The deflation time bomb
By Mike Whitney
Online Journal Contributing Writer
Jan 14, 2008, 01:03
"Is there anyone who still does
not understand that talk of 'inflation' by officialdom is just a red herring
intended to distract us from the far more dangerous dragon of deflation?"
--Mike Shedlock; Mish's Global Economic Trend Analysis
We are to about see how much George Bush really believes the
�supply side� mumbo-jumbo he's been spouting for the last seven years.
Last week's Labor Department report confirmed that unemployment
is on the rise (5 percent) and that corrective action will be required to avoid
a long and painful recession.
There's a good chance that the Chameleon in Chief will
jettison his �trickle down� doctrine for more conventional Keynesian remedies
like slashing interest rates, government programs, and tax relief to middle and
low-income people. Last Monday, Bush announced that his team of economic
advisors was patching together an �Economic Stimulus Package� that will be
unveiled later this month in the State of the Union Speech. The goal is to
rev-up sagging consumer spending and slow down business contraction.
Ironically, the UK Telegraph dubbed the stimulus plan Bush's �New Deal.� It's a
shocking about-face for a president that has been clobbering the middle class
since he took office and who balks at even providing temporary shelter for
disaster victims. Now Bush is going to have to give away the farm just to keep
the economy from crashing. Good luck. Clearly, the prospect of a system-wide
meltdown in banking, real estate and equities has become a "Road to
Damascus" moment for lame-duck George.
The uptick in unemployment is just the final part of an
otherwise bleak economic picture. Manufacturing is hurting too. The December
ISM Manufacturing Index plunged to 47.7, its lowest level in five years. The
news put the stock market into a 200-plus nosedive and sent gold soaring over
$800 per ounce. Since then, the news has gotten progressively worse. The market
fell another 200-plus points on the Labor Dept's repor, followed by 238 point
jolt last Tuesday on rumors of (potential) bankruptcy at mortgage lending
giant, Countrywide Financial, and a 2.6 percent plunge in pending housing sales
from the National Association of Realtors. By the time ATT announced its fears
of �reduced consumer spending� the market was already barrel-rolling towards
earth in a sheet of flames.
The Dow Jones is now 10 percent off its yearly high, the
official sign of a correction. More important, equities blew through their
support levels indicating a basic change in the market's trajectory. It's a
primary bear market now and any rebound will be temporary. There's still a lot
of fat to be trimmed before overvalued stocks return to the mean. No wonder
Bush is nervous.
The constant rate cuts and geopolitical jitters have sent
gold skyrocketing. Since August 2007, gold has gone from $650 per ounce to $887
-- a whopping $237 in just five months. If that is not a indictment of the
Federal Reserve and their �loosey-goosey� monetary policy; then what is?
According to the Wall Street Journal �gold and oil have run almost in perfect
tandem. The price of gold has risen 239 percent since 2001, while the price of
oil has risen 267 percent. That means if the dollar had remained as 'good as
gold' since 2001, oil today would be selling at about $30 a barrel, not $99.�
That's right; the price of gas today is attributable to war,
tax cuts and the relentless expansion of credit by the Federal Reserve -- NOT
Escalating energy prices are increasing the cost of food
production which creates a self-reinforcing inflationary cycle. Additional rate
cuts will only weaken the dollar further and put an even greater burden on
Before he left on his �Victory Tour� of the Middle East,
Bush said, "When Congress comes back, I look forward to working with them,
to deal with the economic realities of the moment and to assure the American
people that we will do everything we can to make sure we remain a prosperous country."
The economic realities that Bush will be facing are the
anticipated �hard landing� from a nationwide housing slump coupled with a
credit crunch that is strangling the banking and financial industries. The
country is lurching recklessly into a deflationary death-spiral while Bush
makes a pointless junket to the scene of his biggest foreign policy flop. What
a joke. When he returns, Bush will find that he is constrained in his
�stimulus� plan due to massive fiscal deficits which are the result of the enormous
tax cuts and gluttonous military budget.
�This isn't like 2000 when the US was running a large fiscal
surplus of $300 billion or 2.5 percent GDP,� said economist Nouriel Roubini.
