The deflationary bust

Looking around "Financial Sense"...

Professor Antal E. Fekete revisits his deflationary theory: we have passed a crucial point in debt accumulation. From now (actually, from 2006, he says) onward, the more politicians attempt to stimulate it with debt, the faster the economy will shrink. Gold, the machine's "governor" that set limits to debt, was decoupled from the system a century ago - it got in the way of war financing.

Stephen Tetreault says if there's a rise in stocks, sell: "I do not see a positive bullish catalyst in the making as we head into the earnings sector other than a potential short squeeze, relief rally that should which should be sold into." He notes that deflation means those that can, are paying down debt, but also lenders are widening the margins between the interest they pay and the interest they charge, which gives further impetus to deflation.

Tony Allison says, sooner or later energy is going to cost more. He's thinking about the right point to speculate, the rest of us should consider the effect of higher energy costs on family budgets, and therefore on how reduced disposable income will be allocated.

Captain Hook foresees a time when "the public finally gives up the ghost on stocks in general, correspondingly they will fully embrace the likelihood of deflation, which will trigger a temporary collapse in commodity prices, led by their paper representations." He thinks this will be the time when physical gold will win; I wonder whether that is so, when most of us are so dependent on an electronic system. We're not farmers, selling corn and cattle to each other; the machine cannot be allowed to stop. That's why I think there will be, for a time, a switch to currency inflation; then perhaps a rerun of the early Eighties, as someone public-spirited in public life takes unpopular action to prevent the dive into the abyss.

For E. M. Forster's extraordinarily accurate vision of the future, written in 1909, please click the last link above. Telephone, TV, a populace paralysed by lethargy and wealth in its bedrooms...

More on bonds, and an alternative view

Antal E. Fekete is a professor of money and banking in San Francisco (such a beautiful place, too). He has a pet thesis about the bond market, which is that every time interest rates halve, effectively the capital value of (older) bonds doubles, to match the yield on new bonds.

So as long as we expect the government to try to stimulate the economy by lowering interest rates, there's a killing to be made in the bond market. Theoretically this could go on forever, even in a low-interest environment - the logic holds if rates go from 0.25% to 0.125% - provided the Treasury doesn't simply go straight to zero interest, of course.

Anyhow, his latest essay says that the monetary stimulus will simply be used to settle debts, since debt gets more and more burdensome in a deflationary depression; and settling debt instead of making and buying more stuff, continues to drive deflation. In this enviroment, few businesses will want to take on more debt (certain and fixed) in the hope of increasing their profits (far from certain, and very variable). On a national level, and following the ideas of Melchior Palyi, he now sees every extra dollar of debt as causing GDP to contract.

Therefore, valuations of most assets will continue to decline - except for bonds, which are now the focus for speculators. To this extent, he agrees with Marc Faber (cited in the previous post): we now have a bubble in government bonds.

But something will go bang. The real world shies from the inevitable conclusions of mathematical models. I think it will come as a crisis in foreigners' confidence in the dollar - there will be a reluctance to buy US Treasuries (we've already seen failed sales of government bonds in the UK recently, and when the next one succeeded, that's because it was a sale of index-linked bonds). Even now, the Chinese have switched from Agencies (debts of States and municipal organisations) to Federal debt, and within the latter, from longer-dated bonds to shorter-dated ones. If government debt was an aircraft, the Chinese would be the passenger insisting on a seat next the emergency exit near the tailplane.

To use a different analogy (one I've used before), drawn from the Lord of the Rings, the rally in the dollar and the flight to US Treasury debt seems to me like the retreat to the fortress of Helm's Deep: a last-ditch defence, doomed to be overwhelmed. Can we see a little figure about to save the day by dropping the Ring of Power into the lava in Mount Doom? We can hope; but you don't make survival plans based purely on optimism.

I therefore expect a transition from deflationary depression to inflationary depression, at some point. Perhaps a sort of 1974 stockmarket moment: an apparent turnaround, which when analysed can be shown to continue the real loss of value for some years. Only when national budgets are brought under strict control, will there be the environment for true growth. I don't see a willingness to tackle that, on either side the Atlantic, so disaster will have to be our teacher.

Bonds: up or down?

Where's safe for your money? It's like a minefield: we seem to be zig-zag running between financial explosions. Housing? Overpriced, full of bad debt. The stockmarket? Due to drop when earnings revert to the mean. The commodity market? Distorted by speculation and manipulation.

How about bonds? Clive Maund thinks US Treasuries are due for a pasting as yields rise to factor-in inflation; but Karl Denning is still firmly of the DE-flation persuasion and thinks a stockmarket fall may be our saviour:

The Bond Market no likey what's going on. The 10 is threatening to break out of a bullish (for rates) flag, which presages a potential 4.20% 10 year rate. This will instantaneously translate into higher mortgage and other "long money" rates, destroying what's left of the housing industry.

There is only one way to prevent this, and that's for the stock market to blow up so that people run like hell into bonds, pushing yields down!

He also gives his own theory as to why the Fed stopped reporting M3 money supply rates:

The moonbats claim that The Fed discontinued M3 because they're trying to hide something. In fact they discontinued M3 because it didn't tell you the truth; it was simply NOT capturing any of the "shadow" credit creation caused by all the fraud (and undercapitalized "insurance" which, in fact, is worth zero), but it sure is capturing the forcible repatriation into bank balance sheets when there is no other when it comes to access to capital for companies and governments.

So, two elephants are riding the bond seesaw: fear of inflation, and fear of losing one's capital. I hope the plank doesn't snap. Antal Fekete reckons the bond market can take all the money you can throw at it - but what goes up will come down.

Cash still doesn't seem like such a bad thing, to me.

Will monetary inflation be absorbed by the bond market?

In the previous post, I looked at the expectation that interest rates will rise. But it seems that freaky things can happen if the government tries to stimulate the economy by progressively cutting interest rates and pumping more money into the system.

Professor Antal E Fekete thinks that in a deflationary environment, governmental attempts to reflate by introducing more money will be thwarted by the ability of the bond market to soak up the excess liquidity. Higher bond yields result in lower bond valuations, so reducing interest rates inflates the price of bonds. Fekete says that halving the rate doubles the bond price, and since mathematically you can halve a number indefinitely, the bond market can absorb all the fiat money you can create. Therefore, you can have hyperinflation and economic depression at the same time.

This trap is possible because the abandonment of the gold-and-silver standard means that the dollar has no limit to its expansion. And bond speculators have their risk covered by the need of the government to return to the market for renewed borrowing. If the Professor is right, it would be a nasty trap indeed.

But maybe our conclusion should be that this explains why interest rates must rise.

A quibble on style: especially in England, money is regarded as dull. So financial commentators try hard to add flavour, and in the Professor's case, too hard - it has been difficult for me to detect the meat of the argument under its many-spiced similes. Byron's Don Juan comes to mind:

And Coleridge, too, has lately taken wing,
But like a hawk encumber'd with his hood,
Explaining Metaphysics to the nation--
I wish he would explain his Explanation.

From copper nickel to gold dollar?

A lovely, cheeky idea from Antal E. Fekete in SafeHaven: have the Indian reservations switch from running casinos to minting gold coins, to rescue the integrity of the currency. Maybe PC considerations would inhibit a Liberty-Dollar-type Federal raid.

Interesting also that he echoes my "twang money" idea:

Thanksgiving 2007 is special because we are just re-learning the ancient lesson that no banking system can safely operate without gold. You cannot measure the quality and quantity of debt in terms of another, just as you cannot measure the length of an elastic band in terms of another.