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Wednesday, August 08, 2007 12:35 AM

Fleckenstein (and others) State the Deflation Case

Mish Moved to MishTalk.Com Click to Visit.

I was surprised to see Bill Fleckenstein, a long time believer in inflation, state the case for a Japanese style deflation in the US. But it's right here in America follows Japan's misguided path.

....Given all our problems related to debt, I thought it might be worthwhile, particularly for new readers, to provide a brief history leading up to where we are now.

Taking a big step back, the Bank of Japan acted foolishly throughout the 1980s, which caused that country to experience enormous real-estate and stock bubbles. Japan's stock bubble was really a residue of its real-estate bubble -- actually a credit bubble, as the banks lent money to any corporation with a pulse. (Does that sound familiar?)

Then the institutions that lent the money took forever to write off the bad loans. That's why Japan's real-estate market, stock market and economy did so poorly for more than a decade.

Free money exacts a price

After [the dotcom] bubble, Greenspan took a page out of the Bank of Japan's book and lowered rates to 1%. That helped precipitate the housing bubble here that ended in 2005.

As to why the unwinding has taken so long to commence, only recently has the cause become clear: the mark-to-model fantasy employed by those who have bought the sliced-and-diced mortgage paper.

But the fantasy is unraveling as these structured-credit products are now slowly being marked to market. Just as virtually every subprime-mortgage lender has blown up, Alt-A lenders (the next rung up the ladder creditwise) will blow up -- and, ultimately, many hedge funds will blow up, though we're in the early days of that process.

In the years since our equity bubble peaked, trillions of dollars' worth of debt have piled up throughout corporate America. So now, as we enter recession, we will experience not just a weak economy, real-estate market and stock market, but the exacerbating effect of a mountain of bad debt, completing the analogy to Japan of the 1990s.
Like it or not (and I suspect he might not because he did not use the D-Word itself) Fleckenstein described how and why a Japanese style deflation is headed for the US.

Economist Paul Kasriel at the Northern Trust also describes how a Japanese style deflation can occur in the US. Please read Interview with Paul Kasriel if you have not yet done so.

The D-Word

Two of my favorite professors on Minyanville are not afraid to use the D-Word (deflation). Point #1 in Kevin Depew's daily dose of Five Things was FOMC Preview: Their Greatest Fear.
..... Stocks may still be up but as Professor Bennet Sedacca noted on the Minyanville Buzz and Banter this morning, financials rallied huge yesterday, but what about corporate spreads, the true barometer of the health of the financial industry? "Believe it or not, spreads on brokerage and bank corporates are actually wider than yesterday morning," Sedacca said. That means someone has it wrong. Either equity investors haven't woken up to credit market problems, or credit markets are overestimating the risk of owning corporate debt. "My guess is the credit market has it right," he said.

This explains in part why it feels so treacherous right now. If the markets have decided that too much credit is too easily available, as it appears they already have, then the Fed can simply lower rates to make credit more available. Problem solved. But what if there are two separate but related forces at work: tightening lending standards and reduced credit appetites? Then the Fed has something more serious on their hands.

The key in all of this is not inflation, as most believe. The Fed says they are most worried about inflation risks, but the reality is that they are most worried about deflation risks. Always. Always deflation. The Fed has no choice but to always remind us that the risks are tilted toward inflation, just as the Treasury Secretary, whichever one happens to be in office at the time, must always say that the U.S. maintains a strong dollar policy, even if monetary policy and fiscal policy are conspiring to devalue the dollar.

As for equities, when the dollar begins to rise, and it appears the Fed finally will begin to cut rates, as they inevitably must to try and sustain credit consumption, then it's time to worry. That means deflation is winning.
The Fed is Keeping the Top Spinning

One of the best articles I've on the subject of deflation was Mr. Practical's (Professor John Succo's) article today on Minyanville: The Fed is Keeping the Top Spinning.
The "strong U.S. economy" has been pushed and pushed along by 25 years of hyper credit expansion fostered by the Federal Reserve. When witnessing the tumultuous results of just a slowing down of the credit expansion, one can only imagine the problems that will surface once credit begins to contract in earnest.

