1-Jul-10 News -- World economy in deflationary spiral

[John]

Dear Vince,

> John, I buy your theory, I agree with the vast majority of what
> you write and find it interesting and insightful. I am a fan. But
> I wish you would not say things like, "This is a mathematical
> certainty." If Obama makes the Fed send everyone in the US a check
> for $50,000 then the Dow will never see 3000 again. It could
> happen. People in the US are far too tolerant of crooks running
> public companies and stealing investors money, so I think they
> will get a crash to sort of correct this character flaw in the
> coming generations. But it really makes me uncomfortable when you
> say a particular number for a stock index is a mathematical
> certainty. I don't buy that. Maybe they will send out checks to
> prop it up for a few more years and the crash will be from 20,000
> to 5,000. I think the crash is soon, and 3000 is plausible, but
> talking about the future with such certainty seems wrong.

Over the years, I've experimented with various wordings. I try to use
specific words and phrases to indicate the probability that something
will actually occur.

So, for example, when I say that "my expectation is that Iran will
side with the West in the Clash of Civilizations world war," the use
"my expectation" is meant to signal that it's a personal opinion,
though still advised by Generational Dynamics theory.

As for whether there'll be a stock market crash, there's really no
realistic doubt about it, and that's what I want to convey with the
words I use. It follows mathematically from the Law of Mean
Reversion. Of course if the sun explodes, then there won't be a stock
market crash. But I want to convey to web site readers that if they
stay in the stock market then they're going to lose everything, and
"it's a mathematical certainty" is the best way to convey that
concept.

John

[Higgenbotham]

Everyone can see that if people could make unlimited amounts of gold the value of each ounce of gold would go down. How could dollars be any different?
[...]
But surely the laws of supply and demand apply to dollars also? If you increase the supply the price or value will go down?

Is there anything besides dollars that you think supply and demand don't work for? Where increasing the supply significantly would not lower the value for each unit?

Generally, goods are assumed to not be defective and can get to where the demand is, so the law of supply and demand applies. Dollars aren't like that. [...]

You are arguing that some things counted as money in some measures froze up and so were not good money. But even this does not put any limit on the amount of fresh new good money that the Fed could print.

How is paper money fundamentally different from being under a gold standard with the US government having a magic machine that can make an infinite amount of gold?

In either case, a gold standard with a magic machine or a paper money with a printing press, the money only keeps its value if the government does not make too much of it. If they sent every person in the US 1,000 oz of gold in the first case, or they sent everyone $1 mil in paper money in the second case, the result would be inflation. A printing press in paper money is the same as a magic gold making machine in a gold standard. The only thing holding back the supply of money is government discipline, which is not so very good really.

This last paragraph you wrote is the same thing Indyboy was saying. It would be true if the US were a closed system like Zimbabwe, as John has explained, with no credit market and no use of dollars outside our borders. However, the US is not a closed system and cannot control what political leaders or economic actors in the rest of the world do in response. That relates back to some of the items on my initial list such as international trade lockup and political realities.

Gold is fundamentally different from dollars because increasing the gold supply cannot change the value of the gold created relative to the already existing gold. As I stated above, increasing the dollar supply can have instantaneous effects in already existing dollars. It can wipe out dollars that are part and parcel of the economic system (the examples I gave of the ABCP and muni bond markets as just two classes of dollars). The Fed cannot recreate classes of money that have specific economic functions with a printing press, no matter how hard they try or how much they want to believe it is possible.

As far as what Bernanke can do, he can print enough dollars to destroy the entire credit market and cause our trading partners to reject dollars and replace them with another currency. In the process of doing that, he can also turn the US into a basket case third world equivalent economy with no mortgage market, no bond market, no means for conducting international trade, etc. Once that process is complete then he can create Zimbabwe style inflation to his heart's content. But I don't think political realities will allow him to complete the mission he promised in the helicopter drop speech.

[Higgenbotham]

Bernanke saying he can create positive inflation by creating electronic dollars is equivalent to Bernanke saying the following:

I have discovered a new way to increase the population. I have a machine that can create an infinite amount of men. That will cause the population to go up. Now I am going to double the supply of men and see what happens. If, two years later, the population is going down again, I will not ask why. I will make a plan to double the supply of men again.

[vincecate]

Everyone can see that if people could make unlimited amounts of gold the value of each ounce of gold would go down. How could dollars be any different?

This last paragraph you wrote is the same thing Indyboy was saying. It would be true if the US were a closed system like Zimbabwe, as John has explained, with no credit market and no use of dollars outside our borders. However, the US is not a closed system and cannot control what political leaders or economic actors in the rest of the world do in response.

But the whole world is a closed system for dollars. That the world is bigger than Zimbabwe does not matter. If you double the number of dollars in the world the value of each is going to go down.

