Deflation Has Arrived

Safehaven ^ | 01.28.04 | Robert Prechter

[Beck_isright]

"The deflationary potential is historically large... we risk overwhelming deflation in every corner of the globe." - Conquer the Crash (2002)"

Virtually everyone - and I do not use that word lightly - believes that inflation will accelerate. Stock-market bulls think that the economy is going to boom, bringing inflation. Economic bears expect an inflationary, if not hyperinflationary, monetary crisis. Economists believe that the Fed can inflate at will and is committed to an inflationary policy. The general population is convinced that prices of their homes and property can only go up. The few articles mentioning deflation in recent months have declared the prospect for it "dead."

This consensus is not merely overwhelming but reflects a belief as vast and deeply held as a religion. Investment News in September reported a survey by the National Association for Business Economics in Washington. It revealed, "None of the respondents to the May survey, all of whom were responsible for making macroeconomic predictions, predicted a decline in the consumer price index during the next two years." USA Today confirmed the fact, reporting, "Not one economist [of 67 surveyed] said it was 'very likely' the economy would slip into deflation." That is a consensus!

Against this backdrop of opinion, M3 since September has fallen over two percent, its largest decline in 60 years. This is different from a lack of inflation. It is real, actual, deflation. What's more, M3 has declined despite the strongest quarter of economic growth in decades, the lowest interest rates in half a century and a central bank committed verbally and by action to facilitating the expansion of credit! There is no interest rate spike or recession to explain away the decline in the money supply.

The dichotomy between what is happening and what people think will happen is colossal. Inflation is dead. Deflation is here, now. The monetary trend is no longer close to the edge of the cliff; it is beginning to slide down its face. As this is written, not a single major newspaper, magazine or TV network has done a story on the dramatic contraction in M3. People are so drunk with inflationary certainty that they can't even see that deflation is happening. And if they do, they don't believe that it is meaningful.

Why is there such a consensus that deflation is unlikely, if not impossible? Many people believe that the Fed is virtually omnipotent and can manipulate the money supply (and therefore the stock market and the economy) at will. Is that so? On June 25, 2003, the Fed lowered the federal funds rate for the 13th time in a row, to one percent.

Most observers think that the Fed still has that one percentage point of "ammo" left. But consider: The U.S. has a thriving money-market fund industry, which costs one percent of assets per year to administer. As it stands now, investors are getting extremely low returns from money- market funds. If the Fed were to let its funds rate drop to zero and other short-term rates fell along with it, money- market investors' return after fees could go negative. This event would make holding cash more attractive than holding debt, a situation the Fed surely wants to avoid. The monetary system appears to have reached the point at which pesky reactionary forces will come into play if the Fed tries any more "deflation fighting," no matter what the mechanism.

Why did I put the term "deflation fighting" in quotes? Commentators tell us that the Fed is fighting deflation by aggressively lowering its interest rates, but is that an accurate assessment? After all, the result of deflation - its primary outward symptom - is lower prices. And what has the Fed been doing? It spent over a year lowering the price of renting money. Within that period, in fact, the Fed lowered prices more than anyone! It has participated in the initial phase of the deflationary process as if it were a merchant on the street discounting its wares to a disinterested public. It did so in response to slack demand for its product - credit - just as the auto manufacturers and others are doing with their products. Deflationary psychology brings about lower prices, and the Fed has been lowering its prices. It is powerless to stop the trend.

A persistent decline in the money supply will have consequences. Some things will have to give. One of them will be prices for goods and services. To the astute observer, a change in prices has been in the wind for some time. The PPI has been flat for three years, and now even the CPI has had a down quarter. A severe deflation will also devastate the economy, as it has done in each of the rare times it has occurred over the past 300 years. With M3 dropping, it should be only a matter of months before the economy follows suit.

Are economists concerned? Well, besides the deflation opinion cited above from last year's polls, the only other time that I have ever seen a 100-percent consensus in a survey was... a few weeks ago! In separate year-end surveys of economists, The Wall Street Journal and Business Week independently reported unanimity that the U.S. economy would expand throughout 2004. That's right: not one dissenter. If it is usually wise to bet against a large majority in finance, what does it mean when there is no detectable minority?

I think that the continual denials that deflation can happen, against a backdrop of evidence to the contrary, appear to be part of a typical social psychological progression toward a credit crisis, which in turn will lead to economic contraction. The money supply might rebound for a quarter or two as the stock market and economy top out this year, but at the largest degree of trend, the credit bubble - 70 years in the making - has burst.

In 2001, there was little talk of deflation. Statistics relating to newspaper stories show that by late 2002/early 2003, it had become a commonly used word, even if most writers used it simply to dismiss the idea.

The next word that should begin to slide into the public lexicon is depression. I would like to offer quotes from authorities on the low likelihood of depression, but my diligent staff can find literally no mainstream economists, academics or Wall Street strategists even discussing the possibility. It is too remote even to mention! The term " depression" is where the word "deflation" was a few years ago, i.e., outside the general consciousness. Although no one is using that term now, in coming years it will be everywhere. The first phase will be widespread insistence that a depression can't happen, which will be a big clue that it is happening.

The two "d" words at the end of the subtitle to Conquer the Crash, i.e., "Deflationary Depression," were anticipatory. The book was published at a time when the likelihood of these two events occurring was (and still is) considered - as one economist said at the time about deflation - as remote as "being eaten by piranhas." My advice: Keep your toes on the riverbank.

[Iconoclast2]

How depressing.

