Deflation Continues in Germany

July 30, 2009 · Posted in Global Economics · Comment

Deflation is and has been a global phenomenon for a while now. Germany, too, is not exempt from it:

Consumer prices in Germany, Europe’s biggest economy, posted their first annual decline in 22 years this month largely as a result of lower oil prices, preliminary government data showed Wednesday.

Prices were down 0.6 percent on the year in July — the first fall since March 1987, when they declined by 0.3 percent, the Federal Statistical Office said.

It said the decline was fueled by sharp year-on-year declines in energy and fuel prices, which peaked in July 2008.

Germany’s inflation rate hit zero in May and edged up to 0.1 percent last month. Several other European Union nations have reported a fall in prices this year.

Contrary to what the article goes on to assert, deflation is of course a desirable phenomenon that restores balance and sanity.

As I explained recently, regarding deflation in Japan:

Two fallacies in common reports in the media:

1. That there is a possibility of an impending deflation. – The truth is: Deflation is here and now, has been for a while, and will be for a while.

2. That we have to “fear” deflation. – The truth is: Deflation is a good thing, as I pointed out a couple of times:

Deflation is in essence a correction of the previous misallocations created by inflation.

What turns deflation into a bad thing? When the government tries to stave it off by spending billions and trillions of dollars, thus prolongs the correction, continues the misallocations, and increases the debt burden on the taxpayers. If you want to get an idea of the long term outlook for the US economy, look at Japan. The credit and stock bubble there burst in 1989, and has been deflating on and off since then.

Tags: deflation, germany

Consumer Price Index June 09 – Real Prices Down 6.4%

July 16, 2009 · Posted in General Economics · Comment

The BLS reports:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.9 percent in June before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Over the last 12 months the index has fallen 1.4 percent, as a 25.5 percent decline in the energy index has more than offset increases of 2.1 percent in the food index and 1.7 percent in the index for all items less food and energy.

Looking at the detailed table, one can see that owner’s equivalent rent (OER) went up by 1.9%. If we want to calculate the True CPI, we have to replace OER with the Case Shiller home price index, which most recently dropped by 18.1% over the year. If we do this, we get an overall price decline from 1 Year ago of 6.4%. (Last month’s release yielded a real price decline of 6.3%)

Deflation is alive and well … and accelerating.

Tags: consumer price index, cpi, deflation

Bets on Inflation – Full Steam in the Wrong Direction

July 8, 2009 · Posted in General Economics · Comment

Bloomberg writes Jim Rogers Sells Dollars, Plans to Short Treasuries:

July 6 (Bloomberg) — The dollar and U.S. Treasuries are both likely to slide as soaring government debt in the world’s biggest economy undermines confidence in its assets, according to Jim Rogers, chairman of Rogers Holdings.

“The government is printing lots of money and borrowing even more; that’s not the basis for a sound currency,” he said in a telephone interview today from Singapore. “The idea that anybody would lend money to the U.S. government for 30 years at 3 or 4 or 5 or 6 percent interest is mind-boggling to me.”

Rogers, the author of books including “Investment Biker” and “Adventure Capitalist”, said he holds fewer dollars than a year ago and plans to “short U.S. government bonds someday.” A short bet involves selling a security you don’t own with a view to buying it back after the price has fallen.

A time will come when Jim Rogers, Peter Schiff, Mark Faber, and other hyperinflationists will have to come forward and tell their investors that they were plain wrong. The only other option they have it to continue to predict for years and years to come, in millennial fashion, that someday their prophecy of hyperinflation will become reality. It is not a surprise that a lot of the current phenomena are entirely confusing and mind-boggling to them.

I would advise anyone who is still listening to them on this matter to consider Inflation & Deflation Revisited, take a look around and see what is going on with grocery stores, commercial properties, credit card defaults, friends who are losing their jobs, the immense appetite for savings, etc.

Adjust your investment strategy accordingly, and cash in while hyperinflationists continue lose money.

