Is Deflation Always Bad?

OK...I can hear it now...what kind of question is that?  After all, widespread deflation occurred in the 1930s and look at that period.  More recently, Japan has been in a long-term stagnation deflationary period.  In the 1930s, prices fell and businesses couldn't sell their goods as consumers retrenched.  Consumers retrenched because businesses were laying people off.  An impasse resulted and the economy worsened - or so the story goes.  The stage was set for Keynesian prescriptions.

The only way out, according to today's predominant interpretation of history, was massive government spending via the buildup for WWII.  The forces of deflation had to be overcome!

This is taken as the bible by most economists, in particular those pulling the policy levers today.  The Bernanke/Geithner camp and a goodly part of the Federal Open Market Committee continually call for more stimulus and more quantitative easings.  A smugness has set in based on academic authority.

Could this be wrong?  Look again at the 1930s.  What role did the 1930s deflation play in getting  the economy going after WWII?   It, along with massive pent-up demand for truly wonderful products as the nation transformed itself to a peace time economy, surely was a factor.  In the 1920s, as the business sector boomed and the agricultural sector was in a depression, a new price structure was necessary.  This is what the deflation accomplished.

Closer to the present, what if the continual decline in the purchasing power of the dollar, i.e. inflation, had reached the point in 2003 where the economy needed a fall in the overall price level?  After all, housing prices were already rising robustly, along with college costs, medical costs, etc.

Maybe sometimes the price level (especially the way we measure it!) gets too high and needs to come down.  Furthermore, it is important to remember that price doesn't just fall because of inadequate demand.  There is also the supply impact and the spreading impact of competition.  Then and now, the spread of price information via the internet is unprecedented.  In short, the price search process has shortened significantly for many purchases from big ticket items down to the smaller items.

A Bit of History

After WWI, Great Britain tried to maintain an artificially high value of their currency.  A nation's exchange rate, of course, sets the prices of a nation's goods and services relative to the rest of the world. As a result of Britain's actions, resulting fundamentally from an excess of hubris, gold flowed out; and they begged the U.S. in the mid-1920s to lower interest rates.  The U.S. complied, and stocks roared (even while the agricultural sector suffered), setting the stage for the run-up to 10/1929.

There is a parallel with the 2003 Fed with Bernanke covering the country talking up the evils of deflation and pointing to Japan and their economic stagnation because they were not following sufficiently aggressive macro policies.  Chairman Greenspan bolstered this theme ,and the Fed pushed short-term interest rates down to 1% in mid-2003.  Just like in the late 1920s, stocks took off and hit an all time peak in 2007.  This, with an already strong housing and auto market and the 2003 action, poured gasoline on the fire.

As a result, the cost of housing dropped after the 2003 rate cut, even as the printed price rose!  Mortgage brokers got funds practically for free and, thereby, issued mortgages which required no down payment, options with no payment against principal, etc.  Adjustable rate mortgages ballooned (pun intended)  and the gold rush was on.  The 2003 rate cut was then followed by a sharp rate increase.  It was as if you bought a car for $14,000 and then surprise - the real price is $20,000!  Those who fell into this trap are sometimes among those blamed for the crisis!

Today, the problem may be that prices are too high; and the Fed is desperately trying to inflate the economy by pushing them higher.  It stays stuck on the belief that the only way to get consumers to spend is to scare them into thinking that prices will be higher tomorrow.

Here's some news:  a big part of the economy is in good shape.  Those who have a job see that they have exceptional opportunities in front of them.  Many are watching prices drop and are interested in taking advantage of the new price structure.  There is a lot of talk about the values now available in housing. This process needs to proceed which, in turn,  needs the Fed to get out of the way to let it work. Otherwise, the recovery process could take years if not decades.

Musings on Greece and Euro Zone's Problems

As for me, all I know is that I know nothing.  Socrates

On 9/11 last week, I spent much of the day, like many Americans,  watching footage of the terrorist attacks.  One of the things that really struck me more than it had in the past was the giving of advice by those supposedly "in the know" that cost thousands of lives.  People in the towers called 911 after the first plane hit and were told to stay put--that help was on the way.  Others were directed to go to the roof.  The people who supposedly knew how to respond to a crisis had no idea of what was taking place.  Yet they didn't hesitate to tell  people to stay in their offices as smoke and fire filled the room.  They said help was on the way.  Many times we assume that those in charge know what they are doing.  People in the World Trade Center towers did, and it cost them their lives.

