• 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 dot.com 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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