A Few Thoughts on Deflation

Inflation is familiar to most of us. Inflation tends to occur when the economy is growing. People demand things faster than the market can produce them. To some extent, production capacity grows; but to some extent, smart sellers keep supply a bit tight so they can justify charging more. If you really want the thing, and can't get it at your preferred price, you may be willing to pay a somewhat higher price. Deflation is less familiar. Deflation tends to occur when the economy is not growing or is actually shrinking. People don't demand so much in this case. Sellers still have to pay their bills, so they don't have much choice but to cut prices, in a bid to keep some dollars coming in the door. Now, unlike in an inflationary scenario, there's more stuff than anyone wants to buy; and in the "worst" case, people just plain lose interest in buying. It's really the opposite of the shop-'til-you-drop mindset of the inflationary situation; it's people who realize it makes sense to mind their money carefully, not waste it -- and hold off buying that thing for a little longer, because prices keep dropping. The inflationary scenario is good for people who have enough money but not enough stuff. The economy is growing, the money is there, not much to worry about, so just buy whatever you want (relatively speaking). It doesn't work for everyone, of course -- there are lots and lots of very poor people in this scenario -- but it works for enough people to set a general tone or expectation for what is economically normal or average. When that goes away, as is now happening, it feels like things are no longer normal. The deflationary scenario is good for people who have enough stuff but not enough money. They weren't really feeling a desperate need to acquire more crap right now, so it's OK to postpone purchases while prices drop; and they become more aware that jobs are endangered (because the economy is slowing down), such that they may not be able to get money when they really need it, sometime in the future. When growth continues, it encourages continued consumption. When it continues for long enough, the notion of saving and being cautious can seem quaint. People who learned hard lessons from the Great Depression were sometimes too fearful to take bold risks that could have really paid off financially in, say, the 1960s. But eventually those people passed from the scene -- retiring, dying, being muscled aside by their numerous Baby Boom progeny -- and their restraining hand was loosened. We went from fear of risks to payoffs for wise risks to acceptance of all kinds of risks. It would have been nice if we Boomers could have bottled some of that advice our parents were handing us in the 1960s and kept it, like a vintage wine, to be opened in the 1980s, when the Reagan Administration began dismantling Depression-era regulatory safeguards. So debt became normal -- not only for credit card users, but for financial institutions and government. They fed us tons of debt, in mortgages and cash advances and student loans and military adventures. Debt continues to be the answer, this late in the day, as government tries to employ FDR's Depression-era spending as an antidote to deflation. People in power want to return to "normalcy" -- that is, to an inflationary economy. They have not yet made the transition to realizing that consumers are broke, indebted, and scared. If you gave each American consumer $100,000 right now, there is a good chance that half of it (if not all of it) would go into savings, hiring a bankruptcy attorney, catching up on some bills, and otherwise trying to undo the personal exposure created by the inflationary years. That sort of behavior is not going to recreate a growth economy. It could lay the foundation for a solid, savings-based economy in coming decades, except for that debt problem. Unlike the 1930s, the amounts of individual, corporate, and governmental debt are simply beyond anything that a deflationary economy can pay off. Debts taken out with an expectation of an income of $60,000 look very different when that income drops to $25,000, or below, and many people will be unable to avoid that kind of drop as we continue to transition to a world in which American workers compete against Asian and robotic workers. The U.S. government can continue to spend borrowed money, as long as people continue to be willing to lend to it. There are recent signs that China may finally be starting to back off from that, though, and in any event they should do so if repayment becomes more doubtful. The present impression appears to be that today's deficit spending enhances tomorrow's inflation. So if the lending from China and elsewhere did get consumers spending again, it would be counterproductive for those investors in the sense that they would have helped to arrange a return to a growth economy with, it appears, some potential for high inflation -- which would erode the real value of their investments. In other words, they would have loaned us $1 billion (or whatever), and that would have helped a bit to get things going again, but now that $1 billion would have lost maybe 10% of its value because the dollars with which it is repaid are able to buy less than before. Given the rate at which the U.S. government is now spending money, it appears the next step will be for the spigot to be partly closed. If Obama stumbles and/or if the economy continues to unravel, confidence in the federal ability to repay borrowed money will decline, and the government will have to pay higher interest rates. Other borrowers will have to pay even higher rates if they are to stay competitive with the "safe" rate of interest being offered by investors in U.S. Treasury securities. This will make it harder for the economy to stay in a growth mode, because loans to companies will become more expensive. This all happened because we developed a financial system that was too complexly interwoven for anyone to understand or fix. And that happened because transparency and other regulated behaviors were shut down. The go-go economy that developed under such circumstances is not likely to be replicated under the more restrictive regulations that will be emerging in the coming year or two. The "Roaring Twenties" were a legend even into the 1960s. It increasingly appears that the twin bubbles of the dot-com era and the housing frenzy will stand out, for decades to come, as historically remarkable phenomena. I suspect that what Obama *will* say, in his inaugural address, is that we all need to hope and pitch in and make things better again -- and that what he *should* say is that we may very well be at the start of a second Great Depression, and the remedy is to take a lot of bitter medicine immediately if we don't want it to drag on for years. The bad financial instruments have to be mopped up, regulations must return, a calming social safety net needs to be put in place, financial blood must flow in the streets, and then he will have credibility. They will say he wasn't trying to make it look better than it is; he was just no-nonsense. We need a 5.5-month time-out for bad behavior, with the goal of making this July 4 a heartfelt rededication to a fiscally solid, sensible economy and government. That, I think, is the sort of thing that would make a sufficiently strong impression on where we are and where we are going. One part of that bitter medicine is to accept that retailing has changed. We can get there the fast way, maybe, or we can get there the slow way. The slow way may involve some years of getting used to the sight of boarded-up stores, to the point where old movie scenes of busy downtown business districts look strange and even unrealistic. Slowly, the stores will be converted or bulldozed, malls will become skating rinks and indoor jogging tracks, or in other ways the whole face of the retail world will change -- and that new world will seem normal.

