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March 29, 2007

Deflation and Bernanke's Party Moves
by Charles Zentay

I wanted to thank all those who published my last article (with special thanks to Michael Nystrom of bullnotbull.com who started the ball rolling) and also those who wrote back with comments and thoughts. I was surprised by the number and wide-ranging nature of the responses. However, a theme did emerge. More than any other comment, readers claimed that deflation was more likely to occur than inflation.

In my last article, I promised to talk about two subjects: (i) the fact that many market participants from lenders up to the Fed are trading short-term gain for more longer-term risks; and (ii) the steps we can take to avoid excessive inflation. I will talk about these subjects. However, I first wanted to address the inflation versus deflation argument, because it comes up time and time again.

In my mind, deflation CANNOT occur. I cannot say it strongly enough. Deflation occurring in Japan was a very rare occasion, and it was driven by particularities of their banking system and their central bank's unwillingness to move quickly and aggressively enough. It was not an indication of trends to come in the U.S.

In my not so humble opinion, there are two common misconceptions when it comes to deflation: (i) once interest rates reach 0%, the government can do nothing more to increase liquidity; and (ii) if borrowers are saturated with debt and they will not borrow even with extremely low interest rates, liquidity cannot be created.

The problem with which we (those worrying about inflation/deflation) all seem to be grappling is the excessive debt (consumer, corporate, and government) that has come about in the last several decades. The question is whether that debt is intractable and will lead to a deflationary recession or even a depression, or whether the debt can be overcome through inflation. My belief is that the U.S. government could simply write a check (procedurally not so simple but possible nonetheless) to each indebted American and end this problem. The government could print its own money to cover these checks. Overnight, inflation would spike, but the debt problem would be alleviated. It is my contention that the political pressures are such that the U.S. government and the Federal Reserve will create inflation to alleviate the debt burden. The only question in my mind is whether they will do it in an intelligent way such that more debt is not created, or whether they will only dig us deeper into the same hole and be forced to create more inflation at a later point in time.

Anyway, our esteemed Chairman of the Federal Reserve, Ben Bernanke has written and spoken extensively on the subject of deflation, and I have included a long quote of his below, not to highlight his wit and sense of humor, but rather to show how well understood these issues are and to demonstrate the various tools the government has to overcome them:

The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief...However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero...gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

While those in the deflation camp are no doubt unsatisfied by my concise explanation, I must leave it at that for now. If so inclined, please write me to discuss this matter further, and I will promise to raise valid points on the deflation side of the argument in subsequent writings.

Returning to the matter at hand, I wanted to talk about how pervasive our trading of short-term gains for long-term risk has become. Starting at the top, let's examine the Fed. As you can see from the graph below, the Federal Funds Rate has been lowered (arrows) interest rates to increase liquidity during times of recession (shaded areas). However, since 1987, when Alan Greenspan became Chairman of the Fed, you'll notice that - but for a brief period in the late 1990s - the Federal Funds Rate has been held below its historical average.

Now what's wrong with that? Plenty! During the 1990s a massive deflationary force emerged with the winning of the Cold War and advances in technology. As Chinese, Indian and other international laborers entered the increasingly global workforce, wages for many tasks came down, leading to unprecedented gains in productivity and improvements in standards of living. Further compounding these benefits, foreign countries - which were trading with the U.S. and accepting dollars as payment - were willing to hold these dollars in reserve in their non-consuming and non-inflationary central bank accounts. However, as the economy stayed strong, rather than taking advantage of these benefits, Greenspan, due to his and the Fed's political nature, found it more expeditious to keep interest rates low and encourage massive consumption and consumer indebtedness. Normally, keeping interest rates so low during a period of already-strong economic growth would have caused the economy to overheat and thereby have forced the Fed to raise rates. However, the disinflationary effects of the new international labor and the growth in new technologies allowed Chairman Greenspan to act like a D.J. at a party, pumping up the volume, achieving rock star status, and bringing in more punch bowls exactly when he should have been taking them away. Greenspan, a fan of gold and fan of Ayn Rand earlier in his career, even went so far as to say that money supply no longer mattered. It was no longer a good indicator of what was happening in the economy.¹

Such actions allowed for extremely good times throughout the 1990s, but they also encouraged a massive misallocation of capital into over-consumption and indebtedness rather than savings and a path to longer-term growth. When problems started to emerge and the technology bubble burst, Greenspan doubled his bets and drove interested rates nearly to zero, before slowly starting to raise them just before his departure.

