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Tuesday, December 22, 2009

The Deflation Threat

http://www.americanthinker.com/2009/12/the_defaltion_threat.html

A falling price trend is at first a benefit to consumers. But then it leads to a spiral of economic decline: a depression. Deflation occurs when money for whatever reason becomes scarce, and therefore more valuable. Lower prices are the effect. Producers starve for profits, which leads to layoffs, loan defaults, and bankruptcies. Borrowers find they have to repay with more expensive dollars, so they pay off their debts. Low debt throttles growth and slows purchases. Expensive dollars make exports less competitive. Unsold inventories waste away on the shelf, crumble in value, and must be sold at deep discounts. Prices fall further, and so on, in a vicious circle.

Normal downturns are triggered by cyclic imbalances in which supply temporarily exceeds demand. Growth pauses while inventory excesses are liquidated. This time, however, things are different. The triggering event was an asset valuation bubble -- high stock and real estate prices -- boosted excessively in a buying mania fueled by cheap credit during the last fifteen years. Lots of borrowing creates financial leverage, which pumps up profits during good times and wipes them out during bad. Consumer credit swelled with the aid of cheap mortgages and home equity lines. Businesses borrowed cheap short-term money and invested long-term, expecting to roll the loans over as profits expanded. Most significantly, bankers ran high ratios of what they lent out versus what they took in. All of this borrowing was encouraged by the Federal Reserve Board and Congress to foster social goals like full employment and high levels of homeownership.

But the system eventually became unstable. The real estate that served as collateral for trillions of dollars of debt on the banks' (and the bank-like Fannie and Freddie) balance sheets became priced too high, and for the first time in seventy years, prices began a serious decline. Many highly leveraged borrowers had their equity wiped out, so they threatened to default. An increased sense of risk rippled through these debt pools, erasing much of their value and rendering them unsalable, or "toxic." Soon, a "run," or loss of general confidence, pervaded the U.S. and European economies. Though it has come to be called the housing bubble recession, a better name is the great credit bubble depression.


Deflation stems from a shortage of money. Isn't the Fed creating trillions of new dollars that they lend to banks and to the Treasury for disbursement in "stimulus" programs? Yes, but even as the Fed has recently created $2 trillion in new assets, many times, more money has been and will continue to be taken out of the world's economy through the process of de-leveraging -- that is, the paying off or writing off of a portion of the hundreds of trillions in credit floated around the world. Despite talk of TARP success and nascent recovery, those toxic assets are still on the books, some with the banks and some with the Fed itself. Eventually, much of this money will become worthless. As fast as the Fed is printing new money, money is being destroyed as debt is taken off the table. In the end, the Fed will lose as the quicksand of depression sucks more and more money into its muck.


Ironically, the 60% stock market rally of 2009, which in itself is anti-deflationary, is no source of comfort. Though it's hard to prove why stocks move, the recent rally is most likely due to a "carry trade," in which banks borrow cheaply from the Fed and invest in high-return risk markets like stock, gold, or even foreign currencies. The Fed is encouraging this with low rates precisely because this asset re-inflation makes the dollar less valuable. They are fighting the inevitable deflation.


But they are also creating a new asset bubble just like the one that imploded last year. They have lowered short-term interest to zero. As prices correct downward and the dollar rises as deleveraging continues, the Fed can take rates no lower. The last remedy available is for the Fed to buy government and corporate debt in the open market, literally printing money at will -- adrenaline for a burst, perhaps, but not sustainable. Other government measures like deficit spending and expansion of primarily public sector jobs in the "Stimulus" program are simply wasteful, destroying more dollars in the present and creating public debt to burden the future. These effects are deflationary. Obama's plans for new taxes and regulations, which extinguish dollars, are also deflationary.

What about the oft-cited signs of recovery like upticks in GDP, consumer sentiment, and retail sales? Well, even in a trending economy -- and ours is trending down -- it is normal to see short blips, zigs, and zags against the trend. The numbers are also somewhat cooked for political effect. You'll know that the grip of deflation is tightening if you continue to see more of the following: discounts, price reductions, joblessness, real estate vacancies, bank failures, business failures, public finance failures, pension defaults, loan defaults, shrinking debt and credit, higher savings ratios, and frugal spending.

The depression will be terrible, but it could have a cleansing effect.

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