Contrarian Prediction: Deflation

What we have been worrying about, all along, was that the Fed would keep pumping money into the economy, and this would inflate the currency, making it less valuable vis-a-vis other currencies, precious metals, commodities, etc. That is still certainly a possibility. Suddenly, however, it appears that things could also conceivably go in the opposite direction. The dollar is becoming strong, in the past few days, as people fly to quality. The U.S. economy is at risk, we see, but it is not necessarily as much at risk as other economies. If the government intervenes in the market in Russia, for instance, it intervenes in order to seize your investment; but if the government intervenes in the U.S., it typically (and even now) does so in order to preserve your investment. At this time of panic, gold should be flying through the roof. Instead, over the past couple of weeks, it has dropped in dollar terms. It is not that the dollar is safer than gold; it is that gold (for American purposes) is priced in dollars, and dollars are in demand. Especially the dollars produced by the U.S. Treasury (in e.g., T-bills) and backed by the full faith and credit of the U.S. government. The U.S. government may or may not be good for it, in the long haul; but there are an awful lot of nervous people, around the world, who seem to be of the opinion that if anybody's good for it, the U.S. government is. If we're looking for a paradigm shift in the world economy, away from America at its center, it's not setting itself up as a gradual transition. It's an over-the-cliff kind of transition, where the U.S. economy, dollar, and Treasury all wind up at the bottom in a broken heap. Is that where we're headed? Maybe not, or at least maybe not right away. We've got billions of people out there who seem to be wanting the U.S. to hold itself together and go back to a consumerist orientation, buying things that other people produce, and so forth. China is making a bid to unlock a large quantum of its own purchasing power, in its recent real estate reforms; but that will take time, and it is not clear to what extent it will provide as an engine for global (as distinct from Chinese internal) growth. Presumably the Chinese currency will have to appreciate a great deal before Chinese citizens en masse have the wherewithal to make large-scale purchases abroad. In any case, China has placed its own huge bets on the strength of the U.S. Treasury, and has its own incentives to see to it that those bets do not become worthless. So if there's a lot of interest in seeing the U.S. remain strong, then perhaps we've already seen the dollar devaulation run its course for now. If panic money does come into an underpriced U.S., to buy up our land and our companies and in shopping sprees of other kinds, then perhaps the world will continue to find new ways to fund our lifestyle or, more importantly, our confidence. Those defaulting mortgages could get sopped up pretty quickly if, say, the government were to allow people from abroad to become American citizens immediately, provided they can put up the purchase price of a nice suburban home in cash. Does the world have a couple million would-be applicants who could pay that price? Maybe. Would Americans bitch and moan about a flood of immigrants if (a) they hailed from the four corners of the globe (as distinct from e.g., a Hispanic tide) and (b) they were bailing us out financially? Maybe not. Right now, interest rates (on e.g., T-bills) have fallen to extraordinarily low levels. Hmm -- that sounds like the direction in which we would be moving if we were indeed trending towards deflation. Just to have the U.S. dollar is good enough; people seem to be happy to do that, without needing to earn much interest on it. If the bucket tips over, than all bets are off: everything spills across the floor, and the dollar becomes worthless in a trice. But as long as she remains upright, she may just continue to be the best game in town. It could be some time before people espy a better bet. In a deflationary scenario, the dollar becomes ever more valuable, and people have ever less of it. That, too, sounds familiar. Those debts that were difficult to pay before become impossible to pay now, as wages drop or disappear while principal plus interest compound. An acute problem of indebtedness will leave a large number of debtors unable to pay, and a large number of creditors increasingly insistent on being paid. Typically, this kind of problem will be approached on multiple fronts. Creditors will get shafted, to some extent, in liberalized bankruptcy proceedings; simultaneously, debtors will be expected to cough up even more than they do already. To see it another way, our move toward a common global standard of living for workers will entail, not only a lowering of our wages to compete with our good friends in China and India, but also a lowering of our lifestyles to accommodate longer working hours. In the extreme case, to spin out the scenario further, unemployment could come to be appreciated as in some ways a superior form of existence: not much less financially rewarding, and much more fulfilling. Be that as it may, the indebtedness problem, too, is very familiar now. So there do seem to be these serious bits of circumstantial evidence that are compatible with a possibility of deflation.

