Worried about Inflation, Stagflation or Hyperinflation? You shouldn't be.

For at least 3-4 years now there has been a lot of fretting and hand wringing over the fears of inflation and its uglier siblings.  Certainly, consumer inflation has been growing fairly steadily since the late 1980s.  But with this Great Deleveraging that's now occurring globally, are we really right to worry about inflation, stagflation or hyperinflation?

First, some defintions:

Inflation:  The percentage change in the price level, usually referring to increasing prices.  "Price level" itself can be applied to various measures, most commonly to a basket or bundle of goods and services.

Inflation is generally spoken about as part of the Quantity Theory of Money.  It is through this theory's equations that people usually tie monetary policy to inflation.

Deflation, Disinflation:  The opposite of inflation.  The Great Depression was a deflationary cycle.  Recessions are also deflationary.

Stagflation:  A situation in which economic stagnation or even contraction occur simultaneously with inflation.  Stagflation is particularly interesting because it is theoretically impossible under classical, Keynesian economics.  But, of course, it happened twice in the US, leading to new theories and significant advancement of macroeconomic thought.  Stagflationary cycles have been broken by the central bank intentionally causing a recession, and thus deflation.  This was the famous action of former Federal Reserve Chairman Paul Volker.

Hyperinflation:  An inflationary cycle which compounds out of control until currency is effectively debased to zero value.  Most definitions of hyperinflation describe it as an order of magnitude increase in inflation per year, or 1% per day.  Hyperinflations are relatively rare, and happen primarily as a function of a country's central bank printing money in order to service foreign debts.  Hyperinflation has not occurred (for more than a brief moment as it began) within a country in the modern era so long as that country maintained a credible military force or was credibly protected by a country with such a military force.  These countries choose to default instead of willingly destroying their own population and inciting an internal revolution.  Famous hyperinflations, such as within pre-war Germany, were broken when the Germans militarized and broke war reparation agreements requiring them to repay crushing foreign debts.  More modern hyperinflations have been broken by IMF action (ie, foreign intervention), or by various forms of practical default.

The Case for Inflation

Plenty of internet resources exist describing inflation.  Suffices to say that we have been in a long-run period of general price inflation.  However, it is important to note that perceptions of inflation by average people are often overstated.  They usually do not recognize product-cycle-deflation.  Items such as consumer electronics, computers, and automobiles are exceptionally deflationary, though most people perceive them as steady-state or inflationary.  However, the value of those items rises as a function of technological innovation while the costs to produce them falls as a function of improved production techniques, all while prices tend to remain constant, fall, or rise more slowly than general price inflation.

Inflation is synonymous with a high-return global economy.  It has become more pronounced and recognized as rolling asset bubbles have plagued the global economy.

The Case for Stagflation

Stagflation occurs as some prices, usually prices of inelastic goods such as food and energy, rise rapidly during a period of economic slowing.  Other prices may continue to fall, however, increasingly disposable income falls as people shift spending to essential items for which the price is rising.  Stagflations occur due to some economic shock, such as a war or supply disruption.  Many have made the case that describes our current global situation, particularly in the US.  This case has merit, and I see as the second most likely outcome of the current situation.  It may also be that stagflation occurs as a transition into a more deflationary environment.

The Case for Hyperinflation

Hyperinflation is the least likely conclusion for the US, and for most western economies, in my opinion.  Even were a hyperinflation to ignite within the US, it is more likely we would either intentionally or naturally quickly break into a Great Depression-style deflation, probably as a result of either overt or effective default on our foreign debts.  Most who are calling for a hyperinflation in the US point solely to the "printing of money" as causing inevitable currency debasement.  That is flawed reasoning of linear extrapolation.  As Japan noted during their deflationary cycle, even cutting the interest rate to zero, and making the real rate negative (meaning one pays to store their cash in the bank instead of earning interest on it) did not result in a hyperinflationary debasement of their currency.  Instead they became trapped in a liquidity-trap, as situation in which the central bank lost its ability to affect aggregate demand.  I believe, for reasons outlined later, that this is (somewhat surprisingly, perhaps) where the US is headed.

The Case for Deflation

Financia Capital produced a reasonable analysis and essay making a case for deflation in their document MarketWatch Postscript: A Case for Deflation (PDF), June 2007.  Other notable works can easily be found by way of a Google search on the subject.

I'll leave their analysis to carry the weight of the deflation scenario argument and just bring out some basics here:

• Many products are strongly deflationary, as mentioned earlier.  Computers are an easily describable example.
• Stiff price increases in commodities is a function of global demand more than monetary policy.  During a period of slowing global economic growth, commodity prices subside.
• Pursuit of high-returns coupled with easy-money monetary policy has resulted in rolling asset bubbles.
• When the rolling bubble(s) encounter an end-game scenario, the popping of those bubbles is strictly deflationary.  I argue that real assets (as in real estate) represent the end-game scenario.  The amount of leverage generated and global capital deployed to inflate the global real estate bubble is so massive that no other asset class exists to adequately absorb the accrued inflation.  Therefore, as it pops, strict deflation must occur.
• Attempting to "inflate our way out of" the current scenario will result in a liquidity trap, further complicating deflation.  The system of credit is delevering, which necessarily implies, deflating.  That is, less credit will be available after the correction than before because capital is being levered much less.
• Less credit impacts the consumer sector of the US by decreasing aggregate demand, causing deflation.
• Investors will no longer seek high-returns instead preferring optimal risk-adjusted returns.  This will cause investment, which fuels credit, to be attracted to less risky, lower growth endeavors.  Lower growth adds to deflation.

Please feel free to add your comments, debate, criticize, and discuss.

Comments

[Brand]

Instead they became trapped in a liquidity-trap, as situation in which the central bank lost its ability to affect aggregate demand. I believe, for reasons outlined later, that this is (somewhat surprisingly, perhaps) where the US is headed.

I believe that this is the situation we've found ourselves in for the moment. But how long can that persist within the United States? Japan depended far more on exports than the U.S., so did they really have a choice? The dollar is the reserve currency of the global economy, so would that also mean that the other central banks will also have diminished influence over credit demand?

[randolfe]

The US certainly is not Japan. There will be big differences in a deflationary period here, for both fundamental economic and cultural reasons.

