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Deflation Rising Making the Case for a Lasting Deflationary Environment

New York Stock Exchange just after the crash of 1929; it triggered years of deflation and depression in its wake. It was a financial collapse that led to a deflationary collapse in the real economy.

Source: Modern American Poetry – The Great Depression

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“If Americans ever allow banks to control the issue of their currency, first by inflation and then by deflation, the banks will deprive the people of all property

until their children will wake up homeless”

Thomas Jefferson

Uncle Sam, whom we’ve dubbed the “stimulator of last resort”, is doing all it can to create some inflation. Inflation creation, through the debasement of money, is one thing governments have proven historically they do quite well.

Inflation bails out creditors because it allows them to repay debt more cheaply in the future, paying back the nominal value of debt with currency that loses a substantial amount of real value.

There is no bigger creditor than government.

But that said, at the moment it seems governments are losing the battle of inflation, to deflation, despite pumping money into the market around the clock.

This report makes the case for deflation. In it we examine the powerful deflationary headwinds that could lock the US and global economy into years of deflationary pressures that are reminiscent of the lost years in Japan when they became locked in a deflationary bear hug.

Defining Our Terms

The most common definition of inflation seems to be the phrase: “too much money chasing too few goods.” And the most common measure of this is the Consumer Price Index. But this simple definition implies only money is the problem and only headline prices for goods and services is the proper measuring gauge. There are, however, other aspects of inflation that are important to understand too.

Money in the standard definition must encompass not only money in circulation -- the monetary base -- but also encompass credit, which in a modern financial systems represents a massive amount of purchasing power—governments are hooked on credit, as Ludwig von Mises so eloquently warned us:

"Credit expansion is the governments’ foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish

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government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous."

"The final outcome of the credit expansion is general impoverishment."

In addition, keep in mind that inflation consists not only of an increase in the price of goods and services, but inflation can show up in the price of financial assets -- stock markets, real estate, etc.-- while the goods and services price measure remains subdued.

In fact, this is where the bulk of the inflation was concentrated in the latest boom phase of the cycle. Our concern about the potential for deflation going forward represents a decline in both categories, including goods and services plus asset markets. This is a painful market adjustment process that leaves almost no one unscathed as the market washes away the excesses of the past.

Two key points to keep in mind when thinking of inflation/deflation:

General changes in the price-level are the effect; the cause is a boom generated by central banks artificially lowering the price of credit, transmitted though fractional reserve banking and various sources of credit-creating institutions.

An Austrian School of economics summary from Murray Rothbard:

“The fault of inflation is not in business “monopoly,” or in union agitation, or in the hunches of speculators, or in the “greediness” of consumers; the fault is in the legalized counterfeiting operations of the government itself. For the government is the only institution in society with the power to counterfeit—to create new money.

“…The recession periods of the business cycle then become inevitable, for the recession is the necessary corrective process by which the market liquidates the unsound investments of the boom.”

Now we are in the recession period as the market struggles to cleanse the excess of the massive credit boom years—low interest rates that engendered the explosion of derivatives credit across the globe. There has never been a period in history in which the globe was so highly leveraged with debt—total notional value of derivatives credit has vaulted to about nine-times larger than the amount of global GDP.

A virtual explosion of credit it was.


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The longer and bigger the boom takes to materialize ... and the longer credit is artificially extended by central banks ... the longer the bust phase will take to cleanse the system of malinvestment.

This is the core reason why we believe global deflation could be with us for a lot longer than many believe. The duration could be measured in years.

Hyperinflation Still the Only Way Out? Not So Fast!

But won’t it all lead to hyperinflation eventually, all the government money and debt creation?

‘Maybe’ is the only logical answer to give at this time. It likely depends on whether governments can simply paper over the current crisis, extending again the boom with more debt, as they are attempting to do at the moment. Or whether governments and central banks run out of bullets and the market overwhelms them with the write down of private credit and significant change in sentiment concerning leverage.

Let’s take a look at the scenarios and prospects that have us believing fiscal and monetary policy are not yet inflationary and won’t be for some time to come.

