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Deflation Open Thread

Posted on December 30, 2005
Filed Under Uncategorized |

The price of gold a high of $850 in 1980. Adjusted for inflation, $850 of 1980 dollars is worth $2007 today, according to the Fed’s very own CPI calculator . Today gold doesn’t trade anywhere near that figure - it is “only” around $500, which is both nominally less than its 1980 high, 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 below.

More ideas on deflation at: http://www.bullnotbull.com/archive/market-12302005.html

Thanks and happy 2006!!!



Comments are closed. Thank you.


39 Comments so far
  1. Norman Svelund December 30, 2005 7:56 pm

    I think the government has no choice but to inflate. Anything else will destroy the economy. Besides, inflation robs the people of purchasing power. It’s inflate or die!

    Norm Svelund

  2. Rick Johnson December 30, 2005 8:16 pm

    I forget who made the point that this is not a “currency” inflation, but a credit expansion. All credit expansions end in deflation as liquidation unfolds.

  3. lelio December 30, 2005 9:59 pm

    Listen, I lived in argentina in the 80’s and 90’s. If the governments wants to inflate, they will regardless if people are willing to borrow or not. they will just stop selling bonds to finance the deficit, and start paying the deficits with fresh money from the mint. that will create hyperinflation, that will ultimately destroy the dollar and we will have to issue new currency.
    Living in argentina with hyperinflation meant, having to spend your money fast, becase the milk would be 10% higher in the afternoon than it was in the morning. it was not easy, saving was not possible, all assets were going up in value to compensate. I remember when they issued the new currency (australes) in 83 that the basic monetary unit was the 1 austral bill, several years later the same monetary unit was the 10,000 austral bill.

  4. Sam December 31, 2005 12:03 am

    Well, you have conveniently ignored the defaulting by the public in your two articles!! You are arguing as if people dont want to take a loan!!! How convenient of you to be so naive and argue for deflation!! All you hyperinflationist dont understand what default means!! If I have 1 million $ loan, the easiest way to get out of debt is actually to default - it is so less painful - rather than pay in inflated money!!! And debt default is how deflation happens - not by people ignoring to buy loan!!

    Also, all the hyperinflationists argue that while inflation marches - oops, the fed will be sleeping on the wheel and pulling the interest rate down!! In your wildest dream!! The Fed will jack up the interest rate!! Tell me how the hyperinflation works when interest rates are pushed high to fight inflation (that is supposedly to lead to hyperinflation) actually causes hyperinflation? And why was 1930s in US and 1990s in Japan deflation - even though both the govts printed in copious amount - It was all because of debt default!!!

  5. Rabach December 31, 2005 1:04 am

    I think we will see some deflation, especially in the high cost items such as real estate and vechiles. However I think that the inflation at least in the next several years will still be the biggest problem.

    Think of it this way…if you are not buying high ticket items then you will be paying for stuff at a high rate of inflation despite the fact that the index will not show such a high rate because the big ticket items will hide that fact. In the end it means less money in your pocket.


  6. John E December 31, 2005 2:28 am

    The dollar will be kept up by the simple fact that the world needs a medium of exchange. Oil rich countries plus the Far East might switch to the Euro or to a basket of major currencies but are not convinced that they would be better off.

    In the past one justification for war was to gain lebensraum. This no longer applies, as even assuming that the agressor emerges with a clear win, the prize is almost certain to be radioactve glass. My own take is that the Chinese who tend to think in centuries are planning to buy the USA. Soon they will be able to afford it. Expect your children to see a sign at the Augusta golf course that reads “no dogs or whites beyond this point.”

    As to M3, I think that it has outlived its usefulness. Today organisations like Visa and PayPal have bypassed the dollar bill. Certainly PayPal could introduce a new medium of exchange. Let us call it the buddy (TM). At the moment they use the dollar because everyone knows roughly what a dollar buys. But they don’t have to. They could tie the buddy (TM) to gold, silver, the Swiss Franc, or anything else that the public would accept. Never mind Argentina’s inflation, think Weimar Republic where the postage to send a middle class pension cheque exceeded the value of the cheque itself.

    Conclusion buy gold and farm land,

    This has turned into a rant. I will shut up.

    John E

  7. JWW3+ December 31, 2005 6:44 am

    If cash is going to be destroyed in a hyperinflation, why are so many corporations holding record amounts of cash.
    They are awaiting the depression which will permit them to buy hard assets at 10 cents on the dollar.

    The record amounts of cash will disappear as debt is written off. Everything will plunge inclduing gold. That is why the US dollar is rallying even as gold has been. We owe the world 44 trillion dollars. It will NEVER be paid off. It will be written off - not printed off.

    It will be a depression with or without funny money.

    Happy New Year!

  8. Kiersten December 31, 2005 6:56 am

    Hey Mike,

    I cannot pretend to know about deflation, but there was an inverted yield curve on Dec. 27th, which is strong indicator of a potential economic downturn. “Klaus”, a commenter on Kmareka.com, posted about this:

    Comments (1)

    Regarding your post on the economy, there’s one thing I would like to add. We are very close to experiencing something called an “inverted yield curve.” This means that short-term treasuries/bonds pay a higher yield than long-term bonds. This is the exact opposite of the way it’s “supposed” to work. Usually, you receive a higher rate of interest for having your money tied-up for a longer period of time.

    The story at Smartmoney.com explains it fairly well. One of yesterday’s headlines read:

    Yield Curve Inverts For First Time In Five Years


    The inversion was only temporary, but this situation has been coming on for some time. As the Fed has been raising rates for the last 18 months, the long-term yields had stubbornly refused to move, a phenomenon that even Alan Greenspan couldn’t effectively explain. Now, with the last increase, the short-term rates have pulled about even, so any dip in long-term yield pushes them below the short rates, resulting in an inversion.

