Q&A on the Psychology of Deflation

http://www.whiskeyandgunpowder.com/Archives/2007/20070110.html

Treasuries

"How can purchasing U.S. government debt instruments be a good
investment when almost by definition there will be massive defaults?"

Mish Reply

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.

Weimar Republic

"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?"

Mish Reply

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 ***. 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."

Mish Reply

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?"

Mish Reply

There are two issues here, and they are different:

1.
The Fed has to be willing to cause hyperinflation (I doubt it
is).
2.
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.

Regards,
Mike Shedlock ~ "Mish"
.

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