The US only relies roughly 1/5 on exports for GDP. Up to 80% of our GDP is domestically created, though some argue that number is perhaps down as low as 70% due to the massive globalization of the last 10 years (source, FT about 2 years ago, don't have the paper anymore but I kept if for a long time as I loved to reference it).

The fact we are the reserve currency will affect our deflation. That part is different from the Great Depression era. I see a couple possibilities:

1. The USD loses much or even all of its reserve status. I think this is unlikely over a short period of time. Like avoiding hyperinflations, a reserve currency is the product of a credible, projectable, formidable military.

2. The USD maintains its reserve status but large foreign holders becomes a significant part of the dollar supply. I've heard this referred to as the "decentralized central bank" theory. Basically, after China and Dubai get too many dollars, they can start to act as mini USD central banks. Such action would cause the US (rightfully so) to intentionally isolate the reserve currency aspects of our monetary policy so as to not allow China et. al. to set our rate policy. That would mean, basically, we would have to limit our seigniorage.

So the long answer to your question, in my opinion, is that yes, other central banks will have diminished credit demand influence.

[NTETS]

so my question goes something like this:

i understand that the institutions who bet on the bubble did it in a dilute money supply that was leveraged. what i don't understand is how that dilute money supply ended up exceeding the real asset class. if a home is mortgaged for 500k then i owe 500k + interest. later that home mixed with other homes(for simplicity, 10 similar homes sold in 10 bundles) one would think that even though a bank might have to(or choose to) borrow 500k for that bundle, and even might elect to pay a fee for insurance on top of that, the debt should not have increased. it should still be 500k. following that logic this whole mess should in theory be limited to +/- 10 trillion(the total mort market, fanny, freddie, wachovia, boa, e-loan, countrywide all rolled into one) so can you explain how the market for these securities is estimated to exceed 60 trillion? what was the other 50trillion betting on? general trends that were not written against specific assets? was one loan sold 6x? did all 6 investors expect that they were purchasing "whole" pieces? can you attack deflation from the point of view what specifically is deflating? thanks.

http://www.cbsnews.com/video/watch/?id=4502673n

[randolfe]

It's my belief that the US escapes a liquidity trap not through inflation/printing-money. Rather, it escapes through real GDP growth. The kindergarten rendition of the Great Depression goes roughly as so:

The stock market blew up into a bubble. Banks overextended. The market crashed. Banks failed. The Fed _raised_ rates, and _increased_ bank reserve requirements. Hoover said "let the bad die to clear room for the good". All hell ensued. FDR came in, closed the banks, started massive fiscal spending projects and the Fed lowered rates and printed lots of money. Things got better and we won a war.

Actually, it's more accurate that the US exited the deflationary spiral and liquidity trap through real GDP growth. Real growth inflates the economy "naturally". And we were entering a stiff growth period, augmented by the war effort, though one should note that the war effort was accompanied by gigantic deficit spending.

The reason growth-caused inflation is natural is that purchasing-power doesn't change, even though prices rise. That is, if there is growth, and the Fed prints more money, and those two are equal, then the nominal price of everything is irrelevant. In fact, many prices my grandfather used to complain about when he was alive (which was many decades ago now), had actually _decreased_ when measured by purchasing power parity. That is, it cost much less in 1980 to buy something he moaned about only costing a dollar in 1930, even though the price tag was many times higher.

[randolfe_]

NTETS, that's a complicated question to answer, actually. These markets and the products traded in them were often extremely complex. It's not just mortgage backed securities (MBS), but also collateralized debt obligations (CDO) and other securities.

For a nice explanation of how CDOs work, SeekingAlpha has a good article.

Basically, the pithy, but not terribly helpful answer is that they are derivatives. Derivative values often exceed the value of the underlying assets. The same is true in simple stock options markets. Because people can create offsetting positions, then can create very complex options strategies which are akin to financial alchemy. But everything nets out, theoretically, so life is good. And that's usually the case because if you're doing complex spreads on Microsoft stock using options, you are reasonably sure the MSFT isn't going to suddenly have a value of $0 in the market ... and certainly you won't wake up one day and suddenly the market is just illiquid.

That's what happened with all these MBS/CDO's. The underlying assets quite suddenly became worthless. But the difference is the actual mortgages never traded in any real, open, transparent market like stocks do (and stock options do, for that fact). So, no one could ever trust the true market value of all that paper. Then suddenly the banks started getting whacked, the assets impaired, and forced to mark-to-market to a market that didn't want any of it.

Thus the $60+ trillion created out of a mere $8-$10 trillion in assets. In actuality, they're not even sure how big the derivative market is because it's all traded over the counter, and outside of most regulations.

And that's just the start of this mess. It runs much deeper, with the debt-swaps, ratings agencies, etc. What a mess.

[randolfe_]

*debt-swaps should have read *default-swaps.

[Pasadenan]

"this american life" on NPR public radio stations produced a fairly comprehensive understandable program on the Credit Default Swap issues that aired over the weekend. You can go to their website (I believe thislife.org) to get a download of the broadcast. As they explained it, it was "insurance" in case of a "default" that everyone was buying from one another. And as they saw organizations likely to go down, they "speculated" by buying these on organizations where they had no direct financial interest. Thus $5 Billion in "guarentees" was "insured" for $60 Billion, thus 12 times what it should have been, and with no collateral, and everyone reselling the same "policies", just marking them up; and no regulation because everyone said it didn't need regulating and congress passed a law stating it wouldn't be regulated. But when one goes down; the whole chain system collapsed and it didn't matter that the same policy was sold to someone else; once one party didn't pay, none of them could pay. There was no collateral or reserves set aside to pay anyway.

If it was regulated like insurance, this would have never happened; but then many people that made fortunes on these would not have made their fortunes either.

[Pasadenan]

I know a lot of consumer items are going to continue to drop in price, such as cars, clothes, computers, electronics...

And I know that Oil was $114/barrel a few months back and is now $85/barrel, and that Gasoline was $5/gallon at the begining of July and is now $3.50 per gallon, and that much of the gasoline price increase was speculation...

BUT STILL I see inflationary factors; at about 10% annual; and I'm convinced the government is STILL trying to keep houses from dropping in paper dollar value by adjusting the paper doller value to the current housing prices as quickly as possible.

Of course it can't be accomplished overnight; and I KNOW that some of the price increases are STILL speculation (such as rice selling at over $1/lb when it was about 33 cents/lb just a couple years ago and 50 cents/lb last year, and eggs for a while were over $3/dozen...

