Should we be worried about future deflation or inflation?

There is a lot of worry these days about weather we are in deflation, slipping into deflation or about to enter into an inflationary environment. It obviously makes a big difference in future planning and how investments are allocated. As you can imagine, there are very different views among the different economic philosophies.

Before I get philosophic differences however, I need to provide a simple definition of inflation and deflation. Very simply, inflation means an increase or inflation of the money supply (more money units) and deflation means a contraction in the money supply. In the case of inflation, an increase in money units means that each unit is worth less or one’s purchasing power is diminished. Therefore prices increase. Inflation, the way the word is used today means an increase in prices. Therefore, the cause of inflation is usually misdiagnosed. I’ll talk more about this in other posts. So lets look at the different viewpoints.

Keynesian/Demand-Side View
The big government economists (Keynesians and demand-side economists) are worried that the money spent to date (the stimulus and fiscal and monetary policy) is not enough to fill the spending gap left when consumers and businesses reduced spending.

Influential economists like Paul Krugman, have said all along that the stimulus packages have not been large enough to fill the gap in spending and that now we need a much bigger stimulus package in the neighborhood of $1 trillion more dollars if we are going to turn this economy around. If we do not get that kind of spending, we will slip into a deflationary death spiral that is very difficult to get out of. Therefore, we could end up like Japan in the 1990’s with 10 years or more of almost no growth.

Their definition of deflation is falling prices (due to lack of demand) and they see falling prices everywhere (housing prices, food prices, car prices, etc.) He doesn’t see falling computer prices over the years as detrimental or deflation however. He also does not mention how we are going to repay the loans.

Keynesian/Supply-Side ViewThe opposite position is taken by the less government economists (Keynesians and supply-side economists) who see a marginal improvement in GDP growth, which they have extrapolated into a V shaped recovery. They are worried about the coming inflation because of artificially low interest rates and high debt levels.

They see inflation (a rising consumer price index or CPI) everywhere. They think that unless the Fed raises interest rates very soon and begins to take money out of the system, we will get severe inflation within the next year to eighteen months. Interest rates should be raised to one percent higher then the nominal growth rate of GDP (growth rate before inflation.) So if the economy is growing at 3-4% as they expect, interest rates should be at 4-5% not zero.

Their definition of inflation is a rising CPI index (which is the symptom of inflation, not the cause.) The CPI index as you know is a basket of goods and services the government uses to measure price changes.

Capitalist ViewThe almost no government economists (Capitalists, Austrians, Objectivists) have a much different definition of deflation and inflation. They see deflation and inflation as it was originally defined: expansion or contraction of the money supply. Their view is that the government has been and continues to pump money into the economy (print money), which will be inflationary. However, consumers are currently over-leveraged (too much credit vs. disposable income) and must reduce spending and increase savings in order to b ring their financial lives into balance. This slowdown in spending looks like deflation (prices are being reduced by almost every store advertising.)

Therefore we are currently in a period of de-leveraging, not deflation and until the consumer starts spending again (by using or reducing his savings or expanding his credit) we will not enter an inflationary phase. But based on the money that has been added and expected to be added to the economy, we could be in for serious inflation.

Conclusion

Therefore, your current position should be focused on a de-levering economy, which will take considerable time and considerable pain. However, if the government pumps too much money into the economy (a debatable number) or credit becomes too easy again, too soon, it will be time to reposition yourself for inflation.

What is going on with the market?

As you know, I understand that stimulus money drives up the GDP numbers making it look like the economy is getting better, but I have been very concerned about 2010 because of many impending headwinds:

1. Mortgage delinquencies about to rise significantly. Note, we are now entering the 2005-07 period when the option-ARM’s made up the majority of mortgages (pay what you want to per month and we will add the unpaid balance of principal and interest due to your mortgage)
2. Banks will have to report, for the first time, off balance sheet assets in their first quarter reports,
3. Unemployment is high and probably getting worse (except for government census workers),
4. Mortgage resets have started to rise and with about 25% of homes underwater, there may be no way for most people to refinance,
5. Home inventories are high (over nine months supply at the current sales pace) plus significant shadow inventory (from banks and home owners) is waiting to come on the market when times improve,
6. Current taxes and fees are poised to increase significantly and new forms of taxes (like a national sales tax) may be required to fund our unsustainable spending,
7. State (and local) budgets are in trouble (estimates are from a $200 to $300 billion deficit) and Governors are asking for more help from the Federal Government (who has no money), and
8. Consumers still very over-leveraged.

