Deflation Has Arrived
"Something very strange is going on. The U.S. money supply is shrinking," wrote Gary North recently in these pages. Below, Bob Prechter exposes the U.S. deflation no one seems to see…and which he foretold in his bestselling book of last year.
"The deflationary potential is historically large…we risk overwhelming deflation in every corner of the globe."
– Conquer the Crash (2002)
Virtually everyone – and I do not use that word lightly – believes that inflation will accelerate. Stock-market bulls think that the economy is going to boom, bringing inflation. Economic bears expect an inflationary, if not hyperinflationary, monetary crisis. Economists believe that the Fed can inflate at will and is committed to an inflationary policy. The general population is convinced that prices of their homes and property can only go up. The few articles mentioning deflation in recent months have declared the prospect for it "dead."
This consensus is not merely overwhelming but reflects a belief as vast and deeply held as a religion. Investment News in September reported a survey by the National Association for Business Economics in Washington. It revealed, "None of the respondents to the May survey, all of whom were responsible for making macroeconomic predictions, predicted a decline in the consumer price index during the next two years." USA Today confirmed the fact, reporting, "Not one economist [of 67 surveyed] said it was ‘very likely’ the economy would slip into deflation." That is a consensus!
Against this backdrop of opinion, M3 since September has fallen over two percent, its largest decline in 60 years. This is different from a lack of inflation. It is real, actual, deflation. What’s more, M3 has declined despite the strongest quarter of economic growth in decades, the lowest interest rates in half a century and a central bank committed verbally and by action to facilitating the expansion of credit! There is no interest rate spike or recession to explain away the decline in the money supply.
Deflation: Inflation Is Dead
The dichotomy between what is happening and what people think will happen is colossal. Inflation is dead. Deflation is here, now. The monetary trend is no longer close to the edge of the cliff; it is beginning to slide down its face. As this is written, not a single major newspaper, magazine or TV network has done a story on the dramatic contraction in M3. People are so drunk with inflationary certainty that they can’t even see that deflation is happening. And if they do, they don’t believe that it is meaningful.
Why is there such a consensus that deflation is unlikely, if not impossible? Many people believe that the Fed is virtually omnipotent and can manipulate the money supply (and therefore the stock market and the economy) at will. Is that so? On June 25, 2003, the Fed lowered the federal funds rate for the 13th time in a row, to one percent.
Most observers think that the Fed still has that one percentage point of "ammo" left. But consider: The U.S. has a thriving money-market fund industry, which costs one percent of assets per year to administer. As it stands now, investors are getting extremely low returns from money- market funds. If the Fed were to let its funds rate drop to zero and other short-term rates fell along with it, money- market investors’ return after fees could go negative. This event would make holding cash more attractive than holding debt, a situation the Fed surely wants to avoid. The monetary system appears to have reached the point at which pesky reactionary forces will come into play if the Fed tries any more "deflation fighting," no matter what the mechanism.
Why did I put the term "deflation fighting" in quotes? Commentators tell us that the Fed is fighting deflation by aggressively lowering its interest rates, but is that an accurate assessment? After all, the result of deflation – its primary outward symptom – is lower prices. And what has the Fed been doing? It spent over a year lowering the price of renting money. Within that period, in fact, the Fed lowered prices more than anyone! It has participated in the initial phase of the deflationary process as if it were a merchant on the street discounting its wares to a disinterested public. It did so in response to slack demand for its product – credit – just as the auto manufacturers and others are doing with their products. Deflationary psychology brings about lower prices, and the Fed has been lowering its prices. It is powerless to stop the trend.
Deflation: Something Has to Give
A persistent decline in the money supply will have consequences. Some things will have to give. One of them will be prices for goods and services. To the astute observer, a change in prices has been in the wind for some time. The PPI has been flat for three years, and now even the CPI has had a down quarter. A severe deflation will also devastate the economy, as it has done in each of the rare times it has occurred over the past 300 years. With M3 dropping, it should be only a matter of months before the economy follows suit.
Are economists concerned? Well, besides the deflation opinion cited above from last year’s polls, the only other time that I have ever seen a 100-percent consensus in a survey was…a few weeks ago! In separate year-end surveys of economists, The Wall Street Journal and Business Week independently reported unanimity that the U.S. economy would expand throughout 2004. That’s right: not one dissenter. If it is usually wise to bet against a large majority in finance, what does it mean when there is no detectable minority?
