The Deflation Time Bomb

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Is there
anyone who still does not understand that talk of ‘inflation’
by officialdom is just a red herring intended to distract us from
the far more dangerous dragon of deflation?

Mike Shedlock, Mish’s Global Economic Trend Analysis

We are to about
see how much George Bush really believes the “supply side”
mumbo-jumbo he’s been spouting for the last seven years. Last
week’s Labor Department report confirmed that unemployment is
on the rise (5%) and that corrective action will be required to avoid
a long and painful recession. There’s a good chance that the
Chameleon in Chief will jettison his “trickle down” doctrine
for more conventional Keynesian remedies like slashing interest rates,
government programs, and tax relief to middle and low-income people.
On Monday Bush announced that his team of economic advisors was patching
together an “Economic Stimulus Package” that will be unveiled
later this month in the State of the Union Speech. The goal is to
rev up sagging consumer spending and slow down business contraction.
Ironically, the UK Telegraph dubbed the stimulus plan Bush’s
“New Deal.” It’s a shocking about-face for a president
that has been clobbering the middle class since he took office and
who balks at even providing temporary shelter for disaster victims.
Now Bush is going to have to give away the farm just to keep the economy
from crashing. Good luck. Clearly, the prospect of a system-wide meltdown
in banking, real estate and equities has become a “Road to Damascus”
moment for lame-duck George.

The up-tick
in unemployment is just the final part of an otherwise bleak economic
picture. Manufacturing is hurting too. Last Wednesday, the December
ISM Manufacturing Index plunged to 47.7, its lowest level in five
years. The news put the stock market into a 200-plus nosedive
and sent gold soaring over $800 per ounce. Since then, the news
has gotten progressively worse. The market fell another 200-plus
points on the Labor Dept’s report on Friday, followed by
238 point jolt on Tuesday on rumors of (potential) bankruptcy
at mortgage lending giant, Countrywide Financial, and a 2.6% plunge
in pending housing sales from the National Association of Realtors.
By the time ATT announced its fears of “reduced consumer
spending” the market was already barrel rolling towards earth
in a sheet of flames.

The Dow
Jones is now 10% off its yearly high, the official sign of a correction.
More important, equities blew through their support levels indicating
a basic change in the market’s trajectory. It’s a primary
bear market now and any rebound will be temporary. There’s
still a lot of fat to be trimmed before overvalued stocks return
to the mean. No wonder Bush is nervous.

The constant
rate cuts and geopolitical jitters have sent gold skyrocketing.
Since August 2007, gold has gone from $650 per ounce to $887,
a whopping $237 in just 5 months. If that is not an indictment
of the Federal Reserve and their “loosey-goosey” monetary
policy; then what is? According to the Wall Street Journal
“gold and oil have run almost in perfect tandem. The price
of gold has risen 239% since 2001, while the price of oil has
risen 267%. That means if the dollar had remained as ‘good
as gold’ since 2001, oil today would be selling at about
$30 a barrel, not $99.” (WSJ, 1/4/08)

right; the price of gas today is attributable to war, tax cuts
and the relentless expansion of credit by the Federal Reserve

energy prices are increasing the cost of food production, which
creates a self-reinforcing inflationary cycle. Additional rate
cuts will only weaken the dollar further and put an even greater
burden on maxed-out consumers.

Before he
left on his “Victory Tour” of the Middle East, Bush

Congress comes back, I look forward to working with them, to deal
with the economic realities of the moment and to assure the American
people that we will do everything we can to make sure we remain
a prosperous country.”