Tags: deflation, inflation, jim rogers

Deflation Continues in Japan

June 26, 2009 · Posted in Global Economics · Comment

The AP writes Record fall in Japan prices fuel deflation fears:

Japan’s key consumer price index tumbled at a record pace in May, the government said Friday. The core nationwide CPI, which excludes volatile fresh food prices, fell 1.1 percent from the previous year in the third straight month of decline.
…
With crude oil prices down dramatically from record highs a year earlier, energy and transportation prices fell sharply in May. Fuel, light and water charges were down 3 percent, and private transportation costs tumbled 9.2 percent.
…
Prices for household durables fell 4.9 percent, and those for clothing slipped 0.5 percent.
…
The core CPI for Tokyo dropped 1.3 percent in June, suggesting that prices nationwide are headed further south. Prices in the nation’s capital are considered a leading barometer of price trends across Japan.

“This is consistent with media reports that large supermarkets are marking such goods down as households turn increasingly defensive amid severe employment and income conditions,” said Kyohei Morita, chief economist at Barclays Capital in Tokyo.

Japan’s central bank predicts that prices will keep falling for at least two years. In its latest economic outlook report in May, it forecast core CPI to drop 1.5 percent this fiscal year ending March 2010 and another 1 percent the following year.

Note that in reality the price declines are probably move severe. I am not exactly sure how the numbers are measured in Japan, but in the US for example, real prices are actuall falling at a much faster pace than reported:

When we replace OER with the Case-Shiller home price index, which most recently indicated a year on year drop of 18.7%, prices overall actually fell by 6.3%.

Two fallacies in common reports in the media:

1. That there is a possibility of an impending deflation. – The truth is: Deflation is here and now, has been for a while, and will be for a while.

2. That we have to “fear” deflation. – The truth is: Deflation is a good thing, as I pointed out a couple of times:

Deflation is in essence a correction of the previous misallocations created by inflation.

As I referenced in The Long Term Outlook:

How much deleveraging?

Since the start of the U.S. recession in December 2007, household leverage has declined. It currently stands at about 130% of disposable income. How much further will the deleveraging process go? In addition to factors governing the supply and demand for debt, the answer will depend on the future growth trajectory of the U.S. economy. While it’s true that Japanese firms and U.S. households may differ in important ways regarding decisions about paying down debt, the Japanese experience provides a recent example of a significant deleveraging episode that took place in the aftermath of a major real estate bubble and is useful as a benchmark.

The Japanese stock market bubble burst in late 1989, followed soon after by the bursting of the real estate bubble in early 1991. Nearly 20 years later, stock and commercial real estate prices remain more than 70% below their peaks, while residential land prices are more than 40% below their peak.

Figure 3 compares Japan’s nonfinancial corporate sector with the U.S. household sector over 10-year periods before and after the leverage-ratio peaks. In both countries, leverage ratios rose rapidly in the years before the peak.

After Japan’s bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.

From 1989 on, the Japanese government has launched one stimulus after another to no avail, leaving Japanese taxpayers with the largest public debt to GDP ratio of all industrialized nations.

A burden that the US government seems to be more than willing to have its taxpayers shoulder over the years to come unless someone picks up a history book and tries not to feverishly repeat mistakes others made in the past.

Thus the long term outlook for the US economy is the fate Japan took: A long lasting correction supercycle with one failing “stimulus” program after another, and with on and off periods where the economy slips out of and back into recessions from time to time.

Update: I meant to say “public debt to GDP”, not ” public debt per capita”, even thought that, too, is likely to be accurate.

Tags: deflation, japan

Inflation Fears Meet Reality

June 18, 2009 · Posted in General Economics · Comment

The Bureau of Labor Statistics reports that consumer prices fell by 1.3% over the past year:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.3 percent in May before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Over the last 12 months the index has fallen 1.3 percent. This is the largest decline since April 1950 and is due mainly to a 27.3 percent decline in the energy index.

