This article originally appeared in the June 2010 issue of The Elliott Wave Theorist
TALK ABOUT DEFLATION
The possibility of deflation does not register with many investors. The website Daily Crux—which offers a comprehensive, free daily financial digest—recently conducted an interview that many people have told us helped clarify the issue for them. So with the kind permission of the host, I am publishing the Q&A this month.
Dear Daily Crux reader, This week's interview is going to rile up the Crux readership. Our interview is focused on what is likely the central investment question of our time: "Is crazed government bailout and stimulus spending going to produce runaway inflation? Or are banks and consumers in such bad shape that demand for goods, loans, and services is set to head lower, which will produce lower prices and deflation?"
The Daily Crux staff expects inflation in the long term. But we have no crystal ball, and neither does anyone else. So this week we're talking to the world's highest profile and most outspoken investment guru in the deflation camp, Robert R. Prechter, Jr. Prechter has garnered a wide following with his long career of market calls using a market model called the Elliott Wave Principle, which incorporates the idea that markets are driven by waves of optimism and pessimism. Prechter's work on crowd psychology—called socionomics—is some of most insightful analysis you'll read on the subject.
For Robert's take on the "inflation vs. deflation" argument, read on.
Justin Brill Managing Editor, The Daily Crux ––––––––––––––––––––––––––––––––––––––––––
The Daily Crux Sunday Interview Q&A with Robert Prechter
The Daily Crux: Hi, Bob. Thanks for talking with us today. You've been a successful market analyst for over 30 years, but over the last several years you've become well-known for your outspoken calls for deflation and a big bear market in stocks. In fact, you're probably one of the few market experts calling for outright deflation.
Robert Prechter: That's for sure. You can count staunch deflationists on one hand. There are so few that I can name them.
Crux: Most of our readers are familiar with the arguments for inflation. We saw a crash in 2008. The Federal Reserve and the government responded to the crisis by "printing money," easing credit, and bailing out the banks and big financial institutions. All this easy money and credit will lead to inflation. Can you give us a brief, easy-to-understand explanation of how deflation could happen in a paper-money, reserve currency system like ours, and why you think it's likely?
Prechter: Sure. In the simplest terms, creditors will stop lending, which will keep the credit supply from inflating. And debtors will default, causing the supply of outstanding debt to deflate. This will overwhelm government and central-bank efforts to inflate, and will result in deflation. These trends have already begun.
Believe me, I understand people's resistance to this scenario. The case for runaway inflation seems so logical. Over the past eight years, the Fed's lending rates have twice fallen to zero, meaning that credit is free. The Fed has created $1.5 trillion of new money. Central banks around the world have offered unlimited, cost-free credit. The government is spending money like mad. And the Fed and the Treasury have bailed out or guaranteed another trillion or two of bad debt and promise to cover even more. Oh, and the Chairman of the Fed swore eight years ago that he would drop money from helicopters.
There is only one problem with the logic involved: It does not lead us to present conditions. In the great inflations of history –such as what occurred in Germany in the 1920s and Zimbabwe in the 2000s—several things happened: The money supply zoomed; interest rates soared to double and triple digits; commodity and stock prices went up; consumer prices rose relentlessly; and people raced to get rid of money as fast as they got hold of it.
Today, not one of these events is happening. In fact, the opposite is happening: M3 (a measure of the amount of money and credit in the system) is contracting at its fastest pace since the 1930s. Interest rates on Treasury bills are stuck at zero. The CRB index of commodities is at half its value of just two years ago. The stock market is lower than it was 10 years ago. The PPI and CPI (measures of producer and consumer prices) have a zero rate of change. People are struggling to get anyone to part with a dollar: They can't get loans, they can't sell their houses, and they can't land a job. And Walmart is cutting prices. This is the "Bizarro" version of Germany and Zimbabwe: everything's backwards.
Crux: Well, not everything. Gold is at all-time highs.
Prechter: And so are Toronto real estate and vintage wine. But let's put these markets in perspective. There have been three great credit-inflation peaks over the past ten years. In 2000, many stock markets around the world stopped going up. In 2006, real estate stopped going up. In 2008, commodities stopped going up. Stocks, commodities and real estate are three massive markets worldwide.
Here in 2010, a few late bloomers are making new all-time highs. I never thought the long term inflationary topping process would take this long, but it has.
At each of these peaks, investors have focused on one area or another. Every time it's happened, the area of focus has reversed trend, plummeting in price by 50% or more.
