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Saturday, June 04, 2005 2:43 PM


Same Data / Different Interpretation


Sometimes I wonder if I am on the same planet as those that espouse hyperinflation. The debate between inflation, stagflation, deflation, hyperinflation and just plain "flation" has been raging for years. Most sides do not even state the other side's viewpoint correctly. Now perhaps I mean that most do not understand my viewpoint correctly which is indeed a different thing altogether. Then again there is so much general confusion that it is high time we get a decent dialog going so we better understand other points of view. In that regard I have been following the "deflation debate" with Jim Pulplava on the Financial Sense News hour.

Let's backtrack to May 7th, 2005. In a one hour commentary (the third hour) Jim Pulplava attempts to explain Why the Deflationists Simply Don't Get It.

Here is a summary of what he was saying on May 7th, at least as I heard it:

#1 "Deflationists do not understand what money is."
#2 "Deflationists mistakenly equate productivity gains for deflation."
#3 "Imports will cost you more if value of dollar goes down."
#4 "Deflationists do not understand that there are two economies, a financial economy and the real economy. There can easily be asset deflation in financial economy but inflation in the real economy."
#5 "Deflationists believe the CPI numbers."

#1a "Deflationists do not understand what money is."
This a tough issue. I believe Jim is correct. However I believe I can simplify the statement and still have it be correct. Let's try this: People do not understand what money is. Thus I contend that it is not only deflationists that do not understand money, but almost everyone. I suspect part of the reason is that most people do not care, and another part is because there are so many confusing definitions of "money", that it is very hard to get agreement from anyone on just what it is. Case in point: We have M1, M2, M3, and MZM definitions. There is also Austrian Money Supply theory but I have seen at least three different definitions of Austrian Money Supply. We have a subset of people that think "gold is money" or "silver is money" and finally we have a tiny subset of people that think gold is the only money. If that was not bad enough, people often confuse wealth with money as if their house appreciating in value makes them wealthy. Well I am going to hazard a guess that Jim agrees with me that rising home prices do not make people "wealthy" since current replacement costs are high and nothing is really gained by escalating housing prices unless and until one takes that profit out and decides to rent. Obviously it would be impossible for everyone to sell their houses and rent. This subject is in fact so complicated that I want to devote some time to discuss credit vs. money, as well as the various Mx definitions of money in a later blog. As it sits, I will accept Jim's statement that "Deflationists do not understand what money is" simply because there is no precise agreement as to what money is. Without an agreement as to the definition of money, there has to be confusion and we can sure see that!

#2a "Deflationists mistakenly equate productivity gains productivity gains for deflation."
I disagree. Perhaps some do but I suspect most do not. As for me, I believe this statement from Milton Friedman Inflation is always and everywhere a monetary phenomenon. In fact, let's look at more statements by Milton Friedman that I accept:

  • Inflation is always and everywhere a monetary phenomenon. To control inflation, you need to control the money supply.
  • Inflation is like a drug. Its stimulating effect temporary. Only larger and larger doses can sustain the stimulus, before the chaos of hyperinflation removes all the gains.
  • Annual consumption is a function of people's expected lifetime earnings – not just their income at the current time.
  • Keynes was wrong on just about everything, and his followers are wrong on absolutely everything.
  • State licensing rules limits entry into the professions, thereby allowing professionals to charge higher fees than if competition were more open. That (more than the public interest) is why professionals love licensing.
  • Rent controls have the opposite effect to those intended. Rental property becomes less profitable and is taken off the market. Instead of delivering cheap housing for all, the controls actually produce a chronic shortage.
  • Exchange rates should float freely.
Thus productivity is productivity and monetary inflation/deflation is monetary inflation/deflation. I can not speak for deflationists everywhere but the idea that deflationists in general confuse productivity with deflation seems wrong.

#3a "Imports will cost you more if the value of dollar goes down."
Jim, I will give you a free shot at taking this one back. Imports may or may not cost more regardless of what the US dollar does simply because of productivity and other factors such as wage differentials as discussed above. Thus computers, computer software, underwear, clothes, wheel barrels, and in fact most goods coming from China have fallen in price. Congress is currently discussing placing 27.5% tariffs on goods from China as if that would help US manufactures win back market share from China. Unfortunately it will not help a thing. Wage differentials are just too great for the US to win back market share from China. This idea was presented in Would Floating the Renminbi Solve Anything?. More to the current discussion, if Tariffs were imposed and prices rose 27.5%, would that be inflation? The correct but non-obvious answer is no, assuming one accepts the definition that inflation and deflation are monetary phenomenon . This is another weakness in the arguments of many inflation alarmists who see all price rises as inflation but dismiss all price decreases as "productivity".

