I wanted to pass on an email conversation I had with a friend of mine who is a policy analyst in Washington. He believes that deflation can always be contained or countered with effective monetary policy. I disagree for the most part. My position is that deflation can be delayed for a period while debt is amassed. Central banks can contain periodic bouts of deflation, as we saw in 2000 when the Fed was able to navigate through what would have been a nasty recession. Back then people were still willing to take on debt. The biggest bubble was yet to be blown. Far more leverage would be introduced via the housing bubble than ever existed in the NASDAQ bubble. So they were able to contain deflation….then. However, as explained in a previous primer, debt must be repaid with interest. Thus it represents a claim on future earnings and consumption. If a secular shift in mindset occurs and many people try to repay debt while few try to take more on, it exerts tremendous deflationary pressures. If the Fed can’t convince people that it is a good time to take on more debt, then a self-feeding cycle begins. Alas, animal spirits at work!
The bursting of Japan’s property bubble marked the beginning of a two decade battle to slay the deflation dragon. The battle is ongoing, though property values and stocks are over 75% lower than they were at their peak. So it’s easy to see who won. Nevertheless, it begs the question of how incompetent their central bankers must have been to let this happen. They must not have had access to the brain power of Helicopter Ben or some of the other central banker clowns out there today. Regardless, on to my conversation. It’s come to my attention that we have some very astute students of economics who frequent this lowly blog. Perhaps they could weigh in and offer their opinion of who won this tilt or perhaps offer alternate viewpoints. Let’s get it on!
Round 1: The email that started it…
Prior to posting my musings here, I would email them out to a select few blessed individuals. Here is one such email….and yes, sometimes I can gloat a little:
“As always, David Rosenberg has perfectly captured the current state of affairs
in his recent op ed in the Globe. It is a beauty!
As you have all heard me say before, we are facing the beginning of a secular
shift in consumer attitudes that will result in less credit being created, more
savings and debt repayment, and a general embracing of a renewed frugality. The
result of this is highly deflationary as the money supply shrinks and consumer
prices and leveraged assets are squeezed. This is unavoidable. Add to this an
aging population which as we speak is passing its peak spending years and it is
safe to say that demographics are not on our side. I have been saying all this
since 2008. It may have even been 2007. It is not hard to see that incomes in
the entire western world can no longer support aggregate debt levels,
particularly at the consumer level. This is the backdrop behind the coming real
estate correction and will prove to be the great equalizer. No community will
be able to say “it’s different here” as the backdrop of powerful deflationary
forces exerts pressure on ALL communities. Granted, those that experienced the
greatest irrationality in the run-up (Vancouver, Toronto condos, etc) will see
asset values ravaged more than most as real estate prices will be halved, but
that’s not to say that any community will escape unscathed. Sorry to burst you
bubble (no pun intended).
As you all know that I have been ridiculed by virtually each and every one of
you for my views on what I believed would be emerging trends. It’s all good. I
still love you all. But let me take you back for a moment. You have to admit
that when you first heard me articulate my position on real estate and deflation
in general, your initial thought was “what’s this dude smoking”, or something
along those lines. But you probably couldn’t shake it. And the cold logic that
challenged your worldview was probably what left you most unsettled. While you
may still be hesitant to believe that I will be proven right in the near future
(I will), at the very least you have to admit that my views are far less fringe
than they once were. If you were honest, you would probably admit that you know
there is some truth in what I am saying, but the reality of what that does to
your net worth and future plans makes sleeping at night easier if you can just
convince yourself that I`m some young punk who doesn`t know what he’s talking
about. Maybe I am a clueless punk. And maybe real estate and debt levels can
continue to increase forever while incomes stagnate. But more likely you may
have missed the subtle signs that a new paradigm was around the corner. Isn`t
change the only constant? Perhaps that is why this great quote from the
legendary investor Bob Farrell resonates with me, and should with you too:
“Change of a long term or secular nature is usually gradual enough that it is
obscured by the noise caused by short-term volatility. By the time secular
trends are even acknowledged by the majority, they are generally obvious and
mature. In the early stages of a new secular paradigm, therefore, most are
conditioned to hear only the short-term noise they have been conditioned to
respond to by the prior existing secular condition. Moreover, in a shift of
secular or long-term significance, the markets will be adapting to a new set of
rules while most market participants will be still playing by the old rules.”
Old rules are out. It’s not that “this time it’s different” or “the sky is
falling”, as there are multiple example of this very phenomenon of asset and
monetary deflation (Japan being the most recent) from which to draw parallels.
