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Debt, Inflation, & Deflation
The truth about Federal Reserve expansion policies; however, is significantly different from perceptions. A more correct assessment of expanding credit is this…. The United States has transformed its monetary system into one that's credit-based. In such a system, the aggregate level of debt influences price trends. Furthermore, in a credit-based economy, a creditor lends money to a debtor. At that instant, the creditor holds a monetary asset that fluctuates in value. The debtor normally uses the proceeds to purchase goods, services, or investments. From the debtor's perspective, the immediate impact from this loan is twofold: (a) Spending power is enhanced in the short-term, and (b) as loan payments begin, disposable income is reduced over the long-term. When new credit being issued exceeds old credit being paid off, it creates inflationary pressure during the months immediately following the lending. Additionally, excessive lending creates steady, continual deflationary pressure once loan repayments begin. Over the long-term, every short-term inflationary benefit is offset by an equal and opposite looming deflationary force. That's why, throughout history, great credit inflations (bubbles) always end with prices crashing back down to a level roughly equal to the level at the start of the inflation. In the United States, the deflationary potential created from new loans has been deferred for several decades by both Congress and the Federal Reserve providing consumers, homeowners, and business owners with incentives to borrow (rather than save) anytime a deflationary threat became real. The repeated process of deferring deflation convinced the majority that government leaders can and will permanently prevent a serious deflation. However, that perception is based on incomplete thinking. The remainder of this letter will show why the long-delayed deflation is highly likely to strike in the coming months and years. Led by Paul Tudor Jones, managers at the Clarium hedge fund have recently positioned their clients for deflation and depression rather than inflation and recovery. In a September 1 article entitled, Goldman Sachs Wrong on Economic Recovery, Macro Hedge Funds Say, Cristina Alesci explains part of the deflationary case:
It seems that most investors have either forgotten or completely ignore the fact that banks hold hundreds of billions of dollars of toxic assets. These are assets that are valued on quarterly earnings at levels well above market-price. Even though bank executives were successful in pressuring regulators to changing accounting rules, they still hold the toxic assets. The financial crisis persists. The only factor that has changed is confidence. Investors and executives are more confident now - even though actual financial conditions have continued to deteriorate. It's simply a matter of time before the newfound confidence reverts back to panic and deflation. Some believe that future inflation is a foregone conclusion because government control over the banking system has been greatly enhanced as a result of the financial crisis. Smaller institutions have been failing in ever increasing numbers, while the rescued banks meeting the "Too Big to Fail" criteria now increasingly dominate all areas of the country. These large banks now operate under increased political control. In an August 28, 2009 Washington Post article, entitled Banks 'Too Big to Fail' Have Grown Even Bigger, David Cho describes various issues related to the new banking environment:
Does this new system of "government favored banks" really mean that inflation is a foregone conclusion? As a direct consequence, it does mean that the majority of financial assets and liabilities are now on the balance sheets of a handful of banks. The greatest risk lies on the asset side of the ledger. That's where losses are being hidden and disguised in droves. To be sure, look at what's happening to property values in the private sector. That ultimately represents the collateral behind bank assets. The liability side of the ledger also poses risk if depositors suddenly decide to flee banks in a big way. This threat is greatest among foreign depositors. These are both looming deflationary threats that are mostly being ignored for now. Government officials always overlook the fact that a deflationary recession cleanses unstable debt from the financial system. Nonetheless, since the Great Depression, officials have remained paranoid of deflation. In particular, recent Federal Reserve chairmen, Alan Greenspan and Ben Bernanke, have publicly stated their knowledge of the Great Depression and their ability to avert a similar disaster. In a statement prior to becoming the Fed chairman, Bernanke said that if conditions became too desperate, the Fed could simply drop dollars from helicopters to re-inflate the economy - thus earning the nickname Helicopter Ben. Following the tendencies of his predecessors, Bernanke's interventions again prevented the natural debt-cleansing process of free markets. As a result, bad debt keeps building within our financial system. Excessive risk-taking is repeatedly encouraged. And allocation of credit becomes increasingly distorted and misplaced. In the final stages of a monetary-system built on ever-expanding credit, the debt problem becomes so huge that government efforts to stabilize the system repeatedly fail. That's the stage the US economy now finds itself. At this point, even the combined