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December 18, 2008
By Bud Conrad
Editor's Note--
Bud Conrad is the Chief Economist for
The Casey Report a
report started by one of the legends of the financial industry.
Almost thirty years ago I read Doug's best selling book "Crisis
Investing," which was the best selling financial
book in 1980. Doug has greatly influenced my thinking on
investing. Doug is
widely recognized for his skills in identifying high-return
investment opportunities.
Battle of the 'Flations
One of
the most hotly debated topics among financial talking heads
these days is, “Deflation or inflation, what is it going to be?”
There is no question
that we are currently experiencing asset price deflation and
economic slowing. But we, the editors of
The Casey Report,
see this as a transitional phase. In our analysis, the truly
extraordinary and historic levels of government spending and
bailouts being deployed to keep the economy afloat are certain
to lead to inflation in the not-too-distant future.
While
our long-term view remains solidly in the inflation camp, over
the past four months, the U.S.’s financial problems have caused
deflation in many important asset classes. Put another way, a
reduction in asset prices amounting to about $14 trillion (in
housing, equities, etc.) is bigger than the government’s
countervailing actions of around $3 trillion -- the total, so
far, arrived at by combining the measures taken by the Fed with
the federal government bailouts.
But
there are important differences between a sharp collapse in
asset prices and the potentially leveraged stimulus packages.
The
Fed’s actions, if taken in normal times, would be multiplied
throughout the banking system as banks used the new money to
increase their lending and, in so doing, leveraged the funds
throughout the entire economy. This time around, however, while
the Fed has been extremely accommodating to the banks, even
going so far as to make direct loans to them, the effect is
moderated. That’s because of tighter lending standards, the need
to replenish capital, and the demise of many complex structures,
which were previously available for securitizing and selling
loans on to others.
As a
result, the banking system as a whole is not responding to the
stimulus. It can be thought of as pushing on a string. Simply,
as large as the stimulus has been to date, it has not yet been
enough to offset the effects of the economic collapse. The
resulting deflationary pressure increases concern over a
downward spiral in the economy.
Another
way to view this is that consumers and businesses alike are now
anticipating deflation, which makes saving and survival the
primary goal (in an inflation, spending becomes the primary
goal, unloading the money before it can lose value). Of course,
a cutback in spending and demand drives down the price of
things, at least temporarily.
But the
longer-term expectation is that Bernanke’s assertion – an
assertion now backed up by action – that the government can and
will print new money to any extent needed is the more important
force.
As long
as there is evidence of serious economic collapse, it can be
expected that the bailout programs will be ratcheted up. And, to
the extent that the public expects deflation – and so businesses
reduce prices to raise cash and reduce inventories – the wave of
price inflation experienced in the spring of 2008 will be
moderated. But within the seeds of that positive are the very
big negatives that the government, seeing that its extraordinary
money creation is not being evidenced in rising prices, will be
emboldened to go even further.
This is
of great importance because, unlike in the 1930s, there is no
limitation on what the government can do, because there is no
gold standard to enforce monetary discipline. Instead, the world
is afloat on a sea of massive new government spending and credit
facilities. After a lag, the stimulus will perform the expected
actions of reinstating credit and debasing the currency. But
never lose sight of the fact that the government is creating
money out of thin air. Some call it bailouts, we would call it
legal counterfeiting on an epic scale.
In the
New Deal, FDR created the FDIC and guaranteed bank deposits, set
minimum bank deposit rates, and brought the discount rate to
almost 0%. He cut the dollar/gold exchange rate from $20.67 to
$35 and confiscated gold; i.e., devalued the dollar by 40%.
While
the beginning of the collapse from too much credit was parallel
to the previous experience of the depression, the response today
is different. The size of the monetary stimulus and the risk to
the dollar from foreign holders -- who can also see the
implications of the out-of-control deficits -- strongly argue
for a return to inflation much sooner.
How much
sooner? Impossible to say, but remember: deflationary or
inflationary fears are not the independent agent that will
determine whether or not we will see inflation (though, in the
intervening phase, they will certainly be an important economic
driver). The Federal Reserve is throwing everything it can at
the financial markets to fight deflation. As you can
see in the chart below,
the Fed has doubled the size of its balance sheet since
September.
On
December 16, the Fed cut interest rates to a range of between a
quarter of a point and zero. That is lower than ever in the 94
years of their existence. And they promised in the accompanying
announcement to provide additional funds to “stimulate the
economy through open market operations and other measures that
sustain the size of the Federal Reserve's balance sheet at a
high level… the Federal Reserve will purchase large quantities
of agency debt and mortgage-backed securities to provide support
to the mortgage and housing markets.”
At this
time individuals and companies alike are sensing deflation and,
as a result, are raising cash… in the process deleveraging the
extreme debt loads. That is causing downward pressure on asset
prices and, soon, a serious contraction in the economy as more
and more companies lay off workers and cancel spending. This
will not be a happy holiday season. And it will be a long-term
recession and maybe even a protracted depression.
But the
fact of the extraordinary deficit spending is there for all to
see and, over time, more and more will see it. And, more to the
point, understand it. In fact, thanks to the Internet and
always-there financial media, the shift in sentiment can happen
almost on a dime. Slowly at first, and then faster, fears over
inflation will return, but this time they will be well founded.
The
economic downturn could be protracted, but that does not mean
that the deflation will be protracted. Instead, once we are
through this phase, we expect to see poor economic conditions,
but against a backdrop of rising inflation. Stagflation is a
word that remains in our vocabulary.
Inflation or deflation – whatever the current market trend,
there is a way to play it. Every crisis contains opportunity as
well as danger… and many of those who manage to mitigate the
risk and grab the opportunity have made a fortune in times like
these.
Making the trend your
friend and riding the market “riptides” that can lead to
exceptional returns in the double, triple or even
quadruple digits is easier than you think… with a little
help from experts who have been correctly predicting – and
profiting from -- these riptides for years.
Learn more about "Riptides" here.
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