Q&A on the Psychology of Deflation
Following are questions and comments in regard to “Significant Shifts In Psychology.” The volume of responses was enormous, but many of the questions keep getting asked time and time again in response to various posts. I decided to take as many of these questions as I could find, including some from the Motley Fool and address them in this post.
Typically, the questions or comments are about cultural differences in Japan, a belief that printing presses can always defeat deflation, that we are in some sort of ’70s rerun situation, public obligations will cause inflation, the Fed can reflate the housing bubble, and comparisons to the Weimar Republic. Let me address these questions and comments.
- “To even compare the citizens of Japan to the U.S. is stupid, stupid, stupid, Forrest Gump!”
- “Culturally, the Americans are spendthrifts compared with the Japanese”
- “Japan’s culture is older than 200 years, and culturally, they are different and it does matter”
- “The comparison to Japan is hollow. North Americans have become drunk on excess and will keep spending until the repo vans appear in the driveway.”
Comparisons with Japan are not stupid at all. It is important to understand both current differences, as well as trends. The biggest differences are demographics (an aging population and immigration policies) and consumer debt. The former is a deflationary force in Japan, the latter a deflationary force in the U.S. Consumer debt is an enormously deflationary force when it reaches the point it cannot be serviced. We are at that point now, and we face additional deflationary pressures of outsourcing and global wage arbitrage.
When it comes to spending, one also has to remember that it was not that long ago that the savings rate in the U.S. was 8%. That savings rate steadily declined to the point at which it went negative for 18 consecutive months. What cannot continue will not continue, by definition. A negative savings rate cannot continue forever. There will be a trend reversal in the U.S. back toward the norm on saving, and sooner or later, a trend reversal back toward spending in Japan. After a 20-year bout with deflation in Japan, it is too easy to say they are a nation of savers. Likewise, after a massive 20-year spending spree in the U.S., it is easy to project that trend forever into the future. Neither trend can last forever. The savings rate in the U.S. has only one way to go, and that is up. A reversal toward savings in the U.S. will actually be quite supportive of the U.S. dollar.
As for demographics, notice that the open-door policy of immigration in the U.S. shows signs of closing. That is a trend shift with potential implications for future housing demand. If immigration in the U.S. slows, it will slow the need for housing (and everything related to housing). In contrast, Japan will eventually open up to immigration for the simple reason it will have to. Trends change. Both Japan and the U.S. are showing major signs of reversal on many fronts. The deflationary forces are building in the U.S. just as they are slowly receding in Japan. So…is it stupid to make comparisons with Japan, or stupid to not make comparisons to Japan?
Pushing on a String
“The Fed cannot manufacture growth (it will end up “pushing on a string” in the end). The Fed CAN certainly manufacture inflation. There’s a big difference between the two. Perhaps you are missing it?”
Exactly what is it I am missing? The Fed can print, and I never denied it. Whether or not it accomplishes anything depends on willingness of banks to lend and consumers and businesses to borrow. Besides, doesn’t pushing on a string imply a failure to create inflation?
Solve Deflation by Printing
“The answer to any deflationary whiff is massive printing of dollars. The Fed can use this money to bail out failing banks, bail out failing hedge funds, buy trillions in mortgages. Since the money supply would otherwise be contracting, the result is no deflation. A standstill in money supply growth instead of a big contraction. This is what Mish doesn’t seem to understand. All you have to do is look back no further than the early 1990s to see how this works. There was massive deflation in the form of failed S&Ls and real estate, and the U.S. basically printed money to bail out the banks.
“The banks and hedge funds and large pools of borrowed money will have their hands out for central bank bailouts. The central banks will print massive amounts of money to bail out these institutions. There will be unbelievable demand for money from the big financial institutions. That will result in no deflation whatsoever. The money supply will be contracting, but to prevent defaults, the central banks will be printing money, so the net result will be NO deflation. This has happened again and again, so I’m not predicting anything that hasn’t already happened. The big financial houses will be lining up for loans, and this will counteract any deflation. Individuals and financial companies will need bailouts to meet their real obligations, and this will be inflationary. Remember, the S&L bailout in today’s dollars would be something like $300 billion. That is not chump change.”
