Wednesday, August 29, 2007

Inflate Incomes, Deflate Assets

Ever since the Great Depression the worst nightmare of all Fed and Treasury officials has been the prospect of deflation gripping the US economy. This fear was the driving force behind Mr. Greenspan's decision to lower rates post the dotcom crash and with even greater urgency after 9/11. The system was flooded with cheap dollars and the ghost of deflation past was exorcised - at least for a while.

The consequence of this largesse was the greatest leap in debt creation and credit-related derivative finance ever seen in history. Real estate and financial assets immediately benefited and leaped to all time highs, not only in the United States but all over the world. Bubbles were created in London, Marbella, Shanghai, Las Vegas, Moscow, Dubai, Mumbai - and all points between. I believe I am not exaggerating when I say that the credit-asset bubble is now much bigger and has greater global reach than the dotcom one.

It is also much more dangerous, because it involves the very core of the world's financial system: credit and asset instruments denominated in US dollars, the de facto global reserve and transaction instruments. US Treasurys are the most widely circulated debt and dollars are used to price everything from crude oil and natural gas to copper, scrap iron and sugar - plus the shipping rates to transport them. "Dollar Hegemony" is not a rhetorical expression but a fact that translates into matchless global power. If the dollar were to be debased, or otherwise overthrown from its position of dominance, it would carry with it the larger part of America's power and supremacy.

With this introduction, we now turn to the present, i.e. the credit contraction and asset deflation currently in progress. The debate as to what is likely to occur as a consequence in the near to medium future is delimited by two extreme positions: "super-inflationism" and "super-deflationism". The former is closely related to devotees of gold as a storehouse of value (a.k.a. gold bugs) and the latter is often associated with survivalists, autonomists, Die-Off theorists and the like. There are many positions in between, the two most common being stagflationism and navel-gazing market Nirvanism (all will be well if we just let Mother Market take care of things).

My opinion (which will buy you nothing, unless you also have a one euro coin, in which case you can knock down an espresso in Rome) is that hyperinflation is out of the question, at least to the very considerable degree that monetary and fiscal policy can influence matters. I am certain that no President, Treasury Secretary or Fed Chairman will knowingly and willingly sacrifice the dollar's standing as global reserve currency in order to gain temporary relief for highly leveraged speculators. Officials will certainly provide assistance so that the transition to lower asset valuations is accomplished in as orderly a manner as possible, but there will be no massive monetary bailout. The Fed, at least, has already signaled its intentions along these lines and - significantly - so have the ECB, BOJ and PBoC.

Instead, I believe, we have already entered a period of drawn-out asset deflation which will last as long as it takes to reduce the massive debt accumulated over the past decade and repair the damaged balance sheets and income statements of households. The personal saving rate (the percentage of income that remains after expenditures) will need to rise substantially above zero, by a combination of lower consumption plus higher wage and salary income. This will pressure corporate profits, which, however, are at record levels as a percentage of GDP and can be reduced with little damage to the overall economy. Overstretched speculators will suffer, but that is part of the de-leveraging process.


The bottom line is that we should follow a process that gradually repairs middle America's finances, with the objective of achieving a three-way stability between incomes, debt and asset valuations. If we do not we may end up at one of the extremes described before, which will be a real disaster.

19 comments:

Miju said...

If you are right it is going funny to observe that America will adopt the Japanese philosphy used after their bubble explosion in the 90's : no growth no rapid restructuration to avoid a violent vertical zig zag in the banking system economy. And who were the major critics of the japanese solution ? America....
regards
Miju

Anonymous said...

I believe I am not exaggerating when I say that the credit-asset bubble is now much bigger and has greater global reach than the dotcom one.

No question. With dotcom I guess there wasn't enough time for the inflation of equity assets to greatly affect real estate, certainly not globally, as happened later with low interest rates and lowered lending standards. Rather than using margin to buy stocks, people took out loans to buy houses; after dotcom, who could blame them?

If the dollar were to be debased, or otherwise overthrown from its position of dominance, it would carry with it the larger part of America's power and supremacy.