    As the Smartmoney article points out, this inversion last occurred in 2000–right before the economy tanked. In fact, the inverted yield curve has been an excellent predictor of economic downturns. The classic example was in the late 70s/early 80s, before the economy went south and stayed there for a good 5 years. It wasn’t until Reagan raised taxes that things started turning around.

    What is most interesting is that there has been very, very little coverage about the inversion. It has been coming for at least a year, but no one is talking about it. Instead, what you’ve been getting in the financial press is a lot of hot air about how great the economy is doing. (And it is–for those at the top of the economic pyramid.) Rather, the financial press is telling you to invest; that earnings are great, that companies have a ton of money, and that they are going to start spending it, taking pressure off the need for continued consumer spending.

    Sure. And I believe in The Tooth Fairy, too.

    Posted by Klaus on December 28, 2005 at 6:25 pm

  9. Major December 31, 2005 8:33 am

    We are a service economy now and that’s where I find inflation now.

    The two dollar tomato in the market probaly cost $.10 to grow = $1.90 to process into my shopping cart.

    My Medical Insurance company — last year I could call and talk to a live person. It has now de-evolved into some version of Dantes inferno with an infinity of circular push the button options. I am not kidding when I say you can stay on the phone for 2 hrs. and not talk to a live person and still fail to get an answer to my question. Less service and cost more money? That’s inflation.

    Watch sevices - that’s where the real inflation is…

  10. Gary Whitehead December 31, 2005 8:33 am

    Dear M.A. Nystrom,
    YOU are quite correct on the ‘deflation’ scenario [as opposed to the hyperinflation reaction] coming 1st.

    The reason that I am writing however . . . is to ask you for your postal address. There is a VERY important page of a book that I want to xerox and send to you. Will this be possible? You will NOT believe who wrote this summary/projection [copied as a testimony in 1954 yet purported to be applicable to THIS era in TIME!].


    Gary Whitehead

  11. Groucho December 31, 2005 8:52 am

    I see the ‘flation debate continues……
    Let’s see…who decides if we have inflation/deflation?
    As the world’s reserve currency and commodity transaction
    currency, the dollar issuer get’s to control world wide monetary appreciation/depreciation.
    As we just saw over the last 3 years the US govt(white house, congress, treasury & Fed)can pump inflation into the system very easily.(think oil, gold, other commodities, real estate, bonds, stocks but not “CPI”)
    Unforunately, this has been done on the back of unsustainable credit/debt creation.
    In the US, we still live in a democracy(though I doubt that Bush and the neocons think that is anyway to run a country)…(I wonder if the NSA is reading this even now)
    Because of democracy, those in control of govt have to placate a majority of the VOTING population.(rember
    Bush getting the christian right out in mass?)
    Bush brought Bernanke into the White House before accepting him as the “rightful heir” to the Fed throne. He must feel confident that Bernanke will help keep the far right in power or he would have chosen some one else.
    My point here being, the US govt(currently far right wing) will try to placate a voting majority of the population to stay in power.
    The govt will try to bale out each and every crisis that comes up. “The US budget deficit will surely soar like nothing that has come before”. (like cheney says “deficits don’t matter”..unless things change and then they do)
    If Asian CB’s keep buying treasuries, so much the easier for the govt. They wont have to load up the Fed’s balance sheet so quickly. But eventually they will have to take on “Quantitaive Easing” to extraordinary levels. I believe they will have to far surpass the amount of printing the BOJ has done.(BTW, will the technicians at the NY Fed get Carpal Tunnel syndrome from all the repo clicking they’re going to have to do?)
    So we know that the govt will print money like there’s no tomorrow and at some point put most of it on the FED’s balance sheet.(maybe we should make a long term contract with the middle east and asian central banks that we’ll keep taking their oil and manufactured “crap” as long as they keep taking our treasuries)Don’t you think the FED would love that deal?
    But, some how I don’t think asian CB’s will continue the game once they see their “vendor financing leverage” over the american consumer dwindling away, as it should over the next year or two.
    So it seems that when it’s all said and done we should have a repeat of the Japanese experience with american characteristics.
    How will the US “correction” differ than what has transpired in Japan? To see the future means we need to understand the Japanese experience.
    This is what I will be doing over the next year, studying Japan’s experience and then relating to the US system and trying to figure out similarities and differnces.
    My guess is we should have long term moderate deflation, probably in stair step fashion as the govt reacts to the data points they recieve.
    Hopefully, the govt will “do the right thing” and do what they can to help remove the unsustainable debts hanging over citizens heads, through a slow well thought out “default” program.(a good nation wide coservative saving/investing advertising program to teach people the difference between speculating and investing could prove very usefull,too)
    Of course, an exogenous event, so large that it would incapacitate the govt(pandemic, nuclear terrorism, etc.) could always happen that would quickly collapse todays global economy.
    Maybe we will need those silver and gold coins after all?

  12. Joe G. December 31, 2005 9:43 am

    Don’t we have inflation and deflation at the same time?

    We’ve already seen deflation in the stock market and now its coming in the housing market. We’re also seeing deflation from the globalization arbitrage and information technology.

    At the same time, we’re seeing inflation in goods and services that can’t be served through the globalization arbitrage or information technology. Inflation in hard commodities chased by a glut of dollars will seep into general prices at some point.

    So far these two forces have managed to offset each other. We could end up with either depending on which way it tips?

  13. Nish December 31, 2005 10:20 am

    From your article, deflation is possible for the simple fact that money creation today is electronic. But when we talk about deflation and inflation we can not simply talk about general prices but that of consumer (nessecity goods) vs luxary goods. If we take into account housing prices, medical care, college tuition and energy costs, I would bet that inflation has occured.

