How Will Deflation Play Out?

I received the following question from "Suanny" on Silicon Investor" on December 29th.
Note: I cleaned up a few typos, punctuations, etc. to make the following a bit more readable.

Mish
I have been following your views on deflation for some time. You tend to limit the argument expansion and depletion of credit that defines more clearly the discussion so an individual will be able to follow. Trying to debate baskets of goods and their pricing would take the discussion all over the map. You make a great case, however it difficult for me to see how this will play out in the real world.

The inflation guys are just the opposite. They seem to be very sure how things play out but have difficulty explaining why or supporting their position. Although most of your positions are well supported I have difficulty understanding just how things will play out in your opinion and how policy or events might alter that view either in timing or severity. I think most of us especially me have a distorted view of what a modern day deflation would mean.

Mish technically you may be correct when you mention that the price an item which has just tripled, has fallen 10% is deflationary. As a consumer it feels like a temporary relief from inflation. I believe much the frustration in the inflation deflation debate stems from the inflationist clear vision of the future with rather cloudy evidence backing it up your solid arguments supporting a vague vision of what a modern deflation might look like. I for one would like to see more of your ideas what effect this credit contraction could have on various areas of our lives.

Suanny that was an excellent question and it also comes up time to time in responses to my blog as well. Before I answer your question as to how this will affect people's lives, let me reiterate my position once again as to what deflation is as well as clear up a couple of misconceptions that people have. Quite simply inflation is an expansion of money supply and credit. Deflation is the opposite, a contraction in money supply and credit.

How inflation starts and ends can be found in an Interview with Paul Kasriel with who I am in complete agreement.

Mish: How does inflation start and end?
Kasriel: Inflation starts with expansion of money and credit.
Inflation ends when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and /or speculation no longer makes any economic sense.

Mish: So when does it all end?
Kasriel: That is extremely difficult to project. If the current housing recession were to turn into a housing depression, leading to massive mortgage defaults, it could end. Alternatively, if there were a run on the dollar in the foreign exchange market, price inflation could spike up and the Fed would have no choice but to raise interest rates aggressively. Given the record leverage in the U.S. economy, the rise in interest rates would prompt large scale bankruptcies. These are the two "checkmate" scenarios that come to mind.

Predicting the end is extremely difficult especially as the powers that be are doing anything and everything to keep the bubble expanding. Three years ago would anyone have thought that neg-am "liar loans" would have become as widespread as they did or that people would be camping out overnight to get into a lottery to buy a Florida condo or that companies would be going into debt to buy back shares while insiders are bailing like mad and no one would care? But just as happened with Florida condos, supply of many things is destined to dwarf demand.

Yes I have been early and as such subject to taunts and ridicule. I have been even compared to Prechter who was at least 20 years too early in his call. It is an invalid comparison because I have only been talking about this for several years at most while Prechter clearly missed a massive disinflationary cycle boom led by increased productivity, the internet revolution, and falling energy prices. I also disagree with Prechter on what is going to happen to the price of gold. I am not attempting to trash Prechter as I find Ewave analysis itself quite useful. One must separate views of the person from use of the tools. Finally I believe peak oil will prevent a complete collapse in the price of energy. Yet economically and financially the conditions in the US are quite similar to those of 1929. You may wish to consider reading 1929 Revisited.

But just because economic conditions are similar to 1929 does not mean I am calling for a global depression. I have never called for such an occurrence although I admit it is possible. I also admit hyperinflation is possible even though I think it is extremely unlikely. Oddly enough I give more chance to hyperinflation happening (1-2%) than others who tell me that I am the one who is stubborn while at the same time telling me that deflation is "impossible". Go figure.

The main misconception I want to clear up involves these statement you made "Mish technically you may be correct when you mention that the price an item which has just tripled, has fallen 10% is deflationary." I have really never said any such thing. Perhaps you are mistaken because certain people attribute things to me all the time that I have never said. I have staunchly maintained what inflation and deflation are, and a 10% drop in prices is certainly not deflation.

Prices may be dropping as a result of deflationary pressures but it is important to understand cause and effect. For a discussion on cause and effect and putting the cart before the horse as most inflationists do, please consider Inflation: What the heck is it?

The internet and other massive productivity improvements kept a lid on prices and masked real inflation (an expansion of money and credit)as noted in my interview with Kasriel. But as long as the ability and willingness of businesses and consumers to take on additional credit is intact (especially consumers), inflation is nearly guaranteed to win out. The key then is finding the point at which "checkmate" occurs.

On occasion I do discuss prices. I try and make it perfectly clear that when I do I am discussing prices and not inflation or deflation per se. Some have asked me to start saying "price inflation" or "monetary inflation" etc but even if I don't it should by now be extremely clear as to what I am talking about. The primary reason for discussing prices is that every inflationist under the sun moans to high heavens every time the price of anything rises even as they ignore prices that are falling such as: copper, natural gas, crude, oil, lumber, home prices, prices at Walmart, prices at Circuit City, and prices at many restaurants.