As can be seen this CPI-U measure applies a rise of 0.5% for “Housing”. How realistic does this appear? It is obviously a mirage. It is a result of the fact that the so called owners’ equivalent rent (OER) has replaced real home prices in the index. It contributes 24.433% to the current CPI-U and is included as a component of “Housing”.

This prevented the CPI from raising red flags during the housing boom, and it is now skewing price declines significantly

When we replace OER with the Case-Shiller home price index, which most recently indicated a year on year drop of 18.7%, prices overall actually fell by 6.3%.

As I said 11 days ago:

…this is not the stuff from which inflations are made.

I expect a reversal of market data to adjust to real conditions sooner or later. I think Treasury Notes will be a good call. The dollar should start to rise again against other currencies. I think gold is likely to do fine. It is merely back to where it was before the inflation fears began. Silver’s excessive gains, however, may have partly been fueled by these inflation expectations. I would advise caution here. It may be time to ring the register on some silver gains and buy at another low.

Treasuries have rallied since then. Stocks have fallen. The dollar has gained, albeit rather moderately. Gold saw a minor drop while silver fell by about 6%. Virtually all inflation expecation indicators that I posted in that article have begun to change direction. I expect this to be a pervasive and extended trend over the next weeks and months with gold beginning to bounce back stronger than silver. Whenever expectations are so out of whack with reality, a market correction tends to be due … time will tell.

Tags: cpi, cpi-u, deflation, inflation

Inflation Fears vs. Reality

June 7, 2009 · Posted in General Economics · 2 Comments

Markets everywhere are unanimously heralding a return to dollar inflation…

Perceptions:

Inflation expectation is up:

Click on image to enlarge.

Stock markets are up (S&P 500 below):

Click on image to enlarge.

Treasury yields are up (10 year Treasury Note yield below):

Click on image to enlarge.

Spreads between Treasury Inflation Indexed Securities and regular Treasuries have widened significantly:

Click on image to enlarge.

The dollar is dropping against major currencies:

Click on image to enlarge.

Inflation & Deflation Revisited

June 5, 2009 · Posted in Global Economics, Monetary Economics · 15 Comments

I have in the past defined inflation as an increase in the true money supply. I defined deflation as a drop or only a very minor increase in the money supply. In those strict terms I have interpreted economic data correctly. I said we were in a major inflation through the 90s and from 2001 through 2006, then I switched to the deflationary camp and later, and toward the end of 2008 again supported the inflationary view. The chart below shows the money supply growth up until the end of 2008.

I include only actual money in cash or in checking accounts in my data. I still would not change a word of what I said regarding what is and what is not to be included in the true money supply, the supply of the medium of exchange inside a country.

But I admit that I used an insufficient definition for inflation and deflation. What I was really referring to was monetary inflation. We create definitions in order to understand and/or explain cause and effect of market events.

I agree with Mish in that:

I prefer a practical definition of deflation that matches and even predicts what the credit markets and stock markets are going to do, not some definition that is useless for anything but academic debate.

Inflation is broadly understood as an event where, due to monetary intervention, a large group of people consumes and/or produces differently from how they would have consumed or produced without the intervention. The dislocations of demand versus supply generally cause prices to rise differently from how they would have risen/fallen without the intervention. I explained these phenomena in the consumption business cycle and the production business cycle. Deflation is the reversal of this development back toward market equilibrium.

I said in The Dispute About the True Money Supply:

We are trying to ascertain the true money supply for a reason. We want to explain the current and the future development of asset and consumption prices in the country, measured in dollars. The more money is available for spending the higher will the prices be. But prices emerge in exchange transactions where money is surrendered in exchange for goods and services. They change over time as a result of continuous ongoing exchange transactions. As a tendency, they change with every additional exchange transaction. The medium used in these transactions and thus affecting prices, and nothing but it, is what we need to measure (…)

…maybe if we want to know how many media of exchange are available. But it won’t necessarily help us in explaining inflation and deflation. Why? It’s simple. Inflation is created based on how much money people think they have, not how much they actually have. People act based on perception. Their error will only become apparent at a later point in time. In addition to that, prices don’t necessarily have to emerge through exchange transactions only. When two investors agree on a certain price to trade claims to money from some business, then all other holders of the same may see that same price on their broker statement at the end of the day without having done anything.