�Now that all the fiscal stimulus bullets have been spent on the most reckless
and unsustainable tax cuts in history -- the administration is left with very
little room [to maneuver] in bad times . . . We are now stuck in a situation
where the room for any meaningful fiscal stimulus . . . is gone. . . . We did
indeed waste all our macro policy bullets in 2001-2004 in 'the best recovery
that money can buy' and now we are left with relatively limited room for
monetary and fiscal policy stimulus. This is one of the main reasons why the
recession of 2008 will be more severe and protracted than the mild 2001
recession.� [Nouriel Roubini's Global EconoMonitor]
Still, there will be a stimulus package -- however meager --
and there'll also be more rate cuts by the Fed. That means that gold and oil
will continue to soar and the dollar will continue to get hammered. Bernanke's
options are limited; as are Bush's. The system is grinding to a halt and the
Fed chief will have to use the tools at his disposal to try to stimulate
economic activity. It won't be easy. Presently, he faces a number of
challenges. Home prices are falling, retail spending is off, commercial real
estate is in a sharp downturn, and many of the major investment banks are
capital impaired from their poor investments in mortgage-backed bonds. If the
Fed's "low interest" smelling salts don't revive the comatose
American consumer -- and get the cash registers at Target and Billy McHale's
ringing again -- the world will face a global slowdown. That's why the Fed
Funds' rate will probably get hacked by 50 basis points by month's end and
Comrade Bush's economic team will concoct a fiscal bailout plan worthy of Fidel
Are we there, yet?
A growing number of market analysts believe we're already in
recession. David Rosenberg of Merrill Lynch put it like this: "According
to our analysis, this [recession] isn't even a forecast any more but is a
present day reality."
Rosenberg argues that a weakening employment picture and
declining retail sales signal the economy has tipped into its first month of
recession. . . ."Mr. Rosenberg points to a whole batch of negative data to
support his analysis, including the four key barometers used by the National
Bureau of Economic Research (NEBR) -- employment, real personal income,
industrial production, and real sales activity in retail and manufacturing.�
Whether one chooses to call it a recession or not is
irrelevant. When the two behemoth asset-classes -- real estate and securities
-- begin to cave in, there's bound to be some ugly fallout. Housing stayed
strong during the dot.com bust. Not this time. No way. The whole system is
keeling over and it could take the bond market along with it. As the two
gigantic equity bubbles lose gas; consumer spending will stall, business
activity will slow, more workers will get laid off, and prices will tumble.
Equities and commodities will be hit hard (even gold) and housing prices will
dive to new lows as the pool of potential buyers grows smaller and smaller.
These problems will be further aggravated by the lack of
personal savings and the huge debt-load which will push increasing numbers of
homeowners, credit card customers, even student loan recipients into default.
By 2009, bankruptcy will be the fastest growing fad in American pop-culture.
Many experts are now predicting that home prices will dip 30
percent by the end of 2008. That means that nearly 20 million homeowners will
be �upside-down,� that is, they will owe more on their mortgage than the
current value of the house. (Imagine owing $400,000 on a home that is currently
worth $325,000!) 40 percent of all homeowners in the US will be upside-down by
the end of next year. This is a grave systemic problem that will have
widespread implications. Experts already know that when mortgage holders have
�negative equity� they are much more inclined to put their keys in the mailbox
and skip town. Hence, the name for this increasingly common practice -- �jingle
Secretary of the Treasury Henry Paulson is desperately
trying to put together a national �rate freeze� to avoid, what could be, the
most devastating surge of foreclosures the world has ever seen. Paulson's rate
freeze does not offer �New Hope� as promised but, rather, a lifetime of
servitude paying off an asset of ever-decreasing value. Underwater homeowners
are better off taking the hit to their credit and letting the bank repo the
house. Let the bank worry about it. They created this mess.
The housing bubble is deflating faster than anyone had
anticipated. Overall sales have slipped more than 40 percent from their peak in
2005, whereas prices have gone down a mere 6.5 percent. Prices, which are a
lagging indicator, have a lot further to drop before they touch bottom. Robert
Schiller, Professor of Economics at Yale University and author of �Irrational
Exuberance,� predicted that there was a very real possibility that the US would
be plunged into a Japan-style slump, with house prices declining for years.
