Sunday, January 13, 2008

Deflation vs. Inflation vs. Both

Much has been written (here and elsewhere) regarding the rampant stupidity that caused us to reach this financially lethal point in history, but there remains one key unsettled question.

Among the few bloggers and individuals who understand the gravity of the current economic situation, there appears to be a growing debate as to whether or not to prepare for inflation or deflation. Most bearish observers seem to be leaning to the inflation/hyper-inflation scenario as the most likely outcome. Belief in the hyper-inflation scenario is abetted by the government's persistent under-reporting of inflation, the high price of gold (~$900) and the weak dollar - i.e. recent conditions.

I, and a few others, (EWI for example) believe strongly that the next episode will be a severe round of deflation leading ultimately to hyper-inflation. So, true, hyper-inflation will be the end result, but the circuitous route of getting there (via deflation) could see many bears wiped out, especially the current cohort of gold fanatics.

The reason to expect deflation has to do with the money multiplier and the expansion/contraction of credit. For the past 30 years credit has expanded to an unparalleled extent. Based on a fractional reserves system, banks take in deposits and then write loans against the deposits, holding only a fraction of the deposit in reserve. Once the loan is deposited at the next bank, then that bank makes additional loans against the same original deposit, holding again only a fraction in reserve. So forth and so on, until for each $1 in original deposit, there are now many dollars worth of loans outstanding. Therefore, the "money supply" consists of physical money (dollar bills, coins etc.) and derived money (electronic deposits). In precise terms, physical money is M0 and derived money is M2. M2 happens to be many times larger than M0, due to the money multiplier. The key issue is that once economic collapse goes into full motion (it's only in slow motion now), then the money-multiplier will actually go into reverse and not expand, but collapse. Here are the key reasons to expect a collapse in M2:

1) Bad Loans/Defaults, will cause banks to raise reserves and forestall making new loans to preserve needed reserve capital

2) Lack of new deposits: Due to general lack of confidence and highly public bank runs (think Northern Rock, recently), eventually people will pull their money out of the banks and stash it, which will cause a reduction in the reserves base

3) Repricing of exotic investments: As we are already seeing, there are many illiquid "assets" in the system that are "marked to model", not "marked to market". As each of these come to light, banks and other financial institutions will realize they are under-capitalized

4) Most importantly, a collapse in collateral values which we are already seeing in the housing market. This collapse will spread to all markets (commercial real estate, private equity etc.) and cause many borrowers to be upside down in their loans (owe more than the asset is worth), causing a downward spiral in asset values.

5) Borrowers won't be willing to borrow and lenders won't be willing to lend. Classic deflationary behaviour.

Bernanke and Co. will eventually realize that the situation they are facing is highly deflationary, but they will be slow to act, meanwhile the Ponzi deleveraging of M2 will be lightning fast. Ultimately Uncle Ben will throw cash from helicopters like he promised, but he will need a million helicopters to keep up with relentless unwinding of the massively leveraged M2 money supply.

The corollary: The money supply is massively leveraged, resembling an inverse pyramid with a very small deposit base and a very large derivative credit supply. Since it takes only $1 in deposits to support several dollars of loans, then each dollar removed from the deposit base will have a corresponding leveraged contractionary effect on the supply of outstanding credit ("money").

Strategy: In the short-term, it's time to own cash or short-term Treasuries (gold made a recent new high, but the dollar did not make a new low - very bullish for the dollar). The time to own precious metals for the long-term is down the road a bit: Once the current horde of short-term gold speculators has long vanished, and the deflation thesis becomes widespread, and the Fed has lowered Fed Funds several more times (and realizes they are pounding sand)... THEN THAT WILL BE THE TIME TO OWN PRECIOUS METALS