The economic
realities that Bush will be facing are the anticipated “hard
landing” from a nationwide housing slump coupled with a credit
crunch that is strangling the banking and financial industries.
The country is lurching recklessly into a deflationary death-spiral
while Bush makes a pointless junket to the scene of his biggest
foreign policy flop. What a joke. When he returns, Bush will find
that he is constrained in his “stimulus” plan due to
massive fiscal deficits, which are the result of the enormous
tax cuts and gluttonous military budget.

isn’t like 2000 when the US was running a large fiscal surplus
of $300 billion or 2.5% GDP,” said economist Nouriel Roubini.
“Now that all the fiscal stimulus bullets have been spent
on the most reckless and unsustainable tax cuts in history –
the administration is left with very little room (to maneuver)
in bad times . . . We are now stuck in a situation where the room
for any meaningful fiscal stimulus . . . is gone. . . . We did
indeed waste all our macro policy bullets in 2001-2004 in “the
best recovery that money can buy” and now we are left with
relatively limited room for monetary and fiscal policy stimulus.
This is one of the main reasons why the recession of 2008 will
be more severe and protracted than the mild 2001 recession.”
(Nouriel Roubini, Global EconoMonitor)

Still, there
will be a stimulus package – however meager – and there’ll
also be more rate cuts by the Fed. That means that gold and oil
will continue to soar and the dollar will continue to get hammered.
Bernanke’s options are limited, as are Bush’s. The system
is grinding to a halt and the Fed chief will have to use the tools
at his disposal to try to stimulate economic activity. It won’t
be easy. Presently, he faces a number of challenges. Home prices
are falling, retail spending is off, commercial real estate is
in a sharp downturn, and many of the major investment banks are
capital impaired from their poor investments in mortgage-backed
bonds. If the Fed’s “low interest” smelling salts
don’t revive the comatose American consumer – and get
the cash registers at Target and Billy McHales ringing again –
the world will face a global slowdown. That’s why the Fed
Funds rate will probably get hacked by 50 basis points by month’s
end and Comrade Bush’s economic team will concoct a fiscal
bailout plan worthy of Fidel Castro.

We There Yet?

A growing
number of market analysts believe we’re already in recession.
David Rosenberg of Merrill Lynch put it like this: “According
to our analysis, this [recession] isn’t even a forecast any
more but is a present day reality.”

argues that a weakening employment picture and declining retail
sales signal the economy has tipped into its first month of recession.
Mr. Rosenberg points to a whole batch of negative data to support
his analysis, including the four key barometers used by the National
Bureau of Economic Research (NEBR) – employment, real personal
income, industrial production, and real sales activity in retail
and manufacturing.” (UK Telegraph)

one chooses to call it a recession or not is irrelevant. When
the two behemoth asset-classes – real estate and securities
– begin to cave in, there’s bound to be some ugly fallout.
Housing stayed strong during the bust. Not this time.
No way. The whole system is keeling over and it could take the
bond market along with it. As the two gigantic equity bubbles
lose gas, consumer spending will stall, business activity will
slow, more workers will get laid off, and prices will tumble.
Equities and commodities will be hit hard (even gold) and housing
prices will dive to new lows as the pool of potential buyers grows
smaller and smaller.

These problems
will be further aggravated by the lack of personal savings and
the huge debt-load which will push increasing numbers of homeowners,
credit card customers, even student loan recipients into default.
By 2009, bankruptcy will be the fastest growing fad in American
pop culture.


Many experts
are now predicting that home prices will dip 30% by the end of
2008. That means that nearly 20 million homeowners will be “upside-down”,
that is, they will owe more on their mortgage than the current
value of the house. (Imagine owing $400,000 on a home that is
currently worth $325,000!) 40% of all homeowners in the US will
be upside-down by the end of next year. This is a grave systemic
problem that will have widespread implications. Experts already
know that when mortgage holders have “negative equity”
they are much more inclined to put their keys in the mailbox and
skip town. Hence, the name for this increasingly common practice
– “jingle mail.” Secretary of the Treasury Henry
Paulson is desperately trying to put together a national “rate
freeze” to avoid, what could be, the most devastating surge
of foreclosures the world has ever seen. Paulson’s rate freeze
does not offer “New Hope” as promised but, rather, a
lifetime of servitude paying off an asset of ever-decreasing value.
Underwater homeowners are better off taking the hit to their credit
and letting the bank repo the house. Let the bank worry about
it. They created this mess.

