Deflation is looked at by economists in different ways. The most appropriate definition for deflation is ‘a contraction in the supply of money and credit’. It is not falling prices, although falling prices are a consequence of deflation. One should not confuse the two concepts as prices can decline without deflation. Inflation is the opposite of deflation, in that it is an expansion in the supply of money and credit. Clearly we are in a period where falling supply of money and credit is real and probable.
Inflation is all most people know as it was part of our lives each year from 1933 to 2008. Many analysts and economists still call for the return of inflation and potentially hyperinflation. Reality is, the signs are not there for inflation but deflation appears to be the most likely probability. There is a strong historical basis for this belief as well as many economic and fiscal signs pointing strongly towards it.
Most of the arguments for inflation are based on the US Federal Reserve and other major world Central Banks continuing to inject monies into world economies through quantitative easing programs. So far the amount Central Banks have injected into the economy is unprecedented.
The size of these balance sheets (currently more than $15 trillion) relative to the capitalization of the world’s stock markets (presently more than $48 trillion) is shown in the chart below. A normalized level for Central Bank balance sheets relative to world market capitalization is around 10%. It is now above 30%. A 200% increase from normal times. This is unprecedented in the history of Central Banks.
Central banks are ruling markets to a degree that no generation has ever seen. The reality is that the Central Banks will not be able to print forever. Until a worldwide exit strategy by the Central Banks can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of Central Bank balance sheets. Societal pressures are going against more monetary easing, especially in the US and Germany. The US Fed Chief Bernanke is also getting resistance internally within the Federal Reserve. Serious concerns have been brought forth by the Kansas City, Philadelphia, Dallas and Richmond Federal Reserve Presidents. It is important to note that there are only 12 Federal Reserve Presidents. The Fed is clearly fracturing internally, and its power to inflate will face serious future resistance. Credibility is fading as their previous actions are now viewed to prop up the banks and brokerages but provided little help to Main Street. Negative sentiment towards Central Banks is growing worldwide; therefore it will get more and more difficult for further action.
The question must be “has the Central Banks inflating policies been effective”. A simple answer is yes, they did prop up banks, at least short term. The actions also pushed up stock markets prices worldwide as well as commodity and precious metal prices. The general economy has very modestly improved but given the many trillions injected by both Central Banks and Governments into the US and World economies and banks, the impact has been muted. It could be argued that the policies have done nothing but increase the problem dramatically, as household debt problems has expanded to become a sovereign debt problem as well. Debt is now viewed as unmanageable in many countries worldwide including Japan, US, UK, Spain, Greece and Italy to name the leading debtors. Reality is that debt has taken hold in almost all countries worldwide.
What can prevent deflation…increased bank lending to its customers, both individual and business. The problem is the banks are full of toxic mortgages and are doing what they can to clean up their balance sheets. They cannot take on any more risk. Also the FDIC has increased oversight which has made bank lending come to a standstill. We have also seen lawsuits against former bank officials that are believed to have committed fraud. Much more conservative policies are enacted in such a climate. There is great anger against the banks, which is also deflationary. Banks will either increase their lending, which is highly improbable, or deflation will continue to pressure the US and world economies. One other major point is that an international coalition of governments agreed to raise the reserve ratios for banks in the near future (Basel 3), which is also deflationary.
Governments have been one of the primary reasons that we are not mired in a world of deflation today. They have taken on significant amounts of debt worldwide. It is now at a point where there are serious threats of sovereign defaults in European countries including Greece, Spain and Italy. The US is close to $16 trillion in debt and growing at a rapid pace. Many economists agree that if you include unfunded future liabilities, the debt is raised to over $100 trillion. Clearly these numbers are not sustainable. Austerity has taken hold in Europe and most of the developed world. It will be a theme in the US future as well. Austerity policies are deflationary. If you look at debt to GDP levels of major developed countries, they are at the highest levels in history and will find it near impossible to continue to expand. Deleveraging the debt worldwide is the theme today, both individuals and governments.
Deleveraging through pay down of debt is inevitable. We are seeing the movement in that direction now. The trend has just begun and when it takes hold, deflation has the potential to spiral out of control. Government finances are out of control and when creditors start to lose faith in the potential for repayment, we will see austerity forced upon nations, if bankruptcies do not occur first. We have been seeing Central Banks support government deficits since the financial crisis in 2008. The trend has been slowing in 2012 as there is a belief that there is too much debt worldwide and confidence is waning. The theme of austerity is gaining momentum.
