius mind game. So clever in fact, that I am only now appreciating the audacity of it. In his speech, he tells a story: Imagine that an alchemist has learned to make unlimited quantities of gold at no cost, he says. What would then happen to the price of gold, and when would it happen? The price of gold he tells us, would plummet immediately - before the alchemist produced a single ounce - because markets discount future events immediately. Economists the world over nodded in agreement. Yes, they said, this is so. Then Bernanke lays the punch line on us:
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, (emphasis mine) the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
In effect, when President Bush nominated Bernanke to head the Fed in late 2005, Bernanke became the credible threat. "An inflationary madman is coming to the Fed! Run for cover!" And everyone did. Look at how everyone's favorite inflation indicator - gold - reacted to the threat. Immediately, I might add.



That was a cool trick, Ben! But what are you going to do for an encore? With the housing collapse, worry about deflation is once again creeping in around the margins, and for good reason. In that sector, we already have deflation. Prices are falling; unemployment is rising.

Credit, which has grown steadily since the stock market bottomed in 2003, is being destroyed as housing continues its collapse. For those yet uninitiated into the secrets of modern money, credit is synonymous with money, because all money is debt -- which is just the other side of credit. For example, say a bank extends credit to a borrower to buy a house. That credit becomes the borrower's debt, but the bank's asset. (More debts for the people means more assets for the banks.) The borrower uses his new credit to buy a house. Where did the bank get the "money" in the first place? Why, the Fed printed it of course! (Weren't you paying attention when Chairman Bernanke was speaking?)(Confusing? Don't worry - it's meant to be). The point is that the recent inflationary spiral of printed money pushed housing prices up and up over the past years. When all the qualified buyers were exhausted, banks began loaning money to unqualified buyers to keep their assets growing and the credit expansion going.

But a recent study tells us that 2.2 million homes will soon be lost to foreclosure. This means that banks extended credit to borrowers for them to buy houses, but the borrowers soon found they couldn't make the required payments. As a result, the bank takes the house back. Suddenly a mortgage that was worth hundreds of thousands of dollars in cash flow to the bank over its 30 year lifespan is gone. In its place the bank has a house it does not want -- one that undoubtedly has been trashed by its erstwhile owners as a way of "getting revenge on the man" who is repossessing his house. (Some angry former owners have stripped properties of appliances, cabinets, even light fixtures. More vindictive owners have been known to plug drains with concrete and turn on the water.)

Furthermore, because of the declining real estate market there is little chance the bank can sell the house again for anything close to what it got the first time -- especially if it has been trashed. But sell it must. The more REO's (bank-speak for "real estate owned") a bank has on its books, the worse its balance sheet, which means declining share prices. Banks need to sell those properties! Quick! One article estimates that 25% of all pre-owned homes on the market in Dallas are forclosures! This puts incredible downward pressure on prices because banks are the definition of "motivated sellers." As opposed to regular sellers who will wait to get "their price" before selling, banks will sell at just about any price to get the property off their books...

And thus begins the deflationary spiral. Credit is destroyed, jobs are lost, payments are missed, bankruptcies declared...

Um, Earth to Bernanke - We have a problem. If you want to preempt deflation, here is your chance!

In the latter half of his 2002 speech, Bernanke launches into numerous ways the Fed could stimulate an economy suffering from deflation. Compared to stories about alchemists and printing presses, this part of his speech is relatively boring, and you can practically hear him mumbling through the text. It all boils down to one thing anyway: lowering interest rates. This, Bernanke says, would solve deflation.

But would it?

There is an old saying that you can lead a horse to water, but you cannot make him drink. The human corollary is that you can offer a man a loan, but you cannot make him borrow. In spite of what Bernanke says, the Fed does not "print" money. It must loan it into existence, but this requires willing borrowers. Consumer spending powers 70% of the US economy. So how do lower interest rates translate directly into money in the pockets of US consumers? That's what newly homeless consumers will need, in order to keep "powering" the economy. Of course credit card rates will go down, but will that be incentive enough to continue spending?

As the foreclosures work their way through the economy, you may begin to hear stories about how people you know have lost their home. But when it turns out that your neighbor - or a close friend - gets laid off from his well paying, seemingly secure job and falls behind on his mortgage payments...Well, you might think twice about upgrading your 39" LCD TV to the new 52" plasma model - even if you can get it for 0% interest (for the first six months). More likely you'll start thinking about building up a cash nest egg of your own. But saving - which for most Americans means paying down debt - is deflationary. Maybe you could sell some stock, while price are still high. (Also deflationary) Downsize your McMansion? Good luck, and also deflationary.

But let's get back to Bernanke's story about the alchemist. Don't we all know that alchemists don't exist, and that alchemy is a discredited pseudo-science? Would Bernanke's story have had the same impact if he were talking about the Tooth Fairy, or the Easter bunny? But for the sake of argument, let's humor him about the alchemist: What if the alchemist really couldn't make gold from thin air, but he just said he could. Then what would happen to the price of gold? It would still probably drop on his initial announcement, but as people realized he was bluffing, the price would return to normal. The alchemist's effect on the price of gold would have just been temporary. But certainly the alchemist's inability to make gold would have nothing to do with his desire to do so. The alchemist wants to be able to make gold - it's just that he can't. It's impossible. This brings us back to what Mises warned us of: There is no means of avoiding the final collapse of a boom brought about by credit expansion. Like spinning gold from thin air, it's impossible.

Which one of these men are you more inclined to believe?



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As always, comments are welcome on this story.

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Note - I didn't get to everything I wanted to in this article, so coming next: The Specter of Deflation, Part II. If you would like to be notified when this article is released, please subscribe to my low volume announcement list

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Other articles of interest:
Video: Paul Krugman on the Housing Bubble
What Everybody Already Knows about 2007
Memories of 1929 - Part I
Memories of 1929 - Part II

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COMMODITY TRADERS:
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