This latest credit reflation is the weakest yet, so it hardly inspires confidence that today's isolated bull markets will end any differently. Each time a bull market matures, investors are sure it can't reverse. They said that about technology and internet stocks; they said it about real estate; they said it about oil. Now that a couple of markets are at all-time highs, we hear the same argument about them. This is natural, because investors always want to own markets that are way up. But investors in those previous booms are never going to get back to break-even. Many of them were ruined.
Crux: OK, but what do you say to the argument that the Fed has the power to create inflation—to create an unlimited amount of money and credit, and inject it into the economy—at will? And because of this deflation is practically impossible?
Prechter: This is the argument I answered way back in early 2002 in my book, Conquer the Crash. Since it came out, the Fed has offered unlimited credit. It has been injecting money. Yet there has been no runaway inflation.
There are so many problems with this argument that I can't fit them all in a short space. But I'll mention four key points.
First of all, the banks are ruined. They lent out every penny of deposits, and their loans are increasingly non-performing. They can't borrow any new money, because they're already underwater. And consumers are also broke, so they can't borrow more, either. Unlimited Fed credit is irrelevant. No one can afford to pay banks interest any more.
Second, the only active creditors left are sovereign governments. And as Greece proved, governments have limits. They can't print their way out, because creditors will abandon them if they do. They need their creditors too much to choose printing. Greece agreed to austerity. Britain is talking about austerity. The Tea Partiers are demanding austerity. At some point, members of Congress will have to stop borrowing and spending, because voters will oust them if tthey don't.
Third, the idea that the Fed can inflate "at will" is going to be challenged. Is the Fed going to monetize—what's often referred to as "money-printing"—another $57 trillion worth of dollar debt, shore up trillions more of foreign debt and guarantee $600 trillion worth of derivative promises? Not likely. Can the Fed's $2.3 trillion balance sheet—already over-inflated—keep a quadrillion dollars worth of worldwide IOUs from imploding? Not a chance. Its own governors are already fighting about the monetization it orchestrated in 2008-2009. The Fed has been historically accommodating so far, but cracks are appearing in its resolve. Some of its own governors disagree on Bernanke's extreme policies, and that's after monetizing only 1/7 of 1 percent of the world's outstanding IOUs.
Fourth is the crucial importance of social psychology. Voters are getting angry about the bailouts. Congress is talking about auditing the Fed for the first time since it was created in 1913. Suddenly Ron Paul is popular, and he wants to abolish the Fed. These changes are not random. They come about because of the trend away from positive social mood and toward negative social mood. To use a historical example, the downtrend in social attitudes starting in 1835 resulted in the complete elimination of the U.S. central bank. The Fed is ultimately either sanctioned or destroyed by the people, and people's attitudes change. It could easily happen again.
Publications like yours—by pointing out the terrible dangers of central banking and hyperinflation—are helping to promote this new change in social attitudes. People are becoming terrified of inflation and sick of the borrowing that spurs it. That's a good thing in the long run. But it will actually help bring about deflation.
Crux: But, ultimately can't the Fed simply "print" money if it appears deflation is starting to win? The "drop money from helicopters" analogy you mentioned earlier? Wouldn't that prevent outright deflation and ultimately lead to inflation or even hyperinflation as the dollar is devalued?
Prechter: To begin with, the printing analogy is flawed. The Fed does not operate a press, as the government of Zimbabwe did. It creates new money only when it buys IOUs. This may seem to be a distinction without a difference, but it's actually very important. These IOUs are the Fed's assets, and it doesn't want worthless assets backing its notes.
Even if the Fed were to monetize every dime of currently outstanding, dollar-denominated debt, it would create no net inflation. The money-plus-credit supply would be the same. And price levels—especially for investments—are based on the total of monetary assets, not just base money.
Even so, there is no way that the Fed will buy up the entire world's stock of lousy IOUs. It has always wanted pristine assets on its books. Remember, it didn't buy Fannie and Freddie's IOUs until it got the Treasury to guarantee them.
Then there is the so-called moral hazard—not that the Fed cares about morality—meaning that if the Fed were to begin buying everyone's IOUs, people would immediately issue more IOUs as fast as they could and sell them to the Fed. It couldn't keep up with the volume.
But these scenarios are fantasies. In reality, self-preservation will eventually motivate the Fed just as it motivates every other institution. Buying too many worthless assets would cause the Fed's self-destruction, and I think it will balk at going that far.
Crux: OK, so you don't think the Fed will go that far. But what if the government got involved and tried to inflate its way out by issuing massive amounts of Treasury bonds to the Fed? Wouldn't that create inflation?