Since buying gold and dumping fiat currency -- the dollar -- is the favored reaction for those concerned about inflation, we think it’s important to take a look at the relationship between gold and US dollar index since the dollar began floating against the other major currencies back in 1971, triggered by the abandonment of the dollar-gold standard.

The chart blow is a monthly chart. The US dollar index is represented by the black line, whereas the red line represents gold. There are some key takeaways from the information in this longer-term view:

1) Mirror Image Effect: Major bear markets in the dollar are usually met with major bull markets in gold, and vice versa. There is an economic reason for this: gold is priced in US dollars (the world reserve currency) and as such, because gold is a reflection of global purchasing power across national borders, for it to maintain its purchasing power it must go up in price as the relative value of the US dollar goes down.

2) Gold soars on goods-inflation and sometimes on financial asset-inflation: Gold soared in the 70’s and would eventually peak around 1980, as did almost all prices of real goods in the classic cost push inflation environment (some say we got classic wage inflation because of relative strength of the economy, which we aren’t getting now, and because the US economy was more a closed-loop system; now many goods are sourced outside


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the US keep prices lower and replacing much of the past labor component), driven largely by the overhang of government spending (Vietnam War and Great Society welfare spending -- maintaining a dollar-gold standard peg became unsupportable). But it was exacerbated by the energy crisis in 1973 thanks to the OPEC oil embargo on the United States; this inflation showed up in consumer prices. But the monetary inflation that boosted gold, and whacked the dollar, showed up in asset price inflation -- stocks, real estate, and commodities -- but headline consumer prices, though higher, remained in check.

However, when US asset prices and the dollar rose from 1992 through 2000, gold prices fell but started to rally again once the dollar topped in 2001-02.

You can see how gold soared in price starting around 2001, thanks to very low Fed Funds rates at the time. Gold prices were supported by the massive build up in US dollar-based credit flooding the globe in the form of derivatives credit—those nasty little vehicles that sparked the proverbial credit crunch. Incidentally, if we mark the realization of the credit crunch as the day the US government was forced to rescue the former investment bank Bear Stearns, it is the exact day when the US dollar index bottomed and gold prices topped.


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A key question then: Does the credit crunch represent a sea change in the global economy that could usher in a change in the long-term trend of the US dollar ... and gold for that matter?

If deflation prevails, we think the dollar goes higher and gold falls. But a return of inflation thanks to the massive overhang of money now in the system could rocket gold higher and push the US dollar sharply lower.

It’s not all about the money! Or at least not right away ...

From the moment interest rates began dropping, from the moment stimulus money was legislated, from the moment new lending facilities were created, from the moment quantitative easing was agreed upon, the inflationists began screaming from the top of their lungs.

Marc Faber, for example, in the middle of 2009 told us he was 100% certain the US would experience hyperinflation. His time frame for that call we do not know.

What we do know, though, is that inflation seems to be missing in action. And considering the droves of analysts expecting price increases on the back of substantial money pumping and money creation, it’s funny that inflation is nowhere to be found.

One of the common refrains from those who believe in the inflationist side of the equation is that inflation is first and foremost a monetary phenomenon; therefore the money supply is the most important thing to watch. If money supply goes up, inflation will follow.

The chart below shows the unprecedented increase in the growth of the US monetary base. It’s surged around 95% since a year ago ...

Monetary Base Chart Next Page


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... but we haven’t seen headline inflation do anything. Prices are falling sharply across the US economy, as measured by the Consumer Price Index (chart below):

As the following startling statistics from Leto Research show, the evidence goes beyond just consumer prices:


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• The annual rate of deflation of the Consumer Price Index in July was -2.1% – the worst deflationary episode since August 1949.

• For the 11 months from Sept. 2008 to July 2009, the annual rate of CPI fell in an almost identical way as in the 11 months from October 1929 to August 1930.

• The three main Producer Price Indices (the prices producers pay for finished, intermediate and crude goods) had their biggest declines on record during July 2009.

