The topic du jour is deflation. I must have read 40 or so treatises on the deflation debate this week alone. Some are rather lengthy and boring (some economists must intentionally try to be obscure and hard to read - you can't be that bad without really trying), and others are quite thought-provoking. I have written at length on deflation in the past, but from the volume of questions I am getting, it seems time to charge once more into the breech. I will try to come at the debate from a rather different point of view, lay out the risks, and see if we can find some investment insights.
Why are there such a wide variety of opinions on whether we will have inflation or deflation, and what the results will be? To get an understanding of the issue, we need to briefly delve into the philosophical arena.
A good place to start will be a letter I got from a (former) reader.
"After reading your e-mail data for months now and comparing it to information I have received from other technical advisors, I believe your mind is warped and not focusing on the extreme problems facing the United States today."
I get a few like these every month. I more often get letters from readers convinced I am in the doom and gloom crowd, only capable of seeing what is wrong with the world and predicting a dire future for their retirement.
I am reminded of a Gerry Rafferty line: "Clowns to the left of me, jokers to the right of me; here I am stuck in the middle with you." (You do remember Stealer's Wheel, don't you?)
Of course, I am usually in the Muddle Through Middle as well. As I read more than 200 articles, reports, essays and letters each week in an effort to glean some understanding of the economic world, I am more and more convinced that this is precisely the place we should be.
Not that I am always right. Far from it. But I hope I make you think through your own positions.
I make sure (or rather my associates and many readers make sure) that I read a lot of material, many by much better thinkers than your more or less humble analyst, who specifically disagree with my positions. Other than the few who can be assigned to the idiot file (I do keep one for occasional reading amusement), they can be compelling and logical essays.
As often as not, I find that the basis for disagreement is not in the logic of the arguments or the facts presented, but in the presuppositions of the analyst or writer.
To oversimplify somewhat, if you start with the premise that Republican presidents are bad, then everything Bush does is seen in a bad light. If you start with the presumption that Democratic presidents are bad, then everything Clinton did was suspect, if not outright evil.
In religion, Cornelius Van Til taught us that the place to begin an intelligent discussion is before you begin to look at the "facts."
"The issue between believers and non-believers in Christian theism cannot be settled by a direct appeal to 'facts' or 'laws' whose nature and significance is already agreed upon by both parties to the debate. The question is rather as to what is the final reference-point required to make the 'facts' and the 'laws' intelligible." (Defense of the Faith, Philadelphia, 1967).
It is the same in economics, or for that matter, most any human discourse. Someone who starts with Keynes as his basis for understanding of the flow of economic happenings will look at the "facts" in quite a different manner than someone who starts with von Mises and Hayek as his basis for reason. A proponent of Marx will come to different policy prescriptions than followers of Friedman.
But what if you have no "guiding light"? No basis for comparison? Then you are subject to the logical presentations of potentially flawed presuppositions, leaving you cast adrift upon the tide of ideas.
That is why it is especially important to read those logical representatives of thinking with whom you disagree, no matter how uncomfortable it makes you. If you disagree, you must know why. If you cannot then rationalize your current position, then you must be willing to change, or you will suffer the fate of those who must be right at all costs: it will generally cost you all you have.
I don't want to be too presumptuous about the reader above, but my guess is that he is a rather poor investor. He has made assumptions about the world. He is fixed on them, as a sailor on the North Star. He knows with a visceral certainty the rationality of his views.
He forgets that second most memorable of all lines from Keynes: "The markets can be irrational longer than you can be solvent." (The first is "In the long run, we are all dead.")
That is not to say you should not have investment convictions and act upon them. Of course you should. But you should constantly analyze your decision in the light of new information and test those assumptions against the thinking of others. If you cannot do so, then you are in serious danger of wanting the world and the market to conform to your wishes and fears about reality.
The market will do what the market will do, and in the short run, rationality has nothing to do with it. It will not conform to your wishes. The last Nobel Prize in economics went to a psychologist who proved that investors are irrational. You must make your views and wishes conform to the market, or suffer for a potentially long time waiting for the market to become "rational."
George Orwell gives us the following thought on wishes and fears:
"In general, one is only right when either wish or fear coincides with reality - we are all capable of believing things which we know to be untrue, and then, when we are finally proved wrong, impudently twist the facts so as to show that we were right. Intellectually, it is possible to carry on this process for an indefinite time: the only check on it is that sooner or later a false belief bumps against the solid reality, usually on a battlefield."
I would change the last sentence to end; "... sooner or later a false premise bumps up against the solid reality, usually on the bottom right-hand corner of your balance sheet."
Deflation Bad. Inflation Good.
I hope you found that walk down quotation lane enlightening, but I can hear the audience asking, "So, what the heck do Van Tillian pre-suppositionalism and Orwellian musings have to do with deflation?" Let's see if I can make a connection.
