Sunday, June 20, 2010 12:15:02 PM
Back and forth...back and forth...I feel like a friggin' see saw when it comes to the inflation/deflation debate. Just when I think I have my mind made up...Harry Dent http://www.hsdent.com makes a compelling case for deflation. Here's a lavishly interesting article in his paid newsletter. The way he puts it, he says he's putting a nail in the coffin on the inflation/deflation debate once and for all.
I have so may paid newsletters I cannot justify renewing this one. If we can get 10 people from this board to pitch in $35 each...we can all create a common email address and share a username/password to get this one. Who's interested?
Warning--It's mighty damn long. However...if we get this right...we'll be able to grow our assets substantially over the next 10 years if we prepare.
Here's a snippet:
When Rodney Johnson or I give presentations these days, it is typical that the host of the conference or a
speaker to follow will say “I agree with everything Harry (or Rodney) just said, except the part about deflation.
There is no way we aren’t going to get inflation down the road from the government’s unprecedented stimulus
and monetary policies.” The classic graph everyone is
looking at is Chart 10, which shows how the Fed roughly
doubled the monetary base in just four months—an
unprecedented monetary stimulus going back to the
1930s and 1940s. But as we have shown in past issues
and will show more in this one, the recent monetary
expansion is nothing compared with the massive private
debt that has accumulated in the past decades and the
deleveraging of that private debt that has only just begun.
The Fed is aiming a monetary fire hose into a tidal
wave of debt deleveraging. This will not succeed in
changing the inevitable and necessary deflationary
environment ahead!
This is the most important issue for investors,
business people, and the government. If you don’t
understand that deflation is the only possible outcome, then you will make the wrong decisions even
though you saw the downturn coming.
A quick example: Peter Schiff was one of the forecasters who clearly saw the banking crisis coming ahead of
time. However, he gave the typical inflationary advice: bet against the U.S. dollar in foreign currencies and buy
gold. His investors lost money in the last stock crash. We showed in our last newsletter that when stocks
crashed from May 2008 into March 2009, the dollar rose 20% and fell. The same thing will occur in the next
crash, except gold is likely to be hit much harder next time. So, in this “New Year 2010” quarterly issue, we
are going to put the final nail in the coffin on this inflation/deflation debate, as it is the most critical issue for
you to understand:
1. After the greatest credit bubble in modern history, we simply will have to adjust to a lower level of
borrowing, spending, and growth. Deflation and the deleveraging of credit is the only way to do that.
Deleveraging is the reduction of debt, and it is occurring at both the personal (mortgages, credit cards,
etc.) and business (lines of credit, straight loans, commercial real estate loans) levels. That will be painful in the short run — but very healthy in the long run by reducing debt, home prices, and the cost
of living and doing business. It is painful because adding leverage – spending borrowed money – gives
a person or business more dollars than is created through normal income channels (wages or revenue).
These extra dollars allow for greater spending which increases business activity and raises the
standard of living. But it has to be paid back. This arrangement works well ONLY if the value of what
was pledged for these loans rises faster than the rate of indebtedness. This is where the current
situation failed. Because borrowing was done largely by pledging real estate, when prices began to fall
the debt structure began to crumble. There is no way for our system to reflate asset prices to the point
where these debts will be made good.
2. Our economy follows seasons just as everything in life does. We are moving from fall into winter.
Winter means falling price levels or deflation, with no exceptions in modern history. Inflation comes in
the summer season, as in the 1960s and 1970s. The fall season follows with disinflation and a bubble
boom leveraged by new technologies moving mainstream and falling interest rates. Depressions always
follow bubble booms, again with no exceptions in modern history (1840s, 1870s, and 1930s).
3. Economists and laymen alike are missing the very big picture by focusing on money supply instead
of the massive growth in private credit that vastly overwhelms monetary growth. Steve Keen is the only
current economist that seems to understand this fully. Robert Prechter is the only major forecaster
other than us that clearly sees deflation ahead instead of it being an “if the government does this, or if
they do that” issue.
4. Inflation favors gold, commodities, sounder foreign currencies, and often emerging country stocks,
and it obliterates long-term bonds and stocks, as in the 1970s downturn. Deflation favors the U.S.
dollar, short-term cash and cash equivalents, and, after the crisis starts to hit fully, long-term bonds.
The only common denominator between inflation and deflation is that they both hurt stocks, but
deflation obliterates stocks even more than inflation does.
The Simplest Explanation from a Non-Economist
Before we outline the logic of deflation in this time period, let me start with the simplest and most direct
statement I have come across. It comes from Steve Ballmer, CEO of Microsoft and from one of Steve Keen’s
blogs:
We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective
I would bring is not one of recession. Rather, the economy is resetting to a lower level of
business and consumer spending based largely on reduced leverage in the economy.
Steve Ballmer just described the deflationary process perfectly without using the words deflation or monetary
policy and without using any economic jargon. Another simple way to view this is like a waterfall (Chart 11).
The economy needs to transition to a new lower and more sustainable level of growth after an extreme bubble
in credit artificially raised asset prices and consumer spending. The only way for that to happen is for asset
values and consumer prices to fall and for credit to deleverage and be restructured dramatically, which will
settle the economy at a new, lower, and sustainable level from which we can grow again.
The only possible path from these heights of asset values and bad loans against them is deflation and
the write-off of such bad loans at the expense of the lenders, not the taxpayers!!! That transition is scary, and it is rapid when prices really
start to fall—as we can already see in housing. It is backbreaking
as we hit the “bottom of the pool,” before we
consolidate and then flow and grow in a more orderly
process again. However, this deflationary transition is a
necessary part of the innovation and growth process, as
we will summarize ahead. Even the credit bubble is a
natural part of the process, although total lack of
regulation can cause it to go too far when pure speculation
is allowed instead of productive investment, as clearly
occurred in this case in the U.S.
This is also clearly a once-in-a-lifetime process, as the
economy only goes through this winter season or
deflationary adjustment every 60 to 80 years in history.
The economy’s life cycle is similar to our own in time
frame. So, we return to our most core concept: The 80-Year
New Economy cycle. In Chapter 1 of the revised paperback
edition of The Great Depression Ahead, we used a new
version of this cycle (Chart 12 here) that corresponds
more to the normal seasons we are used to rather than the
technology or business cycle, which moves more in terms
of its four stages (innovation, growth boom, shake-out,
and maturity boom).
In this chart there are two lines. The red line represents
the consumer price index (CPI). Think of inflation like
temperature. High temperatures and high inflation come
in the summer. Low temperatures and deflation come in
the winter. In between these two seasons you have more
balanced temperatures or prices, which the economy and
consumers like much better and which represent a better
balance of supply and demand. The green line represents
the economy or stock market. It rises during the demographic
booms that presently come about every 39 - 40 years and then falls during the demographic slowdowns that
follow. If you go back a century or more, this cycle revolved more around two 29- to 30-year commodity boom
and bust cycles rather than two 39- to 40-year demographic cycles. At that time, we were still mostly farmers
in an agrarian economy wherein commodity prices and innovation around them were more critical, and our
life cycle was closer to 60 years than the 80 years it is today.