If printing cured deflation, neither the Great Depression nor a 20-year bout with deflation in Japan would have happened. I refer you to these comments made by Paul Kasriel in an “Interview With Paul Kasriel”:
“If the banks are unable or unwilling to extend the cheap credit being offered to them by the central bank, then the economy grows very slowly, if at all. This happened in the U.S. during the early 1930s.
“U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero, but it would have little positive effect on economic activity or inflation.
“Short of the Fed depositing newly created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances…
“Most people are not aware of actions the Fed took during the Great Depression. Bernanke claims that the Fed did not act strong enough during the Great Depression. This is simply not true. The Fed slashed interest rates and injected huge sums of base money, but it did no good. More recently, Japan did the same thing. It also did no good. If default rates get high enough, banks will simply be unwilling to lend, which will severely limit money and credit creation.”
In addition, comparisons to the S&L crisis are invalid. There was an enormous capacity for consumers and businesses to take on credit at that time. Today, consumers are financially strapped and businesses have no reason to expand. Overcapacity is rampant, and the economy is running on fumes of financial speculation. This is 1929 revisited, not an S&L crisis.
Individuals may need bailouts, but it is presumptuous to assume they will get them in time, if at all. In fact, if you look at the Bankruptcy Reform Act of 2005, you will see corporations intending to make consumers debt slaves forever. Oddly enough, the Bankruptcy Reform Act is doing in practice what some claim culture did to Japan (prevent write-offs).
The simple fact of the matter is the Fed has no ability to put money into consumers’ pockets, and even if it did, it certainly could not prevent consumers from paying down debts, rather than going on a spending spree. Besides, the Fed has shown no propensity to bail out consumers at the expense of banks. Does anyone remember Greenspan’s recommendation that consumers use adjustable rate mortgages right at the very low in yields?
“In 2012, Social Security runs short of revenues; this will be an inflationary force. I’m sure I don’t need to mention Medicare, the Pension Benefit Guarantee Corp. (a GSE) increasing in obligations as domestic companies go insolvent with respect to pensions, etc.
“The entire situation of unfunded liabilities (not only in the U.S.) is likely to become a major political as well as economic problem in the next decade.”
Running short of revenues means that taxes will have to be increased, benefits slashed, or alternatives found. None of those are inflationary, and I expect some combination of all of those to occur. Already, we see medical outsourcing, and that trend is in its infancy. That will reduce costs. I also expect the next Congress to allow drug imports from Canada. That will not only lower costs, but lower corporate profits, as well. As for domestic companies going insolvent, I agree. GM and Ford are high on the list. That would be a hugely deflationary event (destruction in credit) should it happen.
Medicaid, etc., will become a huge problem eventually, but first things first. The consumer debt problem is a far bigger problem for the here and now.
Jobs and Wages
“Congress can create (useless) jobs. Congress can raise wages. Fannie Mae can revive the housing bubble. Congress can put money directly into consumer pockets (think $1,000 tax credit to every filer). Congress may be willing to cause inflation.
“The only variable the government cannot directly affect is consumer psychology. But in wartime, it doesn’t have to — the government can step in as the buyer and borrower of last resort.”
Fannie Mae has no power to reinflate the housing bubble. That notion is just plain silliness. Congress can, indeed, create jobs. Japan tried that and built a lot of bridges to nowhere. It did not cure deflation, but instead took Japanese national debt from zero to 150% of GDP.
Congress can also raise wages. But how many small businesses will go under if it does? Massively raising wages or putting on huge tariffs to “save U.S. jobs” would each kill U.S. jobs. Loss of jobs is not an inflationary thing, in that it will without a doubt increase bankruptcies.
Congress can indeed throw money into people’s pockets with still more tax cuts or tax credits. If it does, would it help the right people? Enough to matter? Once again, we come up to the issue of will Congress bail out the little guy at the expense of banks? I suspect not, but it may try something. If it does, will it backfire? I suspect so. The belief in Congress to do something that will work is staggering. The creation of Fannie Mae to make housing more affordable did the opposite. The “war on terror” increased the likelihood of terror. Invading Iraq was supposed to free up oil to pay for the war. Did it? We fought the Vietnam War on the “domino theory.” What happened? The Smoot-Hawley Tariff Act was supposed to save U.S. jobs — did it? Exactly what did the “war on poverty” accomplish? Now, all of a sudden, there is some massive belief that Congress will do something intelligent and that it will work to stop deflation. I find that amusing.