For the time being, price of eggs has gone back to $1/dozen at selected locations. But potatos are not dropping back to 10 cents/lb, but are staying at about 20 cents/lb; and Apples are not dropping back to 33 cents/lb, but are staying at about 90 cents/lb.

But where I've seen the most uniform price increase is chocolate. Within 1 year, "fun size" chocolates that would normally be given at holloween have changed packaging across the board from 10 in a package for a dollar to 8 in a package for a dollar; thus a 25% increase. I kept expecting a price drop for competion as we approach Halloween, but I have not seen it yet.

Thus the dollar is only worth 80% of what it was a short while ago. I think this trend will continue.

Sure, it is good to use a "basket" of goods; but the basket I would use is nothing like what the Federal Government uses, and I am having difficulty getting the exact ratio of each product the government tracks. They also average over a lot more outlets than I'm interested in. I'm really only interested in the lower priced range, within the local area. Averaging with really high end stores doesn't give me a better picture of what is happening. I don't care that gasoline is lower priced in Texas as it doesn't meet the California Air quality requirements and doesn't included California sales tax and highway tax. I also don't care if Shell or Mobile, or Union stations next to freeway off ramps charge 20% more than other stations such as ARCO... as I'm not planning on buying at extra high prices when I get no extra benifit for that money. If I'm tracking the lower priced; the middle and upper prices will usually move in similar pattern.

So, though stagflation may likely be a possiblity; I'm still expecting inflation in normal consumer necessities, until the housing prices have stabalized in terms of # of chocolate bars...

And for things like clothes; it never makes sense to track "list price" as the "real" price is closer to what they will clear them out for at the end of the season. You know they are still not losing money at clearance prices, even if the clearance prices do not cover store overhead nor any profit. And so far, watching clearance prices, I'm not seeing clothing prices increase yet, and do not expect them to as we still use esentually overseas slave labor, and there is substantual competion from different countries for us to import our clothes from them.

So, food, energy, insurance, phone service, medical service, car repair... are the things that should be looked at to see what the dollar is really worth at any given time.

[randolfe]

The way credit default swaps worked wasn't quite how you described. It is true that default swaps traded OTC, so they weren't regulated like an exchange traded security. I agree that is a problem, same as the mortgage paper.

The allegation was that hedge funds were exploiting default swaps by buying up default swaps on a company while simultaneously launching a bear-raid by shorting the stock. The falling stock price forced the rating agencies to lower the rating of the company, which then caused the CDS to dramatically increase in price. Theoretically, if the hedge fund managed to bankrupt the company, then they'd make money by their shorts going to zero, and they'd make money by collecting their CDS returns or, in some cases, converting those into a debt-claim in the bankrupt concern.

There is probably some truth to that scenario, but I doubt it was as widespread as the torch & pitchfork crowd claimed. The only companies really at risk were banks with lots of MBS/CDO paper which they had to mark-to-market during a bear-raid because of the FAS rules.

[randolfe]

Phone service is extraordinarily deflationary. By no measure can it be considered inflationary. Car repair (of average-aged autos) is also deflationary, as a function of the rising complexity of the automobile and value of the component parts.

Medical and insurance costs aren't so much inflationary as they are the result of regulatory pricing and tax distortions.

[Pasadenan]

I would consider a $102 medical insurance premium going to $550 in only 11 years "inflation". That is substantually more than double per decade.

Very little of that had to do with "regulation", very little of that had to do with "risk" or "age bracket". The tax benifit does not exist for people that don't spend 2% of their income for medical expenses, or don't itemize, and don't qualify to declare it as a "business plan". And the tax benifit deductions did not change during that period, thus those are not the causes.

The causes are primarily
1) AMA monopoly
2) FDA being run by the drug companies
3) Drug companies "selling" unneeded drugs on commercial telivision
4) Expensive unneeded tests using expensive equipment
5) Misdiagnosis and malpractice causing lawsuits
6) Free or reduced medical costs to various parties that have to be passed on to the people that will pay.

[Pasadenan]

I'm not sure how you can consider telephone service "deflationary"... The regulatory agencies rarely lower the rates; and if they do, it is only a few cents, and it doesn't stay that way for very long. They usually tend to raise the allowable rates, and of course the phone companies charge what they are allowed to charge. Maybe it is not 5% per year increase, but it has consistently gone up. What was a $16.33 a month bill 11 years ago is now a $25 per month, with no change in service, and no outgoing calls throughout. That comes to 3.95% annual inflation.

And car repair? Battery price increased more than 50% in 4.5 years. (9.4% annual inflation). I have not found a single car part that is less expensive now than it was 10 years ago.

And all the mechanics are charging more for their service. Even the smog check places charge more. Their prices never go down, and I never get "more for my money". Of course it is true that the prices jumped substantually when the added the dynomometer requirement forcing several smoke check places out of business and requiring substantual extra investment for those that still wanted to do smog checks. But I do have my records to chart the price changes.

Similarly, an oil change used to run about $12; and now runs about $24; but I forgot the time frames, so I will need to check my records. Still, my guess is more than 5% annual inflation.

Antifreeze has not gone down in price either. I used to buy a gallon for about $2 when on sale. Now it is about $18 a gallon; and the price is high enough they now sell it diluted so that people will not be so shocked and will think they are getting a bargin. A part of that cost increase is environmental regulation.

[randolfe]

I'll find some data for you. I've been in telecom since the 80s, and it is widely understood that pricing per value in telecom has been extraordinarily deflationary. Just take long-distance rates, or data rates for an example.

Price per unit continually decrease in telecom, not increase. That's the problem with lay folk interpreting inflation: you tend to forget about the denominator, which also changes.

[Pasadenan]

And lets not forget postage or other shipping.

42 cents first ounce domestic now; 39 cents first ounce domestic just 1.5 years ago. That comes to 5.1% annual inflation. Or $3.80 for 2 lb priority shipment 10 years ago and $7.70 now; 6.6% annual inflation.

All countries have to maintain inflation at slightly above the interest rates the banks pay. Some products it is easier to track than others; especially when regulated, as these prices never go down and don't change every other week, and don't have substantually different pricing depending on the outlet.

Sure, we are seeing deflation in several sectors now, especially housing and new cars; but things like postage and phone service still steadily increase in price, showing that the dollar is still being intentionally devalued.

