Inflation vs. Deflation debate

Research on Safe Withdrawal Rates

Moderator: hocus2004

Post Reply
Oso Travieso
* Rookie
Posts: 1
Joined: Fri Apr 30, 2004 11:46 am

Inflation vs. Deflation debate

Post by Oso Travieso »

Hello SWR board.

I wandered over here following the invite from hocus on the prudent bear board. Hocus has suggested that it is OK to broaden the scope of topics if they relate to SWR.

I am somewhat suprised to not see a topic on inflation vs. deflation.
I would like to start one since I believe the concept is central to the viability of any SWR model.

I have long followed mannfm11 at Pru Bear, but haven't registered there for a variety of reasons. I suggest researching that board for extensive background on a question I'd like to raise especially to mannfm11.

To try to summarize my take away from mannfm11's previous comments: Deflation is almost inevitable in the US due to the drying up of liquidity. The treasury may try to push money on banks in an effort to get it in circulation, but banks won't lend without a rational expectation of both getting their principle back along with some return.

I've long considered this as somewhat counter-intuitive, since we basically have the fed promising to drop money from helicopters if needed. I'd been unable to come up with a good counter argument to mannfm11's points until somebody pointed me to

http://www.presidency.ucsb.edu/site/doc ... 933&id=157

reading some of this, I think I found how the government may get around the banks rationality to get money in people's hands; as they have done this before:

snippit:

Then we come to the relief that is being given to those who are in danger of losing their farms or their homes. New machinery had to be set up for farm credit and for home credit in every one of the thirty-one hundred counties of the United States and every day that passes is saving homes and farms to hundreds of families. I have publicly asked that foreclosures on farms and chattels and on homes be delayed until every mortgagor in the country shall have had full opportunity to take advantage of Federal credit. I make the further request which many of you know has already been made through the great Federal credit organizations that if there is any family in the United States about to lose its home or about to lose its chattels, that family should telegraph at once either to the Farm Credit Administration or the Home Owners Loan Corporation in Washington requesting their help.

end snippit:

This is from FDR's fireside chat on Oct 22, 1933.

So here we have a precedence that if things get bad enough, the government will bail out the banks by assuming loans of questionable value. They of course put it in different terms.

It is easy to imagine the Treasury dept using banks as their agents to federalize mortgages and credit card balances. The government "helps the poor people"￾; the banks get new management fees; everyone who matters wins. They once again privatize profits and shift losses to the public purse.

Comments are invited as I hope to journey with you-all on the road to true understanding, wherever that might lead us...
User avatar
BenSolar
*** Veteran
Posts: 242
Joined: Mon Nov 25, 2002 5:46 am
Location: Western NC

Post by BenSolar »

Oso Travieso wrote:[I've long considered this as somewhat counter-intuitive, since we basically have the fed promising to drop money from helicopters if needed.
Greetings, Oso Travieso :)

Welcome to the board(s)

I agree with you that it seems the Fed can likely find a means to prevent deflation since they can print as much money as they want. Inflation worries me more. I could be wrong of course. These are incredibly complex issues and I have little real grasp of them. :?
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 »

The Federal Reserve is intent on preventing deflation. One reason is that they need positive interest rates to have any influence. Another is that recent experiences with deflation (combined with a fiat monetary system as opposed to a hard-money/gold standard) have been poor: the Great Depression and the last decade in Japan. We are outside of the range of the Federal Reserve's knowledge in terms of making successful policy decisions.

The Federal Reserve controls short-term interest rates. It offers to buy and sell short-term money in unlimited quantities. [This has worked out much better than setting bank interest rates by law/decree.] It has a theoretical ability to affect long-term interest rates via direct purchases and sales of stock and bonds. It won't do either (and it will especially avoid stocks since that means taking ownership from the private sector) unless it has no alternative.

The Federal Reserve faced an unusual situation this last time: Europe, Japan (and the Far East) and the United States economies were all slowing down at the same time. Prices were falling because demand was falling, not simply because productivity was rising and not because of tight money. The last time this happened was just before the Great Depression. The Federal Reserve was afraid that a US recession could turn into a worldwide depression.

We have been through an extended period of artificially inflated demand via low interest rates. The hope was that the normal level of economic activity would remain high enough for a normal level of demand to return. It looks as if it has.