"I hold," we are more or less told by numerous authorities, "that a little inflation every now and then is a good thing." (With apologies to T. Jefferson.)
How can we be having deflation when everything seems to be going up in price? Won't deflation guarantee that we go into a Depression? If the Japanese couldn't avoid deflation, how can we? Can a central bank avoid deflation without creating even more problems?
All good questions, and the answers depend upon your pre-suppositions.
Whether deflation is beautiful or ugly can be in the eye of the beholder. I am on the Atkins diet, have lost 15 pounds and think the deflation of the spare tire on my mid-section is rather a good thing. However, last night as we left the restaurant, I was not very happy with the deflation of the right front tire of my car.
In our private consumer lives, we are all for deflation. In fact, we work hard to find ever lower prices. We reward businesses like Wal-Mart and Dell who can sell us things we want at prices lower than we paid last year. Their sales increase even as the prices we pay decrease.
Price deflation is the natural by-product of a productive, competitive economy. Gary Shilling points out in his must-read book called Deflation that wholesale prices dropped on average 1.8% per year from 1880 through 1996, yet national incomes rose 5% per year.
As an example, corn prices dropped over and over again as productivity rose and transportation became faster and cheaper. People had to pay less for food and had more to spend on other items and save for the future, which increased the capital available for investment and growth.
Frank Shostak of the Mises Institute writes, "Based on the view that price deflation is bad news, many experts suggest that the Fed should adopt a policy of targeting inflation. According to this logic, while price deflation causes consumers to postpone buying, which in turn leads to economic depression, price inflation leads to the exact opposite. Hence by targeting price inflation the central bank could influence consumer buying and therefore general economic activity. The remedy for an economic slump brought about by price deflation is inflation, or so it is held.
"Moreover, if a fall in prices causes people to postpone their buying, why wasn't this the case with regard to personal computers? Computer sales between 1992 and February 2003 increased by 127%, notwithstanding the fact that prices of personal computers fell by 80% during this period."
"Also, between January 1992 and February 2003 the prices of appliances fell by over 20% while sales of appliances during this period increased by 129%."
As consumers, a fall in prices is exactly what we want. I want the cost of gasoline to go down. I typically buy clothes when they are on sale. My telephone bills are a fraction of what they were ten years ago, with far better services. We shop for the best deal, unless time is more valuable than money.
In a competitive free market, we should expect prices to come down over time, as various businesses try to find ways to get me to buy their product or service. Price makes a big difference.
So why is everyone so worried about deflation?
Because deflation can have a dark - a very dark - side. It is one thing for a business to cut prices because they have figured out a way to lower costs. It is another thing for them to have to cut prices because there is too much product produced by all their competitors yet they have not figured out how to deliver that product (or service) with lower costs.
Such a "deflation" in prices results in lower profits. When this happens to a few companies, we think of it as the Darwinian way of the business world: only the strong survive. C'est la guerre. When this happens to a multiple and large segments of the business world across an entire country, it is called a recession, as businesses cut spending and employment.
This - the recession - has the unfortunate affect of reducing demand even as there is too much capacity.
And therein lays the concern in economic circles about deflation. No one is actually concerned when prices drop for good (productivity and competitive) reasons. The concern is when prices start to fall because of too much supply and lack of demand. This typically precedes a recession.
This is a topic we have touched on before. Briefly, in the optimistic 90's we simply built too much capacity to produce a wide variety of products. Business investment in production capacity, plus Y2K changes, created a large boom for all sorts of technology and manufacturing.
In the US, we are currently using less than 75% of our production capacity. Historically, the long-term average is 82%. There is little incentive for businesses to invest in new production lines when they can produce all the consumer wants now. The rather large part of what business investment there is stems from introducing new cost-cutting systems or replacement of worn out machines. There is not a lot of equipment being bought to add to capacity.
Recoveries from recessions are usually led by increased business investments, growing consumer spending and a boom in housing. We are seeing nothing like a real increase in business investment, consumer spending never really dropped so it is only capable of rising very modestly and housing is still near peak averages.
If consumer spending were to drop or housing to soften, we would slip back into recession. Recessions are inherently dis-inflationary. That means inflation declines during recession. Since we are so close to "0" inflation, it is quite possible we could see actual deflation.
Thus the Fed is faced with a serious dilemma. If interest rates rise, it will clearly hurt the housing market if the economy is not growing at a healthy pace. Further, as mortgage rates drop, people re-finance their homes. This helps a consumer economy in two ways. First, it lowers the monthly payment, so it increases the money available for other purchases or savings. Secondly, it allows home owners to take some of the equity out of their homes and spend it on home improvements, paying down other loans or whatever.