The End of Capitalism as We Know It

Basically, as my dad would have put it, they keep horsing around until somebody gets hurt. The subprime mortgage meltdown is a case study on the topic. When there’s an opportunity to make money, people tend to pile on. They did the same thing in the dot-com bust some years ago. They do it on every market that heads upwards. Prosperity, real or hoped-for, carries its own logic and momentum. People keep going; they ride the surfboard right up to the sand. This ain’t gonna work in environmental matters, though. Sooner or later, somebody is going to make honeybees extinct; or a bazillion square miles of ice are going to cut loose from Greenland and flood dozens of coastal cities around the world; or there’s going to be a pandemic, born of a warmer environment or greater human incursion into animal habitat. Something, anyway, is going to kill a boatload of us, and scare the rest of us so badly as to turn public opinion decisively against the free market. It’s going to happen because people are just going to keep focusing on economic growth until they run head-on into a wall. Because, as my dad would have said, they don’t know when to quit.

Recession: Acceleration at the Top

On the subject of recession, envision two models of shifting views. In the first model, belief that a recession may occur grows linearly. Last week, 40% of economists (or whoever) believed that we would have a recession. This week, it's 50%. Next week, it will be 60%. That, I think, is an unlikely model. The alternative, I suggest, is a logarithmic or accelerating model. The acceleration occurs because recession means fear and pain. One might expect a similar acceleration in predictions about any undesirable but increasingly probable development. In this acceleration model, people initially resist believing in the negative outcome. The positive was good for them, and they want it to continue. So instead of ratcheting up by 10% per week, as perhaps it should, the opinions of economists (or whoever) initially increase by only 5%. Last week, 40% of economists publicly admitted that we were approaching a recession; this week, 45% of economists did so (even though the facts were such as to support that finding by a full 50%). It is like a rollercoaster. You do not just go directly into a 45-degree drop. First, once everyone is on the train, you roll out of the station. You screw around for a while -- up, down, up, down. Nothing major. Finally, you come to the big drop-off. But it does not happen all at once. There is a gradually steepening curve. You know what comes next. It is really scary, and there is no way on Earth to stop it. But you are not yet prepared to embrace it; and for a few seconds, the rollercoaster does not actually force you to embrace it. You are going down -- soon, but not for another fraction of a second. There is still time to hope, and to fear. That's Part I. Next, you do go over the cliff. You are indeed plunging downwards at a 45-degree angle. But it feels like 75 degrees. You're moving like a bat out of hell. You feel like you are going straight down. So now the economists are fully focused. We are into a recession: it will be a bad one, we don't know when it will end, etc. Now, instead of an increase from 50% of economists this week to a tally of 60% next week, the pace picks up. Now everybody is a believer. You go from 50% in one week to 75% in the next week. This is what panics are all about. People sell when they actually might not need to sell. The bottom might come soon. Or it might not; we really have no idea. The point here is simply that opinions change at an accelerating pace, not a linear one.