I think that the continual denials that deflation can happen, against a backdrop of evidence to the contrary, appear to be part of a typical social psychological progression toward a credit crisis, which in turn will lead to economic contraction. The money supply might rebound for a quarter or two as the stock market and economy top out this year, but at the largest degree of trend, the credit bubble – 70 years in the making – has burst.
Deflation: The Difference Between 2001 and Early 2003
In 2001, there was little talk of deflation. Statistics relating to newspaper stories show that by late 2002/early 2003, it had become a commonly used word, even if most writers used it simply to dismiss the idea.
The next word that should begin to slide into the public lexicon is depression. I would like to offer quotes from authorities on the low likelihood of depression, but my diligent staff can find literally no mainstream economists, academics or Wall Street strategists even discussing the possibility. It is too remote even to mention! The term "depression" is where the word "deflation" was a few years ago, i.e., outside the general consciousness. Although no one is using that term now, in coming years it will be everywhere. The first phase will be widespread insistence that a depression can’t happen, which will be a big clue that it is happening.
The two "d" words at the end of the subtitle to Conquer the Crash, i.e., "Deflationary Depression," were anticipatory. The book was published at a time when the likelihood of these two events occurring was (and still is) considered – as one economist said at the time about deflation – as remote as "being eaten by piranhas." My advice: Keep your toes on the riverbank.
for The Daily Reckoning
January 24, 2004
Editor’s note: Founder and president of Elliott Wave International, Robert Prechter has been publishing market commentary since 1976. After a successful career as an analyst and trader – during which Financial News Network (now CNBC) dubbed him the "Guru of the Decade" for the 80’s – Bob expanded his firm in the ’90s to provide analysis for institutions on every major financial market in the world. Bob is the author of 13 books on finance, of which his most recent title is Conquer the Crash – an international, New York Times and Wall Street Journal bestseller.
"Let Rome in Tiber melt, and the wide arch of the ranged empire fall!
Here is my space…Now for the love of Love and her soft hours.."
This morning, we gaze out upon America’s teetering Empire of Debt and collapse into a poetic mood. We’re so amazed at the yin and yang of it all…
Everywhere we look, we see an exquisite…but precarious…balance between things that are equally extravagant and equally absurd.
On the one hand, all the world’s governments are desperate to destroy their own currencies. On the other, the markets are working overtime to destroy the supply of it. Since Jan. 1 of last year, for example, the Japanese have spent nearly a quarter of a trillion dollars trying to keep their yen down. But the U.S. is doing an even better job of destruction. Despite Japan’s efforts, the yen rose to a 2- year high against the dollar.
So far, in Europe, "Old World" central bankers have resisted the urge to ruin. But they probably cannot restrain themselves for much longer. Germany is in recession. Budgets are busting. And employment is threatened by the strong euro. The European Central Bank will probably cut rates before long.
Meanwhile, from Atlanta comes a report illustrating why it is that a credit-led boom cannot last forever. "Burned by the economy, consumed by debt," is the headline in yesterday’s Constitution-Journal. The article describes the poor Muckle family – victims of the Federal Reserve. The Muckles took the bait the Fed offered: they bought on credit, and – for a while – savored the joys of the lowest interest rates in 45 years. Then, Mr. Muckle found his income reduced. Rather than cut back on spending, the Muckles merely filled in the gap – like the nation itself – with borrowed money.
The trouble with credit is that it costs something. And now we discover that the average credit card holder pays $1,000 a year in interest. And here’s a softball question for Daily Reckoning readers: how much would he pay if he had no credit card? Answer: nothing.
Has the credit made him richer or poorer? Answer: it has made him poorer; he has $1,000 less to spend.
It all seems so obvious to us. But these are strange times. And many people have come to believe that you can have all the yin you want…without ever having to worry about the yang of it.
Not so, dear reader. Not so. There’s another side to every story. A nuance to every fact. Another fool on the other side of the trade and a bust to every boom.
The yin of the last half a century has been what our friend John Mauldin refers to as the "Supercycle" – the rise of consumer-credit capitalism. People switched their attention from assets to cash flow…from balance sheets to monthly operating statements…from long-term wealth building to paycheck-to-paycheck financing…from saving to spending…and from ‘just in case’ to ‘just in time.’
