A version of this essay was first published in The Daily Reckoning.
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"The deflationary potential is historically large... we risk overwhelming deflation in every corner of the globe." - Conquer the Crash (2002)
Virtually everyone - and I do not use that word lightly - believes that inflation will accelerate. Stock-market bulls think that the economy is going to boom, bringing inflation. Economic bears expect an inflationary, if not hyperinflationary, monetary crisis. Economists believe that the Fed can inflate at will and is committed to an inflationary policy. The general population is convinced that prices of their homes and property can only go up. The few articles mentioning deflation in recent months have declared the prospect for it "dead."
This consensus is not merely overwhelming but reflects a belief as vast and deeply held as a religion. Investment News in September reported a survey by the National Association for Business Economics in Washington. It revealed, "None of the respondents to the May survey, all of whom were responsible for making macroeconomic predictions, predicted a decline in the consumer price index during the next two years." USA Today confirmed the fact, reporting, "Not one economist [of 67 surveyed] said it was 'very likely' the economy would slip into deflation." That is a consensus!
Against this backdrop of opinion, M3 since September has fallen over two percent, its largest decline in 60 years. This is different from a lack of inflation. It is real, actual, deflation. What's more, M3 has declined despite the strongest quarter of economic growth in decades, the lowest interest rates in half a century and a central bank committed verbally and by action to facilitating the expansion of credit! There is no interest rate spike or recession to explain away the decline in the money supply.
The dichotomy between what is happening and what people think will happen is colossal. Inflation is dead. Deflation is here, now. The monetary trend is no longer close to the edge of the cliff; it is beginning to slide down its face. As this is written, not a single major newspaper, magazine or TV network has done a story on the dramatic contraction in M3. People are so drunk with inflationary certainty that they can't even see that deflation is happening. And if they do, they don't believe that it is meaningful.
Why is there such a consensus that deflation is unlikely, if not impossible? Many people believe that the Fed is virtually omnipotent and can manipulate the money supply (and therefore the stock market and the economy) at will. Is that so? On June 25, 2003, the Fed lowered the federal funds rate for the 13th time in a row, to one percent.
Most observers think that the Fed still has that one percentage point of "ammo" left. But consider: The U.S. has a thriving money-market fund industry, which costs one percent of assets per year to administer. As it stands now, investors are getting extremely low returns from money- market funds. If the Fed were to let its funds rate drop to zero and other short-term rates fell along with it, money- market investors' return after fees could go negative. This event would make holding cash more attractive than holding debt, a situation the Fed surely wants to avoid. The monetary system appears to have reached the point at which pesky reactionary forces will come into play if the Fed tries any more "deflation fighting," no matter what the mechanism.
Why did I put the term "deflation fighting" in quotes? Commentators tell us that the Fed is fighting deflation by aggressively lowering its interest rates, but is that an accurate assessment? After all, the result of deflation - its primary outward symptom - is lower prices. And what has the Fed been doing? It spent over a year lowering the price of renting money. Within that period, in fact, the Fed lowered prices more than anyone! It has participated in the initial phase of the deflationary process as if it were a merchant on the street discounting its wares to a disinterested public. It did so in response to slack demand for its product - credit - just as the auto manufacturers and others are doing with their products. Deflationary psychology brings about lower prices, and the Fed has been lowering its prices. It is powerless to stop the trend.
A persistent decline in the money supply will have consequences. Some things will have to give. One of them will be prices for goods and services. To the astute observer, a change in prices has been in the wind for some time. The PPI has been flat for three years, and now even the CPI has had a down quarter. A severe deflation will also devastate the economy, as it has done in each of the rare times it has occurred over the past 300 years. With M3 dropping, it should be only a matter of months before the economy follows suit.
Are economists concerned? Well, besides the deflation opinion cited above from last year's polls, the only other time that I have ever seen a 100-percent consensus in a survey was... a few weeks ago! In separate year-end surveys of economists, The Wall Street Journal and Business Week independently reported unanimity that the U.S. economy would expand throughout 2004. That's right: not one dissenter. If it is usually wise to bet against a large majority in finance, what does it mean when there is no detectable minority?
I think that the continual denials that deflation can happen, against a backdrop of evidence to the contrary, appear to be part of a typical social psychological progression toward a credit crisis, which in turn will lead to economic contraction. The money supply might rebound for a quarter or two as the stock market and economy top out this year, but at the largest degree of trend, the credit bubble - 70 years in the making - has burst.
In 2001, there was little talk of deflation. Statistics relating to newspaper stories show that by late 2002/early 2003, it had become a commonly used word, even if most writers used it simply to dismiss the idea.
The next word that should begin to slide into the public lexicon is depression. I would like to offer quotes from authorities on the low likelihood of depression, but my diligent staff can find literally no mainstream economists, academics or Wall Street strategists even discussing the possibility. It is too remote even to mention! The term " depression" is where the word "deflation" was a few years ago, i.e., outside the general consciousness. Although no one is using that term now, in coming years it will be everywhere. The first phase will be widespread insistence that a depression can't happen, which will be a big clue that it is happening.
The two "d" words at the end of the subtitle to Conquer the Crash, i.e., "Deflationary Depression," were anticipatory. The book was published at a time when the likelihood of these two events occurring was (and still is) considered - as one economist said at the time about deflation - as remote as "being eaten by piranhas." My advice: Keep your toes on the riverbank.
Regards,
