Why You Should Bet on Deflation

By Seth Hettena, San Diego

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Monday, Jan. 23, 2009 | I wanted to thank Rich Toscano for writing about deflation (Part I is here. Part II is here.). It's an important issue and I hope people will read his commentary and try to form their own opinions.

While there are many, many causes of the financial crisis, the general financial illiteracy in this country is surely one of them. The United States is the largest economy in the world, but few of its citizens understand it. Most don't even try.

To that end, I'm writing to present the counter-argument in support of deflation and I do so in the hopes that more readers will join the discussion.

First, I take deflation to mean a general decline in prices. We don't have to look far to see tangible evidence of falling prices. Housing prices, as Toscano has well documented, have plummeted. Gas prices are down considerably. And local stores are advertising all sorts of deals to induce consumers to spend, spend, spend.

Those are major sectors of the economy that are experiencing huge contractions. Best Buy put it best by saying it is witnessing "seismic changes in consumer behavior."

After an orgy of consumer spending, Americans now are becoming a nation of savers. That's bad news for our economy because 70 percent of the U.S. gross domestic product derives from consumer spending.

There's no doubt that there's a general decline in prices. When demand drops, suppliers lower prices. The question is whether this is a short- term decline or a long-term, extremely destructive decline such as the Great Depression or the Japanese bust of the 1990s. I believe it will last here in the US as long as we continue to prop up our failed banking system, which may be a long time indeed.

The bond market, which is extremely sensitive to inflation, is a good place to look for just such a forecast of inflation rates. One such forecast is known as the TIPS spread, which is the difference between 10-year Treasury notes and 10-year Treasury Inflation Protected Securities (TIPS). There's not much of a difference between the two. Why? Despite the massive infusion of government dollars into the financial system, the bond market is forecasting little to no inflation over the next 10 years.

Why is this? Because the bond market puts far less faith in the government's power to print money than Toscano does. In Part II of his deflation essay, Toscano notes that "The Fed is now printing money in order to lend directly into the mortgage market." Well, not exactly.

The Fed is buying mortgage-backed securities from to lower mortgage rates and increase liquidity, but banks must still provide the mortgages.

These aren't measures designed to "get around" the banking system. The Fed buys and sells securities through its open market operations in New York, which our new Treasury Secretary Tim Geithner used to run.

These trades are made through 19 (as of September) banks and bond dealers known as primary dealers, who then lend to other banks in the system. It still has to work through the banking system, not around it.

Nor does the Fed print money. The Treasury does. What the Federal Reserve does when it buys securities is credit a bank's reserves.

Banks are required to maintain money in reserve, usually around 10 percent, to protect deposits. This is where the Fed has been putting its money, in the reserves of banks. And that, I think, is where the money has remained (unless it got paid out in dividends or ridiculous bonuses). Banks have stopped lending because many are no longer solvent. They are merely trying to hang on while they weather the storm.

Japan is often cited in debates about inflation because the country experienced a prolonged bout of deflation from which it has not fully recovered. Toscano says that the government of Japan could have ended deflation by dumping large amounts of cash on its citizens, but it wasn't politically feasible.

I don't think it was economically feasible, either. Dropping cash on the street corner would bypass inflation and move us directly to dangerous and destabilizing hyperinflation (think Germany post WW I). As Toscano notes, Japan is a nation of savers which helped them survive the crisis. We've only recently started saving.

As for the hypothetical example of Alice, Toscano is right. Alice technically hasn't lost money. However, a financial institution or a corporation that owned the shares of XYZ company that Alice did is required to write down the value of its investment and take a loss.

Granted these aren't cash losses, but they still affect the share price (market value) of a company. For banks, it's even worse. The problem many banks are having now is that they had to write down so much of their assets that they are technically insolvent.

It's true that much has changed since the Great Depression. But one thing hasn't changed, and it's something these charts don't measure: the amount of leverage in our financial system. Our financial system became hopelessly addicted to easy credit and over the past few years, and our banks took on way, way too much risk.

As Irving Fisher wrote in his 1932 essay Debt-Deflation Theory of Great Depressions: "Easy money is the great cause of over-borrowing.

When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with the borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts."

Ultimately, this is the strongest case for deflation. By saving banks from failure, we may delay their inevitable collapse, but we reward failure and scare away investors and fresh capital, the oxygen of our financial system.

Anyone fortunate enough to be sitting on cash now isn't likely to put it in a U.S. bank or buy U.S. bonds. As a result, the destruction of our financial superstructure will continue no matter how much the Federal Reserve inflates its balance sheet.

Editor´s Choice
The reader comments you won't want to miss. (Editor's Choice selection do not represent the views of the editors. They are comments that seem to add to the discussion as opposed to less productive insults or arguments.)

"Nor does the Fed print money. The Treasury does. What the Federal Reserve does when it buys securities is credit a bank's reserves." Please explain to me why that isn't ultimately the same thing as printing money. The fact of the matter is that the Federal government is "borrowing" wealth to finance the trillions in bailout spending and its other obligations. Of course we're beginning to see deflation, which is exactly what's supposed to happen after a bubble bursts. The problem is that instead of letting the bubble burst completely, our stupid leaders are effectively printing currency. Eventually, that currency will hit the market, and when it does, common sense dictates that there will be price inflation. If you study the Wiemar Republic, you'll learn that deflation actually preceded hyperinflation.