After decades of this flight to hazard…the trend seems to be nearing some inflection point. Even with interest rates at 45-year lows, the bankruptcy numbers seem to be edging towards 2 million per year – including the Muckles. It is not hard to imagine what would happen if interest were to go up. All of a sudden, the monthly payments would be higher. People would have less to spend.
That is Bernanke’s paradox. In trying to head off deflation – by destroying the value of the dollar – he risks putting dollars in short supply. Even a modest inflationary boom might boost interest rates to 7%…or even up to 9%. But American households couldn’t stand it. They wouldn’t have the money to make their monthly payments. One could easily imagine that in the yang of the next credit downdraft…as many as 3 million people might go bankrupt each year – over a ten-year period!
Not that we expect higher rates anytime soon. That would be too simple. Too straightforward. Too un-poetic.
Over to you, Addison:
Addison Wiggin, with the latest in the markets…
– "Dollar Rally Disintegrates," says Bloomberg. The euro rose nearly 2 cents yesterday to $1.25. Gold rose, too. The correction seems to be over. The gold price jumped to $4.13.
– On the Street of dreams, all eyes were focused on earnings reports. Yesterday five Dow companies reported…but only one, Johnson and Johnson, was positive. The Dow subsequently shed 71 points to close 10,582. The S&P 500 also ended lower, but only by a point, closing the session at 1,138. The Nasdaq gained 7 and a half points to 2147.
– "The Dow has had a pretty good move recently," Arnie Owen of the trading firm Merriman, Curhan, Ford & Co told USAToday, "and it’s not going to go up every day. But the underlying strength in the market is still there. We’re not just seeing fund money coming in. It’s investors putting money to work."
– We here at the Daily Reckoning wouldn’t exactly call buying stocks at a P/E of 28 "putting money to work," but then again we seem to be making a name for ourselves as curmudgeons. Still, isn’t it wiser, we ask, hat in hands, to take the word of the old-timers over those actively engaged in separating fools from their money?
– Jeremy Grantham, for example, in his most recent report to shareholders, made this astounding statement: "Today we have substantially the worst prospects for long-term global investment returns of my 35-year career when all asset classes are considered, particularly for U.S.-centric investors. The asset classes collectively are simply the most overpriced they have been. There are no large categories [of stocks] that are good hiding places."
– "In times like these," friend and colleague Steve Sjuggerud points out, "Richard Russell probably put it best: ‘He who loses least, wins.’
– "Nobody wants to hear negativity," says Sjuggerud. "But I don’t see this as negativity…I see it as reality." Sjuggerud, following up on Grantham’s remarks in his Investment U e-letter, published a list of list of P/Es of all the world’s major stock exchanges. He found that there are none trading below a P/E of 17, save Russia, which is trading at 8 times earnings. Malaysia, Indonesia and South Africa are trading at 17 times earnings…while most of the rest of the world’s stock markets are much, much higher. Japan is trading at 111, but is second to the Nasdaq speculation machine, currently trading at 126 times earnings.
– "Only the huge, politically-driven stimulus gives cause for hope," Grantham told his shareholders, "and that is for a short-term reprieve or rather ‘stay of execution.’"
– What do you do when there’s no place to hide? Well, ‘invest in gold’ is one refrain you may have heard from your editors. In times of uncertainty, it’s a safe haven – that much is true. But it’s also been beaten down for so many years that even over $400, it still looks like a bargain.
[Editor’s note: Dr. Sjuggerud has helped to assemble a massive 104 report showing individual investors 18 ways to take advantage of the gold bull market that may prove to be the only investment story worth talking about in 2004. The report includes insightful commentary from Richard Russell, Jim Rogers and our own Bill Bonner.
– As you’ll recall, we have also been pondering the meaning and potential impact of a decline in the money supply. "M3" – the broadest measure of cash used by practitioners of the dismal science – has been falling steadily falling since August. At first, it was merely a peculiarity of the marketplace…a random anomaly. Now, we’re beginning to see a trend develop.
– Gary North makes a rather convincing case that we’re in the midst of a bank run…not unlike the one that happened following the crash of ’29. But this time, suggested North in these pages last Monday, it’s happening in slow motion – so it’s barely perceptible.
