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Don't Count Deflation Out Yet

by M.A. Nystrom
December 31, 2005
Cambridge, MA

My recent article - 2006: To Bull or Not to Bull? generated a lot of interesting comments, both on the blog portion of my website, as well as in private emails. If there is any consensus, it seems to be that we're heading towards a repeat of the 1970's, with high inflation and stagnant growth. Personally, I'm not counting out deflation just yet, and I'll tell you why.

First just a quick review of terms: Inflation, in its simplest terms means an increase in the money supply. Deflation is the opposite, a decrease in the money supply. The effect of inflation is rising prices, while the effect of deflation is falling prices. It is hard for any of us to imagine deflation, because with the Fed in charge of the money supply, the amount of money in circulation has only gone up. Inflation is all we have ever known. As a result of these simple mechanics, one dollar today has lost about 95% of its purchasing power, when compared to a real silver dollar in back in 1913 (the year the Federal Reserve was established).

Please verify this yourself, by going to the CPI/Inflation caluclator on the site of the Minneapolis Fed. It is a very interesting exercise, made even more so by the fact this damning piece of evidence against the Fed is actually supplied by the Fed itself! (Thanks to George Ure at Urbansurvival.com for pointing this link out). As I was saying, if you go to the site and fill in the blanks . . .

If in (fill in year) I bought goods or services for $ (fill in amount) then in (fill in year) the same goods or services would cost $       (hit calculate to see results)

. . . you will find that stuff that cost $100 back in 1913 would cost you $1,965.66 today - roughly a 95% decrease in your purchasing power!

You can also use this calculator to compare prices of goods in other years as well. So if we type in $850, which was the price of gold in 1980, we find that it should be worth $2007 today, if its price merely kept up with inflation. Of course gold today trades for "only" around $500 - nominally less than its high in 1980 -- but 75% less when adjusted for inflation! The Fed has done nothing but print money, M3 has gone parabolic and yet gold - history's best measuring stick for inflation -- actually indicates deflation. Think that over for a while, and after you've been thoroughly confused and then come out on the other side to clarity, post your explanation to my blog for everyone's edification.

The point of this exercise is to demonstrate that things are not as straightforward as they may seem. The subject of inflation and deflation is one of the most confusing issues facing investors and economists today, and despite what the so-called "experts" say, I don't think anyone has it figured out completely. That includes both Alan "Conundrum" Greenspan and Helicopter Ben. (Note Wikipedia's definition of a conundrum: any problem where the answer is very complex, possibly unsolvable without deep investigation. A mystery or paradox can often be phrased as a conundrum)

Helicopter Ben seems to think that the Fed can easily print money, monetize any bad debts, flood the system with liquidity and float the economy downstream to brighter days on a featherbed of inflation. But what if this turns out to be a "conundrum" as well? If it were so easy, why aren't we all still living under the rule of the Roman Empire? Rome essentially tried the same thing, clipping and shaving their coinage and employing other dastardly tricks in an attempt inflate their way out of monetary crises, but their Empire fell just the same. The resolution to the US's economic mess, and by default the world's, is extremely complicated and will not be resolved without substantial pain.

Looking over the statistics in a book on my shelf called Deflation: How to Survive and Thrive in the Coming Wave of Deflation, by A. Gary Shilling, I was struck by some interesting points. The book was published in 1999, just at the point that the US was heading straight towards a deflation. If you recall that period of time, the argument for deflation in the US was overwhelming: We had relative peace (peace is deflationary; war is inflationary). The Federal budget was balanced to the point that there was actually a surplus, and the extra money was going to be used to pay down government debt (imagine!). Both the rise of China and the rise of internet commerce were widely and correctly understood to be deflationary. The dollar was getting stronger, while Asia was languishing in the aftermath of its own crash, and nations compteing to make their currencies cheaper. Instead of worrying about a strengthening yuan, pundits were worried that China would devalue its currency, further contributing to deflation. By the end of 2000, the Nasdaq crash was an event that loomed large in the deflationary puzzle. By Spring of 2003, Greenspan himself was fretting about the possibility of "an unwelcome substantial fall in inflation." That's Greenspeak for deflation.

So what happened over the last 2-1/2 years to make the threat of deflation disappear?

As I said last week, while you can offer a man a loan, you cannot make him borrow and spend. If he is feeling uncomfortable about his debt load, the prudent man will cut back on his expenses and pay down some of his debt. But one entity that is always willing to borrow and spend is the government. In the early 2000's, as the American consumer looked to be tapped out, the stock market was crashing, and deflation was on the economy's doorstep, Bush stepped in with a hefty tax cut (do you remember the IRS mailing you a check for $300 for being a good little consumer?). Furthermore, almost simultaneously with Greenspan's fretting over deflation came the most inflationary event that any government can produce: War.