• Since the modern PPI indices go only as far back as 1948, a good way of comparing producer prices between now and 1929-30 are the indices for commodities, industrial commodities, metals, and farm products; the price levels of all these suffered worse declines in 2008-09 than in 1929-30, except for commodities which suffered the same price decline now as then.

And if you’re looking elsewhere for inflation, perhaps thinking it’s different in the rest of the world, South African consumer price inflation has been cut in half, falling from 13.7% in August 2008 all the way to 6.7% in July 2009. The Eurozone in July 2009 reported inflation running at -0.6%. And Japan, no stranger to deflation, saw a record plunge in consumer prices in July; -2.2% from the year ago period. Even in China, after experiencing an unprecedented flood of lending, reported its consumer prices fell by 1.8% in July.

So what’s the deal? Why isn’t all this money pushing up prices?

The deal is that money is not moving through the economy. All this money that’s “flooding” the system is being saved or used to pay down debts or thrown into stock markets. You can see this clearly from an indicator referred to as the Velocity of Money. If the velocity of money falls, and it has actually plunged thanks to the credit crunch, it means the money being created is not being spent in the real economy. So, if people aren’t chasing real goods with the money created, it doesn’t impact prices:


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It may not be a strech to say that we could see a secular change in the spending habits of the American consumer thanks to a devastating hit to his wealth and newfound appreciation for what “over leveraged” really means. If so, the velociy of money could continue lower and stay lower for years to come.

Over the near-term, when you consider banks are still sitting on the money they received from the US government and not doing much new lending, it also paints a deflationary picture and proves it is not always about money. Check out the massive increase in reserves sitting at the banks…

Money not getting to the market and plenty of debts to be paid down amidst a structural shift in consumer attitudes is occurring; inflation may have a tough time making a comeback. Consumer credit outstanding is actually starting to decline; it’s an indication debt attitudes are changing…


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This is the first time we’ve seen any discernable change in the consumer debt pattern since the early nineties, when consumer credit began to explode upward.

Thus, US consumers are deleveraging -- not spending. And this deleveraging is intensifying. Here are comments on the recent decline in Consumer Credit for the month of July from Leto Research:


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CONSUMER CREDIT CONTRACTING SHARPLY: Consumer credit declined by -$21.6 billion in July from the previous month, at an annual rate of 10.4%. This is the sixth consecutive month of declines. The -$21.6 billion contraction is in dramatic contrast to the consensus expectation of -$4 billion and is more than double the contraction of the previous month. Moreover, the June contraction was revised to -$15.5 billion from the previously reported -$10.3 billion. Household deleveraging is proceeding at a much faster pace than the market has assumed so far. This presages further weakening of consumer spending going forward and strengthens the gathering deflationary pressures.

So, if Mr. US consumer is still the big dog (as he represents over 70% of the US economy), hunky dory growth assumptions may soon be ratcheting down to very subpar levels, reducing the demand for all types of global raw materials ... and prices to boot. Perhaps the risk bid is lessened, but it’s still in play.

It’s not only consumers, non-financial businesses are also deleveraging. Part of it represents concern about the future, part is lack of new growth opportunities, and part is about lack of access to credit…


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But guess who is not deleveraging? You guessed it, the US government. They are piling it on in an effort to stimulate the economy. But this we believe could sow the seeds of subpar growth for many years to come, eventually adding to deflationary pressures.

By this point the consumer retrenchment is no secret; it’s the duration of this trend towards saving and deleveraging that’s up for debate.

The still weak employment situation should continue to play a key role in the savings versus consumption decision. An improved employment picture will likely support stronger consumption. But if the sentiment change on debt is secular because of a major scare, that will likely mean we won’t see consumption return to pre-crisis levels.

Plus, given the change in the regulator environment on capital requirements and lending standards, consumer access to credit will be significantly limited compared to what it was before credit crunched. That’s another downer for consumption and price levels; business spending and investment are facing the same constraints.

