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Monday, December 24, 2007 10:53 AM

Not Your Father's Deflation: Rebuttal

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Peter Schiff argues it's Not Your Father's Deflation.

Among those rational enough to perceive the looming economic downturn, a heated debate has arisen that centers on whether the slowdown will be accompanied by inflation or deflation.

Those in the deflation camp believe that money supply will collapse as a natural consequence of the implosion of the biggest credit bubble in U.S. history. As loans go bad, assets, which collateralize these loans, will be sold at fire sale prices to satisfy creditors. It is also argued that a recession will reduce consumer discretionary spending, causing retailers to slash prices to move their bloated inventories. This is the way the situation played out in the 1930's and this is how many expect it to happen today.
My Comment: Indeed that is part of the debate but by no means all of it. Schiff misses many deflation arguments in that simplistic analysis. We will get to them momentarily.
There are several key differences between then and now, which argue against the classic deflationary scenario. In particular, the Fed's ability to pump liquidity into the market in the 1930's was limited by the gold backing requirements on U.S. currency. No such limitations exist today. This distinction is critical. When credit was destroyed after the Crash of 1929, the Fed was not able to simply replace it out of thin air. Today however, the Fed will likely print as much money as necessary to prevent nominal prices from collapsing. In fact, in the infamous speech that spawned his "helicopter" sobriquet, Ben Bernanke explained how the printing press can be used to stop deflation dead in its tracks.
My Comment: Schiff makes a false assumption that the Fed can replace credit out of thin air. The Fed is simply not in control of credit at all. The Fed can encourage borrowing but it cannot force it. The second failure by Schiff pertains to monetary printing. There are constraints on the Fed that he ignores. For example the Fed cannot simultaneously target both money supply and interest rates. Should the Fed pursue a massive printing campaign, interest rates will rise. Think of the consequences for housing and commercial real estate. Schiff ignores the consequences of interest rates on existing debt, much of which is variable rate. Furthermore, think about what rising rates would do to future expansion plans of businesses.
To fully understand the way inflation and deflation affect prices, we need to differentiate between assets, such as stocks and real estate, and consumer goods, such as shoes and potato chips. If we measure prices in gold, as we did during the 1930's, both asset and consumer goods prices will fall, with the former falling faster than the latter. So in that sense the deflationist are correct. However, in terms of today's paper dollars, this outcome is completely impossible. During deflation, money gains value, so prices naturally fall as fewer monetary units are required to buy a given quantity of goods. In the coming deflation, real money (gold) will gain considerable value, so prices will therefore fall sharply in gold terms. Paper dollars however, which have no intrinsic value at all, will lose value, not only as the Fed increases their supply, but as global demand for the currency implodes.
My Comment: While it makes sense that the demand for currencies other than gold fall, it is important to understand that it is not just the US dollar we are talking about. There is no major country on the gold standard so it is relative demand between other competing currencies that will determine how fast they fall in relation to gold.

In addition, we no longer have a US or even a Western world economy. Global wage arbitrage puts enormous downward pressure on wages. That pressure will not go away no matter what the Fed does.

Regardless of what anyone thinks, prices can only rise to the extent that people can afford to pay for goods and services or that banks are willing to extend credit. Without a driver for jobs, and with downward pressure on wages for the jobs we do have, prices will be constrained. If somehow prices rise above people's ability or willingness to pay for them, there will be not be buyers. Look one step ahead: Think of the consequences for jobs if people stop spending because they cannot afford to pay for things. Take still one more step: What does that do to the existing pile of consumer debt? Schiff fails to look ahead at what he is proposing.
The way I see it there are only two possible scenarios. The more benign outcome would we be one where asset prices fall, even in terms of paper dollars, but consumer goods prices continue to rise. This would be the stagflation scenario.

