Fixing a Deflation: A Most Intelligent Analysis

I have reprinted in total an interview between fund manager Ray Dalio and Barrons. This is the most detailed and well-thought-out description of what is a deflation and how it is repaired that I have seen. It echoes my thoughts and commentary almost verbatim, but with a lot more detail and credibility. Read on to understand what is happening and how we get out. I will put my commentary in brackets[]:

http://online.barrons.com/article/SB123396545910358867.html?page=2&page=sp

SATURDAY, FEBRUARY 7, 2009 INTERVIEW

Recession? No, It's a D-process, and It Will Be Long

Ray Dalio, Chief Investment Officer,
Bridgewater Associates

By SANDRA WARD

AN INTERVIEW WITH RAY DALIO: This pro sees a long and painful depression.

NOBODY WAS BETTER PREPARED FOR THE GLOBAL market crash than clients of Ray Dalio's Bridgewater Associates and subscribers to its Daily Observations. Dalio, the chief investment officer and all-around guiding light of the global money-management company he founded more than 30 years ago, began sounding alarms in Barron's in the spring of 2007 about the dangers of excessive financial leverage. He counts among his clients world governments and central banks, as well as pension funds and endowments.

"The regulators have to decide how banks will operate. That means they are going to have to nationalize some in some form." No wonder. The Westport, Conn.-based firm, whose analyses of world markets focus on credit and currencies, has produced long-term annual returns, net of fees, averaging 15%.

In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7% net of fees and Pure Alpha 2 delivered 9.4%. Here's what's on his mind now.

Barron's: I can't think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.

Dalio: Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.

Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?

Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.

You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.

You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and a depression?

The D-process is a disease of sorts that is going to run its course. When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?

The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s. Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt.

Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.

As goes GM, so goes the nation?

The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money [Exactly, but keep reading, the story gets even better].

It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.

Isn't the process of restructuring under way in households
and at corporations?

They are cutting costs to service the debt. But they haven't yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.

What are you suggesting?

An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.

So where do things stand in the process of restructuring?

What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.

The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth.

There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector -- that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

Is a restructuring of the banks a starting point?

If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.

On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks aren't going to have money, and yet we can't just let them go to nothing; we have got to do something. But the future of banking is going to be very, very different. The regulators have to decide how banks will operate.

That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?

Nationalization is the most likely outcome?

There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?

Let's say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in -- say $100 billion -- and going to get all the garbage at a leverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down.

Does this give you comfort?

Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I don't think they are going to come up with a lot of private money, not nearly the amount needed.

To the extent we are going to have nationalized banks [Citi, BAC for sure, as I have maintained; they are already Fed controlled, if not completely nationalized], we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending.

So whose money is it, and who is protecting that money?

The biggest issue is that if you look at the borrowers, you don't want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.

Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower.

If you shouldn't have lent to them before, how can you possibly lend to them now?

I guess I'm thinking of the examples of people and businesses with solid credit records who can't get banks to lend to them. Those examples exist, but they aren't, by and large, the big picture. There are too many non-viable entities. Big pieces of the economy have to become somehow more viable. This isn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.

By the way, in the bear market from 1929 to the bottom, stocks declined 89%, [note: in 1929 the DJI stocks were very extended and had the same kind of PEs as 2000. When stocks tanked in 2008, the PEs were much lower because the air was already let out of the stock market, so we will not need to see a DJI of 1400 before this is over. We probably already has seen the DJI low] with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.

At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn't get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.

In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933. [The timing of the change in Presidents is remarkable in its similarity. The market decline and recession started in 1930 and two years later, there was an election. This time, the housing market peaked in 2006 and two years later, there was an election. I think we are in early 1933 if we use the Great Depression as our reference. That was a great time to get long the stock market]

Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?

The Federal Reserve is going to have to print money [my blog friends who fear the printing press need to pay attention here. This point is why I discount what I hear from Marc Faber, Jim Rogers and Peter Schiff. They don't know their history]. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression [this answers the question about who will lend us the money to back the printing press]. We are in a position where that will eventually create a problem for currencies and drive assets to gold [which, in this context, is okay. I am long gold, but I am also long our economy].

Are you a fan of gold?

Yes.

Have you always been?

No. Gold is horrible sometimes and great other times [because its only value is as an alternate currency or jewelry. Gold has NO inherent value. It is an unproductive asset]. But like any other asset class, everybody always should have a piece of it in their portfolio.

What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.

Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity [this is a point that changes my thinking a bit. I think in terms of either / or; but Dalio makes the case for an overlap of the appreciation of both asset classes].