[Pasadenan]

Price for data has increased in 8 years too. 56k baud rate... constant.. but the quality of service has decreased in evening hours do to increased traffic. Price was $110 per year 7 years ago, now $131.40 per year ---> SAME SERVICE; I don't forget the denominator; the extra speed is useless if I won't buy it! That comes to 2.6% annual inflation, and that does not even include the increase in cost for the phone service, that is paid for separately.

Besides, the "fax" costs have also gone substantually up since marketers have mined the phone number and are spaming on the fax machine daily using up substantual toner and paper, which have also substantually increased in price.

10 years ago I was buying a new toner cartridge with sufficient toner for 5,000 sheets of paper for $10. For that printer, I now pay $55 for the same toner cartridge (18.6% annual inflation). But for the fax machine, I only get 2,000 sheets per cartridge and the cartridge costs $115.

I dropped my long distance plan last year as the prices were too high and I was getting no benifit.

[randolfe]

Pasa, that reasoning is so wrong I don't know where to start. You've done little more than outline for us how people cannot get past nominal price thinking. The price for data has increased? I'll have to kindly ask you to step back and reapproach this discussion as you're way off in the weeds.

[randolfe]

On home ownership during a deflationary period:

* If you own a home outright, you should sit tight during deflation, regardless of when you bought (even if you bought far above current market value).

* If you own a home with 25% equity or more, and you bought your home at a price previous to your area's bubble (between 2000 and 2003, generally), then you should sit tight. Maintain your current fixed-rate loan, but be mentally prepared to refinance into an adjustable, balloon or other product later. That is counter-intuitive given the common wisdom of the past 30 years, but deflation is a different animal.

* Be prepared to pay your home off or pay down your mortgage substantially when the time comes, if you are able.

* If you don't have a home currently, then don't buy one yet.

* If you don't have a home currently, and have the cash to buy one with little or no financing, and your area's prices have honestly stabilized (meaning you believe jobs and incomes are secure in your area), then you can buy.

* Do not enter into new fixed-rate mortgages in order to buy a home. If you have fixed-rate debt, and deflation ensues, then you will lose money every time you pay your mortgage because you're paying future interest with more valuable dollars. Again, this is contrary to the common wisdom of the past 30 years.

--

Bear in mind this is why my grandparent's generation (the GI/WWII generation) held the tenant that one should *never* have any debt. Debt was bad, and ruined families during the Great Depression and War Years. Even when my granddad did have debt, it was ultra-short-term, usually payable as a lump sum, which he used to bridge a short period until he could get cash in hand. Unfortunately for his generation, these principles didn't serve them well after the war, and cost him and my grandmother a lot of returns through the rest of their lives.

Now things might be reversing again, and the common wisdom which has carried my generation and the boomers before me, and Y-ers after me, all our lives could cease to serve us. You have to be willing to take a big step back and constantly look at everything objectively.

Also, I caution, that everything said above is almost exactly *opposite* in a high inflation environment. That's the real, sinister thing about periods like this. We could well experience some rising inflation, maybe even stiffly or stagflationarily, before slipping into deflation.

That will really tax our ability to think clearly and keep an objective view on how to best protect and preserve the wealth of our families.

Not investment advice. Seek the advice of a licensed, certified professional before making investment or financial decisions.

[astrid]

Randy: I don't know enough to argue against your economic analysis, but do want to say that the New Deal helped the US avoid a fall into nationalism/fascism/extremism. (That's my main reason for supporting the bailout with all its faults. Even though my family and I are in good shape to survive an economic depression, I worry the destabilizing effects of a prolonged depression on this country.)

[randolfe]

I agree Astrid. I am not one of those free market "fundamentalists" who like to portray FDR and the New Deal as if they were the worst things to ever happen to this country. I believe FDR was an archetypal leader such as we are in dire need of today. He did what was necessary to save the USA and put us on track towards dominance which has lasted the better part of a century now. Had history been written as the neo-Hooverites would have it, the world would be a much different place today with the US having exerted much less influence, and other powers such as Russia and Japan having exerted much more influence.

What these folks don't like is the remnants of the New Deal as they exist _today_. But, in my opinion, that is myopic thinking not appreciative of the context in which the New Deal was forged.

[astrid]

Also, completely OT but I made a mistake going to Iceland last year. I could have gone now and saved 50%!

http://www.independent.co.uk/news/business/analysis-and-features/iceland-dancing-on-the-brink-of-bankruptcy-954587.html

[TunaFish]

What should you do if your mortgage is underwater? :)

[randolfe_]

Tuna, if you're upside down in your mortgage then you have some serious self reckoning to do. I argued quite a bit on Zillow that such a decision is not a moral or righteous one given today's environment. Basically, 99% of those who'd argue that you have some moral obligation to pay your mortgage dutifully regardless of how much it destroys your family are pissed off sellers who can't sell, or are realtors/brokers. In reality, we all do what we have to and justify it best as we can.

Most people, when faced with financial ruin and denying their children a better life, will probably choose to walk away and start over (if they live in a state where that is possible, which is most bubble-states).

Add in a deflationary spiral, and staying in a home that's upside down in equity is financial suicide.

[pasadenan]

Well, if you can get me the same data service for a lower cost, rather than a higher cost, then by all means tell me how I can do it.

It is completely double speak and manipulation of numbers to compare unequal services and then claim prices went down because you are getting "more". What you are really claiming is that I'm paying more to subsidize YOUR service. That makes no sense; we don't even have the same providers. It is like in the 1984 book when Smith states he doesn't remember what an Lemon is because an Orange is a yellow color. If it is not the same product, you cannot compare the price even if someone claims it is the same. Higher available data rates does not lower the number of lines needed, nor does it allow one to keep all the same numbers if one decided to not pay for a line.

The only price I care about when checking for inflation is the lowest price readily available for the specific product/service. The data provider is not my telcom provider. And the local connection cost with their maintenance/billing/energy.... has gone up per copper line, and they don't offer me more anything. The unit is flat rate per month, or metered rate per month plus per minute charge. Both the flat rate and the metered rate have gone up, and so has the per minute charge and the government mandated fees.

It is a very good measure of the devaluation of the dollar as the price rises steadily with no extra benifits of any kind; but perhaps not as good a measure as postage since the rate of rise for telephone service is not quite as steep as the rise in postage costs.