Professor Shiller, co-founder of the respected S&P
Case/Shiller house-price index, said, �American real estate values have already
lost around $1 trillion [�503 billion]. That could easily increase threefold
over the next few years. This is a much bigger issue than sub-prime. We are
talking trillions of dollars� worth of losses.� [Times Online]
Schiller's on the right track, but his estimates are way too
conservative. After all, in 2002, the median price of a single-family home in
Los Angeles was $270,000. But, by 2006, the cost of that same house had doubled
to $540,000 -- �pushed by unbridled speculation fueled by unparalleled access
to mortgage capital.� [LA Times] The problem was cheap credit that was readily
available to anyone who could fog a mirror. All that has changed. The banks
have tightened up their lending standards, and jumbo loans (loans over $417,000)
are nearly impossible to get. So, why doesn't Schiller believe that prices will
return to 2002 levels? They will. And they'll go even lower; much lower. In
fact, real estate is quickly becoming the leper at the birthday party; everyone
is staying away. That means that prices will fall -- and more rapidly than
anyone imagined. The word is out on housing and it's not good. The blood is in
the water. Get out before the pool of mortgage applicants dries up entirely.
The US banking industry has never faced greater challenges
than it does today. Many of America's largest and most prestigious investment
banks are seriously under-capitalized and buried beneath hundreds of billions
of dollars in complex, structured investments that are being downgraded on a
weekly basis. On top of that, many of the banks main sources of revenue have
vanished as investor interest in sophisticated mortgage-backed bonds and
derivatives has disappeared altogether. For example, the sales of
collateralized debt obligations (CDOs) �plunged 85 percent to $15.69 billion in
the fourth quarter.� Also, �The value of Alt-A mortgages . . . issued in the
third quarter fell 64 percent to $39.3 billion from the second quarter�s record
high of $109.5 billion . . . S&P said the dramatic drop is the result of
�unprecedented credit and liquidity disruptions� for both borrowers and
lenders.� [Dow Jones] These are steep declines and represent a serious loss of
revenue from the banks' bottom lines.
Many of the banks are simply in �survival mode� trying to
conceal the magnitude of their losses from their shareholders while attempting
to attract capital from overseas investors to shore up their sagging
collateral. [via Sovereign Wealth Funds]
The banks are now struggling to fulfill their function as
the main conduit for providing credit to consumers and businesses. They have
curtailed their lending as their capital base has steadily eroded through
persistent downgrading. The Federal Reserve has tried to resolve this issue by
opening a Temporary Auction Facility (TAF), which allows the banks to secretly
borrow billions from the Fed without the embarrassment of disclosing the
transaction to the public. The banks are also free to use mortgage-backed
securities (MBS) and commercial paper (CP) as collateral for securing the Fed
repos. It's a sweetheart deal and more than 100 financial institutions have
already taken advantage of the Fed's largesse.
This is a bad sign. It indicates that the banks are
seriously overextended, �capital impaired,� and need a handout from the Central
Bank to keep from defaulting. It means that the vaults are stuffed with
worthless mortgage-backed slop that they are deliberately hiding from their
shareholders and depositors. If there were adequate regulation, then the banks
would never have been allowed to dabble in such risky debt-instruments as
subprime loans and toxic CDOs. The whole catastrophe could have been avoided.
Instead, hundreds of billions of dollars will be wiped out, a number of banks
will fail, and public confidence in their institutions will be shattered.
Last week, the Federal Reserve announced that it �will
increase the size of two scheduled auctions of emergency loans by 50 percent to
$30 billion as part of a global attempt by central bankers to restore faith in
the money markets.� [AP] In other words, the Fed will provide an even bigger
begging bowl to prop up the banks to maintain the appearance of solvency. It is
an utter sham.