And so we find ourselves in today's predicament. Rates have been brought back up to 5.25%, still low by historical standards, and yet the economy is slowing down under the weight of its debt and the cost of that debt even with low interest rates. At the same time, the disinflationary force of international labor is beginning to run its course and actually turn into an inflationary force, as Chinese, Indian, and other laborers' wages go up and these noble workers begin to consume! In addition, foreign central banks, up to their gills in dollars, are no longer content to keep these dollars innocuously hidden away; they too are spending these dollars - in this case to acquire other assets.

So, on one hand in emerging markets, you have younger, less affluent workers with little debt coming up the ladder and driving inflation up, and on the other hand, you have older Americans who are burdened by debt and are now becoming the source of global disinflationary forces. Oh how times have changed. And rather than prepring us for these changes, Greenspan has put us into a situation whereby we enjoyed short-term gain, but now face greater long-term risks.

The evidence, I'm afraid is all around us. On March 27, 2007 (the day I wrote this article), the Wall Street Journal had an article on its front pages with the headline: "As Economy Grows, India Goes for Designer Goods: Mr. Murjani Sell $100 Hilfiger Jeans; A Boom for Vuitton." The article talks about how "India's economic boom and the expansion of its companies overseas have created a new class of consumers who have money and care about global brands." In the same Wall Street Journal, there is another article titled: "Sketchy Loans Abound: With Capital Plentiful, Debt Buyers Take Subprime-Type Risks." This article mentions how:

In a frank moment several weeks ago, Bill Conway, co-founder of private-equity heavy-weight Carlyle Group, issued a directive to employees warning of a corporate debt market bubble. Wall Street bankers bluntly describe it as a house of cards, too. So here's a questions. If borrowers and lenders alike agree the corporate debt boom can't last, why isn't anyone stopping it?...The fuller answer tunnels into the Street's cynical heart, and why it has always been so profitable to work there: Hedge-fund managers, buyout artists, and bankers get paid for short-term performance. The long-term consequences of their actions are, conveniently, someone else's problem. People inside the big banks are eerily candid about the credit cycle creeping to an end. They also candidly admit they don't want to get caught missing the next big deal. Their banks, and their own bonuses, might suffer. So they ply ahead..."The fabulous profits we have been able to generate," Carlyle's Mr. Conway said in a letter to his employees, resulted in large part from the availability of cheap debt. The bankers, he added, "are making very risky credit decisions."²

In my mind, so much of the supposed financial innovation that has occurred over the last two decades is partially about spreading risk but more so about getting the risk of the deal away from its originators. That way, bankers can take more risk. They can earn large fees and bonuses, but not suffer the consequences if the deal turns sour at a latter point in time - all over which seems good during decades of declining interest rates. However, we know how this "innovation" turned out when it came to subprime lending: bankruptcies and foreclosed houses. The question is now whether we will suffer the same consequences of "innovation" in other areas as well.

If we, the worrywarts, the party crashers, the cynics, are correct and these debt problems are actually an issue, what is to be done? To inflate or deflate: that is the question. Whether 'tis nobler in the economy to suffer the slings and arrows of outrageous recession. Or to take arms against a sea of debt and by opposing end them?

One of the respondents to my last article, Robert Waxman, succinctly captured this dilemma as follows:

Yes, it seems that the "inflate or die" mantra is in full force at the fed, but in that mode the dollar's value is consistently eroded. Would it not be sensible at some point for the fed to allow deflation (or the potential for it)? I ask this "dumb question" to make my point which is this: The fed issues "notes" which have value to the extent that society accepts them as payment for goods and services. The extreme of inflation is the worthlessness of fed "notes" (Weimar republic or zimbabwe) while the opposite extreme is ever increasing purchasing power of fed "notes" which become scarce during deflations. Would the fed not wish to have their "notes" maintain or increase in value at certain times along the way to maintain credibility/confidence in their system? Yes, recessions/depressions are painful, but it seems to me that, if it remains unbroken, inflation will cause the most severe pain that the system can offer.