    Gold is not a good indicator of inflation as it used to be because the big banks and the western governments horded gold since the 1913s. They manipulate the price of gold but selling a lot lately to boost our confidence in the fiat (money creation) system. The true price of gold should be a lot higher today.

    As you said deflation may occur if housing market declines, stock market declines, and a lot of weealth is lost due to bank failures and such, but this will only be in the luxury goods market. We see plasma tvs coming down in price but not health care costs or energy costs. Gasoline is down, but heating gas is up. The energy sector has it so good for all seasons expect for spring and fall.

    Kings and queens are alive today as they were thousands of years ago but today they are hidden and controlling the fiat money system to grab more wealth everyday. This time it is global.

    Too bad there is no gold standard. Us crazy economists, financial analyst, hedgers and such could probably use our brain power in developing science and producing something tangible to benefit man kind. Instead here we are on wall street, insurance industries, and banking looking for ways to make a quick buck instead.

  14. Rich December 31, 2005 11:08 am

    Hey Michael.

    I think your question is best answered, regarding gold, by GATA and the manipulation of the POG.


  15. Piero Suarez December 31, 2005 5:28 pm

    Forget delation!

    If you look at the history of many countries with high trade and/or government deficits, you will see that in no single case have countries chosen the deflation route. Latin American economic devaluations offer many examples. The deflation route is much more politically and economically expensive. The masses do not understand that if wages fall slower than prices of goods they are better off. They will simply bitch that their wage is static or falling. The elite that took us off the gold standard did it to inflate the hell out of us. They make money via the inflation tax. Why would anybody think that they will go the opposite route if they have a choice ? They will try to drop money off the helicopter like Ben suggests (hyper inflation) before they give up and accept deflation.

    If the US was a net creditor to the world, the case could be made that they would allow deflation because it was in the best interest of their savings/investments, but being a huge net debtor and being able to control de unit of accounting of a debt? Its a no brainer! The FED will try to make it look like deflation is coming, to print even more money. The only reason they are going to stop publishing M3 is because they are preparing the printing press and don’t want people to find out as fast as they could just how fast they are inflating the money supply. The government spend billions in retarded weapons that no body will use and in meals that Halliburton makes, but they want to save what was it? 5 million dollars in the calculation of M3??? Stupid excuse. If you really cared about the dollars exchange value and were not planning a major printing increase, you would not spook people with such a stupid excuse. YOU WOULD SHOW THE WORLD THAT YOU ARE NOT INCREASING THE MONEY SUPPLY; AS SHOWN IN M3. AS SUCH, THE DOLLAR WOULD BE MORE VALUABLE RELATIVE TO OTHER CURRENCIES THAT DO GET INFLATED.

    Most likely we will have to prepare for another war or terrorist incident. Why? Because these are great inflation machines and also allow more implementation of measures to reduce individual liberties (patriot acts). These measures will most likely be needed to control de masses when very difficult economic conditions occur.

    Even if deflation was to SEEM to occur, it would just be the cause for more inflation. Inflation is the reason central banks exist. Inflation is the method all prior governments and empires have chosen. Its the easiest, less costly (politically) and the problem can sort of be prolonged longer and longer. If you allow deflation to occur, with the high debt load the US consumer has, you will have an immediate depression. With inflation, the current administration can keep on passing the hot potato to the next administration. Maybe I can hold it long enough!

    I contend that whenever governments have had a choice (choice exists today because money is fiat and can be inflated) they will chose inflation.

    Finally what about gold and silver: Obviously in an inflationary case, these will move up and up. But lets assume I am wrong and deflationary forces do predominate. What happens to gold and silver?

    If you are a net debtor to the world and your economy and banks and mortgages and car companies start failing because of a debt collapse, do you want to be holding dollars? Would you hold them because it might provide you a gain in real terms (dollars become more valuable because supply is reduced)? I think I rather hold gold and silver, because you never know if those dollars you hold will not be confiscated, taxed , or somehow controlled when things get real tough. I can not see any scenario in which holding dollars would be better than gold or silver – inflationary or deflationary. DEFLATION IF IT OCCURS, COULD PRODUCE UNCONTROLLABLE CONSEQUENCES (economic, financial and probably social) and this is precisely when holding fiat is (confidence based paper) is risky.


  16. rpetersson December 31, 2005 6:34 pm

    Isnt it amazing how the govts spin goes so far as to include this whole deflation/inflation debate? We are told over and over and over gain by Greenspan and co. how the “big, bad evil” (inflation) has been tamed while all along, housing, health care, education, energy etc, etc are all clipping along at 10%+ yearly gains? John Q. has simply accepted this with a no questions asked response by simply tapping into his/her “mother of all credit cards”, home equity. So while we, the public, have accepted Greenys nonsense, I fear all we have done is to pass these “phoney” cpi inflation numbers on to our (not mine) home debt. The govt “Rents Index” used to calculate housing inflation is a joke and everyone knows it. Now we find the govt will no longer post M3 data. Anyone who believes these 2 and 3% inflation will hopefully not be teaching Econ.101 at the high school or University level.

  17. Thraxton December 31, 2005 8:25 pm

    Inflation erodes the value storage function of money; changes in prices are a function of the change in value of the dollar, and have nothing to do with the goods themselves.

    Inflation is not all bad. It has the nifty effect of eroding debt (as well as savings). This is perhaps the biggest reason that the national debt is not the monster that everyone makes it out to be (at least not yet). Think about it: With modest inflation, this debt *never* has to be repaid. Not a single penny of the $8.5 trillion. The governmetn simply has to balance the budget for the next 30 years, and keep inflation running at a 3% average.

    At the end of the period the debt, though the same dollar value, would effectively be obliterated. Folks seem to miss that in their handwringing.

    (Of course I’m all for fiscal sanity in Washington and am not arguing the national debt is a good thing.)