#4a "Deflationists do not understand that there are two economies, a financial economy and the real economy."
There are two economies for sure, by Jim's definition if nothing else, and we can clearly see some prices inflating and other prices deflating, which as we discussed is completely different than money supply inflating or deflating. Adding to the confusion money supply can be seen as shrinking, slowing in growth, or still exploding up depending on the definition of money. This conundrum is solved by agreeing to what money is. Many inflationists see hyperinflation based on M3, the broadest measure of money that includes many items that are clearly (in my mind anyway) credit as opposed to money. If money is credit, then we have one answer. If money is gold we have another. If money is M1 or M2 or M3 or MZM we have a third fourth or fifth answer. Thus while we may agree and understand that there are indeed two economies, the lack of agreement about "what is money" and "what is inflation" prevents a valid discussion.

#5a "Deflationists believe the CPI numbers".
This is patently false, at least as a universal statement. Perhaps some do, then again perhaps some inflationists that believe in a strict definition of money do believe in the CPI. Once again the question arises, are we debating prices or are we debating the fact that "Inflation is always and everywhere a monetary phenomenon". I am willing to assume and am waiting Jim's reply that he agrees that inflation is a "monetary phenomenon". The question then is, how does that phenomenon manifest itself? For the record I think that the CPI is grossly understated yet I am a firm believer that deflation is 100% inevitable. Is this a conundrum? No not really. For example, right now is there much doubt that we are in stagflation? The problem is that is yet another term that we need to define. Generally the term means rising interest rates and stagnant growth. Unfortunately that definition has nothing at all to do with either inflation or deflation, both of which pertain to rising or falling growth in money supply as discussed above. Thus we could be in stagflation and deflation at the same time or stagflation and inflation at the same time. IMO the term "stagflation" is just a cop out used broadly whenever the stock market is not advancing but interest rates are. Finally we have disinflation which is the slowdown in the rate of inflation or the downward movement of prices in general. Sheeesh! Neither disinflation nor stagflation are monetary phenomenon but both are discussed hand in hand with inflation and deflation that at least in my viewpoint are! Is it any wonder people are confused? All these terms and all these viewpoints, most of which are not correctly applied by the masses sure lends credence to the idea that "There is a whole lot of 'flation' going around"! As for the CPI, there is zero doubt, at least in this long term deflationist's viewpoint that prices are currently understated especially when it comes to housing and energy costs. This too will be the subject of a future blog as once again the answer is not as simple and straight forwards as inflation alarmists believe. That said, right now the CPI has probably vastly understated the rate of inflation, and in general I think I would think that Jim Puplava and I are more or less in agreement on this fact.

Hopefully the above discussion lends credence to my assertion that deflationists are not the only ones who are confused and that deflationists are not the only ones who do not know what money is and that deflationists in general believe in the CPI. The big question, however, is not hindsight but foresight. Where do we go from here?

Fast forward to May 21st 2005 Financial Sense New hour entitled The Big Picture.

Following are some of the key ideas from that discussion:
  • Credit is created in many ways, most notably GSEs including Fannie Mae and Freddie Mac
  • The US economy added 2.7 trillion dollars in debt last year
  • The US economy added 10 trillion dollars in debt over the last four years
  • We are borrowing 20 dollars for every dollar of savings
  • Real estate prices are rapidly rising
  • The "real key" as to what is coming is what happens when the economy starts to weaken
  • There is a shortage in commodities, notably oil on account of "peak oil"
In addition a number of "Tipping Points" were discussed:
1) Leveraged carry trades – after the FED started hiking people looked further and further out on the risk curve
2) Potential to make money drops as FED hikes
3) Carry trade could unwind as FED hikes
4) Major consumer credit problem
5) Trade wars with China
6) Consumer debt. US consumers keep putting off the day of reckoning.
7) Consumers are now relying on the inflationary increases of the Housing market to support spending.
8) If the consumer gets in trouble banks will be holding a lot of worthless paper.
9) Banks had a cushion previously because of 20% down payment required. There is no cushion now because of 100% or even 125% housing loans.
10) There is less equity in housing, so it’s easier to walk away from property if the situation worsens.
11) Loan standards have been lowered via "no doc" and "stated income" loans.
12) GM is in trouble.
13) Pension plans are in trouble with invalid assumptions about future returns.
14) To keep the recovery going, everything must be perfect... foreign funding deficit – no trade war - no hedge funds go under – no banks go under - consumers not go under – real estate prices stay inflated etc

