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Wednesday, December 26, 2007 3:02 PM


Peter Schiff Replies to Deflation Rebuttal


In response to Not Your Father's Deflation: Rebuttal, Peter Schiff graciously responded in the comment section on my blog with the following three points:

1. I believe that eventually long-term interest rates will head much higher to reflect significantly higher inflation expectations, particularly here in the U.S. where a lack of domestic savings in the absence of willing foreign lenders will put even more upward pressure on rates.
My Counter: In long time frames I happen to agree. US rates will eventually head higher, just as Japanese rates will eventually head higher. The question is when and in what order. Long term rates in Japan fell to .25%. They can fall to that in the US. I am not saying will, I am saying can.

In shorter time frames there is an enormous pent up demand for US treasuries as treasuries are nearly universally despised domestically. Never before in history has everyone turned bearish right at a market top. Perhaps this is it. I doubt it.

However, let's assume Schiff is correct: Long term rates quickly start to rise because foreigners will not finance our debt. What would that do to default rates on housing, store expansion plans, hiring, wages, prices of homes, and prices of other assets? Unless and until consumer debt is wiped out, rising rates would massively increase default pressure as well as pressure asset prices.
2. Any credit the Fed provides will be spent. It is not necessary that the banks that originally borrow it loan it to Americans to buy houses or U.S. businesses to buy equipment. They can use it to buy oil, gold, wheat, foreign currencies or invest in foreign dividend paying stocks. As long as the Fed enables banks to borrow dollars below the rate of inflation, they will borrow all they can and invest the proceeds in appreciating or higher yielding assets. Then those dollars will be spent into circulation bidding up consumer prices.
My Counter: Citigroup (C), Morgan Stanly (MS), Merrill Lynch (MER), E*trade (ETFC), Ambac (ABK), MBIA (MBI), and Countrywide (CFC) are so capital impaired they all needed cash infusions, some from foreign companies, just to be able to continue operations.

We have not yet even seen the fallout from Alt-A or pay option ARM resets. And the fallout from rising credit card defaults has also not yet begun. For more on Credit cards please see Credit Card Defaults move to Forefront of Deflation Debate.

There is also the commercial real estate implosion and its aftermath to consider. For more on this topic, please see Commercial Real Estate Dominoes Collapse.

It is an enormous stretch of the imagination to think that banks are going to be rushing into wheat, foreign currencies, oil, or anything else, in light of the above.

For the sake of argument however, let's assume banks start speculating in wheat, corn, and oil. In that case, (assuming prices do go higher which is certainly not a given) prices of food and energy would be bid up still further beyond the average consumer's ability to pay for them. This would increase pressure on defaults and bankruptcies. Consumers are already having trouble enough right now. Foreclosures and credit cards are proof enough. On the other hand, should the speculation fail, banks would be still further capital impaired, possibly bankrupt.

The housing bubble at least provided jobs. Speculation in wheat would not create any jobs. In fact it would do nothing but increase the malinvestments that would blow sky high, sooner rather than later. Where are the jobs going to come from to allow people to pay back existing debt or keep buying stuff?
3. Yes, all currencies are troubled, but the dollar is unique in that the American have borrowed so much money that we can not afford to repay, and have a phony economy that can not function without access to low cost imported products and foreign vendor financing. In the coming crisis, the U.S. will enter a serious recession; the dollar will fall sharply, sending both consumer prices and interest rates soaring. There will be wide-spread unemployment, and assets prices, such as stocks, bonds, and real estate will fall (if inflation gets out of control, stock and real estate prices might rise in nominal terms, but in that case their real declines will be even greater.) I can assure anyone that if they think they can ride this out is in U.S. treasuries or by stuffing dollar bills under their mattresses, they will be very disappointed. Just ask anyone in Zimbabwe who might have reached a similar conclusion.

My commentaries are kept short for a reason and are never meant to constitute a complete argument. For a fuller explanation of my position I suggest reading my book, "Crash Proof".
My Counter: Now we are getting somewhere. Here is something I wholeheartedly agree with Schiff about: "American[s] have borrowed so much money that we can not afford to repay".

