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Friday, August 28, 2009

Deflation It Is

Really sorry for the absence, but I am running so tight on time that I have been quite short of sleep for two weeks.

However, part of the problem has been family medical problems which have been sucking up a lot of my time. Those are all greatly improved and I will have more time next week. I am vastly relieved over the outcomes.

These last few weeks have been decision points for a time for the US economy, so I have been trying to keep up with the retail survey. And the results are now unequivocal. The BEA is wrong. Real incomes are dropping quite substantially; we are doomed to deflation. The problem is both incidental consumer credit and lower incomes, and thus is quite intractable.

The reason why this time of year is so decisive an index in retail is due to several factors which give a reasonable observer a fix on two important US demographic segments. The first segment is the seniors, comprising about 12% of the US population, but having a disproportionate share of the assets on the whole. At this time almost all seniors are moving out of the doughnut hole and into the second period of prescription coverage. This gives the segment as a whole a boost in incomes, and you can see the effect in stores (since Part D was passed). This year it is a total bust. Stores have been trying to raise food prices and failing miserably.

The second are families with school age children who do spend substantially for back to school. The bulk of the spending is stuff like stationary, notebooks, clothes and shoes. Spending there has been constrained, shifted to discounters, and spread out over a much longer period than normal.

The implication here is that US consumers are totally tapped out. There will be no infusive boost, and the more energy prices rise, the more US consumer profits will fall.

Thus, if the Fed fails to raise rates this year, the excess of money out there will remain in commodities, and the US will subside into a second period of economic decline. On my last post, I thought David Pearson explained it well:
What do you call a situation where incomes are deflating in nominal terms at the same time that one group of prices is rising steeply?

I call it a Latin American country after a maxi-deval. Import prices go up, domestic (i.e. services) prices deflate, unemployment spikes, and real wages take a big hit, which in turn spurs manufacturing exports.

It does seem to fit the current U.S. situation, doesn't it? What do Latin Central Banks have to do after such a deval? Raise interest rates to get the currency to stabilize, just as you suggest. This is called an "austerity measure", and it was U.S.-imposed dogma during the 90's. Ironic, isn't it?
For the record, my Spanish is quite good. I do not find this ironic at all - it is a matter of economic fundamentals.

What I do find ironic is that economists should cling to words associated with theory without clarifying their own thinking. There are multiple causes for a rise in prices, and one of those causes has nothing to do with money supply, but cost of production and the cost of holding real assets. Negative real interest rates create a situation in which the cost of holding commodities is very low. In terms of supply and demand relationships, many current commodity prices are asinine. But when you calculate in both the expectation of some rebound and currency/interest rates, abruptly these prices look more realistic. However, the prices are created not by economic fundamentals, but by central bank policy.

China is giving up its battle to create bubbles, in part because it has apparently realized that it is likely to hurt its internal economy. They will ease off slowly. But the Fed is pushing on the wrong string and is going to end up cutting the throat of the US economy, and when it does, there is a possibility that the Chinese retraction, combined with the Japanese situation, combined with world excess production capacity, combined with the worsening fundamentals in some South American economies, combined with hysterically bad US legislative policy will all add up to a genuine world depression. I hope not, but the possibility now exists.

Failure to properly examine what happened during the Great Depression has left many economists babbling nonsense. All types of stimulus are not equal, and stimulus projects that do not cycle income directly through the population along with attempts to throw money into the financial system simply divert economic corrective processes into the creation of new bubbles, which must inevitably deflate.

This all should be considered jointly with Japan's situation. Japan has consumer deflation without a doubt, very much lower exports (especially to China), and apparently shrinking consumer incomes. It is almost impossible for the world economy to revive if both Japan and US consumers are hacking lower like this.

In a few days I should be back posting much more regularly unless further disasters occur. Until then, I would like to leave you with this FACT:
In the wake of the Great Depression, professor salaries were cut 30-50%. I am in possession of an article written in the 1930s by a Yale faculty wife, which laments the passing of the "genteel" class, and records that one-tenth of their income was being spent solely to buy milk for their children.

Think about it. At that time the "upper middle class" suddenly experienced plumber envy. The time of free fantasy is over. Then factor in similar (although milder) income trends and consider the massive amount of debt held by this segment of our population. It ain't pretty, folks.

