Good Deflation and the Greenspan Indian Summer

The recent stock drop worldwide is a warning shot across the bow of the Fed, to come to grips with the growing imbalances in the world economy.  The borrowing of 8% of US GDP from the rest of the world is not a sign of strength of the US economy but a transfer of wealth to the rising economies in Asia.  What we are seeing is the coming to an end for the Greenspan Indian Summer, this period of unexpected growth and prosperity that the Fed created by flooding the economy with liquidity after the stock market crash from 2000-2002.  Greenspan is fairly clear (for a central banker) that he was attempting to stave off the deflationary depression that normally follows the bursting of an asset bubble - the so-called Kondratieff Winter, which is a bit obscure in mainstream economics but was mentioned by name by Greenspan.  The latest Fed chairman is a self-acclaimed expert in deflationary depressions, and got the nickname Helicopter Ben for a speech he gave in which he said the Fed could always prevent a Kondratieff Winter by helicoptering in money and dropping it on the economy.  But did their inordinate fear of deflation, and misreading of the current situation, cause them to over do it?  Let's take a deeper look.

Why this inordinate fear of deflation?  Inflation can be cured as Volcker did in 1980 by dramatically increasing interest rates.  The cure is harsh but the patient lives.  Deflation is trickier since the Fed cannot lower rates below 0%.  The Japanese went into a deflationary depression after their bubble burst in 1989, and for 15 years they limbered along with rates down to, yes, 0%.  That didn't work.  Nor did massive government spending, the cure that Keynes proposed during our Great Depression.  That didn't work for us, either - it took the war in 1942 to get the US economy back on track, and it took a slow workout of Japanese banking imbalances to get their economy back on track. 

Is this fear justified?  Perhaps not - when the US did not have a central bank, it worked its way out of the deflationary depression of 1837-42, and 1893-96 (when the dreaded D word was coined).  The Austrian School of economics looked at these and other examples and concluded that the economy would work its way out of the excess that led to the market crash, after a re-adjustment period - if the government would not intervene.  The Great Depression may have been shorter and less severe if the government had let it run its course, but we will never know, as that experiment is too politically treacherous to run.  And so, Japan kept its banks afloat and prolonged its deflation, and Greenspan flooded the US with liquidity and created the current worldwide imbalances.  It is a rare central banker with the courage of a Volcker to take the cure.

This time it is different, or so it is always said.  In our time the great event is globalization, brought on by the Internet and by the tearing down of the Berlin Wall, literally and metaphorically.  The scale of new members entering the open world - India and China in particular - is driving the global imbalance.  China has tied its currency to the Dollar, so weakness in the Dollar does not rebalance trade but causes imbalances elsewhere - in particular, in a much higher Euro:Dollar ratio than would be expected.  More importantly to the Greenspan Indian Summer, it allows a form of deflation to exist which may have misled the Fed.

Deflation comes in two varieties: the 'bad' deflation of a currency deflating, increasing in value relative to gold and other measures of a stable currency; and the 'good' deflation of lower prices due to productivity or innovation.  The Kondratieff Winter inevitably comes with bad deflation.  Bad deflation is caused by a shrinking of the money supply and the velocity (re-use) of money.  Money is created by credit - a bank loan creates new money for example, well beyond what is printed.  Banks that loan off fractional reserves can lend many multiples of the currency in their accounts, thus creating 10 or 100x the money that came from currency.  With derivatives, and accounts created by borrowing from some other agency, this can be vastly multiplied.  It is this multiplication of credit that creates the asset bubble of the Kondratieff Fall - what we went through in the '90s, and in the '20s, and twice in the prior century; and what Japan experienced in 1980s, and possibly what China is now experiencing.  When the musical chairs stop, money evaporates, as loans are called and assets liquidated to pay them off.  As the stack of credit falls, money from credit disappears. This is more dramatic than just selling stock at a loss, since there is a buyer on the other side - money just changes hands.  But when stock is bought on margin (debt), when the debt is called, the stock is sold and the debt retired - the 'money' from the margin debt simply disappears.  There is no other side, just a chagrined former stockholder and an an aggrieved margin lender.  This phenomenon of credit money disappearing is what made the crash in 1929 so devastating, as purchasing power disappeared from the market.  When the Kondratieff Winter comes, money has disappeared, velocity has slowed (as banks fear to lend), and bad deflation sets in.

China pegging to the Dollar is creating massive good deflation. Everything seems cheaper if we wait - computers, electronics, cameras, toys.  In that situation, the US could pump more money out and not see much in the way of inflation of goods and services - the good deflation tempers the inflationary pressure.  Seems like an ideal situation, except ...

Milton Friedman was recently asked in Israel to give a Talmudic answer to summarize his learnings from economics.  He said there is only one rule, and all else is commentary: there is no such thing as a free lunch.

In our case the inflationary pressures show up elsewhere.  In real estate. In commodities.  Indeed, in a continuation of the asset bubble of the '90s. The Fed's inflation counters do not watch assets per se, but inflation in goods and services.  Although they like to stop the "irrational exuberance" of asset markets, their tools are not designed for both stable currency and steady asset appreciation.  The Fed may have put the brakes on too hard in 2000, and put on the gas too hard in 2002. 