A number of clear signs of deflation have emerged this year:
Ø Bond yields of perceived high quality bonds (led by US Treasuries and German bonds) are at their lowest levels in history
Ø Europe is in an economic recession and falling fast. They also face dire fiscal issues
Ø European bank loans are at risk and Germany has little appetite to bail out it’s neighbor countries and banks
Ø Real estate has continued to contract, with a number of experts not expecting a bottom for years
Ø Many sectors of the stock market are down 30-60%
Ø Producer price index (PPI) is contacting throughout the world
Ø Consumer price index (CPI) is also contracting and has recently seen its biggest drop since 2008
Ø Commodity prices are down about 40% from their peak in 2007
Ø Gold and silver have contracted significantly from their 2011 highs
Ø The velocity of money (average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time) is as low as it has been since the Great Depression
Ø Austerity is taking hold in many countries worldwide, with a tightening of expenses and increase in taxes
Ø De-leveraging (paying down of debt) has begun among individuals with little appetite for new debt
Ø Japan has been in and out of deflation since 1990 and continues to reel from it
Ø China clearly has overcapacity, building infrastructure at a rapid pace over the last decade. Now their economy is slowing down with the world and stresses on their banking system are increasing
In the end it simply comes down to the fact that there is too much unpayable debt in the world that has accrued over the last 50 years. Defaults have increased and once faith is lost in creditors, defaults will greatly accelerate. The entire system is gorged with debt. Defaults could become systemic, leading to a spiral effect of further debt write downs, negative psychology and further bankruptcies. It is a cycle of devastation and reverses the positive side that was experienced during the accumulation of debt since 1970’s, including significant increases since 2000. Governments, Central Banks and financial institutions have been reckless in their desire for growth. The future has been spent and the brunt of the pain will be borne by the average taxpayer. Many believe that governments and related agencies like the FDIC will be able to stop a credit meltdown, but reality is that these institutions have not money to save the banks or individuals. Debts are just too large.
There is an estimated $184 trillion of total debt in the world today. If you look at it relative to Global GDP, there is $2.66 of debt for every $1 of GDP. Deleveraging is needed. In periods like this, the world will experience a significant increase in write-downs and bankruptcies. Let’s say 15% of this debt is needed to be written off (modest amount given the secular bear market we are in). That equals to $27.6 trillion – unmanageable as banks worldwide and governments do not have the finances or balance sheets to cushion such a blow. This addiction to debt cannot end well and is extremely deflationary. This type of environment is at risk of leading to a deflationary market meltdown. When fear and panic are the primary emotions enveloping the markets, a move to perceived risk free assets can easily occur. We have seen that begin, reflected by all time lows in US, German and other perceived safe governments bonds. All risk assets (stocks, risk bonds, commodities and precious metals) sell off and it can be deep and fast.
Home owners are debt slaves as close to 50% of homeowners now have mortgages as large as the value of their home. Also college students are drowning in debt as there is now $1 trillion outstanding student debt. Youth unemployment is at unprecedented levels, above 20% in the US and actually greater than 50% in Spain and Greece. Of those working, many are underemployed and either working contract or part-time work. This will have impact for decades to come unless this problem is resolved. This group is needed to help sustain the real estate market and general consumer consumption which is about 70% of the economy. This also is very deflationary.
Banks will not lend to individuals where risks are high as their current bank and individual balance sheets are fraught with write-downs or potential ones. When banks lend money, it gets deposited into another bank, which re-lends it with the cycle continuing. This is called a ‘multiplier effect’. Bankers have lent out about 97% of their deposits. When defaults gain momentum, the multiplier effect goes into reverse. This will be one of the primary factors showing that a deflationary crash has begun. In this environment all assets including real estate, stocks, risky bonds, commodities and precious metals drop in value; many of which disappear and are worthless. The best place to be in such an economic environment is cash, treasury bills and some foreign government debt such as those issued by Switzerland and Singapore.
An alternative to a deflationary scenario is hyperinflation. Although much less likely, it is important to analyze the possibility. It is where confidence in the currency of a country erodes and individuals and institutions shift the monies to real assets. Asset prices will then rise and the purchasing power of their money falls. Others recognize the falling purchasing power of their currency and also exit from paper into real assets. We saw this in Germany in the 1920’s and Zimbabwe in 2008. This scenario occurs during periods of unsustainable government deficits, like we are seeing today. You usually see Central Banks monetize a significant portion of the government debt during these periods. We have also seen this, especially in 2011-12, where the Federal Reserve has become the biggest purchaser of US Treasuries.
A potential scenario that cannot be ignored is that deflation continues to take hold of all asset classes including real estate, stocks, commodities and precious metals. Once deflation drives down asset prices significantly, there will most probably be support for major Central Bank intervention. At that time, extremely aggressive action would be taken by all world Central Banks, led by the US Federal Reserve and the European Central Bank. Monetizing assets would become a world theme. The US dollar and Euro as well as many fiat currencies would severely depreciate, moving economic pressures from devastating deflation to high inflation, potentially hyper inflation. In this scenario, deflation is initially the greatest force, followed by unprecedented Central Bank intervention moves to their preferred scenario of inflation but risking a breakdown of fiat currencies and a dangerous economic hyperinflationary situation.
Hyperinflation is much more improbable than deflation. There is too much debt and much less real money in the world, concentrated in few hands. Therefore given this environment, the focus will be on protection of assets through safe institutions in cash or treasury bills. Psychology will be negative as asset values fall. This is a process that is very difficult to reverse once it takes hold of society. The one signal that hyperinflation is a strong possibility is a rapid rise of gold and silver, commodities and stock markets. Tied with this will be a fall in the currency and in government bond prices. In deflation, perceived highest quality bonds will rise in value and all other assets fall. Time will tell but one of these scenarios is very likely on the horizon. Brace yourself as both scenarios would be painful to all and devastating to some.
About the Author: Mr. Sammut is on the Board of Directors of the Financial Policy Council and he is the President of Fortrus Financial Inc., an investment education and strategy firm. He specializes in creating investment strategies including all asset and currency classes. His firm designs strategic plans without the conflict of interest of managing the assets. Mr. Sammut can be contacted at the website: www.fortrusfinancial.com
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