- “Japan would probably get out of its deflationary trap easily if it would simply declare war on Malaysia and ramp up defense spending accordingly”
- “Can the Fed create jobs? Yes, it’s called the draft, the oncoming decades of resource wars brought on by Peak Oil will keep sucking up the more and more desperately unemployed that the government is underreporting”
- “Can the Fed raise wages? If a million extra soldiers enter the work force, the money does not need to be distributed to the already employed, but the newly employed. The effect is the same new spending.”
If Japan declared war on Malaysia, I suspect it would immediately collapse the entire worldwide house of cards in derivatives, possibly causing a worldwide recession, if not worse.
As for the U.S., the last I checked, the Fed could not declare war. Also the last time I checked, the people in the U.S. are sick of war and want out of the current one. Of course, Bush is ramping up another 20,000 soldiers, but those are not new soldiers. Even if those were new jobs, in the grand scheme of things, 20,000 is not a lot of jobs. I suspect 500,000 housing-related jobs will be lost in the next recession, and that is just housing related. Besides, Bush has announced he wants to “balance the budget.” Of course, we know without a doubt that is a lie, but I suspect we are going to see a few vetoes coming out of the president and increasing looks at pork-barrel spending, and a few other things as well.
“Mish, you sound very much like Robert Prechter in this article — that mass social mood drives the markets and the stock market is the barometer of social mood. This is the same thing Robert Prechter has argued for a decade, with the stock market as the leading indicator of social mood, but he is a loser.”
Prechter may be right about social mood, but he was horribly off on both his deflation call and his call on gold. He missed a huge disinflationary boom, otherwise known as “Autumn” on the K-Cycle. Thus, he was not off by a decade, but decades. As for gold, he seems to think it will do poorly in deflation, and I disagree.
“It is an indisputable fact that housing and stocks are the two most influential assets to the masses. I believe Japan failed to stop deflation because the central banks pumped uncontrolled money to both stock and real estate at the SAME TIME; when both collapsed, deflation it was. I believe Greenspan and Bernanke have learned such that pump one of them and let the other down — mutually cancel out the negative effects. Possibly, pump one of them too much higher to gain a net positive effect on social mood. This is what’s happening today.”
Housing and stocks are indeed the two essential asset classes. There is also evidence that foreign central banks are attempting to prop up those assets with their policies simply to keep consumers consuming. But to propose that the key is to prop one up and then the other and that will accomplish something is basically absurd. For starters, housing is far more important to most people than stocks. Close to 70% of the nation owns a house (using the word “own” loosely). Many “own” multiple houses. In 2005, close to 35% of all homes sold were second or investment homes.
In contrast, the amount held by most people in the stock market is small. Furthermore, studies have shown that there is a greater propensity to spend increases in home prices than stock prices. Given that most houses are not paid off, there is also a huge liability should prices decline, as is happening now. This has the effect of contracting credit. You can see it now in bank willingness to make subprime loans. That is just the start of what is going to happen to housing. Stock prices simply cannot in any way, shape, or form counteract a complete debacle in housing. If defaults get big enough, regardless of what anyone tries to do, credit spread will widen, and that will undoubtedly be bad for stocks. It is just a matter of time.
Again, I am stunned by the massive faith people seem to have in the Fed and the government to do something intelligent that will keep the bubble expanding in an orderly fashion. I am also stunned by the belief that propping up the markets can possibly work in the long haul. Intervention seldom works, and when it does, it is only in the short term, and normally only in the direction of the prevailing trend.
I happen to believe that housing is the bubble of last resort. Housing created jobs, and borrowing against home prices kept people spending. What now? I keep asking, but no one has ever been able to tell me about the next biggest bubble that creates jobs and credit to the extent that housing did. The problems here are extreme. In a nutshell: We need a bubble in the U.S. that creates U.S. jobs (as opposed to jobs in China), with rising wages that allow the servicing of that debt, and a continued expansion of credit by willing and able lenders and borrowers both. How likely is that?
“Mish, you actually ignore an enormous amount of 1990s monetary theory by Bernanke and Co. about how they would have dealt with Japan’s deflation.”
It is Bernanke who fails to understand the Great Depression, even though it was his favorite study. You can listen to a man who proposes dropping money out of helicopters, but I prefer to listen to someone like Paul Kasriel or professors John Succo or Scott Reamer on Minyanville. Bernanke does not understand either the cause or the cure of the Great Depression. That is the simple fact of the matter.
