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.

China: Reduce Inflation by Dumping Dollars?

The Chinese government is worried about inflation in its overheated economy. I noticed someone's remark, the other day, that China would welcome a slowdown in the U.S., because that would reduce American demand for Chinese goods, giving the Chinese authorities a better chance to stabilize their economy. China is a heavy subsidizer of the U.S. government's budget deficits. If China invested less in American government bonds, the U.S. government would have to offer higher rates of interest in order to attract lenders who would continue to subsidize its deficits. It seems like those higher interest rates would compete with other would-be borrowers (e.g., American corporations). Also, higher borrowing costs would increase pressure on the U.S. government to lower its spending. In both of those ways, a Chinese departure from the dollar would seemingly facilitate the sort of U.S. economic slowdown that China is said to prefer at this point. I don't know if I have all those things right, and I also don't know if those steps will actually occur. A separate point is simply that it is now conceivable that, as one would expect, a big lender (e.g., China) eventually becomes able to manipulate the options and circumstances of its borrower (e.g., the U.S.). Such things have happened in the past -- with e.g., the Arab oil embargo of 1973-74. But the ability to influence the rate of interest that the U.S. government must pay nonetheless does seem to be a different kind of event.

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.