Confusion reigns: A crisis-driven global rush to dollar liquidity is not deflation
In the crisis stage of a debt deflation, defined by Fisher and Minsky as a reduction in debt financing, credit and money market panic causes banks to stop lending and borrowing from each other, pay off existing loans to shore up their balance sheets, and build reserves against expected future losses. This creates a short term spike in demand for the currency in which the debt is denominated, in the current case dollars. To the uninitiated, this looks like monetary deflation. A strengthening currency and falling interest rates also characterizes monetary deflation. That can in time produce commodity price deflation, so the confusion is understandable. But don't be fooled.
Today the Wall Street Journal explains the recent surge in the dollar in dollar demand:Dollar Surges Amid Hustle For Supplies OverseasWhat will happen when this temporary dollar carry trade reverses? When?
Oct. 7, 2008 (WSJ)
The dollar is in demand because many foreign banks engaged in short-term borrowing in dollars to fund various activities in recent years. Now, one normal channel for getting those funds or rolling over such debt -- borrowing from U.S.-based banks -- is gummed up, as banks are leery of lending to one another.
At the same time, banks world-wide are also looking to reduce their overall borrowing as part of a race to clean up their balance sheets. Where that borrowing was in dollars, they need dollars in order to repay it.
"There is a pyramid of leverage" in the financial system built up over years, says Mark Astley, CEO of Millennium Global Investments, a U.K. currency manager with $15 billion in assets. "This isn't going to be over in a couple of weeks."
The global demand for dollars pushed the U.S. Federal Reserve to announce a major expansion of its "swap" lines with other central banks, which allow them to provide liquidity in dollars to their local commercial banks. The Fed now has arrangements with nine other central banks, which together provide access to a total of $620 billion.
Still, that hasn't been enough to ease the squeeze. Some of the demand for dollars has spilled over into the currency markets. There, participants can buy dollars outright, or use derivatives known as currency swaps to exchange one currency for another at two different points in time.
Some investors say the appetite for dollars is akin to the demand for the yen. The yen surged against the dollar and the euro Monday; late in New York one dollar bought 101.61 yen, down sharply from 105.14 Friday.
The yen's ability to thrive stems from the fact that in better times, investors borrow in yen to take advantage of Japan's ultralow interest rates. But when volatility rises or investors need to cover losses elsewhere, they undo these maneuvers -- known as carry trades -- and buy back yen, boosting Japan's currency.
Meanwhile, by borrowing so much in dollars, foreign banks may have created "the biggest carry trade of all time," says Hans-Guenter Redeker, a currency strategist at BNP Paribas in London.
The dollar will weaken rapidly. When? The de-leveraging of the "pyramid of leverage" will take from two to six months but not likely more than that.
What will happen to all of the money that the Fed is issuing to keep the banks liquefied?
To answer that we need to go back to the original source of the problem: asset price inflation.
Asset price inflation leads to asset bubbles that pop, resulting in asset price deflation. Today asset price deflation is occurring in the residential, commercial, and corporate sectors of the US and European economies. Asset price inflation was financed by credit created in the endogenous credit markets, not by central banks issuing fiat money. Asset price inflations and deflations are separate from commodity price inflations and deflations for this reason. However, when asset price deflation threatens to spill over into the overall economy due to a sudden withdrawal of purchasing power from households and businesses, the Fed steps in to substitute government issued money that the panicking and dysfunctional endogenous credit markets are no longer producing.
The chart above shows money flows through the economy. Consumers borrow new money into existence when they purchase cars, homes, and other items on credit through the banking system, resulting in Mb cash balances for households. Businesses and government also borrow money into existence. On one side of the balance sheet (the lenders') lending money into existence (dotted lines) results in an asset. On the other side of the balance sheet (the borrowers') borrowing (dashed line) creates a liability. Once created, the money flows through the economy. The banks fund the new debt through the Credit market. The Monetary agency (Fed) funds the Credit market and government via short term lending. When the Credit markets seize up, as they have recently, the Fed steps up its short term lending to the credit markets. In a drastic measure, it buys securities directly, acting as "buyer of last resort" in order to keep maintain money creation.
The Fed is responding to the seizing up of credit markets with heroic reflation measures, such as outright purchases of commercial paper today. Once liquidity is restored, the money created for that purpose will remain in the economy, potentially producing massive inflation. The Fed will later attempt to withdraw the money by targeting the price of money, that is, interest rates: the Fed will raise rates rapidly.
Future inflation clues
One way we can validate our expectation that inflation will follow the Fed's mass money creation effort is to watch the oil and gold markets. Both are pricing in a future decline in the value of the dollar, despite obvious future declines in demand for oil and gold that will be caused by the developing global recession. This also occurred during and after the 2001 recession when gold and oil started to rise in spite of disinflation in wages and other prices in the economy as the Fed pumped liquidity into the banks and government spending stimulus accelerated.
Future inflation expectations are reflected in recent increases in oil and gold prices even as the dollar has spiked; dollar and oil/gold prices are long term negatively correlated but can be short term positively correlated. The recent spike in the dollar reflects a short term crisis driven rush to liquidity while rising gold and oil reflect expectations of longer term inflationary impact of excess liquidity and dollar weakness.