In particular, they may have seen the good deflation and been spooked as to bad deflation.

Now we have the situation the Austrian School is most afraid of - the government's attempts to avoid re-adjustments from an asset bubble have simply prolonged the bubble and made the potential fall worse.  Helicopter Ben is in his own turbulence.  Does he raise rates to prevent creeping inflation, risking putting the brakes on too hard and watching the deck of credit collapse?  Or does he ease off the pedal and let inflation creep up, hoping it will subside by itself with the continuous countervailing downward pressure of good deflation? 

The recent fall of stocks worldwide coincided with this dilemma reaching general awareness.  The rebound right now is expected, and reflects increasing confidence that we will muddle through.  Yet the imbalances continue to grow, and will need to be dealt with, sooner if not worse later.

Comments

[EN]

Very interesting piece. Perhaps you would enjoy the book: "The Creature from Jeykll Island".

I am not sure I understand the logic behind the "Helicopter Strategy". Bernanke's notion is that he can print his way out of a Kondratieff Winter phase once interest rate cuts no longer provide any re-flationary effect. Correct? BUT ... if he prints, he destroys the bond market. If he destroys the bond market, he destroys all that easy credit that he tried to push in the first place! So the debt gets purged regardless of the printing strategy but gold certainly benefits by monetizing.

The movement is Gold has gone past the point where one can still consider this a fourth wave in a secular bear market. Rather, a new bull market must have started in 2001 and we are now in a wave 5 eventually to new all-time highs. So, overall, we are in an inflationary environment for at least the next decade or two. This means that there will be NO stock market crash in the sense of 1929.

If the move down that started in 2000 is the A wave of a massive fourth wave, then the move up from the 2003 low is a B wave and not even close to being finished. So, after a 4 year cyclical bottom within the next 6-12 months, we will get another run up to finish the B wave and then a final C wave to finish the correction by the time the 40 year cycle is due to bottom in 2014. It is during that final C wave phase that the 2002 lows are tested that we will see the deflation but it is unlikely to be as bad as the bears think because this is not the end of any grandsupercycle phase.

Finally, I am not sure anybody can really benefit from deflation because while prices for electronics and other goods and services may fall, don't governments tend to raise taxes in deflationary environments to support social programs and thus our biggest expense, taxes, rise?

[yelnick]

EN, I have read ther Jekyll Island book. The Fed has failed in its prime missions - the Dollar is worth 4c since then, and they didn't stop massive bank failures in the early Depression. Bernanke's idea is that the Fed has several levers to increase liquidity (interest rates, open market activities, reserve requirements), and all could be used when the bad deflation starts without much impact on inflation or the Dollar since the purpose is to backfill for falling credit - it theoretically works if overall credit remains about the same.

What he is most worried about is the 'liquidity trap' of ther '30s, where banks had the ability to lend but had seen so many bank failures they held back. In that scenario the Fed cannot drop Dollars out of a helicopter, because they tried it in the '30s and the banks didn't lend. Pushing on a wet noodle so to speak. Sadly for the Fed, it was their failure to support the banks that caused this psychology - in other words, the Fed has a fourth lever beyond the three mentioned above which is to support failing banks, and they didn't use it back then. Compounding the problem were uncoordinated policies from FDR, particarly due to a political aversion to big banks and a romantic desire for small S&L's and regional banks (ala "It's a Wonderful Life"); big national banks could have withstood the runs that took many small banks down.

I agree with your overall view - this is a fourth wave from 2000 to probably around 2014, not the Big One down. Might break as a big flat; or might break as a triangle.

But we are not out of the deflationary depression risk. In 1873 we ended the first big RR bubble, and then had a slow slide and a 2d bubble before the deflationary depression of 1893-6. It was short and sharp, and so might this one be. It was also during a period of good deflation, a slow appreciation of the Dollar when the US returned the gold standard accompanied by massive productivity improvements in steel, railroads and similar technology.

[MC]

Why we boom and bust? The only mistake the Fed made was not slowing the equity bubble that ended in 2000. There was no way the Fed could stop the correction that followed. Once the first mistake is made you have to pay for it. We are creating other mistakes because we don't want to suffer the full payback we should have for the tech bubble. Trillions of dollars of wealth disappeared. We now have a housing bubble. It will bust and we will have another correction. I can't think of any thing we can throw at the housing bubble to reduce the damage. Volcker fixed the economy because he was a smart man. His "lets pay now so we can benefit alot later attitude" worked too well. He left the country in such good financial position that was we think we can solve every problem because there was so much he fixed that can be broken.
A solutiton? Let try this. Housing appreciation and stock market appreciation should be considered inflation when the Fed sets its policy. When the total stock market capitalization increases. Thighten monetary policy. Maybe this would have toned down the equity bubble, maybe not. Rates should have been rising from 1995 to 2000. If Elliot Wave truly does work. We will never do something this logical.