Often times in the financial arena, observers believe those in charge know what's going on.  In 2006, we listened as Greenspan and Bernanke claimed the housing crisis wouldn't have a major macro economic impact.  Today, Sarkozy and Merkel and, for that matter, the world's central banks have center stage.

Added into this is the obvious fact that those in charge have to parrot the party line.  A good example comes from the world of sports.  Reporters corner players after a string of losses and ask them how the team is doing.  Their response is predictable.  They talk about taking the season one day at a time, practicing harder, being professional, blah, blah, blah.  They'll never say the truth--that in fact the team is freaking out and the players have lost confidence in the coaches and prima-donnas have destroyed team unity.

Speculative activity enhances volatility and compresses the time frame.  In 1992, Soros made a huge bet against the pound sterling and made over $1 billion when the devaluation occurred.  Today Soros wannabees have put on huge bets against the euro, as reported by the Commodity Futures Trading Commission.  A point to ponder is that today this speculative bet is considerably easier to put in place. Practically anyone can buy the  EUO exchange traded fund - the Proshares UltraShort exchange traded fund.  There has to be some undiscovered law in finance that says the probability of a major financial accident increases as the ability to make leveraged bets becomes more widely available.

Europe is losing dollars as U.S. money funds are moving funds out.  The dollar, of course, is the world's reserve currency; and it can be supplied by running the printing press.  This the Fed has committed to do along with other central banks in 3 liquidity operations.  Still, the major forecasters are predicting a fall in the euro through year end and into 2011.  Credit default swap rates are up sharply, and the yield on 2-year Greek debt climbed to 80% at one point.  The major confusion surrounds the impact of Greece potentially leaving the European Union.

The situation is similar to a family where most members are financially responsible but one consistently runs up the credit card and requires others to bail them out and refuses to become financially responsible. The responsible members have lent money to the problem member and can't decide if "toughlove" is appropriate or if continual bailout and hope is the right course.  Greece's debt is 140% of its economy.

On the truth-telling issue, it is extremely disconcerting when the leaders claim the $440 billion euro European Financial Stability Facility (EFSF) is large enough to buy debt as needed during the crisis when, in fact, every expert has said that this isn't the case. 

Adding insult to injury, economic growth in the Euro Zone is weakening.  Economic growth can solve a lot of problems.  Unfortunately, it isn't happening here.

Is This Another Great Depression?

John Maynard Keynes

The Dow is down 450 points, the S&P 500 is off 50 points, the 10-year Treasury note yield is close to 2%, and gold is up $31/oz.
 
As a long time observer of markets, I have studied and wondered about how it felt as the 1930s unfolded.  I 'm not claiming to be an expert on the Great Depression like our esteemed Federal Reserve Chairman, Ben Bernanke, but have read widely on the subject.

I find it ironic that Bernanke et al. find Federal Reserve policies  responsible for the duration as well as the magnitude of the 1930s economic downturn when, today, a well-supported argument is emerging pointing to the Greenspan/Bernanke Fed  playing a major role in today's debacle.  To wit:  look at today's inflation report and anemic employment number, both of which have been heavily affected by Fed policy.

It wasn't long ago that even the mention of the possibility of the U.S. entering a 1930s economic downturn was laughable.  The response was always a dimissive "we know too much today" in terms of economic policy to counter economic downturns.  Implication:  we are a lot smarter than they were in the 1930s!

The fact of the matter is that, at this point, just about everything, including the kitchen sink, has been thrown at the economy; and the response has been pitiful.

John Maynard Keynes, in the General Theory of Employment, Interest, and Money, famously painted the capital markets as a type of beauty pagent judging contest where the goal was to  guess which contestants others would think most attractive-thereby breaking down into an onion-peeling type situation.  Today all eyes are on governments.  What policies will they enact next?  What will be the outcome of the next press conference or Jackson Hole speech?  Investors are worrying about how other investors will react to government policies.  These events--in lieu of future earnings and other company and economic fundamentals.