One Factor Auguring a Depression

It seems fairly clear, by now, that Ben Bernanke is very concerned -- almost preoccupied -- with the performance of the stock market. Since last August, his interest rate cuts have repeatedly proceeded for the purpose of saving the market, and despite warnings of potential inflation. The dollar is now at an all-time low against gold and is also very low and headed further downward against key currencies, including not only the euro but also the Chinese yuan, which is moving at a gradual but increasing pace toward becoming a freely traded currency. The low value of the dollar means that dollar-denominated investments perform poorly for international investors. As has been often noted, a foreign investor who entered the U.S. stock market five or six years ago, at the start of its recent and remarkable rise, would have *lost* money because of the contemporaneous decline in the dollar's value. Actual and potential foreign investors are not ignorant of this. They have funded the deficits of the Bush years, buying U.S. government securities because they have believed in the safety and profitability of investments in America. During the past year, however, such investors have become more audibly concerned about the sense of such investments. Steps are being taken -- gradual steps, but significant ones -- toward diversifying away from the U.S. economy. U.S. consumer purchases and government expenditures are founded, alike, on cheap credit. If money becomes less available and/or more expensive, consumers will borrow and spend less, and the government will be less able to afford to hire people, build and buy things, and otherwise stimulate the economy. Money will become less available if foreign investors supply less of it. Rationally, they should be doing so; and over time, by present trends, they will do so. It is not yet clear whether we are now in the opening phase of a massive readjustment to a more realistic world, one in which money is supplied to us based upon our present productivity and competitiveness, as distinct from faith in our future promise. But there is a good chance that that day has arrived. We face unprecedented competition on both counts, as rising economies (especially in Asia) offer seemingly endless supplies of people willing to work hard and live cheap. The market is confident that Bernanke's Federal Reserve Bank will again cut rates, two weeks from now, perhaps by as much as a half-point. (Some are betting on an even greater cut.) Foreign investors are undeniably paying attention. The standard wisdom continues to be that Asia cannot fully decouple its prospects from America's -- that, in other words, if the U.S. sneezes, Asia will catch a cold. But foreign investors cannot be expected to continue to invest where they will realize a negative rate of return. There remain an unacceptably high number of unknowns and negatives in today's stock market. Stocks may not be overvalued in historical terms. But there is a good chance that they are overvalued within a context of troubled times. It is not obviously a good time to cast a vote of confidence in the S&P 500 -- a vote that, essentially, things will return to where they were a year ago. That sort of renaissance seems unlikely in the near term. In short, the market and Fed policy seem to be based upon a worldview that says we have been coping with some difficulties, but that they will ultimately resolve themselves and good times will return. This is bull market thinking: it is the mentality in which everything finally turns out OK. Yesterday's market rout suggested that doubts are now emerging in the bull market mindset. Descriptions of that rout included the key word "panic." Panic is a bear market concept. It is the recognition that companies whose stock you own can go bankrupt, that you can lose your shirt, that the elevator to the penthouse also goes all the way to the basement. The stock market has been extraordinarily resilient despite repeated and growing pressures on multiple fronts. Some unknown portion of that resilience derives from the inexperience of a generation that has known largely good times. Even the recession of 2001 was mild, in contrast to the successively greater hardships known by previous generations, as one goes back in time to 1991, 1980, and, of course, 1933. If the American century were not over, one might expect a continuation of that pattern of successively milder national economic hardships. But this generation, unprecedentedly fortunate in its exposure to hardship, may yet encounter the novel thought that what goes up can go down. Panic remains possible for today's investor. People can reinterpret recent bad news through the bear's eyes. In that event, that grey expanse above us, presently perceived as a set of storm clouds over the economy's forward march, may instead come to be seen as the surface of the ocean, far, far above one's head. In such an event, thoughts go to survival, and standard valuations become rapidly recalculated. The U.S. government, including the Fed, does not presently understand the nation's capital markets, nor does it have the power to fix them. Nobody understands them fully; nobody has that power. Bernanke's consensus leadership style is, moreover, the wrong style for uncertain times. He is a brilliant man -- he is as competent as they come -- but the impression is growing that the Fed does not have the power and wisdom that investors were previously willing to credit to Greenspan's Fed. The impression grows that the Fed is becoming desperate, and that its desperation arises from its impotence. The Fed is behind the curve, and my hunch is that it will not (and could not) get ahead. What it can and apparently will do -- much to the lifelong regret of Bernanke, student of the Great Depression -- will be to alienate the foreign investors whose deposits in our economy have made the bull market possible. It does seem that there will be a wrenching readjustment, and that bear market thinking will come to seem more realistic.