Inflationists are also quick to point to recent movements in corn and grain prices ignoring the fact that prices are not much different than they were in the 1940's. More importantly corn and grains are both weather related as well as subject to ridiculous policy decisions by the government such as ethanol promotion and subsidies. Well the Fed can not control the weather nor can the Fed's interest rate policy solve peak oil problems nor can Fed policy do a thing about poor governmental decisions to promote inefficient use of ethanol. While on the subject of poor policies, consider some 300 programs designed to make housing affordable. At the top of that list would be the creation of Fannie Mae, and that policy has backfired in every way imaginable. Government programs attempting to do something usually accomplish the opposite.

That is a crucial point to understand. Interest rate policy can not in any way counterbalance poor government policies. That statement would hold true even if my some miracle the Fed actually managed to find the so called "neutral rate"!

Bad governmental policies make the Fed's job all the more difficult. In reality the Fed is attempting to micro-manage things much the same way that Russian central planners attempted to manage their economy and we all know how well that worked out.

We do not let the Fed set the price of orange juice even though that is probably far easier to do than set interest rates in a global economy. In short we would all be better off if the Fed simply absolved themselves and let the market set rates. We would still have government distortions but at least we would not have Fed distortions on top of government distortions.

How Debt Money Goes Broke

Before I answer your primary question let's first explore How Debt Money Goes Broke

Debt is self-liquidating when used to generate future income, from which interest is serviced and principal repaid. Used for any other purpose, it is non-self-liquidating and results in payment obligations with no countervailing source of income.

How does it end?

A debt-based monetary system has a lifespan-limiting Achilles heel: as debt is created through loan origination, an obligation above and beyond this sum is also created in the form of interest. As a result, there can never be enough money to repay principal and pay interest unless debt is continually expanded. Debt-based monetary systems do not work in reverse, nor can they stand still without a liquidity buffer in the form of savings or a current account surplus.

When debt grows faster than the economy, the burden of interest is bearable only so long as the rate of interest is falling. When the rate of interest reverses course, interest charges start rising faster than debt growth. This point was reached on 16 June 2003, the day the yield on the benchmark 10-year Treasury bottomed at 3.09%. Since then, debt grew from $32 trillion to $40 trillion, an increase of 25%. During the same period, annual interest charges rose by over 50%, from $1.28 trillion ($32 trillion at the prevailing average interest rate for debtors of 4%) to $2.0 trillion ($40 trillion at 5%). When interest charges exceed debt growth, debtors at the margin are unable to service their debt. They must begin liquidating.

Dipping into savings or running a current account surplus can offset liquidation for a time. The greater the pool of savings and the current account surplus, the longer an economy can endure liquidation at the margin without experiencing cascading cross-defaults. The US in the early 1930s and Japan in the early 1990s had such a liquidity buffer. In both cases, mobilizing domestic savings to increase government debt reversed the decline in total debt outstanding in two to three years and interest rates stayed low because savings financed the new debt. As a result, interest charges no longer exceeded debt growth and the need for marginal debtors to liquidate disappeared.

The US is now in a fundamentally different position than it was in 1930 or Japan was in 1990. Aside from a dearth of domestic savings, its vulnerability is compounded by a current account deficit. There is no buffer and no margin for error. Thus, when interest charges, now $2 trillion per year and accelerating, overtake annual debt growth, now $3 trillion and decelerating, liquidation will immediately trigger cascading cross-defaults. Without domestic savings to mobilize, the Fed cannot facilitate the expansion of government debt to fill the breach and simultaneously hold down interest rates. It cannot win the battle to keep debt growth greater than interest charges, the precondition for the viability of a debt-based monetary system. Once started, cascading cross-defaults consume all debt within an economy. The Fed has only two options: institute a new monetary system with a new currency or return monetary authority to the market and shut down.

As an adjunct to the above article let me repeat some comments made by
Professor John Succo on Minyanville in regards to Debating the Flat Earth Society.

As central banks rain liquidity (credit) down on markets, its long range effects eventually cause the very thing central banks are trying to avoid: deflation. The reason people don�t understand this is that it is cumulative: the accumulation of debt is in itself inflationary, but at a certain point it becomes unmanageable. Why is this?

Easy or free money (when central banks drive real interest rates below inflation rates) is irresistible. It wouldn�t be if people managed risk properly but they do not. Easy money causes competition for �projects� to increase: companies with free money take risk with it for less and less return. We are seeing deals getting done in LBO land and commercial real estate being built using very aggressive assumptions and low cap rates. With all that �money� out there rates of return drops dramatically. Everyone is starved for income.

At the very time that income and returns are dropping debt is increasing. Less income with more debt means that eventually it gets impossible to service that debt.

What does it all mean?

Finally! to answer your question.
What it means depends on several factors.

1. How much debt people have
2. How much people depend on home prices
3. How much people depend on the stock market

The coming deflationary downturn is clearly not going to affect everyone equally.

Those with little debt and few assets and high in cash are going to be huge winners. Cash and/or or gold will be king. Those leveraged in massive amounts of real estate lording it over on everyone else for the last 10 years are likely going to seriously regret that decision.