Spring and Boom: 1942-1968
The last deflationary winter season was 1930-1942. That season was followed by a spring boom. It is
commonly thought that World War II brought us out of the Great Depression. However, in reality, the rising
earning, spending, and borrowing cycle of the Bob Hope generation from 1942 into 1965 to 1968 drove that
long expansion (on more like a 44-year lag for peak spending back then). As price levels rose again, interest
rates also gradually rose as well. Asset prices, including housing, merely were returning to normal predepression levels. Rising interest rates don’t favor rising speculation, so there was no excessive credit or
asset bubble. The radical new technologies that emerged out of the winter season, such as computers and jet
travel, were moving into niche markets and had a greater impact on extending the previous technologies, from
autos to electrical appliances to phones, radio, and TV at first. Those maturing technologies had saturated our
economy thoroughly by the late 1960s.
Summer and Inflation: 1968-1982
In the late 1960s came inflation and a long-term recession, or “stagflation,” partly from the downtrend in
spending and productivity of the aging Bob Hope generation. We have shown for two decades how in this
modern economic cycle inflation has correlated largely with the huge investment in raising young people and
incorporating them into the workforce and not with commodity prices as in the past (see Chart 13). The Baby
Boom generation created the largest inflationary cycle in
modern history. That cycle reversed as this massive
generation became increasingly productive and began
earning, spending, and borrowing more money as they
raised their families from 1983 into 2007—a simple 46-
year lag for the average peak in spending (as per our wellknown
Spending Wave that we won’t repeat here).
If the first cause of inflation is a new generation of
expensive young people in modern urban societies
wherein they are so expensive to raise, the second has its
roots in the technology cycle. Our ability to grow in
earning and spending also depends on new technologies,
infrastructures, and business models (like the assembly
line in the past cycle). During the summer season, old
technologies and industries totally saturate the economy
and lose their ability to generate higher productivity. The
up-and-coming generation of producers and consumers is still young, expensive, and very low in productivity.
It was no accident that the 1970s represented the lowest decade for productivity gains of any in the last
century. Over the course of the summer season, a second round of innovations by the young generation
generates new technologies (like the microchip, the PC, operating system software, and wireless phones for the
Baby Boom generation), and extends these technologies into the mainstream. When that generation got into
its spending cycle from the early 1980s onward, it adopted the newest technologies. That creates a new burst
of productivity gains on top of their natural aging cycle.
Fall and Bubble Boom: 1983-2007
The fall stage is the most dynamic. The new technologies finally move mainstream for the first time, creating
huge new growth industries that restore very high productivity. At the same time, that young generation
naturally moves into a massive productivity cycle as it ages. High growth, high productivity, and falling interest
rates (due to falling inflation rates) creates a “bubble boom.” Paradoxically, even though most such bubble
booms become extreme and end in violent busts, they create massive experimentation in new business models,
which pays off in spades for decades to follow. New business and organizational models create stronger
productivity gains longer than do new technologies, but new technologies make such new business models
possible – as motors, electricity and phones made the assembly line possible. Let’s resummarize an important
principle here. In our modern economy, productivity and higher standards of living are driven by two key factors:
1. The aging of highly skilled (only in the last century and only in the most developed countries)
new generations from workforce entry into their peak in spending and productivity around age
46.
2. The practical application and entrepreneurial innovation of new technologies into new
infrastructures, tools, products, and business models that make workers more productive.
For the present cycle, this strong rise in productivity from the aging of the Baby Boom generation and the
mainstream impact of such technologies as portable computers, cell phones linked through the Internet,
broadband technologies created a disinflationary economy despite very strong growth rates in demand. The
same baby boom generation and their new technologies also expanded supply even faster. In such a
disinflationary fall season, you get strong growth and falling inflation and interest rates, the best possible
combination. Ultimately, that leads to very low interest rates, which increasingly encourages speculation in
the new growth industries and the stocks and assets that arise from them. In the present cycle, the Fed
lowered interest rates to unprecedented levels during a boom that was beyond market forces. Keen
appropriately calls this “Ponzi lending”! That’s when a dangerous asset bubble is created: people want to get
wealthy through speculation and not from work or from making productive investments in a truly new
capacity. Everyone wants to be a “millionaire” day trader or house flipper from their own homes.
The dramatic growth of new technologies first created the bubble in tech stocks that peaked in 2000.
Speculation rapidly shifted to the housing bubble. The Fed moved short-term rates to 1% in reaction to the
tech bubble crash, which fueled the bubble even more. Speculation also then spread to the next great stock
bubble in emerging country stocks like China and Brazil and to the growing commodity bubble. The emerging
market bubble peaked in late 2007 and the commodity bubble in mid-2008. Suddenly, a credit crisis and
banking meltdown came seemingly out of nowhere to end this great bubble boom. However, the bubble boom
was due to crescendo between late 2007 and early 2010 anyway, due to the natural peak in Baby Boomer
earning, spending and borrowing trends that we have been predicting for over 20 years. Now we have felt the
first cold winds of winter, and we are about to see the biggest blizzard of our lifetime: The Debt Crisis of 2010-
2012.
Winter and Deflation: 2008 to 2020-2023
The only way out of a massive credit bubble is for it to deflate. If you pump it up further, it will only burst to
greater extremes a bit later. There comes a point in any bubble at which the bubble bursts from its own
extremes. You can’t inflate it further, as there is no one left to borrow more money as they are saturated with
debt, or buy assets at ridiculous prices that are clearly not sustainable. Homes prices and debt levels hit
extremes back in 2005-2006. Debt ratios have now far exceeded the Roaring 20s, especially in the consumer
and financial sectors – and they will go higher before reversing down as GDP will slow faster than debt at first.
We will look at that more in the next section, where we bring in Steve Keen’s research.
Our economy would have seen deflation ultimately even without this extreme credit bubble.
Chart 14 shows the natural extension of the aging of the Baby Boomers. Spending slows down dramatically
and debt levels naturally decrease after consumers reach age 42 to 50. Thus, workforce growth will slow as
Baby Boomers retire in greater numbers, because the Echo Boom generation entering the workforce is smaller
than the Baby Boom generation. If the workforce slows and ultimately shrinks, we will have to make fewer investments in infrastructure, education, and training,
which will be deflationary. If young people are inflationary,
then the natural corollary is that old people are
deflationary. They retire debts, require smaller houses and
investments in durable goods and assets. They spend less
and live off of their past investments. Again, just ask the
Japanese! The one indicator (labor force growth) that
correlates better than any other with inflation in a postcommodity
world in which labor productivity is key, is
predicting deflationary trends into around 2023.
Workforce trends will contract even faster in Japan and in
Europe down the road, especially in southern Europe.
This Echo Boom generation is the first generation to be
smaller than the previous one in centuries. It is truly
unique. The classic reason that we see deflation after a
bubble boom like 1914-1929 or 1865-1872 is that credit creation outstrips the ability of the economy to grow
in the disinflationary fall season. This excess credit creation occurrence fuels speculation in asset prices—a
speculation that is not useful, as would be investment in areas such as productive capacity. However, even
excess investment in productive capacity can be deflationary at some point as it ultimately creates excess
supply vs. demand. Naturally supply will exceed demand in the late stages of a demographic boom. This is
a predicament that businesses won’t recognize until it happens. Both the demographic downturn in spending
and the demographic deceleration in workforce growth point toward an extended economic slowdown, which
is deflationary.
