My Two Cents - "Clash of the Titans "

 

11/17/2006

Much has been made recently about the anticipated gridlock that resulted from last week's elections. However, that is not the only battle raging behind closed doors. More recently, and more importantly, another epic battle has ensued out of the public eye, the results of which will determine American prosperity and standard of living for many years to come.

While much cheerleading has gone on about the seemingly sudden disinflation condition in the economy, particularly a monumental drop in producer prices last month, it is becoming more and more clear that an alarming divergence is beginning to form between inflationary and deflationary forces. I have long been vocal on the position that the powers that be cannot and will not tolerate a deflationary recession/depression. However, a trend is beginning to form: various economic measures seem to be pointing in the direction of disinflation/deflation while current government policy and action point 180 degrees in the opposite direction. It is my belief that these recent developments will go a long way towards determining the 5-7 year macroeconomic trend.

The case for deflation...

Clearly, there are several classes of products in which the prices have been falling and continue to do so. Homes, many commodities and energy stand out in particular. In the chart below, note that the CRB Index is at a critical juncture, leaning heavily on the 50 day moving average. Clearly, the near-term trend is in the downward direction as is outlined by the 200-day moving average:

Look at the continuous contract for Unleaded Gasoline and you will see a similar pattern. There was rampant speculation that the price of gasoline came under political pressure, but again, note that price is leaning against support in the form of the 50 day moving average and is well under the falling 200-day MA:

Unleaded Gasoline - Continuous Contract

To add to matters, the price of homes has been coming under recent pressure as inventories have built up, and buyers have stepped to the sidelines. There is a good deal of evidence pointing to the likelihood that not only are we not through with the downside in housing, but that it has yet to begin (despite what David Lereah thinks). The chart below shows that an important trendline has clearly been broken with regards to home prices. I feel that the next few months will tell the tale and we'll find out which way this is going to break.

Median US Home Prices

The case for inflation...

To understand the case for inflation, one only needs to look at the real value of our national debt and the overall mindset of the American government. Given the direction our economy is heading, it is very likely that the national debt will continue to grow larger and sometime next year, Congress will have to grant itself an even bigger credit card limit. This happens because governments, particularly ours like to spend more than they receive on vote-gathering programs and the like. In the case of smaller countries, this behavior usually results in hyperinflation because the central bank is forced to get the extra money by printing since it lacks the capacity to borrow. In our case, we have the ability to borrow huge sums of money because foreigners want dollars to buy oil and other products. Our reserve currency status enables this debt accumulation to continue in extremis. Were the dollar to lose that preferred status, the loans would dry up; and quickly.

Were the government actually inclined to pay off the national debt, it would make much more sense to pay off the $9 trillion in dollars that aren't worth as much, thereby reducing the real value of the debt. Inflation benefits debtors whereas deflation benefits creditors. Since the US government can control the downward value of the dollar (by printing), it can create a situation where it can clandestinely default on a significant portion of the national debt.

In a deflationary setting, however, the opposite would be true. The government would be forced to pay back the loan in dollars that were worth more, thereby increasing the real value of the debt. The problem is that the government has no honest dollars with which to do this. It is insolvent. Any dollars it has it gets by printing or more borrowing. Even our tax dollars do it little good as a substantial portion goes towards servicing the national debt.

Clearly, it is fairly simple to make a case for price deflation. However, for REAL deflation to occur, an actual contraction in the money stock must occur. Money and credit would need to be destroyed as opposed to maintained, or even worse, created. Keep in mind that the Fed will do whatever it can up to and including dropping money from helicopters to keep real deflation from setting in. For the aforementioned reasons, the government simply cannot afford genuine deflation.

Consumers have been trained to hate deflation because it is always explained in terms of falling home and stock prices. Conversely, they have been trained to love inflation, again because it is expressed in terms of rising home and stock prices. From a consumer's standpoint, deflation would not be a bad thing; the dollars in their pocket would buy more. Sure, the TollBrothers-built ATM wouldn't exist anymore, but they wouldn't NEED all that extra money if their dollars were worth more.

As we navigate this critical juncture, the two titans slug it out on the American financial landscape. Deflation vs. Helicopter Ben. Let's just hope that this time Ben can't afford to fill his helicopters with gas.

Until Next Time,
Andy

 

Graham Mehl is a pseudonym. He is not an ‘insider’. He is required to use a pseudonym by the policies of his firm when releasing written work for public consumption. Although not an insider, he is astonishingly bright, having received an MBA with highest honors from the Wharton Business School at the University of Pennsylvania. He has also worked as an analyst for hedge funds and one G7 level central bank.


Andy Sutton is a research and freelance Economist. He received international honors for his work in economics at the graduate level and currently teaches high school business. Among his current research work is identifying the line in the sand where economies crumble due to extraneous debt through the use of economic modelling. His focus is also educating young people about the science of Economics using an evidence-based approach.