Regarding the debt--- I also was one that believed one should never be in debt, except for a house since one could not save as fast as the inflation rate, and one would have some living expenses regardless, and one could always liqidate the property if one needed out of debt. But the interest rate they charge always seemed to be higher than one could get for a low risk investment, thus the soundest investment was to pay off the loan, thus mine is paid off.

I started using credit cards some time ago for "convinience" since there was no cost to use it when paid off, and it often allowed discounts, or ablity to purchase when checks weren't accepted, or when doing mail-order over the phone, or when one didn't have the cash on hand, and also wanted a record plus insurance benifits offered by the card company.

But when the economy changed so drastically, and card companies just started handing out 0% interest cards; it really made no sence not to use their cards and run up a debt in order to have more cash on hand, but still get the benifit of discounted prices.

It is hard to know if a fixed or variable rate for a mortgage would be better now; but it is looking like the interest rates will remain low, so a fixed rate is probably not good. But I'm not about to take out a new mortgage unless buying at a rediculously low price for a very desireably property.

As we all know, leveraged buying in a downward market will easily wipe out savings, and could put one in substantial financial hardship. I know a Realtor in his late 80's that did that in the 1980's, and he is still having to work hard to cover his living expenses since he lost all his retirement savings.

[pasadenan]

When the phone company replaces the six copper lines to my structures with one fiber optic cable, and still provides the power with emergency backup to operate the system, and they decide to reduce the price for minimal service (per connection per month...) due to the rapidly falling demand due to wireless and cell ussage, then I will believe basic phone service has become deflationary; until then, even with our present defationary cycle, basic phone service is still remaining inflationary.

I don't think inflating our way out of the housing bubble will create a liquidity trap simply because the Government has and will intervene to maintain liquidity as the value of the dollar continues to change. But as usual, the govenment will continue to manipulate the numbers to try to hide the true inflation rate, and will try to keep annual inflation under 12% in most sectors to avoid panic & hording.

The hard thing to predict is when incomes will start rising to meet rising food and energy costs. As long as people are being laid off, and employers refrain from hiring, most people will not ask for raises as some income is better than no work at all. Outsourcing of labor to other countries has contributed substantually to this problem.

It is hard to guess if the government will intervene on the outsourcing issue. A minimum wage does no good if you can't find a job since people overseas will do it for 1/10 the cost, and the employer is no longer requred to pay taxes and social security and benifits for that work.

And negotiated union rates or "prevailing wage" won't help either if everything can be outsourced.

[randolfe_]

Pasa, you're obviously not interested in approaching this subject objectively. Telecom services are easily measured per unit without subjective value discussion. Price per bit. Price per minute. Price per service unit.

You don't have to trust me, these objective metrics have been used by the big telecoms worldwide in numerous judicial challenges to antitrust actions.

Please refrain from hyperbole on these threads. You've already consumed over 50% of the thread space with most of your narrative being barely relevant to the original topic. You hijacked and earlier thread with your ANN idea. That's fine, but I'll again kindly ask that you request a dedicated thread if you have a separate topic to discuss.

[Busybee]

Randy,
I have read your posts since you were on Zillow and highly respect your contributions. I've learned a lot from you and other people on these boards but I'm still at the beginning of the learning curve. Here's the deal, I'm struggling to understand the following quotes from above: "Do not enter into new fixed-rate mortgages in order to buy a home. If you have fixed-rate debt, and deflation ensues, then you will lose money every time you pay your mortgage because you're paying future interest with more valuable dollars" and from pasadenan "As we all know, leveraged buying in a downward market will easily wipe out savings, and could put one in substantial financial hardship.". I've been waiting on the sidelines since 2004 and my husband and I are finally ready to commit to a mortgage. We have enough saved to put down minimum FHA downpayment (I know not a lot, but when will we ever save for 20% of So.Cal home prices), and we both have pretty reliable jobs even with the prospect of a very bad economy (Me: City employee Hub: Chevron engineer), and plan on leaving about 4 months of mortgage payments in the bank as a safety net (reason we're not giving a larger downpayment). So, we can definitely make our payments and will only buy a house affordable within our means and have no plans of moving anytime soon (hope to live in home for next 20+ years). Currently, we're not renting (live with Mother-in-law so we can save most $), have no debt, but we need our own space and something bigger than guest quarters (present situation). So, we want to take the plunge (knowing values will drop because we don't want to wait until 2010 when we may have reached "the bottom"), but I'd like feedback given your thoughts about deflation affecting us. Thanks.

[randolfe]

Busybee

There are a couple of questions in there. Firstly, it is essential to understand leverage. Realtors were running around Zillow acting like leverage was some magical mana from heaven right up until the world started blowing up precisely because of leverage. (They are calling this the "Great Deleveraging", after all).

Leverage always hurts you more when things go against you, than it helps when things go for you. Think of it like this: if you are levered 10-to-1, then you will benefit if the asset you're financing appreciates by a factor of ten -- because you were able to buy 10 dollars worth for your dollar of cash you put up. But there's no free lunch. You pay a hefty interest cost for the luxury of that leverage.

That leads to a first-principle: amortization. If you have never done so, open up Microsoft Excel, and create a 360-period (30 year) full amortization schedule. Make 4 columns: payment, interest payment, principle payment, and balance. Then play around, and watch how drastically those numbers change in the early years -- like in the first 5 years -- whenever you change the length of the loan (30 year, 40 year, or 15 year, generally), or the rate, or the starting balance.

Now that you've done that, you can see how much interest adds up during the say 5 years you own that home, which is subtracted from your leverage advantage if prices rise.

But if prices fall, then you lose whatever value the home sinks by _and_ the interest you pay. That accelerates your downside losses. If you're early in an interest-heavy amortizing mortgage, like in the first 5 years, then your suffering from leverage in a down market can be quite severe. And the more prices drop, the faster you go underwater.

...

[randolfe]

Now that we've covered how leverage and interest works, you have to consider inflation/deflation over the period of time you own the home.

If inflation was really, really, terribly high -- like say 20% as it peaked in the 70s, then you would be very happy to own a home with a 6% fixed 30 year mortgage. And since the rate difference is so large, even if your home lost value, and the leverage worked against you, up to a point a lot of those paper-losses would be offset by the fact you've managed to protect yourself against inflation. You're paying back the loan to the bank with less-valuable dollars. So the bank is getting screwed because they aren't getting enough interest from you to make their loan "worth while", compared to what inflation demands they earn on their lent out money.