Prechter: If the government tried to do that, bond holders would get spooked, and interest rates would go up and stay ahead of the printing. At the same time, other credit prices—municipal, corporate and consumer—would implode. When the supply of credit is far bigger than the supply of money—and it is by a huge margin—the value of old credit can contract faster than new bonds can be printed. The net result would still be deflation.
But this is not the most likely scenario. Have you noticed that even the Fed chairman has been telling Congress it needs to stop spending and borrowing? The Fed doesn't want this to happen any more than other creditors do.
If the Treasury's interest rates do soar, it will not likely be due to inflation fears but to fear of government default. If the government is forced to pay higher and higher rates, it will become a black hole for money. Spiraling Treasury rates would suck money from other sources, causing banks, municipalities and companies to fail, ruining all of their debts, which would be deflationary.
Crux: Will hyperinflation ever happen in the U.S.?
Prechter: It certainly might. But it could only happen after the bond market implodes, not before. Then, if politicians get hold of a press, they might decide to print. But this is political conjecture, not monetary analysis. First we have to cross the deflationary valley, and this could take longer than almost anyone thinks.
Crux: So what you're saying is that inflation is possible, but that it can't happen until deflation has run its course. What would you be looking for to indicate that deflation was over and that inflation was beginning to become a danger?
Prechter: A banking crisis, in which thousands of banks shut their doors. Thirty-three percent unemployment. A ruined private and municipal bond market. And a panic in government bonds. If all those things happened, then you would have to be on the lookout for legislation allowing the government to take over the printing of money or to force the Fed to monetize new federal debt at a rapid rate. I think we will have to see all these things before hyperinflation will become possible. If all of this happens, trade all your greenbacks immediately for gold and raw land.
Crux: Are there any scenarios that would change your mind, that would make you think you may be wrong and that inflation is becoming a threat?
Prechter: If the S&P index, real estate and the CRB commodity index all take out their price highs of 2006-2008, it would probably be enough to indicate runaway inflation. We keep a very close eye on all the key markets and will try to be ahead of any such development.
Crux: What do you think about buying gold as a crisis hedge? You're often pegged in the media as anti-gold.
Prechter: I love gold. It's money. Our fiat system has no money, just debt. Outlawing gold as money in the U.S. was one of the most harmful decisions the government ever made. Our economy would thrive if contracts denoted payment in gold instead of paper.
That being said, there has been no worse investment than silver over the past 30 years, and gold has not done much better. You have to pick your markets and your spots. In 2001, 95% of futures traders polled for the Daily Sentiment Index thought gold was going lower. That was a bottom. Now 98% of them think it's going higher. This is probably not a bottom.
Also—and I know this will sound controversial—gold is not a crisis hedge. It goes up most when the economy is expanding, not contracting.
In crises, people want cash. Debtors owe dollars, and creditors are owed dollars. That's what they'll need, and that's what they'll want back. During the serious part of the coming debt implosion, dollar bills and surviving dollar-denominated IOUs will likely go up in value faster than gold, which means the dollar price of gold will probably fall for a time.
But I also believe—maybe it's more of a hope—that the days of fiat money are numbered. The only solution to our monetary problems is to get government out of the money business. Like every other business in which government becomes involved, this one has become polluted beyond recognition.
I also think it's wrong to advocate a government gold standard. Governments always eventually ignore such standards. An English pound used to be worth a pound of silver. What's it worth now?
Private institutions should provide money. Companies such as GoldMoney are already doing it. That's the model for the future.
Crux: So if deflation is coming, how do you recommend investors prepare for it?
Prechter: Investors should be primarily in greenback cash and Treasury bills, while holding a core position in gold-bullion coins and bags of U.S. silver coins, sometimes called "junk silver."
They should hold no corporate bonds, municipal bonds, mortgage debt, auto debt, credit card debt, foreign debt—aside from Swiss money-market claims (the Swiss equivalent of T-bills)—or any other IOUs that will soon evaporate in value. They should own no stocks or investment property. They should avoid all but the safest banks on the planet. Experienced traders should be short the S&P.
Anyone who wants detailed instructions on how to do all this should read the second half of Conquer the Crash, which is a manual on how to take advantage of a deflationary environment.
Crux: That's quite a list. Any closing comments?
Prechter: I realize my forecast for deflation differs from most bears' views, and calling for depression certainly differs from the bulls' views. But I'm convinced that deflation and depression are already underway and about to get much, much worse. You can avoid the impact of both trends if you are prepared, and you can even profit from these trends if you are properly positioned.
To close, I want to say that I really appreciate your open-mindedness in posting my thoughts. Thanks for the forum!
Crux: You're welcome. Thanks for talking with us.
Prechter: My pleasure.