The more catastrophic scenario is one where asset prices hold steady or even resume their ascent, while consumer goods prices rise even faster. This of course is the hyper-inflation scenario, and is the worst possible outcome. I see no possible scenario where consumer goods prices fall in term of paper dollars.
My Comment: Schiff sees only two possibilities because he ignores a half dozen variables as well as downstream consequences of those variables.
  • Banks are unwilling to lend
  • Consumers and businesses are unwilling to borrow
  • Consumers stop buying goods they cannot afford
  • The Fed attempts to print but rising interest rates put an end to it
  • Global wage arbitrage
  • Jobs
I will add to the list in the recap at the end but for now let's continue with more of what Schiff has to say.
Many mistakenly believe that when the U.S. economy falls into recession, reduced domestic demand will lead to falling consumer prices. However, what is often overlooked is the fact that as the dollar loses value, the rising relative values of foreign currencies will increase consumer demand abroad. As fewer foreign-made products are imported and more domestic-made products are exported, the result will be far fewer products available for Americans to consume. So even if the domestic money supply were to contract, the supply of goods for sale would contract even faster. Shrinking supply will be a major factor in pushing consumer prices higher in America.
My comment: Once again Schiff is making an assumption. That assumption is the US dollar drops. It is a dangerous place to be when 90% think a certain something will happen. I suggest anti-dollar sentiment is indeed that bad even though the Euro is massively overvalued vs. the US dollar as is the British Pound. The fundamentals in the UK and EU are as bad as in the US and the property bubbles just as big. As an aside I do expect the dollar to sink vs. the Yen.

Even ignoring currency issues, Schiff is making another huge assumption about the of supply of goods. Take away the US market for goods and China and Japan have massive overcapacity. Without exports to the US and Europe, China would crash. This situation might change 10 or so years down the road, but export economies are not remotely close to being able to ignore the US consumer, at least not now or anytime soon.

Let's now turn our focus to stagflation. When someone says stagflation I am not sure what they really mean. It's important to have definitions so I will repeat mine. Inflation is the expansion of money and credit. Deflation is the contraction of money and credit. Stagflation does not really fit in to the discussion per se. By context though, it seems as if Schiff is talking about prices. For more discussion on the definition of inflation and deflation please see Inflation: What the heck is it?

I concede the prices of imported goods can rise as Schiff suggests and one of the ways is by tariffs. However, remember what Smoot-Hawley did to the great depression: Tariffs forced import prices higher, killed trade, and worsening the Great Depression. Was that "stagflationary" or "depressionary"?

There are other ways prices can rise and one of them is the effect of peak oil. Peak oil in and of itself simply does not belong in the inflation/deflation debate at all.

Schiff continues:
In addition, since trillions of dollars now reside with our foreign creditors, even if many of these dollars are lost due to defaulted loans, those that are not will be used to buy up American consumer goods and assets. As a result of this huge influx of foreign-held dollars, the domestic dollar supply will likely rise even if the Fed were to allow the global supply of dollars to contract, forcing consumer prices even higher. In fact, a contraction in the domestic supply of consumer goods will likely coincide with an expansion of the domestic supply of money. The result will be much higher consumer prices despite the recession. So even though Americans will consume much less, they will pay much more for the privilege.
My Comment: once again Schiff ignores wages, jobs and the ability of people to pay for massively rising prices. Furthermore, any influx of foreign dollars will likely be in the form of convertible deals like that we have seen between Bank of America (BAC) and Countrywide (CFC), Citigroup (C) and Abu Dhabi and Morgan Stanley (MS) and China Investment Corp. Those deals all involved shareholder dilution, none of them did a thing for US jobs or wages, and none of them is going to force any prices higher on anything, especially consumer goods that Schiff is talking about.
The real risk of course is that the Fed gets more aggressive as it realizes that the additional credit it is supplying is not flowing where it wants. If the Fed drops enough money from helicopters it will eventually reverse the nominal declines in asset prices.

Unfortunately, that road leads to hyper-inflation and disaster. No matter what, even if the Fed succeeds in propping up nominal asset prices, they can do nothing to sustain their real values. Consumer goods prices will always rise faster, leaving the owners of those assets poorer no matter how high their nominal values climb.
My Comment: This is where Schiff goes off the deep end. There is no risk of the Fed "dropping money out of helicopters". Schiff ignores the fact that the Fed is a private business. The Fed is no more apt to give money away than Pizza Hut is apt to give away free pizzas for a year to all comers.