The housing
bubble is deflating faster than anyone had anticipated. Overall
sales have slipped more than 40% from their peak in 2005 whereas,
prices have gone down a mere 6.5%. Prices, which are a lagging
indicator, have a lot further to drop before they touch bottom.
Robert Schiller, Professor of Economics at Yale University and
author of Irrational Exuberance, “predicted that
there was a very real possibility that the US would be plunged
into a Japan-style slump, with house prices declining for years.

Shiller, co-founder of the respected S&P Case/Shiller house-price
index, said: “American real estate values have already lost
around $1 trillion [£503 billion]. That could easily increase
threefold over the next few years. This is a much bigger issue
than sub-prime. We are talking trillions of dollars’ worth
of losses.” (Times Online, UK)

on the right track, but his estimates are way too conservative.
After all, in 2002, the median price of a single-family home in
Los Angeles was $270,000. But, by 2006, the cost of that same
house had doubled, to $540,000 – “pushed by unbridled
speculation fueled by unparalleled access to mortgage capital.”
(LA Times) The problem was cheap credit that was readily
available to anyone who could fog a mirror. All that has changed.
The banks have tightened up their lending standards, and jumbo
loans (loans over $417,000) are nearly impossible to get. So,
why doesn’t Schiller believe that prices will return to 2002
levels? They will. And they’ll go even lower; much lower.
In fact, real estate is quickly becoming the leper at the birthday
party; everyone is staying away. That means that prices will fall
– and more rapidly than anyone imagined. The word is out
on housing and it’s not good. The blood is in the water.
Get out before the pool of mortgage applicants dries up entirely.


The US banking
industry has never faced greater challenges than it does today.
Many of America’s largest and most prestigious investment
banks are seriously under-capitalized and buried beneath hundreds
of billions of dollars in complex, structured investments that
are being downgraded on a weekly basis. On top of that, many of
the banks main sources of revenue have vanished as investor interest
in sophisticated mortgage-backed bonds and derivatives has disappeared
altogether. For example, the sales of collateralized debt obligations
(CDOs) “plunged 85% to $15.69 billion in the fourth quarter.”
Also, “The value of Alt-A mortgages . . . issued in the third
quarter fell 64% to $39.3 billion from the second quarter’s
record high of $109.5 billion . . . S&P said the dramatic
drop is the result of ‘unprecedented credit and liquidity
disruptions’ for both borrowers and lenders” (Dow Jones)
These are steep declines and represent a serious loss of revenue
from the banks’ bottom line.

Many of
the banks are simply in “survival mode” trying to conceal
the magnitude of their losses from their shareholders while attempting
to attract capital from overseas investors to shore up their sagging
collateral. (via Sovereign Wealth Funds)

The banks
are now struggling to fulfill their function as the main conduit
for providing credit to consumers and businesses. They have curtailed
their lending as their capital base has steadily eroded through
persistent downgrading. The Federal Reserve has tried to resolve
this issue by opening a Temporary Auction Facility (TAF), which
allows the banks to secretly borrow billions from the Fed without
the embarrassment of disclosing the transaction to the public.
The banks are also free to use Mortgage-backed securities (MBS)
and commercial paper (CP) as collateral for securing the Fed repos.
It’s a sweetheart deal and more than 100 financial institutions
have already taken advantage of the Fed’s largesse.

This is
a bad sign. It indicates that the banks are seriously overextended,
“capital impaired” and need a handout from the Central
Bank to keep from defaulting. It means that the vaults are stuffed
with worthless mortgage-backed slop that they are deliberately
hiding from their shareholders and depositors. If there were adequate
regulation then the banks would never have been allowed to dabble
in such risky debt instruments as subprime loans and toxic CDOs.
The whole catastrophe could have been avoided. Instead, hundreds
of billions of dollars will be wiped out, a number of banks will
fail, and public confidence in their institutions will be shattered.