But if there is even mild deflation, say just -5% inflation, then the bank is more than happy to collect your 6% fixed loan payments. They're ecstatic, in fact. Since home prices are dropping, and your equity returns are sinking due to the previous comment's leverage function, you're already suffering. But now, instead of having very high inflation to cushion your burden, you're struggling to find ever valuable dollars to hand over to the bank, for an ever less valuable asset.

Even when your home stabilizes in price, you're still losing rapidly due to deflation. Your home will need to reflate by almost four times the deflation rate for you to break even. The difference there is harder to explain: why -5% inflation hurts much worse than +20% inflation. It centers around the way that prices and salaries move in our economy, the way fixed-income and inflation-indexed things work, and the way that growth destruction hurts the economy more than monetary debasement.

You can think of it like this, for an oversimplified but common-sense, folksy explanation: Sellers of things are always more reluctant to lower selling prices than they are to raise them. Employers of workers are always more willing to pay lower salaries than they are to pay higher salaries. That extends to governments, indexed benefit plans, organized labor contracts, and, of course, housing. It should also be obvious that if those two things hold true, then deflation creates a vicious cycle whereby decreasing prices costs jobs due to lower demand, which then increases the supply of labor, which lowers salaries, which means people can afford less, which further forces lower prices, and so on.

[busybee]

Randy,

Thank you for your detailed responses. I'll have to re-read through them thoroughly and do my excel spreadsheet homework you recommended to make sure I fully understand. Okay, what do you think is the probability we will see deflation and which do you think would be a better option if we do see deflation: rent a house or buy a house significantly below our means? Or other options?

[randolfe_]

Busybee

Please keep in mind these are just my opinions, and you should treat them with the skepticism you would treat anything you find on the Internet.

I believe we are at significant risk of deflation. If I really knew 100% that there was going to be deflation then I would position myself to make a couple hundred million dollars and retire to Mauritius. Same if I knew for certain there would be very high inflation. The fact is, there is always a risk that things don't go the way they "should".

And right now the Fed and their counterparts across the world are trying to do everything possible to avert deflation. They should be commended -- at long last -- for not sitting around on their hands guaranteeing another Great Depression. But, even for all their efforts, I think deflation may still occur. It just might not be as bad as the 30s. We can hope, at least.

As far as buying a house or not ...

If you really feel compelled to buy then I would definitely do so as conservatively as possible. Unfortunately, from what you said before, that means waiting and getting a lot more cash for down payment _and_ trying to find an absolutely low-end priced foreclosure. "Below your means" is kind of an irrelevant statement right now because "means" has become so distorted. Buying at 3-times your income never used to be "below your means" until about the start of this decade. We bought our first home at 2.2-times our income, and while we were conservative, that didn't feel "below our means". We sweated our early mortgage payments like everyone else. We worried we were in over our heads. And that was 1996, which is only 12 years ago. So buying at 2.5 or 3.0-times your income shouldn't be considered "skimping" or "being cheap".

You get three big benefits from buying on the low-side, assuming you have decided to buy and not just rent:

1. Your mortgage payments will be lower, exposing you to less interest-rate risk if there is deflation.

2. You are less at risk of financial distress in the case of illness or job loss, which can be very aggravated during a huge recession. Back in the early 90s I worked with a lot of people who lost their jobs between 91 and 93. Many of them had to take jobs earning between 60%-75% of their former salaries. Those who had bought homes (condos mostly then) were in some serious straights.

3. You are less exposed to home price drops in absolute dollars. If you buy a $250K foreclosure and it drops 10% more, you only lose $25K. If you buy a $1mm McMansion, and it loses 10% you're out four times that much. Also, low-end homes tend to lead the correction, even if they take longer to recover, so they're more fully corrected than the suburban million dollar homes.

On renting: I and others have talked about how to properly value rent -v- buy. I have a spreadsheet on this blog which will help you with that, as will a hundred other decent calculators on the web. In general, it's usually a wash in normal times minus some generally minor tax differences and about 1% net of inflation in appreciation. But renting affords flexibility and lower risk of financial distress.

But I'll say this: during the Great Depression it turned out to be the most rational thing to do was rent, even when rent was over twice the cost of owning. That was how powerful the deflation was. You were better off having flexibility in your cash-flow than in saving 50% on what it cost for your housing. Many rich people walked away from their mansions took refuge in upscale rental buildings. I talked about this at some length in a thread I argued almost 2 years ago on here. I'll link it in the next comment.

[randolfe_]

This article, about half way through, I got into a debate with a guy who insisted on referring to the Great Depression. Ironically, at the time I didn't think a deflationary depression was on the table, so I ended the conversation after it turned pointless. But some of what I wrote has context today, given that I took the trouble to look up what happened to different socioeconomic groups in terms of wealth during the G.D.

In short, the rich lost most of their wealth in the 30s and 40s due to the deflation and later the war-economy rules. Most of what they lost was real-estate wealth. What would become the middle-class later gained most of their wealth during that period, which they did as a function of 2 main variables: (1) no debt, (2) number of working-age people in the family. So families of 8-10 with half being teenagers earned enough deflationary cash to be able to buy real estate so that by the end of the Depression & War, they had risen in terms of real wealth while the rich had slipped.

Just something to keep in mind when all the pro-real estate cheerdorks go parading around like they represent some nouveau rich simply because they've figured out how to trade a debt note for a land title. Were there to be another Depression anything like the last, nearly all of those people will emerge out the other end faring far worse than simple renting families who lived within their cash-means and earned wages-for-cash, which they then put to use buying modest homes (mainly for cash) after the dust settles.

[Brand]

Randy, I have the sense that deflation is greatly overplayed as a value-enhancer of cash. How much did things really deflate during the Great Depression? If I'm in 80% cash right now, could that be worth 2-3x in five years? I doubt it.

[randolfe]

Brand

Deflation is much more difficult to measure that way than inflation. As I mentioned, deflation destroys real growth (it is actually real contraction), which is much more damaging economically than inflation-caused debasement. Growth can occur during inflation, it cannot during deflation.

