Overview

The US and other governments around the world have a major problem: powerful asset deflation has taken hold, and governments lack the power to directly cure asset deflation. However, when it comes to symbolic or fiat currencies, governments do have full power to stop monetary or price deflation at will, so long as they are sufficiently determined. This dual relationship opens up a loophole for the US government: it can't really cure asset deflation, but it can fool almost the entire population into believing that asset prices have recovered.

Understanding this loophole may be the single most important financial survival task for investors over the next five to ten years. In this article we will explore the limits of government power, show how deception can be used to cover up those limits, and introduce some of the opportunities that open up to investors when they see through the deception.

(This article is Part 3 of Puncturing Deflation Myths. While Parts 1 & 2 are referenced herein, it can be read independently.)

Assets & The Limits Of Government Power

First, let's consider the value of assets. Assets can be tangible, such as real property or precious metals, or they can be financial, such as stocks and bonds. Whatever the asset, individual investors will only buy them at prices that make sense to them. If because of government intervention, the price for an asset is at a different level than what the individual deems desirable, then the individual will elect not to purchase that asset at that price.

So, much as it would like to, the government doesn't directly control the value of assets in a free market. It doesn't control what people will pay for them, nor how many hours somebody will work to acquire an asset, or what other assets they will trade-off for that particular asset. That said, governments can influence the value of assets, and often strive to do so.

One way of influencing asset prices is to control the supply of credit. The more credit that is put out there, the easier it is to buy large quantities of an asset with relatively little money down. This facilitates bubble creation, which leads to assets rising very rapidly in price. For example, the ease of buying stocks on margin in the 1920s is believed to be a major reason for the stock market collapse of 1929. When asset prices collapse and don't bounce back - that is asset deflation, and stock prices during the 1930s in the US (and around the world) are a classic example of persistent asset deflation.

This is also the lesson of what happened in Japan in the 1970s. The graph below is of a financial asset, the Nikkei 225 stock index, and it is a prime example of the persistence of asset deflation, even in the face of two decades of massive attempted government interventions.

As covered in my article, "False Lessons From Japan: Part 2 Of Puncturing Deflation Myths", what happened in Japan during the 90s and 2000s is widely misunderstood. It wasn't monetary or price deflation that vexed the government; Japan actually experienced price inflation over those two decades (as measured by the CPI). The problem in Japan was asset deflation, and the government was near powerless to cure this problem.

As hard as it has tried over a 20 year period, and as much as it has "quantitatively eased", the Japanese government simply has not been able to get stock or real estate asset prices back up to where they were before. The reason is that individuals have to cooperate if asset deflation is to be cured in real terms. Specifically, individuals have to cooperate by risking their savings, perhaps even all of their savings. If individuals have been burned too badly by the collapse of a bubble, it may take a generation or even two to get people in a state of mind where the government can lead them down that path again with a loose credit policy.

The Current Catastrophic Danger From Asset Deflation

Many people would say that the true lesson of the early 2000s in the United States is the demonstration of what an extraordinarily loose credit policy can do in terms of asset prices. Low cost and easily obtainable mortgages led to a real estate bubble, even as easy and loose corporate bond markets led to a booming private equity market, with leveraged buyouts being an important factor in maintaining an overvalued stock market.

The problem is that Wall Street, the government, and much of America has effectively bet everything they have on these asset bubbles not only staying inflated, but continuing to expand. Pensions long ago became "the tail that wags the dog", for state governments, local governments and most major corporations. Almost every state and local government in the US that has full time employees has entered into promises for future benefits, which it anticipates being unable to cover from ongoing tax revenues. Some of these promises are unfunded, others are fully "funded" (meaning they have adequate current portfolios given the investment return assumptions), but the mechanism all comes down to the same thing. Via the mechanism of the markets, vast sums of money and resources will flow from the outside economy into the local economies for all the states and cities, and will pay for the legally binding promises that would otherwise be unaffordable from current revenues. In other words - the asset bubbles have to not only be maintained, but must continue to inflate, or else the pension obligations bankrupt every level of state and local government.

Governments aren't the only ones relying on asset bubbles, so are most of the major corporations. Oh, the defined benefit plans are disappearing fast in terms of the ability of workers today to participate, but there are still tens of millions of workers covered, and many trillions of dollars of pension and health care benefits that will have to be paid. Future benefits that would destroy corporate profitability, and drive many corporations into bankruptcy.

