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Ned W. Schmidt

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Ned W. Schmidt,CFA,CEBS is publisher of THE VALUE VIEW GOLD REPORT and author of "$1,265 GOLD", published in 2003. A weekly message, TRADING THOUGHTS, is…

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Deflation or Delusion?

HEADLINE from the future:

New York: The merger of the NASDAQ into the largest self regulated exchange in China was completed today. The new market firm will retain offices in New York while corporate headquarters will be in Shanghai. Electronic trading will continue at the New Jersey site, but as a subsidiary unit of the Global Trading Center. At present the Global Trading Center is the world's largest computer based, securities market system in the world and resides at a massive computing center in Quandong province in China.

Every article should have a purpose, hopefully a single purpose. That goal was the original intention. However like all grand intentions, distractions develop along the way. With that realization, the intention of these few words is to address the panic attack over DEFLATION on the part of some central bankers, financial journalists and market mavens.

Deflation, or rather that word, has given market commentators something they have not had since the "New Economy." More articles have been spawned on the fear of deflation in a short period of time than would be the case with a major national disaster. The deflation focus has now been used to rationalize every possible investment decision. We are told to buy stocks cause of the deflation concern and also to buy bonds because of the deflation concern.

Some paper asset is always assumed to be the solution to all situations or developments. These people are amazing. These stocks will benefit from the deflation fear. Those stocks will benefit from the collapsing dollar. Some stocks will make you rich because of the tax bill. Always some paper asset with these people. Have they ever opened their minds to any other alternative?

The "new economy" was a delusion used by the Federal Reserve to rationalize an aggressive monetary policy. As we all now know, and as many of us knew then, a bubble was in the making. The simple lessons to remember are, one, that this economic delusion was real in their minds. They really believed that a new era of guaranteed productivity growth was upon us. Second, that belief was sufficiently strong to allow for the monetary policy that created and then burst the stock market bubble.

The delusions regarding inflation and deflation are real in many minds. They actually believe that the Federal Reserve has controlled inflation. Second, they truly believe that the only way to save the U.S. economy from deflation is an aggressive monetary policy. But they refuse to recognize the ramifications of their actions. That U.S. monetary policy is creating a Mortgage and Housing Bubble is readily discernable. Any argument to the contrary is defeated by no more than a graph of applications for housing refinancing.

This effort is not intended as a treatise on the Mortgage/Housing Bubble. However, a Wall Street Journal article just inflamed our mind.(28/06/03, p.1) Apparently many, including our good Fed Chairman, believe that housing magically spews out wealth. Housing prices are apparently guaranteed by some secret force in nature to increase in value. WSJ reports of the Chairman's views, "But as more Americans own their homes, he told Congress last week, the impact of home values on the economy which he started to follow more than 30 years ago is only going to 'increase, rather than decrease.'"

Now, before we go on. Sometime today go out in your yard and turn facing your house. Do you see anything of real value spewing out of it? Are any real goods coming out the windows? Is it somehow producing a miracle software while it sits there? Of course not! The only thing that makes the value go up is the printing of money and the creation of debt. But the gurus tell us not to worry for an army of immigrants making the minimum wage will buy your house at an ever higher price.

What follows from this is that rational reasoning means nothing. The Federal Reserve is going to remain aggressive on monetary policy until something "blows." The question is what is that event that forces the Federal Reserve to respond, causing the Mortgage/Housing Bubble to burst. That event will be the final kick for the U.S. economy, sending it down into a second and far more serious contraction.

The dollar's devaluation has not yet caused the Federal Reserve concern. That fall in value must influence some variable or event that can influence the Federal Reserve's decision making. One of those "events" could be liquidation of U.S. debt securities by foreign investors. The second one is a reversal of the attitude on inflation. Or perhaps another, unthought of at this time.

The "Delusion of the Decade Award" should go to the notion that somehow the Federal Reserve has controlled inflation. Their wisdom or divine guidance are believed to have allowed them to maneuver inflation down to wonderful levels. That this belief is a delusion is part of our message. That the Federal Reserve has control of inflation seems to contradict the whole idea that deflation is a risk.

Perhaps we had better get back on the intended track. History has been composed of a number of civilizations, empires and nations that have risen and faded. These waves of economic rise and fall go back in time to the earliest activities of mankind. Centers of industry, trade, commerce and credit have appeared and disappeared. The first graph looks at the most recent century or so of that history.

London rose as the center of the British Empire, reaching a peak of dominance in the late 19th century. That city was the center of commerce and finance. Barings nearly collapsed the first time in the 1890s over a bubble in Russian and Latin American bonds. While the projects backing those bonds look strange now, these ideas were certainly no wilder than that of the internet bubble. As World War I appeared on the scene that position of global financial center was transferred to New York.

The last wave peaked in Tokyo in 1990. Tokyo rose to be the last great center of commerce and finance. Japan continues as the second largest economy in the world as a result of that ascendancy. Japanese banks dominated the list of largest financial institutions. Mizuho, of Japan, continues as the largest bank in the world by assets. That reign over global finance began to unravel with the bursting of the Japanese bubble in 1990.

A new wave with China as the economic and financial driver seems now to be forming. However, that discussion will have to await another time. Suffice it to say that the China's growing demand on global inputs, and the money to pay for them, will be the driver for the next round of higher global prices. We need to return to ripples from the Japanese bust.