The Federal Reserve believes that productivity has increased permanently (because of computers, etc.). Employment levels are beginning to rise once again (although the unemployment rate never rose above the traditional, theoretical lowest sustainable rate of 6%) as demand has increased more than enough to compensate for earlier productivity gains.

There is uncertainty as to whether the potential long-term growth rate has increased. If so, inflation will take longer than many expect. Today's natural short-term interest rate is 3.5% to 4.0%, not 1%. The Federal Reserve will increase rates only after it has seen both sustained inflation and solid employment gains. There will be some inflation, no doubt. But it is likely to be limited.

In terms of investments, this unusual activity has sent many people who would have normally stayed with short-term investments such as CDs into riskier markets. In turn, their presence has sent others in other markets into riskier investment classes than they would have normally chosen. That is, the entire spectrum of investors has been shifted toward greater risk since the short-term interest market has effectively disappeared.

OTOH, I am beginning to increase my (short-term) cash (equivalents) for the first time in my life.

Have fun.

John R.
JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 »

I got the unemployment statistics wrong. Unemployment peaked in June 2003 at 6.3%. It was 6.0% in December 2002. It was 6.0% or higher from April 2003 through October 2003. Otherwise, it has stayed below 6.0% ever since the previous low of 3.8% (April 2000).

For a long time, it was commonly accepted that an unemployment rate below 6.0% would necessarily lead to excessively high rates of inflation.

Have fun.

John R.
Mike
*** Veteran
Posts: 278
Joined: Sun Jul 06, 2003 4:00 am

Post by Mike »

In terms of investments, this unusual activity has sent many people who would have normally stayed with short-term investments such as CDs into riskier markets.
Even before today's low rates, savers in taxable accounts tended to lose ground to inflation after taxes in many years. This long term rip off of savers may be contributing to this country's low savings rate. Conservative people have switched to saving by building up equity in their homes. They then pressure politicians to restrict permits to build new home so that home prices keep going up faster than inflation.
mannfm11
* Rookie
Posts: 13
Joined: Mon Apr 26, 2004 5:15 pm

Deflation is a financial Phenomenon

Post by mannfm11 »

I appreciate the quote from FDR. FDR nationalized the property in the United States on March 9, 1933, using the trading with the enemy act as amended, by basically making the American people the same as the enemy. It is our property that collateralizes the US dollar and nothing else. In response to what Roosevelt so cleaverly pulled off, bailing out the bankrupt Federal Reserve and making his poor Wall Street buddies fablously wealthy by then revaluing the dollar in gold after he seized all the gold held by Americans in the United States, exempting off shore supplies. Deflate the value of everything, let people imagine cash is still the same as gold, but pull a switch where all the cash is owed by to the bank instead of the gold being owed back to the people was a real scheme that few understand.

There will be no helicopter drops. Bernanke must be the dumbest person on earth that ever engaged in banking and those that took this nonsense seriously only do so out of ignorance. If the bank fails to gain collateral against its paper, then the paper ceases to serve as anything, much less money. So, the more likely result is the government will attempt to bail out the mess the way it is doing at present, running deficits allowing the bank to issue credit owed by the government that is actually owed by those that hold the currency. Since this debt will always bear interest, there will never be enough money to pay it off. Thus, the government and the banking system will continually do what Roosevelt started, the seizing of all property as collateral for the debt.

Take a look at Japan. Japan had more foreign reserves than about any country on earth and had the only really properly functioning industrial machine left in the world at the end of the 1980's decade. But, it reached the limit of debt support, as all the money they saved was not really saved, but not spent by one group and owed by another group. The debt became unsupportable and overinvestment became the norm. Once industry was overbuilt, then investing in real estate became the game. Does this look familiar or not. Japan lowered its interest rates to zero, the government threw yen in the streets and the system never recovered. Finally in the guise of supporting the dollar, the Japanese government did the only thing they could do to create money, buy the credit instruments of a stronger country with their money, money they ran off on the printing press. The last I heard, it would take 100% of their GDP to bail out the banks, so they are using the United States for leverage to attempt another shortcut.

I am going to look bad on this call for maybe 6 to 24 months. Deflation is an irreversable condition. There is $34 trillion in debt as of a couple of years ago. As this debt becomes more and more insolvent, it will be repriced, meaning more debt is going to only be had at a greater interest rate, not a less interest rate. This phenomenon always preceeds a deflation or comes with it. Revalued debt is also decreases the amount of leveragable debt banks can use to leveage additional credit on.