  18. Jimbo December 31, 2005 8:36 pm

    Mr. Nystrom says in his article “. . . 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!”

    But how many people in 1913 had cell phones, the internet, TV, a movie theatre in their homes (DVDs), intercontinental travel at moderate expense, a 76 year average lifespan, fast autmotive transportation, computers and 2500 sq ft climate controlled houses (national average for new homes I think)?

    I can deal with inflation against my points (dollars), as long as the standard of living keeps rising. What is wrong with a little inflation if it keeps everything in motion?

  19. Gavin January 1, 2006 6:59 am

    Dear Michael,

    I’ve read 18 postings so far but not one mention of Peak Oil or fuel prices. Amazing. Without a sufficient and readily supply of fossil fuels, the money supply cannot grow. Debt based paper is dependent on energy. This is how we deflate. When will stop taking this for granted?


  20. Jimbo January 1, 2006 9:16 am

    I may be in the minority here, but I think Peak Oil was a construct put together by the Administration to justify a lot of nefarious activity. Its chief proponent is Matt Simmons - a Bush loyalist. Then there is a bunch of scare mongering going on by naive followers - it is reminiscent of Y2K. A lot of bark, no bite. If oil is going to $100, why isn’t it there already?

    Yes, we will run out of oil one day, but high prices like these encourage alternatives and conservation. This is why the market is “efficient” at allocating resources. Sometimes.

    Yes, I know that oil goes into fertilizer, plastic, etc. but there is so much sickening waste in this country that we could easily, tomorrow, cut our usage by half and not really suffer.

    The bigger picture is the dollar, not oil. The dollar is the (unfair) source of America’s economic and military supremacy. That may soon change:

    “Barring a U.S. attack, it appears imminent that Iran’s euro-denominated oil bourse will open in March 2006. Logically, the most appropriate U.S. strategy is compromise with the E.U. and OPEC towards a dual-currency system for international oil trades.”

    Iraq was trading oil in Euros before we attacked them as well. It doesn’t take much to put two and two together. Read the whole story here:


  21. Nate January 1, 2006 9:57 am

    Gold is perfectly priced according to the Fed’s inflation calculator. In 1933 it was $35/oz and now it should be $523/oz. After the end of the Psuedo Gold standard in 1971 it deviated too high or too low depending on inflation expectations and market dynamics. If inflation expectaions were to take hold again then it would deviate to the high side at $600-800 or if deflation or just a mild inflation were to be expected then Gold would deviate to the low side in the 300’s like it did in 1999 when it was undervalued(should of been $449/oz) according to the Fed calculator. Gold at $850 in 1980 was an unjustified overshoot during a panic-induced inflation mania and shouldn’t be used as a reference point. Now there’s a slight discrepency in the calculation since Gold was pegged at $20/oz in 1913 till 1933. Gold’s/Us Dollar purchasing power declined due to monetary inflation by 1933 and should of been $26/oz but instead the dollar was devalued and pegged at $35/oz and lost 26% of its real value overnight and 43% of its nominal value. In short, since 1913 the dollar lost 95% of its purchasing power and Gold at $523/oz is fairly valued on a neutral, no market expectaions basis. 20/523=96% loss. Now to put in perspective, the dollar and Gold value as pertaining to purchasing power stayed constant from 1800 to 1913 with wide swings of inflation and deflation in between unlike since 1913 it’s been all Inflation except for that little depression period. A nasty deflation is long overdue. If it will be mild then Gold will fall though.

  22. stu mann January 1, 2006 12:36 pm

    just re-read THE GREAT RECKONING from 1992. JD Davidson & Lord Rees-Mogg identified all the right evidence, but their conclusion seemed to be all wrong - there was no Great Depression during the 1990’s.

    Or maybe there was.”Depression” doesn’t have to mean 25% unemployement - it can also mean 25% misallocated labor. That’s most likely what occured, and we’re still gliding along that cul-de-sac now, unable to turn back, following a sensible internal logic which to the independent observer appears down-right nutty.

    The 1990s saw America try to nulify the competitive threat of an entire generation. The entrenched Baby-Boomers downsized, under-educated, threw up academic road blocks, even changed the rules - everything in its power to prevent those who followed from taking even a slice of their place in the sun. The resultant deindustrialization, Housing Boom and asset inflation are the positive results.

    The negative results will be soon be catagorized as ‘deflation’. Since the market reflects the ‘human condition’ which lies beneath, the entire generation of burger flippers rather than machinists, or doctors better at administrating than at identifying illness, or builders who can build quickly rather than well, or lawyers working longer hours rather than engineers; all these changes result in ‘deflation’.

    Things will lose value because the people who are supposed to buy them have lost value because the generation above them kept them locked in a closet. Gold and oil won’t offer anywhere to hide. It’s the people.

  23. tz January 2, 2006 11:38 am

    I am in the middle of doing “The Johnstown Flood” as audiobook, but it has a few incidents which provide what might be a good analogy.

    In one case there was this large stone bridge which held back the water for a while, partially because it was clogged with debris that was at the leading edge of the flood. So what happened is that there was a large initial push when the first dam collapsed, and some of the energy was spreading out, but this second unintentional dam created a second lake where it could regather force before continuing.

    GATA(.org) has noted that Gold is manipulated. I don’t know if I agree with all the details (it might be more Fed “open-mouth” than deals behind closed doors), but if you can talk gold down it will give bad readings, much like an unplugged fire extinguisher, or putting a bag of ice (or hot water bottle) on the thermostat.

    Also note that as long as “paper gold” is considered as good as physical metal, that can be a drag or a push on the price. If you can sell futures and options or even stocks, you can push the price a lot easier. Consider Palladium when it went ballistic until the TOCOM decided to interviene.

    Such will introduce noise into the system, however you can’t hide everything.