Inflation vs. deflation
The size and scale of the approaching recession is
impossible to forecast. The real estate and stock markets will undoubtedly see
trillions of dollars in losses, but what about the estimated $300 trillion
dollars of derivatives, credit default swaps and other abstruse counterparty
options? Will the global economy freeze up when that ocean of cyber-capital
suddenly evaporates? Will that virtual wealth simply vanish into the ether when
the underlying assets (CDOs, MBSes, ABCP) are downgraded to pennies on the
dollar, or when the number of home foreclosures catapults into the millions, or
when the dollar slips to a fraction of its current value? No one really knows.
But Atlanta Fed President Dennis Lockhart summarized what we
can expect in a speech he gave last week, titled �The Economy in 2008.� He
said, �A sober assessment of risks must take account of the possibility of
protracted financial market instability together with weakening housing prices,
volatile and high energy prices, continued dollar depreciation, and elevated
What the upcoming recession �will look like� has been the
topic of a fierce debate on the Internet. Everyone seems to agree that this is
not a typical economic downturn resulting from overproduction,
under-consumption or malinvestment.
Rather, it is the crashing of humongous equity bubbles that were generated by
the Fed's abusive expansion of credit and the unprecedented proliferation of
opaque structured-debt instruments. Many believe that the unwinding of these
bubbles will trigger a round of hyperinflation, which is already evident in
soaring food, energy and health care costs. These prices are bound to increase
substantially as the Fed continues to cut rates and further undermine the
But the real issue (it seems to me) is the unfathomable loss
of market capitalization, the growing insolvency of maxed-out consumers, and
the inability of the banks to freely extend credit to responsible loan
applicants. These three things are likely to drag down all asset-classes, slow
business activity to a crawl, and compel consumers to hoard rather than spend.
The dollar will strengthen in a deflationary environment. (if that is any
Paul L. Kasriel, Sr. V.P. and Director of Economic Research
at The Northern Trust Company, answers some typical questions about deflation
in a recent interview with economic guru Mike Shedlock (Mish).
Mish: Would you say that consumer debt in the US as opposed
to the lack of consumer debt in Japan increases the deflationary pressures on
the US economy?
Kasriel: Yes, absolutely. The latest figures that I have
show that banks' exposure to the mortgage market is at 62 percent of their
total earnings assets, an all time high. If a prolonged housing bust ensues,
banks could be in big trouble.
Mish: What if Bernanke cuts interest rates to 1 percent?
Kasriel: In a sustained housing bust that causes banks to
take a big hit to their capital it simply will not matter. This is essentially
what happened recently in Japan and also in the US during the Great Depression.
Mish: Can you elaborate?
Kasriel: Most people are not aware of actions the Fed took
during the Great Depression. Bernanke claims that the Fed did not act strong
enough during the Great Depression. This is simply not true. The Fed slashed
interest rates and injected huge sums of base money but it did no good. More
recently, Japan did the same thing. It also did no good. If default rates get
high enough, banks will simply be unwilling to lend which will severely limit
money and credit creation.
Mish: How does inflation start and end?
Kasriel: Inflation starts with expansion of money and
credit. Inflation ends when the central bank is no longer able or willing to
extend credit and/or when consumers and businesses are no longer willing to
borrow because further expansion and/or speculation no longer makes any
Mish: So when does it all end?
Kasriel: That is extremely difficult to project. If the
current housing recession were to turn into a housing depression, leading to
massive mortgage defaults, it could end. Alternatively, if there were a run on
the dollar in the foreign exchange market, price inflation could spike up and
the Fed would have no choice but to raise interest rates aggressively. Given
the record leverage in the U.S. economy, the rise in interest rates would
prompt large-scale bankruptcies. These are the two "checkmate"
scenarios that come to mind. (Read
the whole interview.)
Summary: When banks don't lend and consumers don't borrow;
the economy crashes. End of story. The whole system is predicated on the
prudent use of credit. That system is now in terminal distress. Everyone to the
Perhaps the whole �inflation-deflation� debate is academic.
The real issue is the length and severity of the impending recession. That's
what we really want to know. And how many people will needlessly suffer.
Whitney lives in Washington state. He can be reached at firstname.lastname@example.org.
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