[MHD]

It's so interesting to observe humans and their behaviors. Just a couple of days ago as I watched TV, the big news was the drop in the markets and how inflation and Walmart's slow sales were a big concern for the economy. Two days later the markets are right back where they were before the big drop and inflation concerns have gone away. It's magic, I tell you!

[MHD]

MC... in case you haven't studied history, we humans are complete and total idiots, so logic and rational thoughts are really not in the cards, so to speak.
Yelnick, you've been very quiet as of late with EWI's current views. Have they closed shop?

[Eberhardt Reissner]

The economy is essentially a loop. There are many trends that are both causes and effects of inflation. A great way to see this is through system dynamics, a computer-aided modeling of complex systems.

One important trend is a sharpening of the fuzzy line between NEED and WANT. Right now, people need ipods and cars and clothes and toys and electronics in addition to food, warmth and shelter.

When money is dumped upon a public that is afraid to spend it --because of low employment and high fear-- you get stagflation in the EXTREME. The things that rise the most in nominal terms are food and fuel. People move in with the inlaws, share the rent if they can, and eat cheap, filling foods like potatoes.

Despite helicopter drops, we might see nominal deflation in cars, electronics, clothes, toys, and most real estate while things like food and oil rise... and gold rises as people attempt to deal with an apparently incessant rise in those more important things.

[rdneu56]

In spite of all the well reasoned fundamental arguments why the market should crater, the market stubbornly refuses to do so...
It appears that the results of most wave counting efforts have been pointing in the same (wrong) direction for several years in a row now. A most convenient explanation is the nefarious Plunge Protection Team, supporting the markets through sinister interventions always at just the right time to cheat the bears out of well deserved profits.
Alas, there are so many more fairytales that explain everything and forecast nothing...
It is impossible to list them all.

[AA]

I tend to agree with EN's comments, with the only addition that within the B up, we will see an abc sequence, where a is about to complete.

[rob]

great post, yelnick

[gem-x]

Elliott Wave Search Engine!

http://www.WAVEGENIUS.com

[Nostradamus]

Does anyone actually believe the Grand Supercycle exists?

See http://en.wikipedia.org/wiki/Grand_supercycle

[ag]

yawn:) watch the sky!

[rc]

Seems crazy (to me, I'm a housing bubbler), but looks like FNM is beginning a large (multi-week) up-move, and TOL and the HGX are also heading higher. So long-term interest rates are headed down (even though I think the fed will raise once again) and the housing market (despite PHM's results Friday) wants to froth some more???

And what's with these long interest rates? They just _do not_ want to go up. They've practically ignored the gyrations in the fed rates. Now, 10 year rates are just hitting the upper end of a multi-year declining parallel channel... maybe they'll break up or just drop back to the lower end. The odds are the trend continues. And based on FNM, looks like others are figuring the same.

Just observations. Personally, I don't get it, but guess I don't have to.

[rc]

Nostradamus: "Does anyone actually believe the Grand Supercycle exists?"

Does anyone actually believe EW's exist? I'm not an EW'er (and so am objective). I do think there is an underlying signature or form underlying biological progression and growth. I don't think the more arcane rules of EW are worthwhile which is why I don't spend precious time studying them -- I haven't seen the cost effectiveness from following its practitioners.

Nevertheless, what's appealing about EW (and which applies to its practitioners) is its long term, broad perspective on human history. There are clearly larger forces at work, such as population growth, resource depletion and technological advancement, and currents and eddies. And these larger forces are also clearly reaching a parabolic top. So, big, historical, thousands of years' significant, changes are occurring.

[yes]

U.S. Wireless Online

[MOOMINOID]

I think EW is very useful at scales from intraday up to periods of 20 years. I don't think there is any logic to claiming however that there are waves in the stockmarket that are longer than the secular bulls and bears.

[tony caldaro]

GEM-X "Does anyone actually believe the Grand Supercycle exists?"
No, not in this corner. There isn't any historical data to verify it. We only started keeping daily records on market movement in 1885. The rest is conjecture.

RC: "Does anyone actually believe EW's exist? I'm not an EW'er (and so am objective)."

I'm an EWer and objective. Objective EW exists :)

Moominoid: "I don't think there is any logic to claiming however that there are waves in the stockmarket that are longer than the secular bulls and bears."

Totally agree!

[sky is falling]

could this be the start of something big? I vote... no.

Others?

[Nostradamus]

And now watch the dollar bears get carted off........

[rc]

tony c: "start of something big?"

My RUT short-term re-joined my mt, and lt signals on a sell. I sure didn't expect the upswing to end so fiercely (and lost profits on a long position I planned to exit this morning -- exits are always the key). This is the 2nd week in a row with a selloff after the weekend followed by a recovery the rest of the week, so this may play out again. But, my objective call is to go with the signals and patterns... bearish flag broken and continuing the trend; and... you ew'ers will laugh, but couldn't this be the start of a 3rd wave down in the RUT with the recent upswings the previous 7 trading days the completion of an abc (clearly an up-down-up)? So... yes, could well be not the start, but the resumption of something BIG.

Also... 10-year yields barely blipped up... still don't get the long term treasuries... is this anticipating a slowdown? Must be... that the fed will raise & keep inflation in check... and the yields are going to invert again.