The latest GDP report showed that business investments fell at an annual pace of 10.9% in the second quarter, following an extreme drop of 39.2% in the first quarter. Much credit is being given to healthy and better-than-expected earnings reports, but it’s important to keep in mind that much business activity has been due to cutting costs and cutting jobs – not a sustainable means of growth. Even while inventories have been buffeted in the last couple months, new orders for manufacturers remain depressed.


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The following chart has begun circulating the web in the last month or so:

The blurb attached at the left of the chart ends by saying that discretionary spending is bound to bounce back, after plummeting in the last few quarters. Ok, sure ... but what kind of bounce should we be looking for here? If consumers hadn’t already set their minds on drastically improving their personal financial situation then maybe we’d see a return to the common 18-19% range.

This crisis and deleveraging period is unlike any other in history, and it seems the US consumer may go back to the old way of doing things.

Meaning: maybe consumption becomes more dependent upon income rather than credit, which we know will tighten. Overall, spending based on income is healthier for an economy, but the impact of that change from a consumer hooked on credit is again deflationary. Problem is: personal income is on the decline and could be under pressure if the US experiences years of subpar growth.

Over the past four quarters total income from wages and salary has declined by 4.7%, the most on record dating back to 1948.


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In short, the weight of all the private deleveraging in the market place is still overwhelming the weight of public debt being thrown on the market. And because the government is now overwhelming and burdening the market, we believe industrialized economies will suffer subpar growth measured over years, not months.

From the data we have provided above, we think it is strong evidence that this is NOT your normal business cycle. We believe a secular shift is taking place in the global economy that will lead to these deflationary forces remaining in play for much longer than many now expect.

Structural Headwinds are Powerful and Deflationary

We think the global economy is facing some major structural headwinds due to this secular shift:

Structural Headwind #1: Less-Efficient Economies

Governments by virtue of punishing the free market will make economies less efficient. We will likely see subpar growth and spare capacity for the next few years. This reduces demand for resources and final goods, easing pressure on supply. We think John Plender, columnist for the Financial Times, summed this up well in an FT article that was published Saturday, 29 August 2009:


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There remains a real question about the robustness of the recovery. Fiscal expansionism, which shifts the burden of indebtedness from the household to the public sector, is a jump-start remedy that cannot be sustained because indefinite increases in borrowing threaten sovereign debt ratings. Other policy measures, such as “cash for clunkers” car scrapping schemes, bring expenditure forward, leaving a hole later on.

The problem of global imbalances has lessened, but has not been resolved, since the US still carries a disproportionate amount of the reflationary policy burden. The collapse of business investment spending in the UK indicates how difficult it is for current account deficit countries to rebalance their economies away from debt-financed consumption towards investment and export-led growth.

In the private sector corporate profit margins have held up well against the recession, thanks to cost-cutting. Yet one company’s cost-cuts subtract from another company’s revenues. As wages are cut and people laid off, consumption is dented. Much of the upturn in global manufacturing simply reflects the end of a savage inventory adjustment, which is a one-off boost to the economy.

A more profound question is whether the stock market has sufficiently grasped the nature of the post-crisis model of capitalism the world is moving towards. Governments will be exercising greater control over the management and levels of profit in banking, the motor industry and elsewhere. Regulation will increase, as will taxes. And the populist backlash against bank bonuses threatens to spill over into a wider resentment of profits and wealth creation.

There is real core damage to wealth creating enterprise because of US government policies. Consider this precise and scary summary of the state of affairs as seen by Criton Zoakos of Leto Research [our emphasis]:

“The massive bailouts of the last twelve months are being used to sustain a global asset price bubble. The pre-crisis price levels of financial assets represented future income streams of pre-crisis levels of production, trade and GDP. Those future income streams were destroyed when global production collapsed 16%, trade 25% and GDP 9.7%. Government bailouts and guarantees aimed at supporting asset price levels in effect replace the lost future income streams that economic activity once provided with future income streams provided by pledged tax revenue. “…By legitimizing this singular emphasis on financial regulation and by ignoring the paramount issue of the massive global shortage of investment opportunities relative to savings, President Obama is doing serious injury to the United States.