[Guest]

But the whole world is a closed system for dollars. That the world is bigger than Zimbabwe does not matter. If you double the number of dollars in the world the value of each is going to go down.

The world has hundreds of currency alternatives to dollars, whereas inside the borders of the US and Zimbabwe, unlike the rest of the world, the particular currencies of those 2 countries are legal tender and there are no alternatives. Any political entity outside the US borders can reject payment in dollars at any time and the US cannot force the use of dollars on other political entities, whereas an entity inside the US border cannot legally conduct business in anything except US dollars. Several countries have recently refused to accept US dollars. I believe Iran recently required Japan to pay for oil in Euros. Since dollars have a multi-faceted nature, the value of the dollar is subject to feedback loops and nonlinearities due to man's free will and is not a simple inverse function of quantity (as in value equals a constant divided by the quantity).

And, like I've been saying, any dollars created need to have a functional use or they sit idle. This gets into the money velocity issue cited in the intial list. The Fed cannot recreate a muni or corporate bond market that has been locked up due to illiquidity.

[Higgenbotham]

If the value of the dollar were a simple inverse function given by

value is equal to a constant divided by the quantity

and the determination of quantity were a simple fact as Bernanke claims, then the value of the dollar could be easily calculated to be exact. But the value of the dollar cannot be determined using this method. That's because it is subject to forces outside the Fed's control or unforeseen feedback loops like the Greek debt crisis.

Also, the inflationists who believed that the exchange rate of the dollar would fall to about 50 when the Fed doubled the monetary base were wrong. The exchange rate of the dollar has risen since the Fed doubled the monetary base.

[vincecate]

If the value of the dollar were a simple inverse function given by

value is equal to a constant divided by the quantity

and the determination of quantity were a simple fact as Bernanke claims, then the value of the dollar could be easily calculated to be exact. But the value of the dollar cannot be determined using this method. That's because it is subject to forces outside the Fed's control or unforeseen feedback loops like the Greek debt crisis.

Also, the inflationists who believed that the exchange rate of the dollar would fall to about 50 when the Fed doubled the monetary base were wrong. The exchange rate of the dollar has risen since the Fed doubled the monetary base.

I do not contend that people instantly cut the value of dollars in exactly half if you exactly double the number of dollars. It could be less, or it could be much more. If people decide that is the beginning of a trend and that the number of dollars will be doubling again and again they might bail on dollars after the first doubling. Value is determined by the market using supply and demand.

Also, there is usually a delay, on the order of 2 years, between when the money supply goes up and when the price inflation hits.

http://pair.offshore.ai/38yearcycle/#delay

The fed is now paying interest on "excess reserves". This means that the banks keeping excess reserves with the Fed is just like loaning money to the government. It has the same effect on the bank (earns interest), the money supply, and inflation, as loaning money to the government. So this can, for a time, keep the money out of circulation.

http://pair.offshore.ai/38yearcycle/#moneylaundering

[Higgenbotham]

I do not contend that people instantly cut the value of dollars in exactly half if you exactly double the number of dollars. It could be less, or it could be much more. If people decide that is the beginning of a trend and that the number of dollars will be doubling again and again they might bail on dollars after the first doubling. Value is determined by the market using supply and demand.

Also, there is usually a delay, on the order of 2 years, between when the money supply goes up and when the price inflation hits.

http://pair.offshore.ai/38yearcycle/#delay

As you've noted (referring to the realization by the market that a means exists by which the supply of gold could be increased at no cost), Bernanke said the following in the helicopter drop speech:

"Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal."

Bernanke similarly predicted that there would likely be an immediate market reaction to the news that a monetary authority is planning to expand the supply of dollars. He further states:

"By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

Bernanke also implies but does not state as directly as in the reference to gold that by "credibly threatening" to increase the number of US dollars in circulation, he can provoke an immediate market reaction. But he leaves open the possibility that if that does not happen, a deflation can still be reversed anyway:

"If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."

My summation of this and prediction in a nutshell:

Had Bernanke been correct, the initial evidence of market anticipation of inflation should have been seen in the exchange rate of the dollar. It would be expected that higher prices of imports (especially with higher prices then moving into other areas) would lag that initial evidence and there would be some resulting inflation.

The dollar did fall somewhat through 2009 as Bernanke had indirectly predicted, then it reversed in late 2009 and is back up near 2 year highs. Commodity prices lagged a bit as would be expected and oil and copper prices, for example, hit their highs this year before reversing.

As the sovereign dominoes in Europe began to topple, the US was given some breathing room in the government debt market as there was a "flight to quality" on a relative basis. It's likely that honeymoon will soon be over and US government bond rates will begin to rise as the US becomes like any other nearly bankrupt sovereign and the dominoes continue to roll. That will nail the second half of the coffin shut as far as having any further immediately easy and painless ability to generate inflation and "growth" goes, as ability to service the debt becomes the issue and further borrowing is out of the question.

