Confessions of a Deflationist

Confessions of a Deflationist: As those who have been following my blog since I began writing this almost 3 years ago, you will know that I have been ringing the alarm bell about the coming deflationary tsunami which we are in the middle of. The basic thesis of the deflationary scenario is that the global economy has been growing on the back of an unprecedented level of debt, and debt creation over the last 40 years. The most recent example of this force in motion was the concept of home equity extraction, which drove the economy from 2003 to 2007, as rising real estate prices allowed homeowners to borrow more against their homes, those monies were recycled back into the economy. With equity extraction in reverse, homeowners are struggling to pay back their debts, or walking away, and spending less in the economy. The same situation occurred in the peripheral EU countries, Ireland, Iceland, Greece, Spain and Portugal, except these countries have borrowed against the illusion that their debt was as good as that of Germany, the rock of the EU. Just as the rates on subprime loans approached that of prime loans in the early 2000s, so did the yields of the peripheral EU countries get real close to that of Germany. Investors poured money into these debts, as well as toxic CDO derivatives of the subprime market. 


The premise behind the deflationist view is that eventually, these toxic debts cannot be serviced, lenders discover that the borrowers are over-indebted with a greater risk of default and refuse to roll these debts over, and in the case of the US housing markets, the value of the collateral drops to levels well below the amount of money borrowed. Even the viability of the US as a borrower has been called into question, as our cumulative debt is now approaching GDP, and growing at a $1.1 to $1.3 trillion annual rate, or 8-9% of GDP each year. On the surface, that would seem unsustainable, except for the fact that the Fed will buying most of this new supply. I go back to the Before Its News (BINS) article I linked in my October 18th blog, which suggested that all debts could be replaced by printing new cash. The Fed started doing this in 2008, and is committed to doing the same today, under the cover of their dual mandate. Regardless of the rational, the Fed and the government has been desperately working to fill in the holes left in the wake of a collapse in the debt markets. Whether the Fed is replacing debt with newly printed cash, banks are told they do not have to recognize the losses (and mark to market) their bad debts, or the government is propping up our banking system with piles of cash (TARP), the picture is reminiscent of the boy with his fingers in the dyke.

As for issues with peripheral EU sovereign borrowers, the EU (and their trillion rescue fund) gave Greece a reprieve, but it seems that fall-out from that experience, is starting to limit what this EU rescue facility will guarantee. At a time when German and US rates are both around 2.5%, yields on Ireland’s 10 year debt is approaching 8%, Greece is 11%, with Portugal is above 6.5%.


I submit to you, in keeping with the absurd position of the BINS article, that if the government replaces all debts with new cash, then there will be no debt collapse, and hence the deflationary outcome will never occur. Deflation will occur when measured in the context of real money, ie – gold or silver. In fact, if you recall the last two graphs on the attachment to the October 25th blog, it should be apparent that we have been watching a collapse in the stock market (in gold terms) since 2000. In fact, stocks, relative to gold, is down over 80% over the last 10 years. And so it is with the Fed, which has committed to increase its balance sheet, from $900 billion before the crisis began in 2008, to over $3 trillion according to yesterday’s announcement. To the extent that all debts are replaced with new cash, and in this case with the Fed swapping government debt for cash, then the deflationary scenario will only be occuring when measured in terms of gold, but not dollars.


Along these lines, a reader writes in with the following question:


“Is your long term thinking still that the S&P is going to 250?”


We are going to collapse at some point. Printing money, unless they do so by the trillions, not just a trillion, is not going to sustain things, although it can pump some air into a deflated raft, and the raft will float for some time. In my opinion, how far we fall will depend on how long we can sustain the current level of prices, or even inflate things some more. And I better attach a caveat to my S&P 250 forecast, which is that if Gold goes to 5000, that is almost 300% above current levels, then the S&P could just stay here, or even go to 1500. Yet such a shift would move the S&P/Gold ratio from 88% to 33%, which represents a 67% collapse in the S&P in real terms. This would be analogous to gold staying right here, and the S&P collapsing to 400. 


As I have discussed in previous blogs, it is far better for the government to inflate everything, rather than deal with the sticky consequences of having to cope with the consequences of bad debts. Nonetheless, it is becoming apparent to me that I should own other real assets, such as stocks of  resource companies, and other commodity based companies. With the market making new recent highs, I am not going to chase the market at this point, but rather, develop a shopping list for when a correction occurs.


Before getting too carried away with the rewards of inflation, let me suggest that there are certain things which the government will not be able to do. For one, the EU is moving away from the concept of a blanket guarantee for debt holders of the debts of the PIIGS. As yields on these sovereigns widen, they are at risk for a collapse in the fiscal affairs of these governments. Will the EU be there to offer hundreds of billions of dollars for Ireland, Portugal, or Spain? Or if they do, they have vowed to let bond holders take losses, which means they could easily have to bail out their banks, which hold much of these credits. While those of us in the US figure we are immune to what happens within the EU, market action last spring proved that is a bad hypothesis.


And what about the deficit reduction commission which is supposed to put forth their upcoming recommendations within a few weeks? What will be the effect on the economy if the government cuts back on it ambitious $1.2 trillion expected deficit, especially with the tea partiers now in important spots in the House?


In short, my best guess is to remain flexible. I consider holding a decent chunk of your savings in precious metals, and I have been a monotonous voice in this regard since gold was in the 800s, as a wealth preservation strategy all along, and I still feel that way. To that end, a reader asked me if we should be adding more gold and silver at current levels. My basic answer would be yes, except I would rather do so after the current run has corrected. We are in the heart of the usually bullish fall season for precious metals. Tactically, I am concerned that new investors in gold at current prices will dump their holdings if gold drops $100 to $400 an ounce, which is clearly possible when a correction occurs. In 1975, gold dropped by 50% to $100 an ounce, before it jumped 8 fold over the next 5 years. This is another reason why I like the idea of holding physical gold; the temptation to sell it with a few mouse clicks does not exist.


Lastly, let me suggest that if the government can figure out a way to eliminate all debts, or prop up the bad ones, like the foreclosure moratorium and eased bank and insurance company rules on holding bad debt, then these actions, and printing of trillions of dollars, will cause risk assets to do better. However, as the prevalence of new money proliferates, then financial assets will depreciate relative to real assets. Even under this scenario, real estate could make money, just not as much as other real assets.