On Managed Deflation (aka "Screwflation")

In the past week, both Steve Keen and Stoneleigh have independently posted up some interesting observations that support and reinforce each other.

First up is Stoneleigh's Et tu, Commodities? 

Our most consistent theme here at The Automatic Earth has been the developing deflationary environment and the knock-on effects that will follow as a result. Now that the rally from March 2009 appears to be well and truly over, it is time to revisit aspects of the bigger picture, in order for people to prepare for a full-blown liquidity crunch. October 2007-March 2009 was merely a taster.

As we have explained before, inflation and deflation are monetary phenomena - respectively an increase and decrease in the supply of money plus credit relative to available goods and services - and are major drivers of price movements. They are not the only price drivers, to be sure, but they are usually the most significant. People generally focus on nominal prices, when understanding price drivers is far more important. A focus merely on nominal price also obscures what is happening to affordability - the comparison between price and purchasing power.

* * *

While credit expansion (inflation) is a powerful driver of increasing prices, credit contraction (deflation) is a far more powerful driver of decreasing prices. Credit, having no substance, is subject to abrupt fear-driven disappearance. Confidence and liquidity are synonymous, and confidence is once again evaporating quickly, as it did in phase one of the credit crunch (October 2007-March 2009). As contraction picks up momentum, the loss of credit will rapidly lead to liquidity crunch, drastically undermining price support for almost everything. With purchasing power in sharp retreat, however, lower prices will not lead to greater affordability. Purchasing power typically falls faster than price under such circumstances, so that almost everything becomes less affordable even as prices fall.

Credit expansion reversed in 2008, and this is deflation by definition. Despite the talked-up attempts to monetize debt through quantitative easing - a deliberate attempt to stoke inflation fears in order to counteract the psychology of deflation - money plus credit has been in net contraction. Talk of monetary growth based on only the money fraction misses the elephant in the room, since the vast majority of the effective money supply is credit, and the tightening of credit is by far the dominant factor.

* * *

We stand on the verge of a precipice. The effects of the first real liquidity crunch for decades will be profound. We are going to see prices fall across the board, but far fewer will be able to afford goods or assets at those lower prices than can currently afford them at today's lofty levels. The social effects of this will be enormous, and will spread to many more countries. The collapse of our credit pyramid will be the driving factor and it will sweep all before it like a hurricane for at least the next several years. Beware.

Next up is Steve Keen's developing "Credit Accelerators," which seek empirically to measure the phenomenon Stoneleigh mentions above, i.e., that credit expansion (contraction) drives price increases (decreases).

If we go back to the week before last, Stoneleigh's colleague, Illargi, had his own interesting post, in which he quoted from a piece by Larry Kudlow that argued that the recent explosive growth in the U.S.'s M2 monetary aggregate.  Kudlow's piece is entitled The Deflationary M2 Explosion:

This is a very disconcerting development. Normally, big M2 growth would signal a faster economy, and maybe even higher inflation. But as economist Michael Darda points out, the velocity, or turnover, of money seems to be plunging.

“The recent pickup in broad money in the U.S. looks like a dash for risk-free cash assets,” writes Darda. He also notes that widening corporate-credit risk spreads and shrinking government-bond rates signal a recession risk, not a coming boom.

So contrary to monetarist theory, the M2 explosion seems more closely related to a deflation/recession risk. Economist-blogger Scott Grannis writes, “The recent growth of M2 surpasses even the explosive safe-haven demand for money that accompanied 9/11 and the financial crisis of late 2008. Something big is going on, and it can only be the financial panic that is sweeping Europe as money flees a banking system that is loaded to the gills with PIIGS debt.”

Grannis concludes, “In short, it looks like there is a run on the European banks and the U.S. banking system is the safe-haven of choice.”

When Jesse looked at that same M2 growth, he mockingly asked "Dude, where's my deflation?"  The answer, of course, is "right in front of you, but you are too blind to see it."  Indeed, it's almost as if he had himself in mind when he said the following:

There is certainly no lack of people who remain obstinate in their errors and illusions. I have a little more respect for those who try to maintain their theories while at least accepting the obvious. But unless they can create a whole of it, their theory is found to be lacking.

Jesse's error/illusion is twofold.  First, like most everyone else, he is ignoring credit's role in the inflation/deflation equation.  Second, he mistakenly believes that M2 is driven entirely by Fed policy and fails to understand that it is the banking customer who determines the vast majority of how much wealth is held in banking deposits instead of in equities and bonds.  He cannot be blamed for this, however, as Milton Friedman was the first to employ this kind of sleight of hand with monetary aggregates, when he argued that a contractionary M1 during the Great Depression implied a contractionary Fed policy when, in fact, M0 showed an expansionary Fed policy.  It was simply overwhelmed by depositors' lack of trust in banks to hold their uninsured deposits (there was no FDIC, back in the day).

Charles Hugh Smith: An Ideologue Who Fails To Acknowledge His Own Ideology

I will always remain a big fan of CHS, but I can no longer take him seriously.  Today's post was yet another foray into righteous, self-delusional rationalist arrogance, which he labeled as "too practical" but which I label as shortsighted, foolish, and just as ideological and "cargo cult" as the right/left strawmen he sets up as his opponents.

All I can conclude is that CHS is a true believer in capitalism.  And it is this belief in captialism that blinds him to the fact that it is captialism itself that he decries. 