Imagine a society with a relatively free market and a certain amount of fiat money in circulation. Now imagine the central bank or one of its fractional reserve banks offers to A a new credit of $100, pushing down interest rates and pushing up the prices for debt instruments. Now imagine the person A who receives the loaned money passes it on as a loan to someone else, B. If A is certain that he’ll be paid back with interest he will consider the claim to future money as good as money. B may do the same and so on and so forth.

All participants in this chain will think their claim to $100 is actually $100 of money owned. Each of them will, at worst, consider it a wash: I owe $100 and I am owed $100. In other cases they may value the asset owned higher than the money owed, especially when government intervention creates an ongoing demand for these claims by buying them up or by offering guarantees to banks who buy them up (see Fannie Mae and Freddie Mac) and push up their prices. Everyone will continue spending the rest of their other money as if their claim was as good as money. But what if the final debtor in the chain has squandered the money and defaults. Now others in the chain may default as well: The price of the claims drops to zero.

Suddenly reality kicks in and everybody realizes that they never owned as much money as they thought. “I have my money in mortgage backed securities.” or “I have my money in corporate bonds.” may be some of the things they used to say before their net worth evaporated. But they never had money in anything. They had given their money away in exchange for a future claim to it. There was never enough money in circulation to pay off every debt in the first place. This is when people begin appreciating true cash again, with no strings attached, earned money. Everybody will be scrambling for it on order to pay off their debts. Others see this happening before their eyes and will save more than they used to.

The US economy has been at the center of a worldwide network of such cascading credit relationships. Central banks loaned fiat money to fractional reserve banks, those would pass it on to financial institutions which would make it available as wholesale mortgages, individual mortgage banks would take those on and make loans to homebuyers. Insurance companies would insure one or the other loan in the chain and again consider the insurance policy as good as money, using it as collateral to obtain … more credit. On top of that, huge pension plans would invest money in such financial institutions and insurance companies. This is just one example of how the entire world economy has been permeated by credit that is now imploding.

Consumer behavior will obviously change drastically as a result of this. This is exactly what has been going on for the past 2 years. It is a credit deflation. The sum of money inflation/deflation and credit inflation/deflation can thus be defined as total inflation/deflation. The amount of debt at this point is so huge that the pure money inflation/deflation component almost doesn’t matter: The true money supply is currently at around $2.14 trillion. According to Michael Hodges, in January 2009 total Debt in the US excluding unfunded social security and medicare commitments is estimated at roughly $60 trillion, and at around $174 trillion when those are included.

Some may now ask “But what about the Fed with all its money pumping and printing?”. But the Fed is not just printing money and unloading it over our cities. The only way the Fed and other banks can currently add money to the economy is by offering credit. But when it offers credit then naturally someone on the other end must accept it. When the demand for credit dries up the game is over. Robert Prechter offers a great illustration with his Jaguar example:

Jaguar Inflation

I am tired of hearing people insist that the Fed can expand credit all it wants. Sometimes an analogy clarifies a subject so let’s try one.

