The Horror of Deflation

The Federal Reserve Board, along with MSNBC and a couple of other financial reporting networks have been touting the terror of deflation.  The first question should be, is there a problem with deflation?  Ah, that is a relative question.  If the price of retail goods, in particular foodstuffs, gasoline, and other everyday necessities go down (due to deflation with is really a reduction of demand over supply) then for the average individual that is good.  The cost of living goes down.  On the other hand if that same deflationary influence reduces wages, then that may be a problem. True, you cost of living has decreased but your wages may have decrease by a similar amount or percentage.  The two reductions may offset each other.  But regardless of CPE and wage, debt service and reduction does not decrease.  The amount you borrowed and the interest and the principle payments stay the same but are now a larger percentage of your reduced wage.  Debt remains a constant and is only measured by the increased or decreased relative percentage of your income.  Thus if your debt service which may be both principle and interest, becomes harder to maintain because your income has been reduced then deflation is not doing you any favors.  Inflation is your friend when your debt service has been extended beyond your comfortable margin to maintain.  But inflation is also a tax since all costs of living rise, often faster than your income.  On the other hand, with deflation, wages tend to be sticky, more resistant to reduction.  On the same line, unemployment becomes more common as businesses seek to reduce their costs.  It is often easier to gain productivity at the expense of sticky wages.

So far all this doesn’t sound too bad, so why is the Fed badmouthing deflation?  It is the problem of interest rates.  We have seen at least a decade of very low interest rates as administered by the Fed.  How does the Federal Reserve affect interest rates?  Every bank, large and small, must keep a certain percentage of their capital or deposit funds with the Federal Reserve Bank.  This is done for one, reasons of safety, and two, reasons of liquidity.  Liquidity is that amount of cash that flows through the system.  If the banks all decide to buy bonds and other securities, then there is little cash left in the system for those who want cash.  If there is too much cash the Fed may decide to raise deposit rates to stem the flow of cash.  How fast cash turns over or circulates through the system is called the velocity of money.  Velocity is that thing that happens when the public, the corporate, and the government sectors are spending large amounts of money.  So when it comes to setting interest rates, what the Federal Reserve sets is the interest rates for deposits made by the banks into there Federal Reserve accounts and the rates that they might borrow funds overnight from the Fed.  If these rates are raised, then the banks must pay raise their rates as the supply of money is less than the demand.  Raising rates means that it costs all three sectors of the economy to borrow money.  The higher the cost the lower the demand for borrowing.  Are you with me so far?  So, the percentage of capital in circulation, along with deposits from customers, determines the amount of money flowing through through the economy.  The interest rates the Feds charge determine the interest rates the banks charge.  If the Fed were paying five percent on deposited funds, which would be considered extremely safe, then the banks might decide to deposit more of their funds, both paid in capital and customer deposits.  that puts a premium on funds to be loaned to the public, the corporate, and the private sectors.  So we have something of a working of the Fed and monetary flows.

How does deflation affect all this?  One man’s asset is another man’s liability.  Money is usually lent against some asset that can be sold for the cost of the loan and other costs.  If you buy a house and take a mortgage against it so that you can pay for the house, that real property should be valued at a high enough value to more than cover the loan amount.  This is why one, back in the old days before all the below prime loans had to front a 20% payment, or effectively finance 80% of the value of that property.  The idea was that it was far too unlikely that in bad economic times the value of a property would drop more than 20% and that that particular percentage would cover the process of any default proceedings.  Well, so much for honesty in the mortgage business.  Sub prime became the rage, falsification of income and financial date became the norm, and property asset bubbles became the rage.  Deflation means that the demand for a particular asset has declined and thus the value of assets in that class has declined.  You bought that house for a million dollars and can’t find a buyer to buy it for more than $750,000, you’ve got a problem and so does the bank.  And the fact may be that a particular property is now only worth half its previous value.  This is what deflation does to asset value, it reduces them to pre-inflated levels.

Okay, so far, so good.  Why is the Fed afraid of inflation?  Two words, Quantitative Easing.  The Fed decided to try and increase the liquidity of the financial system so that inflation would have a chance to float growth of GDP and get the economy growing again.  Unfortunately the assumption that economies need inflation to grow is a false one.  If two percent is good, then why was the five, six, seven, eight, nice, and ten percent inflation we experienced in the sixties, the seventies, and the early eighties so bad?  Please explain to me, Mr Paul Krugman, why this is so.  The fact is, Nobel Prize or not, his imperial highness can’t.  But worse than that, what the Fed did was to buy assets.  First it was Treasuries, the 30 and 20, and 10, and a lot of 7 and 5 year government bonds.  Now since the Fed had reduced the Fed rate to less than a half percent, that meant the the treasuries paid very little interest.  So the Federal Reserve bought all those treasuries with money it created in a computer.  It didn’t need to hand over cash, just create money for nothing, so to speak.  Than mean that banks, hedge funds, insurance companies, and the like sold to the Federal Reserve their bonds on what is known as repurchase agreements.  That means that they are suppose to repurchase them at a later time.  But if the interest rates rise, and this is what is beyond the power of the Fed, those bonds become worth a lot less.  You see, the Fed isn’t the only one who determines interest rates.  The commercial market that allocates funds according to the quality of the asset (also known as its safety or ability to repay the funds with interest) and the interest rates can decide to ask premiums above that paid by the Federal Reserve Bank.  You see, the Fed doesn’t provide the money for corporate bonds, debentures, and the like.  Banks, both investment banks, retail banks, hedge funds. venture capitalists, and a host of others lend money.  Got that so far?