Because of that, it isn't as simple as your dollar suddenly spends 3x better. What has historically happened instead is that your dollar either doesn't spend at all because companies & services fail, or when it does it spends far beyond just 2-3x. During the Great Depression many things could be purchased at 1/10, 1/20, even 1/100 in some cases. But other things simply were no longer available at any price because the producers/sellers had gone under. Even with real estate, there were literally entire neighborhoods where they couldn't sell houses for any price, but not because they couldn't find someone willing to pay ten-cents. But rather because the municipalities ended up with foreclosed properties, and the banks which would have taken them in the normal process no longer existed, were indefinitely closed, or simply refused to take them. So these houses were there, and when they could be sold many went for 1/20th of their last sale value, but a lot of them just sat vacant.

Same with cars, which sat unsold on lots. Food which rotted in the closed, locked stores, etc. Remember the Grapes of Wrath: fruit rotted on the ground of fields in California, even though throngs of refugees from the dust bowl sat just outside the fence willing to pay pennies, or trade labor for that fruit. But the farmers were better off simply eating their own fruit and letting the rest rot.

Assuming all that doesn't happen this time around, were there to be a deflation, then the main thing you'll have to worry about are:

1. interest rates vis-a-vis fixed payment debts.

2. durable goods.

Already, if you've been paying attention, the value-adjusted prices of just about every durable imaginable, including effective automobile pricing, have been dropping at a rapid rate -- at a rate much faster than the normal product-cycle deflation.

The wild card in durable goods deflation is how the global trade scenario unwinds. It could be that things like consumer electronics stop deflating, or even inflate, if trade with China et. al. break down, either by politics or by currency.

[Brand]

Well, without FDIC insurance, people literally lost everything in the Great Depression. So I can imagine deserted neighborhoods where nobody even has the cash or inclination to buy a house. But we're not there right now, because the government is pumping so much cheap money into the system that anyone with a high FICO and a downpayment should be able to get a 6% loan.

Places like Buffalo and Akron are there because of shrinking populations, though.

Even in desirable Fort Collins, the real estate sales volume seems to have fallen off a cliff, and prices are slowly sliding -10% towards -15%, with more to come. Cars are certainly cheaper, especially gas guzzlers. So durable goods are deflating. Even the oil bubble seems to have popped temporarily.

But at what point will that decelerate? Surely productive assets like arable farmland won't depreciate nearly as fast, or nearly as deeply?

[randolfe]

Well, farmland in much of the country is effectively valued at depression levels. Where I grew up in the midwest, and worse where my wife grew up (she actually grew up on a working farm which was finally sold off a couple years ago) they pretty much can't give away farm land. Arable farmland. Much of the land-value has been driven by sprawl development, transportation-related sales (selling to the gov't to build roads), and if you're lucky, to a factory-farming operation.

The traditional, independent, family farmer is a dying breed. Most I know still farming are diversified into livestock, specialty crops (like Edamame quality beans), or they have a 2nd (or even 3rd) job. The land isn't worth much, especially now that nobody is buying it up to cut into new construction parcels.

[flak]

Randy, I've been following your posts since you started on Patrick's site (I used to comment there, but had reverted to lurking before you arrived.) I'm so glad that you decided to recharge this site!

I don't want to derail the discussion above - but would you think about addressing a comment you made in the 'No Treasury Bailout' thread? You wrote, "Iceland is in the same boat as New Zealand, South Africa, Australia, and Canada, in that order of peril -- they will/are taking the brunt of the carry-trade unwinding."

Can you shed any more light on the mechanics of this? Or (perhaps a more readily answered question), why Canada? I hadn't realized that Canada was much of a hub on the carry-trade route.

[randolfe]

Thanks Flak. I can answer the Canada question straight away: it's not, really. I was mistaken when I wrote that about how much the CAD was part of a carry trade. But the CAD is still strongly dependent upon the direction of the USD, so it should continue to appreciate as the USD appreciates versus the EUR.

Of course once deflation sets in, predicting the direction of cross-rates will be very difficult because they'll be driven more by assessments of merits of government interventions, than by normal fundamental forces.

Perhaps someone who's more of a carry-trade expert will comment on the specific technicals of how that unwinding hastens deflationary forces. The best I can do is say it represents capital withdraw.

[Brand]

Well, Iceland is screwed simply because the banks' debt is mostly in euros, and they're still on the krona. Iceland can't run the treasury press to inflate their way out of the problem, and the nationalized banks have 9x national GDP in debt.

In a word... hosed.

[randolfe]

Ouch. Yes, they are indeed screwed. Right now their only order of business is who to beg for a foreign bail out.

That raises another question: if Russia bails them out, will they exit NATO and set up Russian bases? Is this Russian retaliation for the US missile shield?

[Brand]

The Bush administration continued its campaign of idiocy by not helping Iceland. We had a military base there until very recently, and Iceland is quite clearly a highly strategic location.

The British are triple-idiots. The Icelanders froze a bunch of British accounts at their banks, and by blocking any aid the English financial uber-lords just incentivized Iceland to write British citizens off the list of creditors. Well done, chaps! If Iceland's government was so desperate as to accept a loan from Russia, that should have been a clear signal to the ECB that they needed to exercise mercy and common sense. How could Europe possibly let a first world neighbor go bankrupt, let alone one that held so many assets denominated in euros? It was yet another expression of European protectionism and selfishness. A dose of irony would make that entire continent smarter. Early last week the German finance minister was up at a podium chastizing the Americans for losing their superpower status and smugly mocking their well-deserved financial catastrophe... and this week, who was queued up at the ECB soup kitchen line, asking for a handout?

Raging, spectacular, unmitigated foolishness.

All the continent had to do was limit the damage and restore some liquidity to Iceland. Instead, they let the house burn to the ground with their own furniture inside. Does gloating seem like such a good idea now? There is surely no way to reverse the damage, and if the Iceland nationalizations cut loose the mainland subsidiaries, that's another batch of bankrupt institutions that need to be absorbed by Britian and the euro-based economies.

Note: I may be completely off about this, not knowing the intricacies of intra-European politics. But this just seems like an easily prevented catastrophe, allowed to burn for no reason beyond sheer provincialism. As always, just my two cents.

[Brand]

Also, that was something of a tin foil hat rant. Apologies.

That said, intentionally shoving Iceland into a situation where they had to take cash from Russia is just a mind-blowing foreign policy blunder.