efforts of the Federal Reserve and the US Treasury will fail to fix the debt-problem. That's because too many individual and businesses hold too many bad debts that have no hope of ever being repaid. A financial system built on ever-expanding debt is always doomed to fail - it's simply a matter of time before the expansion reaches its breaking point. By preventing a series of minor deflations spread out over a period of several decades, the Federal Reserve has created an environment that will force one massive deflation (striking within a relatively short period of time). By allowing bad-debt to continually build within the banking system, the Fed has created a situation that guarantees our government will completely loses control. That almost happened last autumn, and it's guaranteed to happen sometime in the future. It's only a question of when. In an article entitled A Recovery Foundation Built on Sand, Michael Pento, the chief economist for Delta Global Advisors, describes how current government interference only prolongs financial agony, while never solving the underlying cause - which is excessive debt:
I agree with Pento on every point, except for one - a devastating bought of inflation is unlikely. In the United States, two camps of thought dominate the marketplace. The bullish camp believes that government interventions can be fine-tuned to hold inflation in-check, while allowing the economy to expand. The bearish camp believes that government interventions will eventually unleash uncontrollable inflation that will send the price of gold, oil, and other commodities soaring to sky-high levels - while sending the economy into a prolonged tailspin due to reduced purchasing power. But more than likely, both camps are wrong. And the hyperinflation expected by the bearish comp is even more unlikely than the bullish viewpoint. Why? Throughout the world's financial history, there has never been a case of hyperinflation in a country using a monetary-system based on credit. Hyperinflations only occur in countries that use currency for money. That's an important distinction that cannot be overlooked. A credit-based monetary system prevents severe inflation in two ways. (1) During times of rising inflation, investors avoid bonds in favor of hard assets. As a result, bond prices deflate, causing great losses for existing debt holders. (2) During times of financial stress, bonds backed by questionable assets deflate in value. Hence, even though the par-value of outstanding debt may increase (leading some to believe that inflation will soon strike), the market-price of that debt can and will deflate substantially, depending on the conditions. This leads to loss of wealth and reduced purchasing power for creditors. If potential lenders become too alarmed by deflated credit values, they stop lending. That's exactly what happened during the Great Depression, during the early 1980s, and once again during 2008. And that's why credit markets froze. And deflation of debt resides at the center of the toxic asset problem at the major banks. Bankers say their illiquid holdings should be valued close to par-value. Knowledgeable investors say they should be valued at market-price. Devaluation of credit has struck in a big way, and the deflationary repercussions continue to spread. Even though bankers gained accounting relief via political pressure, accountants don't provide payments. But debtors and markets do. Eventually, bankers must face up to the distressed levels of their toxic assets. Will the myriad array of government programs unfreeze the credit markets? Absolutely not! The only credit markets that remain completely unfrozen are the markets for government debt, agency debt, and private debt guaranteed by the government. However, in the process of opening its checkbook to firms with sufficient political clout, the ultimate bubble of all bubbles is now forming - a US government debt bubble. Identical to all other bubbles, the government debt bubble will eventually burst. At some point, the ever-expanding supply of debt will simply overwhelm the market. No entity is bigger than the market, and markets always prevail over participants who abuse or attempt to corner trading. This applies to governments as well as individuals. Government cannot continue borrowing in large quantities indefinitely without paying a steep price for that luxury. At the first hint that large holders are leaving the market, a mad scramble by other owners will severely deflate the value of bonds. More than likely, such a panic will start in the corporate sector first, and then spread to government bonds later. In this scenario, even substantial intervention by the Federal Reserve will fail to prevent panic. Why? History shows that when a monetary authority overpays for an asset in an attempt to halt a panic, private holders willingly dump a seemingly endless supply of assets onto the authority - eventually overwhelming the intervention attempt. A close examination of credit conditions shows that recent interventions have failed to improve the private sector environment. This implies that our government is now throwing good money after bad at an alarming rate. And this increases the risk of pending failure of federal access to the debt markets. The ineffectiveness of government efforts can be inferred from an August 20 Bloomberg article, entitled Corporate Defaults Soar to $453 Billion, S&P Reports, Caroline Hyde and Paul Armstrong describe the latest news on the ability of corporations to repay their debts.