While the dollar is bad, it doesn't mean necessarily that the bond market is bad. I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first.

Ideally, creditor countries that don't have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don't have the problems that we have -- and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive.

Other currencies will decline in relationship to the yen and in relationship to gold [hmmmm, I don't know if "less bad" is good enough for me. I think Japan is in this with the rest of us; though recent currency action supports Dalio's case here].

And China?

Now we have the delicate China question. That is a complicated, touchy question. The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody's desire in terms of stimulus.

China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did get out. But they don't have to buy more. They are not going to continue to want to double down.

From the U.S. point of view, we want a devaluation [YES!! this is the point I always make: we must create inflation to get out of this problem, thereby devaluing the dollar]. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.

But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.

And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China attractive. [this is a major thesis of mine, and I own FXI, the China equity index fund and will buy more. This is a long term phenomena that will last my lifetime. China will be the major source of commodity demand for decades, so commodities are a great investment here]

You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?

A wave of currency devaluations and strong gold will serve to negate deflationary pressures [YES!! another of my points: inflation cancels deflation], bringing inflation to a low, positive number rather than producing unacceptably high inflation [this is the point where Faber, Rogers and Schiff are most wrong because they do not acknowledge the role of cancellation of deflation] -- and that will last for as far as I can see out, roughly about two years.

Given this outlook, what is your view on stocks?

Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.

Thanks, Ray

.

Refuting the Arguments of Gold Bugs

Today, I answer the blogposts of a couple of gold bugs who are a little overwrought with the idea of a new age where gold is king:

"Another Case for Gold": http://livingoffdividends.com/2009/01/31/another-case-for-gold/comment-page-1/#comment-32504


"Boy, Nirav, is the author of this piece mixed up. There are parts of it that are correct, but the overall picture is decidedly mixed and confused.

You and I have been in agreement that gold and other precious metals and hard assets will benefit from a period of monetary expansion once the deleveraging is done. I believe that as long as dollars are printed to replace the financial assets lost in write-downs, there is no inflationary pressure created: no extra demand chasing too little supply. (and in fact, we are now entering a period of excessive inventory, whether houses, cars or clothing, which is the source of all deflations).

But once inventory (supply) is back in balance, then all the excess money supply (demand) will probably cause inflation. How much inflation will be determined by how fast the Fed and Treasury can remove the dollars from circulation. One way is as the author described: by selling Treasuries. But this also is the source of one of his misdirections. Here are the errors I saw in his arguments:

1. “if the Fed floods the market with Treasuries, it will achieve exactly the opposite effect it’s looking for — it will cause rates to rise” - POINT: when the Fed uses this policy of selling Treasuries to reduce monetary supply, it is INTENTIONALLY trying to raise interest rates (see Paul Volcker in 1980). Interest rates must go up to attract buyers to Treasuries. That is the whole point, which addresses another of his confused arguments:
2. “Do you really think the Chinese and the Japanese are going to buy Treasuries at a 2% yield if the Fed is panicking and trying to buy dollars to stop an inflationary price explosion?” POINT - NO, of course not. The Fed already knows it will need to raise interest rates to attract capital to Treasuries once de-leveraging (fear) is out of the market. The very low rates of today are a product of global fear of economic failure. I find it very interesting that global wealth is flowing to the US dollar through Treasuries and not to Gold. It really refutes the Gold Bug argument, doesn’t it?
3. “They’re not going to fund an inflationary dollar at 2%. Ever.” POINT - DUH!! Come on, the author of this piece seems smart and well-educated, but this statement makes me wonder. First, the mechanism for issuing debt of any kind, government or corporate, is through auction. The 2% rate is a product of what the market will bear, not some Federal fiat. Interest rates of all types are set by the market, not be some pre-ordained decision. The Fed officials (really, any one educated in economics) understand that when we enter a period of excess money supply (we can only wish for that right now), then interest rates will be bid higher.
4. The reason for this is also Economics 101: investors are only concerned with the REAL return of an investment, not the NOMINAL return. The real return is the investment return minus inflation. So, the market will ALWAYS require a return that is positive or in excess of inflation. 2-2.5% is the normal expected REAL return for a riskless investment (Treasury). How do we know this? It is quoted every day in the Treasury Inflation Protected Securities (TIPS). When inflation is negative, as it is right now with a contracting GDP, very low interest rates still generate positive Real Returns.
5. “[In the past] the U.S. money supply was much smaller, and our ability to borrow was much stronger. But those days are gone.” POINT - many younger writers, or those not solid students of economic history, forget the context of “the past”. In the 1950s and early 60s, America’s economic nexus, America was the only country with its economic infrastructure left intact after World War 2. America was never bombed or invaded and its manufacturing infrastructure had been built to the sky in support of the Western World’s war machine. Because hard assets were plentiful, soft assets (currency) were not widely needed. People miss this very important point. Currency is just a substitue for real or hard assets. Those assets can be buildings, machinery, coal, oil or gold. American then, like China now, had lots of assets and against those assets, loaned the rest of the world money so they could rebuild theirs. When you loan money, money supply contracts, just as when you borrow money in expands.
6. The author (and most goldbugs) forget that currencies are comparative. If the entire world prints more money in concert, how can any harm be done? The dollar is just a unit of measure that represents economic exchange. Each dollar represents a fractional claim on the national aggregate assets of America. When I was a small boy, $1 meant a lot (could buy 3 loaves of bread). Today, $1 is probably represented by $10 in making purchases (still buys 3 loaves of bread). Does that change my life in any way? NO. Does it change my buying power in any way? NO. As long as my income is 10 times what it was before (and on average for Americans, it is), it is a wash. No one cares. And as long as the rest of the world follows the same path, it matters not. But, if you hold Real Assets over that time period (gold or real estate, among others), they will hopefully be worth 10 times as much, but probably no more (at least not for long). So, does that ounce of gold today buy any more than it did in 1972? NO. Money is symbolic and comparative, and to try to make some case for a new paradigm for Gold is as hopeless and mindless as those who tried to dismiss it entirely 10 years ago.