That’s enough. I am not trying to get you depressed; I just wanted to make a point.

I am trying to understand why the market continues to rise and why traders are apparently throwing risk out the window again. Bears are down to a low 21%. Then I learned about Richard Russell’s latest newsletter. He publishes the DOW Theory Newsletter and is one of the most respected market analysts anywhere. Plus, almost “everyone” buys his newsletter including Goldman, hedge funds, the Bank of China, etc. In his latest newsletter, he explains that he expected the market to close below a critical number (10,750) last Friday which would have turned the market negative. However, during the final six minutes of trading, volume suddenly surged and lifted the DOW above the critical level of 10,750. This was very unusual and caused him to ask:

“Where did that very late buying come from? I have to think this was one of the most flagrant cases of manipulation that I have every seen. Was it the Fed; was it Goldman or Morgan Stanley buying futures on orders from the Fed?”

Note: he is not enamored with the Fed to begin with. But, it got me thinking.

Fiscal and monetary policy is being run by Keynesians (and has been since FDR.) Keynesians believe that in a crisis, you quickly lower rates, print money and then stimulate the economy to fill the drop or gap in spending. If you stimulate enough, the economy (GDP) will “climb” and soon consumers will believe the economy is coming back and will start growing again. The return of the consumer completes the circle and allows the government to hand off the economy, once again, to the private sector.

Now to complete this conspiracy theory, imagine the Fed and the Treasury sitting around wondering how they are going to get the economy going again when “the demand-side” or consumer is over leveraged and can’t buy or borrow money and the banks can’t lend because of impending asset losses and the capital asset requirements needed to remain solvent.

I am not a conspiracy theorist by nature, but I am having a difficult time understanding this market and continue to search for answers.

Are Our Economic Woes Behind Us Or Ahead Of Us?

The way the market has been performing (Dow hitting a high of 10,750 in September and now six months later, with volatility, it is almost flat at 10,550.) Does that mean our woes are behind us or still in front of us? Following are a Macro and Micro view of what is occurring and what might occur.

The Aggregated or Macro View of the Economy

There seems to be two overriding views of the economy. The first is that both demand-side and Supply-side economists (Keynesians) see the economy through the lens of an aggregated economic model or the GDP. When you look at the economy this way, you see the “big picture;” but you don’t see the depth or interrelationships among elements within the economy.

For example, you see the economy growing at 5.9% in the fourth quarter---exactly what, you as a Keynesian, expect. This gives you confidence that the government is doing the right things to fix the economy. First, monetary policy: lowering interest rates and expanding the money supply and than fiscal policy: providing stimulus to get the economy back to normal and subsequently growing.

Now, with the economy focused in Washington (where the money is) and the math looking better: 5.9% growth; you could see our woes as being behind us. Even though Q4 inventory adjustments contributed 3.4% of the 5.9% GDP growth and inventories actually fell $39 billion. That’s the way the GDP model works and you could say that since it fell at a slower pace, things are getting better.

I think the macro conclusion is that things are turning around and with some additional stimulus; the government can keep this economy growing.

The Capitalist or Micro View Of the Economy

The other view, the capitalist view, sees the economy as interactions between individuals (micro view) rather than as an aggregated model (macro view.) Therefore, they look at how the pieces of the economy work on a supply-demand basis with constantly adjusting prices to achieve equilibrium.

This view sees the 5.9% GDP growth but looks at the longer-term implications. For example, in 2010 we are going to get another peak in mortgage resets (July) at a very high level of about $97 billion and remain high through September of 2011. Once this second wave of resets begins (which was in November of 2009) it takes about three months to get delinquencies reported and another three months before we get foreclosure notices. How many mortgages actually go into foreclosure we can only guess? But it will be in the millions.

The government could forestall some of these foreclosures through various programs (loan modification, not letting homes go into foreclosure until they have been rejected by a loan modification program, continuing to allow buyers to make 4% down payments and subsidizing them with $8,000 cash, etc.)

Also, bank credit remains very tight. Banks are not only restricting loans, the Federal Reserve is telling them not to increase dividends or buy back stock so they can continue to build up reserves. If this doesn’t make it difficult to get loans, the a new accounting rule that goes into effect in the first quarter of 2010 which requires banks to disclose their off balance sheet investment vehicles, will make it even more difficult. The only company we’ve heard from so far is Freddie Mac and they said they may be considered insolvent when they report. They are however; going to continue buying mortgage backed securities that are at least four months delinquent (no worry, they are tax payer owned.)

