Testing the Deflationistby Gary North There are a handful of newsletter writers – but not one economist – who predict deflation. Why no economists? There is an old line, "where there are four economists, there will be five opinions." You would think that there would be at least one Ph.D-holding economist out there somewhere who is predicting price deflation. Maybe there is, but I have not found him yet. Note: nobody is predicting monetary deflation. The deflationists are predicting monetary inflation and price deflation. So, when you read someone who says that price deflation is just around the corner, you can be 99% sure that he is not an economist. That doesn't mean that he's necessarily wrong. It does mean that he can't find any back-up among the hordes of specialists who are paid to forecast such matters. He therefore has a problem in directing you to evidence. He is offering mostly opinion – the opinion of those who have either been wrong for their entire careers and whose arguments never change (e.g., Martin Weiss), or someone who has only recently become convinced regarding the arguments that have been wrong for a generation (e.g., escalating debt, "pushing on a string," etc.). What you should look for is an argument based on something quite recent, some new "something" that will change everything. THE LITMUS TEST Here is my suggestion. If someone is telling you that deflation is coming, ascertain this: Has he sold his home? Is he now renting? This is a reasonable question to ask. It's the old line, "Put your money where your mouth is." Now, he may be in a special situation. He may live in a region where home prices, unlike prices nationally, will go up during a deflation. I'd be interested to know where this place is, other than Northwest Arkansas, which has Wal-Mart, and is experiencing constant in-migration. The person should be promoting the purchase of real estate in his region, because the economy is so powerful, so growth-oriented, that even a recession/deflation cannot call a halt to it. He should be telling you what the characteristic features are of a region like his, which can go against this looming secular fall in prices. I say this because, quite frankly, I don't think anyone in the deflationist camp is so confident about his position that he has told his wife, "Honey, we're going to sell the house and become renters. A great deflation is coming." Why not? Because she doesn't believe this scenario, any more than I do. She is not about to have her nesting instinct challenged by some theory of consumer prices that says that the Federal Reserve System can create all the new money it wants, but prices will still fall, and that the U.S. government can go to war in the Middle East, and oil prices can go through the roof, but prices in general will fall. Her response will be some variant of this: "Where should I forward your mail?" If a man is so confident and persuasive about the looming price deflation that he has persuaded his wife to sell their home, and they are either living in rented space or at least have their home up for sale, then you should pay closer attention to his theory. He really believes it. It's not just some idea that he's kicking around. A deflationist scenario that doesn't include housing prices is a scenario that is not worth considering. Housing is where the leverage is. It's where more Americans have more debt and lower interest rates than anywhere else in the economy. It's where more Americans have more of their net worth than anywhere else. It's where the slowdown never took place in 2001. It is where consumers are willing to spend their money, no matter what. For that matter, I cannot imagine any scenario for widespread price decreases that does not place a fall in housing prices at the center of the analysis. If the housing market is still showing signs of life, then why should anyone believe that the credit money being issued by the FED is not manifesting itself in the one sector of the economy that combines long-term debt, high leverage, low interest rates, and a combination of capital goods with consumer goods. With a home, you can have your cake and live in it, too. You can justify buying (or staying in) a home that you can't really afford because you can call it an investment rather than what it really is, your wife's main payoff for living with you, especially if she is in the labor market earning a salary. If the deflationist says, "Real estate is different," he is saying that the largest single component of the American economy is different from the economy in general. What insulates real estate from the rest of the economy? What makes real estate different? It was different in 2001 because mortgage rates were falling. It was different because wives always want to move up. But why would real estate be different in a true deflation? Real estate prices are not like the price of a stock or bond. Each piece of property is different. Also, people live in their homes. Housing prices rarely fall across the board. This is because the fall in the price of one home is not imputed to all homes. So, price deflation in homes is difficult to measure. Instead of price reductions we see lower liquidity: a slow market. But people have to live somewhere. One event that would put downward pressure on housing prices would be rising long-term interest rates (mortgages). But these appear during times of general price inflation: an increase in the inflation premium of long-term loans. If real estate is different, then the deflationist should be writing about how to invest in real estate and where. He should be recommending REITs. He should be recommending firms in the home construction industry. He should be going through Morningstar and Value Line, looking for real estate-related investment opportunities. If he isn't, why isn't he? Send him an e-mail. Ask. WHERE ARE THE STATISTICS? Anyone who argues that deflation is coming soon is arguing that prices in general will