At the present time, most economists and investors greatly underestimate the deflationary impact from the intrinsic loss off wealth continually occurring in the corporate sector. Of course, these losses aren't limited to businesses. The financial environment for homeowners continues to deteriorate as well. In an August 20 release entitled Delinquencies Continue to Climb, Foreclosures Flat in Latest MBA National Delinquency Survey, the Mortgage Bankers Association reports that delinquencies continue their record ascent:
As the preceding press release indicates, overloading homeowners with more debt doesn't improve their ability to repay existing loans, and it certainly doesn't improve the prospects for the national economy. The current preferred solution (now used by the major banks) of extending more credit for troubled homeowners only buys more time while placing an increased burden on debtors. In this case, extending loans increases the deflationary pressure throughout the economy. That's because it fails to create additional buying demand (because proceeds from the increased mortgage flow back to the lender) - while the pressure to sell homes and other assets remains. On the paper-side of the equation, with an increased mortgage against an unchanged home-price, the intrinsic value of the mortgage actually deflates in value. (Note: To calculate the intrinsic value of a paper asset, divide the market-price of the hard asset that serves as collateral by the par-value of the loan.) If home prices continue to decline, the intrinsic market-value for outstanding mortgages deflates even faster. The rising delinquency rate only reflects the start of a long sequence of related problems. More importantly, the following article highlights the fact that, in today's economic environment, once a delinquency occurs, there's virtually no chance of recovery for a lender. Executives at major banks are in complete denial of this fact. These executives claim they can recover most of the par-value of their toxic assets. An August 25 Wall Street Journal column, entitled Fewer Catching Up on Lapsed Mortgages, James Hagerty describes the darkening plight facing over-leveraged homeowners. This suggests that bankers are oblivious about the value of their troubled loans:
In spite of efforts by both the administration and bankers to solve the foreclosure crisis, the darkening economic situation has proved too great to overcome. The plain truth is that few distressed properties fall into a category that permits assistance. In addition, recent publicity about the long-term eviction process may actually encourage people living on the edge to default. By doing so, a homeowner gains a year of rent-free living before being evicted. For financially troubled individuals, this can mean a savings of tens of thousands of dollars (causing at an equivalent loss to the lender).
