Deflation and Defaults: The Path Downward from Debt and Excessive Spending.

Abstract: The answer to the question whether any economy is experiencing inflation or deflation depends critically on precise data on prices and the money supply. Since the US system uses masked or archaic methods to determine these parameters the question cannot be easily answered until one effect or the other becomes obvious from wide changes in prices or the money supply. Furthermore, the assessment of sovereign debt is difficult as the Fed can print money off-balance sheet. Our debt levels are outrageous and now approach 100% of our GDP while our deficit ranks up there with tottering states like Iceland, Greece, Britain and Spain. They are also locked in a socialist spend mania where the loss of political power can only happen when spending is cut.  California has now decided to ‘wait’ and see if they get some federal alms of almost 7 billion dollars and hope that their tax revenues will increase as they willingly drive businesses out of the state with high taxes, fees and anti-capitalist bias.  Thus, we are in some grey area in terms of inflation or deflation but that matters little as the continuation of our current spending is terminal in inflation terms. We will default on our debt along with many other countries either piecemeal as in the cases of California and New York or as a federal union. We are all locked into socialist governments now and they will not cut spending as they are dominated by greedy unions or in power. Those greedy unions will strike and prevent spending cuts thus resulting in more borrowing and more debt.

The topic of deflation, in particular, always induces a contentious political and economic dispute[1] consisting of those players who insist this phenomenon is in progress, and can actually prove the existence thereof, in a fierce battle with the opposing forces who insist we are inflating. The analysis process to solve this riddle is seemingly wrought with technical difficulties because there are many varied financial inputs and calculations that must be assessed by the jury in this trial until a final verdict is returned. It appears that identical economic elements can be used to argue either case thus leading to a conundrum.

Lessons from the Great Depression: The Deflation fundamentals from Irving Fisher:

“Following the stock market crash of 1929 and the ensuing Great Depression, Fisher developed a theory called debt-deflation. According to the debt deflation theory, a sequence of effects of the debt bubble bursting occurs:”[2]

1.     Debt liquidation and distress selling.

2.     Contraction of the money supply as bank loans are paid off.

3.     A fall in the level of asset prices.

4.     A still greater fall in the net worth of businesses, precipitating bankruptcies.

5.     A fall in profits.

6.     A reduction in output, in trade and in employment.

7.     Pessimism and loss of confidence.

8.     Hoarding of money.

9.     A fall in nominal interest rates and a rise in deflation adjusted interest rates

Is there anybody reading this who can not see all of these nine points not glare out from this page if you are watching our economy? So, the forces of disinformation are now aided by politics and thus surge forth to ‘correct’ the deflationary model alarm and attack its adherents.[3] We are certainly deflating as the fed threw some 7.36 trillion dollars into the rescue pot that we know of.[4] This was in September of 2008 and the money supply M2 only budged from about 7.95 trillions to 8.4 trillions months later suggesting that this money was swallowed up in  some financial black hole.  M3 was masked so we cannot add in certain credit items that contracted with the financial crisis in September 2008.

Arguing for deflation in addition to Fisher’s Nine Points above,  we can look for four factors: a decrease in the CPI [Consumer Price Index[5]], hoarding of money, decreases in bank credit and the more unusual case of Confiscatory deflation whereby deposits are frozen or attached. That hasn’t happened yet as banks that experienced active runs such as Wachovia and Indy Mac[6] were rescued.  Arguing for inflation in a given case we should look for the diametric opposite change in the price of goods and services—increasing  prices rather than falling—and an increase in the money supply M2. Here is where the elegant simplicity of this apparently simple algebraic exercise fails because exact estimates of prices and the true money supply are influence by politics, questionable algorithms for their determination and other matters. It turns out that ‘money’ has four categories all rather independent:

M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.

M1: The total of all physical currency part of bank reserves + the amount in demand accounts ("checking" or "current" accounts).

M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000).

M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of Eurodollars[sic]  and repurchase agreements.

Unfortunately for the purist, the money [M to be general] here is difficult to assess as the government ceased to publish M3 for some reason, probably political.  M2 is published and is about 8.4 trillion at this writing. So the quest for accurate prices is complicated by the fact that the CPI is wrought with calculation difficulties such as using critical mathematical weights and assumptions for an entire decade thus ignoring numerous current price effects from the introduction of new products or from consumers switching purchase choices among similar commodities.[7]

This means, quite simply, that the absence of precise data reduces the argument to a level of absurdity until the pertinent numbers become very large. Since there is confusion and uncertainty any politician can make a grand case for either process being currently dominant or the equally rational case that neither is present. Since the current position is hazy the prospect of spending aids those in office.

Now, excessive debts influence the money supply and prices and can, theoretically, force deflation or inflation from the direct effects of government’s attempts to correct for economic problems.  Here, we must include an accurate assessment of debt and this quest becomes as difficult as the calculation of prices or the money supply. For example, we recently found out that Greece hid their debt. Rogoff “speaking in Tokyo,  actually used the phrase "out of control" to describe Japanese fiscal policy (debt to GDP is over 200% there), but also focused on Greece, the EU, and the U.S.[8] We have no idea how much money the Fed has spent off-balance sheet and cannot know what the FOMC[9] is buying or selling.