This week,
the Federal Reserve announced that it “will increase the
size of two scheduled auctions of emergency loans by 50 percent
to $30 billion as part of a global attempt by central bankers
to restore faith in the money markets.” (AP) In other words,
the Fed will provide an even bigger begging bowl to prop up the
banks to maintain the appearance of solvency. It is an utter sham.

vs. Deflation

The size
and scale of the approaching recession is impossible to forecast.
The real estate and stock markets will undoubtedly see trillions
of dollars in losses, but what about the estimated $300 trillion
dollars of derivatives, credit default swaps and other abstruse
counterparty options? Will the global economy freeze up when that
ocean of cyber-capital suddenly evaporates? Will that virtual
wealth simply vanish into the ether when the underlying assets
(CDOs, MBSs, ABCP) are downgraded to pennies on the dollar, or
when the number of home foreclosures catapults into the millions,
or when the dollar slips to a fraction of its current value? No
one really knows.

But Atlanta
Fed President Dennis Lockhart summarized what we can expect in
a speech he gave last week titled “The Economy in 2008.”
He said:

sober assessment of risks must take account of the possibility
of protracted financial market instability together with weakening
housing prices, volatile and high energy prices, continued dollar
depreciation, and elevated inflation.”


What the
upcoming recession “will look like” has been the topic
of a fierce debate on the Internet. Everyone seems to agree that
this is not a typical economic downturn resulting from overproduction,
under-consumption or malinvestment. Rather, it is the crashing
of humongous equity bubbles that were generated by the Fed’s
abusive expansion of credit and the unprecedented proliferation
of opaque structured-debt instruments. Many believe that the unwinding
of these bubbles will trigger a round of hyperinflation which
is already evident in soaring food, energy and health care costs.
These prices are bound to increase substantially as the Fed continues
to cut rates and further undermine the dollar.

But the
real issue (it seems to me) is the unfathomable loss of market
capitalization, the growing insolvency of maxed-out consumers,
and the inability of the banks to freely extend credit to responsible
loan applicants. These three things are likely to drag down all
asset-classes, slow business activity to a crawl, and compel consumers
to hoard rather than spend. The dollar will strengthen in a deflationary
environment (if that is any consolation?).

Paul L.
Kasriel, Sr. V.P. and Director of Economic Research at The Northern
Trust Company answers some typical questions about deflation in
a recent interview with economic guru Mike Shedlock (Mish):

Mish: Would you say that consumer debt in the US as opposed to
the lack of consumer debt in Japan increases the deflationary
pressures on the US economy?

Yes, absolutely. The latest figures that I have show that banks’
exposure to the mortgage market is at 62% of their total earnings
assets, an all time high. If a prolonged housing bust ensues,
banks could be in big trouble.

What if Bernanke cuts interest rates to 1 percent?

In a sustained housing bust that causes banks to take a big
hit to their capital it simply will not matter. This is essentially
what happened recently in Japan and also in the US during the
great depression.

Can you elaborate?

Most people are not aware of actions the Fed took during the
great depression. Bernanke claims that the Fed did not act strong
enough during the Great Depression. This is simply not true.
The Fed slashed interest rates and injected huge sums of base
money but it did no good. More recently, Japan did the same
thing. It also did no good. If default rates get high enough,
banks will simply be unwilling to lend which will severely limit
money and credit creation.

How does inflation start and end?

Inflation starts with expansion of money and credit. Inflation
ends when the central bank is no longer able or willing to extend
credit and/or when consumers and businesses are no longer willing
to borrow because further expansion and /or speculation no longer
makes any economic sense.

So when does it all end?

That is extremely difficult to project. If the current housing
recession were to turn into a housing depression, leading to
massive mortgage defaults, it could end. Alternatively, if there
were a run on the dollar in the foreign exchange market, price
inflation could spike up and the Fed would have no choice but
to raise interest rates aggressively. Given the record leverage
in the U.S. economy, the rise in interest rates would prompt
large scale bankruptcies. These are the two “checkmate”
scenarios that come to mind. (read
the whole interview here

Summary: When
banks don’t lend and consumers don’t borrow; the economy
crashes. End of story. The whole system is predicated on the prudent
use of credit. That system is now in terminal distress. Everyone
to the bunkers.

the whole “inflation-deflation” debate is academic.
The real issue is the length and severity of the impending recession.
That’s what we really want to know. And how many people will
needlessly suffer.

19, 2008

Mike Whitney’s
[send him mail] lives
in Washington state.

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