The reason that we will see an extreme debt crisis between mid- to late 2010 and mid- to late 2012 is
the deleveraging of the greatest credit bubble in modern history, which started in 2008. The U.S.
government temporarily halted that meltdown with a massive response in short-term stimulus – like a
big cup of coffee, or in this case, more like cocaine. In so doing, they clearly addressed the symptoms
and not the cause. This financial meltdown will return by the late summer of 2010, when the next
round of mortgage resets hit—what we have called “the ticking time bomb” in many past issues of our
newsletter. Steve Keen and the Importance of Private Credit
In a world of confusing economists who always seem to focus on symptoms rather than causes and who
inevitably miss the forest for the trees, there is one economist who sees the present situation clearly and
explains it correctly. That is Steve Keen from Australia. In his article and blog, “The Cavaliers of Credit” (and
many others at www.debtdeflation.com/blog), he identifies the key financial trend in this unprecedented credit
bubble and its inevitable bursting: private credit.
Keen demonstrates clearly that it is not monetary policies and the creation of money supply that drive credit
cycles and the broadest creation of money. It is simply the banks and other private institutions that create
loans. We have similarly seen the government not as an instigator of growth or decline; instead just as a
predictable reactionary agent to changes in the economy. Simplistic monetary theory goes like this: The
Central Bank (Federal Reserve in the U.S.) injects money into the system by purchasing bonds from banks or
financial institutions. Banks “create” money by lending out 90% of their deposits, keeping only 10% in reserve requirements—or what is called “the fractional reserve system.” The banks keep lending until they ultimately
create $10 for every $1 they have on deposit. However, that is not how it works in the real world, as Keen
shows in painstaking detail (we won’t cover it here; see his report referenced above). Banks create loans in
response to business and consumer demands. The banks find the reserves to cover themselves later. In fact,
they can borrow such reserves from the Federal Reserve through the discount window. Ultimately, there is
little limit on lending, as fractional reserve requirements in the U.S. are 10:1 and only apply to consumer
deposits, not to business and commercial funds. The limit only comes when consumers and businesses are
saturated with credit and cannot borrow further or when asset prices are driven so high by speculation that
they start to fall and investors don’t see the potential for higher prices anymore.
If the banks don’t lend and consumers and businesses don’t borrow, injections of monetary stimulus
by the government will not create growth in credit or inflation. What will happen instead is that we will
see financial institutions sitting with tremendous “excess reserves” in their accounts at the Fed,
dollars that are not being lent. This is exactly what is happening today! The government doesn’t
create or drive credit bubbles, consumers and businesses do, unless there are regulations that restrict
such excesses—and there weren’t any of significance in the U.S.
We will summarize some important principles here and explain them below.
1. The government did not create this boom, the maturing of the massive baby boom generation and
the advance of new technologies did. The Baby Boomers are now peaking in their long spending trends.
Computer technologies have saturated our economy for now. These are trends we have been predicting
for over 20 years, and they have little to do with government policy. Hence, we have an extended
slowdown ahead until the next generation and the next wave of technologies move mainstream, from
around 2023 forward. The growth in productivity and demand needed to reinflate the economy is not
possible at this point. Hence, the government stimulus ultimately will fail.
2. The government did not create this credit bubble through monetary policies — financial institutions,
businesses, consumers, and investors did. Those trends were fueled by rising productivity and
spending and by falling inflation and interest rates from demographic and technology cycles. The
government failed to put in place and enforce any meaningful regulations, so the bubble went to
unprecedented extremes in the U.S. No one can study history and not conclude that human and
banking greed will always go to extremes when conditions are right and when they are allowed to
continue. The government clearly added fuel to the bubble by lowering interest rates to even below
already falling market levels every time a bubble burst, to try to compensate. Those policies simply
made the bubbles worse; that means a greater meltdown ahead.
3. If the government did not create this boom or bubble, then they cannot stop the natural
demographic slowdown or the more violent deleveraging of the greatest credit and real estate bubble in
modern history. This is where our work on demographic trends and Steve Keen’s work on how private
credit (not money supply created by the government or monetary policy) is the 800-pound gorilla are
unique to understanding this “once-in-a-lifetime” waterfall event just ahead!
Before we get into Steve Keen’s insightful analysis, let’s review the basics of monetary theory in Chart 15:
Money Supply X Velocity of Money = General Price Level X Real Income (or real productive
capacity). In short, MV=PY. There are four variables that can change
in this equation, not just money supply. Velocity is a
measure of how fast the money supply turns over. In other
words — are banks lending and are consumers and
businesses spending and investing?
We repeat Chart 16 from past issues. The velocity of
money has been dropping like a rock and thus far has
roughly offset the monetary stimulus from the Fed. That is
why we have had near-zero inflation. However, excluding
home prices, which are not directly calculated into the
CPI. We have not seen out-and-out deflation in prices yet.
That is the other variable (general prices) besides real
incomes or output. The prices of such output (goods and
even assets like real estate, commodities, and stocks that
drive the cost of goods) can fall when bank lending
contracts enough that consumer and business demand
contract as well. This situation leaves excess supply of
goods, and you get a spiral of price discounting in general
goods that we have only just begun to see in housing and
cars. It ultimately builds on itself, as we have seen in
home prices. Lower prices trigger defaults, business
failures and unemployment, which trigger more defaults
and so on.
Imagine prices of consumer goods spiraling downward
like the price of housing has, just not to as extreme a
level. That is deflation. Such deflation squeezes
margins and profits in business and generates a
survival-of-the-fittest environment that creates
extreme consolidation and efficiency long term. That
is an important part of the winter season, but it is
brutal to financial institutions, workers, and
businesses at first. Such business failures add to the
loan failures from speculation and falling asset values.
Only at this stage will we know that we are getting
closer to the end of the deleveraging and debt crisis.
We are not even close yet! But this painful process
creates lower costs of business and lower costs of
living which is beneficial longer term.
The bigger issue is the continued fall in asset values from
unsustainable speculation in the boom and credit bubble.
What is a near $1 trillion increase in the monetary base
compared to an $18 trillion loss in household net worth
between June 2007 and March 2009? Chart 17 updates
our past annual chart with quarterly data and shows a
bigger loss than suggested earlier. We expect that $25 to $30 trillion in net worth will be destroyed by 2013 when
this deleveraging is largely complete.
When consumers, businesses, and banks realize that
this devaluation of assets is more permanent, then
loans will be restructured realistically and we will
destroy tens of trillions of dollars of debt. That will be
a very good thing long term.
Here is where Keen’s analysis is essential. Most private
debt is lent against assets like real estate or business
assets. When assets fall, debt levels will be restructured
and destroyed on a lag. We have already covered the lags
from falling real estate values to technical default to
foreclosure in past issues, but the lags last 1.5 to 2.0
years at a minimum. We covered this issue in great depth
in past issues, so here is simply a summary.
The ticking time bomb: The great majority of defaults
that have already occurred have not gone into
foreclosure. Defaults are rising at rapid rates despite
the economic recovery. This banking crisis will
continue to build despite the recovery and are set to
suddenly wreck the recovery again as they did after
the boom in 2007 and as they will continue to do
through the late summer of 2010, when the next
round of mortgage resets predictably hit.