It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing Jaguar automobiles and providing them to as many people as possible. To facilitate that goal, it begins operating Jaguar plants all over the country, subsidizing it with tax money. To everyone’s delight , it offers these luxury cars for sale at 50 percent off the old price. People flock to the showrooms and buy. Later, sales slow down, so the government cuts the price in half again. More people rush in and buy. Sales again slow, so it lowers the price to $900 each. People return to the stores and buy two or three, or half a dozen. Why not? Look how cheap they are! Buyers give Jaguars to their kids and park an extra one on the lawn. Finally, the country is awash in Jaguars. Alas, sales slow again, and the government panics. It must move more Jaguars, or, according to its theory – ironically now made fact – the economy will recede. People are working three days a week just to pay their taxes so the government can keep producing more Jaguars. If Jaguars stop moving the economy will stop. So the government begins giving Jaguars away. A few more cars move out of the showrooms, but then it ends. Nobody wants any more Jaguars. They don’t care if they’re free. They can’t find a use for them. Production of Jaguars ceases. It takes years to work through the overhanging supply of Jaguars. Tax collections collapse, the factories close, and unemployment soars. The economy is wrecked. People can’t afford to buy gasoline , so many of the Jaguars rust away to worthlessness. The number of Jaguars – at best – returns to the level it was before the program began.

The same thing can happen with credit.
It may sound crazy, but suppose the government were to decide that the health of the nation depends upon producing credit and providing it to as many people as possible. To facilitate that goal, it begins operating credit production plants all over the country, called Federal Reserve Banks. To everyone’s delight , the banks offer the credit for sale at below market rates. People flock to the banks and buy. Later, sales slow down, so the banks cut the price again. More people rush in and buy. Sales again slow, so it lowers the price to 1 percent. People return to the banks and buy even more credit. Why not? Look how cheap it is! Borrowers use credit to buy houses, boats and an extra Jaguar to park out on the lawn. Finally, the country is awash in credit. Alas, sales slow again, and the banks panic. They must move more credit, or, according to its theory – ironically now made fact – the economy will recede. People are working three days a week just to pay the interest on their debt so the banks can keep offering more credit. If credit stops moving the economy will stop. So they start giving credit away at zero percent interest. A few more loans move through the tellers’ windows, but then it ends. Nobody wants any more credit. They don’t care if they’re free. They can’t find a use for it. Production of credit ceases. It takes years to work through the overhanging supply of credit. Interest payments collapse, banks close, and unemployment soars. The economy is wrecked. People can’t afford to pay interest on their debts , so many bonds deteriorate away to worthlessness. The value of credit – at best – returns to the level it was before the program began.

I also explained this, albeit a bit less vividly, in Sick and Tired of Debt. I recommend reading Prechter’s excellent paper The Guide to Understanding Deflation in full. Nowhere else have I seen the concepts behind deflation explained so precisely and with so much foresight.

A lot of economists and investors, such as Peter Schiff and Marc Faber are ignoring the ideas that I outlined above. They are expecting a Weimar style hyperinflation. I used to think the same way. But I wasn’t looking at the details. Weimar Germany’s hyperinflation happened because the German government simply printed money, actual currency, in order to pay off debts owed to the victors from World War 1. Zimbabwe did the same thing to honor IMF loans. This is nothing near to what is going on in the US. Money is created by issuing new debt, not by paying it off. When people have had enough, it ends.

Hyperinflation is simply not going to happen under the current conditions. So long as credit remains the only means for the Federal Reserve Bank to “inject” money, deflation will continue to run its course.

What will happen after the debt is written off? Who knows. We may or may not see a hyperinflation at some point in the far distant future, depending on how monetary policy changes over time. But to put all your eggs in that basket, and to do so right now would be a mistake.

Tags: credit, debt, deflation, inflation

The Dollar Crisis in its Final Chapter

April 23, 2009 · Posted in Monetary Economics · Comment

A prescient outlook from Chapter 20 of Richard Duncan’s The Dollar Crisis:

Chapter 20: Bernankeism

Anticipating the Policy Response to Global Deflation

“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”
Fed Governor Ben Bernanke, 2002

The Fed would already be faced with its worst nightmare, deflation in the United States, had the price of oil not risen above US$50 a barrel following the U.S. invasion of Iraq. Globalization is exerting tremendous downward pressure on the U.S. cost structure that can only intensify in the years ahead as service sector jobs follow manufacturing jobs offshore. A correction in the U.S. current account deficit will cause the floor to drop out from under global prices and threaten the world with a 1930s-style deflationary depression. The following paragraphs will consider how policymakers in the United States are likely to respond to that event.