Hasn't it already been debased? Is it realistic to believe that the debt will ever be repaid? Or even serviced without massive restructuring? Will future US taxpayers, many of whom will be immigrants, and who had nothing to do with acquiring the debt, and also cannot be fairly said to have benefited from it in any way, want to have their incomes siphoned off for that purpose? I wonder...

eh

Anonymous said...

right, perhaps a bit late, and perhaps you already heard of it, but here in holland there's a documentary about "what will happen when the dollar falls": vhttp://www.vpro.nl/programma/tegenlicht/afleveringen/24877874/

it *is* in dutch, but parts of it are in english. the idea is: let's make a scenario about what will happen when the dollar falls, and show that scenario to economists around the world. funny how some things in there are happening right now.

Hellasious said...

Re: dollar debasemed already

No, though the dollar is certainly no longer the ONLY global reserve currency, it is still by far the largest and most important one. Losing that status would be a real disaster, far greater than S&P going down 50%.

Debt does not have to be "repaid" as such; it can be rolled over. In order for that to happen for the "good" portions of debt, a large portion of the Mickey Mouse debt that was created in the past 5-10 years has to be wiped out. This is almost all of the financially engineered debt, such as hybrid CDO's made up of CDS's, etc. This type of financial debt has nothing at all to do with the real economy, it is just a financier's way of betting on spreads.

Regards

GaudiaRay said...

hellascious: Debt does not have to be "repaid" as such; it can be rolled over. In order for that to happen for the "good" portions of debt, a large portion of the Mickey Mouse debt that was created in the past 5-10 years has to be wiped out.

h- Assume one wipes out a large portion of the US asset and debt in the private sector. We're left with federal debt which has an interest charge that must be serviced.

I ask... much less tax base, probably 10-30% less income and same debt load.

To me, that spells an impossibility to sustain the store of value of that debt.

The USD will drop either by choice or by consequence, imo.

What do you think?

Hellasious said...

To gaudiary

Tax base: No question that the tax base must be raised, if only to restore fairness.

1. Raise corporate tax rates to 40% and no BS like offshore gimmicks

2. Raise personal income tax rates to 50% for the top 2% income earners (everything included), 45% for the next 3%, 40% for the next 5% and leave the rest alone.

The federal debt load is not nearly as onerous as the "drown govt. in a bathtub" polemicists would have you believe. Yes, when unfunded liabilities are included things are dire, but that is not debt, per se.
If all other debt were to somehow evaporate (it won't) federal debt would be a cinch to service.

Larry said...

$74 trillion in debt, obligations, and guarantees, almost none of it which is self-liquidating. Housing that has to drop by a min. of 50% to be affordable by real people again. A country that has been deindustrailized.

I see no resembalance whatsoever to the creditor, manufacturing, hard working, culturally sound Japanese long deflation situation.

kmh said...

Hellasious said:

"
Tax base: No question that the tax base must be raised, if only to restore fairness.

1. Raise corporate tax rates to 40% and no BS like offshore gimmicks

2. Raise personal income tax rates to 50% for the top 2% income earners (everything included), 45% for the next 3%, 40% for the next 5% and leave the rest alone.
"

What is to stop companies and wealthy individuals from reincorporating elsewhere, leaving the problems to those who can't afford to deal with them? Here is another benefit of globalisation, and perhaps the ultimate test of American patriotism: When the going gets tough, the tough can get going.

What concerns me is that in the absence of dollar hegemony the remaining source of US power is military dominance...

yoski said...

I totally agree with "If the dollar were to be debased, or otherwise overthrown from its position of dominance, it would carry with it the larger part of America's power and supremacy."

But I believe we will inflate our way out of debt and sacrifice the dolloar for the following reasons:
1. An inflaction is politically much easier to sell than a (asset)deflation.
2. "This (asset deflation) will pressure corporate profits"
Are you nuts? We will have no such thing. Politicians will not bite the hand that feeds them.
3. The "Dollar Hegemony" might already be on its way out due to various reasons. There is a high level of saturation of important creditors. KSA & China have more $$ than they know what to do with, literally. Some producers of critical raw materials are already accepting Euros or Yen as payment (Venezuela, Iran, Russia).
Even more important, the latest sub-prime debt scam with AAA ratings plastered on them has destoryed a huge amount of confidence and goodwill throughout the world. Once our good name is already tainted we might as well go for broke.
4. Current M3 money supply is going up in double digits around the world. The numbers in the US were so scary that the FED stopped publishing them. (Currently estimated around 11%), other countries are much worse. Anyway, inflation is a world wide problem not only limited to the US...go to go

Kicker said...