If you think the Fed’s monetary policies and money supply
are central, look at Chart 18 from Keen. Private debt in
the U.S. reached $42 trillion by the end of 2008 with M2
(a measure of money supply) at $8 trillion and the
monetary base or M0 (money of zero maturity) at under $2
trillion. Who is the 800-pound gorilla here? How come an economist like Steve Keen is standing virtually alone
in pointing out this simple and obvious fact? The answer is, first, that economists are in denial and, second,
that they live in a theoretical world, not in the real world.
Chart 19 from Keen makes the point even clearer. Here, he looks at the ratio of private debt to M0, which was
47:1 at the top. Even after this unprecedented increase in the monetary base, it is 36:1. The ratio of private
credit to M2 is dropping but is still approximately 6. The only mildly rising measure is M3, and that won’t last
long.
Private credit massively outweighs money supply at any level of money supply measurement.
Economists and laymen have their eye on the wrong ball. Private debt also greatly outweighs public
debt, by 3:1, even after the recent advance in government debt. Of the $42 trillion in private credit,
we are likely to see at least half disappear through loan repayments, restructuring, and outright
bankruptcies in the coming years. We saw far more than 50% of private credit eliminated in the Great Depression. Is the Fed going to create $20 trillion plus
in stimulus and debt to offset that? Would China or
U.S. citizens allow that, especially when the present
massive stimulus program fails by late 2010 and given
that the U.S. is now the greatest net debtor in the
world when it was a net creditor (like China today)
coming into the 1930s depression?
Chart 20, repeated from Keen, shows debt ratios as a
percentage of GDP. Private debt is nearing 300% and will
exceed that when GDP falls further in 2011 and beyond.
M0 is a bit above 10% of GDP. So, again what should we
and government officials be focusing on?
Chart 21 summarizes the debt deflation theory of
depressions and how it leads to a negative feedback spiral
that feeds upon itself. The totally revised chapter 1 of our
revised paperback edition of The Great Depression Ahead
also deals with this topic. Chapter 6 also is largely
rewritten for our updates to projections for emerging
countries that have different dynamics more around
urbanization and workforce growth more than the
Spending Wave.
The other must-read book on this topic is Robert
Prechter’s recently revised 2002 book, Conquer the Crash.
Prechter and I have disagreed in the past about when this
deflationary scenario would unfold, but we both agree on
the stages of the long-term business cycle. We agree even
more on the fact that the real deflationary cycle and
depression is just ahead. He is the only forecaster and
long-term researcher who understands that deflation is the
only option after such an extreme credit bubble. Steve
Keen’s blog (debtdeflation.com/blog) is also a must read,
as we have already mentioned. He comes out with new
blog posts every month or so.
The Long View
We can’t put deflation into full perspective without looking
at one more very important long-term cycle, Chart 22.
Every 500 years (Richard Mogey’s version is 510 years), we
see larger inflationary and deflationary cycles that result
from macro innovations like the printing press, tall sailing
ships, gunpowder and, more recently, computers,
television, jet engines, and nuclear power. The last such
long cycle bottomed during a winter of deflationary trends
that started in the early 1800s and lasted into World War II. During this longer winter, we saw a series of depressions: 1835-1843, 1873-1877, 1883-1886, 1893-1896
and 1930-1942. Since the late 1800s we have been in the next major inflationary cycle.
We will see a strong deflationary cycle within a broader inflationary cycle that doesn’t peak until
around 2150. Hence, deflation is not the long-run trend any more than it was after the 1930s. This
long-term cycle shows a positive underlying growth trend, despite a devastating deleveraging trend in
the coming decade. This makes us less bearish than many other bearish forecasters.
The current 500-year cycle will revolve around globalization: in particular, the growth of emerging countries
that have lower incomes but much larger populations. It will also see the alternation back from Western to
Eastern or Asian dominance, as occurs in every other cycle, as Richard Mogey points out. The bigger point is
that inflation will be the trend after 2023 or so. We could see the greatest 29- to 30-year Commodity cycle in
modern history into 2039—2040, as emerging countries from China to India to Indonesia to Brazil dominate
growth and are much more commodity intensive.
Summary Insights from Understanding Natural Deflation and Depression
Cycles
If you combine our demographic and technology cycle models with Steve Keen’s private debt and speculation
models, you can clearly understand and largely foresee the most unexpected events of a lifetime. Almost no
one has lived long enough to really experience deflation with depression, so we just don’t intuitively
understand them—even though these conditions have occurred together every 60 to 80 years throughout
history. We have seen inflation in consumer prices, home values, and stocks all of our lives. Economists like
Ben Bernanke and Paul Krugman study the Great Depression from their armchairs and simply think that the
government could have prevented it with stronger monetary stimulus. The truth is that you can’t prevent the
winter economic season; it is a natural part of the cycle. You can make it less extreme only by not allowing
the credit and asset bubbles that are natural to the fall season to become so excessive. Trying to prevent
deleveraging makes it worse, much like trying to take more heroin to avoid detoxing. Sooner or later, you either
detox or you die!
Keen points out that it is banks and financial institutions that ultimately create and drive credit growth, not
the Federal Reserve or central banks. He has the best models for showing how that works in the “real world”!
As the present economy slowdown shows, financial institutions cannot force credit. There must be demand.
From our models, new generations create the technological innovations (more in the off seasons of summer
and winter) that then move mainstream as the new generations create their own demand and supply cycle
from aging and growing in their work experience and productivity. That creates the demand for housing, cars,
and all types of consumer goods, and borrowing to finance those durable goods, including college and our kids
education which, in turn, creates demand for businesses to borrow to expand capacity, and so on to meet
consumer needs.
Our models show that bubble booms naturally occur in the fall season due to the combination of powerful
technologies moving mainstream (leveraging growth and productivity) and falling interest rates. While these
factors encourage both productive investment in capacity and creation of new technologies (including the
massive experimentation in new business models that creates many breakthroughs), they also increasingly
encourage speculative investment that is not productive. Keen’s work shows how such speculative investment
ends up going to extremes and kills the financial system. Our models also stress that this gyrating system of four seasons is endemic to all cycles and phenomena and
has its own logic that advances our standard of living and evolution altogether. For example, the bubble boom
and credit bubble lead to the very important effect of fostering massive experimentation in new business
models at times when neither governments nor major corporations have a clue about how new technologies
will change business models. Private investment is the only way to accomplish true technological innovation.
When the credit bubbles burst and the deleveraging sets in, we get the survival-of-the-fittest challenge, which
narrows the field quickly down to the companies that got it right—either by accident or on purpose. That is
how the real world innovation process works. Government officials and economists simply don’t understand
this process; they think it is something to be prevented, not encouraged, managed and regulated to the best
results out of its natural wisdom. The truth is the private economy and the “invisible hand” are much more
powerful than the government, which both our work and Keen’s clearly show. So, the economy wins in the end
and the free market system works. That’s the good news. The bad news is that we are about to enter into the
most brutal stage of the seasonal cycle, from mid- to late 2010 into mid- to late 2012.
It was no accident that the greatest mass prosperity boom in history followed the Great Depression!