Relatively speaking the top 2-4% or so will not be affected much as a class (individual results will vary) as many in this group have more money than they know what to do with. They can ride out the storm outright if they are wealthy enough, and the second tier can ride it out as long as they keep their jobs.

In the next step down, baby boomers who thought they could retire by selling their houses will find themselves scrambling for supplemental income after retirement to maintain their lifestyle, or by cutting back on their standard of living or both. Retirement for many will be delayed. Those most affected will be those most dependent on the bubble in housing or stocks to maintain lifestyle. It will be a rude awakening for such folks and that awakening just might last for years.

Those heavy in stocks but light on real estate will be a lot more liquid. How those folks turn out will depend on how far down they ride the wagon. I suspect that many who need "just one more double" are not going to get it and instead will have 40% less than they have now 5 or 7 years from today.

Those overleveraged in stocks and real estate and relatively high in debt but not in the upper echelons of income will bear the full force of the downturn.

There is simply no reason we can not be following a Japanese style prolonged deflation. Housing prices fell in Japan for 18 straight years or so and that could happen here. More than likely a 5-10 year decline is reasonable. No doubt people will be chiming in "the US is not Japan" and yes they are correct. From a deflationary aspect our consumer debt makes things far worse. On the other hand our demographics makes things better (assuming we do not get as phobic about immigration as Japan did). Those are both major factors and for the sake of argument I assume they balance out.

Oddly enough those on the low end of the scale probably do alright compared to current conditions. They have tons of debt (relative to income), few assets, no house (or deep in debt on one), no stocks, no 401K, no medical insurance, and nothing to lose in bankruptcy. I expect many to take that way out and I will not blame them one bit if they do. Those with literally nothing to lose, obviously lose nothing.

Under the Democrats I expect to see some revisions in the bankruptcy laws as well as revisions in fees and interest rates on credit cards. If we do not get those revisions then expect far more bankruptcies. Heck, expect them whether or not we see those revisions. The result will be a forced reversion to the mean from the haves to the have nots (at least to the extent that bankruptcies wipes existing debt).

As far as prices go, deflation is not going to cure peak oil, shortages in natural gas, the China factor, bad government policies, or increasing demands for resources in emerging markets. On the other hand there is massive overcapacity everywhere that I have talked about many times. Overcapacity in the midst of a weakening economy has already put downward price pressures on places like Walmart, Home Depot, Circuit City, etc. Land and home prices have begun falling and will likely continue to fall for years. I expect to see demand for marginal services such as nail salons and yard work to plunge. Where there is overcapacity and falling demand expect to see layoffs and corporate bankruptcies. Lots of small businesses will likely go under. Unemployment will rise. That will further reduce demand for goods and services putting even more price pressures on suppliers. The process will continue until it plays itself out.

We must also consider how the Fed and Government will react to the downturn. This is by no means a given. Many think a "helicopter drop" will be invoked. I believe otherwise for reasons I have stated many times:

1. The government and Fed will not bail out consumers at the expense of banks and creditors.
2. The Fed can print but the Fed can not create jobs or determine how or even IF that money would find a use.
3. Hyperinflation if achieved would end the game at the expense of everyone, including the wealthy and the Fed itself. Deflation on the other hand allows the game to continue.
   

No doubt the Fed will attempt to inflate just as Japan attempted to inflate but those attempts failed. Likewise the Fed will fail. Their attempts to prevent deflation a few years back only succeeded in creating a bigger bubble that now will be deflated away.

Although we know the government will try things (most of them completely stupid), we do not know exactly what they will be. Will there be another Smoot Hawley Tariff? Are we going to start a war with Iran? Is so, how will China and Russia respond? Will we antagonize China into dumping treasuries or dollars in some sort of major international currency fight? How soon and how far will Japan rate hikes affect various carry trades? What happens to the AMT (alternative minimum tax) a year or so down the road and or to various tax credits that are set to expire?

We can speculate on answers to those questions but no one really knows. Yet, the answers to those questions may very well determine how fast or how slow the overall scenario plays out.

What we do know for sure is that the Fed and the government will attempt something, we just do not know exactly what at this stage. Oddly enough, even though we do not know what will be done, it is perhaps possible to see what one of the beneficiaries would be. Gold is a likely winner in this mess. Gold and money in general are historically trash in disinflation and hoarded in deflation. Unless it's different this time, gold and cash and treasuries will do well. In contrast those holding junk bonds, houses, stocks will see those values plunge.

Deflation will not be the end of the world for the US any more than it was in Japan, but it will cause a pronounced shift in consumer behavior and investment psychology.

Behavioral Psychology

• There will be shift away from consumption to saving
• There will be a shift away from risky assets to less risky assets (and lower returns)
• There will be changes in retirement plans
• There will be a shift in mentality from "have to have it now" towards some semblance of planning.

Those are good things actually and they will allow for replenishment of the pool of real savings that has now been completely exhausted.

Suanny, you asked what you might have thought was a simple question, but as you can see the answer was long and complex.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/