Good! Glad to have you back. Unfortunately, I have been fascinated by the Great Depression for a long time. And I don't like what I see now. I think that we are not going to see any green shoots for a long time. Not a good thing to look forward to as you get older. It is currently taking the income of three working adults to keep our utilities up and the house going.
Nice to have you back
Dear MaxedOutMama,

This is a comment I made to a post on "Blue Crab Boulevard":

For far too long now the economists have been “flying the instruments instead of the airplane”. There are a number of competing schools of economic theory. They are all quite complicated and elaborate but all are based on the reading the tea leaves - financial data. What if they’re wrong? What if the numbers don’t mean what they think they mean?

Here’s the view from the from the trenches and not the rarefied air in which they fly. It is informed by the older generation. My parents lived through the Great Depression - I know the thinking of that generation quite well.

Bottom line - the money is going into the mattresses. We saw what happened in the Depression - no matter what was tried the money just refused to flow. All kinds of theories about fiscal and monetary policy - the levers and strings just didn’t work.

Right now the whole edifice of post war economic growth has crashed about our feet. We were caught in a massive credit bubble that has burst. Used to be “I wonder if my credit is good enough to get that new car?” Now it’s “I wonder if I’ll have a job next week?”.

I wouldn’t be surprised if the economy, as measured by the numbers, was abolutely flat for the next ten years.


Real incomes are dropping quite substantially; we are doomed to deflation.

if the Fed fails to raise rates this year, the excess of money out there will remain in commodities

Real incomes are dropping, but if there’s an excess of money, nominal incomes should rise. What I see from your posts (and others) is less activity, but more dollars. It is depression with inflation. Wheee.

Somebody (maybe via Naked Capitalism, or was it here?) showed that all the money the Fed has created has not led to inflation because the banks are keeping the money on deposit with the Fed.

The excess money is inflationary only when it circulates. The Fed is discouraging circulation by paying banks to park the new money with them. This also makes the banks falsely appear to be solvent.
Welcome back, and hope everyone is feeling better.

Please explain a bit more clearly why Higher Interest rates are required to fix the problem. That's counter intuitive to Mr. Old School bond trader here.

I can't believe the timing. I too have been in a posting slump lately. I log on today, read the news, then post...

Deflation Hitting New Records

I then come over to your site to see if you have posted anything recently. Imagine my surprise when I see "Deflation It Is"!

I knew there was a reason I always make sure to read your blog!
cf said..

Don't mean to step on Mama's toes but let me take a shot at it.

Why would anybody want to lend money at a rate that is less than the anticipated inflation rate?
Seems to me that, in the intermediate term at least:

1)We will likely see steady or falling prices for most domestic goods & services, coupled with rising prices for imported goods

2)Normally, this situation would lead to an expansion of domestic production; however, this will be suppressed to a considerable degree by the energy policies of the Obama administration & even more by the general uncertainty created by his radicalism.

3)Certain privileged domestic industries will be able to raise prices even in this environment: elite universities being the prime example, but also many others, such as law firms with a regulatory practice.
Hi Roy; Expected 5-10 year inflation is about 2.5% methinks. It can be derived from Gov't TIPS bonds. Most debt with that maturity trades above that rate.
cf said..

Yup. But we are in very uncertain times - see the recent adjustment in projected deficit from 7 to 9 trillion. Quite a large adjustment in 6 months. I suspect the internalized risk premium for even the safest investments is above 5%. The prudent investor is going to sit on his cash - park it in treasuries - until things settle down.

Glad that there's improvement in the family's health. I hope the issues will soon be fully resolved.
Welcome back, and look forward to more education from the blog.
God bless you, dear, and good to have you back, even if your prognosis is chilling. But our 'leaders' just don't seem to see it coming. Economic disaster and even worse, I fear...
Paul Krugman, an admitted political activist...


Glad you're back. I've also noticed the BEA income numbers seem to clash with reality. For one thing, interest earned seems rock-solid (no cost to seniors of zero rates!), then there's non-wage, rents, and proprietor's income all holding up okay under the circumstances (nothing for the small business owner to worry about!). What other measures of income do you use to identify the real trend?