The debt crisis of 2010-2012 will occur despite the government’s intentions. It will be the best thing
that can happen to leverage the massive innovations of the bubble boom, or fall season, that is now
behind us and the radical innovations that will occur in the winter season ahead. Flexible
entrepreneurial companies and the dominant leaders in larger industries will be the biggest winners
and will survive to thrive in the next spring season with very little competition.
I have so may paid newsletters I cannot justify renewing this one. If we can get 10 people from this board to pitch in $35 each...we can all create a common email address and share a username/password to get this one. Who's interested?
Warning--It's mighty damn long. However...if we get this right...we'll be able to grow our assets substantially over the next 10 years if we prepare.
Here's a snippet:
When Rodney Johnson or I give presentations these days, it is typical that the host of the conference or a
speaker to follow will say “I agree with everything Harry (or Rodney) just said, except the part about deflation.
There is no way we aren’t going to get inflation down the road from the government’s unprecedented stimulus
and monetary policies.” The classic graph everyone is
looking at is Chart 10, which shows how the Fed roughly
doubled the monetary base in just four months—an
unprecedented monetary stimulus going back to the
1930s and 1940s. But as we have shown in past issues
and will show more in this one, the recent monetary
expansion is nothing compared with the massive private
debt that has accumulated in the past decades and the
deleveraging of that private debt that has only just begun.
The Fed is aiming a monetary fire hose into a tidal
wave of debt deleveraging. This will not succeed in
changing the inevitable and necessary deflationary
environment ahead!
This is the most important issue for investors,
business people, and the government. If you don’t
understand that deflation is the only possible outcome, then you will make the wrong decisions even
though you saw the downturn coming.
A quick example: Peter Schiff was one of the forecasters who clearly saw the banking crisis coming ahead of
time. However, he gave the typical inflationary advice: bet against the U.S. dollar in foreign currencies and buy
gold. His investors lost money in the last stock crash. We showed in our last newsletter that when stocks
crashed from May 2008 into March 2009, the dollar rose 20% and fell. The same thing will occur in the next
crash, except gold is likely to be hit much harder next time. So, in this “New Year 2010” quarterly issue, we
are going to put the final nail in the coffin on this inflation/deflation debate, as it is the most critical issue for
you to understand:
1. After the greatest credit bubble in modern history, we simply will have to adjust to a lower level of
borrowing, spending, and growth. Deflation and the deleveraging of credit is the only way to do that.
Deleveraging is the reduction of debt, and it is occurring at both the personal (mortgages, credit cards,
etc.) and business (lines of credit, straight loans, commercial real estate loans) levels. That will be painful in the short run — but very healthy in the long run by reducing debt, home prices, and the cost
of living and doing business. It is painful because adding leverage – spending borrowed money – gives
a person or business more dollars than is created through normal income channels (wages or revenue).
These extra dollars allow for greater spending which increases business activity and raises the
standard of living. But it has to be paid back. This arrangement works well ONLY if the value of what
was pledged for these loans rises faster than the rate of indebtedness. This is where the current
situation failed. Because borrowing was done largely by pledging real estate, when prices began to fall
the debt structure began to crumble. There is no way for our system to reflate asset prices to the point
where these debts will be made good.
2. Our economy follows seasons just as everything in life does. We are moving from fall into winter.
Winter means falling price levels or deflation, with no exceptions in modern history. Inflation comes in
the summer season, as in the 1960s and 1970s. The fall season follows with disinflation and a bubble
boom leveraged by new technologies moving mainstream and falling interest rates. Depressions always
follow bubble booms, again with no exceptions in modern history (1840s, 1870s, and 1930s).
3. Economists and laymen alike are missing the very big picture by focusing on money supply instead
of the massive growth in private credit that vastly overwhelms monetary growth. Steve Keen is the only
current economist that seems to understand this fully. Robert Prechter is the only major forecaster
other than us that clearly sees deflation ahead instead of it being an “if the government does this, or if
they do that” issue.
4. Inflation favors gold, commodities, sounder foreign currencies, and often emerging country stocks,
and it obliterates long-term bonds and stocks, as in the 1970s downturn. Deflation favors the U.S.
dollar, short-term cash and cash equivalents, and, after the crisis starts to hit fully, long-term bonds.
The only common denominator between inflation and deflation is that they both hurt stocks, but
deflation obliterates stocks even more than inflation does.
The Simplest Explanation from a Non-Economist
Before we outline the logic of deflation in this time period, let me start with the simplest and most direct
statement I have come across. It comes from Steve Ballmer, CEO of Microsoft and from one of Steve Keen’s
blogs:
We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective
I would bring is not one of recession. Rather, the economy is resetting to a lower level of
business and consumer spending based largely on reduced leverage in the economy.
Steve Ballmer just described the deflationary process perfectly without using the words deflation or monetary
policy and without using any economic jargon. Another simple way to view this is like a waterfall (Chart 11).
The economy needs to transition to a new lower and more sustainable level of growth after an extreme bubble
in credit artificially raised asset prices and consumer spending. The only way for that to happen is for asset
values and consumer prices to fall and for credit to deleverage and be restructured dramatically, which will
settle the economy at a new, lower, and sustainable level from which we can grow again.
The only possible path from these heights of asset values and bad loans against them is deflation and
the write-off of such bad loans at the expense of the lenders, not the taxpayers!!! That transition is scary, and it is rapid when prices really
start to fall—as we can already see in housing. It is backbreaking
as we hit the “bottom of the pool,” before we
consolidate and then flow and grow in a more orderly
process again. However, this deflationary transition is a
necessary part of the innovation and growth process, as
we will summarize ahead. Even the credit bubble is a
natural part of the process, although total lack of
regulation can cause it to go too far when pure speculation
is allowed instead of productive investment, as clearly
occurred in this case in the U.S.
This is also clearly a once-in-a-lifetime process, as the
economy only goes through this winter season or
deflationary adjustment every 60 to 80 years in history.
The economy’s life cycle is similar to our own in time
frame. So, we return to our most core concept: The 80-Year
New Economy cycle. In Chapter 1 of the revised paperback
edition of The Great Depression Ahead, we used a new
version of this cycle (Chart 12 here) that corresponds
more to the normal seasons we are used to rather than the
technology or business cycle, which moves more in terms
of its four stages (innovation, growth boom, shake-out,
and maturity boom).
In this chart there are two lines. The red line represents
the consumer price index (CPI). Think of inflation like
temperature. High temperatures and high inflation come
in the summer. Low temperatures and deflation come in
the winter. In between these two seasons you have more
balanced temperatures or prices, which the economy and
consumers like much better and which represent a better
balance of supply and demand. The green line represents
the economy or stock market. It rises during the demographic
booms that presently come about every 39 - 40 years and then falls during the demographic slowdowns that
follow. If you go back a century or more, this cycle revolved more around two 29- to 30-year commodity boom
and bust cycles rather than two 39- to 40-year demographic cycles. At that time, we were still mostly farmers
in an agrarian economy wherein commodity prices and innovation around them were more critical, and our
life cycle was closer to 60 years than the 80 years it is today.
