28 October 2008

Musings on deflation ~ It's here ~ But what's next?

I've been thinking about a lot about exactly what is happening in the world economy these days. I decided to break down the actual facts and see what can be gathered from them.

Arguments in favor of deflation:

1) collapsing commodity prices
2) rising dollar
3) collapsing housing prices
4) falling stock prices
5 falling MZM

Those are very good arguments for deflation. However, there are weaknesses to each of these arguments.

1) commodity prices have collapsed over the past three months, but they haven't done so in a historical deflationary way. For example, farm prices began declining in 1927, and general prices didn't decline in the cities until 1930.
Why this is significant is that classic deflation takes time to build up for the same reasons that classic inflation takes time to build up. It simply doesn't happen this fast.
Now this doesn't preclude deflation happening today. It only means that what is happening is not a classic case of deflation.
An alternative explanation would be a massive deleveraging by global hedge funds. They invested heavily in commodities and they have now been forced to sell. This is not the same thing as deflation. It's more like the collapse in commodity prices and real estate in the late 1980's.

2) this is the weakest case for deflation. The most obvious thing wrong with it is the rise of the Japanese Yen. The Yen is not a reserve currency, yet it is rising against the dollar. Why? Because it is an unwinding of leverage.
I should also note that prices have not come down in he grocery store. If the dollar really was rising, don't you think that the price of food would come down?

3) collapsing house prices certainly have a deflationary effect, and is probably the strongest case for deflation.

4) while technically deflationary, this has never been directly associated with deflation. Stocks crashed in 1974 and 2002 without there ever being deflation.

5) now we get the most interesting, and applicable, part of the argument.
In fact the MZM is not falling significantly. So far only the rate has changed, not the overall stock. There was a far bigger decline from 2001 to 2004.
What's more, the Fed's credit is exploding. The deflationist argument that it won't make it through to the rest of the economy is interesting, but unproven. If deflationists are wrong in this regard then they are going to be wrong in a very big way.

6) we also have the massive bailouts. Deflationists say they haven't had any effect yet. But the fact is that they haven't really been rolled out yet. Today is the first day that we are seeing the full effects of the bailouts, and this is merely the leading edge.

So does all this prove that we aren't having deflation? Not at all. No one will be able to say for certain except in hindsite.
But it does give very strong case that what we are experiencing is deleveraging and no deflation.

Any comments from people other than Viper?

RE: Great Summary imo nm aussiebear NEW 10/27/2008 2:37:36 PM

RE: Forest and trees John... SuperCycleBear NEW 10/27/2008 3:21:34 PM
I think we're getting too close to the trees John and missing the forest.

There is absolutely NO doubt in my mind we are currently in the midst of one of the greatest deflationary episodes in history. To deny it is to dogmatically and pigheadedly deny the obvious. We would not have had the massive intervention to slow the financial collapse, if it were not the case. The result of that intervention .has produced the benign deflationary "LIST" you formed

However, as you point out it is not the typical deflation as few have resulted in (or from) changes to the global financial architecture - like this one seems likely to do.

As the architecture is going to change (but to what no one is quite sure, yet) so too will policies and strategies for navigating the fin. markets. Therein the difficulty lies. How can one take advantage of a new system if the details are to be 2nd guessed. I reckon it will involve a reduction in the role of the USD and a link to some extent to a tangible non financial asset that will give the medium of exchange some intrinsic value - hence the belief that gold will better than hold its real value over time - not nominal value but real value.

The USD rally is the final hurrah for the old system. It will be interesting to see who is going to step up to the plate and buy the USD$125 000 000 000 bonds.

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