For example, what he describes as the "Savior State" is the exact same thing that Jamie Galbraith describes as the "Predator State."  Where both men recognize that the [insert perjorative adjective here] State is detrimental to the individual, at least Galbraith rejects the lie that all our workers need is better training and education.  Any fool can see that if the jobs aren't there, being better trained and educated can't earn you a job.  CHS isn't burdened by that kind of insight.

The worst part is that CHS seems to be angling his attack on the state as if he were an anarchist, but his recommendation (indentured servitude to the state) seems certain to entrench the power of the state over the individual.  Moreover, if his twisted concept of "workfare" was workable, it could not be allowed to "crowd out" the highly skilled labor of the private sector contractors to whom the state currently ourtsources.   In other words, there is no way the powers that be would allow the indentured servants to gain skills that empower them to compete against the private cartels.

But let's overlook that naivete and focus on the inanity of his recommendation.  His complaint about welfare, which is spot-on-- i.e., that it atomizes the individual and detaches him from society-- is not adressed by involuntary servitude, which should be anathema to the free-thinking, Austrian-leaning libertarian that CHS portrays himself to be.  The kind of workfare that CHS advocates would do little more than create an American caste of untouchables who would never be able to attain the kind of job that they might be capable of simply because they fell below the line one time. 

You might as well make welfare recipients sew a star of David on their work clothes, Chuck.  But, of course, to you the vast majority of Americans are worthless whining fools deserving of all that's coming to them.

The right to earn you own way through life is a human right.  The welfare state was constructed to perpetuate the canibalism of capitalism while denying that basic human right.  The recipients of welfare are not saved by the state but the prey of the state.  They're the coppertops of this particular instantiation of the matrix.

I'm glad the man is taking some time off.  I'd suggest he go away for a year or more and get in touch with his inner humanity.  It is apparent to me that he's just another rationalist Jedi who has become enamored by the Dark Side.

People matter, Chuck.  Stop pretending that everybody but you is a dick.

Oh, by the way, here is the link to his latest drivel.

To be fair, and to defend my continuing respect for the man as a rational thing, here is his post from yesterday.  He thinks much more clearly when he focuses on process instead of outcomes.

Charles Hugh Smith: Of Two Minds, Neither Thinking Very Clearly

Today's offering from CHS asks the question: If the Market Crashes, Who Owns Enough Stock to Even Care?  

He answers the question "basically nobody."  Why?

Since 81% of all stocks are owned by the top 10%, a stock market crash has little effect on the bottom 90% of Americans.

But this was just as true when the stock market crashed in 1929, and yet it led to the Great Depression, which affected the bottom 90% of Americans more than anybody else.

Wait.  There's more:

If the market crashes, high-end retailers and restaurants would likely see sales fall significantly. While there would be consequences, we should be careful not to overstate the stock market's role in the nation's Main Street economy.

Again, this was true in 1929. 

A final insight from Mr. Smith:

One last point: those who exited the stock market won't care if it crashes because they opted out of playing the risky game altogether.

On the one hand, CHS is literally correct in that there is no direct or immediate effect of a stock market crash on the vast majority of the populace.  On the much larger and far more practical hand, a stock market crash will cause the owners of wealth who were "invested" in the stock market to undertake actions that will be shockingly deleterious to everybody else.  When, as a society, we allow debt-leveraged financial speculation, there is no way to "opt out of playing the risky game altogether."  To believe otherwise is depressingly naive.

Paul Craig Roberts' Take on S&P's Downgrade of the US

He views it as all part of a war between the FIRE sector and the military/security complex.

Interesting stuff.

The Fallacy of Fractal Geometry

One thing that I've struggled with for well over a year now is that "fractals" are typically described in terms of geometry and/or probability, while my fractal theory of cognition does not fit easily within that paradigm.

Within the last 24 hours, I realized that even the concepts of the fractal geometry of nature and fractal finance do not truly describe geometry or probability.  Rather, they describe the result of applying a force to an object.  In the case of a coastline's fractal geometry, the force is erosion, and the object is rock, soil, etc.  In the case of a stock price's fractal charts, the force is human decision-making, and the object is the stock price.

Viewed through this prism, my fractal theory of cognition is entirely consistent with the broader theory of fractals, which suggests that we can better understand the fractal geometry of nature by focusing on the physical constants at play, many of which are defined in terms of stress (force) per unit area.  In this sense, fractals are not a "geometry" at all but a very complex derivative of stress (force) and strain (reaction to force).

How to Simulate QE3 When You're Not a Central Bank: Downgrade Long-Term U.S. Sovereign Debt

Jesse tells us that S&P has downgraded long-term U.S. sovereign debt while leaving the current rating for shorter term treasuries (2 years or less) intact.  Full report here.

Jesse thinks that this is all a set up for QE3, but I think he's wrong.  There's no need for QE3 with this downgrade, and QE3 wouldn't work anyway.

I predict that the long term effect of the downgrade will be that people will pile into 2 year treasuries, driving yields down, just as they did during QE2.  At the same time, the yields of 10-year and 30-year bonds will rise, just as they did during QE2.  This time, however, those yields will rise a bit (if not much) higher because they are no longer tied solely to the prospects of inflation (which are truly non-existent) but to the risk of default (which is also non-existent).  This downgrade is all about creating yield premiums that are not warranted in view of the state of the real economy, making long-term treasuries an attractive investment.

I wouldn't be surprised to see equities continue to sell-off because all the yield you need will be found in long-term treasuries that are priced at a premium when compared to inflation expectations (or should I say deflation expectations).

Screwflation is in full effect.