The specter of deflation is creeping back into the collective consciousness. I just noticed three separate articles on Yahoo discussing the various impacts of deflation on the economy. This is all right on time, because similar to 2008 pre-Lehman, the stock market has come off a retracement high, shuffled sideways for the past 3 months and should now be ready to fall off the next cliff. So, this renewed preoccupation with deflation evidences a psychological shift in mentality from reflation back to contraction, indicating we are fast approaching the next point of recognition, as it finally dawns on everyone that we are headed for a "double dip" of historic magnitude.
Price Deflation
The concept of (price) deflation is not as simple or complex as most people seem to think it is. The fact is that few of us (except my 93 year-old grandmother and others her age) have ever experienced a sustained price deflation. In order to have a sustained price deflation across ALL asset categories at the same time, requires a decrease in the supply of money. Likewise, in order to have a sustained price inflation across the board requires an increase in the supply of money. By contrast, when the price of oil goes up because the Saudis have embargoed oil exports as occurred in 1974, that in itself is not a cause of inflation (assuming no change to money supply), because the extra money used to purchase oil draws down demand from other sectors of the economy and hence lowers prices elsewhere.
Fanatical Libertarians tell us that there is nothing wrong with deflation and that all of the media hype around deflation is simply scare-mongering. Well, unfortunately these Libertarians are fantasizing about supply-side deflation resulting from a fixed money supply and increasing production efficiencies. Whereas, the type of deflation we are about to experience is a demand-side deflation wherein the price of everything drops simultaneously because there is no demand (aka. purchasing power), and where businesses go bankrupt en masse because they can't meet their fixed costs. This leads to mass unemployment and personal bankruptcy as jobs are lost, asset (home prices) crater, all the while debts (mortgages etc.) remain contractually fixed in value i.e. payments stay the same.
Credit deflation
As indicated above, credit deflation axiomatically leads to demand-side price deflation simply because there are too few dollars chasing too many goods. And despite all of the yammering and hand wringing over hyper-inflation, the Fed's unprecedented monetization of debt (~$3 trillion) has failed to yield economic reflation let alone price inflation. Credit deflation is all but inevitable now because there still exist record levels of debt (~ 4x GDP) and the renewed slowing of the economy will bring about a chain reaction of delinquencies and bankruptcies.
Just this week, the Fed announced that it is considering another round of quantitive easing (buying of debt) as a mechanism for further easing credit markets. This is an act of desperation, since the first round of debt monetization did not work, so what makes them believe this time will be different? As long as borrowers are insolvent and unable to borrow and lenders are ever-more cautious, then adding more cheap money to the pile of existing cheap money means banks will just buy up more financial assets (stocks, bonds etc.) sending yields even lower and making the inevitable market crash that much worse.
More to the point, as I explained previously here the money supply, which consists primarily of credit (loans) and to a much lesser extent currency (cash), is a giant Ponzi Scheme all of its own. And when it inevitably unwinds, it will collapse like a cheap tent at a rate that even Fed monetizing couldn't possibly offset, as there is over $50 trillion in credit outstanding (not to say that it will ALL go into default, but the largest part eventually will in my opinion).
Then there are those who believe that all of this debt is not an issue because it's largely money "we owe to ourselves" i.e. American lenders. Despite the trillions in U.S. debt owned by foreigners, it's actually true that most is held here in the U.S., to which I say "so what?" This "owe it to ourselves" argument is illustrative of the type of disinformation now commonplace in the Idiocracy. Simple reasoning shows why...
Let's say I borrow $20,000 from you - thanks buddy ! Then a year from now I've lost my job, declared bankruptcy, and unfortunately you lose the entire loan because I spent every last dime. What happens? According to the "we owe it to ourselves" morons, nothing happens - case closed. Umm, except, here is what happens in the real world: First off, I am bankrupt, so I am shut out of the credit markets - can't get a loan/credit card and my spending drops to nil. Second, the $20k of your money I spent last year was a one shot deal, so GDP was boosted by $20k last year but this year drops by that amount (think of this in the aggregate). Meanwhile, I liquidated your savings, so you too are piss broke, won't/can't spend (due to the reverse wealth effect), have lost confidence in the credit markets and are now hiding what is left of your money in the safest place possible i.e. buried in the forest. That in a nutshell is credit deflation.
The more you think about it, the more you realize it would actually be better to have all of U.S. debt owned by foreigners so that we could leave them holding the bag and not experience the adverse impacts of the reverse wealth effect. Yes, the U.S. dollar would fall relative to other currencies (although all nations will be doing their best to debase their currencies as well), but a lower U.S. dollar would: (1) improve the trade deficit (2) put China out of business (3) put WalMart out of business...i.e. the trifecta !!!
Monetary Policy No Longer Working
As I have said before, monetary policy is no longer working. Fiddle fucking with the price of money only causes the misallocation of capital and does not lead to a long term increase in economic production. It creates perpetual boom and bust cycles, and these latest grand attempts by Greenspan and Bernanke to "smoothe" the economic cycle by side-stepping recessions with ever more monetary "stimulus" just means this bust cycle will be the Mother of All Clusterfucks.
What Now?
The fact that the Fed is once again considering quantitative easing (debt monetization) emboldens my willingness to own Treasury debt of various maturities as I described here , because it's always nice to know that the Federal Reserve is the buyer of last resort for your primary assets.
In addition, until foreigners find an alternative safe haven for their trillions in assets, the dollar and hence Treasuries will continue to be the safe haven of choice and everyone can pretend for a little while longer that we are not borrowing to pay interest on prior borrowing (aka. ponzi borrowing). When we get through this deflation cycle, that will be a different story. As I've said, when you start getting a pack of crisp new $100s in the mail from the U.S. government each and every month (e.g. "Stimulus v6.0" or something like that) , then it's time to worry about inflation....