As to number 14 above, Jim asks the question:
"What are the chances we will get that lucky? I just do not see it".

Bingo!
Jim, I concur 100%.

We will NOT get that lucky. Consumers will go under, housing will implode, perhaps some banks do get in trouble, people will attempt to walk away from housing loans that go bad, hedge funds are overleveraged in carry trades that will go awry, and consumers will face their day of reckoning about taking on additional debt.

If ever a case was made for deflation, Jim, you just made it.
I see fourteen tipping points, all of which I agree with and all of which have the potential to destroy the leveraged mal-investments in housing, carry trades, consumer spending, and consumer debt.

In Deflation is in the Cards I outlined ten reason for deflation. Oddly enough, or perhaps not oddly enough, some of them sound like the fourteen tipping points above. Without further ado, here are the Mish top ten reasons why deflation is inevitable:

1) Enormous consumer debt
2) Falling wages
3) Global wage arbitrage
4) Credit expansion that can not be maintained
5) Mal-investments
6) Over capacity
7) A world-wide housing bubble
8) A re-inflated stock market bubble
9) The normal business cycle
10) Past history

This is the scenario I envision:
Wages continue to fall due to outsourcing, mergers, and global wage arbitrage
Home prices level off then fall sharply
Home equity loans stagnate as result of stagnating home prices
Home building stalls because affordability finally starts to matter
Trade jobs fall with falling home starts
Expansion of Walmarts, Home Depots, ect. stops with the slowdown of new home subdivisions
Retail expansion peaks and stalls
Consumer sales slow with the slowing economy
Bankruptcies increase
Consumer lending based on rising home prices falls flat
Credit growth declines
The US goes into a recession
Layoffs in the financial sector increase
Layoffs in the real estate sector increase
Credit is destroyed in more bankruptcies
Deflation is finally recognized in hindsight
Hyper-inflationists throw in the towel

Falling home prices, and the resultant slowdown in trade jobs coupled with rising unemployment are the Achilles’ heel of inflationists. They can not explain how this scenario leads to further inflation. Nor can inflationists tell me how home prices can keep rising as long as we have global wage arbitrage, falling wages, and loss of jobs. Home prices can NOT rise above wage growth over the long haul! The destruction of credit and money along with an increasing number of bankruptcies that will accompany a significant downturn in housing is the very essence of deflation.

There it is in a nutshell. From where we are, continued inflation, or wimpy forecasts of stagflation are simply not possible. The whole hyperinflation theory will blow up as soon as consumers hit the brick wall in ability to take on more debt. Show me rising wages and I would accept that inflation might be a possibility. I see no reason to believe rising wages are about to happen and although housing may (for some time) continue to support consumption, WHEN not IF housing turns the result can NOT be anything other than DEFLATIONARY.

On two key points, however, I believe I am in complete agreement with Jim:

#1) The FED will attempt to fight the upcoming battle every step of the way.
#2) The FED's attempt to fight deflation will ultimately be good for gold

It's sad to see but this FED has learned nothing from history. The root cause of the great depression was an over-expansion of credit, not a lack of stimulus to fight the downturn as Bernanke has suggested. One can not defeat the business cycle by throwing more money at it. All hyperbolic credit expansions end the same way, a credit crunch and a contraction. It will NOT be different this time. The FED's latest attempt to beat the cycle just added to the housing bubble/consumer credit bubble additional debt that will eventually be deflated away not inflated away. Ultimately, I do not believe Greenspan will be any more successful at beating the business cycle than Japan was.

I repeat my take: Deflation is in the cards.
OK Jim. Care to make a friendly wager of a box of Omaha steaks on it?

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

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