Is it realistic to believe that the debt will ever be repaid?

The US can't default on debt in it's own currency. Every dollar will be repaid.

The USD will drop either by choice or by consequence, imo.

The USD isn't going to drop if the world goes into a recession. After all, most of the worlds debts are denominated in Yen and USD. In a recession, the only money that flows are debt payments and if your debts are denominated in USD?

Look at the recent market action. When the markets fear a recession, the YEN and the USD strengthen against the EUR.

In other words, the problem in the world is that we've built too much production capacity. USD reserves are just a call option on future US consumption. The USD isn't going to drop in a big way until the world decides it wants to import more than it exports. Do you see the Asia or Europe doing that soon?

I see no resembalance whatsoever to the creditor, manufacturing, hard working, culturally sound Japanese long deflation situation.

People forget that before the Japanese crash they had introduced 100 year mortgages. They called them "generational" mortgages. Japan's debt in the late 80's had out-stripped incomes. The problem that Japan has been struggling with for the last 20 years is how do you discharge that debt?

In Japan's case, the debt was discharged through 10 "stimulus packages" that effectively transfered the debt to the government's shoulders. Now, how does the Government discharge that debt? Every time they attempt to raise taxes or cut spending it plunges the country back into deflation.

If you are right it is going funny to observe that America will adopt the Japanese philosphy used after their bubble explosion in the 90's

Japan's no-failure policy has only prolonged the collapse. It would have been much better to allow bad debts to be discharged through bankruptcy courts. That would have freed corporation from the debt burdens, cleared out over-capacity issues, and set the stage for future growth. Liquidating the banks would have been a good option.

China is following the same policies with the same ends. Look at the non-performing and special mention loans issues they have.

Edwardo said...

I believe there are some crucial items that you have left out in discussing the inflation vs.deflation issue.

While I too, for the reasons you cite, find the idea that the dollar might be hung out to dry, preposterous, (and I have written as much on this blog), it is an ironclad fact that in all fiat regimes, and the U.S. is unquestionably a fiat regime, all roads ultimately lead to inflation.

The Great Depression, as hideous as it was, has, in any reasonable assessment, amounted to a mere bump on the road to an utterly devalued currency in real terms, which is the only basis worth considering. In a mere ninety four years, since the inception of The Fed/income tax double headed hydra, the U.S. dollar has lost almost one hundred percent of its purchasing power. All we need imagine going forward is that this essentially uninterrupted trend accelerate.

American hegemony, and it's ultimate international symbol, the dollar, have been and are becoming something to be defied and shunned by some very powerful players, China, Russia, and their less powerful, by by no means neglible surrogates, Iran and Venezuela immediately come to mind.

Perhaps more pertinently, we might ask, who are the most powerful entities in the U.S? Who owns our political and economic system and what outcome would they throw weight behind considering the tremendous wealth they stand to lose should the U.S. choose to move in the direction of the more equitable system you have outlined?

And while I don't have an absolutely definitive answer to my own question, I am put in mind of the Bush family's fairly recent purchase of a vast tract of land in Paraguay.

Edwardo said...

I believe there are some crucial items that you have left out in discussing the inflation vs.deflation issue.

While I too, for the reasons you cite, find the idea that the dollar might be hung out to dry, preposterous, (and I have written as much on this blog), it is an ironclad fact that in all fiat regimes, and the U.S. is unquestionably a fiat regime, all roads ultimately lead to inflation.

The Great Depression, as hideous as it was, has, in any reasonable assessment, amounted to a mere bump on the road to an utterly devalued currency in real terms, which is the only basis worth considering. In a mere ninety four years, since the inception of The Fed/income tax double headed hydra, the U.S. dollar has lost almost one hundred percent of its purchasing power. All we need imagine going forward is that this essentially uninterrupted trend accelerate.

American hegemony, and it's ultimate international symbol, the dollar, have been and are becoming something to be defied and shunned by some very powerful players, China, Russia, and their less powerful, by by no means neglible surrogates, Iran and Venezuela immediately come to mind.