Reflation Economics (or "The Minsky Solution")

As your resident amateur economist, I would like to offer up an article coming from one leg of the PIMCO triumvirate (Paul McCulley, the others being Bill Gross and Mohamend El-Erian) who rule the private sector bond world.

McCulley is the Central Bank expert of the group and his expertise is near Nobel Laureate in its quality and insight. The PIMCO group anticipated the current banking crisis and declared the cause well in advance of the blowup. The PIMCO team labeled the cause as the "Shadow Banking System" and saw the leverage that was being created by hedge funds and others using the tools like "carry trade" to create money through leverage.

Like the rest of us, this group of economists thought the outcome of "shadow banking" would be inflation, as easy money created excess demand. None of them forecast the total collapse of the system and the resultant deflation. However, McCulley suggested the possibilty through his analysis of Hyman Minsky's work as an economist 30 years ago. McCulley uses Minsky to explain money growth and contraction, and does so at times with his stuffed bunny he keeps in his office (he calls "Bun-Bun").

I thought you might find this article insightful. Here is a sample with my paraphrasing in parantheses:

(It is the explicit responsibility of the Fed to provide a “more than proportionate” response to an economic contraction). That is indeed what is needed to save capitalism from its inherent debt-deflation pathologies. The paradox of deleveraging and the paradox of thrift are beasts of burden that capitalism simply can’t bear alone (that is to say, Capitalism is not a perfect economic system, but occassionally needs help when excess greed or fear get in the way). Only the Minsky Solution can lift that load.”

Here is the entire article:

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCB+December+2008+McCulley+All+In.htm

PIMCO and specifically, Paul McCulley, is the originator of the idea of “Shadow Banking”, which has come to dwarf the Federal Reserve system in the last 10 years. The amount of assets controlled by the shadow bank makes central bank policy implementation difficult, if not impossible. Shadow banking is the creation of money from nothing by private institutions, like hedge funds. Such financial institutiosn were increasingly deregulated in the 1990s and 2000s. Because they could use instruments like the “carry trade” to create money with very little invested capital, by use of massive leverage, the system effectively grew the money supply outside the control of the Central Bank. This was thought to be inflationary by the PIMCO team as late as 2007, but proved to be deflationary instead.

Now, that the shadow banking system is collapsing, it is following exactly the Minsky model. The Minsky Moment, modeled as the “Ponzi Unit” (in the McCulley chart), was achieved almost exactly at the time the biggest real-life ponzi scheme was uncovered, the Madoff Fund. Talk about life imitating art!!

So, the real central bank must transfer the leverage that is disappearing in the private sector, to the public sector, in order that the economy does not collapse into oblivion. I would like to ask Mr. McCulley what is the step to follow in the Minsky Model: how does the leverage that the public sector absorbs from the private sector get resolved? By time alone?