America’s free trade policy, which it has pursued for decades, is obviously flawed. Free trade between countries with enormous wage rate differentials, and within an international monetary system entirely lacking in any mechanism to prevent large-scale, persistent trade imbalances, is untenable. However, U.S. policymakers are afflicted by the collective hypnosis of conventional wisdom which has taught them that free trade is good and must always be good under any and all circumstances. It is anyone’s guess as to how much longer those in charge of economic policy in the U.S. will cling on to this strange idea.

Meanwhile, it is almost certain that they will respond to the approaching crisis by applying the two great economic policy tools of the last century: Keynesianism and monetarism. The abuse of those tools will prolong and exacerbate the death throes of the dollar standard.

The first recourse will be to employ more fiscal stimuli. With prices falling and in light of the extraordinary amount of paper that has been created in recent years, interest rates will be very low and there will be little difficulty in paying interest on a much larger amount of government debt. It would not be surprising to see the U.S. budget deficit surpass US$1 trillion by 2007 or 2008 if the U.S. current account has come down significantly by that time.

If, at that point, the U.S. current account deficit has been reduced, foreign central banks would not have a sufficient inflow of dollars to finance such a large deterioration in the U.S. budget deficit, even assuming that Fannie Mae and Freddie Mac have ceased issuing any new, competing, debt of their own.

The Fed, however, as Governor Bernanke explained, has already put considerable thought into how to deal with such a contingency and stands ready, in Bernanke’s opinion, to support “a broad-based tax cut” through “a program of open-market purchases to alleviate any tendency for interest rates to rise.”

How long could such “cooperation between the monetary and fiscal authorities” underpin the global economy? For quite a number of years, most probably. Economic cycles play themselves out over very long periods of time. Moreover, U.S. policymakers will use every last tool at their disposal to prevent, or at least delay, a global depression. An economic system underpinned by large-scale fiscal stimulus financed by central bank monetization of government debt could hardly be described as capitalism (perhaps the term “Bernankeism” would be appropriate) but, with any luck, it could stave off disaster for a considerable length of time.

Nevertheless, despite the best efforts of policymakers to keep the dollar standard alive and to stave off the depression that would most probably follow its collapse, ultimately, one of the following scenarios is likely to overwhelm even Bernankeism:

1. A protectionist backlash against free trade, resulting in a trade war similar to that which occurred during the Great Depression.

2. A U.S. asset price bubble (as interest rates fall toward zero) that drives property prices so high they can’t be financed even at very low interest rates. This is similar to what occurred in Japan at the end of the l980s.

3. A meltdown of the under-regulated US$200 trillion derivatives market. (Two hundred trillion U.S. dollars is roughly six times global GDP.)

4. A loss of nerve on the part of policymakers that deters them from undertaking ever more unorthodox economic policies, resulting in a “deer in the headlights” kind of policy freeze.

5. A decline in interest rates to 0%, or very near 0%, as in Japan at present.

Any one of the first four scenarios could undermine the dollar standard, but the final scenario, where interest rates fall very near 0%, would certainly deal it a fatal blow. From that point, the only option left to stimulate aggregate demand would be to drop paper money from helicopters. That too would fail, however, for who would accept paper dropped from helicopters in exchange for real goods and services? Hyperinflation would quickly set in. Economic transactions would then be conducted through barter rather than via the medium of a debased script. Eventually, a gold standard would re-emerge.

Exactly how these events will unfold is impossible to forecast; nevertheless, the eventual outcome is within sight. The dollar standard is inherently flawed and increasingly unstable. Its demise is imminent. The only question is, will it be death by fire — hyperinflation — or death by ice — deflation? Fortunes will be made and lost, depending on the answer to that question.