Each of these Great Economic and Financial Waves in history has had some common characteristics. An epicenter of commerce, trade and finance developed. That center dominated global finance and credit. Financial speculation eventually became rampant. Prices of securities and other assets were pushed higher, beyond their value. The bubble then burst, sending major economic shockwaves throughout the country and globe.

Inflation and deflation are always monetary phenomenons. Those monetary phenomenons are transmitted through the banking system. For while an individual bank can not create money, the banking system due to a fractional reserve requirement can create money. The connection between the central bank and the economy's pricing environment is the lending activity of banks.

In the modern era, that lending mechanism takes "high-powered money" from the central bank and creates vast quantities of "ordinary money." That process of multiplying money through the lending of money is what causes the global money supply to grow. As would be expected, inflation rises whenever this process is in an expansionary mode. Asset prices move higher. The central bank may have provided the high powered money but bank lending is what leverages it.

Naturally, the process can go into "reverse." If banks restrict their lending activity the size of the "leveraged" money supply ceases to expand. An expanding money supply, measured by the rate of increase, is the fuel for prices. More fuel means higher prices. Less fuel, or a slowing supply of fuel, leads to lower prices. That latter development leads to low inflation, or perhaps deflation.

When for whatever reason the bank lending process falters, the whole process reverses. As banks reduce their lending, the growth rate of the money supply declines. The growth rate of the money supply has great influence on inflation and asset prices. Faster money supply growth, due to bank lending, causes higher inflation and higher asset prices. Slower money supply growth, due to weakening of bank lending, causes lower inflation and lower asset prices.

Japanese bank lending dominated the era up to the 1990s. The same could be said about the British banks during their reign, and U.S. banks up to 1929. Their subsequent lending contraction caused inflation to become deflation and asset prices to crumble. No magic wand or divine intervention, simply the mechanics of money.

What has been experienced since 1990 is not some magic era of inflation control. Rather, what has been experienced is the collapse of the lending process created by the Japanese banks. The next graph helps to visualize this process.

Source: Bank of Japan for Japan Loans & Discounts

We need to spend some time on the data shown in this graph. The solid line is the year-to-year rate of change in the U.S. Consumer Price Index Less Food & Energy. That plot uses the left scale. The second series, small triangles, is the year-to-year rate of increase in loans at Japanese banks, and uses the right-hand scale. This latter series has been advanced by two years.

What the graph shows is that the rate of change in loans at Japanese banks had a strong influence on the U.S. inflation rate two years later. Notice that the rate of change in Japanese bank loans peaked two years before the high in U.S. inflation, using this measure. The declining rate of increase in Japanese bank lending acted as depressant on global inflation all through most of the period of time shown in the graph.

Remember that what we are witnessing in this graph is the collapse of the banking system in the world's second largest economy. That this process would then influence global inflation is more than reasonable. Japan was both the epicenter of an economic and financial miracle as well as the epicenter of the greatest financial collapse since 1929. Naturally such an event would influence global prices just as the collapse of the U.S. banking system did so during the Great Depression.

Two points are worth noting. First, the declining inflation rate shown in the graph is not due to some miracle capability at the Federal Reserve. Rather, it was the collapse of the dominant global financial center and the world's second largest economy. No magic wand at the Federal Reserve, but simply the unwinding of the influence of the great Japanese miracle.

The second point is that the collapse of the Japanese financial system seems to be close to an end. A turnaround may not happen tomorrow, but the worst is over. The major depressing force on global inflation is now dissipating. A "bottom" for Japanese banks does not ignite global inflation. What is happening is the ending of the major depressant on inflation. The removal of a major negative on inflation simply allows other factors now developing, like the expanding China economy and a devaluing dollar, to influence global and U.S. inflation.

Now, let us turn to our favorite subject which is Gold. In the next graph is portrayed the U.S. dollar price of Gold, using small triangles and the right-hand axis. The solid line is the rate of change of Japanese bank loans using a solid line and the left axis.

The peak rate of increase in Japanese bank loans coincides with the peak in Gold shown in the graph. Note carefully what we are seeing in this graph is the declining rate of change in Japanese bank loans acting as a depressant on all asset prices. Gold's price has not been immune to this process. And we might add that the depressing nature of bank conditions in Japan also served to strengthen the dollar which hurt Gold.

With the bottom here or approaching in Japanese bank lending, the depressant has expended most of its forces. Gold, like other prices, is having a negative removed. The positive influence of this depressant on the U.S. dollar is also fading. The removal of a negative is the same as a positive for Gold.

The coming Gold Super Cycle is in part a product of the ending of the Japanese down wave and the emergence of a new up wave for the world, likely led by China. Financial asset prices were the beneficiaries of this period, and Gold suffered. A reversal of these rolls is in process. Gold, and other real assets, will dominate over the next 10-20 years. Financial assets will wither.

In 2004 the floor on Gold will likely be something above U.S.$400. U.S. financial assets are incredibly over bought and optimism extremely high. The NASDAQ is again facing the risk of falling by a third or more by the end of the year. Gold will likely break the U.S.$400 barrier by year end.

Remember that Gold investors have two friends. The first friend is the trend, which is up. A second friend is the Federal Reserve which is committed to policies that will benefit Gold investors. The Federal Reserve, and their groupies in the journalism and the investment worlds, would do better worrying about the destruction of the U.S. dollar in process rather than deflation. Stay aboard for the ride to above U.S.$1,200.

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