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm

To My Good Blog Buddy, Nirav

(Note: Nirav's post tried to make the case that Deflation is just a mirage made up by government flunkees to fool us into believing massive printing of dollars is needed. This would lead to Hyperinflation that would sink our economy. Instead, Nirav wants to see big tax cuts and dramatically lower government spending, along with increased consumer saving and decreased spending. He comes from the Jim Rogers school of economics). http://livingoffdividends.com/2008/12/18/the-deflation-scam/#comment-26971

Nirav, I had a hard time understanding the point of this post Nirav, I had a hard time understanding the point of this post.

The title declares that Deflation is a Scam. This implies it is something made up or false, maybe a government conspiracy. But nothing in the post makes the case for any of that. Your data from the Government show that we have experienced a -12.9% contraction on “All Items” through November. That is the definition of deflation. Are you saying those numbers are made up or falsified? The same data show that in some areas, like Education, there has been some small inflation. But overall, we are experiencing a currency deflation.

It would really be quite hard for you to convince me or probably most others, anything else. We can see it all around us, whether it is gas prices, home prices (and eventually rent as vacant homes create competition for apartments), utilities; even food will come down since raw ingredients like grain have dropped a lot in six months.

There is no question that we are experiencing deflation right now, today. The only question that can be debated is really more a speculation: will we experience deflation tomorrow? I commented in my last post that the government is TRYING to create inflation. It is working very hard to push people away from cash. By definition, that is the only way out of deflation. Any increase in price, even just to get us back to zero price change, would be defined as inflation (or maybe “dis-deflation”?)

Because inflation is the only way out of this mess, it is better to just plan for it (invest in the correct stocks and commodities, and probably not bonds), rather than make arguments that we shouldn’t have inflation. Almost all economists agree that some amount of inflation is required in a healthy economy. Inflation means growth. It means there is demand for the economy’s goods and services. It is excessive inflation that is a problem (over 5% maybe?) not inflation itself. Deflation ALWAYS means a sick economy. It is never desirable for declining aggregate prices since it means too little demand for the amount of goods and services the economy can produce at optimum production.

And what does any of this have to do with tax policy? A deflation is not a tax event nor is an inflation. “The head of the International Monetary Fund, Dominique Strauss-Kahn, warned that advanced nations will be hit by violent civil unrest if the elite continue to restructure the economy around their own interests while looting the taxpayer.” Huh??? That statement by someone name Strauss-Kahn(S-K for short? I don’t have much regard for economists with the IMF) makes little sense. Is S-K a Republican or conservative? What does he/she mean by “restructure the economy around their own interests while looting the taxpayer”? That is non-sensical.

The assertion by some that a Republican controlled government would “restructure the economy for their own interests”, though I would not agree with the notion, is at least logical. Republican’s generally favor “supply side” economics that reward the captains of industry (high tax bracket) with the hopes of “trickle down” benefits to the proletariat workers. I understand how this could be perceived as “looting the taxpayer” in the way of S-K’s thinking.
But the new Democratic Administration and Congress, which support and are driving our current economic strategy, are trying to reflate and support the massive financial restructuring TO BENEFIT the proletariate, NOT the elite. The Dems are for socialism, if anything. Obama himself said he wants to redistribute wealth from the rich to the poor. So, current policy favors the poor. Seems hard to get to Civil Unrest from here.

Now a good deflation, that is how we get civil unrest. High unemployment goes with deflation, almost by definition: as prices fall because of declining demand, business cuts back its production to decrease supply; to cut back production it lays off workers; fewer paid workers creates lower demand leading to even lower prices; and so on. Once there is 15% or more unemployment with many literally out in the streets with nothing to do: well you know the saying about idle hands. Check out the civil unrest in France the past few years for a reference.

So, stop worrying so much about inflation. It is the least of our worries right now. To get to hyperinflation requires the destruction of a country’s productive assets, ala Germany after WW1. Then, any printing of money is hollow, since it can’t be exchanged for anything tangible (like the dollar can be for desirable American assets like Pebble Beach). As long as money is exchanged for assets, even if impaired, it is not devalued by the action. This is why TARP is not really “printing money” as many proclaim. Something was received in kind for the capital infusions, namely assets, either ownership for taxpayers in the company (80% in a a couple cases) or in securities held, like RMBS’s or CDO’s (which contrary to popular opinion, do have some value).

It is much easier to pick good investments during inflation than right now during a deflation. Do you know even one good asset class right now? The answer is no, unless you cite the horrible US dollar (that no one wants, until right now, when it is all anyone wants). I welcome inflation. 5%, no problem, in fact GREAT; 10%, I can still find lots of ways to make money; 20%, okay, there is a limit, but we saw in 1980 how we get out of that one.

