Primer #1: What is deflation?

You’ll hear lots of discussion on this blog about deflation, as I believe it will be the dominant financial force over the next several years.

We should take a minute and understand just what it means.

Those who know me will know that I have long maintained that deflation and not inflation will dominate the near future, much to the shock of everyone, as inflation has been a given for so many years now.  The repaying of debt and a new consumer frugality are in the cards.  This will be the natural by-product of even a modest housing correction as the wealth effect will cut deeply in reverse.  Heck, even without a housing correction it’s hard to imagine how people can continue to amass debt and neglect savings for much longer barring the re-emergence of significant inflationary forces (not gonna happen).

In order to understand money creation and destruction, we must understand how money is created in our society.  Without getting too much into it, all you need to know is that there are several measures of ‘money’.  When we think of money we tend to think of the stuff we hold in our wallet, pockets, or coffee holders in our car.  However, that physical currency constitutes only 5% of the ‘money’ in our system.  The vast majority is bank-generated credit, which spends the same as minted currency.

Think about it for a moment.  When someone takes out a mortgage to buy a home, does the bank actually stuff a suitcase with stacks of hundred dollar bills for the lender to deliver to the homeowner?  No it does not.  Instead, the bank literally types it into their computers and new money has just been created.  I know that sounds crazy, but it is true.    ‘Money’ has just been generated out of thin air.

So where does the bank get the money to lend out?   The very basics work like this:  You deposit money into the bank.  They keep it in a vault for you, right?  Heck no!  They turn around and lend out virtually the entire amount (unlike our neighbours to the south, our ‘sound’ banks have no maximum leverage ratios) to someone looking for a loan.  That new bank-generated credit, which spends the same as freshly minted currency, causes the money supply to expand.  The person who took out the mortgage (or line of credit, or credit card, etc) then spends that money.  The person who receives that digital money has it transferred into their own bank account.  Guess what….that is now considered a NEW deposit which that bank can now lend out.  The process repeats itself, with that bank lending out all the deposit so on and so.  You’ll note that after a while, a tremendous amount of ‘money’ has been created out of the initial deposit.  Interesting, eh?

The whole system works great for the banks (which make massive amounts of money paying you peanuts on your deposits while lending out all of your money and then some at much higher rates, banking the difference), as long as the expansion in credit remains intact.  However, what happens when people stop borrowing and spending, and start saving and repaying?  We’ll get to that in a minute.
But first, consider two important implications of the process I just described for you:
1)  New bank-generated credit (which has accoutned for 95% of the growth of the money supply) must be repaid with interest.  Which means that the entire system requires an ever-expanding supply of credit to continue to service the pre-existing debt.  Which means, THERE IS NEVER ENOUGH MONEY IN THE SYSTEM TO ACTUALLY REPAY THE EXISTING DEBT!  Think about that for a moment.  Chris Martenson does a great job of explaining this in his Crash Course.  It’s worth a watch.
http://www.chrismartenson.com/crashcourse/chapter-7-money-creation

2)  If even 5% of depositors showed up at the big banks and asked for their money back, the entire system would immediately grind to a halt, since the banks never actually have enough reserves to honour all their deposits (hence the name ‘fractional reserve banking’).  Seriously!  This is called a bank run and they happen all the time all over the world.

Okay, now let’s make sure we understand the concept of inflation before we connect the dots.  Despite how the Bank of Canada calculates inflation (the rise in prices as shown in the ‘Consumer PriceIndex’), inflation is not defined as a rise in prices at all.  That is the most obvious symptom of inflation but would be akin to defining a cold as a runny nose.  The runny nose is once again the symptom.  In the words of Milton Friedman, “inflation is always and everywhere a MONETARY phenomenon”.  In other words, it is the result of the aggregate money supply multiplied by the speed at which that money changes hands.  As one or both of those factors increase, assuming a stable supply of goods, the value of those goods rises accordingly.  THAT is inflation.  The process that I just described for you is HIGHLY inflationary in the short term as great amounts of new money are created out of thin air.

There are actually two elements to understanding consumer price inflation:  the money supply and the velocity of money.  To understand the velocity of money and how it affects prices, just consider what would happen if people all of a sudden decided that they would save 50% of their pay and store it under their mattress.  All else being equal, that would mean less money in the system competing for a relatively stable supply of goods.  Deflation.  This is where the inflationists have it wrong.  Some are calling for massive inflation because of all the `quantitative easing’ being done in the Western world to combat deflation.  Quantitative easing is close to printing money by the central banks, though not quite.  If the velocity of money stayed constant, then yes the inflationists would be right.  But it is not!  Instead in the U.S., the velocity of money has collapsed as consumers are saving and repaying their loans and banks are uneasy to lend.  It is akin to printing billions of dollars and then burying them in a pit.  It won’t impact prices one iota.