When rates go back up, the music stops. Today, mortgage bankers expect that 2003 will be a record year for re-financing. Bloomberg rates show a 30 year mortgage at 5.11% (source: bankrate.com), although the newswires keep talking about a national average of 5.4%. 15 year rates have dropped to 4.52%.
(I remember that when I wrote in the fall of 1998 that 30 year mortgages would drop to 5% before the end of this cycle I had more than a few readers tell me I was nuts. We are getting quite close.)
The Fed is hoping that if they can keep the consumer and housing music going long enough that eventually the economy will grow enough to reduce the excess capacity and business investment can take up the slack from consumers.
But to do so means they must keep short term rates low for quite a long time. The Fed all but promised to do so this last week. That helps bring down longer term rates as well. Here is how that works.
One of the risks of buying a three year bond is that rates will rise and your bond be worth less. Today three year rates are 2%. If you buy and 90 day rates rise next month to 2% and 3 year bonds rise to 3%, you are stuck with a 3 year bond worth less if you sell it. But if you rates do not go up for two years, then in two years you have in effect a one year bond paying 2%, when one year rates are 1%. That makes your bond more valuable.
Businesses and investors (read hedge funds) can figure out how to profit from this "carry." The longer you think rates can stay down, the longer the time length of bond you can buy without a great deal of risk. The effective guarantee by the Fed of lower rates has the effect of bringing down rates across the spectrum.
Whip Deflation Now
As I have often noted, there is a tide of bad deflation sweeping the world.
Eisuke Sakakibara, the Japanese monetary guru known as Mr. Yen, told the London Financial Times: "Deflation is beyond the power of monetary authorities to prevent. Even if we don't yet have [global] deflation, you have to concede that we have disinflation, he said, attributing falling prices to rapid productivity gains in manufacturing, particularly in China. "Deflation is a structural, not a monetary phenomenon." (Bonner, the Daily Reckoning)
Part of this attitude may stem from the fact that he failed so miserably to halt deflation in Japan. He is the poster child for academic studies on what not to do about deflation.
But he does have one point. Japan and Europe have "structural" problems in their fight against deflation. Japan has a banking system that is corrupt and essentially bankrupt. They have avoided reforms that are desperately needed, trying everything but actually fixing the problem.
No matter how much money the Japanese central banks print, they cannot stimulate business loans. Even at "0" percent interest, healthy businesses simply do not seek money. The Japanese bank system lends money to companies which are bankrupt to keep them in business. To cut them off and let them go out of business would mean the banks would have to write off the bad loans. Many observers think that Japanese banks as a group are essentially bankrupt, loaded down with bad debt they refuse to write off. Thus, deflation is structural. Until they bite the bullet of true reform, Japan will remain a basket case.
Europe, and especially Germany, has its own problems. I think it is now safe to say Germany is in recession. The "authorities" will reveal this to us in a few months. Their problems are compounded by ridiculous labor rules and huge government guarantees for social services. Their tax revenues are down, yet expenses are up. They are in a European Union treaty, which in theory prevents them from running large deficits, though they are ignoring this (as is France), as they cannot raise taxes in a recession and they refuse to cut spending. Their population is aging. The European Central Bank is still fixated on fighting inflation in Europe as a whole, while Germany is getting ready to go into outright deflation, so they get little or no relief from the central bank. As the Euro rises against the dollar, their export industries, which have been the heart of what little growth there has been, are seeing rapidly shrinking sales and profits.
Germany's government (as well as that of France and much of "Old Europe") seems unwilling to bite the bullet of true reform, and thus they face the very real prospect of outright deflation.
No Pain, No Gain
This is all the result of a very straightforward proposition: no politician can get elected (or re-elected) by promising pain. They get elected by laying the blame for any current pain at the feet of the opposition.
Thus, Europe and Japan, which represent some 42% of the world's economy, are simply not going to be the growth engines they should be. They need to reform their systems, but that would require politicians to advocate short-term, and at this point potentially serious, pain. The US, with our huge trade deficit and over-valued dollar, will not be the growth engine we have been in the past. We, too, are reluctant to embrace reforms which are not politically possible.
The fact that the markets will eventually force this pain is not the issue. Pain deferral is part of the democratic human condition. It is only when faced with overwhelming problems that we collectively rise to the occasion.
And now we come back to presuppositions. There is a school of economic thought started by Ludwig von Mises called the Austrian school. Maynard Keynes is the founder of the Keynesian school of economic thought.
Let me quote these paragraphs written by Shostak, with a section from von Mises:
"Prices will also develop a declining tendency on account of the bursting of the monetary bubble. In other words, once the bubble is burst this undermines various nonwealth-generating activities that sprang up on the back of prior monetary pumping. Note however, that this fall in prices is welcome news because the fall indicates that the diversion of real wealth from productive activities was arrested. In short, a fall in prices is indicative that the healing of the economy has begun.