Perhaps more pertinently, we might ask, who are the most powerful entities in the U.S? Who owns our political and economic system and what outcome would they throw weight behind considering the tremendous wealth they stand to lose should the U.S. choose to move in the direction of the more equitable system you have outlined?

And while I don't have an absolutely definitive answer to my own question, I am put in mind of the Bush family's fairly recent purchase of a vast tract of land in Paraguay.

Anonymous said...

The US can't default on debt in it's own currency. Every dollar will be repaid.

According to the historian interviewed (see link), defaults can and do occur; in fact, non-payment seems to be the rule. Personally, I see a restructuring as more likely, especially in light of the coming 'entitlements crunch'.

But regarding a possible default, and considering the demographic change inexorably overtaking America, and that a country is nothing more than its people and the government elected (nominal democracy, politics as usual), it is not unreasonable to ask: Why should a country that is made up primarily of Hispanics and Asians, the vast majority of them with no more than a couple generations of roots here, and, speaking of Hispanics (at a minimum), who are disproportionately poor, agree to have their pockets emptied to fill those of relatively better off, mostly white retirees, as well as foreign bond holders?

eh

Anonymous said...

Sorry -- here is the correct link for "disproportionately poor" above.

eh

François said...

A question for you all.

Is the country ready for a courageous and unpopular government soon (within 2 years). Since this is what the situation requires if the the country wants to avoid the natural way-out, uncontrolled inflation?

I have absolutely not the faintest idea on that sensitive subject.

America has been in some situations able to recover its strength and morale fast. But is it now in a situation to do it?

Face the problem. The whole thing is quite rough :
- no helicopter to rescue the housing market,
- let the courts clear the WS mess even if a few banks go belly up,
- raise fairly heavy taxes "à la belge" to pay for public deficits

I currently see no evidence in the press that the country will face the problem in an orderly manner.

So to me that's an uncontrolled deflationnary bout with home prices getting down the ladder is now pending ... but only in the short run. And certainly not because the administration did handle it. Bernanke is!

Edwardo said...

francois asked:

"Is the country ready for a courageous and unpopular government soon (within 2 years). Since this is what the situation requires if the the country wants to avoid the natural way-out, uncontrolled inflation? "

History argues... MAYBE. In my veiw, there have been two great nation threatening crisis that have occurred in the U.S. since its inception, The Civil War and The Great Depression. Two great and good leaders arose who met the challenges of the day, but I am far from certain that the nation will find another once more. It would take a short book to explain why this is so.

However, recall that before Lincoln came on the scene, he was preceded by a long line of mediocrities. We have certainly had a long line of sub par administrations going back many many years. Of course Bush and his administration are no mediocrity, but rather an unholy horror.

Anonymous said...

Is the Federal Reserve Charade going to try and push on a string with lowering the Fed Funds Rate again?...If so, will this be the end of the USD and thus the end of the Federal Reserve Charade?....

Juan said...

hellasious,

just to note what you likely already know, the national income and product accounts (nipa) provide a variety of corp. profit measures, some of which, such as nonfinancial, remain - as percent of total national national income - well below the 1960s peaks.

sure, corp profits have come up since the '01-'02 collapse but much of the improvement has not had to do with real production capital generated economic profit but with a type of substituting of financial 'profit' for real, i.e. the profit data have been inflated which is not just a demand-side effect. i've always found it interesting that this phenomena was noted as early as the minneapolis frb's 1974 annual report, but has certainly become much more exaggerated within this and the previous cycle.

on the off chance, i would recommend a look at dumenil and levy's paper on 'the real and financial components of profitability', which deals with most of the post wwii period.

my point though has to do with the increasingly credit dependent and fictitious nature which more recent cyclic recoveries have had, even as equity markets boomed upwards. there is, you see, a contradiction here and one which you touched on in an earlier post.

being still more reductionist, i would end by saying that no economy can REproduce itself on the basis of circulation capital; casinos with money but without food fail.

MAR said...

Amazing to read this post now. I just came to this exact realization (it's either going to be hyper-inflation or a serious deflation) this week. I wish I was reading this blog when this was posted. I would of gotten out of the market before the real fireworks started. Now it looks like I will have to sell on a rally.