Fleckenstein (and others) State the Deflation Case

SPOT GOLD DOWN $7.00+ THIS MORNING?

DEFLATION?

"....Given all our problems related to debt, I thought it might be worthwhile, particularly for new readers, to provide a brief history leading up to where we are now.

Taking a big step back, the Bank of Japan acted foolishly throughout the 1980s, which caused that country to experience enormous real-estate and stock bubbles. Japan's stock bubble was really a residue of its real-estate bubble -- actually a credit bubble, as the banks lent money to any corporation with a pulse. (Does that sound familiar?)

Then the institutions that lent the money took forever to write off the bad loans. That's why Japan's real-estate market, stock market and economy did so poorly for more than a decade.

Free money exacts a price

After [the dotcom] bubble, Greenspan took a page out of the Bank of Japan's book and lowered rates to 1%. That helped precipitate the housing bubble here that ended in 2005.

As to why the unwinding has taken so long to commence, only recently has the cause become clear: the mark-to-model fantasy employed by those who have bought the sliced-and-diced mortgage paper.

But the fantasy is unraveling as these structured-credit products are now slowly being marked to market. Just as virtually every subprime-mortgage lender has blown up, Alt-A lenders (the next rung up the ladder creditwise) will blow up -- and, ultimately, many hedge funds will blow up, though we're in the early days of that process.

In the years since our equity bubble peaked, trillions of dollars' worth of debt have piled up throughout corporate America. So now, as we enter recession, we will experience not just a weak economy, real-estate market and stock market, but the exacerbating effect of a mountain of bad debt, completing the analogy to Japan of the 1990s.

Like it or not (and I suspect he might not because he did not use the D-Word itself) Fleckenstein described how and why a Japanese style deflation is headed for the US.

This explains in part why it feels so treacherous right now. If the markets have decided that too much credit is too easily available, as it appears they already have, then the Fed can simply lower rates to make credit more available. Problem solved. But what if there are two separate but related forces at work: tightening lending standards and reduced credit appetites? Then the Fed has something more serious on their hands.

The key in all of this is not inflation, as most believe. The Fed says they are most worried about inflation risks, but the reality is that they are most worried about deflation risks. Always. Always deflation. The Fed has no choice but to always remind us that the risks are tilted toward inflation, just as the Treasury Secretary, whichever one happens to be in office at the time, must always say that the U.S. maintains a strong dollar policy, even if monetary policy and fiscal policy are conspiring to devalue the dollar.

As for equities, when the dollar begins to rise, and it appears the Fed finally will begin to cut rates, as they inevitably must to try and sustain credit consumption, then it's time to worry. That means deflation is winning.

Addendum

My friend who posts on Kitco under the alias "Trotsky" just pinged me with this comment: "absolutely correct - this at the root of the misunderstandings out there. because credit is used as a money substitute in the financial markets, it acts as an inflationary force in the asset markets (and this spills over into the real world as the imaginary wealth thus created leads to overconsumption and malinvestments), but it is all ephemeral - in the end, it is still credit, not money. as soon as money is needed in lieu of credit, such as has now happened in the CMO and CDO markets, it becomes clear that the money simply isn't there."

Aug 8, 2007
Mike Shedlock / Mish
email: Mish
http://globaleconomicanalysis.blogspot.com/