Banks and other financial corporations are in even worse shape. Trillions upon trillions of dollars have been lent out for securitized loans - that are either backed by property, or in the case of the private equity market, by an ever inflating asset price for corporations. If the value of the collateral implodes, then so does the value of the loans, and the thin capital reserves are gone in a flash. (Realistically of course, the capital reserves are already long gone, but this will radically increase the pressure.)

The danger with deep and extended asset deflation is that everything breaks. The real estate market collapses. Most pension funds in America go bankrupt. Many major corporations and most financial institutions in America go bankrupt.

The Government's Loophole - Deceiving The People

Consider an asset. It could be a house, or it could be a portfolio of stocks. The price today is $100,000. The price in three years is $200,000.

How would you describe the move from $100,000 to $200,000? The mainstream media and the average person would say the house or stocks doubled in price. In the context of the current inflation / deflation debate, many economics commentators would call it inflation. Unfortunately, these perspectives set people up to be the natural victims of government deceptions. To understand why, let's consider two values for the purchasing power of a dollar in three years.

First, we'll assume the dollar loses 10% of its value to price inflation or monetary inflation. This means there are 200,000 individual dollars, each of which are really worth 90 cents, which means that the real value of our assets - that is, what our asset will buy for us in today's dollars - just climbed to $180,000. We have asset inflation in real terms simultaneously with monetary inflation. And the most important result is that our pre-tax net worth just went up by 80%.

Now let's go back to this same example and say that the asset climbs in value to $200,000, but instead of the dollar being worth ninety cents the dollar falls in value to ten cents. That $200,000 price, when each of the dollars is only worth ten cents, means that the real value to us in purchasing power terms is only $20,000. So we didn't gain 80% in our net worth, we lost 80% of our net worth in purchasing power terms.

From the way most people are viewing the inflation / deflation debate, these two cases of $100,000 turning into $200,000 are both examples of inflation, and are indistinguishable on the surface. All they see is the green bar above, which is nominal dollars.

Reality, on the other hand, is either column (A) or column (B). Either your net worth went up 80%, or it went down 80%. To distinguish between the two you HAVE to separate asset deflation / inflation from monetary inflation / deflation. Anyone who does not is setting themselves up for victim status, being fooled by the "cure" for asset deflation. (This fundamental flaw with the way that inflation and deflation are often defined is explored in my article "Can Theory & Jargon Destroy Your Net Worth?", linked above).

This danger is particularly acute given that the Federal Reserve and Treasury understand these principles quite well. Placing our example in perspective, let's say that we had a huge bubble, and the proper value of this asset in purchasing power terms is in fact to return to $20,000. Let's further assume that the massive asset deflation scenario is the "correct" one in a truly free market. Meaning that where we start at $100,000 is the peak of a bubble, and rational investors refuse to return to that price in purchasing power terms until that generational memory is lost to time.

What history shows is that on an inflation-adjusted basis, on a real basis, the government can't do all that much to fight investors getting smarter after they've been "burnt by a hot stove". Many governments have tried and failed in the aftermath of bubbles.

But here's the loophole.

The government doesn't control the value of assets, but it does control the value of the currency. It can do something that actually fools almost all of the people almost all of the time. The government can devalue the dollar. It can create inflation. What the government can do is it can take that hundred thousand dollar asset, that wants to fall to $20,000 in real terms, and let it fall, but still make it worth $200,000 in nominal terms simply by devaluing what each of those dollars are worth. Which means the homeowners are no longer underwater, and the banks are no longer insolvent.

There is a lot of information here for a short article, but as I've written extensively elsewhere, so long as the purchasing power of money is destroyed faster than the purchasing power of assets, an illusion of asset inflation is created.

An illusion of doubling our money for the simple example here.

An illusion that is potentially deadly for your investments and standard of living for the next several decades - but which is impossible to see through if you take the most common approach to looking at inflation or deflation, which is that it must be one or the other.

Real Estate & Pensions

The numbers above were both simple and large for teaching purposes, but there are a number of different ways in which monetary inflation can be used to hide asset deflation. As an example, let's say that you have an asset, call it real estate, that from an economic perspective needs to return to its real estate bubble price of $700,000 a house. Otherwise many homeowners are locked into their houses with negative equity, and the foreclosures just never stop coming.