    I would also note that in most Kondratieff waves, the period from disinflation to outright deflation is marked by a short and sharp inflationary spike. That would make what is going on in things like real-estate, oil, and copper a sign that deflation is coming.

    The mechanism of deflation is the collapse of the debt pyramid. For now, the world is managing to prevent it using inflationary means (hence producing the spike). But when this ends, the whole system will be broken. Realize that the loose credit depends on having derivative players and hedge funds that will write or buy things like default swaps, interest rate swaps, etc. and not just deposit some cash in a bank to loan out. When that blows up there will be no one to collateralize debt, insure it, or anything similar, nor can it be rebuilt quickly.

    So assume the credit creation and leverage mechanisms are no longer there (the hedge funds are bankrupt, any remaining won’t desire leverage, nor will anyone want to lend to them) - the big question is whether the central bank can successfully inflate in such an environment. Home Depot doesn’t have enough wheelbarrows and carts to haul piles of depreciating bills. If your car blows up, it doesn’t matter if you get 200 gallons of gasoline - your bicycle can’t use it.

    Maybe something can be done with credit cards and banks to distribute “helicopter money”, but I don’t think Ben “burn the currency” Bernanke will find it quite that easy. At Asia Times, Henry Liu describes the structure of the repo market, and Doug Noland does the same for the credit market as a whole at prudentbear.com in his credit bubble bulletin. The key problem is what happens when this entire infrastructure is gone, or if enough of it will survive.

    This also might explain the money expansion without the obvious inflationary effects. It was something like the stock market - lots of new money, but it went into asset inflation. Now real-estate and other credit has expanded. Sort of like that second bridge which became a temporary dam. The flood is there, but it first sloshed into the stock market, then into real-estate, and some into foreign hands. But if there was a large enough sink-hole and cavern system, there would have been no flood, so, just like stocks (which deflated), whatever assets the money is going into now might collapse in value taking the extra money with it (they are taking cash out of their homes today, they might pull it out of banks and other M3 components if those are the only things left standing tomorrow).

    Or one final analogy - the blackout. It was caused by TOO MUCH electricity, not too little. When a powerline faulted and shut down, there was no place for the electricity to go, so a cascade started where each line ended up tripping until the whole system collapsed. Created money has to go somewhere. Stocks, but if not stocks, real-estate, if not real-estate, hedging strategies, if not that, then bonds. When one part collapses, a bunch of money ends up shooting back and inflating (or deflating) the value of whatever is in its way. For example, GM Bonds becoming junk caused its stock to be shorted, but because there wasn’t enough to short, Ford and the rest were shorted. Then KK bought a bunch of GM causing a big reversal which was also temporary.

    And with everyone leveraged, the volatility is going to be extreme. That is what always happens (1929 with margin, 1987 with portfolio insurance) - we get dramatic spikes and crashes.

    I think it has been two years since the SPX has lost more than 2% in one day. It was not frequent during the bubble into 2000, but it happened. Things are too calm. Is it not dropping because of intervention, or because everyone assumes intervention so buys ahead of it? I don’t know. I can only say things are unnaturally calm, much like just before a tornado.

    So where is any clarity? I don’t think it is there, but here is a summary: Inflation and deflation are in the system, but being held back by being redirected and dispersed. This will not hold forever, but there will be wild swings when it lets go. We might see both 350 and 750 gold within the next few years, in either order. I don’t think there is much upside for the stock market, but if the credit surge goes there it could shoot up (or down, if the surge ends up going to those shorting stocks - remember hedging normally has a long and a short). When the smoke clears, I’m in the deflationary depression camp - but would note that such was also the aftermath of Weimar and other inflations as well.

  24. Rich January 2, 2006 6:41 pm

    I think Piero Suarez at post #15 is right on the money, so to speak. Central banks inflate constantly, that is what they are in existence to do. Those that control the main Central Bank (the Fed) are in control of the flow of money globally. Through that they are then able to monopolize industry and eventually society, its taken the owners/controllers of the Fed about 100 years to gain a stranglehold over most of the developed world, and they are not going to risk that control by allowing deflation to destabilize the sheep. Bernanke has signalled his intent, if in doubt send in the Fedcopters to drop more credit on the unsuspecting masses.

    When the greenback is finally inflated to oblivion there will be a new World Dollar that will be owned and operated by the same families that have controlled the Fed for 100 years. And the great inflation of a new fiat currency will begin again!

    Cheers Rich

  25. WildWestBill January 2, 2006 7:52 pm

    I have a contrarian’s view of Herr Doktor Bernanke: he’s a plant..ie, a ruse for BushCo’s unwitting acceptance. By whom? the banker boys, who since Paul O’Neil’s revealing insider look at Bush & Co, have managed to screw-up everthing they worked for since 1992, such as: a peaceful ‘new world order’, balanced budgets (remember those?), a real solution to the major demographic challenges (SS, Medicare, Medicaid, etc)…you name it.

    The bankers are going to strike back, and Bernanke is the tool of their revenge.

  26. AK January 3, 2006 9:38 am

    Hi All,
    This is a great site — I get more honest opinion here than anywhere else on the web. Even the experts are useless.

    I have general question and I will appreciate if someone could response to that. We understand that the FED needs to print money to compensate for consumer-products (Chinese Manufacturing) and services (IT-related & India Software) deflation. On other hand, this money inflates hard assets (housing, oil) and non-tradeable goods & services (Tuition, Medical, Insurance). To fight this non-tradeable goods inflation and to create a demand for US dollar (against the Euro & Yen) the FED needs to raise interest-rates.
    How can both be done at the same time — don’t you think FED has created a perfect trade — keep inflating housing, create more credit and take that credit to deposit for a short-term to earn higher rate. Given the increase in money creation is less than increase in short-term interest rate. If that is the case then it is better to hoard (save) US dollar.

