Debtor Nations Dream of Deflation
Think this bubble is big? Wait until you see the next one. Part One of three.
ericjanszen [iTulip, Inc.] | POSTED: 04.06.05 @01:21 on Always-on Netwwork
"We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power."
—Alan Greenspan, appearing before the Senate Banking Committee on Feb. 15, 2005, in response to Democratic Senator Jack Reed of Rhode Island on the topic of funding Social Security.
In my last column, I asserted that since the 1970s, when the world adopted the current floating exchange rate currency system that made the dollar the world's reserve currency, the Fed has overseen four asset bubble cycles. The first was the inflationary boom that topped out when gold peaked at $850 (about $2000 in 2005 dollars), then collapsed in 1981. A second bubble occurred in the early 1990s that engaged all asset classes, the one bubble of the four so far that the Fed has acknowledged was a bubble. The Fed said in FOMC meeting minutes that with its tightening in June 1994, it "very consciously and purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation." The liquidity provided to get the banking system on its feet again led to another bubble in the late 1990s that was concentrated in the stock market. It collapsed nine months after the Fed started to withdraw liquidity from the markets in 1999.
The bubble we are living in today—the fourth since the Bubble Cycle started in the 1970s—is a side effect of the monetary and fiscal stimuli that was applied to counter the deflationary impact of the collapsing 1990s stock market bubble. As Martin Mayer said in his book The Fed: "The truth is that liquidity, the only significant weapon remaining in the central bank's arsenal as decision making moves to the markets, will not necessarily go where you want it to go when you need it to go there." Today's bubbles are concentrated in the real estate market, a side effect of a less visible bond market bubble. However, most asset classes are involved, including stocks, the dollar, and commodities. The Fed started the latest tightening cycle eight months ago. If the pattern of the past three bubbles is an indicator, we can expect some of these bubbles to start to deflate this spring.
Up to a point, I agree with John Mauldin's concept of the "Muddle Through Economy" as an outcome of unsustainable levels of household, corporate, and foreign debt created during past bubble cycles. His theory is that the Fed can walk a line between deflation and inflation long enough for the economy to eventually grow its way out of these imbalances. This reasonable, credible, and hopeful outcome is quite possible, even likely. However, highly indebted nations such as the U.S. today, like the indebted households and corporations that comprise it, are crisis-prone.
One out of every 73 U.S. households filed for bankruptcy in 2003, a record high and twice the rate that we had at the bottom of the previous bubble cycle in 1993, according to the American Bankruptcy Institute. Most were pushed into bankruptcy by an unexpected hardship, such as sudden medical expenses or job loss or both. The Fed itself acknowledges this record level of personal debt:
"Research  by the Federal Reserve indicates that household liability is at a record high relative to disposable income. According to the FRB, 'Some analysts are concerned that this unprecedented level of borrowing and personal bankruptcy might pose a risk to the financial health of American households. A high level of obligation among households could lead to increased household delinquencies and personal bankruptcy, which could threaten the health of lenders if loan losses are greater than anticipated.'"
Similarly, sudden and unforeseen events can push over-leveraged nations into bankruptcy. And an attack by an enemy like Osama Bin Laden, who has pledged to bankrupt the U.S., isn't needed for a crisis to happen. An accident in the massive bank-funded OTC derivatives market that's dependent on low interest rates is a likely trigger.
Assuming a crisis is possible at some point, is the outcome likely to be deflationary or inflationary? Economists like Stephen Roach at Morgan Stanley and Bill Gross at PIMCO cover the range of opinions on whether deflation or inflation is likely to occur after the next post-bubble crisis.
Those who expect deflation as a possible outcome of the collapsing housing and bond bubbles point to Japan as an example of an industrialized country falling into a deflationary cycle following the collapse of asset bubbles. The usual explanation for Japan's fall into a deflationary cycle is that monetary authorities failed to respond quickly enough to prevent a liquidity crisis from developing. In a nutshell, the Bank of Japan allowed the rate of inflation to fall below zero. Once inflation turns negative, monetary authorities can't get the Fed Funds rate below the rate of inflation; they can't lower rates below the negative inflation rate.
But the central bank in the U.S. didn't make the same mistake. Instead, it quickly dropped rates after the stock market crash of 2000 and has held the Fed Funds rate below the rate of inflation for more than four years since then.
In 1999, I came down on the side of inflation as the likely outcome of the U.S. reflation efforts that were certain to follow the 1990s stock market bubble. I thought so for the following simple reason: the Fed and the U.S. government cannot allow millions of indebted households, corporations, and the U.S. government itself to go bankrupt, and a liquidity crisis can quickly develop into a solvency crisis. This was a central tenet of something I dubbed "Ka-Poom Theory," and it is even more true today than it was in 1999, as the monetary and fiscal stimuli applied to counter the deflationary forces unleashed by the stock market crash of 2000 are far stronger today. When this bubble declines, the solvency of U.S. homeowners will be maintained at any cost, even if that cost is a condition of severe inflation.
Next: Ka-Poom Theory Revisited - (iTulip Select)