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THE
SPECTER OF DEFLATION
by Michael A. Nystrom
BullNotBull.com
January 1, 2007
A
specter is haunting the US economy - the specter of deflation. The Fed
and the Treasury - the central powers of Capitalism itself - have
entered a holy alliance to exorcise this specter. The big question is,
will they be able to do it?
From what we know of economic history, credit expansions lead to
economic booms - this much is clear. What comes next is still up for
debate. Austrian economist Ludwig von Mises tells
us "The boom can last only as long as the credit expansion
progresses at an ever-accelerated pace. The credit expansion boom is
built on the sands of banknotes and deposits. It must collapse. There
is no means of avoiding the final collapse of a boom brought about by
credit expansion." (emphasis mine)
Current Fed Chief Ben "Printing Press" Bernanke begs to
differ. He earned his nickname in the now infamous 2002 speech, "Making
Sure 'It' Doesn't Happen Here" prior to his ascension to the
Chairmanship. Though Bernanke never admits to it in his speech, the
unspeakable "it" is more than just deflation, but the very
"final collapse" that that Mises warns of.
In his speech, Bernanke tells us,
The sources of deflation
are not a mystery. Deflation is in almost all cases a side effect of a
collapse of aggregate demand--a drop in spending so severe that
producers must cut prices on an ongoing basis in order to find buyers.
Likewise, the economic effects of a deflationary episode, for the most
part, are similar to those of any other sharp decline in aggregate
spending--namely, recession, rising unemployment, and financial
stress.
He goes on to tell us that the best way to
cure deflation is to avoid it altogether by preempting it. After the
dot.com collapse and the terrorist attacks of 9/11, the Fed lowered
interest rates aggressively, making it clear that there would be
liquidity for all - no need to panic - move along - continue on with
business as usual. In spite of a mild recession, the Fed's
liquidity-for-all program helped the economy avoid a deflationary
collapse. By creating the housing bubble.
From this compilation of deflation
links that I put together, you'll notice that - at least in the
press - the fear of deflation reached its zenith in 2003, shortly after
Bernanke's "Printing Press" speech, then all but disappeared.
Until this year.
What happened? In my opinion two things: First the Iraq war began in
2003. War is always inflationary, and this one was no exception.
Hundreds of billions of dollars were pumped into the economy via
government spending on military hardware, software and personnel. One of
the leading market sectors since 2003 has been the defense industry.
But the second thing that happened was
Bernanke's genius mind game. So clever in fact, that I am only now
appreciating the audacity of it. In his speech, he tells a story:
Imagine that an alchemist has learned to make unlimited quantities of
gold at no cost, he says. What would then happen to the price of gold,
and when would it happen? The price of gold he tells us, would plummet
immediately - before the alchemist produced a single ounce - because
markets discount future events immediately. Economists the
world over nodded in agreement. Yes, they said, this is so. Then
Bernanke lays the punch line on us:
What has this got to do
with monetary policy? Like gold, U.S. dollars have value only to the
extent that they are strictly limited in supply. But the U.S.
government has a technology, called a printing press (or, today, its
electronic equivalent), that allows it to produce as many U.S. dollars
as it wishes at essentially no cost. By increasing the number of U.S.
dollars in circulation, or even by credibly threatening to
do so, (emphasis mine) the U.S. government can also
reduce the value of a dollar in terms of goods and services, which is
equivalent to raising the prices in dollars of those goods and
services. We conclude that, under a paper-money system, a determined
government can always generate higher spending and hence positive
inflation.
In effect, when President
Bush nominated Bernanke to head the Fed in late 2005, Bernanke
became the credible threat. "An inflationary madman is coming to
the Fed! Run for cover!" And everyone did. Look at how everyone's
favorite inflation indicator - gold - reacted to the threat.
Immediately, I might add.
That was a cool trick, Ben! But what are
you going to do for an encore? With the housing collapse, worry about
deflation is once again creeping in around the margins, and for good
reason. In that sector, we already have deflation. Prices are falling;
unemployment is rising.
Credit, which has grown steadily since the stock market bottomed in
2003, is being destroyed as housing continues its collapse. For those
yet uninitiated into the secrets of modern money, credit is synonymous
with money, because all money is debt -- which is just the other side of
credit. For example, say a bank extends credit to a borrower to buy a
house. That credit becomes the borrower's debt, but the bank's asset. (More
debts for the people means more assets for the banks.) The borrower
uses his new credit to buy a house. Where did the bank get the
"money" in the first place? Why, the Fed printed it of course!