Comparisons between 1930 and 2008

It is very clear we are in an historic economic period. As I have said (maybe too many times?) before, "History Repeats (or at least it rhymes)". But which period are we comparable to? The 1930s or the 1970s? This is the big question because the proper investment (and survival) strategy are almost opposite.

The 1930s was a period of terrible deflation leading to economic Depression. There are a lot of parallels between then and now. Are we headed back to the 1930s, or worse? Some would have us think so, in which case sell everything and go 100% to cash and hide it under the mattress.

On the other hand, this period could be more like the 1970s. Again, there are many reasons to think so. And the strategy in this case would be to buy everything possible that is a real asset. Paper money (cash) just becomes more worthless every day with inflation and a stagnant economy. Real assets will grow in value at least as fast as inflation reduces the value of a dollar.

I won't try to answer the question because there is not enough information to know for sure (and if I really knew this answer, I could name my price). But I did find some interesting academic notes on the subject from an Eric Rauchway, an economics professor at UC Davis and author of a noted book on the Great Depression. You can read his notes or hear his podcast at this web link:

http://www.econtalk.org/archives/2008/12/rauchway_on_the.html

If you don't want to take the time to listen or read in entirety, here are a few bullets that compare the 1930s to now, paraphrasing the author / interviewee, Rauchway:

• Fed raised interest rates, first in 1928 to attract foreign investment; Followed by drop in consumer spending. Immediate transfer via the uncertainty mechanism to the real economy.
• Parallel, recent drop in automobile purchases after Fed raised rates in 2006 to cool economy;

• 1930: people afraid they will lose their jobs;
• 2008: Bankers afraid they will lose their jobs and be unable to pay their bank borrowings back. Strange that Treasury Secretary Henry Paulson is angry about that, given the history. Nice parallel with the 1930s.

• Hoover administration created the Reconstruction Finance Corporation in 1932,
• Similar to the Troubled Assets Relief Program (TARP) in 2008.

• RFC originally going to lend money to banks to prop them up. Realized that this is not going to work and they have to recapitalize the banks. Hoover doesn't like the idea of buying bank stocks (nationalizing) in return for the capital (big mistake, as it helps bring public support on board and eliminates moral hazard).
• We recently went through in a few weeks what we went through from January 1932 to March 1933 back then. We sped it up, and we accepted bank equity or warrants in exchange for capital. However, the speed discomfits consumers. Banks now are rather cautious in lending, as a result of speed and uncertainty. Consumers are not yet spending.

• In the 1930s, Fed administrators were frustrated that the banks weren't lending after being recapitalized; RFC said it would lend in their stead, only to find that there weren't enough qualified borrowers.
• Maybe we'll recover much quicker too (because the bank recap was sped up). Uncertainty about what may happen next is offsetting, (though and is holding back lending). Lending encouragement is working as shown by declining spreads between various lending classes like mortgage rates and Treasuries. We must avoid being too conservative in our qualification of borrowers and must make borrowing very attractive with excellent rates and terms;

But here are ways the two periods are quite different, to the benefit of the current period:

• Hoover signed the Smoot-Hawley Tariff Act, with some zeal. Contrary to the myth that he was a laissez faire ideologue. Not a stand-idly-by guy.
• So far we have avoided any protectionist legislation, like rescinding NAFTA. Protectionism shuts off a need source of capital flow.

• Hoover became increasingly desperate through 1932. At some point you have to say Hoover should have been doing more. Hoover tried to coordinate businessmen to prevent a drop in wages. Ineffective, can't get enough businessmen to agree.
• We now know that direct government control of the economy does not work. Nixon proved again in 1972 with wage-price freeze. Get around it by letting companies laying people off--pay higher wages but hire fewer people. This keeps consumers buying, if fewer consumers;

• In early 1930s, unemployment was about 25%, annual figures: just shy of that in 1932, about that in 1933.
• From that experience we know now that unemployment is necessary, so wages will fall to a point to entice firms to hire workers; but if people don't have jobs, economy won't recover, people don't have any money to buy things, so firms have no money to pay for more employees. Circular flow of macroeconomics understood and hard to navigate politically.

• Difference then vs. now: no unemployment insurance, no deposit insurance, no old age pensions--state level and some private stuff, but tapped out by 1931 or 1932. Agricultural difficulties of the 1920s also used up some of these social welfare resources (in farm states).
• Now there is an extensive social welfare safety net at the state and national level; Feds can create money if needed, to keep people fed and sheltered; can also provide funding to states if needed and can provide medical care and food stamps, programs not in place in early 30s.