“Look at the trucking data. Mish, I can’t believe you made the same mistake as Wal-Mart. Truck volume is now back to summer of 2005, pre-Katrina/Rita levels. All your chart shows is a hurricane blip during a time of stagnant volume.”
Exactly what chart are you looking at? Trucking is back to the level of September of 2002. Trucking is a good measure of demand for goods.
“How can purchasing U.S. government debt instruments be a good investment when almost by definition there will be massive defaults?”
How can government bonds possibly NOT be a good investment? Seriously, is the U.S. going to default on Treasuries? It is quite literally next to impossible. The U.S. owes money in its own currency. There is no risk of default. There is a theoretical risk that the U.S. will print money to pay back debts, but that is not what was asked (and I have addressed that elsewhere). In deflation, government bonds, cash, CDs, and most likely gold will be about the only things that do not get hammered senseless. Look at it this way: By definition, cash in deflation increases in value. Treasuries and CDs pay interest, but cash does not.
“What is your assessment of the causes of prior hyperinflations in the U.S., Weimar Germany, and Zimbabwe or France, per that last reference I posted some time ago?”
There is an enormous difference between the current U.S. condition and the Weimar Republic. For starters, M2 has only been growing at an average annual rate of 6.9% since 1969. The monetary base is not expanding anywhere near that fast. These amounts have little to do with hyperinflationary conditions. Credit has increased at a far faster rate recently, but the other side of credit is debt. When individuals or companies are no longer able to service their debt, bankruptcies and foreclosures happen. If bankruptcies and write-offs happen faster than credit and money expand, the result is deflation.
In contrast, the Weimar Republic underwent massive printing to pay war reparations required by the Versailles treaty after World War I. France sent its army into the Ruhr region to enforce their demands for reparations, and the Germans were powerless to resist. Adam Smith writes:
“So the printing presses ran, and once they began to run, they were hard to stop. The price increases began to be dizzying. Menus in cafes could not be revised quickly enough. A student at Freiburg University ordered a cup of coffee at a cafe. The price on the menu was 5,000 marks. He had two cups. When the bill came, it was for 14,000 marks. ‘If you want to save money,’ he was told, ‘and you want two cups of coffee, you should order them both at the same time.’
“The presses of the Reichsbank could not keep up though they ran, through the night. Individual cities and states began to issue their own money…
“When the 1,000-billion mark note came out, few bothered to collect the change when they spent it. By November 1923, with $1 equal to 1 trillion marks, the breakdown was complete. The currency had lost meaning.”
The key issues here are an expansion of credit in the U.S. versus a massive expansion of the monetary base in the Weimar Republic, war reparations, and occupation of Germany by France after the war. Is France demanding war reparations from the U.S. and occupying Chicago until it gets them?
Comparing the U.S. to Zimbabwe is even more ridiculous (The New York Times reports):
“Zimbabwe fell into hyperinflation after the government began seizing commercial farms in about 2000. Foreign investors fled, manufacturing ground to a halt, goods and foreign currency needed to buy imports fell into short supply, and prices shot up…
“Mr. Mugabe’s government has printed trillions of new Zimbabwean dollars to keep ministries functioning and to shield the salaries of key supporters — and potential enemies — against further erosion…
“In February, the government admitted that it had printed at least $21 trillion in currency — and probably much more, critics say — to buy the American dollars with which the debt was paid.
“By March, inflation had touched 914% a year, at which rate prices would rise more than tenfold in 12 months. Experts agree that quadruple-digit inflation is now a certainty…
“Toilet paper costs $417.
“No, not per roll. Four hundred seventeen Zimbabwean dollars is the value of a single two-ply sheet. A roll costs $145,750 — in American currency, about 69 cents.”
Is the U.S. government about to seize farms or private enterprise of any kind?
The last hyperinflationary period in the U.S. (using the word “hyperinflationary” loosely) was in the ’70s and ’80s, when gold soared over $800, oil prices rose dramatically, and interest rates hit 18%. That was caused by a massive wage/price spiral of rapidly rising wages and prices.
Conditions today are nearly opposite. I debunked the ’70s rerun theory in “1929 Revisited.” Today wages are falling on account of outsourcing and global wage arbitrage. Overcapacity is rampant, and the ability of consumers to take on additional credit is limited. Debt servicing is a huge issue now.