[Southack]

"This theory is viable for debate; maybe not in Prechter's world or concepts, but it is a viable debate. Thus why I feel the dollar will become the Weimar dollar of the 21st Century."

Totally different situation today than 1924 Germany.

The U.S. is the largest importer in the world. That makes us the biggest customer.

But if the value of the Dollar declines too much, that will make foreign goods too expensive for Americans to purchase.

At that point, it is the economies of all foreign export-driven nations that will collapse.

But don't fault yourself for not seeing that point. Many esteemed economists on Wall Street still think that it would hurt the U.S. if our Dollar fell, rather than figuring out that it will actually aid the U.S. by making our goods and services cheaper to export.

What's still going on today is that Taiwan, China, India, and to a lesser degree Japan and the EU are all buying Dollars in an effort to prop up our currency. Their central bankers are clever enough to know that they need their best customer to be rich enough to purchase all of their exports. If the Dollar collapses, then their exports to us will be too expensive.

Their very survival depends upon the U.S. being able to buy most of their exports. They can't afford for the U.S. Dollar to become worthless.

But on the other hand, imports and exports are only 15% of the U.S. economy. You've heard of the 80 - 20 rule. Well, in this global game it is the 85% to 15% rule. The rest of the world could cease to exist and 85% of our economy wouldn't even know it. The Dollar could collapse and we'd simply increase our existing factory utilization rates to make up for the demand in [what were once foreign supplied] goods.

So our incentive for maintaining an over-valued Dollar is pretty darn low...possibly even negative.

Let the Dollar crash to 1000 Dollars per Yuan. Let it crash to 10 Dollars to the Euro. Who cares?!

Not you. Not me. Our homes will still be worth the same number of Dollars. Our investments will be unphased (mostly), and our savings will still have the same domestic purchasing power.

Vacations to Europe and Asia would be a bit out of the question, but we'd simply travel more domestically rather than overseas.

And the central bankers in Europe and Asia know these things full well. They know that they have to keep our Dollar propped up or it is Game Over for their own export-based economies.

They can't afford to lose their biggest customer, and that's what a declining Dollar would do to them.

[Dec31,1999]

Does anyone have any learning on what happens to gold in times of deflation?

Doesn't there have to be a crash before true deflation takes hold? And if the gov't prints its way out of the crisis, doesn't that give rise to an inflationary depression instead? I think the author is mistaken. He's been preaching deflation for years, but the ironic part is that the coming collapse will probably be inflationary, not the opposite.

[AdamSelene235]

Let the Dollar crash to 1000 Dollars per Yuan. Let it crash to 10 Dollars to the Euro. Who cares?!

Let it crash to $100 a barrel of Light Sweet Crude !!!

We're invincible !!!

You've been telling us that oil is going come back down to the $20's for some time now.

When, Southack, When?

[XBob]

76-"The Federal Reserve's answer to "how much money and when" is a vector sum of people, half of whom have been appointed by bankers, and the other half by politicians. This was a stroke of genius, because politicians can always be relied on to advocate for easy money, and even inflation, because it's a hidden tax. Meanwhile, the bankers hate inflation because lenders are hosed by inflation. In fact bankers want deflation, so that the money they're paid back is worth more than the money they lent out. Find the vector sum of what some studious people with those self-interests want, and the odds are, you're between the hash marks most of the time.... even though none of 'em really know for sure until waaaay later whether they were right."

very astute

[Southack]

"You've been telling us that oil is going come back down to the $20's for some time now. When, Southack, When?"

I think that we can safely conclude that I was wrong about $25 oil, certainly for the short term.

On the other hand, my oil stocks have performed rather well...so at least I've made good money even while being wrong.

[SAJ]

''Main Street'' would prefer also that politicians actually represent constituencies, that laws actually be enforced in an even-handed fashion, and that citizens get at least some amount of value in return for their tax dollars.

OK, none of these results occur, or only rarely so, and therefore it's both fair and accurate to observe that Main Street is, effectively with regard to both the political and financial worlds, smoking dope.

I don't particularly like this result, mind you, having dealt with the Wally St. World types for 25+ years, but the fact of the matter is that, financially at least, this lot rule the roost.

Former President Eisenhower's famed warning about the ''military-industrial complex'' absolutely **PALES** in its menace, in comparison to today's politico-financial complex.

[dpwiener]

so, dpw, it would be higly desirable to deflate (decrease) your salary, while your loan amount increases (due to interest), and decrease your salary as you get more experience ???

On average it would be desirable to deflate people's salaries if overall price levels were dropping at least as fast, and preferably much faster, due to increased productivity and technological improvements. If my salary drops from $100k this year to $98k next year, but prices have dropped so much that the real (deflation-adjusted) value of my wages is $102k, why shouldn't I be happy? I can buy more than I could before, and under our progressive income tax system my real tax bite declines.

Of course this is just one example. Depending upon an employee's actual worth, his or her nominal wages might still go up or down even in a deflationary environment. If a person had skills and experience which were heavily in demand, that person might still be able to command a raise from $100k to $105k even while most others workers were seeing their salaries fall.

As far as loans go, a stable (or at least predictable) money supply would be factored into the borrowing costs and interest rates when the loan was first taken out (or else it could be refinanced).

[RadioAstronomer]

bttt for later read.

[abbi_normal_2]

bookmark at 100

[AdamSelene235]

On the other hand, my oil stocks have performed rather well...so at least I've made good money even while being wrong.

A cynic might think you do not allow your political biases to extend to your investment strategy.