Right now it seems like the answer is death by ice – deflation…if by deflation the author is not referring to pure monetary deflation, but rather to a money & credit deflation (or wealth deflation as I would prefer to call it) as per Mish’s model. On the correctness of his predictions on trade and budget deficits, please consider Trade Deficit Continues to Decline and President Obama’s Budget.

Tags: deflation, richard duncan, the dollar crisis

KrugmanWatch – About that deflation risk

February 19, 2009 · Posted in General Economics · 1 Comment

Paul Krugman is a terribly confused economist. His shallow theories justify virtually every measure of government intervention and sound palatable to the common man who seeks intellectual justification for false policies.

We shall expose his falsehoods on a regular basis in this blog.

In About that deflation risk Krugman writes:

There has been a distinct change in tone from the Obama team today, as they seem to have become suddenly aware that there’s a real risk that the stimulus plan will either fail to pass, or be emasculated to the point that it doesn’t come close to doing the job. Obama himself has warned of catastrophe if we fail to act, and — finally!– denounced the tax-cut philosophy.

It is of course not surprising that Krugman blindly supports the common notion that there was some kind of tax cut philosophy at work under the Bush administration and that the financial crisis is proof that it failed. It is probably unnecessary to point it out again, but whoever cares to look at the actual numbers will immediately realize that all these tirades against a supposed tax cut philosophy are complete nonsense. As I explained in Obama Makes an Unnecessary Gamble:

The tax cuts were completely insignificant, the spending kept on growing. In fact, the only period in the post war history of the US where taxes where higher than now was from 1997 through 2002. That aside, taxes are at an all time high right now. So please , everyone, stop spreading the nonsense that what has happened in the past 8 years is a proof that a policy of limited government, little government spending and low taxes has failed.

So to everyone reading Krugman, assuming he is even remotely right on tax cuts, please can that notion immediately. Krugman goes on to write:

Meanwhile, Larry Summers has finally made the point I’ve been pushing for a while — that we’re at major risk of falling into a deflationary trap.

It’s at best amusing, but certainly not surprising that Krugman is about 3 years late with this realization. In fact he still talks about the possibility of a deflation. He doesn’t realize its past existence. The US had begun slipping into a deflationary period in mid 2006 already, when the True Money Supply growth had begun dropping below 3%. This was precisely when the housing bubble begun to deflate and one by one the other bubbles, viz. stocks, commodities, foreign exchange, followed. My economic indicator, the true money supply, enabled me to predict these developments a long time ago. This asset price deflation keeps going on to this date. Now, almost 3 years later, after the money supply has actually begun to grow by more than 3% again, Krugman begins to realize that there might be a deflation looming.

But worse yet, he doesn’t even know what the essence of a deflation is. A deflation is a correction of the previous misallocations created by inflation: The over-employment of resources in risky longer-term projects and an underemployment of resources in the consumer goods and basic materials industries, coupled with an over-consumption of consumer goods and a lack of capital from savings. The Business Cycle would certainly be an appropriate read for Mr. Krugman.

The worst thing the government can do is to try and fight the deflation. It will accomplish nothing but to slow the correction and create a long and painful period of adjustment, very much like the lost decade in Japan.

I thought it might be useful to present a bit of evidence behind that concern. The figure above plots an estimate of the output gap — the difference between actual and potential GDP, as a percentage of potential — and the change in the inflation rate. Both series are taken from the IMF WEO database, for convenience, and use data from 1980-2007.

It’s not a perfect fit — this is economics, not physics, and anyway stuff besides the output gap bounces inflation around from year to year. But still, there’s a clear correlation, driven largely but not entirely by the deep slump and disinflation of the early 1980s, and an implied slope of about 0.5 — that is, every percentage point by which real GDP fall short of potential tends to reduce the inflation rate by about half a point over the course of the year.