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Back to Mr. Rothbard and an example of government policies that significantly prolonged the Great Depression by hobbling the market’s regeneration qualities, as penned by Mr. Rothbard in 1963 in his book titled, “The Great Depression.” A prescient account of current government policy it is:

To prolong a Depression…

1) Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.

2) Inflate further. Further inflation blocks the necessary fall in prices, thus delaying the adjustment and prolonging the depression.

3) Keep wages up. Artificially maintenance of wage rates in a depression insures permanent mass unemployment.

4) Keep prices up. Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.

5) Stimulate consumption and discourage savings. We have seen the more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of capital even further. As a matter of fact, any increase in taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption. Some of the private funds [taxed away] would have been saved and invested; all of the government funds are consumed.

The real threat is government’s attempts at a solution are not only prolonging, and possibly dooming, subpar global growth for years to come, but it could be sowing the seeds of yet another crisis, or double-dip recession. This is especially dangerous when you consider central banks and global authorities are already running low on ammunition to counter the impact of deflationary pressures.

There is limit to taxing power and monetization of debt, assuming the goal is not to completely destroy an economy but rather to save an economy.

Structural Headwind #2: China’s Growth Potential

Growth in China could be hampered going forward due to soaring excess capacity, asset bubbles and bad loans piling up on the books of banks. This would mean price levels for final goods exported from China will continue to fall and feed global deflationary pressures.

Peking University economist Michael Pettis summarized this problem as follows in a recent editorial appearing in the South China Morning Post:

So Chinese policymakers have had to choose between policies that boost employment in the short-term while making the overcapacity problem in the long-


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term worse and, on the other hand, force a more efficient adjustment in the domestic imbalance while increasing job losses.

Until now, Beijing had come down resolutely on the side of boosting employment. It had shifted a massive amount of resources, mainly through the banking system, into new investment in infrastructure and new production facilities. This created jobs and boosted consumption, but it did so by expanding current and future production even faster, only worsening the domestic imbalances and making China even more reliant on US consumption.

It probably had no choice. As in nearly every major economy, the first instinct of policymakers since the crisis began has been to enact measures to slow unemployment growth. If unemployment grew too quickly and caused consumption to fall, it could easily tip the economy into a long-term and irreversible contraction.

But there was always a limit to how far Beijing should push. It could continue spending like crazy on good and bad projects to keep workers employed, but if all this spending simply increases capacity faster than it raised consumption, the net result would be an unsustainable debt burden and a more difficult reckoning.

That is why we should welcome the signs that Beijing may be reaching the limits of its investment push. The government believes that it has created enough momentum to avoid the worst consequences of the global crisis and the contraction in the export markets, but it is also stepping back from creating a worse crisis.

Structural Headwind #3: Energy Prices

It is becoming clear that Peak Oil is a hoax. There is plenty of oil supply on the market (ditto for natural gas) and plenty of new technology in play that will lead to even more. The Saudi’s have ramped up production capacity significantly. And historically when we have witnessed major global recessions, oil demand takes years to return to pre-recession levels globally.


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(Note: we refer you to a brilliant article on this subject in the September/October 2009 edition of Foreign Affairs magazine, written by Edward Morse, titled, “The Age of Cheap Oil.”

• In the oil industry, the most important new factor that accounts for low prices is the return of surplus production capacity among the members of the Organization of the Petroleum Exporting Countries (OPEC) for the first time since 2002-3.

• Further disproving the peak oil theory, since 2003 Saudi Arabia has also successfully engaged in a massive campaign to increase its production capacity (not just its actual production). This means it has committed to being able to raise its output quickly and massively in the event supplies from the second- and third-largest producers in OPEC are disrupted. Saudi capacity was 9.5 million barrels per day in 2002. Huge production expansions, including a new field that opened in June and can yield one million barrels a day, have raised capacity to 12.5 million barrels per day. Another one million barrels per day of potential capacity is on standby, meaning that it could be developed within


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12 to 18 months. And because of Saudi Arabia's efforts to increase its production capacity, OPEC's total production capacity could exceed 37 million barrels per day in 2010.This would be a record level: five million barrels per day more than in 2002 (before the strike in Venezuela) and more than ten million barrels per day above today's level.