Spring and Boom: 1942-1968
The last deflationary winter season was 1930-1942. That season was followed by a spring boom. It is
commonly thought that World War II brought us out of the Great Depression. However, in reality, the rising
earning, spending, and borrowing cycle of the Bob Hope generation from 1942 into 1965 to 1968 drove that
long expansion (on more like a 44-year lag for peak spending back then). As price levels rose again, interest
rates also gradually rose as well. Asset prices, including housing, merely were returning to normal predepression levels. Rising interest rates don’t favor rising speculation, so there was no excessive credit or
asset bubble. The radical new technologies that emerged out of the winter season, such as computers and jet
travel, were moving into niche markets and had a greater impact on extending the previous technologies, from
autos to electrical appliances to phones, radio, and TV at first. Those maturing technologies had saturated our
economy thoroughly by the late 1960s.
Summer and Inflation: 1968-1982
In the late 1960s came inflation and a long-term recession, or “stagflation,” partly from the downtrend in
spending and productivity of the aging Bob Hope generation. We have shown for two decades how in this
modern economic cycle inflation has correlated largely with the huge investment in raising young people and
incorporating them into the workforce and not with commodity prices as in the past (see Chart 13). The Baby
Boom generation created the largest inflationary cycle in
modern history. That cycle reversed as this massive
generation became increasingly productive and began
earning, spending, and borrowing more money as they
raised their families from 1983 into 2007—a simple 46-
year lag for the average peak in spending (as per our wellknown
Spending Wave that we won’t repeat here).
If the first cause of inflation is a new generation of
expensive young people in modern urban societies
wherein they are so expensive to raise, the second has its
roots in the technology cycle. Our ability to grow in
earning and spending also depends on new technologies,
infrastructures, and business models (like the assembly
line in the past cycle). During the summer season, old
technologies and industries totally saturate the economy
and lose their ability to generate higher productivity. The
up-and-coming generation of producers and consumers is still young, expensive, and very low in productivity.
It was no accident that the 1970s represented the lowest decade for productivity gains of any in the last
century. Over the course of the summer season, a second round of innovations by the young generation
generates new technologies (like the microchip, the PC, operating system software, and wireless phones for the
Baby Boom generation), and extends these technologies into the mainstream. When that generation got into
its spending cycle from the early 1980s onward, it adopted the newest technologies. That creates a new burst
of productivity gains on top of their natural aging cycle.
Fall and Bubble Boom: 1983-2007
The fall stage is the most dynamic. The new technologies finally move mainstream for the first time, creating
huge new growth industries that restore very high productivity. At the same time, that young generation
naturally moves into a massive productivity cycle as it ages. High growth, high productivity, and falling interest
rates (due to falling inflation rates) creates a “bubble boom.” Paradoxically, even though most such bubble
booms become extreme and end in violent busts, they create massive experimentation in new business models,
which pays off in spades for decades to follow. New business and organizational models create stronger
productivity gains longer than do new technologies, but new technologies make such new business models
possible – as motors, electricity and phones made the assembly line possible. Let’s resummarize an important
principle here. In our modern economy, productivity and higher standards of living are driven by two key factors:
1. The aging of highly skilled (only in the last century and only in the most developed countries)
new generations from workforce entry into their peak in spending and productivity around age
46.
2. The practical application and entrepreneurial innovation of new technologies into new
infrastructures, tools, products, and business models that make workers more productive.
For the present cycle, this strong rise in productivity from the aging of the Baby Boom generation and the
mainstream impact of such technologies as portable computers, cell phones linked through the Internet,
broadband technologies created a disinflationary economy despite very strong growth rates in demand. The
same baby boom generation and their new technologies also expanded supply even faster. In such a
disinflationary fall season, you get strong growth and falling inflation and interest rates, the best possible
combination. Ultimately, that leads to very low interest rates, which increasingly encourages speculation in
the new growth industries and the stocks and assets that arise from them. In the present cycle, the Fed
lowered interest rates to unprecedented levels during a boom that was beyond market forces. Keen
appropriately calls this “Ponzi lending”! That’s when a dangerous asset bubble is created: people want to get
wealthy through speculation and not from work or from making productive investments in a truly new
capacity. Everyone wants to be a “millionaire” day trader or house flipper from their own homes.
The dramatic growth of new technologies first created the bubble in tech stocks that peaked in 2000.
Speculation rapidly shifted to the housing bubble. The Fed moved short-term rates to 1% in reaction to the
tech bubble crash, which fueled the bubble even more. Speculation also then spread to the next great stock
bubble in emerging country stocks like China and Brazil and to the growing commodity bubble. The emerging
market bubble peaked in late 2007 and the commodity bubble in mid-2008. Suddenly, a credit crisis and
banking meltdown came seemingly out of nowhere to end this great bubble boom. However, the bubble boom
was due to crescendo between late 2007 and early 2010 anyway, due to the natural peak in Baby Boomer
earning, spending and borrowing trends that we have been predicting for over 20 years. Now we have felt the
first cold winds of winter, and we are about to see the biggest blizzard of our lifetime: The Debt Crisis of 2010-
2012.
Winter and Deflation: 2008 to 2020-2023
The only way out of a massive credit bubble is for it to deflate. If you pump it up further, it will only burst to
greater extremes a bit later. There comes a point in any bubble at which the bubble bursts from its own
extremes. You can’t inflate it further, as there is no one left to borrow more money as they are saturated with
debt, or buy assets at ridiculous prices that are clearly not sustainable. Homes prices and debt levels hit
extremes back in 2005-2006. Debt ratios have now far exceeded the Roaring 20s, especially in the consumer
and financial sectors – and they will go higher before reversing down as GDP will slow faster than debt at first.
We will look at that more in the next section, where we bring in Steve Keen’s research.
Our economy would have seen deflation ultimately even without this extreme credit bubble.
Chart 14 shows the natural extension of the aging of the Baby Boomers. Spending slows down dramatically
and debt levels naturally decrease after consumers reach age 42 to 50. Thus, workforce growth will slow as
Baby Boomers retire in greater numbers, because the Echo Boom generation entering the workforce is smaller
than the Baby Boom generation. If the workforce slows and ultimately shrinks, we will have to make fewer investments in infrastructure, education, and training,
which will be deflationary. If young people are inflationary,
then the natural corollary is that old people are
deflationary. They retire debts, require smaller houses and
investments in durable goods and assets. They spend less
and live off of their past investments. Again, just ask the
Japanese! The one indicator (labor force growth) that
correlates better than any other with inflation in a postcommodity
world in which labor productivity is key, is
predicting deflationary trends into around 2023.
Workforce trends will contract even faster in Japan and in
Europe down the road, especially in southern Europe.
This Echo Boom generation is the first generation to be
smaller than the previous one in centuries. It is truly
unique. The classic reason that we see deflation after a
bubble boom like 1914-1929 or 1865-1872 is that credit creation outstrips the ability of the economy to grow
in the disinflationary fall season. This excess credit creation occurrence fuels speculation in asset prices—a
speculation that is not useful, as would be investment in areas such as productive capacity. However, even
excess investment in productive capacity can be deflationary at some point as it ultimately creates excess
supply vs. demand. Naturally supply will exceed demand in the late stages of a demographic boom. This is
a predicament that businesses won’t recognize until it happens. Both the demographic downturn in spending
and the demographic deceleration in workforce growth point toward an extended economic slowdown, which
is deflationary.