What exactly is this supposed to be evidence for? Krugman plots a change in inflation rate against a so called output gap which is supposed to be the gap between actual and potential GDP. How does he determine potential GDP? Either way, all this is based on inflation and GDP data provided by the government, data that is highly unsatisfactory and insufficient. It may be too much to ask of Krugman to expect him to have looked into alternative measures that actually provide useful information, such as True GDP. Either way, we all know we are seeing effects of a long term deflation as I explained above, Krugman doesn’t need to provide more proof for it. But he is dead wrong in viewing it as an evil.

And right now the CBO is saying that in the absence of a policy action the average output gap will average 6.8 percent over the next two years. Do the math: if anything like the historical relationship between output and inflation holds, we’re looking at major deflation.

OK, maybe that relationship won’t hold — getting to actual deflation may take a deeper slump than merely reducing the inflation rate. And maybe a regression driven in part by 80s data isn’t a good guide to current events. But deflation is a huge risk — and getting out of a deflationary trap is very, very hard.

We truly are flirting with disaster.

Yes, we are in a deflation and have been for many years. We don’t need Mr. Krugman to dwell on the obvious for us. Nor do we need to listen to his utter nonsense regarding its dangers. All we need to do is look at good data. Everyone shall decide for himself if he trusts indicators that correctly predicted future developments years ago, or if he trusts a Keynesian clown who saw absolutely nothing of this coming in time, who can do nothing but sway with shallow common notions, and apply a substantially flawed kindergarten theory whenever he needs to.

To get a taste of what expects you when reading The Conscience of a Liberal, this well qualified amazon review certainly tells a lot:

Paul Krugman continues to spin dubious conclusions from fuzzy thinking. First of all, Krugman should be discredited simply because he buys into the idea that the government has shrunk in the last few years. Anyone who thinks that George W. Bush has been an exemplar of limited government has obviously been living underneath a rock for the last eight years. The War on Terror has been a mammoth by itself, but Bush’s appointment of inflation-happy Fed chief Ben Bernanke, the Medicare Prescription plan, “No Child Left Behind”, etc. and compassionate “conservatism” in general have been every bit as welfare statist as a liberal like Krugman. Also Krugman falls for a whole lot of historical nonsense like many. For instance, he talks about the huge gap between rich and poor during the Industrial Revolution, completely ignoring the role that high tariffs, the National Banking Act, and government subsidies for numerous industries such as railroads had in the whole way. Not to mention new laws that were passed during the Industrial Revolution which exempted many industries from punishment for violating other people’s property with pollution. He claims that the New Deal is what created the Middle Class in the 50’s. Apparently someone forgot to tell him that after FDR died and WWII ended, most New Deal programs were abolished (Social Security might still be with us, but it’s headed for a collapse) and federal spending was cut by over a trillion dollars. Plus, the prospects of peace really helped out the Stock Market. Much of this and more was covered in the far more scholarly “Depression, War, and Cold War” by Robert Higgs, someone who’s far more of an economist than Paul Krugman with his discredited Keynesian ideology is.

Tags: deflation, paul krugman

Federal Reserve Balances Decline

February 4, 2009 · Posted in Monetary Economics · Comment

Since the Federal Reserve released its balance sheet from December 18th 2008 reserve balances have steadily begun to decline. On that day they amounted to a total of $2.25 trillion. Since then they have dropped by roughly 15% to $1.99 trillion on January 29th.

At the same time retail sweeps have been falling since October 08. I have been talking about a resurgence of inflation since the money supply growth seemed to have exceeded the 3% mark lastingly. However, it looks like I called that way too early. It will be important to watch how the true money supply will develop over the next few months. Recent trends and data indicate that it might be headed back down and that all recent reflation attempts by the Fed could fail completely.

Deflation, it is true, is not easy to beat, if at all possible. It might work if the correction is a mild one. When faced with a global financial tsunami, it should be rather impossible.

Tags: deflation, federal reserve balance sheet, federal reserve bank, inflation

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