At best, the Fed can provide liquidity. Yes, the Fed will do everything it can under the sun to get consumers to borrow and banks to lend. However, in the end the Fed cannot force either.

Ultimately the Fed will be constrained by ZIRP (Zero Interest Rate Policy), just as Japan was. Given massive overcapacity in housing, commercial real estate, restaurants, nails salons, etc there is simply no reason for businesses to want to expand business. Nor is there any reason for banks to be willing to extend credit to all but the most credit worthy borrowers. Rising defaults may even impair capacity to the point many banks are unwilling or unable to lend at all. The only reason expansion got as carried away as it did is the psychology at the time suggested residential and commercial property would forever rise. That psychology changed. More on psychology in a bit as it is a key factor.

Liquidity from the Fed is in reality nothing more than a loan. Liquidity is not the same as free money and the Fed will not be giving away the latter. Furthermore, liquidity is a coward. In the face of rising defaults spreading to commercial real estate, home equity loans, and even credit cards, the Fed's attempts to add liquidity will go straight down the drain.

Things ignored by Schiff
  • The Fed is a private business unable to give away money
  • The Fed would not give away money even if it could. Ultimately it would destroy their own wealth and power.
  • The Fed can provide liquidity (loans) but not capital (money). However, liquidity is a coward in the face of rising defaults.
  • The Fed can encourage but not force banks to lend or consumers of businesses to borrow.
  • The Fed can at most control either interest rates or monetary printing.
  • A massive printing campaign that actually found its way into the market would cause interest rates to rise, further putting deflationary pressures on both residential and commercial real estate.
  • There is rampant overcapacity in housing, commercial real estate, and autos, so there is no reason for businesses to expand.
  • Global wage arbitrage is an enormously deflationary force.
  • The Fed cannot create jobs or force wages higher.
  • Even if the Fed found some back ended way to give money to banks, and they actually carried that plan out (both are doubtful) it would not help cash strapped consumers pay back loans.
Starting with one faulty assumption that lack of a gold standard changes things, Schiff ignores 10 major things that remain the same. Here is a bonus 11th: velocity. Let's discuss velocity through the eyes of Japan:

Some argue that Japan never went through deflation. One basis for that argument is that "money supply" as measured by M1 never contracted over a sustained period. The other argument is that prices as measured by the CPI never fell much. Once again we have a flawed argument about consumer prices and a flawed argument that only looks at money and not credit.

Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. Those are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark.

In the end, one factor alone is going to seal the fate. That factor is called the psychology of deflation. Simply put, the Fed cannot force consumers or businesses to borrow or banks to lend.

The lesson from Japan should be crystal clear on this. If Schiff's argument held any water, Japan would not have been in deflation for 18 years. An argument that the US is not Japan is a red herring. Schiff's thesis is that lack of a gold standard somehow prevents deflation. That thesis has already been blown out of the water.

Finally, the massive consumer debt overhang in the face of global wage arbitrage and rising unemployment increases, not decreases, deflationary pressures in the US. If one is looking for differences, there is no internet boom to look forward to provide jobs and cushion the deflation blow as happened in Japan. Another difference is the savings rate. Japan had savings to draw from. The US does not. Once again this increases deflationary pressures in the US. Debt is deflationary when it hits the point it can no longer be serviced.

A careful examination shows there was only superficial analysis made by Peter Schiff when he argued It's not your father's deflation. The housing boom has gone bust. A commercial real estate bust follows. Consumer psychology and bank attitudes towards risk taking are changing slowly but surely. The rate of change will pick up rapidly once unemployment starts to rise.

In the final analysis, deflation is all about risk taking and psychology (the ability and willingness of consumers to borrow and the ability and willingness of banks to lend) not about the gold standard.

Addendum: For continued discussion please see Peter Schiff Replies to Deflation Rebuttal.

Addendum #2:

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
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