Excessive spending with funding by borrowing creates asset bubbles and when these burst wealth is summarily lost thus decreasing the possibility of addressing the debt and frequently prompts the printing of money to mollify the problem.  I predict California is building its own ‘green’ asset bubble by forcing higher energy costs with solar collectors and windmill machines using deficit funding.[10]Such an asset bubble is presumably starting to reach a critical phase in China[11] according to Kenneth Rogoff coauthor of the new book This Time is Different: Eight Centuries of Financial Folly with Carmen M. Reinhart.[12]

Debt is economically and politically dangerous and here is a quote[13]:

“Feb. 24 (Bloomberg) -- Ballooning debt is likely to force several countries to default and the U.S. to cut spending, according to Harvard University Professor Kenneth Rogoff, who in 2008 predicted the failure of big American banks.

Following banking crises, “we usually see a bunch of sovereign defaults, say in a few years,” Rogoff, a former chief economist at the International Monetary Fund, said at a forum in Tokyo yesterday. “I predict we will again.””-- Harvard’s Rogoff Sees Sovereign Defaults, ‘Painful’ Austerity [Emphasis is mine in all quotes.]

Now, when the Core CPI[14] changes abruptly from some long term trend then the experts become upset. We can read dire warnings from Michael A. Kamperman  on this matter:

“The Core CPI index was reported as minus .1%.  This is the first time since 1982 the core rate has been negative.  It won’t be the last.  We are in store for many more negative Core CPI readings over the next couple of years.  Housing costs in the form of rent and owner’s equivalent rent make up over 40% of the Core CPI rate.  While the government should be using an estimate of actual home prices to calculate the cost of home ownership, it remains wedded to the concept of using owner’s equivalent rent  which was introduced in 1983.”[15]-- More Core CPI Deflation is Inevitable [look at his charts at this link]

Thus the Core CPI is ignoring the house asset bubble in some respects as it offered the false indication that home ownership was rising based on rent estimates.  For proof of this, today, the US stock market dived briefly as “… the Commerce Department reported that new-home sales skidded 11.2% in January from December. Economists had expected sales would rise 3.8%. The drop erased all gains made in the housing market during the past year.”[16]

As for spending we hear:

“Although the federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures,” Mr. Bernanke said in a prepared statement.”[17]-- Bernanke Reaffirms ‘Extended Period’ of Low Rates

February 24, 2010, 10:24 AM 

This spending is what is driving our deficit into an ocean of debt[18] and we rank high amongst the list of other losers who may soon default on their sovereign debts:

* Figures from OCED forecast in November 2009. [19]

The debt is crushing. Since there are only 65 million workers to handle 12 trillion dollars in National Debt [soon to be 14 and rising] and only half of them pay taxes above the median of $32,000 then this works out to $192,000 each for these workers and that ignores Social Security, Medicare, Medicaid and state debts.[20][21] But, there is no signal to stop spending even th0ugh massive debts cannot be managed without gifts as we see in the Greek Case, soon to bring at least some of the EU architecture crashing down:

“It has three main aspects. The first is the well-known fiscal bit. The Greeks have overspent and over-borrowed. Now they face national bankruptcy. The EU offering loans will buy time but won't solve the underlying problem. If it makes gifts – thereby effectively making Greek debt its own – it will encourage other countries, especially Spain, Italy and Portugal to behave in the same way. In this case, the credibility of the euro in the markets will be shredded and support for the currency in the rest of Europe will crumble. As the ECB's former chief economist put it last week, why should German taxpayers fund excessive Greek public sector pensions?”[22]--The current Greek crisis is merely act one of a much wider tragedy By Roger Bootle Published: 9:15PM GMT 14 Feb 2010 [Emphasis is mine in all quotes.]

Does this sound like the California, New York, New Jersey drama with the federal government?  This Greek Problem reminds me of California[23][24][25][26] [Our National Leper[27]] and its incompatibility with financial fitness, morality, sobriety and society.[28] How do you narrow economic differences between prudent states and cavalier spendthrifts?  None of these states can even imagine how or when their debts will be paid off. California now hopes for a miracle in revenues and will ‘wait.’ The federal stimuli had a very short and shallow effect on the economy. Attempts to provide “stimuli” lead to disasters like the previous ‘jobs’ program that spent $92,000 per job![29] And, then, we spent $24,000 per car on the Clunker Follies and a mere $43,000 per house on the housing scam. [30] This is a farce.

“Officially, the state has another gap of about $20 billion, and Schwarzenegger has proposed a budget that relies, incredibly, on getting an extra $6.9 billion in federal aid. But the Legislature, while making some moves on the current year's shortfall, appears to be joining Schwarzenegger in the "rosy scenario" approach.

While Schwarzenegger hopes for a federal bailout, Democratic legislative leaders are hoping that a surge in revenue in January is a portent of economic recovery that would soften otherwise deep cuts in health, welfare and education spending.”[31]-- Dan Walters: Rosy scenario peddled as California budget savior [Emphasis is mine in all quotes.]

This is insanity. And what, might we ask, would California or Greece do about a similar or larger budget deficit in 2011? Oh, they would address that! Sure.  The unions have strangled California, Greece, other failing parts of Europe, New York State, Michigan and other entities.

All they can do is tax and spend and they cannot, as yet, tax but they will try soon.

All the Rogoff/ Reinhart warnings are lost in the shuffle to grab and sustain political power. We know that socialist governments can only sustain their power by continuous spending and that means spending other people’s money. We are on the same path as the U.K. and Greece and will experience the same fate and pay the same price: poverty and chaos.  We will default soon with the government’s cleptocratic method of controlled inflation then Asia will halt buying our debt and we will have to print more money leading to more inflation and so on and so forth.

Those who make such decisions in Washington and Sacramento have to be voted out at all costs.

rycK

Comments: ryckki@gmail.com