be falling. He is arguing that, in general, the upward move of prices will be reversed for the first time since 1940. This is an astounding argument. He is saying that the economic fundamentals of six decades are about to change, but not the following fundamentals: tax policy (Keynesianism), Federal Reserve policy (Greenspanism), or wives' policy ("Where should I forward your mail?") What fundamentals? It always comes back to this one: debt. There is going to be a great default. I ask: By whom? By an American bank? The Federal Reserve will simply buy the underlying bank assets with newly created money. The primary function of the Federal Reserve System since 1913 has been this: to insure money-center banks against default. Every other officially stated goal is political window dressing: full employment, stable prices, or even the buyer of last resort for U.S. government debt. The FED is an insurance agency for the money-center banks. When it comes to fiat money to secure the solvency of a money-center bank, this law rules: "There's more where that came from." Then there is consumer debt. Somehow, this supposedly is about to reach critical mass. I ask: Where is the evidence? Click through to the Federal Reserve's statistics for the household debt service burden. See if there is anything that indicates a major change, i.e., some unprecedented figure that says, "turning point ahead." I wrote the following in the January 10, 2002 issue of my twice-weekly e-mail newsletter (which you can subscribe to for free at the end of this essay):
It's time to click through again to see what, if anything, has changed. If nothing much has changed, then the person who is predicting deflation, like Lucy Ricardo, has a lot of 'splainin' to do. I refer readers to the weighted median consumer price index, published by the Federal Reserve Bank of Cleveland. It also reveals minimal change. Prices are rising at about 3% per annum, just as they have done for years. At this point, the deflationist and the inflationist begin a version of "My father can beat up your father." It's "My statisticians' assumptions are better than your statisticians' assumptions." So, let me re-focus the argument. No matter whose methodological assumptions are better, each group retains them over time. The statisticians have a theory of how to "weigh" certain numbers as to their importance in the retail economy. What is most significant for predicting deflation is the presence of a new secular trend in the numbers. This trend should be so significant that every set of assumptions regarding significant prices will reveal a downward move of prices. The assumptions have not changed. The statistics-gathering methodology for the survey has not changed. So, if there is a significant change in the direction of prices, it should be visible in all of the price indexes. It is the change of direction, not the assumptions regarding their correct "weights," that is significant. Click through. See if you can detect any significant change. See if you can see a slowing in the rate of price increases. If you don't, then you should ask yourself: "Where is there evidence of a looming reversal from price inflation to price deflation?" See if a secular downward move of prices is indicated. http://www.clev.frb.org/research/mcpi.txt Remember, the deflationist is predicting a great reversal of over six decades of price trends. This will be no minor event. This will be an event of such magnitude that it overturns all prevailing economic theories: monetarism, Keynesianism, supply-side, Greenspanism, and surely Austrianism. It will mean that a secular and accelerating increase in the money supply produces falling prices in the absence of rising productivity. Obviously, if economic productivity increases faster than the money supply, we can have falling prices. For example, the price of computer power has been falling by at least 40% per annum for years. But the increasing productivity of nothing else matches the increase in productivity of productivity of computer chips. The price of software has not fallen nearly so fast, nor has the price in frustration of getting the software up and running. I take advantage of economic data on websites. I include a lot of click-through links. I refer you to charts, tables, and other statistical indicators. You can verify what I am saying. You can of course argue with my conclusions. You may be able to suggest better click-throughs. But remember this rule: "You can't beat something with nothing." DEFLATION PLUS... ? If the rate of price decreases is not sufficient to justify selling your home, then who cares? First, the secular trend of consumer prices is upward – I believe about 3% per year. It has been this high for many years. Second, the rate of increased output for the economy is in the same range: about 3%. Sometimes it's higher, sometimes lower. If we were to experience a decline in prices, but without a comparable decrease in productivity, I would be one happy fellow. If prices were to fall by 1% a year (e.g., Japan since 1999), but production would rise at 2% per annum, that would mean a net increase of output of 3%. That would be approximately what the increase in output has been in the West for the past 250 years. Long-term, it has made us all fabulously wealthy compared to almost anyone in 1750. Yes, richer even than kings when it's tooth-pulling time, let alone appendectomy time. From 1930 to 1932, American prices fell by 25%. In 1932, 25% of the labor force was out of work. That is deflation with depression. That would be significant. That would be worth selling your home for now, getting into cash, and waiting. But "getting into cash" is the problem, isn't it? We can't get into currency this fast. There isn't enough of it in circulation. Then what? FDIC-insured bank accounts? The FDIC has only about a dollar invested in government bonds for every $100 in insured deposits. What good is the FDIC unless the FED is ready