Why won't asset price deflation lead to commodity price deflation as occurred in the 1930s?
We believe the Fed will succeed in producing enough liquidity to prevent asset price deflation from spilling over into the commodity prices. Unfortunately, we also expect the effort will further undermine the dollar, producing inflation in goods and services that are sensitive to energy prices.
I see deep discounts and fire sale prices at the local grocery store. Isn't that deflation?
Cutting prices to burn off inventory is indeed deflationary. But deflation refers to the condition of a self-reinforcing process of declining demand, rising unemployment, falling wages, and falling output. This happens in countries that are net creditors and have a positive trade balance, such as Japan in the 1990s and the US in the 1930s. That cannot happen in the US because the US is a net debtor that achieves low goods price inflation via imports of goods from low wage producers. Elsewhere in the economy where trade with low wage countries does not contain inflation, such as insurance and tuition costs, inflation is high. The US finances its trade deficit via the sale of financial assets. As US demand for imports falls in recession, demand for US financial assets is also declining for a combination of reasons, including loss of confidence in US markets. As a result, the US will experience a combination of rising prices and falling demand and output.
Consider the example of your local grocery store and its fire sale. Across the entire retail food sector you will see sales as the recession deepens. The question is, what is the new equilibrium price between the price your grocer pays for new goods and how much he can charge for them?
Clearly he cannot stay in business for long if the input costs for his goods remain higher than the price he can charge his customers. Input costs must fall as well to match the new lower end user sales prices that are meeting demand in the slower economy or he will not be able to restock the next cycle of inventory and sell it at a profit.
Unfortunately, with oil still 400% above 2001 prices due to the weak dollar, producer prices are still high and rising. If your grocer does not have a lot of cash on hand to wait out a decline in input prices, he will have to go out of business because he cannot sell every unit of inventory at a loss for long. If the dollar remains weak, as we expect it to, input prices will not fall much if at all; many grocers will have to go out of business; with less competition for customers the survivors will have sufficient pricing power to charge the prices they need to charge to stay in business.
What happens if half of the grocers in your area wind up going out of business? As floor space per capita shrinks by 50%, stores that survive get to charge what they need to sell at a profit over input costs. A new, higher equilibrium price for food at a smaller number of grocery stores will result as the number of grocery stores in your area declines. Those prices may be higher than they charge today. As a result your grocer's customers' buying behavior will change. Customers will buy less and they will substitute lower quality products.
That's how it is in countries where the standard of living has declined because the nation had lost purchasing power. If you were in Mexico during their bond, currency crisis and inflation that is what you saw. Or in Russia in the early 1990s, but more extreme. Or Argentina in 2001 but very extreme. A similar process happened in the US in the 1970s.
Politicians will claim we are suffering from temporary "stagflation" but a more honest phrase is "now we are poor." The only cure is to improve the pricing power of the US, and the only way to do that is to restructure the economy to produce, save, and invest instead of trade inflated assets, borrow and consume. It will be a long road.
What's the status of the Debt Deflation Bear Market that EJ warned subscribers about on Dec. 27, 2007 when the DOW was at 13,365?
As of today, the DJIA is quickly catching up with the performance of the Nikkei in the first year of Japan's post bubble debt deflation in 1990. As the US markets continue to price in the US debt deflation, the DJIA is now off 30% from the time of that call versus 40% at this point in the first year debt deflation process for the Nikkei.
iTulip Select announced and started to track the Debt Deflation Bear Marked Dec. 27, 2008
in an article Time, at last, to short the market ($ubscription).
Since then the DJIA has declined 30%.
I didn't listen to you guys and stayed in the stock market. Am I screwed? Should I sell? I also didn't listen to you in 2001 when you said gold was going to go up or at all of the other times when others were calling gold a "bubble" in 2004, 2005, 2006... Is it too late to buy?
These are the most frequent questions we get. We generally advise against selling into a panicky market, but these are unusual times. A very large domino is still to fall: credit default swaps.
Four trillion in OTC credit default swap gross market replacement value (the notional value is just silly) of credit debt default insurance that can never be paid has been taken out against trillions in mortgage and corporate debt that can never be repaid. The CDS are thousands of hand written contracts sans clearing house, settlement based on novation, the weakest form of contract settlement. A huge disaster waiting to happen. It's been waiting to happen for at least nine years:
Derivatives markets guarantee a winner for every loser, but they will over time concentrate the losses in vulnerable sectors. Nature obeys Mayer’s Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ain’t got want to get and speculate. The logic behind margin requirements in stock markets and capital requirements in banking also holds in the derivatives markets. Permitting highly leveraged institutions to hold private parties behind closed doors is the political version of selling volatility: the predictable likely gains will one day be overwhelmed by an equally predictable disastrous loss. - Martin Mayer, Somebody Please Turn on the Lights, Derivatives Strategy, 1999Buying gold on the short term dollar bounce is probably a sound move, if you buy into our general thesis that a new global currency regime is needed that does not have the dollar at its center; a smaller role for the dollar in the global economy is not dollar positive.
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