    Now, I would like to understand how this situation effects the economy, Japan & China Foreign reserves holdings and in general global finance.


  27. Administrator January 3, 2006 11:21 am

    Hi AK,

    Thanks for the comments and the compliments on the site. It is really the thoughtful posts and discussion that are valuable.

    My opinion is that the Fed will try to walk a very fine line between raising rates and killing growth. As you said, they need to try find an interest rate level that supports the dollar without killing the economy, and that will be a difficult task. The Fed only has control over short term interest rates. They’ve been pushing those up, hoping that the long term rates will go up as well. They have not - something Greenspan called a ‘conundrum.’ Now the yield curve is basically flat, which is bad for the economy.

    The reason this is bad is because most of the big finance companies/banks make money simply by borrowing short term funds, and lending them long term. They keep the difference between the two rates as profit. Now that there is very little difference between long term and short term rates, it is harder for financials - like banks and mortgage companies - to make money. The high rates work against the housing market by 1) making housing prices more expensive and 2) making refinancing less attractive.

    Since so much of the economy recently has relied upon the housing/refinance sector, the higher rates are bound to slow the economy. The Fed can’t have it both ways. Higher interest rates will/already have killed the housing market. This will likely lead to more unemployment - both for blue collar construction workers and white collar bank workers - and lower house prices. These are both deflationary, and will likely lead to recession.

    But you are right that higher interest rates should make the dollar more attractive to foreign investors. Banks can borrow at lower rates in foreign countries (such as Japan) and lend here at higher rates. This should have the effect of supporting the dollar and making it stronger. A stronger dollar is also deflationary, because goods and services become relatively more inexpensive for those who have dollars.

    A strong dollar is good for US businesses, because we mainly buy goods from overseas. Not much is manufactured here any more - much is imported and repackaged. So if a company like Walmart buys a lot of cheap goods with a strong dollar, they can resell them, and keep a higher mark-up.

    The whole thing should be self-balancing. A stronger economy should lead to more employment here at home. In theory, that is. There are a whole host of other issues to consider as well…But I hope that this has somewhat answered your question.


  28. AK January 4, 2006 12:08 am

    Thanks for the response. I agree with all of the above. It seems the main issue is to keep balance between high dollar-demand and reducing current-account deficit by inducing inflation (lowering dollar value). That should be very hard, especially if Iran starts Euros-Oil trades and China & Japan reduce dollar-holdings.

    Wow! This will be very hard and I hope for the best since the consequences could be very-very dangerous.

  29. Michael Pivtorak January 4, 2006 10:29 am

    Took a liberty of using a different point of time for the price of gold. It was $35 in 1972. Then used Fed’s CPI Inflation Calculator to get the price in 2005 of $162.94. Then applied your logic and compared this price to the current gold price of $533 – looks like inflation to me. Still love your writings.

  30. KD January 5, 2006 2:23 am

    Deflation is certainly plausible given that our previous credit expansions designed to ward off even the slightest of recessions has resulted in both excess supply (Asia) and a tremendous build up of credit at all levels - consumer, corporate and government.

    The comments are correct above - the Fed’s mission is to inflate but at an “acceptible” pace (i.e. the public has bought off on the idea that the purchasing power of the currency will decline as long as it declines at a moderate pace, in this case, nearly 50% since Greenspan came into office). However, the Fed has one tool which is aimed at influencing demand and supply for credit. Should this tool prove ineffective, Bernanke’s Helicopters won’t do the trick on account of scale.

    The Fed can create money by expanding its balance sheet but its balance sheet is small compared to the total amount of what we count as “money”. As such, it does rely on the markets’ willingness to expand credit in order to grow the supply of money or even to keep it level. As long as demand for credit is a function of its price, the Fed can manipulate the cost of credit as to stimulate demand for credit and therefore keep the supply of money expanding. However, should demand for credit cease to be stimulated by its price (interest rate) then the Fed is essentially powerless to stimulate money growth the offset deflationary forces.

    This is, of course, a real danger when credit growth is largely a function of demand for credit collateralized by the high-momentum asset in the economy, in our present case, housing. Should the momentum be lost, demand for credit may cease to be stimulated by its cost. In other words, much of the demand for credit during a bull run of the collateral asset may be a result of expectations of future price appreciation of the underlying asset (i.e. speculation) as opposed to demand resulting from a cost advantage over competing alternatives (i.e. cheaper to buy than to rent).

    This is, in fact, the Japanese experience and can be termed “debt aversion” since both corporates and consumers became more concerned with retiring debt (through either redemption or default) which was secured by a decling asset (there real estate) than with either expanding consumption, investing or speculating. As such, no level of interest rate was low enough to stimulate the demand for credit. From 1991 to 2005, the M2 money multiple declined by 50% - meaning the BOJ was doing its job (expanding its balance sheet and injecting reserves into the banking system) but the market was not biting the bait.