Posted by Scott Vines | reply to this comment
January 23, 2009 9:38 pm

We have now both monetary deflation and, starting, price deflation. I wonder, however, why the Fed doesn't buy long-term treasuries in the order of trillions. That would pump money directly into the economy and should take care of monetary deflation. Of course, they would have to guard against future inflation, but couldn't they start with it by forcing continued deleveraging, e.g. by increasing the reserve requirements of banks in a predictable stepwise fashion? Once deflation disappears, the banks would NOT be able to return to their merry ways if reserve requirements are above 50%. The banks would scream, because it would reduce their possible profits, but they brought it upon themselves.

Posted by Peter T | reply to this comment
January 24, 2009 4:00 am

when you define "spread" as "the difference between T-bonds and TIPS," you mean the difference in YIELD between these two kinds of bonds.

Posted by amy roth | reply to this comment
January 24, 2009 6:14 am

11 Comments so far on this story...

Seth, let me say first that your understanding of how the economy works in this country is some what naive.The Federal Reserve runs our economy. What is the Federal Reserve? It is twelve private banks that control the flow of money into our economic system. Who owns these twelve private banks? That would be J.P. Morgan, Rockefeller, Wallberg to name a few.Can a private citizen own stock in these banks? No, the only people who own stock in the private banks are family members and some privileged friends. These twelve banks are tightly aligned with the Bank of England. The Federal Reserve Act was passed in 1913. with much influence from J.P.Morgan, who had caused a major bank failure ten years earlier by reducing the amount of money in circulation. Before the Federal Reserve Act, we depended on the government and some banks to run the economy. to be

Posted by zollner | reply to this comment
January 23, 2009 5:01 pm

What does the Federal Reserve have to do with the Federal Government? Nothing except the name. The President is allowed to appoint a chairmen to the Federal Reserve, who serves a ten year term, after approval from Congress.During the Civil War Lincoln went to the Bank of England to ask for a loan to pay for the war. The interest was so high he declined, instead he created our own currency called the Greenback, paid off the war debt without interest. Imagine that! In the Constitution we are allowed to print and coin our own money, we gave up that right when the Federal Reserve Act was passed.Jefferson and Jackson fought the central bankers through out their terms, finally Jackson was able to kick them out. Since the Fed was put in place in 1913 we as a country have had nothing but war and rising interest rates.

Posted by zollner | reply to this comment
January 23, 2009 5:32 pm

Wait until the bailout and stimulus hyper-spending cycle is complete. Within a matter of a few years deflation will turn into severe inflation. We cannot continue to spend like drunken sailors expecting no ill consequences. This is a ticking time bomb.

Posted by NativeVoice | reply to this comment
January 23, 2009 8:12 pm

Scott, I think it would be correct to say that the Fed creates money. Saying the Fed "prints money" is confusing to people and not correct. My point was that the Fed has to work through our broken banking system, which has its own problems. There is an agency problem here. The Fed wants to inflate our way out of the crisis, but the banks have a different set of interests. They have required capital infusions from the government to remain solvent. It's worth considering that the banking system has written down $1 trillion of bad assets. Some analysts think there is ANOTHER TRILLION that needs to be written down.

Posted by Seth Hettena | reply to this comment
January 24, 2009 12:45 pm

I think Harry Rady from Rady Assets said it best here: link

Posted by Jerry Altman | reply to this comment
April 16, 2009 2:23 am

Yes, Amy, thanks for the correction.

Posted by Seth Hettena | reply to this comment
January 24, 2009 12:44 pm

As Rich writes, the Treasury and the Federal Reserve can print new money as fast as the Weimar Republic did in Germany, but it probably shouldn't. At this point big banks and hedge funds are remaining mum about the hundreds of trillions of dollars in bad mortgage backed deposits and credit default swaps they're sitting on, hoping to avoid the eye of federal bank examiners and the SEC. When those toxic assets are finely brought out into the light, hundreds of additional companies will go into bankruptcy, or be forced into mergers with any surviving healthy banks, if any of those will exist. No matter what happy talk we hear from the politicians and regulators, we're headed into what will become known as the Bush Depression, so put your money in the safest place you can find and try to wait out the storm.

Posted by Watcher | reply to this comment
January 24, 2009 11:45 am

Seth and Rich have done a valuable service. Kudos, again, VOSD. We're now experiencing a combination of asset price deflation and commodities price inflation, coupled with stagnant or dropping wages. Mix-in vast 401k losses affecting nearly every worker, with the fall in available investment capital. Dump the unsustainable government and private debt loads into this ugly swamp, requiring inflated prices for goods, services and rents...the stench's overpowering. We're currently gagging on this toxic-cocktail of both deflation and inflation. Time for fundamental changes in our economics and behavior. It can get even worse.

Posted by Fred Williams | reply to this comment
January 27, 2009 6:03 am

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