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SPEAKING FREELY
Dipping into
deflation
By Doug Wakefield
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click
here
if you are interested in
contributing.
After the 2000-02
stock market decline, I embarked on a journey to
study as much as I could about history and
systemic risk in the financial world. In the
process I learned that most of us, novices and
professionals alike, know very little about the
history of our markets and thus are blindly
following the conventional wisdom of "the
experts". If we knew history and could get past
our own natural biases, I believe we could
dramatically increase our chances for financial
success. With the Dow falling from 10,984 on March
7 to 10,087 on April 15 of this year, this has
become much more than an academic discussion.
While it is easy to lose the overall direction of
the markets in day-to-day moves, its general
direction in the next few years is of crucial
importance to all.
Most of our current
circumstances can be traced to inflation (and
possibly deflation) as reflected in the money
supply. In discussing inflation we do well to
first start with a simple definition. Webster's
defines inflation as: "An increase in the volume
of money or credit relative to available goods
resulting in a substantial and continuing rise in
the general price level." Deflation, on the other
hand, would reveal the opposite: "A contraction in
the volume of money or credit that results in the
decline of the general price level."
So I
ask you, "Can you or I create money legally?" If
you answered "no", then congratulations, you just
passed economics and law 101. The answer, we both
know, is that we, as individuals, are not capable
of doing this. So where is all this money coming
from?
Since I was a child, the amount of
money in the United States has grown
significantly. According to the Federal Reserves
Historical Data on the money supply (as measured
by M3), when I was 18 months old in 1959, the
money supply stood at $US292 billion. Of course it
continued to grow so that by the time I started
college in September 1975, it had reached $1,145
billion. Even though I was totally clueless as to
what was causing inflation, I nevertheless, began
to notice its impact on the world around me.
Prices were going up everywhere. Paul Volcker
would seek to curb what was the worst inflationary
expansion of money and credit ever in US history
by raising rates significantly. So, by the early
80s, the US and the rest of the world were
experiencing the highest interest rates in
history. While interest rates had climbed to 14%
on long-term government bonds by September 1981,
this would be dwarfed by rates in most Latin
American countries. In 1981 Chile's short-term
bank loans returned 47%, and Brazil's 49%.
But things changed in the early 1980s for
the United States. Even though other countries
would still face high interest rates throughout
the 80s, we would start cutting rates and making
credit more and more plentiful. By May 1995, when
my third son was born, the money supply had
climbed to $4,476 billion. But something peculiar
was occurring; even as we inflated credit more and
more, goods prices were deflating. Increasingly,
we were shipping our raw resources overseas. The
Asian Rim, China, and India were able to produce
what we wanted to consume for a fraction of what
it would cost to produce these items in the United
States. Inflation was showing up, only now it was
appearing in our asset prices instead of our
consumption prices. This would go on to produce
the fastest-growing stock market in history and
continue to cause real estate prices to climb.
In the meantime, on the other side of the
world, we failed to notice what was happening to
Japan, the second-largest economy in the world. As
our markets were roaring, in 1989 the Japanese
markets began a long-term secular bear market.
They would watch their stock values decline and
their real estate holdings fall sharply from
growing price deflation. In fact, commercial real
estate values fell 90% from 1989 to 2003. Since
the government cannot make people borrow and spend
money, deflation was something that the Japanese
government could do nothing to stop. Meanwhile, in
America, our money supply, and therefore
inflation, continued to grow.
In January
of 2000, I breathed a small sigh of relief. The
Y2K scare was over, and we were entering a new
millennium and a "New Era". The sky was the limit.
What most of us didn't realize is the fact
that from August 1982, when the Dow Jones
Industrials hit 777, to the January 2000 level of
11,722, the money supply had grown from $2,396
billion to $6,605 billion. Consumer credit had
grown from $383 billion to $1,541 billion. And
while we only have information back to June 1985,
the Federal Reserve (historical data on Real
Estate lending from Financial Companies) revealed
a growth in real estate lending from $25.8 billion
in mid 1985 to $177.1 billion in early 2000. These
numbers confront us with the fact that much of the
boom in the stock market and otherwise was
actually the consequence of a massive inflation of
money and credit.
So where do we stand
today? Are we facing a deflationary or an
inflationary environment? To answer this question,
let's look at the growth of the money supply since
the bubble popped in early 2000, how this increase
appears to have affected us, and what we can learn
from Japan.
As of March 2005, the money
supply stands at $9,532 billion. Stated another
way, the same amount of credit has been produced
from the time I was age 42 to 47 as was produced
from the time I was 18 months old until I was 28.
The last five years have also seen consumer credit
grow from $1,541 billion to $2,122 billion and
finance company real estate lending grow from
$177.1 billion to $282 billion. Clearly, the
cutting of interest rates from 6.5% in January
2001 to a low of 1% in June 2003 made it very
appealing for Americans to borrow money.
On the other side of the world, Japan has
lost money for so many years that its
institutional investors and banks invest in the
bond market as opposed to the stock market. The
value of the Nikkei closed 72% lower on May 17 (at
10,825) than its high (of 38,915) in December of
1989. To this day, its people are focused on
saving and its businesses are focused on debt
reduction rather than expansion and growth.
Cheap money policies have allowed us to
continue to borrow. We have taken this money and
maintained or increased our rate of consumption
and purchased assets. The swell in dollars has
created a swell in demand. While consumption
prices have stayed low because of globalization,
asset prices have inflated greatly. The primary
effect of asset inflation can be seen most clearly
in real estate prices, yet the stock and commodity
markets reveal this as well. As our borrowing
capacity begins to tap out, who will keep
"inflating" these asset prices?
If we are
forced to pay down debt and thus have less money
to buy assets and consume, is the next major
obstacle inflation or deflation? Every investor
will witness the answer to these questions. Our
history, and that of Japan's, teaches that asset
classes and investment strategies work very
differently in a long-term deflationary cycle. The
real question is whether we, as individuals, will
prepare now or be caught off guard at some point
in the future.
Doug Wakefield is
the president of Best Minds Inc, a registered
investment advisor. He can be reached at
doug@bestmindsinc.com
(Republished
with permission from Prudent Bear. Copyright Best
Minds Inc 2005)
Speaking Freely is
an Asia Times Online feature that allows guest
writers to have their say. Please click
here
if you are interested in
contributing. |
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