And here lies the crux of the matter: what the Fed has done over the last 25 years is artificially decrease the relative value of real money in the U.S. system while increasing the relative value of debt. It has done so with no concern for the level of income generated to pay that debt back. The Fed through their hyper expansionary credit policy and Wall Street through financial engineering have loaded the system with debt not supported by a commensurate level of future (present) income.

But the Fed has been able to accomplish what it has only because investors, for the above reasons, have lost sight of this hidden risk. The Fed doesn’t really have the power to create more and more of this artificial liquidity called debt; they need investors to cooperate. Here is why.

The Fed really only can do two things (Prof. Succo has explained this situation, but let's go over it again). [Mish comment: Prof. Succo's previous explanation follows these excerpts]. They can lower margin requirements for banks, the amount of capital they have to hold to make loans. That it has already driven to basically zero. So the Fed cannot allow banks any more “leeway” than it already has.

They can also perform open market money operations like REPOS and coupon passes. The Fed calls up big banks and buys their government bonds out of their portfolio. But they don’t buy them with real money; they buy them with credit newly created just for that purpose. The big bank can then lend that credit out in a much greater amount because the Fed only requires them to keep a small fraction of that credit to support whatever the bank wants to lend out. This is our wonderful fractional reserve system. If everyone went to the bank to get their “savings” at once they would find that they could get out less than 1%.

But here is the key. The bank must ultimately be willing to lend it and then find some investor to borrow it. This has been no problem whatsoever over the last several years. Now most investors realize that they have too much debt, that their level of income cannot support it. Banks realize this too and have increased their lending requirements. The last borrower is always the most aggressive speculator.

So most market participants are now looking for ways to pay back debt (deflation) just when the Fed is desperate to get investors to borrow more (inflation).

The top is only beginning to wobble. When people tell me “there is so much money out there” I tell them that no, there is so much credit out there. This will be a muli-year process of debt reduction and deflation to correct what the Fed has wrought.

Best regards,
Mr. Practical
Those are small snips from a great article. I recommend clicking on the link above and reading the entire piece.

Money vs. Debt

As noted earlier here is Minyanville professor John Succo on Money vs. Debt.
Mini-Minyan Mailbag
Minyan MC to Professor Succo:

I was given these general statistics on U.S. circulation of dollars, and I was wondering if they were somewhat accurate?
$2 trln was put in circulation from 1776 through 1990
$2 trln more was added and was put in circulation from 1991 through 2000 (for a total of $4 trln)
$2 trln more was added and was put in circulation from 2001 through 2003 (for a total of $6 trln)
$2 trln more was added and was put in circulation from 2004 through 2005 (for a total of $8 trln)
$2.8 trln more was added and was put in circulation from 2006 through 1st half 2007 (for a total of $10.8+- trln)

So, essentially, in the last six and a half years, circulation of U.S. Dollars has increased by 170% (10.8 minus 4.0 = 6.8 trln dollars added to the system). And what do people say about free money?
What do you think?

Professor Succo to Minyan MC:

Minyan MC,
Yes, but it is not really “money”. The stats you quote are “debt”.
There is no “money” any more.
The actual money used to be backed by gold.
Actual money stock is 0.001% of what people call the money supply.
The money supply is really the debt supply.
Thanks to Mr. Practical, Kevin Depew, Paul Kasriel, and John Succo for helping explain how a Japanese style deflation could hit the US. The key point is deflation is caused by a massive increase in credit/debt not supported by a commensurate level of income. In simple terms, there is no way to ever pay back what has been borrowed. It's also critical to understand the distinction between a hyperexpansion of credit and a hyperinflationary printing of money. The former is what caused the Great Depression (and is happening again now), while the latter happened in the Weimar republic and is happening right now in Zimbabwe.


My friend who posts on Kitco under the alias "Trotsky" just pinged me with this comment: "absolutely correct - this at the root of the misunderstandings out there. because credit is used as a money substitute in the financial markets, it acts as an inflationary force in the asset markets (and this spills over into the real world as the imaginary wealth thus created leads to overconsumption and malinvestments), but it is all ephemeral - in the end, it is still credit, not money. as soon as money is needed in lieu of credit, such as has now happened in the CMO and CDO markets, it becomes clear that the money simply isn't there."

Mike Shedlock / Mish

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