    Some things to worry about: 1) the Financial CP, Repo and Securities Lending markets are growing very quickly and are doing the heavy lifting with respect to funding the consumer credit expansion being intermediated by the capital markets - while the market is currently very liquid, its fundamental starting position is short liquidity as a key vulnerability. 2) The shift in asset allocation strategies of “real” money (institutional investors) to “alternative assets” (private equity and hedge funds) results in a greater degree of leverage and an over crowding within the “high risk” segments of the asset markets. This is related to point 1) above since the expansion of short-term collateralised lending is largely influenced by the demand for credit (leverage) on the part of “alternative asset” managers. 3) The supply of credit is largely intermediated by the capital markets, which are now massive relative to the real economy. Risk intermediation in the capital markets is performed by large investment banks and banks and is practically concentrated to a few dominant firms. These firms all allocate risk as measured by the same models for which volatility is the primary determinant on the margin of “risk”. As a result, when “volatility” increases, risk budgets effectively decline and when volatility decreases risk budgets effectively increase (at a given moment, capital is essentially fixed, while the amount of capital required against a specific risk exposure is variable and a function of volatility). This is reasonable in isolation but it suffers from the Fallacy of Composition (not all can do what is reasonable for one to do). In this case, the risk intermediation capacity of the capital markets is highly correlated to recent historical volatility and there is very little differentiation across the firms operating in the markets. This is the soft underbelly of our current system. 4) Our savings are low (a rational response to low interest rates and budget deficits- again Fallacy of Composition though) and our debt ratios are expanding at precisely the wrong time in history - when we are about to enter into an unprecedented change in the age composition of our population. From a long term perspective, our savings rates should be higher than normal today in anticipating of the ageing of our populations. The opposite is the case.

    Speculation is high. Debt is large relative to incomes and productive capacity - and the imbalance are still growing. Productive capacity in the former “closed” economies of China, India and Russia is expanding quickly and coming onto the global markets. Savings are low. Our population is ageing and the first Baby Boomers reach retirement age in four years.

    There are plenty of reasons to believe that the Fed may loose its ability to influence the demand for credit and therefore money supply and therefore inflation. Food for thought: if the money supply grew at the same rate as nominal GDP, we would already see deflation in the CPI statistics. Also, with respect to inflation - keep in mind that the S&P 500 trades at the same price today as it did 40 years ago when the price is denominated in gold. All of the increase in the price of the S&P 500 over the past 40 years, therefore, is explained by monetary inflation as opposed to real growth earnings…

  31. Dip January 5, 2006 7:27 am


    Great defaltion articles & comments but no debate.These questions need answering Mike.
    1. How will America pay back the debt without inflating? I’m not taking about the $8 trillion but about total American debt including medicare aswell. $72 trillion in all.
    2. Once the Fed signaled that interest rates were going up, it was obvious the dollar would follow. Warren Buffet was not paying attention don’t you think?
    3. I think the natural course should be deflation, but as you pointed out in your article, Bush went to an inflationary war and Greenspin dropped rates. Won’t the government think of something else to prevent deflation? How about another stock market bubble? This could carry on for years & years.
    Hope you answer on the blog or privately.

    Thanks & regards,

  32. Dip January 5, 2006 7:41 am

    Hello again,

    I forgot to mention the inverted yield curve and end of term for the Fed persident. When Greenspin took the helm, there was the 1987 stock market crash, property bubble & property bubble crash of 1989. Surely Greenspin has engineered another recession by raising interest rates when he did to coincide with the handover. No-one would blame Greenspin (like no-one blamed Volker) or helicopter Ben. So the recession (deflation) should start around April 2006 for a year and then the stockmarket will explode upwards just in time for the presedential election campaign.

    Once again, I hope I get a response.

    Thanks & regards,

  33. Administrator January 5, 2006 5:53 pm

    Hi Dip,

    Thanks for the comments. Just for the record, I don’t have any magic ball that sees into the future, only my opinions based on what I’ve learned over the past few years reading and watching the markets.

    To respond to your questions in the first post:

    1) Why do you assume that we will pay back our debts? Many individuals/corporations/governments in the past have failed to repay their debts, and many more will in the future. Default is part of the system. As noted above, some minor inflation is nice for debtors, because it eats away at the debt automatically.

    2) Warren Buffet has proved himself to be an excellent investor in undervalued companies. The knowledge required for this is different from what is required for currency speculation. He was out of his area of expertise.

    3) “Can’t the government think of something to prevent deflation?” The answer is the same as to why the government did’t “do something” to prevent hurricane Katrina. They can’t. Get Prechter’s Conquer the Crash, or his Socionomics book here, and read about the “potent director’s fallacy.” The economy has a life of its own. The Fed is tiny in comparison. Why didn’t they get King Kong down off that building without killing him? They don’t know how. They’re not really in charge, they’re only pretending to be. That is the big secret.

    A new stock market bubble cannot simply be created. There needs to be something tangible,or credible, or at the very least, mysterious behind it.

    I agree, the inverted yield curve looks like trouble for the economy. As you mentioned, the four year presidential cycle is pointing down, as well. So yes, a recession, if it has not already started, is probably near. Did you hear Snow crowing about how good the economy is today? Sure sign of a top. I don’t know about stocks “exploding up” after the recession. A bounce, sure, but unless we see new highs soon, I don’t think we’ll see them for a while.


  34. Dip January 6, 2006 2:05 am

    Thats really cool of you to respond Mike. My response:
    1) If America did not pay back, they would default. This would not cause a recession or depression but a total collapse of civilisation. Governments, businesses, pensions & people have so much money invested in US bonds, one default, would a massive panic. Dollars would become worthless. What do think the outcome of a US default would be?
    2) How true
    3) I agree that a bubble needs something to feed on (radio 1929, internet 2000, property 2006) but these things can be engineered around something ordinary like tulips. I only mentioned this because some investment sites feel that money leaving the stockmarket may enter the tech sector again with GOOGLE leading the way.
    Most commentators say Katrina was ignored as the White House was focusing on Iraq/Iran too much.
    4)Our own Gordon Brown always says how good the economy is. All about positive market reinformcent to keep sentiment up. Its only good because the government has borrowed so much and spent it. I could borrow a million pounds and call my self a millionaire but that isn’t the real truth. I hope 2006 is really bad economically, to get rid of the mal-investment and to sober people up and become more financially astute.


  35. Dip January 6, 2006 2:09 am

    It is a shame you can’t edit a post. In item 3 I meant property market and not stockmarket.
    …I only mentioned this because some investment sites feel that money leaving the property market may enter the tech sector again with GOOGLE leading the way.