• The disappearance of spare Saudi production capacity was the most critical element in driving up prices from 2003 to 2008 -- and its reemergence should be the most critical element in keeping them low over the next three years (or more, if global demand fails to rebound enough).

• The high prices of the last decade have also spawned massive technological breakthroughs, including in some surprising places. The United States used to be considered a country that would eventually suffer a long-term natural gas deficit and be condemned to import supplies, some piped from Canada, others shipped as liquefied natural gas (LNG) from around the world. But high gas prices -- as high as $13 per million BTUs in 2008, some 160 percent more than prices today -- have spurred phenomenal developments in technologies to drill for natural gas trapped in shale rock throughout the United States.

• Most analysts expect that once the world economy starts recovering, global oil demand will rebound to its former growth rate…But a return to prior growth rates is unlikely. For one thing, the market is responding to last year's high prices. Tracking the trend, the International Energy Agency has lowered its estimates for oil demand in 2030: it forecast 106 million barrels a day in its 2008 report, down from 116 million barrels a day in its 2007 report. Projections of future demand will inevitably be cut even further: one extraordinary lesson of the last 60 years is that after every spike in oil prices, demand growth flattens considerably.

Structural Headwind #4: Cheaper Food

Looking back to the period that most resembles today’s recession, prices for commodities suffered mightily during the Great Depression. From the final quarter of 1929 through the first quarter of 1933 (a little over 3 full years) prices for many softs and grains crashed. The steepest of the crash came early, in 1930; but the severe price declines extended another roughly 40-50% on average in the two years that followed.


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Based on the CRB commodities index, the initial plunge from the high in 2008 to the low this year, commodities prices sank by more than 57%. It took only eight months to give up that ground.

But if we expect a similar plunge to follow now, as it did in the early 1930s, then assuming another 40% drop beyond the lows (or a little more than 50% from current levels) is not an unreasonable forecast. Among the components of CRB index are wheat, corn and soybeans that each got clobbered at the onset of the credit crunch in 2008.


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Structural Headwind #5: Consumer Wealth Repair

It’s estimated the US consumer alone has lost $14-$16 trillion in wealth over the past couple of years. Thus, it is no surprise savings rates are increasing and debt levels are decreasing as Mr. Consumer repairs his balance sheet.

July of 2009 marked the sixth consecutive month of contraction in consumer credit. And it was quite a set-back. Credit sank by -$21.6 billion, or 10.4% annually, from the previous month. Not only was the drop five times larger than economists had forecast, but it was also the largest decline on record.

This same dynamic is in play across all industrialized countries, and many emerging market economies, throughout the globe. This will be a major drag on global consumption, which should be another headwind for prices and resource consumption.

Learning a Lesson from Japan

One last anecdotal point concerning fiscal stimulus and the impact of money and credit on inflation in a modern open economy: let us point to Japan.

We believe Japan could be the poster child for the US and other industrialized economies going forward. When Japan’s stock market popped in 1989, followed by a bursting of its real estate


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bubble a couple of years later, the Japanese government went hog wild with fiscal stimulus and the Bank of Japan pushed benchmark interest rates to zero.

What happened?

Well Japan has been mired in the grips of deflation ever since. And of late the government keeps increasing stimulus, and guess what ... deflation is getting worse.

So, if deflation is here to stay for a while, we would expect the US dollar to remain well supported.

Bottom Line: Deflation is winning!

Though we understand and respect the inflationist argument, until we see real traction on the demand side of the equation, it’s our belief strong global deflationary headwinds supported by subpar industrialized world economic growth will win the battle over the inflationary forces of government stimulus. The time-frame will likely be measured in years as the United States is now traveling down the same failed path that’s mired Japan in a long-term deflationary bear hug.

Jack Crooks and John Ross Crooks III Black Swan Capital www.blackswantrading.com 18 September 2009


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