Debt that cannot be repaid will not be repaid by definition. It will be defaulted on. That is the very essence of deflation. Rising foreclosures and credit card delinquencies are already proof of concept.

Here is a second statement by Schiff that I wholeheartedly agree with: "There will be wide-spread unemployment, and assets prices, such as stocks, bonds, and real estate will fall."

Once again those ideas are central to the deflation debate. Rising unemployment will increase the number of defaults and bankruptcies.

Yet, somehow we are supposed to believe that in spite of enormous and growing capital impairments fueled by rising unemployment and falling real estate values, that banks will be speculating in wheat and other commodities. This just is not plausible.

However, should it happen, it would only add to the malinvestments to be defaulted on. The problem is there is no way for consumers to pay back debt, and there is nothing the Fed can do about it. The Fed cannot create jobs, build stores, or give money away.

As an aside, one argument I expected to see from Schiff but did not was the creation of government jobs. However, Japan tried that approach and it did not work. There are no guarantees it would be tried here, or if it was that it would work. After all, deflation is about willingness and ability to extend/take credit. Once sentiment peaks, like a pendulum it has nowhere to go but the other direction. Led by housing and now shifting into commercial real estate, leverage buyouts, mergers, and even retail spending, the pendulum has reversed course.

Because the Fed can encourage but not force lending, that shift in the pendulum affects the Fed greatly. The Fed can enhance the current primary trend (as it did in the creation of the housing bubble), but neither the Fed nor anyone else can reverse the primary trend.

Regardless of encouragement, who are banks going to be lending to when asset prices are falling and unemployment is headed higher? And those are conditions that both Schiff and I agree on. With enough defaults, banks will become so capital impaired they could not lend even if they wanted to! We are seeing signs of that in Citigroup already.

And as I have said before, the Fed is a private business. The Fed is not going to give away money any more than Pizza Hut is going to give away free pizzas for a year to all comers.

As far as Zimbabwe goes, Zimbabwe was massively running the printing presses. The situation in the US is drastically different. In the US, credit has far outgunned monetary printing (proof can be found by comparing M3 to base money supply). Printing does not work because it does not get money into the hands of those that need in debt.

Global wage arbitrage is a massive deflationary force putting huge wage pressure on US jobs. Rising unemployment will do the same. Rising unemployment will affect sales as well as prices. Prices of goods and services cannot rise above peoples willingness and ability to pay higher prices. That is a simple economic fact.

Already we are seeing massive price cuts by retailers this holiday season. See Blue Christmas for Target as an example. This is happening in spite of rising raw materials costs and energy costs. Good luck to stores that think they can raise prices. Perhaps some high end or specialty stores can. It's clear there is downward price pressure in nearly everything else but essentials like energy and food.

To date, I have not seen a single plausible all encompassing theory that started with massive consumer debt accompanied by rising unemployment and sinking housing prices that leads to hyperinflation prior to a deflationary collapse happening first.

This discussion with Schiff has obviously not changed my mind. If anything, Schiff appears to be adding to the deflationary hypothesis by agreeing with my assertions that unemployment is going to rise, housing will continue to slump, and most importantly debt cannot be repaid.

Nonetheless, in case I am missing something I am going to read his book. This is a critical subject as far as how one prepares for the outcome so it is important to consider all points of view.

The reason the inflation/deflation discussion is important is because there is are dramatic differences in how one prepares for each outcome in terms of investment ideas. Many people have been writing to me wondering what to do. I will offer some ideas on how to prepare for both hyperinflationary as well as deflationary outcomes coming up shortly. Finally, I would like to thank Peter Schiff for taking the time to add to this discussion.

Addendum:

Is the Fed a Private Institution?

I need to make a clarification to one thing I have said above in referring to the Fed as a private institution. My statement was incorrect.

See Who owns the Federal Reserve? for this clarification: "The Federal Reserve System is not "owned" by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects."

That statement does not materially change arguments presented above or elsewhere about the powers of the Fed.

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