However, it was insane for that market to ever go past $400,000, because that is all that even a relatively affluent population could afford. So the government makes credit as easy and cheap as possible in an attempt to reinflate the asset bubble to $700,000 a home, but the population refuses to get burned again, and the market refuses to move out of a range of $350,000 to $400,000 a house. This is a classic example of asset deflation that could easily persist for decades, so long as a dollar remains more or less a dollar.

The "solution" is neatly illustrated above. Make a dollar worth 57 cents. If a real value of $400,000 is all that people will pay, then with time, the nominal value of the house will rise to $700,000. The homeowners are no longer underwater, the pace of foreclosures drops drastically, and the bank losses, when foreclosures do occur, drop drastically.

Next, consider the dilemma of the pension funds. It could be the State of California, or your local city government, or just about any major corporation that has been around for several decades. Legally binding promises have been made based on the belief that markets always rise and reliably compound wealth. (I wrote my first book pointing out what an exceptionally bad and historically unsupported idea that was, back in 1993.) So for example's sake, if the market value of a portfolio doesn't rise from $35 billion to $50 billion, then the pension sponsor is in serious trouble. Enter asset deflation, and the portfolio goes down to $25 billion, and refuses to go back up. An event that leads to systemic bankruptcy at every level of state and local government, as well as many or most corporations in the United States with major pension obligations.

Unless, as illustrated above, a dollar becomes worth 50 cents. Asset deflation is entirely covered by monetary inflation. Rephrased, the destruction of half of the value of the pension fund (and your) assets is entirely hidden by the destruction of half of the value of your money. Everybody is legally solvent again.

March 1933: Creating Monetary Inflation In The Midst Of Asset Deflation

Can that really happen? Can there be monetary inflation in the midst of asset deflation? Absolutely. It has happened time and again, and is indeed the norm for nations in deep economic trouble. When the economy is collapsing, and the value of the currency is plunging - the value of the nation's assets don't actually rise in purchasing power terms. The impoverishment of a nation doesn't mean that the nation's homes and businesses grow steadily more valuable in purchasing power terms.

On the contrary, they are likely plunging. Much as we have seen with Iceland recently, which is simultaneously experiencing massive asset deflation and substantial price inflation. At this point, the assets have fallen more in value than the currency, so Iceland's assets are down in nominal dollar terms as well as purchasing power terms. However, if a floor is reached in asset values, even while the currency continues to rapidly erode, Iceland's assets can be expected to recover to their past levels and even surpass them. This creates an illusion of recovery, even as what matters to people, the purchasing power of their assets, remains devastated. This is a path that has previously been traveled by Argentina and Germany, among others.

Those are examples of more or less accidental inflations, where the government didn't mean to destroy the value of the currency. Which raises the question: would a government ever do this deliberately? Break a downward deflationary spiral and create monetary inflation, even in the midst of massive asset deflation?

Absolutely. Ironically enough, one of the best 20th century examples of a government's ability to create inflation at will, even in the midst of depression, can be found in the US Great Depression.

As covered in my article "Inflation During The Great Depression, Part I of Puncturing Deflation Myths", the evidence can be found in March of 1933. The US dollar was domestically gold-backed at that time, with the right to exchange paper currency for gold. That changed within the first few days of Franklin D Roosevelt's administration, and even though they kept the name "dollar" the same in order to fool everyone, the dollar was fundamentally changed right then. (This deception was a "Big Lie" strategy that is still quite successfully fooling most economic and financial commentators today, more than 75 years later.) The United States dollar went from gold-backed to symbolic in a week, meaning the new dollars had very little in common with the old dollars.

The result as shown on the chart is that right in the heart of the Great Depression - the biggest depression of the 20th century in the United States - the seemingly unstoppable negative spiral of price deflation was reversed, and inflation was instantly generated instead. The government does have absolute power to inflate or deflate when it comes to a symbolic currency, and I would argue that this is the true lesson of the US Great Depression.

Housing In The 1970s

Now, let's go to that silly example of curing housing deflation. Could people actually be fooled by that in the real world?