• In 1930s as people lost jobs, they drew money out of their savings, putting pressure on the banks. Banks already suffering because foreign debt was going into default (post WW1); stock related debts (margin accounts) going into default; municipalities and states going into default. No brake, no way of softening the blow.
• Today we have FDIC deposit insurance, hence eliminates runs on banks. Banking system won't collapse.

• In 1930s, there is a stark contrast between Hoover in 1930 and Roosevelt in 1933 (with hindsight). Hoover doesn't do anything to stop the bank runs. People's savings just vanish, no recourse. Lack of confidence in the system with no deposit insurance, people wondering if their bank will be next.
• We have many protections in place today to avoid bank runs as witnessed recently, especially Indymac

An even earlier depression in 1894, was the worst depression before the Great Depression. It was 40 years before the 1930s Depression (notice the 40 year cycle?) and somewhat fresh in people's minds, pretty horrible, but we don't have good measures. What happened to banks in 1894? There were pressures on banks.

There is controversy over how bad the unemployment was and how contraction of the money supply contributed to the 1894 Depression. But in 1930s, the money supply contraction can't be laid at Hoover's feet--the Federal Reserve was at fault for that. They created money on one hand to recapitalize failing banks, but took it away with the other, believing if they didn't it would create uncontrolled inflation (which we now know is better than uncontrolled deflation and is the stated goal of Bernanke and probably L Summers to come).

Hoover did increase spending, limited by institutions of the day (or lack thereof) and circumstances. But the Federal government wasn't big enough in the early 1930s to have a big effect on the total economy. Hoover tried to create big increases of public works by working with the state governments. But too little, too late, not enough stimulus."

These are the conclusions, in short, of Eric Rauchway. They are even better understood by Ben Bernanke and also by new, incoming Chair of the Council of Economic Advisers, Christina Romer. She is said to be more an authority on the Great Depression than Bernanke.

Logically, the best way out of excess debt is inflation. Inflation allows the debt to be paid in ever cheaper dollars, at the expense of the lendor, of course. But that is a story for a later day. So, if Bernanke and Romer have learned from the 1930s and do everything that it is said Hoover, and then FDR did not do, namely not doing enough to stimulate the economy, I think it is a solid bet they will ere on the side of over-stimulation which will lead to inflation and a run in hard asset prices.

Paul McCullough Proclaims the Fed on the Right Track

Check out this morning's CNBC appearance by Paul McCullough. He is one of PIMCO's three leaders, that includes Bill Gross and Mohamed El-Erian (who left PIMCO to be Harvard Trust Fund's manager of $38B, but came back to PIMCO and is highly respected). The three of these guys don't get it wrong too often.

http://www.cnbc.com/id/15840232?video=938759900

So, if we are in for a period of stabilization due to the pouring on of liquidity into our financial system, and then due for some significant inflation to pay for all that stimulation needed to save the financial system and home values, we should be positioned accordingly with our portfolios. And because this has been our thesis for the past year or more, we are.

But I never thought we would go through this severe a deflationary recession to get to the expansionary inflation; only talked about it as a remote possibility since I thought the Fed / Treasury knew enough history to avoid it. Bernanke undoubtedly does. But don't underestimate the ability of the Congress to get in the way of solving our national problems. They have no trouble getting us in (way too loose regulation on lending / banking and way too socialist in home lending policy), but want to find someone else to blame when the stuff hits the fan (I am thinking of a certain Sen. Barney (Fife) Frank).

Thinking about how to lever up at these depressed stock price levels leads me to two of the Proshares ETFs: DIG and UYM. Both use leverage to get 150% of the Dow Sector index. Here is a sampling of their holdings and performance (naturally, miserable the past few months):

UYM

http://profunds.com/ProFundsProfiles/FundID_402/Basic_Materials/Profile.fs

DIG

http://profunds.com/ProFundsProfiles/FundID_413/Oil_and_Gas/Profile.fs

"Dr. Doom" Marc Faber calls for a Huge Market Rally

There is a certain Marc Faber, who is an anti-American Swiss national, living in Hong Kong, who has long called for the demise of the American stock market and the US dollar. He is interviewed in Barrons's regularly, and is a member of that journal's elite "Investor Roundtable".