to pump money into the economy to stem a tide of bankruptcies. But if the FED is able to inflate, why should there be price deflation? Even if there were price deflation, why would it lead to falling output? Price deflation is great if production doesn't fall even faster. I like falling computer prices. I would like other falling prices if I could locate any. Price deflation without falling productivity would be what I have always dreamed of. So, why should any consumer worry about price deflation? Only if deflation means rising bankruptcies and falling production. That is, only if deflation means a contracting division of labor. The person who predicts deflation has another assumption: the coming deflation will create a contracting division of labor, which will produce bankruptcies, rising unemployment, and social pain. If he doesn't have these negatives in mind, then he should be telling you that you should be buying corporate bonds, preferably "junk" bonds that pay higher rates of interest than conventional bonds. If he is telling you to buy U.S. bonds or German bonds, then he is predicting falling prices, rising risk for non-government entities, and economic contraction. So, before you change your investment plans to adjust to the coming deflation, be sure you are clear in your mind which kind of deflation. Is it mild deflation (1% per annum) alongside rising productivity? If it is, sit tight. Do nothing except sell your gold and silver. (If you're a farmer, sell your farm.) Nothing bad will happen. But if the deflation forecast is for deflation plus economic contraction, you must decide what to do about your home. It's time to sell it. Be sure that the person who is warning you about deflation plus contraction has sold his urban home. If he lives in the country and owns it free and clear, he may have decided that the threat of riots is greater than the threat of falling rural housing prices. But anyone who lives in a city and who predicts both deflation and economic contraction should be a renter if he is single and a home owner only because his wife holds the upper hand and thinks the way I do: there isn't going to be a deflation. THE CRACK-UP BOOM There is a long-term deflation scenario that I accept: the scenario presented by Ludwig von Mises in 1912. He predicted the possibility of long-term monetary inflation, followed by price inflation, followed by a contraction in the division of labor, followed by a raging mania to get out of money and into commodities. This scenario, he called the crack-up boom. It is always followed by the adoption of a new currency unit and massive readjustments in the economy. This is the depression stage. The worse the crack-up boom is, the less painful the following deflationary period. The best example is 1924 in Germany, the year following the cessation of mass inflation. The economy recovered rapidly. It had been almost destroyed, 1921-23. "Been down so long, it looks like up to me." To get through a mass inflation, you must not be a creditor: bonds, mortgages, pension fund. To get through a transition to a new currency and deflation, you must not owe any money. The only strategy that gets you through both scenarios is life in a debt-free rural setting and a low division of labor. Barter will get you through mass inflation. It can also get you through complete deflation. But barter is inefficient. It is an acceptable production strategy only during a collapse of the division of labor. It is ruinous for middle-class people and wealthy people, which is what e-mail readers are. So, to predict deflation after an inflationary crack-up boom is legitimate, but it requires two separate investment approaches. What works during mass inflation kills you in the deflationary period. Here is my favorite story that illustrates this. Before he died, I knew Dr. Norbert Einstein. He was Albert's cousin. He was a banker. He told me that only late in the German inflation did his Aunt Rosa catch on to what was happening to the value of money. She then wanted to get into goods and out of money. But the truly marketable goods were gone. They were being hoarded. All she found was a large inventory of bedpans. She bought them in late 1923. Then came the currency reform of December, 1923. It produced the recession of 1924. There was Aunt Rosa, figuratively sitting on top of a pile of bedpans. GET THIS ONE RIGHT I remember in 1975 hearing C. V. Myers tell attendees at a gold conference, "If you get this one wrong, you'll lose everything." He was predicting deflation. He got it wrong. He didn't lose everything. Still, it would have been more profitable to have gotten it right. I suggest that you bet on a continuation of trends that have prevailed for over 60 years:
I predict the following trends:
If there is a trend-reversing unforeseen event, it will be deflationary in its effects, unless the FED is capable of responding. That is, the event will threaten a systemic failure of the bank system. This would clearly be both deflationary and depressionary. But it will be unforeseen. It will not be a continuation of "business as usual." Japan has been grinding down since 1990, but no event has triggered a collapse. Because I think an unforeseen event of this type is possible, I still recommend having currency in reserve (small bills) and coins. I also recommend the usual: food reserves, water reserves, and so forth. I recommend a rural or semi-rural location. That is, you had better have some reserves for a shock to the division of labor. But, barring what Greenspan calls cascading cross-defaults, we are gong to suffer price inflation. Those who predict deflation are not predicting cascading cross-defaults. They are predicting business pretty much as usual. My recommendation: if you're going to plan for business as usual, plan for price inflation. August 31, 2002 Gary
North is the author of Mises
on Money. Visit http://www.freebooks.com.
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