The U.S. Dollar
“The dollar will collapse causing hyperinflation.”
Collapse against what? People seem only to look at the situation in the eyes of the U.S. dollar. There is massive credit expansion right now in Europe, the U.K., China, and emerging markets (and has been for years on end, actually). Credit is actually expanding faster in Europe now than the U.S. The problems in the U.S. are severe, but Japan, Europe, and the U.K. all have their own problems. Japan has a national debt 150% of GDP. The U.S. is not close to that.
In addition, people keep forgetting the dollar has already collapsed. What else do you call it when the dollar falls from 120 to 80? Did that collapsing dollar cause either hyperinflation or the price of imported goods to massively rise? I think not. Just look at prices of anything and everything coming from China as proof. What did happen was a bubble in credit lending caused a massive increase in the price of housing, and that bubble is now collapsing.
Speculation in anything and everything is still running rampant. Not just in the U.S., but everywhere: equities worldwide, junk bonds, emerging markets, commodities, etc., all with leverage. The unwinding of that leverage is likely to be supportive of both the dollar and Treasuries. A reversion toward savings in the U.S. will also be supportive of the U.S. dollar and Treasuries. A flight from junk will be supportive of U.S. Treasuries.
If and when the Fed starts fighting deflation by lowering interest rates, I believe, but cannot prove, that gold will be the beneficiary. But it will not be just a gold rise against the U.S. dollar, but a rise in gold compared with all fiat currencies. The dollar is likely to crack in due time, but now does not seem to be the time. Even IF the dollar were to crack now, it is debatable as to what effects that might cause on the prices of goods and services in the U.S. Besides, a focus on the dollar is secondary to credit and debt servicing issues. Yes, the dollar will ultimately collapse, right with every other fiat currency, and the answer to the question I posed, “Against what?” is gold.
Able and Willing
“Mish, your question, ‘Is the Fed willing to cause hyperinflation?’ implies that the Fed could cause hyperinflation. If that’s true, couldn’t it by definition stop deflation by causing enough inflation to offset whatever deflationary forces arise?”
There are two issues here, and they are different:
- The Fed has to be willing to cause hyperinflation (I doubt it is).
- Even IF the Fed is willing, banks and consumers and businesses have to oblige.
If the Fed initiates a massive printing campaign and banks do not lend (because they are not willing to or consumers are not willing to borrow), the velocity of that printed money is zero. In that situation, printing in and of itself simply would not do much of anything. As noted before, the Fed by itself cannot create jobs, raise wages, force banks to lend, deposit money into people’s accounts, or cause a psychology shift to make people or businesses want to borrow.
The Fed, in conjunction with Congress, could, in theory, cause hyperinflation, but only to the detriment of banks and themselves, and, in fact, everyone else, too. Once again, if deflation were so easy to avoid, the Great Depression and the Japanese deflation would not have happened.
My Final Thoughts
I am amazed at the near universal belief that everyone seems to have in the Fed and the government. The arguments proposed and the comments made seem to imply that the Fed can pull off some sort of miracle bailing out consumers by causing wages to rise, property values to rise, and the stock market to rise, and to create enough jobs so that everyone can live happily ever after.
That is not exactly a fair statement, because some think the Fed will overdo it to the point of causing hyperinflation. Either way, people give the Fed far too much credit and intelligence, when history proves otherwise. Yes, the Fed has, for what seems like forever, been willing to blow bigger bubble after bigger bubble. Here is the key: It was able to do so because banks were willing to lend and consumers were willing to borrow.
It can’t go on forever, simply because the ability to service debt at some point becomes impossible. The pool of real funding (savings) dries up, and financial speculation on its own accord stops being supportive of the real economy. Financial and asset speculations of this magnitude throughout history have never ended well. There were deflationary crashes in Japan, the Great Depression, the South Seas bubble, the John Law Mississippi bubble, Tulip Mania, etc. In each case, the bubble collapsed after sentiment changed toward speculation. Once sentiment changed, it was never again revived.
The root cause of the bubbles was a massive expansion of money and credit in conjunction with massive speculation by the public. Given that the cause of those bubbles was that expansion of credit and speculation, it is incredulous to believe that the Fed or the government can cure the problem by throwing still more money at it. That has never worked before in history, and it won’t be different this time, either.
Mike Shedlock ~ “Mish”