There will be tremendous opportunities around the corner and we will once again
see true and organic growth, but it will not be until these debts have been
written off or paid off, both of which are deflationary. Simply put, to blindly
assume that our future will look anything like the past 50 years of essentially
continuous credit expansion and asset inflation while ignoring the Ponzi-like
mechanism that has allowed for this is pure and total folly. Do so and ignore
these warnings at your own peril.
Round 2: J responds…
I agree with you in so far as you describe the formation of a bubble.
Where I disagree is this idea that deflation is unavoidable. I also
would love to see a macro model that confirms that we need deflation
to get through this mess.
One quick note: deflation will make it harder not easier to pay off
debts. It is aziomatic: deflation increases the debt burden.
Round 3: Ben hits back
I’m well aware that debt burdens increase during periods of deflation. I’ve
never suggested that deflation will make debts easier to service. In terms of
deflation being unavoidable, remember that deflation is a monetary phenomenon
associated with a decreasing aggregate money supply. The by-product of this is
usually falling consumer prices, though that is not the definition. With 95% of
the money supply being bank-created credit, you need further credit creation
going forward to ward off deflation. So the question is where the debtors will
come from. Consumers are maxed out. Period. They have (wisely) begun saving
again and have begun either paying off existing debt or defaulting on that
debt. Both are deflationary. You also have tremendous demographic forces
exerting deflationary forces. In a consumer driven economy like the US or
Canada, you HAVE to have consistent credit growth to sustain the economic
‘growth’ illusion. When the credit stops, the party’s over, as we are now
seeing. Of course that’s not how a normal, healthy economy functions, but we
don’t have a normal, healthy economy, do we? We have one based on the fallacy
of perpetual growth driven by ever-expanding consumer debt levels. Now you can
have the Fed step in to become the new borrower, but getting that money into
that hands of consumers and then getting them to spend it is proving extremely
difficult as consumers are actually being prudent with their money and saving it
or reducing debt burden. And remember that even the Fed has its own limits. I
know you think that the bond market will never rebuke the Fed, but that is a
very dangerous assumption to make, and you are flat-out wrong if you think that
any sovereign has an unlimited debt ceiling to play with. Now you can print the
money, but again, how do you get it into the hands of the consumers and how do
you get them to be foolish enough to keep spending? And if the velocity of the
money supply or overall credit continues to fall at a greater rate than your
printing presses can get the money into the economy, you’ve accomplished
nothing. This is the state we find ourselves in.
So, the question remains: Who will the new debtor be? Show me this and I will
agree that there is at least a way to postpone the deflation to come. But to
what end? The money must be repaid and with interest. As debt is a
claim on future earnings and therefore future consumption, debt in the long-term
is deflationary by its very nature. So what is the eventual end game here? How
will you pay off the debt without exerting deflationary forces? To think you
can do so is lunacy. Deflation is the inevitable outcome. The question is the
timing. Perhaps you can show me how we can kick the can down the road a little
further, but I doubt it.
Forget your macro models for a minute. Let’s admit that macro models
have done nothing to prepare people for this current economic crisis, nor have
they given us any idea of how to get out. I don’t need a broken economic model
to tell me what is glaringly obvious. I’m not sure why recessions and all
economic pain must be viewed as such a terrible thing. I agree that recessions
are painful, but I do think that they are unavoidable and necessary. I’m not
sure where you get the notion that we can undo the past decade of poor financial
management and mis-allocation of capital without any pain at all. Can the
household who takes on too much debt and manages their finances in an imprudent
manner manage to correct the ship without a bit of belt-tightening and
sacrifice? If not, then where do you get the idea that we as a nation can do
it. It doesn’t make sense.
Round 4: J with a low blow…
Hard to debate you when you don’t look at the data or the models.
Also, I can name just off the top of my head a bunch of economists
that predicted the crisis using the kind of macro models I am talking
about: Robert Schiller, Nouriel Roubini, Paul Krugman Joe Stiglitz,
Mark Zandi, Morgan Stanley’s Stephen Roach, and so forth.
You’re not wrong on what got us into the mess. I just disagree with
prescriptions for getting out of it and your idea of deflation as
being unavoidable. I get that you have this Austrian thing going on,
but I don’t buy into things I cannot model and which make it
impossible to prescribe to people. How in the world do you expect a
legislator to pass your prescriptions if you cannot even pass on some
element of empirical estimation of what it will produce?
I did a post a few days ago on the Austrian view, in reference to our
correspondence. Would love your comments (and I say this know you’ll
Ok, have to run. Good chatting.
Round 5: Ben ‘Rocky Balboa’ Rabidoux staggers to his feet….