[astrid]

Iceland is particularly vulnerable because their banks expanded and acquired several times their GDP in Euro denominated debt. The New Yorker had a story about their currency problems on April 21 of this year. The rest of the countries are not nearly so leveraged and are not likely to experience out and out failure.

But I'm reading up on New Zealand just in case a travel bargain presents itself.

[astrid]

I will say that Iceland felt a little unreal when I was there last year. There were banks and new construction everywhere. The RE prices were quite high (near BA prices). The locals were driving SUVs that consumed $8/gallon gas. And there were bank and accounting branches everywhere, which struck me as being a bit odd at the time.

[astrid]

OT but very much on everyone's mind. I must say I didn't expect the Great Deleveraging of 2008 to come quite so fast and furious. The banks are dumping so quickly that the masses are getting panicky.

[randolfe]

I don't think that's off topic at all, Astrid. Very much in line with the point of this thread, in fact.

I'll admit that the pace of some of the collapses has surprised me as well. I expected a bit more effectiveness from the institutional investment complex, and from the more solid part of the credit complex. That probably betrays my residual bias towards neo-classical economics. Even though I know behavioral economics (Austrian school) tend to drive how these events play out, I can't help but sometimes resorting to Keynes -- whose theories I actually think will get us out of this mess after the dust starts to settle.

But the collapse is gaining momentum fast. Sort of like a hurricane. It takes forever to get there, but once it makes landfall you're surprised at how fast and how bad it comes on.

[randolfe_]

Brand

That doesn't sound tin-foil-hat at all. After opening the FT this morning I went and started reading some of the UK press on the net. Holy sh*t! I mean, holy sh*t!!!

I would not be at all surprised to see EUR = USD parity within the next year. And GBP = USD parity is not off the table. We'll have to start a whole separate to properly take Europe out back for a whippin'.

I will note that I and some of you guys were about the only "doomers" who were questioning the whole Peter Schiff crowd when they said that the dollar would collapse to be worthless, and that the EUR would take over as the global currency. I remember Schiff and his disciples about 2 years ago strongly advising everyone to sell USD-denominated companies, including oil companies, and buy buy buy EUR-denominated, European-market focused companies.

How'd that work out for them? I know my Vivendi holdings, denominated in EUR, held in Paris, is down approaching 40% now, and it gets worse every day with the EUR revaluation.

My point is, as always, you can't predict the unpredictable. Schiff isn't a medium. He can't know how deflation will play out. He's just extrapolating out current trends without any regard for how strange times bring on strange events.

[astrid]

It's scary that this is just step 2 (step 1 being the collapse of the I-Banks). For right now, the main manifestation of the deleveraging are the stockmarket drops. People who carefully saved for retirement will care, but it's still not real for most people. We haven't seen any runs on the bank, or "safe" businesses losing their lines of credit, or people losing their "safe" jobs.

Short of getting a gun and putting my savings into physical gold/dried pasta, I think I'm as well prepared for this as anyone. But it still scares the bejesus out of me whenever I think about the implications.

[randolfe]

I wouldn't build a bomb shelter just yet. I sort of doubt we'll see 1930s-style bank runs. If for no other reason, we simply bank differently now. You don't really need physical cash to survive. You can use a credit/debit card and electronic money. That affords the government a lot of tools to prevent runs.

I don't think the next step is bank runs, though there will be plenty of bank failures (see next thread). I rather think it's a deep, harsh recession. One that just keeps getting worse, and worse, and worse. I remember the 1990-93 recession. In late 1990 people were arguing there was no recession, and there wouldn't be one. By 91 most acknowledged we were in a recession, except for political partisans. Bush sr. lost the election mainly for arguing there was no recession, which pissed off people; Clinton only had to utter "It's the Economy Stupid" to win.

By 93 people had finally given up and accepted that downsizing, rightsizing, outsourcing were here to stay. People were accepting the relationship between employee & employer had forever changed: no loyalty expected, none given.

Even as late as 95 many people were still feeling we were still in recession, even though the dot-com was already sprouting. That was half a decade of perceived bad times -- and it was probably a mild recession compared to what's coming.

This one will be at least as bad as the 70s. By the end of that one (which I watched on tv as a kid) farmers were rioting, driving around the fountains in DC in their tractors. Interest rates were 20%. Everyone was resigned to the fact Germany was the emerging world superpower, and the Japanese were buying our country, feeling like we'd lost WWII in the long run. Our military was viewed as impotent, the Russians were pumping away with a miracle Soviet economy (even though it was all rigged), and we couldn't even rescue 50 some hostages from our Iranian embassy.

And, if I'm honest, I still think this recession will be worse than all that. Probably a lot worse.

[steve]

hi guys, great conversation and could not be more thought provoking. i am a physician who was forced to learn about plants as a "pre-med" when I should have been taking economics and business courses to learn how to handle the money i would some day make. Still young in my 30's but getting scared enough to start learning as much as I can in case it really hits the fan. I'm not knowledgeable enough to contribute to your conversation, just posting to ask what your thoughts are on John Williams' Shadow Government Statistics website, especially his Hyperinflation Special Report from April. Scared the crap out of me. . .

[randolfe]

Thanks Steve. I think John's shadowstats site has some interesting information. I like his reverse-engineering of hedonics. I don't like his extrapolations, and I think he misses some important macro factors.

As for hyperinflation: again, as I've stated at least a thousand times now -- hyperinflation has never occurred to a nation which maintains a credible, military capable of projecting military power outside of its borders.

A bunch of people like to beat the hyperinflation drum, but they are misinformed. Of course, anything is possible, but hyperinflation would require the utter collapse of the USA, including the collapse of our military.

The reason is simple: hyperinflation occurs when a nation prints money in order to service foreign debts, and then that spirals out of control. It is a brutal transference of wealth out of the country to foreigners. When that gets out of hand, then the government has a decision to make: (1) keep printing money and sending wealth away to foreigners, resulting in a revolution or worse; (2) default and tell the foreigners to take a hike.

Israel chose #2. Russia chose #2. Even the granddady of all hyperinflations, prewar Germany, chose #2 once they failed through #1 into a dictatorship. The USA simply will not honor foreign debts to the point of starving its own people. The people won't allow it.

You should instead be worried about
a. Stagflation
b. Deflation

By the way, all the references to modern stagflation episodes outside of Israel and Russia are directly related to IMF policies. Joseph Stiglitz has written extensively on this subject.