The reason that we will see an extreme debt crisis between mid- to late 2010 and mid- to late 2012 is
the deleveraging of the greatest credit bubble in modern history, which started in 2008. The U.S.
government temporarily halted that meltdown with a massive response in short-term stimulus – like a
big cup of coffee, or in this case, more like cocaine. In so doing, they clearly addressed the symptoms
and not the cause. This financial meltdown will return by the late summer of 2010, when the next
round of mortgage resets hit—what we have called “the ticking time bomb” in many past issues of our
newsletter. Steve Keen and the Importance of Private Credit
In a world of confusing economists who always seem to focus on symptoms rather than causes and who
inevitably miss the forest for the trees, there is one economist who sees the present situation clearly and
explains it correctly. That is Steve Keen from Australia. In his article and blog, “The Cavaliers of Credit” (and
many others at www.debtdeflation.com/blog), he identifies the key financial trend in this unprecedented credit
bubble and its inevitable bursting: private credit.
Keen demonstrates clearly that it is not monetary policies and the creation of money supply that drive credit
cycles and the broadest creation of money. It is simply the banks and other private institutions that create
loans. We have similarly seen the government not as an instigator of growth or decline; instead just as a
predictable reactionary agent to changes in the economy. Simplistic monetary theory goes like this: The
Central Bank (Federal Reserve in the U.S.) injects money into the system by purchasing bonds from banks or
financial institutions. Banks “create” money by lending out 90% of their deposits, keeping only 10% in reserve requirements—or what is called “the fractional reserve system.” The banks keep lending until they ultimately
create $10 for every $1 they have on deposit. However, that is not how it works in the real world, as Keen
shows in painstaking detail (we won’t cover it here; see his report referenced above). Banks create loans in
response to business and consumer demands. The banks find the reserves to cover themselves later. In fact,
they can borrow such reserves from the Federal Reserve through the discount window. Ultimately, there is
little limit on lending, as fractional reserve requirements in the U.S. are 10:1 and only apply to consumer
deposits, not to business and commercial funds. The limit only comes when consumers and businesses are
saturated with credit and cannot borrow further or when asset prices are driven so high by speculation that
they start to fall and investors don’t see the potential for higher prices anymore.
If the banks don’t lend and consumers and businesses don’t borrow, injections of monetary stimulus
by the government will not create growth in credit or inflation. What will happen instead is that we will
see financial institutions sitting with tremendous “excess reserves” in their accounts at the Fed,
dollars that are not being lent. This is exactly what is happening today! The government doesn’t
create or drive credit bubbles, consumers and businesses do, unless there are regulations that restrict
such excesses—and there weren’t any of significance in the U.S.
We will summarize some important principles here and explain them below.
1. The government did not create this boom, the maturing of the massive baby boom generation and
the advance of new technologies did. The Baby Boomers are now peaking in their long spending trends.
Computer technologies have saturated our economy for now. These are trends we have been predicting
for over 20 years, and they have little to do with government policy. Hence, we have an extended
slowdown ahead until the next generation and the next wave of technologies move mainstream, from
around 2023 forward. The growth in productivity and demand needed to reinflate the economy is not
possible at this point. Hence, the government stimulus ultimately will fail.
2. The government did not create this credit bubble through monetary policies — financial institutions,
businesses, consumers, and investors did. Those trends were fueled by rising productivity and
spending and by falling inflation and interest rates from demographic and technology cycles. The
government failed to put in place and enforce any meaningful regulations, so the bubble went to
unprecedented extremes in the U.S. No one can study history and not conclude that human and
banking greed will always go to extremes when conditions are right and when they are allowed to
continue. The government clearly added fuel to the bubble by lowering interest rates to even below
already falling market levels every time a bubble burst, to try to compensate. Those policies simply
made the bubbles worse; that means a greater meltdown ahead.
3. If the government did not create this boom or bubble, then they cannot stop the natural
demographic slowdown or the more violent deleveraging of the greatest credit and real estate bubble in
modern history. This is where our work on demographic trends and Steve Keen’s work on how private
credit (not money supply created by the government or monetary policy) is the 800-pound gorilla are
unique to understanding this “once-in-a-lifetime” waterfall event just ahead!
Before we get into Steve Keen’s insightful analysis, let’s review the basics of monetary theory in Chart 15:
Money Supply X Velocity of Money = General Price Level X Real Income (or real productive
capacity). In short, MV=PY. There are four variables that can change
in this equation, not just money supply. Velocity is a
measure of how fast the money supply turns over. In other
words — are banks lending and are consumers and
businesses spending and investing?
We repeat Chart 16 from past issues. The velocity of
money has been dropping like a rock and thus far has
roughly offset the monetary stimulus from the Fed. That is
why we have had near-zero inflation. However, excluding
home prices, which are not directly calculated into the
CPI. We have not seen out-and-out deflation in prices yet.
That is the other variable (general prices) besides real
incomes or output. The prices of such output (goods and
even assets like real estate, commodities, and stocks that
drive the cost of goods) can fall when bank lending
contracts enough that consumer and business demand
contract as well. This situation leaves excess supply of
goods, and you get a spiral of price discounting in general
goods that we have only just begun to see in housing and
cars. It ultimately builds on itself, as we have seen in
home prices. Lower prices trigger defaults, business
failures and unemployment, which trigger more defaults
and so on.
Imagine prices of consumer goods spiraling downward
like the price of housing has, just not to as extreme a
level. That is deflation. Such deflation squeezes
margins and profits in business and generates a
survival-of-the-fittest environment that creates
extreme consolidation and efficiency long term. That
is an important part of the winter season, but it is
brutal to financial institutions, workers, and
businesses at first. Such business failures add to the
loan failures from speculation and falling asset values.
Only at this stage will we know that we are getting
closer to the end of the deleveraging and debt crisis.
We are not even close yet! But this painful process
creates lower costs of business and lower costs of
living which is beneficial longer term.
The bigger issue is the continued fall in asset values from
unsustainable speculation in the boom and credit bubble.
What is a near $1 trillion increase in the monetary base
compared to an $18 trillion loss in household net worth
between June 2007 and March 2009? Chart 17 updates
our past annual chart with quarterly data and shows a
bigger loss than suggested earlier. We expect that $25 to $30 trillion in net worth will be destroyed by 2013 when
this deleveraging is largely complete.
When consumers, businesses, and banks realize that
this devaluation of assets is more permanent, then
loans will be restructured realistically and we will
destroy tens of trillions of dollars of debt. That will be
a very good thing long term.
Here is where Keen’s analysis is essential. Most private
debt is lent against assets like real estate or business
assets. When assets fall, debt levels will be restructured
and destroyed on a lag. We have already covered the lags
from falling real estate values to technical default to
foreclosure in past issues, but the lags last 1.5 to 2.0
years at a minimum. We covered this issue in great depth
in past issues, so here is simply a summary.
The ticking time bomb: The great majority of defaults
that have already occurred have not gone into
foreclosure. Defaults are rising at rapid rates despite
the economic recovery. This banking crisis will
continue to build despite the recovery and are set to
suddenly wreck the recovery again as they did after
the boom in 2007 and as they will continue to do
through the late summer of 2010, when the next
round of mortgage resets predictably hit.