There is too much attention put on credit cards. They mean very little because the losses on credit cards are always covered in the factoring charges and the carrying costs and the annual fees. I have seen credit cards for bad risks that the fees are so high, the lender almost cannot lose if they get any performance at all out of the desparate customers tha want any credit reference at all. The logical idea is that 5% to 10% of this debt is going to be uncollectable every year, but the bulk of the money is made off customers that don't carry a balance, but charge over $1000 a month year after year. These guys never result in a loss, but the factoring charge is collected none the same. Banks can swallow a lot of this stuff and never flinch. The real danger is the commercial lending getting impaired. Once enough large loan stuff becomes insolvent and the biggest risk, real estate rolls over because of higher interest rates, banks lose the capacity to lend money. I don't know about you, but what I have experienced when banks get into tough lending times is they only want to lend you your own money back or try to comfort a few insolvent accounts out of hope. Money for new ventures isn't available.

What happens when money for new ventures isn't available? Economic activity slows down. Maybe people don't quit buying, but they quit building. If you shut down the home construction industry and the refinance industry down over the next 24 months, M-3 would decline roughly $500 billion. When we get into real hock, the yield on the $34 trillion in debt won't be 6% or 7%, but maybe 10% or 15%. Now, we are talking about over 50% of GDP in order to support and create additional credit. The government of the United States, just like the government of Japan can finance huge deficits, but they cannot reflate the banks and let the same powerbrokers continue to run them. The great secret of the world is the governments are owned by the bankers and even when the bankers have lost their fuse, they still own the governments. The banks can be financed at zero, but that doesn't necessarily mean they can turn a profit or bail out their undercollateralized debt.

Those that preach immediate inflation just don't know the rules of the game because the rules of the game are not taught. You must remember this was a low rate recession not a high rate recession like 1990 or those in the 1970's and early 1980's. We had a housing boom that continued through the recession, brought on by a once in a lifetime shift in the demand curve. We had a continued buying of automobiles, though few if any companies in that business can turn an additional dime out of an additional sale. The game is financing and once the profits of financing are gone, there won't be a sustainable industry left. The current market for Chinese goods and thus the expanding market for Chinese products and the resultant demand for commodities for China will vanish in a twinkling.

The money monster is now throwing its left hand after the central bankers have defended the right hand for a few years and in defense of the left hand, they are going to flip the market. A right hook is coming and it will not be a TKO, but a cold out on the canvas fall. The markets appear to be sniffing inflation, but I think they just don't like the risk in general that is going on right now. We are linked together like a row of dominos and if rates keep moving, some of the dominos are likely to topple.

The solution out of deflation is the liquidation of surplus capacity, the taking of losses and a starting over. The threat of deflation lies in front of us, not behind us. You can only give out so much over in hock debt before the purpose of more debt isn't to buy something new, but to keep the debtor afloat. The idea that the new credit in the system is going to buy more products is only partially true, as most of it is now going to keep the sinking afloat until the losses can be taken. All the while, the world is adding more capacity with the overinvestment and return seeking that is going on due to poor central banking.

Inflation is monetary and financial, but deflation is purely financial. What causes deflation is poor finacial analysis in lending and borrowing. Never in history has financial analysis been poorer than it has been the past 15 years. Credit is now being created in manners that resemble the South Seas and Mississippi bubbles and the collateral won't hold up to create an everending supply of credit. Once the system seizes up, there will be no political will to step in and finance a black hole that will likely exceed what the current Federal budgets is. Even if there is, the game will eventually come to an end and in that vein, we will be looking at inflation and not deflation. I doubt anyone not in debt will accept American currency or any other currency in the world by that time. The result will be again, deflation, as there will be no money.
mannfm11
* Rookie
Posts: 13
Joined: Mon Apr 26, 2004 5:15 pm

I like that response John

Post by mannfm11 »