(Weren't you paying attention when Chairman Bernanke was
speaking?)(Confusing? Don't worry - it's meant to be). The point is that
the recent inflationary spiral of printed money pushed housing prices up
and up over the past years. When all the qualified buyers were
exhausted, banks began loaning money to unqualified buyers to keep their
assets growing and the credit expansion going.
But a recent study tells us that 2.2
million homes will soon be lost to foreclosure. This means that
banks extended credit to borrowers for them to buy houses, but the
borrowers soon found they couldn't make the required payments. As a
result, the bank takes the house back. Suddenly a mortgage that was
worth hundreds of thousands of dollars in cash flow to the bank over its
30 year lifespan is gone. In its place the bank has a house it does not
want -- one that undoubtedly has been trashed by its erstwhile owners as
a way of "getting revenge on the man" who is repossessing his
house. (Some
angry former owners have stripped properties of appliances, cabinets,
even light fixtures. More vindictive owners have been known to plug
drains with concrete and turn on the water.)
Furthermore, because of the declining real estate market there is little
chance the bank can sell the house again for anything close to what it
got the first time -- especially if it has been trashed. But sell it
must. The more REO's (bank-speak for "real estate owned") a
bank has on its books, the worse its balance sheet, which means
declining share prices. Banks need to sell those properties! Quick! One
article estimates that 25% of all pre-owned homes on the market in
Dallas are forclosures! This puts incredible downward pressure on prices
because banks are the definition of "motivated sellers." As
opposed to regular sellers who will wait to get "their price"
before selling, banks will sell at just about any price to get
the property off their books...
And thus begins the deflationary spiral. Credit is destroyed, jobs are
lost, payments are missed, bankruptcies declared...
Um, Earth to Bernanke - We have a problem. If you want to preempt
deflation, here is your chance!
In the latter half of his 2002 speech, Bernanke launches into numerous
ways the Fed could stimulate an economy suffering from deflation.
Compared to stories about alchemists and printing presses, this part of
his speech is relatively boring, and you can practically hear him
mumbling through the text. It all boils down to one thing anyway:
lowering interest rates. This, Bernanke says, would solve deflation.
But would it?
There is an old saying that you can lead a horse to water, but you
cannot make him drink. The human corollary is that you can offer a man a
loan, but you cannot make him borrow. In spite of what Bernanke says,
the Fed does not "print" money. It must loan it into
existence, but this requires willing borrowers. Consumer spending powers
70% of the US economy. So how do lower interest rates translate directly
into money in the pockets of US consumers? That's what newly homeless
consumers will need, in order to keep "powering" the economy.
Of course credit card rates will go down, but will that be incentive
enough to continue spending?
As the foreclosures work their way through the economy, you may begin to
hear stories about how people you know have lost their home. But when it
turns out that your neighbor - or a close friend - gets laid off from
his well paying, seemingly secure job and falls behind on his mortgage
payments...Well, you might think twice about upgrading your 39" LCD
TV to the new 52" plasma model - even if you can get it for 0%
interest (for the first six months). More likely you'll start thinking
about building up a cash nest egg of your own. But saving - which for
most Americans means paying down debt - is deflationary. Maybe you could
sell some stock, while price are still high. (Also deflationary)
Downsize your McMansion? Good luck, and also deflationary.
But let's get back to Bernanke's story about the alchemist. Don't we all
know that alchemists don't exist, and that alchemy is a discredited
pseudo-science? Would Bernanke's story have had the same impact if he
were talking about the Tooth Fairy, or the Easter bunny? But for the
sake of argument, let's humor him about the alchemist: What if the
alchemist really couldn't make gold from thin air, but he just said he
could. Then what would happen to the price of gold? It would still
probably drop on his initial announcement, but as people realized he was
bluffing, the price would return to normal. The alchemist's effect on
the price of gold would have just been temporary. But certainly the
alchemist's inability to make gold would have nothing to do with his desire
to do so. The alchemist wants to be able to make gold - it's just that
he can't. It's impossible. This brings us back to what Mises warned us
of: There is no means of avoiding the final collapse of a boom
brought about by credit expansion. Like spinning gold from thin
air, it's impossible.
Which one of these men are you more
inclined to believe?
© 2007
Michael A. Nystrom
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Michael A. Nystrom
Cambridge, MA
www.bullnotbull.com
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