Now, If the Fed lowers interest rates then investors, both commercial and private my seek higher returns through higher risk loans.  Higher risk means more likely to default (default refers to both the non payment of the service or interest, and the non payment of the matured financial instrument), hence these loans pay a higher premium or interest rate.  Their rating as determined by one of the three rating companies, Fitch, Moody’s, and S&P, indicate the safety or the likelihood of service.  At the top is AAA and what is known as junk is BBB or less.  As investors are forced to seek higher returns they are exposed to higher risk.  Who are these investors?  Insurance firms, pension funds, and many others who have fallen into the trap of paying out funds at too high a rate and investing at too high a risk.  The idea of a pension fund is that monies are collected and invested according the the payout rates in the future,  Insurance and pension funds normally use actuarial standards to compute the funds needed to be collected in the future at the future rates.  Well, at least in theory.  Unfortunately that standard has not been followed since the sixties and in the case of public employees who have used unions for collective bargaining, they will find out that the deep pockets of government are only as deep as the taxpayers will support.  Deflation kills their rate of returns.  Deflation hastens their bankruptcies.

But eventually deflation will raise interest rates, right?  So the insurance and pension monies will be saved, right?  Don’t count on the timing.  All these institutions now invest in anything that promises six or seven or ten or even more percent of return.  As I said before, one man’s assets are another man’s liabilities.  All those state, county, and municipal bonds are only as good as the agencies that have issued them.  When that agency goes bankrupt, all those bonds are now worth quite a bit less and may, in fact, be almost worthless in a bankruptcy court.  Rising interest rates only makes it harder for these agencies to raise money.  And we haven’t dealt with the Fed yet.  So now we have all this QE which was suppose to create inflation but only caused the banks to go on a lending spree and buying spree.  Assets were pushed up to unbelievable levels.  Commodities such as copper, coal, iron ore, crude, all these consumables went skyrocketing.  Where are they now?  Most of them are at their lowest levels in decades.  Why mention this?  Because so many loans were made on commodities, and sometimes the same pile of copper wire, pipe, ingots, etc, was used to secure five or six or even ten loans.  What are the chances one gets ones money back?

Okay, not we come to the really big show, as Ed Sullivan would say.  Derivative such as collateral debt swaps, collateral debt obligations, and other variations on a theme of gamboling.  A derivative, in pure and simple terms is a naked insurance policy.  When you buy fire insurance on your house the insurance company puts part of that premium it collects from you into a reserve fund.  It knows that now every house it insures will burn down, only one percent or so.  That means that it only needs to keep so much liquid assets on hand, such as cash or certificates of deposits.  It can invest the rest of the collected premium.  But derivatives seldom have any reserves behind what they insure. So say you buy a government bond and you don’t think that government bond is too secure (we can use a municipal bond or a corporate bond, etc).  So you friendly banker says that if you pay him some money he will make good any loss you might suffer if that bond goes bad.  To make matters worse, Banks and other financial institutions like to work both sides of the street figuring the obligations will never come due.  Latest figure I heard is that there are almost 200 trillion in derivatives in the marker and more being written every day.  There is not enough money, credit, and first born to cover the failure once it all starts.  And it will start because interest rates far beyond the ability of the Fed to control will rise, and not by a quarter or half a point, but by one and two percent.  The Fed has something close to two trillion in Treasures, mortgage backed securities, junk bonds, corporate paper, and god knows what.  Yeah, it is all repo or repurchase agreements.  But if you can’t repurchase any of that, what then?  If you can repurchase the financial goods at the original price, if that price is far less that current valuation, what can you do?  The Fed is worried that its house of cards is about to fall fasted than a speeding bullet.  The Fed can’t handle deflation because it so screwed up monetary policy.  It relied on Keynesian assumptions that were never true, that economic professors said just had to be true, and will be shown as patently false by the economy.

We and the rest of the world, have been on a half century or more of  bad investment strategies.  We have assumed that economic growth goes on forever.  We have assumed that every time there is a recession the government can buy its way out.  And worst of all, that when a depression comes, that we not acknowledge it and then try to spend our way to prosperity.  It’s not that deflation is bad, just that it doesn’t support stupidity.  The best advice I can offer anyone is to get rid of your debt, get it as low as you can if you can’t pay it off.  Save what income you can, cut your expenditures.  Get rid of the crap in your life.  Switch from Apple to something inexpensive and useful.

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One thought on “The Horror of Deflation

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