Last night (Friday morning Europe time), he gave an interview where he is calling for a huge rebound in the stock market, and a collapse of the US Treasury bond market and US dollar, in response to the current market decline and the monetary expansion to prop up the economy. This is the scenario that I am positioned for, with big holdings in Canadian energy (non-US denominated) and material stocks and funds.

He did end his interview with an ominous warning that if the monetary expansion / reflation does not work, then we will experience a tremendous depression, worse than the 1930s. But this is how he got his title: "Dr. Doom"

Here are some of his quotes. You can see his interview on the right hand bar of this webpage.

"The sheer amount of money governments are pumping into the financial system will eventually lead to a very strong rally in beaten-down assets (aka energy), investor Marc Faber said on CNBC Friday.

But Faber also warned that if the markets remain depressed as liquidity increases the result could be a depression worse than in 1929. (don't know how this could happen...they seem mutually exclusive...either you have an asset deflation-based depression, or inflation. If it turns to hyper-inflation and worthless currency, ala Germany in the 20s or Argentina in the 70s, it would destabilize the economy, but would not be called "a depression").

By and large asset markets are "terribly oversold" now, while investors are going overboard into the U.S. dollar and U.S. Treasurys, Faber, editor of the Gloom, Boom & Doom Report, told "Squawk Box Europe."

"What you could see in the next three months is a very strong rebound in asset markets, in equities, followed by a selloff in bonds and eventually a selloff in the dollar," he said.
Governments and central banks around the world are providing liquidity and that will eventually have an impact, Faber said.

And once the buying starts the rally is likely to be "stronger than people expect" given that financial institutions are sitting on so much cash, he added.

'Colossal Deflation'

"I think the intervention by the government in the past and at the present time has created more volatility, not less, and so right now we have deflation, we have colossal deflation in asset prices," he said, noting that equities alone have lost $30 trillion globally.

But "I assure you if you throw enough money at the system, eventually you can reflate, especially in the United States," Faber added.

Statistically a rebound should happen, but if it doesn't "the air is out" and the world faces an economy "worse than the depression of '29 to '32," he said.

The Great Debate: Is the Fed Too Loose or Too Tight?

I have had a running debate with other blogsters regarding the current Fed policy of loose money. Being a student of history, especially the Great Depression, I know that one of the biggest factors contributing to the Depression was the fact a conservative (Hoover-led) government, Treasury and Federal Reserve kept money tight after the stock market broke down in October 1929. In fact, the Fed raised its Federal Funds rate in 1930 as it reacted to the perceived inflationary threat showing up in reports from data generated in 1928 and 1929 during the Roaring 20s Bubble.

I have contended that as assets aggressively contract, primarily real estate the past two years, some offset is needed to balance the national books. Otherwise, we have a deflation by definition (to little money chasing too many goods) and deflation is never a good thing as it causes people to save excessively (hoard) and not spend. This stops the economy and also feeds on itself. Some of my blog opponents feel that we should just let Free Markets work; that the market will do a better job of solving our problems than government. But history shows otherwise. A free market is a great thing during normal times, but it is too severe a master during times of stress.

To help me make my point, I am borrowing a column from "Barrons Online" posted yesterday. It says all that I have been trying to say, but more eloquently. Here it is:

TUESDAY, OCTOBER 28, 2008
UP AND DOWN WALL STREET DAILY

Pushing on a String or at the End of Their Rope?
By RANDALL W. FORSYTH

Sado-monetarists decry the doubling of the Fed's balance sheet, but is it enough?

THE FEDERAL OPEN MARKET COMMITTEE begins a two-day policy meeting Tuesday amid what now is conceded to be the worst financial crisis since 1930s. And, as in the Great Depression, the U.S. central bank is being criticized for being too easy and risking inflation amidst a severe debt deflation.

The Fed has doubled the size of its balance sheet in just seven weeks to attack the crisis. That has elicited squawks from what Barron's much-missed late friend and colleague, John Liscio, called the "sado-monetarists" who think that the central bank's efforts to cushion the pain of credit contraction invariably puts us on the road to perdition. As when he coined the phrase back in the early 1990s, the Fed is expanding its credit to offset the contraction in credit in the private sector.

Michael T. Darda, chief economist of MKM Partners, notes the Fed has expanded its balance sheet by $900 billion since early September, a seeming eternity ago when the Mets were cruising to the post-season and temperatures were sizzling. But that seemingly Zimbabwe-like 206% annual rate of increase in the Fed's assets in the latest 26 weeks hasn't ignited a monetary inflation. Quite the opposite, in fact.