Compounding this problem will likely be a widening of credit spreads back out toward 2008 crisis levels, which will have the effect of choking the economy harder than ever under the pressure of the increased debt load. Corporate profits and the stock market will likely plummet to below Q4 2008 levels (in other words, the S&P 500 as a whole will be losing money again). Unemployment will likely soar, but this time there will be no means for the government to borrow 10% of GDP as a placeholder and GDP will drop like a stone.

The country will get into anything can happen mode as there will be utter panic.

A second iteration of QE in a panic environment like this seems doubtful. To think that Bernanke or his policies will have any currency at that point seems unlikely because they will be considered to have failed. What seems more likely is that the private sector will tell the public sector to get their act together and cut spending. Things may get violent. Bernanke may get thrown out. Incumbents will get voted out.

My best guess is that by the end of this year, you will not recognize the United States of America. A corollary to that is there won't be much time to be posting on this forum because survival will take precedence over other activities.

[OLD1953]

I like how Bernanke explained that the value of gold would drop if someone found a way to just make as much gold as they wanted. People agree, right? And then he says the US has a way to make as many dollars as they want. So it is easy to drop the value of the dollar, just make lots of them, right? Just like a way to make lots of gold would drop the value of gold, right? In 1929 they could not make all the money they wanted as they were tied to gold. In fact, as people took gold out of the system they were required to remove $2.5 dollars for every $1 of gold removed. So the deflation they had back then under this "inter-war gold standard" is no longer a threat on a pure fiat money system, right? Can any deflationists tell my why Bernanke's argument does not convince them?

If the US government in 1929 had a machine that could make all the gold they wanted, then the money situation back then would be like the money situation today. But since they did not, this time is different.

Or another way to look at it is when they went off the gold standard in 1933 the deflation ended. We are still off, so ...

I'll take a crack at it.

Sure, I can explain why I don't think Bernake can throw the world into inflation. It's actually simple enough, there is no mechanism in place to force dollars into circulation. If they don't circulate, they can't inflate. That's the wall he's run up against.

Now, in THEORY, Congress could change the laws to allow for simply sending every US head of household 3000$ twice a year. Essentially, to keep the boom going, that's what Bush did, on a smaller scale. Yes, that would throw us into inflation. Now, it is possible for Obama to pass such a thing? Answer is simple, of course not. Partisanship has reached a point that a divided government, even slightly divided, cannot act.

Therefore, Bernake can create dollars most certainly, but they cannot cause inflation unless a mechanism can be put into place to force the money into circulation. The public wants savings not loans. And even if they did send out the cash, how much would just go into savings accounts and not circulate? Now, how much money would Bernake have to create to cause actual inflation? The bailout and stimulus were less than two trillion, and M3 (calculated) kept dropping. So he'd have to do more. So, for ease of calculation we'll call it 100 million heads of household, so to match the stimulus and bailout he's got to do nearly 20,000$ per each. But the stimulus didn't cause inflation. He'd have to do more. Even showing up with such a proposal would cause every Senator to drop dead with a heart attack.

I doubt giving that much per year away to business to create jobs would go over any better. Of course, eventually we'll go to a WPA type program, and we'll distribute the money in that fashion. But that's a while coming yet. Then you can talk to me about real inflation, as jobs put money into circulation. Flip side is that (since as everyone runs to point out, we don't have any absolute measure for money now) general inflation can only be measured against production. US production dropping could make up for deflation by dropping rapidly enough to overcompensate. This seems unlikely to happen though, because they cut costs (more deflation pressure) to keep factories in production. If this results in productivity per manhour increases (and it has) we will see even more deflation relative to the dollar per goods produced. Going from deflation to inflation is a major change, and requires major changes to bring it about. Just printing dollars won't do it.

BTW, has anyone seen the unemployment figures given as they would have been in 1933? For better comparison, of course.

(PS: There are a number of instances in the past where inflation occured under the gold standard, even one where only pure gold was used.)

[thomasglee]

I'm finally beginning to understand economics both from reading the posts here and, most of all, from reading many of Martin Armstrong's writings. Are many of you here familiar with Mr. Armstrong? His economic analysis appears to work from a Generational Dynamics theory - even if he doesn't quite say so. His historical analysis and how it applies to our current situation is quite interesting. He see's a coming great, great depression, but as he mentions, it will be nothing like THE Great Depression. OLD, in the last piece I read written by him he does provide a comparison to the depression of 1929 and as he mentions, unemployment was not that bad until the dust bowl came upon us. I highly recommend you google his name and read his writings.