Having said all this, I don't expect a serious double-dip type downturn and don't  believe a 1930s situation is unfolding.  Instead, I see this is as an opportunity with stocks offering exceptional dividend yields and growth prospects for those with a bit longer of an investment horizon.

Still, with politicians driving the bus, it is hard to hold onto confidence.  Be sure to keep your seat belt on!

Greek Default?

Pundits argue that a Greek default is inevitable. Even former Fed Chairman Alan Greenspan chipped in with his two cents last night, and he is one who should know fairly well what it takes to bring an economy to its knees.

Imagine taking a car loan out for $35,000 and and then losing your job. Your car is worth $25,000, the loan is outstanding, and you have no savings. Your peers tell you to cut back on job search expenses and are tired of lending you money. In fact, you owe your friends so much that they are vulnerable if you don't pay them back. This is the situation that Greece and the European Union is in.

Some say that loans would be a waste of time and money - instead just give Greece the money to solve its problems. But, then again, Greece isn't the only country in difficulty and the question is: where does it end. Unfortunately, these situations seem to have an underlying commonality - those who play by the rules and live within their means are expected to bail out and sacrifice to pay for those who live beyond their means.

Plenty of advice has been offered by the U.S. which, ironically, is traveling down the same road. Its municipalities (not to even mention the Federal Government) have over promised and many find themselves in dire straits.

Excellent background on all of this is offered by an interactive site at the New York Times which provides a neat picture of the European Union and the status of each country. The second slide at the site shows that both Italy and Greece have debt-to-GDP ratios exceeding 100%, but 7 of the other 27 members of the Union have debt loads exceeding 75%.

For investors, risk gets measured by interest rate spreads. In the European Union there are 6 countries, as shown on the 7th slide, whose debt pays more than 2% compared to Germany, the benchmark country. Greece's debt has a spread of 15%. The next riskiest is Ireland at 8.6%!

The big concern in all of this is, of course, the much-feared contagion effect. As Greece move closer to default, a major repricing of risk is taking place. The end result is anybody's guess, but chances are it won't be pretty.

Future Crises Not Likely to be as Bad as 2008

Treasury Secretary Geithner on Wednesday told Politico that, although there will be crises in the future, they won't be as bad as 2008.

On the one hand, this is good news. It implies that a 50% drop in stocks, like we saw in 2008 and early 2009,  is not likely.

On the other hand, it raises questions about the naivety of the Treasury Secretary. Does he not grasp the enormity of the Federal budget situation and the dysfunctionality of the U.S. political system. Has he ever asked himself what will happen if interest rates spike higher? Does he grasp the implications of a world where the leading economic power is communist and it is stealthily buying up natural resources around the globe? Does he not fully grasp that crises come in different forms?

His reasoning is that the regulators have the necessary authority from the Dodd–Frank Wall Street Reform and Consumer Protection Act to step in to nip a crisis in the bud.

But this isn't the way things generally work. Setting up a system to solve the last crisis doesn't prevent the next one. In the 1930s, FDIC was established to alleviate bank runs. Guess what? In 2008 we had potential bank runs in a different guise - runs on money market funds.

Treasury Secretary Geithner's demeanor and overall guidance on the debt limit situation could, in fact, set off the next crisis. His "oh well, we've reached the limit but I have tricks I can pull to keep the government running" is just forestalling the necessary increase.  It is giving unwarranted comfort to people that we have time to solve the problem.

Instead, he should be out front with names of people who will be fully responsible for setting up a flight from Treasuries if  it reaches that point. He should emphasize that the American people do not deserve to have the global financial system tested because of outsized political egos. He should be emphasizing that an interest rate spike is possible if we come to close to the point of default.

 In 2006, Greenspan and Bernanke said the housing market weakness was not a serious macroeconomic problem. Today Treasury Secretary Geithner says future crises will be less bad.

I hope he's right!