– And now comes this word of caution from Bob Prechter: "A persistent decline in the money supply will have consequences," Bob writes. "Some things will have to give. One of them will be prices for goods and services. To the astute observer, a change in prices has been in the wind for some time. The PPI has been flat for three years, and now even the CPI has had a down quarter. A severe deflation will also devastate the economy, as it has done in each of the rare times it has occurred over the past 300 years. With M3 dropping, it should be only a matter of months before the economy follows suit."
– With the fever for stocks running rampant on Wall Street and the election beginning to dominate the news cycle, is anyone concerned about a falling money supply? In an essay we’ve published below, Bob points out that not one economist in 67 surveyed by USAToday last May said it was ‘very likely’ that the economy could still be headed for deflation.
– "Besides the deflation opinion cited above from last year’s polls," Bob expands, "the only other time that I have ever seen a 100-percent consensus in a survey was…a few weeks ago! In separate year-end surveys of economists, The Wall Street Journal and Business Week independently reported unanimity that the U.S. economy would expand throughout 2004. That’s right: not one dissenter. If it is usually wise to bet against a large majority in finance, what does it mean when there is no detectable minority?
– "I think that the continual denials that deflation can happen," Prechter concludes, "against a backdrop of evidence to the contrary, appear to be part of a typical social psychological progression toward a credit crisis, which in turn will lead to economic contraction. The money supply might rebound for a quarter or two as the stock market and economy top out this year, but at the largest degree of trend, the credit bubble – 70 years in the making – has burst."
– Deflation, Bernanke’s nemesis and an all-but-forgotten threat to the economy (even among these pages), is the result…and "has arrived," says Prechter. (You’ll find more from Bob below…interesting and potentially hair- raising stuff…enjoy…)
Bill Bonner, back in Paris…
*** Zut! We were counting on a strong rally in the dollar so we could sell our mother currency out at a better price. But hardly had the rally begun than it appears to be over.
*** And Darn! Gold never fell to our remorse price – $400, the last price at which we regretted having not bought more.
*** Oil hit a 10-month high. Dan Denning says a hike in the price of oil is about the only thing that might force up interest rates. We’ve got our eye on it.
*** Why do Americans put up with it? Regulation? Public deficits and debt? Elaborate security measures…and restrictions of their liberty? Disappearing dividends? Lies, folderol, abject nonsense? Don’t worry about it, says old friend Gary North. Quoting from Fred Reed, "No country with really elaborate home-theater has ever risen in revolt," he says.
*** From John Mauldin: "The Supercycle is a description of the long-term decline in balance sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a build-up of leverage.
"However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity.
"Government policies to smooth out the business cycle were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that the balance sheet imbalances and financial excesses built up during each expansion phase were never fully unwound.
"Periodic ‘cyclical’ corrections to the trend occurred during recessions, but these were not enough to reverse the long-run trend. Each time that liquidity was rebuilt during a recession, it failed to bring the level back to the previous recovery high. Meanwhile, the liquidity rundown during the next expansion phase established new lows…."
*** Additional comment from a dead economist, Joseph Schumpeter: "Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own."
*** And a remark from Martin Barnes of the Bank Credit Analyst: "As far as monetary policy is concerned, the Fed has already made it clear that it is prepared to go to extreme lengths in order to prevent the economy from slipping into deflation. If the Fed wants to create inflation, then it can do so by drowning the financial system in excess dollars. Of course, the dollar would collapse, but that would be part of the reflationary process. An end to the Supercycle would be deflationary, so one way to delay the end would be to create inflation in order to devalue the burden of outstanding debt. The bottom line is that the demise of the Supercycle is not imminent. The economy will suffer another downturn in the next few years, but the authorities should still be able to find ways to prevent a terminal shakeout."
John Mauldin ties all the threads together in an excellent article we placed on the Daily Reckoning website. Take a look:
The Supercycle of Debt – America’s Growing Burden
*** We are getting dozens of emails such as this:
"lawn olfactory persistent dominick deterred millionaire prune failsoft guerdon sidecar delegate christendom holdover fallible assassinate depression gibbet continua asperity howard grandfather cryptanalytic adulate rendezvous evangelic."
Apparently, spammers are finding ways to get around spam- busting software – by sending nonsense messages. Thus do we see how the Internet has enriched our lives…and how the Information Revolution has made us all so much smarter.