The average US single family home was worth $18,267 in June of 1972. By June of 1982, ten years later, it was worth $41,084. Many people, perhaps even you, considered owning a home during the 1970s to be one of the best investments of their lives.

Except for the slight complication that a 1972 dollar was worth only 43 cents by 1982. Meaning the average US home experienced asset DEFLATION, dropping to an inflation-adjusted value of $17,796. A decline that was entirely covered by destroying most of the value of the dollar, as shown in the bar on the right. This created the illusion for most of the population of one of the most successful investments of their lives, as shown in the middle green bar. (Being a homeowner in the 1970s did create substantial wealth for millions of households, but as I have written extensively about elsewhere, it wasn't the house that did it.)

When it comes to simultaneous asset deflation and monetary inflation - you really can fool almost all of the people, almost all of the time. This is no theory; it is our collective history.

Complicating Factors

The preceding is not intended to be a comprehensive analysis of a highly complex situation. For example, there are the interrelationships between asset values, interest rates and inflation. There are the issues of inflation-indexed government and corporate promises, and the need for inflation index manipulation. As well as the numerous intertwinings between the financial industry, asset values, the huge global derivatives market, the balance of trade, the upcoming retirement of the Baby Boom and so forth. Then there is the issue of whether or not the government can actually control the rate of inflation once the genie is truly out of the bottle. (The short answer: no way).

You could write a number of books on these subjects - and I have done just that. The purpose of this article is to convey some uncommon but essential knowledge through simplified illustrations, in a manner that is accessible to the general public and in a reasonably concise format.

Summing It Up

Here is a recap of the situation. The government does not control the real value of assets in a free market. In the aftermath of multiple bubbles, financial disaster awaits the nation in what most people would call deflation.

However, there is a loophole. The liabilities and any loss or profit are expressed in nominal dollar terms that generally don't account for inflation.

And the government does have absolute control over the value of the currency in gross terms, because it is a symbol that only exists because the government says it does. Around the world and through history, governments can and do change the rules whenever they absolutely need to, regardless of the price to the nation's citizens in terms of the value of their savings.

So the loophole is that if you want to attempt to dodge economic Armageddon and the destruction of every homeowner, pension fund and bank in the country, the way you do so is by destroying the value of the currency, that then generates a false asset value (in real terms) that is greater than the liability.

Your Financial Future Is A Matter Of Choice

In the real world - most of the people do get fooled most of the time, as sad as that state of affairs is.

At this moment, however, you do have a choice. Which is whether or not to take personal responsibility for your future.

There is a saying: "Fool me once, shame on you. Fool me twice, shame on me." In its essence, that is a statement about taking personal responsibility in an unfair world. This is something that in practice only a very small percentage of the population will do. Through inaction, most people effectively choose victim status, allowing themselves to be fooled twice, and then some.

On the other hand, if you are unwillingto be fooled again, and you are willing to roll up your sleeves and learn, then an unfair world transforms into a world of opportunity. Because here is the real essence of inflation and deflation: they are both REDISTRIBUTIONS of wealth. In each case, and particularly when the two occur together as illustrated in this article - there is a fundamental redistribution of wealth within society. With some people doing much better and others doing much worse.

This fundamental redistribution is more dangerous for some than others. Generally speaking, the higher the degree of monetary inflation and asset deflation, the more the older segment of the population is disproportionately devastated. For the reason that older savers have the savings & portfolios to lose, but lack the decades of peak personal career earnings needed to replace the assets. Which is deeply, totally unfair, but it is the way of the world.

With knowledge, the redistributions can flow to you, rather than away from you. The greater the degree of inflation - the more wealth that fundamental economic forces will redistribute to you. Understand how the redistributions work - and a potentially catastrophic degree of inflation can become the single most financially lucrative event of your lifetime.

But for this to happen, two uncommon steps have to be taken, which will separate you from most of your peers. You have to fully accept personal responsibility for your own future, and say "I won't be fooled again". Then you have to make the choice to learn how to turn societal deceptions into personal opportunity.

Would you like to find practical solutions to the issues raised in this article? Find out how to position yourself to benefit from government deceptions and the attempted cures for asset deflation? Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation - the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? These are among the many topics covered in the free "Turning Inflation Into Wealth" Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at DanielAmerman.com or InflationIntoWealth.com.