I’m not sure what you mean that I don’t look at the data, but you’re right, I
don’t fully subscribe to any one model. I think I have adequately outlined the
factors that are currently driving the deflationary forces and also why they are
unavoidable (as an aside, you conveniently neglected to answer my
straightforward questions from my last email and instead focused on having me
articulate an economic model for you. Perhaps you would like to address those
questions in your reply). You can call my model the ‘Ben model of awesomeness’
if you will. You’re right that I would most closely align myself with the
Austrian model because that’s the one that seems to most resonate with the
current economic situation we find ourselves in. Now, if we can stimulate the
economy back to growth again and begin paying off the debt levels at the
personal and government levels in the next five years, then I will completely
admit that I was wrong and the Keynesian approach was the right one. But it’s
not going to happen.
As another interesting aside, many of the economists that you listed as having
predicted the housing bubble subscribe to very different economic models. Peter
Schiff is (gasp!) and Austrian economist while your Keynesian messiah Mr.
Krugman holds to a vastly different economic viewpoint. So who’s right going
forward? Whose model will you use and what gives you the confidence to know
that it’s right?
Now, if deflation is unavoidable, why are we still experiencing it? We’ve gone
through the greatest peace time deficit spending spree in history and managed to
double the Fed balance sheet in the past 18 months to accomplish nothing.
Surely you see the writing on the wall. The US is likely already back in
recession, and if not will be soon. So what has this approach accomplished?
What are you going to do next except ‘more of the same but bigger’? If that’s
not a silly approach, I’m not sure what is.
I will admit this to you; While I am fully convinced that deflationary forces
will reign until balance sheets and confidence is restored, past the next year
or two is very foggy. I know you would laugh this off as foolishness, but I do
fear that the ‘stimulate at all costs’ approach may set the stage for a
significant ‘inflationary’ event that is not driven by an expansion in the money
supply, but rather a complete revulsion of the American dollar and treasuries
and a flight to hard assets. So you may get your consumer price inflation, but
the economic impacts of such an event would be far greater than the bout of
deflation we are currently fighting. Impossible? Perhaps. We’ll see.
Round 6: J throws the left hook…
Households and businesses are hoarding cash – that is why we can have
massive public spending and no inflation. This is the paradox of
I know – Schiff is an Austrian. Point was to say lots of economists of
all groups predicted the crisis – Keynesians included.
Thought I did reply in my post. Truth be told, I read the e-mails on
the metro and I am sure I miss things from to time in what you write.
Finally, Keynesianism stimulus has worked. Read Zandi and Blinder’s
analysis – unemployment would have been 11.5 compared to 9.5 today.
This is where I said you are not given credit to the data – this is
the most comprehensive empirical assessment of the stimulus.
Love the Awesomeness name. 🙂
Wait a minute!
“Households and businesses are hoarding cash – that is why we can have massive
public spending and no inflation.”
Isn’t this exactly what I’ve been saying? I think I’ve shown why this ‘paradox
of thrift’ will be the more powerful force in the near future, regardless of
what the Fed does. So we agree here! Hallelujah we have a convert!
“Keynesianism stimulus has worked. Read Zandi and Blinder’s analysis –
unemployment would have been 11.5 compared to 9.5 today.”
Of course it’s ‘worked’. But what’s the end game? Do we maintain the stimulus
forever? You see what is happening now that the stimulus is running out. So
you’ve managed to create an artificial bump in economic activity that will
quickly reverse as soon as you stop stimulating. Now what? Let me guess:
‘Stimulate more….and make it bigger!’.
I did read the Zandi paper. the title alone should tell you all you need to know about the credibility of the report: “How We Ended The Great Recession”. Come on! Here’s Zandi just from today admitting that the odds of a ‘new’ recession are increasing and now
sit at ‘1 in 3’ in his estimation. These guys are clowns! Funny how their
story on the economy has changed while mine and the others who get the nature of
the debt deleveraging to come has stayed consistent. We’ll agree at some point,
but it will be after the official numbers confirm my long-standing story and
Zandi changes his story to look like mine
It just struck me: Why are we debating this when we could simply put it to a
gentlemen’s bet. I think we can both agree that the Fed and ‘Helicopter’ Ben
will do everything within their power to combat deflation. So, let’s pick a
measure of aggregate money supply (M3, MZM, AMS or M Prime -my favourite-, TMS)
and a time horizon out to 24 months and then wait and see. If we have a drop in
the money supply at that time, it would be safe to say that is was unavoidable.
I win. If there is any growth in that time, then clearly it was not
unavoidable. You win.
Now to the judges…..