I received the following question yesterday in response to Liquidity Without Responsibility.
Mish- I have been reading your posts for some time, and it does seem like the scenarios you have prophesied are slowly unfolding.
You have mentioned deflation many times, and I know there is debate as to what the definition of deflation actually is…
Just looking at price alone: some prices such as housing are dropping, while others…eg commodities are rising…do you think this divergence will continue, or will we get outright deflation…commodities, housing, wage, manufactured goods etc at some point in this cycle?
Thanks, I appreciate that question. Yes some things that I have called for are happening (especially in regards to housing and housing related credit), while you and others are wondering how the rising price of commodities fits into the picture.
I am a fan of gold and commodities in general and have stated so many times. But the price of commodities or the price of anything is not what determines deflation vs. inflation. The Austrian definitions I use are that inflation is an increase in money and credit and deflation is a decrease in money and credit. Right now it is clear that we are in a state of inflation (but it is not very stable for reasons I will get to later).
Long term I agree with Ron Paul on the US dollar. I agree with him in general about hard assets (especially gold) as well. Yes he is calling for stagflation and possibly an “inflationary depression”. I am not a big fan of the term “stagflation” as many know. I guess the problem I have with it is that I believe inflation and deflation are monetary events while the term stagflation is not. Here is a typical definition of stagflation: “a period of slow economic growth and high unemployment (stagnation) while prices rise (inflation)“. There are countless other definitions all mentioning “inflation” with the general sense I get uses the term inflation in stagflation as meaning rising prices.
Astute readers will also pick up on the aspect of “high unemployment” and scratch their heads over the rock bottom unemployment rate. At a minimum the stated unemployment rate does not take into consideration wages or how skewed those wages are. Others will counter with various “Shadow Statistics” suggesting unemployment is way higher. Arguably the correct way to look at things is where job creation is and where it is headed. Citigroup announced plans to slash 17,000 jobs. MID LEVEL JOBS. Where are those people going? Where are high paying construction employees going? Where is job growth going to come from at the tail end of an expansion? Capital spending is slowing dramatically. What does that say for job creation? The weekly claims numbers also seem to be ticking up again.
But lost in the debate about stagflation is the real meaning of inflation and deflation. Economic growth, unemployment, and prices are nowhere to be found in what I believe is the correct definition of inflation or deflation. Stagflation might say something but it certainly is not (at least by Austrian definition) some sort of in between step between inflation and deflation. The step between inflation and deflation is arguably perfection, not stagflation.
So what’s next? As long as asset prices rise people can pay the bills and an expansion in credit can continue. But we are running into trouble, especially with housing. The containment is spreading as I and others have pointed out. The stock market cheers layoffs like those at Citigroup until people can’t pay their bills. Now we are seeing Congress stepping into the fray (too late of course) hoping to bail out homeowners who are underwater in mortgage payments.
Stress keeps mounting. Other aspects of the proposed bill will shut off credit and subprime lending. Yet congress is too late. The market has already reacted. Where was congress and the Fed four years ago when a bill was needed and might have done some good? Now whatever congress does will just make matters worse.
Many say the stock market is forward looking. I disagree. In fact I have proven otherwise (see Leading Economic Indicators). The stock market is a measure of sentiment towards risk. As long as that risk taking continues the stock market can rise. But gains are harder and harder to come by. So hedge funds have resorted to leverage to make up the difference. Mutual funds and hedge funds are also selling options to gain income. This reduces volatilities. The whole mess of leverage on leverage works until it doesn’t.
In the meantime commodity prices are rising while prices on many finished goods as well as housing are falling. This obviously unstable. But supply constraints and peak oil are not inflation. I keep getting told that there MUST be a pass through of rising commodity prices. I disagree. The cost to produce something is irrelevant as to the price it will fetch. The latter is purely a supply/demand issue. If you disagree look at prices of condos in Florida. They cost more to build than what the can be sold for. Demand is simply too low as a result of mammoth malinvestments and overbuilding. Yet condos are still being built. Projects are headed to completion and the supply of stuff still grows in the face of falling demand. At some point creditors will shut off funding but that has not happened yet.
Clearly this is unsustainable. Ron Paul thinks “An Event” will happen within five years. I happen to agree. But no one really knows when or how insane things will get in the meantime. Remember how high shares of NEW and LEND were just a few short months ago? Remember how subprime did not matter until it did. Remember people camping out overnight to buy Florida condos less than two years ago?
Right now there is credit contraction in subprime and that contagion is spreading regardless of what anyone says to the contrary. But speculation and leverage are still running rampant with enormous amounts of money (debt) funding leveraged buyouts and stock buybacks. The broad markets also still have a huge underlying bid.
More and more of us are talking…
It’s not just me now. Some of the best traders I talk to are noticing the same thing: stocks are heavy and illiquid, yet indexes are well bid and liquid.
The bids I see in index ETF’s are ridiculous for anyone trying to actually buy them intelligently (at the best price). I routinely (like today) am seeing massive bids advertised in the ETF as if the “buyer” wanted to buy them at the worst price possible. In other words, to drive the market up.
Eventually the weak stocks are dragged up kicking and screaming by index arbs.
I can only speculate as to why this is happening. Either “buyers” want overall exposure to the U.S. stock market and they do not care what price they pay, or some non-economic buyer is showing massive bids for some other reason.
As deflationary forces build and central banks run out of inflationary bullets, I can at least wonder at those charged with stimulating sluggish economies understand that if stock prices go down the game is up.
I have felt for the better part of a decade that the Federal Reserve has been targeting asset prices (stocks and real estate) in addition to the real economy, rather than just the real economy as it has done for many decades. This is a direct result of the monstrous amount of debt outstanding relative to the size of the economy. For further proof, please look at a chart of Total Credit Market Debt, courtesy of our friends at Ned Davis Research. Not only is the percentage of credit market debt relative to GDP important, but note the trajectory of the debt growth. What is important to me is that what accompanies debt is debt service, and that debt service requires ever-increasing asset prices to support the debt service.
I wrote recently about a concept called “zero hour” that was initially unveiled by Barry Bannister (who worked for Legg Mason at the time). Essentially, zero hour is defined loosely as the moment at which credit growth no longer has an impact on the real economy. While the US not yet there, I wonder aloud if it is not heading on a course towards zero hour, or as some call it, “the day of reckoning.” I will say this. I do not know when and even if this is to occur. Frankly, for our children’s sake, I hope that it does not. But to blindly ignore the mere possibility of this potential outcome is to be imprudent, particularly with other people’s hard earned capital. If the US does not, as a nation, get its financial house in order (in a short time I may add), then the question becomes not if the US visits zero hour, but when it reaches zero hour.
Clearly the situation we are in is not sustainable. We cannot keep replacing high paying jobs with low paying jobs forever. Debt and financing are not unlimited either. Housing proved that. Using rising asset prices to pay bills can only go so far. Housing proved that as well. Once the impact of reduced capital spending hits the jobs front, there is bound to be a pickup in the inability to service debt. In the meantime please keep an eye on debt and leverage. It is taking ever increasing amounts of both to have an impact. Zero Hour approaches. I don’t know the date but I do know the time.
She packed my bags last night pre-flight
Zero hour nine a.m.
And I’m gonna be high as a kite by then
I miss the earth so much I miss my wife
It’s lonely out in space
On such a timeless flight
And I think it’s gonna be a long long time
Till touch down brings me round again to find
I’m not the man they think I am at home
Oh no no no I’m a rocket man
Rocket man burning out his fuse up here alone
Mike Shedlock / Mish/