I sense because we only had an investment slowdown, we still have the recession in front of us, not behind us. One must realize the growth in the world is in East Asia and to some extent in India and this part of the world has a habit of operating in insolvency, but IMF standards are somewhat enforced. Banking is always done in defacto insolvency, but once it becomes recognized, the insolvency becomes recognized fact. Much credit is being created by out of bank cross collateralization and I think that is a really unstable domino that is getting more unstable by the day. Someone is going to absorb the losses in the massive current upward drift in bond rates and if it isn't the guys that don't have to mark to market (the banks and a few others), then the market is going to lose a significant amount of leverage and we are subject to undergoing some massive and sudden dislocation as the losses are liquidated. Remember that if the banks and FNMA are using these instruments to prevent loss, they are only covering their losses and not making money out of the losses. It is these cross collateralizations that are making credit available and at some point, the technique, though in theory sound, could in practice become either unavailable or cost inhibitedly expensive. Without these hedges, the banks and FNMA might cease to exist as mortgage lenders, destroying the basic collateral they have so successfully created to keep the system solvent the past few years.
Mike
*** Veteran
Posts: 278
Joined: Sun Jul 06, 2003 4:00 am

Post by Mike »

The solution out of deflation is the liquidation of surplus capacity...
Over capacity was a big part of deflation during the Great Depression. The US built up over capacity because war ravaged European factories were not up to the task. Once they had rebuilt, and ramped up production, the excess US capacity was no longer needed. In addition, farm machines made most farmers redundant, and it took them a while to move off of the family farms. A curious phenomenon is taking place today. Imports are reducing the price of commodities that can be sold on the international market because of over capacity in many areas. The fed, determined to prevent a fall in the CPI, swings into action to increase the price of things that cannot be legally imported, such as medicine. Government action is preventing foreign trade from actually benefitting consumers in the way economists promised that it would. Every cost advantage produced by trade is matched by in increase in price elsewhere. The consumer never benefits, they just pay less for one item and more for another.

I suspect that the government will continue this trend. They can prevent a fall in the CPI by granting monopolies to special groups to dispense things like they have with medicine. I read an article in the WSJ that showed why hearing aides cost $2000 instead of $100. It was all a matter of legal monopolies granted to special groups to dispense the things. There is no competition possible by law. Without the law, hearing aides would be imported from Taiwan, and the price would collapse to $100, threatening a fall in the CPI. A few more monopolies of this sort will more than balance cheaper television sets in the CPI.
Mike
*** Veteran
Posts: 278
Joined: Sun Jul 06, 2003 4:00 am

Post by Mike »

As this debt becomes more and more insolvent, it will be repriced, meaning more debt is going to only be had at a greater interest rate, not a less interest rate.
This assumes a more or less free market. We do not have a free market in debt in the US. Most people long ago stopped saving significant amounts of money in banks because they got ripped off by after tax interest rates being lower than inflation. The banks don't really care, because they can just borrow money from the fed to loan out. The fed gets money to loan out by simply printing more of it. This causes inflation, which is why the dollar is worth only 2 or 3 cents compared to what it was worth when the fed was first started. Japan has kept interest rates at zero for a long time, despite an abundance of bad debt.

Japan has deflation partly because they have so many elderly who depend upon savings to live on. They put political pressure on their politicians not to aggressively raise the CPI. The US is a nation of debtors, who put pressure on the politicians to aggressively raise the CPI so they don't have to actually pay back all of the money that they owe.
Mike
*** Veteran
Posts: 278
Joined: Sun Jul 06, 2003 4:00 am

Post by Mike »

I sense because we only had an investment slowdown, we still have the recession in front of us, not behind us.
The slow down was primarily in tech. In the years leading up to Y2K, companies spend oodles of money upgrading their systems in an attempt to defeat the Y2K bug. After 1999, they had new equipment, and thus did not need to upgrade any more for a few years. In effect, they moved the normal 2000-20002 tech spending into the 1997-1999 period. Tech profits soared in 1999 to almost half of S&P profits, then crashed to negative territory for the next few years. This cut S&P profits in half, and the market fell by half in response.

Added to this, some companies went way overboard, replacing whole computer systems. When nothing happened in the countries that did not prepare at all, the CEOs felt betrayed by the tech vendors, and shut their tech spending down even more. I have vivid memories of huge generators being brought in at the place that I worked to power the place when the whole world went dark. Apparently, the tech dept allowed a vendor access to the main computer system. The vendor shut it down, and claimed it was the Y2K bug. The CEO gave the vendor a multi year contract for millions to completely revamp the whole place. After Y2K came, and the world did not go dark, the CEO petitioned the bankruptcy court to please get rid of the horribly expensive computer vendor.
Post Reply