"On this Mises wrote: 'As soon as the depression appears, there is a general lament over deflation and people clamor for a continuation of the expansionist policy. . . . Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holding. This may be properly called deflation. But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after cash holding. The causation is the other way around. Prices of the factors of production-both material and human-have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government of the labor unions to prevent or to delay this adjustment merely prolongs the stagnation.'"
"It follows then that a fall in prices, which is labeled as price deflation, is always good news."
In essence, what the Austrians say is, "Take the pain today so that you can come back stronger tomorrow. The more you avoid restructuring your economic world, the more pain you will have in the future."
If a central bank tries to prime the pump by monetary inflation or an easy money policy, they are creating the seeds for future problems. They are advocates for letting the market work. Many would abolish central banking (advocating a gold backed dollar) and even ending or limiting fractional reserve banking, as they suggest this creates imbalances which produce recession and worse. All good things are the result of an unfettered free market, which will work in spite of the efforts of government to overrule the basic law of supply and demand.
Thus Austrians have very little to promise in times of economic crisis except hard work and pain which will eventually make all things better. Thus, they also rarely get elected to political office, and never in sufficient numbers to have any real effect.
Keynesians would politely (or maybe not so politely) reply "bunk." Falling prices have not been the pre-cursor to recovery in Japan, let alone good news. Letting the market truly alone is a recipe for disaster, especially for the average citizen. A central bank is required to maintain order and to insure proper economic liquidity. Properly run, a central bank can smooth out the large ups and downs that so frequently visit a true free market economy. Simply look at the US when we did not have a central bank. This benefits the population at large by keeping employment relatively high and raising living standards for everyone. All good things are provided by a free market which is tempered in its extremes by a wise government and central bank.
Make your Choice
Is deflation a necessary event to be embraced to cure the ills of excess or is it to be avoided at all costs as the pain of unemployment and depression are too unbearable? Is it better to go sideways for a long time than down for a shorter period? Which pain do you want? Choose wisely.
The vast majority of us are on the sidelines of this debate. What we think makes no difference. While I would opt for much less government involvement than we have today (the Austrian position) what matters is that those whose decisions do make a difference are essentially Keynesian: they believe the government and the Fed should act to avoid recession and deflation. They have openly and clearly indicated what they will do. This is not some secret cabal.
Theirs is the presupposition that deflation is bad.
This means that interest rates are going to stay down for much longer than would normally be the case. To raise rates now or at any time in the near future would invite a swift recession. The Austrians would say this would speed the restructuring process and allow us to come back to a sustainable and much higher growth. The Keynesians would say this would create lots of pain in the form of high unemployment and a collapsing stock market.
Therefore, we are going to have a lot of economic stimulation from the Fed for quite sometime. I think it is clear they are not going to raise rates until inflation is comfortably back above 2% and/or the economy is growing above 3% for a rather long period of time. Since I do not think either of these will happen this year, rates are going to stay on the lower end of the scale for some time. If we start to slip-slide into recession, rates will go lower than all but Gary Shilling or Don Peters can currently imagine.
This also implies an ever weaker dollar, as Rob Arnott pointed out to me this week. In a study he sent me, he demonstrated a correlation between rates and currencies.
I am going to stop here, as it is 3 pm on Saturday and this letter is long enough, and I want to get out of the office. I normally do not write on Saturdays, but there has been just so much distraction this week that I could not get started in time. Plus, I spent a lot of time this week listening to the webcast of the two day long SEC roundtable on hedge funds. It was a very interesting conference. I want to meditate on what I heard for a few weeks, then I will take up pen to share my views. Some of the views expressed disturbed me a great deal. I heard a great deal of paternalism.
I wonder if the small investor will ever be invited to sit at the table as equals with the rich? Why is it that small investors are allowed to buy stocks (which have lost trillions of investor dollars), stock options (the vast majority of which expire worthless), futures (where 95 % of retail investors lose money), mutual funds (80% of which underperform the market) and a whole host of very high risk investments, yet are deemed to be incapable of understanding the risks in hedge funds?
I would not deny, and in fact I would emphasize there are risks in hedge funds, and sometimes considerable risks. I have written rather lengthy papers on hedge fund risks and due diligence. But I would say that there is clearly risk for most, if not all, investments. Why is it that small investors are thought to be able to understand the business risks of Cisco and not the risks of a convertible arbitrage or a long-short equity fund? Hedge funds, by any analysis, are superior to mutual funds on a risk adjusted basis. That is why the rich are flocking to them. Simply being less than rich should not be the basis for exclusion. This is the last bastion of political incorrectness in the country.
Next week my twin daughters graduate from high school. Soon I get to once again experience firsthand the inflation of college costs. Where is deflation when you need it?
Your expecting the Mavericks to deflate Sacramento tonight analyst,