Well, if an expansion in the money supply is inflation, then a contraction in the money supply or a significant drop in the velocity of money is, obviously, deflation.  But how would that happen?  Well it’s happening right now in the US.  The graph shows deflation at work in the US.  It shows the aggregate money supply (known as M3).

You`ll see that it is tanking.    It actually happens quite easily:  People stop taking out credit, begin repaying their outstanding debt or defaulting on it, banks stop lending,  people start saving.

So is that in our future?

Well, consumers are at the point where they must begin paying off their debts.  Debt in Canada has never been higher, currently sitting at almost 150% of disposable income.  The effect of this is two-fold:  It reduces the money supply as that debt is retired, and it also hurts ‘economic’ growth in North America, which has been 70% dependent on consumer spending (we’ll revisit that shortly).  The other effect that is in the cards is an increase in the savings rate.  Currently we are sitting at about a 2.5% savings rate in Canada.  This is well below the 10% of a decade ago and is a country mile from the 20% savings rate in the 1980s.  As this savings rate inevitably increases, money starts to change hands more slowly, leading to a slowing in the velocity of money.

Now for a simple but powerful equation to help you understand the effects of falling money supply and velocity:  MV=PQ

Where:

M = The money supply

V= The velocity of money

P= The price of money in terms of inflation or deflation

Q= The quantity of production, or GDP

If we increase the supply of money and velocity stays the same, and if GDP does not grow, that means we’ll have inflation, because this equation always balances. But if you reduce velocity (which is happening today) and if you don’t increase the supply of money, you are going to see deflation. This is where central banks step in to ‘stimulate’ the economy via money printing (quantitative easing) in an attempt to increase the money supply.  However, this has its limits too as consumers will reach a point where they would rather save the newly printed money, use it to pay off existing debt, or where banks desperate to sit on their cash for future loan loss provisions refuse to lend.  A trillion freshly minted loonies buried in a pit do not cause inflation.  Nor do a trillion loonies sitting in a bank account or a trillion loonies used to pay off debt.  This is what is happening in the US right now, which is why trying to stimulate an economy in the midst of a debt deflationary cycle is akin to pushing on a string.  Japan has been pushing on their string since the 80s.  Despite rock bottom interest rates and quantitative easing, home prices are 80% below their 1980s peak (yes you read that right….80%) while the stock market is 75% below its 1980s peak.  So you see that deflation is a powerful monetary phenomenon that can become self-feeding, difficult if not impossible to remedy, and absolutely ravages leveraged assets.  This is our future.  Bank on it.

So what will be the catalyst?  Well, I already showed you that consumers are pretty maxed out.  However, even more importantly, people will absolutely start saving more and borrowing less (particularly against their home equity) when house prices normalize (read: fall) and/or as interest rates normalize (read: rise).  I know I probably haven`t convinced you of a housing bubble yet, but stick around.  That will be one of the primers to come later this week.  It has been estimated that for every dollar of house price increase, it generates approximately 9 cents of spin-off consumer spending.  People remodel their homes, go on trips they wouldn’t otherwise take, buy new cars or boats, etc.  This has a tremendous impact on the economy (one of the reasons I am confident we will be back in recession by Q3 2010.  It is also self-reinforcing on the way up, but very painful on the way down.  This is the wealth effect which will also be covered in a future primer.

I know you probably haven’t had the concept of deflation explained before, so you may think that I`m some far-out econo-babbler.  I’m not.  The bond market certainly is banking on deflation.  You may not know it, but the bond market is 14 times the size of the stock market and governed overwhelmingly by ‘sophisticated’ investors.  If inflation is a concern, bond investors demand more of a premium, as the money being repaid to them in the future is inflated money with each dollar buying less.  In a time of inflationary pressure, bond yields sky rocket.  The opposite is true of deflation.  Times of deflation mean that money being returned in the future is MORE valuable, so less of a risk premium is demanded.  So what does the bond market see in the future?  Check out the graph showing the historic yield on the 5 year Government of Canada bond (courtesy of Edmonton Housing Bust).

You’ll notice they hit rock bottom in January 09 before the stimulus sugar high kicked in, sparking the great reflation of 09.  Now that the artificial high is wearing off, what is in the response of the market?  Check for yourself.  Yup…no inflation in sight means collapsing yields.  If you have to make a bet based on what the bipolar stock market or the bond market is telling you, bet with the bond market.  This is why interest rates should stay low for some time.  The caveat all along has been that a loss in confidence in the ability of a government to repay its debt by taxing its citizens (a la Greece or Spain) would also cause bond holders to demand a risk premium.  That is not in the cards in North America YET.

So what does this all mean to you?  Well, here are some ways to prosper in a deflationary environment:

1)  Pay off debts.  This is huge as incomes shrink during bouts of deflation, making debt burdens more onerous.