If you think the Fed’s monetary policies and money supply
are central, look at Chart 18 from Keen. Private debt in
the U.S. reached $42 trillion by the end of 2008 with M2
(a measure of money supply) at $8 trillion and the
monetary base or M0 (money of zero maturity) at under $2
trillion. Who is the 800-pound gorilla here? How come an economist like Steve Keen is standing virtually alone
in pointing out this simple and obvious fact? The answer is, first, that economists are in denial and, second,
that they live in a theoretical world, not in the real world.
Chart 19 from Keen makes the point even clearer. Here, he looks at the ratio of private debt to M0, which was
47:1 at the top. Even after this unprecedented increase in the monetary base, it is 36:1. The ratio of private
credit to M2 is dropping but is still approximately 6. The only mildly rising measure is M3, and that won’t last
long.
Private credit massively outweighs money supply at any level of money supply measurement.
Economists and laymen have their eye on the wrong ball. Private debt also greatly outweighs public
debt, by 3:1, even after the recent advance in government debt. Of the $42 trillion in private credit,
we are likely to see at least half disappear through loan repayments, restructuring, and outright
bankruptcies in the coming years. We saw far more than 50% of private credit eliminated in the Great Depression. Is the Fed going to create $20 trillion plus
in stimulus and debt to offset that? Would China or
U.S. citizens allow that, especially when the present
massive stimulus program fails by late 2010 and given
that the U.S. is now the greatest net debtor in the
world when it was a net creditor (like China today)
coming into the 1930s depression?
Chart 20, repeated from Keen, shows debt ratios as a
percentage of GDP. Private debt is nearing 300% and will
exceed that when GDP falls further in 2011 and beyond.
M0 is a bit above 10% of GDP. So, again what should we
and government officials be focusing on?
Chart 21 summarizes the debt deflation theory of
depressions and how it leads to a negative feedback spiral
that feeds upon itself. The totally revised chapter 1 of our
revised paperback edition of The Great Depression Ahead
also deals with this topic. Chapter 6 also is largely
rewritten for our updates to projections for emerging
countries that have different dynamics more around
urbanization and workforce growth more than the
Spending Wave.
The other must-read book on this topic is Robert
Prechter’s recently revised 2002 book, Conquer the Crash.
Prechter and I have disagreed in the past about when this
deflationary scenario would unfold, but we both agree on
the stages of the long-term business cycle. We agree even
more on the fact that the real deflationary cycle and
depression is just ahead. He is the only forecaster and
long-term researcher who understands that deflation is the
only option after such an extreme credit bubble. Steve
Keen’s blog (debtdeflation.com/blog) is also a must read,
as we have already mentioned. He comes out with new
blog posts every month or so.
The Long View
We can’t put deflation into full perspective without looking
at one more very important long-term cycle, Chart 22.
Every 500 years (Richard Mogey’s version is 510 years), we
see larger inflationary and deflationary cycles that result
from macro innovations like the printing press, tall sailing
ships, gunpowder and, more recently, computers,
television, jet engines, and nuclear power. The last such
long cycle bottomed during a winter of deflationary trends
that started in the early 1800s and lasted into World War II. During this longer winter, we saw a series of depressions: 1835-1843, 1873-1877, 1883-1886, 1893-1896
and 1930-1942. Since the late 1800s we have been in the next major inflationary cycle.
We will see a strong deflationary cycle within a broader inflationary cycle that doesn’t peak until
around 2150. Hence, deflation is not the long-run trend any more than it was after the 1930s. This
long-term cycle shows a positive underlying growth trend, despite a devastating deleveraging trend in
the coming decade. This makes us less bearish than many other bearish forecasters.
The current 500-year cycle will revolve around globalization: in particular, the growth of emerging countries
that have lower incomes but much larger populations. It will also see the alternation back from Western to
Eastern or Asian dominance, as occurs in every other cycle, as Richard Mogey points out. The bigger point is
that inflation will be the trend after 2023 or so. We could see the greatest 29- to 30-year Commodity cycle in
modern history into 2039—2040, as emerging countries from China to India to Indonesia to Brazil dominate
growth and are much more commodity intensive.
Summary Insights from Understanding Natural Deflation and Depression
Cycles
If you combine our demographic and technology cycle models with Steve Keen’s private debt and speculation
models, you can clearly understand and largely foresee the most unexpected events of a lifetime. Almost no
one has lived long enough to really experience deflation with depression, so we just don’t intuitively
understand them—even though these conditions have occurred together every 60 to 80 years throughout
history. We have seen inflation in consumer prices, home values, and stocks all of our lives. Economists like
Ben Bernanke and Paul Krugman study the Great Depression from their armchairs and simply think that the
government could have prevented it with stronger monetary stimulus. The truth is that you can’t prevent the
winter economic season; it is a natural part of the cycle. You can make it less extreme only by not allowing
the credit and asset bubbles that are natural to the fall season to become so excessive. Trying to prevent
deleveraging makes it worse, much like trying to take more heroin to avoid detoxing. Sooner or later, you either
detox or you die!
Keen points out that it is banks and financial institutions that ultimately create and drive credit growth, not
the Federal Reserve or central banks. He has the best models for showing how that works in the “real world”!
As the present economy slowdown shows, financial institutions cannot force credit. There must be demand.
From our models, new generations create the technological innovations (more in the off seasons of summer
and winter) that then move mainstream as the new generations create their own demand and supply cycle
from aging and growing in their work experience and productivity. That creates the demand for housing, cars,
and all types of consumer goods, and borrowing to finance those durable goods, including college and our kids
education which, in turn, creates demand for businesses to borrow to expand capacity, and so on to meet
consumer needs.
Our models show that bubble booms naturally occur in the fall season due to the combination of powerful
technologies moving mainstream (leveraging growth and productivity) and falling interest rates. While these
factors encourage both productive investment in capacity and creation of new technologies (including the
massive experimentation in new business models that creates many breakthroughs), they also increasingly
encourage speculative investment that is not productive. Keen’s work shows how such speculative investment
ends up going to extremes and kills the financial system. Our models also stress that this gyrating system of four seasons is endemic to all cycles and phenomena and
has its own logic that advances our standard of living and evolution altogether. For example, the bubble boom
and credit bubble lead to the very important effect of fostering massive experimentation in new business
models at times when neither governments nor major corporations have a clue about how new technologies
will change business models. Private investment is the only way to accomplish true technological innovation.
When the credit bubbles burst and the deleveraging sets in, we get the survival-of-the-fittest challenge, which
narrows the field quickly down to the companies that got it right—either by accident or on purpose. That is
how the real world innovation process works. Government officials and economists simply don’t understand
this process; they think it is something to be prevented, not encouraged, managed and regulated to the best
results out of its natural wisdom. The truth is the private economy and the “invisible hand” are much more
powerful than the government, which both our work and Keen’s clearly show. So, the economy wins in the end
and the free market system works. That’s the good news. The bad news is that we are about to enter into the
most brutal stage of the seasonal cycle, from mid- to late 2010 into mid- to late 2012.
It was no accident that the greatest mass prosperity boom in history followed the Great Depression!
The debt crisis of 2010-2012 will occur despite the government’s intentions. It will be the best thing
that can happen to leverage the massive innovations of the bubble boom, or fall season, that is now
behind us and the radical innovations that will occur in the winter season ahead. Flexible
entrepreneurial companies and the dominant leaders in larger industries will be the biggest winners
and will survive to thrive in the next spring season with very little competition.
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