  36. Administrator January 6, 2006 5:18 am

    Hi Again, Dip,

    A US default would definitely be bad, but I don’t think it would be the end of the world. Maybe the start of a new one, and a better one. We’re always afraid of the unknown, so we avoid it until the very last possible moment.

    The US has a lot of debt to pay back. But if they began to inflate in such an obvious way, then people would drop the dollar like a hot potato anyway, and the effect would be the same.

    I’m not sure that bubbles can be “engineered.” I think they come about organically. So far, Google is leading the way, but there are very few followers…

  37. Dip January 6, 2006 6:25 am

    Hey Mike,
    You’ve risen early (5:18 a.m.)!

    I see you haven’t though about a US default much, but I think this is the key to this western civilisation. When the pound lost the reserve currency status, the dollar took over because America had vast resources to exploit. If people lose confindence, will they buy Euros or Yuans? What happens in the transition period?
    You must have heard Snow saying that if China refocused it’s reserves away from US dollars, there would not cause a dollar problem.
    Maybe your next article could be “Debt, default & the aftermath!”


  38. larry January 9, 2006 9:17 pm

    i think in america we will attempt to inflate out of national debt.always used to work.but then in those cases, we made what the world bought.now we buy what the world sells.we are a nation selling trumped up services and extortionist comissions to each other.capitalism was never meant to replace culture and values.capitalism was supposed to be a tool to enhance all peoples freedom.now,this tortured monster is unrecognizable.we are its slave and not its master.the beast uses us, not we it.the experiment now is at critical mass.no one knows what we have unleashed.it is we.we must face the distortions and imbalances or the beast,like all brainless things,will do the most nasty and unpredictable.period.mindless consumerism has stripped away dignity and common sense.the hole that remains is unrecognizable.it is what we describe as OUR culture.culture/capitalism-capitalism/culture.alpha-omega/visa-versa.make money/print money/steal money/borrow money….beg for money.capitalism produces money but what does money produce.we have it now..a hole;a whole lot of holes….we defy nature and create capitalism.we live in caitalism and defy nature.soon nature will dominate capitalism.man is of nature but capitalism is of man.nature is and capitalism isnt.nature is perfection and capitalism is “ism”.man will always exceed his grasp.we will this time,eventually too.but,nature will prevail and we will survive for it not”ism”.whether the imbalaces reach more incredible levels,is not an issue.the politicians,the special interests,the corporations,the nations,will insure this.in the final evaluation,no amount of synthetic thoughts can ultimately prevail.we want to believe so so much that all problems can be synthesised into obscurity.we can dominate and overcome,but alas for our foolishness we simply deminish ourselves.finally,the people who create these synthetic abstract orders are blind with the power we gave them.hence,they can not see the solution to the problems their minds blind eyes create.the wolf simply cannot protect the chicken coup.it goes against nature.these great men sterring our synthetic world using synthetic rules and synthetic policies are generally blind to nature.their order is the order that rewards them,so how can it not be right.ask anyman are you free.the answer to that will be the truth.the politicians,the special interests,thee…all these do not want that answer.ask anyman.will capitalism make you free.what will he say…money will make me free…THEN I SAY PRINT ALL THE MONEY..then everyman will be free…..do you see….money, more money,fiat money,real money,it will disapoint..money will.disapoint…whether we print more or less or defalt more or less or do nothing more or less…THINK..money did not make the problem, we(they)made the problem.our problem is that we let them.now,no amount of money can really fix IT.we need to be in nature not in money.we need not politicians,special interest….we need STEWARDS…..because(they) will tax us,deflate us,inflate us,DESTROY US…because we let them and to a degree they are us, just more virulent and less natural.so,in review,to debate about inflation,deflation,tax reform,retirement accounts;it all diminishes us.why,we are discussing (their)world.we are playing the game they synthesised and it is a killer game.the game occupies all our common consciousness and feels NORMAL…but it is not right.anyman knows the answer.truth ,money will not set him free….it sets only THEM free….hence the whole debate is moot…..them and us….

  39. Nate January 11, 2006 4:42 am

    To Michael Pivtorak,

    Yes, but Gold in 1972 at $35/oz was grossly undervalued. The US had two standards one paper Dollar that kept on losing value due to monetary inflation, and the Dollar backed by Gold to pay off foreigners. The Gold standard from 1933 to 1971-2 was in name only, all the while, the foreigners were getting screwed. Nixon screwed them even more in 1971 when he eliminated the Gold standard and let runaway inflation take care of the debts. Now input $35/oz Gold in 1933 and Gold should of been $112/oz in 1972. They made believe like there was vitually no inflation during that time, and we had a bona-fide Gold standard. Now input $112/oz in 1972 and you’d get roughly $521/oz in 2005. Right where we are now, sort of. Now take into account that we had sound money backed by a real Gold standard, give or take the spikes in inflation, deflation from 1800 until 1913. Only then, did the nascent inflation start to take hold until it was abrubtly stopped in the 1920’s, and 1930’s(Deppression). So with this rough estimate using the calculator, you start at the period when sound money ceased to exist, roughly 1933 and 1913. Hope that helps.

    Furthermore, regarding th current Gold price. Inflation expectations are starting to take hold, even though that inflation might ultimatley lead to deflation. Now, there isn’t any clear picture for where the global economy is headed, hence there will be lots of hot money speculation into Gold due to that uncertainty. I would wait until all the asset bubbles ( Housing, Commodities) burst before entering the Gold market long term. That may take years, and Gold could very well reach $800/oz if commodities are still propped up due to the reselience of the US consumer and his confidence in holding the fort and falling in love with his home. To buy something is quick and easy, while to sell comes long and hard, even when faced with losses. Watch housing, that will affect everything during the next 2-5 years. anyway, that’s my two cents.

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