2)  Invest in long-dated bonds or even strip bonds.  It is my conviction that we will once again see the emergency level interest rates from the Bank of Canada next year before any serious rise in interest rates.  Corporate bonds and preferred shares will also do well, but only in companies with strong cash flows and little debt.  Avoid the banks and insurance companies though.

3)  Underweight stocks in your portfolio and avoid those with excess debt.  Look at the debt/equity ratio, which can be found at globeinvestor.com

I would be leery of any company with a debt/equity ratio above 0.5.

4)  Save your money.  Periods of deflation always produce tremendous opportunities for those with cash, as its purchasing power increases.  Save money in a high interest savings account or a short-term bond fund or ETF such as XLB-T or CLF-T.

Finally, and as always, avoid following the crowds.  Reduce your consumption and adopt a lower standard of living.  You’ll be in fine shape to prosper in the coming years.

Cheers and blessings,

Ben

 

Added:  This primer is now in a video format

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32 Responses to Primer #1: What is deflation?

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  4. canedoor9 says:

    The graphs and charts links are broken. Would love to see them! Thanks.

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  7. deflationist says:

    I lean towards deflation too, and clearly the bond market is signaling that too. However, many of the inflation camp argue the bond market is being manipulated by the central banks (i.e. central banks are purchasing bonds to flatten the yield curve). I know Japan is still playing the “extend and pretend” game and that their yields are low. People on the inflation camp argue that we cannot compare our problems with Japan because of the savings rate differences and the fact that Japan’s deficits are financed domestically with little foreign creditors. What is your take on this?

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  10. chrisina says:

    Ben,
    you write:
    “New bank-generated credit (which has accoutned for 95% of the growth of the money supply)”

    So please explain why Total CREDIT is $52 trillion while the Money Supply (M3) is only $13 trillion. (see Fed’s Z1 flow of funds fr the data).

    ???

    The simple truth is that the fractional reserve model to describe the creation of credit money is completely and utterly invalid.

    Generations of people have been brainwashed to take for granted this fractional money multiplier model, when the simple fact that credit is an order of magnitude larger than broad money supply shows it is a false story of the way credit money gets created.

    The only realistic way money and credit are created is described here:
    http://en.wikipedia.org/wiki/Endogenous_money
    it satisfies credit >> M3

    (with money multiplier model you would have M3 > credit)

    Conclusion is that reality is even worse than what you think it is.

    • Hi Chrisina
      We’re arguing the same point. The contraction of the money supply will be highly deflationary in the near future. The question is the scale. I’m not sure you can discount the fractional reserve model completely unless you believe that banks are not bound in any way by reserve requirements, unless I’m misunderstanding the theory. Nevertheless, you present an interesting perspective. I’m always interested in broadening my perspectives. I’ll freely admit that the Endogenous Money theory is fairly new to me. I’m happy to look more into it.

      If you’re ever interested in submitting a guest post explaining your perspective on money creation and destruction, I’d be happy to post it.

      Cheers

      • chrisina says:

        Banks are bound by reserve requirements but they look for those reserves later, after they’ve issued credit.

        Either they have sufficient reserves already, then fine, if not they go and look for it at the Fed or from other banks who might have excess reserves.
        If the Fed sees that the entire banking system has reached its reserve requirement limit, then it either relaxes the reserve requirements, or creates new reserves.

        So it’s banks who create credit, this in turn creates the money supply, then the Fed adjusts the monetary base accordingly.

        The money creation process is the exact reverse from what the neoclassical monetarists believe.
        And it’s the only one that makes sense as in reality, credit is order of magnitude larger than the money supply which should obviously be impossible with the fractional reserve model.

        Here you’ll get a much more detailed explanation, with all sorts of graphs and information showing all the evidence you need.
        http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/#_ftn12

        It’s a very important discussion because as long as the people who are at the helm of the Fed and of our economic and monetary system haven’t grasped that the models they take for granted are FALSE, we’re going to be in lots of trouble.

  11. chrisina says:

    I don’t mind writing a guest post to summarize all the ideas of Hyman Minsky (who is the only economist to have ever properly modelled the dynamics of a debt bubble) and of the endogenous money theorist Basil Moore, but I have no idea what format to use ?

    • That would be great, Chrisina. We’re obviously advocating the same message, though from different perspectives. I’m quite familiar with Minsky, but not Moore. Anything you’d like to submit you can attach in a word document and email to me at benrabidoux(at)yahoo(dot)ca

      Or you can just send it to me in an email and I’ll put it in a post. Just remember that my target audience is not necessarily academics or economists, so try to make the language easy to understand and readable.

      I absolutely will post it as submitted.
      Cheers,
      Ben

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  21. OnlyTheBankersLaugh says:

    Hey Ben,

    Why don’t you like bank preferreds? They still seem protected from real estate for a couple of years.

    OTBL

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