I don't know if you've seen the Japanese real wage data series, but we're seeing steeper drops in '09 than ever before. June -- a bonus payment month -- came in at -5.3% year over year. Wage deflation is there in earnest now -- the last decade was just practice!

Last thing: with Chinese loan growth crashing on a sequential basis, the onus will be on the Fed to devalue to take up the slack in Aggregate Demand. Its the only thing they can do when all the money they print boomerangs back into Excess Reserves (contrary to universal belief, monetary policy has not been stimulative of AD). How will the Fed "devalue"? Don't know, but I'm sure they have some levers to pull.
David Pearson,

"I wouldn’t be surprised if the economy, as measured by the numbers, was abolutely flat for the next ten years."

I wouldn't be surprised if the next 10 years looks much like the last 10 years.

I guess we're in agreement.

Here's the scary part. What will the economy look like in the 10 years following that period? What if we're just (as you say) "practicing" for the main event?

"Wage deflation is there in earnest now -- the last decade was just practice!"

In other words, I have this very uneasy feeling that our country will be in much worse financial shape 10 years from now. We continue to borrow from the future. The future therefore doesn't look all that bright to me.
I'm glad things worked out for you, MOM. Welcome back.

Negative real interest rates create a situation in which the cost of holding commodities is very low...when you calculate in both the expectation of some rebound and currency/interest rates, abruptly these prices look...realistic. However, the prices are created not by economic fundamentals, but by central bank policy.

Sounds like a corollary to Gresham's Law.

I think I'm beginning to understand your previous post. David's comment did help me think about it. However, I'm still having difficulty describing the disconnect between high domestic demand for dollars and low foreign demand for dollars. Domestic deflation coincident with dollar devaluation--but what's the precise mechanism?

Sometimes I'm just a slow learner. I'll keep thinking about it.
I posted this earlier over at "Marginal Revolution" ...

Since monetary inflation (as distinct from price increases due to supply constraints) enriches debtors and impoverishes savers, transferring wealth from the latter to the former, the answer to the question of whether debt can be inflated away must depend on the scale of the debt relative to the wealth available for transfer, and the side effects of that wealth transfer.

Clearly, if there's more debt than wealth, even transferring all of the wealth to the debtors cannot cancel the debt.

And even if the debt is less than the wealth, we know from history that there are levels of debt/wealth ratio at which attempting to cancel debt by confiscating the savers' wealth will have such negative economic and political effects as to begin destroying wealth and send a nation into a death spiral.

In the 1970s, much debt was inflated away, and large amounts of wealth transferred from savers to debtors, without sending the nation into a death spiral. But I believe the debt/wealth ratio at the time was surely much smaller than it is today.
Comparing some recent Monthly Treasury Statements against 2008 same-month, I didn't find any decrease in FICA revenue. Considering the extent of job loss and working hours reduction, I find that utterly baffling.

MoM, can you give some guidance here?
Did I perhaps just choose unrepresentative months?
Hello MoM,I am using a borrowed computer,expect a package within 2 days of september 20th.Thanks and God Bless,Tom
Good to see you, MoM. Hope the medical issues calm down.

I think China was trying to blow a "tide me over" bubble to bridge to a return of business as usual. The realization has sunk in that business as usual won't return anytime soon. The US consumer has started saving and inevitably will be buying less in the way of Chinese goods ... thereby undercutting the economic progress that underpins stability in China. Chinese governments for the last three millenia have always understood what happened when economic calamity hit: revolts, eventually resulting in new regimes. Depressions for industrial societies are equivalent to famines for agrarian societies ...

It is not just the financial, but also the political consequences of a worldwide depression that should have everyone worried.
Amaing how we can have "deflation" with the dollar tanking. Fiat currencies suck, if only because of the confusion they cause.

What about the fact that everything that is NOT a financial instrument or domestic service seems to be increasing? Then there's the quality differences. Packages are getting smaller etc.

Its hard to see this as deflation in a monetary sense of the word.

CPI needs to be calculated based on what 90% of the populaiton experiences, not over weighting with the other 10% that make up such a large part of consumption. Most of us don't consume 2nd houses or german automobiles but do consume food and energy.
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