A record percentage -- nearly 25% -- of the high-powered money the Fed has provided effectively sit idle as excess reserves, Darda points out. In other words, banks are sitting on a huge precautionary cushion. Banks are hoarding cash and are loath to lend to each other except for overnight periods.

That means banks are unlikely to unleash a new, inflationary wave of lending; quite the opposite. Yet the high levels of excess reserves in 1937 caused the sado-monetarists of the day to sound the inflation alarm back then and spur the Fed to tighten. That aborted the recovery and extended the depression, resulting in a resumption of the bear market. (Note: check out long term stock price charts and you will clearly see how the stock market cratered in 1937 due to this Fed tightening).

This time around, the deflationary symptoms are everywhere. Industrial commodity prices have been halved while the 30-year Treasury bond yield has sunk to its lowest level ever, under 4% last week. Gold has plunged to around $700 an ounce from $1,000 while the dollar has surged. And risky asset classes have melted down, he notes.

While the Fed is pumping more reserves into the banking system, less is being transformed into broad money and credit. And that money is turning over more slowly (velocity is falling, to use the economists' jargon.) The combination renders Fed policy "far less potent than it would otherwise be," Darda concludes.

That leaves the question, what's the FOMC to do at this point? The consensus of Fed watchers and the futures market is that the panel will cut its federal-funds rate target another 50 basis points (half percentage point) to 1% when it announces its decision Wednesday at 2:15 PM EDT. That would leave the Fed's main policy rate at its previous nadir touched in the past cycle and would, in effect, leave it relatively few basis points left to cut before the funds rate reached zero.

"The question is what the Fed does next," write ISI's Washington policy analysts, Tom Gallagher, Andy Laperriere and Melissa Loesberg. "We think it might have one more conventional rate cut before resorting to unconventional measures. But the real answer is that the Fed will wait for fiscal policymakers to take their turn," they conclude. (Note: this will come in the form of another national "special rebate" of around $1000-1500 that will be passed by Congress during a special session in November and distributed in time to impact Christmas spending, so I predict).

Goldman Sachs' economists also look for a 50 basis point cut from the FOMC but think a 75-basis-point slash, halving the fed-funds rate to 0.75%, is a 33% possibility. An important factor in the FOMC's decision will be the results of the Fed's latest quarterly survey of bank loan officers, which Goldman notes the policy makers will have in hand. This survey, taken in September, will be made public next month. The previous survey released in August showed a sharp tightening in credit standards for consumer, mortgage and business loans.

In other words, the Fed has been pushing on a proverbial string.
More than pure quantitative measures, price indicators show persistent credit tightness. Spreads between market interest rates and risk-free or administered rates have come in from their peaks, but remain elevated.

In particular, the three-month London interbank rate has come down to around 3.50% as of Monday, from the peak of about 4.80% on Oct. 10, but this benchmark remains above the 2.80% that prevailed in September before the Lehman bankruptcy and the Fed's 50-basis-point cut, to 1.5%, on Oct. 8. (Note: Why is Libor still so high, when the Fed keeps pushing the Funds Rate lower? The answer is that banks don't want to lend to each other, or are afraid to, after so much bank carnage. This means that what interbank lending does occur, does so at a higher interest rate than in a freer, less risky market. This impacts us because Libor is the index for many consumer loans and mortgages, and is also a barometer of economic health).

Three-month Libor also remains elevated against OIS -- the overnight interbank swap rate, which reflects the market's view on the fed-funds effective rate. The Libor-OIS spread is down to 263 basis points from a peak of 366 basis points on Oct. 10. But before the crisis, when banks were willing to lend to each other, Libor-OIS was a relatively trivial handful of basis points.

Getting Libor down is a more important, though less visible aim of the FOMC. The Fed's program to purchase commercial paper, which commenced Monday, should take further pressure off the money market. The Fed initially set a rate of 1.88% for top-grade three-month paper Monday, far below Libor, which should help to continue pull the interbank rate lower, according to Banc of America Securities' head of credit research, Jeffrey Rosenberg.

The Fed's unprecedented push of liquidity may have nearly doubled its balance sheet but it still has not offset the private sector's need, according to Bridgewater Associates. The world has accumulated so many dollar debts, and the ability to refinance and expand these debts was so ingrained in the financial system that its breakdown requires an unprecedented response from the Fed. But with so much of the global financial system out of the reach of central banks, the risks to policy makers are numerous.

With debt deflation engulfing the credit markets and the economy here and abroad, the sado-monetarists should get over their Whip Inflation Now fetishes.