Another common theme to the comments last week seemed to be that the government is "stupid." While that may be true, it also appears that they know what they're doing. Deflation is a bigger threat to government power and stability than inflation, and the government knows this. Seeing deflation at the doorstep, the government pulled out all the stops, lowering taxes, lowering interest rates, and starting a dubious war that dramatically increased government spending ($230 billion to date, according to the National Priorities Project). The Administration's shifting justifications make sense in this light - the government needed a war to massively increase government spending. Meanwhile the Fed gave us the lowest interest rates in half a century, thereby creating the housing boom. From all appearances, the government seems to have staved off deflation and turned the tide to inflation.

But not so fast.

A final common theme that I noticed in the blog comments as well as in the private emails to me was Robert Prechter bashing. It is true that Prechter has not been right on all of his predictions, but who is? As I have said many times - no one can see the future. Prechter has made some bold predictions, some of which have come to pass, others that have not, and some that may still come. As a long time subscriber to Prechter's reports, I can say that his primary flaw is not in being wrong, but simply in being early. In a world of media parrots that only repeat what they hear others saying for fear of standing out and - oh, no - perhaps being wrong, Prechter does stand out as a true independent thinker, right or wrong.

If any readers out there believed that last week I was offering a simple menu of two selections for the future course of events, such readers are sadly mistaken. The unfolding economic landscape is much more complex a simple pair of choices can capture. This is not a case of: Coke or Pepsi? McDonald's or Burger King? Paper or Plastic? Dow 400 or Dow 40,000? The point of last week's review was to give readers food for thought, to stretch the mind and take in information that you might otherwise miss. In other words, to get you to think.

One of Prechter's beliefs is that neither the government nor the Fed can stop deflation. For the time being, it seems that deflation has been averted. Maybe the Fed and the government think they can ease off the accelerator for now. But if you have been paying attention, you too may have begun to catch the first wiffs of deflation floating on the headlines of recent economic news:

From a December 8 Wire Story:

The Federal Reserve reported Wednesday that Americans' borrowing fell by $7.2 billion at an annual rate in October, the biggest amount on record, with much of that decline reflecting a record drop of $5.6 billion, at an annual rate, in the category that includes auto loans. The declines were a drop of 4 percent in overall borrowing, the biggest setback in nearly 15 years, and a decline of 4.9 percent in the category that includes auto loans, the biggest drop in 13 years.
By apparent popular demand, the War in Iraq is winding down.

From a December 21 Reuters Story:

WASHINGTON (Reuters) - The U.S. Senate on Wednesday narrowly passed a bill to trim nearly $40 billion from federal spending over five years, including cuts to social welfare programs such as health care for the elderly and poor. Vice President Dick Cheney, in his role as president of the Senate, broke a 50-50 tie when he voted in favor of the spending cuts.

This will have an impact on the companies that have been raking it in from war spending:

From the December 27 - NY Times:

Contractors Are Warned: Cuts Coming for Weapons In addition, there is now greater attention in Washington, both in Congress and at the Pentagon, on out-of-control spending on some weapons. The Pentagon currently has $1.3 trillion of weapons program in its portfolio - with $800 billion of the bills for them still to be paid. The Pentagon has commissioned a major study to make recommendations on curbing these runaway costs.

"Osama is happy for us to spend billions on and F-22A fighter jet systems that can do him no harm," Mr. Wheeler said. "It's hard to conceive of a larger gap between [the Administration's] words and decisions."

Deflation means a stronger dollar, something no one expects. In a sense it is paradoxical that the dollar should rise considering the state of the US economy, but as I said, there are a number of complex relationships. A strong dollar is one thing that Precter predicted months ago when everyone else was doom and gloom, and it is exactly what has since transpired. As Prechter stated in the November issue of his Elliott Wave Theorist:

"The US dollar is doing great. It has now passed the halfway mark with respect to the target given in the June issue of the Elliott Wave Financial Forecast. When we recognized a bottom in 2004, the consensus of the bearishness on the dollar was the most extreme in a quarter of a century, so it was hard to get people to pay attention to this call. No one in the media wrote it up. Every article quoted dollar bears. One of the cappers to our argument was that the media were trumpeting the fact that Warren Buffett and Bill Gates had taken aggressively bearish bets on the dollar. Buffett recently covered 10 percent of his shorts after losing 92.6 million in the first three quarters of 2005. Given the unbelievable extent of bearish sentiment a year ago, we can be confident that there will be a lot more short covering before the dollar's advance is over.

So there you have it. Keep your eyes peeled, and don't count deflation out just yet.

I would love to hear your perspectives. Post them to the blog, here: http://www.bullnotbull.com/blog/?p=24

Next week I'll publish my own outlook for 2006. If you'd like to make sure that you're notified, please subscribe to my low volume announcement list

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