For all practical purposes, single-home owners with a mild delinquency qualify for assistance, and that's it. Abandoned homes, vacation homes, second homes, and investment properties fail to qualify for help. Once a homeowner becomes delinquent, there's still a small chance of recovery - even after a home reaches the pre-foreclosure stage. However, information from foreclosure.com shows that only 20% of all distressed properties fall into the pre-foreclosure category. The other 80% fall in the more serious categories of foreclosures, sheriff sales, bankruptcies, and tax lien sales. See Chart Daily17. Furthermore, homeowners must want assistance before the administration's modification program provides benefit. Increasingly, homeowners deep underwater prefer to walk away from their mortgage rather than continue efforts to salvage their residential investment. In addition to difficulties that are directly visible because of widespread reporting by the media, some less visible financial problems brew beneath the surface. In a September 3 Wall Street Journal article, entitled The Reluctant Landlords, M.P. McQueen describes circumstances that have forced many homeowners to become landlords:
McQueen's article provided several more examples - all with different circumstances, but all with the same underlying problem. Specifically, all of the reluctant landlords receive insufficient rent from their property to cover their existing mortgage - not even considering insurance and maintenance costs. Additionally, all of the landlords believe that if they can just hold out for another year or two, home prices will recover enough to bail them out of their financial mess. Yet, markets seldom accommodate the majority when their finances sit on the edge of insolvency. The extend-and-pretend mentality has stretched far beyond the banking system. This dormant inventory of homes (from reluctant landlords) means that the real supply of homes for sale is much larger than the official numbers show. The bottom line is that home prices remain too high to justify renting. Residential properties must decline by at least half of their current value to bring solid investors into the rental market. Of course, if home prices fall that far, a whole new set of issues will emerge. Similar to inflation, once deflation becomes entrenched, it becomes exceedingly difficult to stop its momentum. Deflation only stops once the majority of debtors become relieved of the debt causing the burden. In the United States, the process has already begun in most areas of the private sector. The public sector will be forced into a similar liquidation once the federal debt bubble bursts.
With parents increasingly unable to assist in educational expenses, students are relying on debt more than ever to get through college. Nonetheless, job prospects for graduates are diminishing. A large number of these loans will assuredly end in default. Yet, this is an area of the credit market that remains open - but only because of its federal association. At this point, the two-tiered marketplace - of federal-related credit markets remaining open and turning out loans full blast while private sector credit markets remain exceedingly tight and undergoing moderate contraction - creates a conflicted environment with deflation occurring in the private sector while inflation continues at the government level. Which of these two conflicting forces will prevail? The numerous (and intensifying) negative factors listed on the previous pages far outweigh political and banking efforts to contain the ongoing crisis. Looking at total debt levels, if derivatives are included on the liability side of the equation, private sector debt exceeds government related debt by a factor of anywhere from 10 to 20 times. So the developing deflationary trend in the private sector will more than offset soaring government debt for the next few years. Inflation may eventually become a problem, but not for years to come - and not until liquidations relieve consumers and businesses of the majority of their outstanding debts. To make a long story short, no painless way exists to relieve debtors from their plight once they've reached the maxed-out stage. And in the United States, we may be approaching the point where 50% of all consumers, homeowners, and businesses have maxed-out on their credit. This has created a tremendous deflationary force that has become next-to-impossible to contain. By preventing deflations during previous cycles, the Federal Reserve and the US Treasury have dammed-up negative monetary forces into a swelling reservoir of deflationary potential. During the summer and autumn of 2008, the deflationary dam nearly burst. Yet, the patchwork system put in place to relieve debtors has only caused the deflationary potential to grow larger and more unruly - as it has allowed some businesses and individuals, as well as the government, to become more deeply indebted. Nonetheless, these past few pages show glaring signs that the deflationary dam cannot be contained much longer. On Tuesday, August 25, the markets cheered news that Ben Bernanke will be re-appointed chairman of the Federal Reserve. Indeed, mainstream economists almost unanimously credit Bernanke with single-handedly saving the US financial system from implosion last year. Yet, the chairman of Morgan Stanley's Asian operations, Stephen Roach, views Bernanke's tenure in a more realistic light. On the same day as the Bernanke news broke, London's Financial Times published Roach's assessment of Bernanke in an article entitled The Case Against Bernanke:
Unfortunately, Bernanke's current solution of massive credit extension (including credit given to unworthy borrowers) mirrors the extend-and-pretend method now being employed by bankers for delinquent homeowners and commercial real estate investors. During recent post-bubble mop-up periods, the Fed inadvertently created new bubbles. Once again, it's engaged in the same type of bubble blowing. The new bubble is quite obvious - at least, for anyone willing to take the time and effort to analyze the situation. This time, a huge bubble in government-related finance is occurring. Credit-risk is being massively transferred from the private sector of the economy to the public sector. Outstanding debt is expanding at alarming rates for the federal government, its agencies, the government-guaranteed private sector, and the Federal Reserve. While credit to the private sector and to state-and-local governments remains severely constrained, borrowers with a direct or implied guarantee from the federal government still enjoy (at least for now) virtually unlimited ability to issue new debt. Nonetheless, similar to other great bubbles, the federal government debt-bubble will burst as well. And when it does, the financial backstop of our "lender of last resort" will immediately evaporate. At that point, nothing will remain to stop the long-delayed deflationary correction. Unlike previous crises, federal officials will hold no weapons to fight the looming deflation. If by chance, the government tries to fight the deflation with increased deficits (which it probably will for a while), the marketplace will deflate the value of its existing debt at a rate faster than it can issue new debt - thus causing more deflation. Inflation has little chance of taking hold until our credit markets are totally destroyed - then inflation becomes a distinct possibility. Once the federal-debt bubble bursts, even potential purchases by the Federal Reserve will fail to revive the bond market. If the Federal Reserve attempts to mop up excessive government debt by monetizing it, holders of existing debt will readily give their paper to the Federal Reserve at a price that will surely be "above market price". By paying prices above fair-value, the Fed will be swamped with offers to sell, and it will quickly "bankrupt" itself (as any buyer would) by repeatedly paying prices that are too high. Interestingly, the Federal Reserve now finds itself in the middle of a losing lawsuit. While the practice of hiding losses may fool some of the people some of the time (and it may have aided in averting financial crises in the past), the Fed's long-term practice of repeated deception only spawns distrust of bankers and our banking system. This distrust will surely intensify as a result of the Federal Reserve's recent refusal to release details of its emergency loans. In an August 27 Bloomberg article entitled Federal Reserve Says Disclosing Loans Will Hurt Banks, financial writer Mark Pittman describes the battle between Bloomberg and the Fed:
What is the Fed hiding? And why? Why do Fed officials think revealing the details of their emergency loans will cause depositors to withdraw funds from troubled banks? Perhaps the Fed's refusal to reveal the information indicates that major banks are in much worse shape than the Fed admits publicly. This is a very curious situation. Instead of handing over the documents to Bloomberg, by pursuing an appeal, the Fed risks a backlash. Investors and depositors are already edgy about the lack of transparency within banking circles. The Fed's refusal to hand over documents can only increase that distrust. When a financial bubble bursts, millions of citizens lose faith in their leaders and institutions. This lost faith adds to the difficulty of re-inflating the economy. To better understand this fact, Japan serves as a great example. Failed attempts to re-inflate the Japanese economy warn of equivalent events in the United States. In an August 28 Bloomberg article, entitled Japan's Jobless Rate Hits Record 5.7% in Blow to Aso, Toru Fujioka and Mayumi Otsuma describe the consequences of the post-bubble environment in Japan:
Actually, in the US deflationary prospects are much greater than in Japan. In Japan, consumers mostly live within their means. In the US, the adjustment needed to reduce spending to a level that doesn't required continual borrowing and stimulus has only begun on a limited scale. Much deeper cuts are required. Overseas lenders won't continually lend to a country that repeatedly over-consumes. Our best hope is that overseas lenders and producers are ignorant enough that they will continue to toil and labor at their expense to provide US consumers with goods for our enjoyment - and all we have to do is continue giving them electronic promises that will never be repaid. But such a work-free outcome seems unlikely to last much longer. Foreign officials and investors are increasingly grumbling about US spending habits. Eventually, they seem certain to do something more serious than grumble - for example, they may soon refuse to buy new dollar-denominated debt, and they may begin selling the dollar-denominated securities they already own. Government efforts to improve the financial condition of the US economy will continue to fail - at least until a deflationary collapse arrives. A deflationary crash will benefit the masses in two ways: (1) It will forcibly relieve debt burdens, and (2) it will bring home-prices and consumer-prices down to more reasonable levels - levels that allow our citizens to buy necessities at levels that don't require massive debt burdens. These two benefits are virtually ignored as policymakers continually work in the direction of inflating our economy. Policymakers incorrectly view deflation as a bad thing and inflation as a good thing. True. Deflation usually results in rising unemployment, but that is offset by the benefits of keeping debt-loads in balance and by keeping prices at affordable levels. Current views toward deflation must be discarded to allow our nation to return to a balanced economy. In order to attain long-term prosperity, markets must return to a pricing mechanism that allows deflation - free from government interference. In addition to the debt monster working against the government, the long-term EUWS cycles (such as the 172-year, 57-year, and 19-year cycles) suggest that confidence in government policies will continue to erode as time passes. Gaining political support for new spending programs will become increasingly difficult. This difficult political environment clearly shows in the administration's struggling efforts to legislate health-care. Once the inevitable deflationary crash concludes, which is probably several years from now, the US economy will finally reach a stage where long-term recovery becomes a possibility. In the process, the holders of existing debt - including banking institutions, pension funds, mutual funds, foreign governments, and other investors - will be financially decimated. A deflationary crash is inevitable. By the end of the crash, the Dow Jones Industrial Average should trade well below the 1,000 level - about 1/10 of its current price. References for Debt, Inflation, & Deflation. Alesci, C., [2009]. Goldman Sachs Wrong on Economic Recovery, Macro Hedge Funds Say. Bloomberg, September 1, 2009. http://www.bloomberg.com/apps/news?pid=20601009&sid=auGWGWlnohNo Chaker, A.M., [2009]. Students Borrow More Than Ever for College. The Wall Street Journal, Sept. 3, 2009. Cho, D. [2009]. Banks 'Too Big to Fail' Have Grown Even Bigger. Washington Post, August 28, 2009. http://www.washingtonpost.com/wp-dyn/content/article/2009/08/27/AR2009082704193.html Fujioka, T.; Otsuma, M. [2009]. Japan's Jobless Rate Hits Record 5.7% in Blow to Aso. Bloomberg, August 28, 2009. http://www.bloomberg.com/apps/news?pid=20601080&sid=aASW1DJWcbho Hagerty, J.R. [2009]. Fewer Catching Up on Lapsed Mortgages. The Wall Street Journal, August 25, 2009. http://online.wsj.com/article/SB125113686930654371.html Hyde, C.; Armstrong, P. [2009]. Corporate Defaults Soar to $453 Billion, S&P Reports. August 20, 2009, Bloomberg. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aM9Q_6ozzhMU MBA: Kemp, C. [2009]. Delinquencies Continue to Climb, Foreclosures Flat in Latest MBA National Delinquency Survey. Mortgage Bankers Association, Washington, DC, August 20, 2009. McQueen, M.P., [2009]. The Reluctant Landlords. The Wall Street Journal, Swptember 3, 2009. Pento, M. [2009]. A Recovery Foundation Built on Sand. Chief economist, Delta Global Advisors, August 17, 2009. http://prudentbear.com/index.php/guestcommentaryview?art_id=10261 Pittman, M. [2009]. Federal Reserve Says Disclosing Loans Will Hurt Banks. Bloomberg, August 27, 2009. http://www.bloomberg.com/apps/news?pid=20601103&sid=aAOhgVw78e3U Roach, S. [2009]. The Case Against Bernanke. Financial Times, August 25, 2009. Contact Information Steve Puetz | The Unified Cycle Theory | Honolulu, HI USA | Email | Website
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The impact from a central bank's credit policy is perhaps the most misunderstood factor in the study of economics. The majority believes easy credit from the Federal Reserve and expanding deficits by the federal government will quickly lead to price inflation. Because of this belief, and because of the Federal Reserve's ballooning balance sheet, a large number of investors have recently embraced "inflationary hedges" and "inflationary investments" aimed at protecting their wealth against monetary depreciation.