In my opinion, Mr. Waxman is EXACTLY correct. The Fed should care about the value of its currency. As Michael Nystrom says, the Fed's notes (dollars) are the source of its power. If the value of those notes erodes, so does the power of the Fed. Yet, however much I agree with Mssrs. Waxman and Nystrom, I think what the Fed should do and what they will do are very different.

Already, the political pressures are mounting. In their latest meeting, the Fed decided to change their language from hitting at a possible rate hike in the future to being more neutral, such that they could lower rates if need. Fed Governor Frederic Mishkin summed up the feeling, saying that "A substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming."

To get a sense of the political pressures placed upon the Fed, look at not only Chris Dodd's reaction to the subprime mess, but also what is happening in Massachusetts. According to a recent article: Boston Mayor "Menino and Massachusetts Secretary of State William Galvin are expected to call for an immediate halt to all foreclosures in the state. Galvin will propose emergency legislation that will give at-risk homeowners a chance to take their cases to court. He said tens of thousands of people in Massachusetts are 'pre-homeless' and about to lose their houses in foreclosures and have little legal recourse." It would seem callous for the Fed to argue that hundreds of thousands of Americans should go homeless now for the noble goal of price stability!

Honestly, I was incredibly surprised to see an article in the main press (or near main press) clearly articulating the predicament into which the Fed has put itself. Todd Harrison of Minyanville.com writes:

Last week, as most of you know, the Federal Reserve announced it was adopting neutral bias on interest rate policy. While inflation remained FOMC members' predominant concern, they wanted to remain balanced in their approach to the economy and the next steps they would take. That's entirely fair, given the conundrum that we collectively face. On the one hand, we've got inflation in things we need to power, educate and feed the world. That's evident when looking at an equal- weighted CRB, which is one sharp rally away from all-time highs. On the other side of the equation, we have the specter of slowing global growth, a debt-laden consumer and cracks in the sub-prime mortgage market which, while isolated, is tied to the global machination through an intricate maze of derivatives...We often say that to appreciate where we are, we must first understand how we got here. There is a difference between legitimate economic growth and debt-induced demand. A simple snapshot of our screens won't tell the entire story. One must juxtapose the U.S. dollar, which has declined 30% since 2002, against the appreciation in stocks. Viewed through that lens, we've gone nowhere fast for the past four years. Alan Greenspan, who is widely credited with navigating our markets through turbulent times, hasn't done us any favors. He rode off into the sunset claiming victory, leaving consumers with adjustable-rate obligations while warning of recession as the dust settled behind him. Make no mistake, he left Ben Bernanke and the rest of us in a pretty pickle. We're up to our eyes in debt, with roughly $3.50 owed for every dollar of GDP. That'll mute the effect of cheaper money in a profound way. Once credit demand and supply start to decline after a massive credit-based inflationary boom, a deflationary credit contraction becomes the most likely resolution. This isn't a popular statement, nor is it fun to fathom. Still, as we weigh the landscape and prepare to listen to our Fed chairman, it's a necessary context with which to absorb his vernacular.

Now, obviously Mr. Harrison is in the deflation camp. I think the Fed will choose innovative policies over hundreds of thousands of American homeless. But Mr. Harrison does do a tremendous job of summing up where we are and how we got here, and he's gotten his piece on MarketWatch, which I was pleased to read when I logged into my E*Trade account. That said, it was released a couple minutes after midnight!

Anyway, I feel I have left several topics still uncovered, including my proposed solutions, but this article has grown long and unfortunately the real world beckons. Yet, if interest seems sufficient, I will certainly write a third party on what can be done. Until then, watch for the Fed to start preparing the road for a rate cut.

1 Contrast Greenspan's words from the 1990s with his writings from 1967: The government has "created paper reserves in the form of government bonds which -- through a complex series of steps -- the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise."

2 Amusingly, the article right next to this one was title "How Borrowing Yields Dividends At Many Firms: The Cheap Credit Now Can Juice Returns Later."

Charles Zentay
thinkinvest.blogspot.com

Charles Zentay is an independent business person who monitors the financial markets very closely. Visit his blog at thinkinvest.blogspot.com.