Are our woes behind us or ahead of us?
We don’t know. If the government continues to kick the can down the road on mortgages and allows the banks to continue to increase assets, it could keep the economy going in the short term. But if mortgage foreclosures become a major problem (number of, no credit, continued unemployment, etc.) we could get another step down. Watch the GDP numbers, watch the delinquency filings, and watch the first-quarter bank results.

Market Rising Faster Than Economy: Five Reasons Why

The market has significantly outperformed the economy recently. It seems confusing because of all the headwinds making economic recovery so difficult. For example: housing and commercial real estate continuing to decline, an over-levered consumer, growing unemployment, etc. However, the market does not seem to be concerned about these headwinds (at this time) so what are traders and investors using to bid up this market? You see and read a lot about the recession being over or that we’ve avoided a depression or consumer attitudes are improving etc. But it appears there are five major reasons the market is outpacing the growth of the real economy.

1. The “economy” is assembled and dissected as a Statistical Model

Remember, most people see the market through the lens of the conventional, statistical model of Gross National Product (GDP.) This model looks at the economy from a consumption point of view: a dollar spent, no matter who spends it, represents a dollar of GDP. This of course is why many people see green shoots all over the place and hear so many declarations from politicians, economists and the media that the positive GDP growth in the third quarter means the recession is over. They don’t seem to consider that a dollar spend today (increase in GDP) is a dollar that has to be subtracted (from GDP) through taxes later. Nor do they seem to consider that the dollar will be taken from someone who could probably use it more effectively.

2. U.S. fiscal policy is out of control

Government spending is out of control and congress has every intention of spending more and more. The government will pump in at least $1 trillion (above tax collections) this year and probably each year for the next ten years. That’s a lot of GDP “growth.” Add to that any new programs that might be enacted like health care spending or cash for clunkers. Also, the $800 billion stimulus package has not worked (business revenues still falling and unemployment has gone from 5% to 10%.) Yet, according to demand side economists (preferred by most politicians) like Paul Krugman at Princeton, we need another, bigger stimulus package if we really want to turn this economy around.

The government may not (at this time, be able to get another big, trillion-dollar stimulus package through Congress. However, they may be able to get a lot of “little, very targeted stimulus packages” through congress like: $11 billion more for home buyers, $33 billion for businesses on tax losses 3-5 years ago, $250 for each Social Security recipient at a cost of $14 billion, how about another “successful” cash for clunkers program because GM needs money, etc. All of this money will push up the GDP.

3. U. S. monetary policy is out of control

The Federal Reserve has reduced interest rates to 0-.25 percent (basically free money for banks); expanded its balance sheet by $1.75 trillion dollars and guaranteed the financial community $4.3 trillion to make sure banks will trade with other banks. The Fed, at its meeting last week, stated again that it intends to keep interest rates low (where they are) for an extended period of time (until the economy turns around or until they see inflation.)

This “liquidity” not only helps the banks recapitalize, it punishes savers and forces them to buy risk assets if they want to earn a return on their money (or simply spend it and help GDP.) All of this liquidity helps consumption, but it also causes malinvestment and the current “carry trade.”

4. Stable, low-cost money encourages a Carry Trade

This simply means you capitalize on the returns you can get by borrowing money at low rates in one country and investing the funds in another country for a higher return. Remember reading about this when people were borrowing the Japanese yen at zero percent interest and investing in the U.S. at a higher rate of interest. Well, you can do that right now without leaving the U.S. We are now the carry trade. Banks can borrow from the Federal Reserve at zero percent and buy longer term Treasuries and make the difference. Or, some can short the dollar (it’s down over 10 percent this year) and use the money to buy higher risk assets (equities, gold, etc) and make even more.

5. Global funds still streaming into the U.S.

This carry trade is not just being done by Americans, it’s global. Countries around the world have more growth than ever and are taking advantage of the declining dollar and the rising assets like equities, commodities, etc. As we saw in the Technology bubble and the housing bubble, the world is awash in money looking for a place it will be treated well.

These are certainly not all of the reasons the market is rising faster than the economy, but they are some of the more significant reasons. Also they may stay in place until the headwinds become too strong.